52 T.C. 457">*457 Respondent determined deficiencies in petitioner's income tax as follows:

The issues presented for decision 1969 U.S. Tax Ct. LEXIS 111">*112 are:

(1) Whether petitioner operated as a farmer's cooperative which was exempt from Federal income taxes during its fiscal years 1958 and 1959;

(2) Should certain amounts transferred by petitioner in 1958 and 1959 from its undistributed income account to its stated capital be treated as patronage dividends and interest payments; and

(3) Was petitioner entitled to deductions in 1958 and 1959 for additions to its reserve for bad debts.

FINDINGS OF FACT

Some of the facts were stipulated, and the stipulation of facts and exhibits attached thereto are found accordingly.

Petitioner is a cooperative organized under the laws of California. 52 T.C. 457">*458 Its principal place of business is in Petaluma, Calif. Petitioner filed its Federal corporate income tax returns on an accrual basis for the fiscal years ended June 30, 1958 and 1959, with the district director of internal revenue, San Francisco, Calif.

Petitioner originally requested and received from respondent in 1922 a ruling of tax exemption as a farmers' marketing cooperative. Respondent renewed the ruling in 1945 and 1952. In 1965 respondent examined the taxpayer's exempt status for the fiscal years in issue. Prior to the examination by respondent, 1969 U.S. Tax Ct. LEXIS 111">*113 petitioner had been filing with the district director a Form 990-C, "Exempt Cooperative Association Income Tax Return." Subsequent to respondent's examination, petitioner filed a Form 1120, "U.S. Corporation Income Tax Return."

Petitioner's bylaws provide, inter alia:

ARTICLE I

Stockholders

Section I -- Qualifications of Stockholders.

No person, firm, or corporation shall become or remain a stockholder of this corporation unless such person shall be actually engaged in conducting a dairy and the production of butter-fat. And each stockholder must hold not more nor less than one share of stock in said corporation for each cow used by such person in the conduct of his dairy business.

In computing the number of cows used by such person or stockholder, for the purpose of allotment of stock, the maximum number for the month of April shall be taken as the basis, except as to allotment of stock to new stockholders, in which case the number of cows actually used at the time of becoming a stockholder shall be taken as the basis, subject to adjustment on the 30th day of April, following.

Each stockholder shall render to the company on the 30th day of April of each year a statement showing the maximum 1969 U.S. Tax Ct. LEXIS 111">*114 number of cows used or employed by him during the month of April of that year and shall re-adjust his holdings of stock in the company either by purchase of more stock or the surrender of stock already held by him for resale by the company, so as to maintain the basis herein provided. In the event that any stockholder shall cease to conduct his dairy, shall dispose of his cows, or for any reason shall cease to be a producer of butter-fat, or such stockholder shall die and his representative or successor in interest shall fail to continue the conduct of the dairy of such deceased stockholder, then and in that event the shares of stock so owned and held by such stock holder, shall be indorsed by the holder thereof, or his personal representative, and redelivered to the company for resale. Any stockholder or his personal representative whose certificate of stock shall have been endorsed and redelivered to the company for resale, as herein provided, shall have the right to have said stock sold by the Board of Directors and the sale of such returned stock shall take precedence over the issuance and sale of treasury stock. The sale price received on last sale of treasury stock of the company 1969 U.S. Tax Ct. LEXIS 111">*115 shall be conclusively deemed and considered as the reasonable value of the stock so returned to the company for resale, and the purchase price received on such resale of stock shall be paid to the Transferor of such certificate within thirty days after receipt thereof by the company, provided, however, that the Board of Directors may advance to the Transferor of such returned certificate the reasonable value thereof. All certificates of stock 52 T.C. 457">*459 which may be indorsed and redelivered to the company, as herein provided, shall not be cancelled but shall be held by the company as the selling agent of the Transferor. During such time as the company shall hold such returned certificate and until a resale thereof, the Transferor thereof shall be deemed and considered as the owner of said certificate and entitled to all dividends or benefits therefrom. In the event, however, that the company shall advance to such Transferor the value of his certificate of stock, then and in that event the company shall be deemed to be the owner of such stock, except as to the right of creditors and as to them the statutory stockholder liability of the Transferor shall continue until a resale of such stock 1969 U.S. Tax Ct. LEXIS 111">*116 by the company.

In the event that any shareholder of the Petaluma Co-operative Creamery shall fail to deliver to the Petaluma Co-operative Creamery at least twenty-five (25) percent of his dairy production in the twelve (12) months preceding the action herein described then such shareholder may offer his stock for resale, or at the discretion of the Board representing the Corporation, the Corporation Board of Directors may demand that such stock be returned to the Corporation for resale. The sale price received on the last sale of treasury stock of the Petaluma Co-operative Creamery shall be conclusively deemed and considered, for the purpose of this section, as a reasonable market value of said corporate stock offered to the Petaluma Co-operative Creamery for resale. The Petaluma Co-operative Creamery shall pay for the shares of corporate stock resold by it in cash when such shares are resold.

