(c) The Board of Trustees shall have the right to determine whether the refunds of margins in or during any fiscal year shall be made in cash or in certificates of indebtedness or partly in cash and partly in certificates of indebtedness. To the extent that refunds are made in certificates of indebtedness, the amounts retained and represented by such certificates shall be such as, in the opinion of the Board of Trustees, are reasonably necessary for the purpose of establishing or adding to reasonable reserves for capital needs; for the purpose of adding new facilities or equipment or adding to or replacing existing facilities or equipment; for the purpose of adding to or replacing working capital; or for the purpose of repaying money borrowed, including that represented by outstanding certificates of indebtedness. Each member authorizes the Board of Trustees to invest all or any part of the refunds of margins due him in certificates of indebtedness of the association and agrees to receive them in place of cash refunds of margins.

[Emphasis supplied.]

After the present petitioner had been so organized as a cooperative association, each of the members contributed1965 U.S. Tax Ct. LEXIS 78">*100 $ 1,000, of which $ 500 was to be paid immediately and the balance was paid over a period of time. They then hired an engineer, and as worker-members they built the association's plywood plant from the ground up. This plant was located in Tacoma, Wash.; and it included a plywood mill, 44 T.C. 305">*314 and an office which was the association's principal place of business. While building the plant, the worker-members received compensation of 90 cents an hour; and at one time a collection of $ 5 apiece was taken up to buy paint for use in painting the plant.

The principal activity of this cooperative association, at all times material including the years here involved, was the manufacture and sale of plywood and related wood products.

The number of members of the association during the years involved was approximately 270; and of these an average of 260 were regular full-time workers in the association's plant. Typical reasons for a member not working were: (1) Military service; (2) prolonged illness; and (3) departure from Tacoma with expectation of returning.

Each member was the owner of 10 shares -- no more or less -- of the association's stock. The holding of such shares entitled1965 U.S. Tax Ct. LEXIS 78">*101 the member to one -- and only one -- vote at any meeting of the association. Ownership of such 10 shares also entitled the owner to work as a member of the association.

The trustees investigated and passed upon all applicants for membership in the association, including transferees of the association's shares. These trustees required, among other things: (1) That any person applying for membership be less than 45 years of age; (2) that he submit to a physical examination and obtain the physician's report thereon, showing that he was in good health; and (3) that the applicant be competent to hold a job in the association's plant. After the applicant had met these tests, he presented himself to the trustees for questioning; and there he was required to agree that he would acquire his shares of the association in good faith, for membership purposes only; that he would sign the association's membership agreement and observe its bylaws, rules, and regulations; that when called upon to work in the plant, he would accept and be capable of handling satisfactorily the work assigned to him; and that he would comply with the usual conditions of such employment.

No shares were issued or 1965 U.S. Tax Ct. LEXIS 78">*102 transferred until the applicant for membership in the association had received the approval of the trustees. After receiving such approval, the president of the association and the new member signed a membership agreement which provided in material part, as follows:

(1) The Association will afford the member employment and refund to him his proportionate share of all margins arising from the production and marketing of wood products in accordance with its Articles of Incorporation and Amended By-Laws.

(2) The member will cooperate with the other members to the end that by their joint efforts the maximum production and efficiency be attained.

[Emphasis supplied.]

44 T.C. 305">*315 Meetings of the association's worker-members were held at least semiannually in accordance with the bylaws. At these meetings various business and operating problems were discussed and dealt with by majority vote. The average attendance at these meetings during the years here involved was 224, or about 83 percent of the entire membership. The matters there dealt with included such things as election of trustees, capital expenditures, production efficiency, new methods of operation, claims, and purchases of1965 U.S. Tax Ct. LEXIS 78">*103 timber.

During the years involved, almost all the workers in the association's plant were members (being about 260 in number). But there also were employed from five to seven nonmembers, who were chiefly young women in clerical positions, and the plant superintendent.