No certificate of stock of this company shall be transferable unless such Transferee is qualified as a stockholder pursuant to the provision hereof and shall file the statement with the company of the number of cows used or employed by him in his dairy business.

* * * *

ARTICLE II

Board of Directors

Section 1969 U.S. Tax Ct. LEXIS 111">*117 VI -- Powers of Directors (as amended August 11, 1952)

The Directors shall have power

* * * *

SIXTH: To declare dividends from the net profits of the business, and in the discretion of the Directors to disburse the net profits of the business to the stockholders in the form of bonus in proportion to the amount of butter-fat delivered by the stockholder to the Company, or to pay over all such net profits to the stockholders in the form of bonus in proportion to the amount of butter-fat delivered in lieu of and instead of dividends, if the Directors shall so determine.

* * * *

ARTICLE IV

* * * *

Section II -- Penalties

It is the purpose of this Company to concentrate the cream produced by its stockholders for the purposes of economy in manufacture, marketing, transportation and sale of the products of this Company, and for the mutual benefit of the individual stockholders of this Company. In order to carry out the purposes of this Company and economy in the manufacture, marketing, transportation and sale of its products, the utmost cooperation among the individual stockholders and this corporation is indispensable, and it shall, therefore, be a violation of the By-Laws for any stockholder to 1969 U.S. Tax Ct. LEXIS 111">*118 sell or otherwise dispose of any of the cream produced by such stockholder from his dairy to any person, firm or corporation 52 T.C. 457">*460 other than this Company. For each and every violation of this regulation such offending stockholder shall be subject to a fine of Ten Dollars, to be collected from such stockholder either by legal proceedings or by deduction of such sum or sums from the dividends or bonus which are due or may become due to such stockholder, or any other moneys due to such stockholder from this Company.

The provisions relating to the 25-percent requirement of Section I of Article I were not included in the bylaws of 1933. Such provisions were adopted prior to the outset of fiscal year 1958.

In accordance with the bylaws, petitioner adjusted its stockownership each April. The adjustment was on the maximum number of cows which each shareholder had milked during that month. Petitioner advised shareholders whether or not they were required to purchase additional shares or to return excess shares for resale.

Petitioner maintained annual accounting records of the amounts of butterfat received from its patrons. The records indicate that in fiscal year 1958 about 45 percent of the shareholders 1969 U.S. Tax Ct. LEXIS 111">*119 delivered some butterfat to petitioner. These shareholders owned approximately 72 percent of petitioner's outstanding stock. The records further indicate that in 1959 about 43 percent of the shareholders delivered some butterfat to petitioner. These shareholders owned approximately 70 percent of petitioner's outstanding stock.

There were two principal reasons why most shareholders were not delivering butterfat to petitioner. One reason was that they had discontinued production altogether. Another reason was that many shareholders preferred to sign contracts with companies such as Safeway, Borden, and Foremost. These shareholders would maintain their membership in the cooperative only to protect themselves in the event that they lost their contracts or produced more milk than they could sell under such contracts.

Prior to 1960, petitioner never considered enactment of a bylaw to provide for the automatic suspension of the rights of a shareholder when he became ineligible to continue as a shareholder. Petitioner also never considered establishment of a reserve for repurchase of stock from its shareholders. Furthermore, the provisions relating to the $ 10 penalty and the 25-percent 1969 U.S. Tax Ct. LEXIS 111">*120 delivery requirement were never enforced.

Petitioner had only one class of stock authorized and outstanding. The original par value of the stock in 1913 was $ 5 per share. In various years after 1917 petitioner transferred amounts from its undistributed income account to stated capital. For example, on June 25, 1958, petitioner's board of directors adopted the motion --

a sum equal of $ 1.00 per share for each share of capital stock of this Corporation issued and outstanding as of June 30, 1958 hereof be, and is hereby transferred 52 T.C. 457">*461 from Undistributed Income of this Corporation, for the fiscal year ending June 30, 1958, to the stated capital account of this Corporation; thereby increasing the stated capital to the total sum of $ 14.00 per share, as of July 1, 1958; after said stock dividend has been deducted from the Undistributed Income that the total remaining Undistributed Income, as of June 30, 1958, as shown by the auditor's report, be distributed to our stockholder members on a per pound butterfat basis on butterfat shipped to the Creamery, for the period July 1, 1957 to June 30, 1958. * * *

The next year on June 25, 1959, petitioner's board of directors adopted the motion --

a 1969 U.S. Tax Ct. LEXIS 111">*121 sum equal to $ 1.12 per share for each share of capital stock of this Corporation issued and outstanding as of June 30, 1959 hereof be and is hereby transferred from undistributed income of this Corporation for the fiscal year ending June 30, 1959 to the stated capital account of this Corporation, thereby increasing the stated capital to the total sum of $ 15.12 per share, as of July 1, 1959; after said stock dividend has been deducted from the undistributed income that the total remaining undistributed income as of June 30, 1959, as shown by the auditor's report, be distributed to our stockholder members on a per pound butterfat basis on butterfat shipped to the creamery for the period July 1, 1958 to June 30, 1959. * * *

All shareholders of record on June 30 received credits on a per share basis for the amounts of $ 1 and $ 1.12 transferred to the stated capital account in 1958 and 1959, respectively. It was inconsequential whether the shareholders were active or inactive patrons. It was also inconsequential how much butterfat a shareholder, if he were active, had delivered to petitioner during the preceding year. The amounts credited to each shareholder were not affected by how 1969 U.S. Tax Ct. LEXIS 111">*122 long he had held his present shares.