About two-thirds of the logs used by the association in the manufacture of plywood and other wood products, were acquired through purchase of standing timber from the Forestry Service of the U.S. Department of Agriculture; and the balance was acquired from timber-owners or on the open market. The products manufactured by the association were sold to commercial dealers or users of such products.

Participating payments in respect of the fruits and increases from the worker-members' cooperative efforts were made to the active worker-members on the basis of the number of hours worked by each, as follows:

(1) On about the 20th of each calendar month, a so-called draw check in the uniform amount of $ 100 was issued to each worker-member. These amounts were in the nature of drawing-account payments to provide the worker-members with current living expenses.

Thereafter, 1965 U.S. Tax Ct. LEXIS 78">*104 as of the end of each calendar month, a so-called advance check was issued to each worker in an amount representing the hours worked by him during the month multiplied by a uniform hourly rate, and less the amount previously distributed to him as a draw check. The said hourly rate was fixed by the trustees in an amount which more or less approximated the average union rate in the area where the association's plant was located. With minor exceptions, hereinafter noted, the payments and distributions received by each worker-member were uniform in relation to the number of hours worked by him, regardless of the character of the services which he contributed to the cooperative endeavor (i.e., regardless of whether he swept the floors of the plant or was in charge of an operating department). The exceptions were: (1) That the trustees received no compensation for their services as such, except a token payment of $ 1 per year; (2) that the general manager (a worker-member selected 44 T.C. 305">*316 by the trustees) received a differential of $ 2,500 in 1958 and of approximately $ 6,000 in 1959 and 1960; and (3) that the officers of the association received no compensation for their services1965 U.S. Tax Ct. LEXIS 78">*105 as such, except a token payment of $ 1 per year.

The amounts represented by the foregoing checks were issued pursuant to section 11 of the bylaws, and they were considered to be advances against the "patronage dividends" thereafter allocated.

(2) At the close of each quarter of a particular calendar year, a patronage dividend check was issued to each worker-member who had participated during that period. For each of the first three quarters, 75 percent of the fruits and increases of the association (called margins) for that quarter, were distributed to the worker-members on the basis of the hours worked by each in that quarter. And then at the end of the year, the total margins for the year were computed and allocated to all worker-members on a pro rata basis according to the hours worked for the full year, less the amounts of the previously mentioned draw checks, advance checks, and patronage dividends which had been distributed for the preceding three quarters of such year.

In the event that the trustees determined, on accordance with section 14(c) of the bylaws, that it was essential to retain portions of the margins for necessary association purposes, then certificates of indebtedness1965 U.S. Tax Ct. LEXIS 78">*106 in lieu of cash would be issued to the worker-members for the portions so retained.

The amounts of the aggregate margins for each year that were distributed to the worker-members as patronage dividends, represented the net proceeds realized by the association from the sale of plywood and related wood products, after elimination therefrom of that portion of these proceeds which was attributable to the participation of employed nonmember workers -- and less the amounts previously advanced to the worker-members through the above-mentioned draw checks and advance checks.

The petitioner association instructed the worker-members to file, for each year, individual declarations of estimated tax based on the anticipated patronage dividends to be allocated to them for such year, and to pay Federal income taxes on all such patronage dividends which they received, either in cash or in certificates of indebtedness. In accordance with the requirements of section 6044 of the 1954 Code, the amounts of all margins allocated to worker-members as patronage dividends were reported by the association to the Internal Revenue Service on Form 1099.

The nonmember workers who were employed at the plant during1965 U.S. Tax Ct. LEXIS 78">*107 any taxable year did not receive any patronage dividends from the margins so allocated; and also any member who did not work during 44 T.C. 305">*317 any particular year likewise did not receive any patronage dividend with respect to margins attributable to such year.

The petitioner association filed a Federal income tax return (Form 1120) for each of the taxable years involved; and it paid tax on the amount of taxable income reported therein. The taxable income so reported was from sources that were not related to any cooperative efforts of the worker-members; and these sources included the following: That portion of the income from mill operations which was attributable to the services of nonmember workers employed at the plant; miscellaneous interest income; small capital gains in 1958 and 1959 only; and other miscellaneous items such as income from the sale of scrap materials, taxable income in respect of fire insurance recoveries, and income from cold-drink machines in the plant. On said Federal income tax returns, the petitioner association excluded from income the amounts of the margins allocated and distributed to its worker-members as patronage dividends.

The Commissioner, in his1965 U.S. Tax Ct. LEXIS 78">*108 notice of deficiency herein, disallowed the exclusion of all patronage dividends in respect of margins.

FINDINGS OF ULTIMATE FACT

The petitioner association operated in each of the taxable years involved on a cooperative basis for the mutual welfare of its worker-members.

The right to all fruits and increases from the cooperative efforts of the worker-members (represented by its so-called margins) was vested in and retained by the worker-members themselves, and not in and by the association as a separate entity -- which association functioned only as an instrumentality through which the worker-members carried on their cooperative endeavors.

Said margins were allocated among the worker-members as patronage dividends, pursuant to a preexisting legal obligation created by the statutes of the State of Washington, the association's bylaws, and the agreements entered into between the association and the workers at the times when these workers became members. Such margins distributed as patronage dividends, arose out of transactions between the cooperative association and its worker-members. And the same were equitably allocated among the worker-members in proportion to the amount of service1965 U.S. Tax Ct. LEXIS 78">*109 which each such worker contributed to the total cooperative effort that produced said margins.

OPINION

The problem here presented is a novel one, insofar as this Court is concerned. The petitioner, as we have hereinbefore shown, is a workers cooperative association located in the State of Washington, which was formed, incorporated, and operated by the worker-members on a 44 T.C. 305">*318 cooperative basis, for their mutual benefit in producing and marketing plywood and related wood products; and this petitioner, acting in accordance with the cooperative plan and pursuant to a preexisting legal obligation, allocated patronage dividends to its worker-members in proportion to the hours worked by them in their joint endeavor.

The specific question to be here answered is: Whether this petitioner, as so formed and so operated, should be regarded for Federal income tax purposes, as a "nonexempt cooperative association" within the meaning of that term as used in the Federal income tax statutes, in numerous rulings of the Internal Revenue Service, and in various judicial decisions (all hereinafter identified); and thus be entitled to exclude from the income which is taxable to itself (and leave 1965 U.S. Tax Ct. LEXIS 78">*110 for taxation to the individual worker-members) the patronage dividends which were so allocated during the taxable years involved.

After considering and weighing all the evidence in the light of the relevant authorities, we are convinced that this question should be answered in the affimative, for the following reasons.

1. Since the year 1926, the Federal income tax statutes have accorded exemption from income taxes to certain cooperative associations composed of farmers, fruitgrowers, and the like -- which engage in the marketing of farm products or the buying of farm equipment for both members and nonmembers, and which then turn back to such participants the net proceeds of the cooperative activities. The provision for such tax exemption is presently embodied in section 521 of the 1954 Code. The parties to the present case agree that the instant petitioner does not qualify for exemption under said section.

Notwithstanding this exemption which is accorded a limited type of cooperatives which are able to qualify therefor, the Internal Revenue Service has recognized for many years, in numerous rulings published since at least as early as 1922, that there are many other cooperative 1965 U.S. Tax Ct. LEXIS 78">*111 associations which, even though they do not qualify for exemption under the above statute, are nevertheless entitled (in their capacity as nonexempt cooperative associations) to exclude from their gross incomes, patronage dividends that are equitably allocated to their participating members pursuant to preexisting legal obligations. Several examples of these administrative rulings, which recognized the right of nonexempt cooperatives to exclude patronage dividends, are: I.T. 1499, I-2 C.B. 189, 191 (1922); A.R.R. 6967, III-1 C.B. 287 (1924); S.M. 2595, III-2 C.B. 238 (1924); G.C.M. 12393, XIX-2 C.B. 398 (1933); G.C.M. 17895, 1937-1 C.B. 56; I.T. 3208, 1938-2 C.B. 127; Rev. Rul. 57-59, 1957-1 C.B. 24.

This same principle that nonexempt cooperatives are entitled to exclude true patronage dividends from their gross incomes has also been recognized by the courts in several reported decisions. See, for 44 T.C. 305">*319 example, Pomeroy Cooperative Co., 31 T.C. 674">31 T.C. 674, affirmed on this point 288 F.2d 3261965 U.S. Tax Ct. LEXIS 78">*112 (C.A. 8); Smith & Wiggins Gin, Inc. v. Commissioner, 341 F.2d 341 (C.A. 5), affirming 37 T.C. 861">37 T.C. 861; United States v. Mississippi Chemical Co., 326 F.2d 569 (C.A. 5); Clover Farm Stores Corporation, 17 T.C. 1265">17 T.C. 1265, 17 T.C. 1265">1277; Dr. P. Phillips Cooperative, 17 T.C. 1002">17 T.C. 1002, 17 T.C. 1002">1010; United Cooperatives, Inc., 4 T.C. 93">4 T.C. 93, 4 T.C. 93">106; Midland Cooperative Wholesale, 44 B.T.A. 824">44 B.T.A. 824, 44 B.T.A. 824">830; Fruit Growers Supply Co., 21 B.T.A. 315">21 B.T.A. 315, 21 B.T.A. 315">326, affd. 56 F.2d 90 (C.A. 9); and Farmers Cooperative Co. v. Birmingham, 86 F. Supp. 201">86 F. Supp. 201 (N.D. Iowa). In the case of 17 T.C. 1002">Dr. P. Phillips Cooperative, supra, this Court said:

Although the Commissioner has held that the petitioner is not exempt under section 101 (12) [the predecessor of section 521 of the 1954 Code], nevertheless he has allowed the petitioner as a cooperative to exclude from income for tax purposes the amounts which it has distributed1965 U.S. Tax Ct. LEXIS 78">*113 in cash as patronage dividends. There is no express statutory authority for this section but for many years the practice has been followed by the Treasury Department and it has received judicial sanction. The theory is that the cooperative is merely a conduit for the patronage dividends * * *.

Also in Harbor Plywood Corporation, 14 T.C. 158">14 T.C. 158, 14 T.C. 158">161, this Court stated:

The reason for this rule is that the patronage dividends or rebates are at all times the property of the member stockholders, and nonmembers, and that the selling association is an agent or trustee or mere conduit for the income.

The mere fact that the cooperative may have been organized as a corporation under local law, is not significant as regards its right to exclude patronage dividends. Indeed, most cooperatives are incorporated and regulated under the laws of some State; and all the above-cited judicial decisions in which the right to exclude patronage dividends was recognized, involved incorporated cooperatives; and at least one of them (United Cooperatives, Inc.) was incorporated under the general corporation statute of Indiana.

Also, the particular name by which a cooperative's1965 U.S. Tax Ct. LEXIS 78">*114 distributions are designated (such as "patronage dividends," "refunds," or "rebates") is not in our opinion determinative of the cooperative's right to exclude the same. Dr. Nourse (the expert witness above mentioned) pointed out during the course of his testimony that the term "patronage" originated with the above-described Rochdale Cooperative that was founded in England in 1844 and operated a retail store -- and in that cooperative endeavor, the participants were of course patrons. He further pointed out that the designation "dividends" has its origin in the fact that most distributions out of corporations are called dividends (even though they may not constitute distributions from the corporation's profits -- as for example, so-called dividends on mutual life insurance policies). Dr. Nourse suggested that the more accurate 44 T.C. 305">*320 designation for amounts allocated by cooperative associations is "participating distributions."

2. In 1951 the Federal tax statutes, for the first time, gave express recognition to the principle that both exempt cooperative associations and also nonexempt cooperative associations are entitled to exclude true patronage dividends from their gross1965 U.S. Tax Ct. LEXIS 78">*115 incomes. In that year, Congress, in section 314 of the Revenue Act of 1951, amended section 101(12) of the 1939 Code by inserting a provision relating to the exclusion of patronage dividends by exempt cooperatives; and in this provision, it was stated that such patronage dividends "shall be taken into account in computing net income in the same manner as in the case of a cooperative organization not exempt." (Emphasis supplied.) And thereafter, this same language was carried forward into section 522 of the 1954 Code, as it existed throughout all the taxable years here involved.

In 1962, President Kennedy brought to the attention of Congress that the above-mentioned provisions of the 1951 Act had proved inadequate in several respects; and he recommended that supplemental provisions be enacted, so that the purpose of Congress, which had been intended to be reflected in the 1951 Act, might be achieved. ⁴ This resulted in the enactment of subchapter T (secs. 1381-1388) of the 1954 Code; and in these new supplemental provisions, Congress again gave express recognition (in sec. 1381 (a)) to the fact that the new and more comprehensive provisions would be applicable, not only1965 U.S. Tax Ct. LEXIS 78">*116 to exempt cooperatives but also to "any corporation operating on a cooperative basis other than * * * [one] which is exempt."

3. Neither the above-cited Federal statutes nor any published judicial decision relating thereto have restricted to any particular type of cooperatives the basic principle that corporations operating on the cooperative basis are entitled to exclude from their gross incomes true patronage dividends or participating distributions allocated by them.

As heretofore shown, section 1.522-1(b) (1) of the Income Tax Regulations defines a "cooperative association" to be "any corporation operating on a cooperative basis." (Emphasis supplied.) This obviously is sufficiently broad to cover both marketing cooperatives and also producing cooperatives.

Furthermore in 1962, when the Congress had under consideration the1965 U.S. Tax Ct. LEXIS 78">*117 matter of making more effective the cooperative provisions of the 1951 Act through enactment of the supplementary provisions which later became subchapter T of the 1954 Code, a question arose as to whether the phrase "business done with or for patrons," which was contained in these new provisions, was sufficiently broad to cover 44 T.C. 305">*321 services done with or for patrons -- so as to cover participating distributions of a cooperative association engaged in the manufacture of plywood. In this connection, the following colloquy was had in the Senate between Senator Kerr (floor manager of the bill), Senator Magnuson of Washington, and Senator McCarthy of Minnesota:

Mr. MAGNUSON. Mr. President, I wish to ask the distinguished Senator from Oklahoma [Senator Kerr] a question.

On pages 295 and 296 of the bill, in the definition of the term "patronage dividend," it is stated that a patronage dividend is a payment "determined by reference to the net earnings of the organization from business done with or for its patrons."

In a case which has been called to my attention -- it involves the manufacture of plywood in the Pacific Northwest, and many of the companies are cooperative 1965 U.S. Tax Ct. LEXIS 78">*118 organizations -- the cooperative renders services for the patron. I wanted to be sure that in the opinion of the Senator from Oklahoma the phrase "business done with or for its patrons" includes services with or for patrons.

Mr. KERR. I think it is clear, both under the interpretation of a patronage dividend under present law and also under the words "business done with or for its patrons," that services rendered with or for patrons are included. Business done is not necessarily limited to products sold to or purchased for patrons. Business done also includes services performed for patrons, as well.

Mr. MAGNUSON. I thank the Senator from Oklahoma.

Mr. McCARTHY. Mr. President, if the Senator will yield, let me say I think this is a reasonable and desirable interpretation of the language; and I believe that any other interpretation would create an impossible distinction.

[108 Cong. Rec. 18322. Emphasis supplied.]

4. The most recent development in this field is the decision of the U.S. District Court for the District of Oregon, in the case of Linnton Plywood Association v. United States, 236 F. Supp. 227">236 F. Supp. 227 (decided 1965 U.S. Tax Ct. LEXIS 78">*119 Oct. 30, 1964), on appeal (C.A. 9). That court is located in the heart of the plywood industry; and said decision was written by Chief Judge Solomon of that court. Both the issue there involved and the facts found by the court were substantially the same as those in the instant case. The opinion of the court, which was in favor of the taxpayer, states in material part as follows:

The Government admits that retained patronage dividends are excludable from gross income of non-exempt cooperatives provided they are either purchasing or marketing cooperatives. It insists that the exclusion is not applicable to workers' cooperatives.

Workers' cooperatives are among the oldest forms of cooperatives and exist in many countries of the world. Many people regard a worker's cooperative as the basic type of cooperative. The Government concedes that if the members had individually created the plywood products and then brought them to the cooperative for marketing, the cooperative would be entitled to the exclusion, but claims that since the members collectively manufacture the products as well as market them, the cooperative is not entitled to the exclusion. I think that this is an illogical1965 U.S. Tax Ct. LEXIS 78">*120 and absurd distinction. In my view, [nonexempt] workers' cooperatives are entitled to exclude retained patronage dividends from gross income to the same extent as purchasing or marketing cooperatives.

44 T.C. 305">*322 To avail itself of the exclusion, a cooperative must satisfy three requirements, (1) The allocation must be made pursuant to a legal obligation existing when the patron transacted business with the cooperative. (2) The allocation must be made out of profits or income realized from transactions with its patrons. (3) The allocations must have been equitably made. United States v. Mississippi Chemical Co., 326 F.2d 569, 573-574 (5th Cir. 1964); Pomeroy Cooperative Grain Co. v. Commissioner, 288 F.2d 326, 328 (8th Cir. 1961). Plaintiff has met all these requirements.

We agree with the views expressed by Chief Judge Solomon in the above case. We have found no published court decision to the contrary.

5. The Internal Revenue Service in 1961, which was subsequent to the taxable years here involved, issued a ruling (Rev. Rul. 61-47, 1961-1 C.B. 193) to the effect that amounts distributed1965 U.S. Tax Ct. LEXIS 78">*121 by a nonexempt cooperative association to its worker-members, are not patronage dividends excludable from such cooperative's gross income. Such ruling is in direct conflict with the above-mentioned decision of the Oregon District Court in the Linnton Plywood case; is unsupported by citation of any statutory provision or judicial authority; and is out of harmony with the basic distinguishing principles of cooperative organizations generally. In our opinion, the ruling is erroneous.

In the instant case, we have found as an ultimate fact that the petitioner association was organized and operated on a cooperative basis by worker-members, who joined together for their mutual benefit in not only marketing their products cooperatively, but also in producing them cooperatively. If, as suggested in the Linnton Plywood case, these worker-members had manufactured wooden products (such as chairs or tables) in their own individual workshops and then had marketed the same through their cooperative association, there could be no dispute that the participating distributions in respect of the marketing function would, when allocated to the members pursuant to a preexisting legal obligation, 1965 U.S. Tax Ct. LEXIS 78">*122 be excludable from the gross income of the cooperative. Here however, because of the nature of the plywood product, the character of the necessary machinery, and the intricacy of the skills required, the members joined in working under a common roof, rather than in separate workshops, to both produce and market their products cooperatively. We perceive of no warrant in law, fact, or logic why these two methods of cooperative endeavor should not be accorded equal treatment for Federal income tax purposes.

We have hereinbefore found as an ultimate fact, and we here hold, that the right to the fruits and increases of the cooperative efforts of petitioner's worker-members (i.e., margins) was vested in and retained by such workers, and not in and by the cooperative association as a separate entity. And we further hold that the amounts of such 44 T.C. 305">*323 margins, which for the taxable years here involved were equitably allocated to the worker-members as patronage dividends pursuant to a preexisting legal obligation, are excludable from the petitioner-association's gross income for Federal income tax purposes.

Decision will be entered for the petitioner.