As authorized by the foregoing motions of petitioner's board of directors, in August of 1958 and 1959 petitioner also distributed as patronage dividends to its patrons all or part of its earnings for the preceding fiscal year. The amount of patronage dividend to each shareholder was based on the amount of butterfat which he delivered to petitioner during that fiscal year. These patronage dividends were in addition to amounts transferred from the undistributed income account to the stated capital account. If a patron disposed of any stock during the fiscal year prior to June 30, he would not lose his right to a distribution based on his patronage during that year. He would lose his right to participate in the amounts credited to the stated capital account.

In the fiscal years 1958 and 1959 the legal rate of interest in the State of California was 7 percent per annum.

For approximately 30 years, Manuel I. Piers has operated a class A milk distributorship (including related dairy products). He operated under the name of Piers Dairy (hereinafter referred to only as Piers) in and about Palo Alto, Calif. Class A milk is for human consumption 52 T.C. 457">*462 and obtains 1969 U.S. Tax Ct. LEXIS 111">*123 a higher price than class B milk, which is for manufacturing purposes.

Petitioner began to supply class A milk to Piers in 1950. From 1963 to the time of trial petitioner has been the sole supplier of such milk to Piers. Under an agreement dated October 1, 1950, Piers agreed to pay petitioner by the 15th day of the month following the month during which the milk was delivered. From time to time thereafter, the parties amended their agreement. The amendments principally concerned the minimum daily amount of milk which Piers must purchase and designation on which day of the following month Piers would make payment. On February 1, 1964, the parties entered into another agreement which replaced the original agreement as amended. The more recent agreement contained substantially the same provisions. The parties at the time of trial were still operating under it.

Since 1954 petitioner has held accounts receivable resulting from its milk sales to Piers. The following table shows petitioner's annual sales to Piers and the accounts and notes receivable resulting therefrom for fiscal years 1954 through 1965:

The notes receivable resulted from conversion of accounts receivable. The security for the notes originally consisted of a second chattel mortgage on automotive vehicles and other personal property, and a second deed of trust on real estate belonging to Piers. Subsequent to fiscal year 1960, the securities became a first chattel mortgage and deed of trust. The higher priority occurred when Piers satisfied an outstanding first chattel mortgage and deed of trust.

During 1956 through 1965 Piers made the following payments to petitioner:

52 T.C. 457">*463 For the fiscal years ending June 30, 1954 through 1965, petitioner's records disclose:

Petitioner has never charged off any amount of the Piers receivables as an actual bad debt.

Petitioner sent an accountant at least once every 2 years to examine the financial records of Piers. The records revealed that Piers had working capital deficits of $ 77,811 on December 31, 1958, and $ 110,434 on December 31, 1959. The net earnings of Piers were $ 21,712 for the calendar year 1958 and $ 16,483 for the calendar year 1959.

At no time during fiscal years 1958 and 1959 did petitioner ever consider discontinuing sales of milk to Piers or intend to enforce collection of the outstanding receivables due from Piers. The sales to Piers even increased after 1959. As a consequence, the indebtedness of Piers to petitioner has increased since 1959.

In its Federal corporate 1969 U.S. Tax Ct. LEXIS 111">*126 income tax return for the taxable year 1958, petitioner deducted $ 19,757.51 as an addition to its reserve for bad debts. Petitioner also included the amount of $ 21,169 in its cost of goods sold as a patronage dividend. In its Federal corporate income tax return for the taxable year 1959, petitioner deducted $ 55,778.39 as an addition to its reserve for bad debts. Petitioner also included the amount of $ 23,634 in its cost of goods sold as a patronage dividend.

In his statutory notice of deficiency for the taxable years 1958 and 1959, respondent disallowed the additions to the reserve for bad debts. The statement attached to the deficiency notice described the additions as unreasonable. The respondent also determined that the foregoing amounts included in cost of goods sold should be disallowed as deductions because such amounts were not patronage dividends.

52 T.C. 457">*464 OPINION

The issues are (1) whether petitioner operated during its fiscal years 1958 and 1959 as a farmers' cooperative which was exempt from Federal income taxes; (2) should certain amounts transferred by petitioner in 1958 and 1959 from its undistributed income account to its stated capital be treated as patronage dividends and 1969 U.S. Tax Ct. LEXIS 111">*127 interest payments; and (3) was petitioner entitled to deductions in 1958 and 1959 for additions to its reserve for bad debts. We must reach issues (2) and (3) only in the event that petitioner was not an exempt cooperative association.

Relying on section 521(b)(2), ¹ respondent has denied petitioner an exemption on two grounds.

1969 U.S. Tax Ct. LEXIS 111">*128 One ground was that substantially all of petitioner's stock was not owned by producers who marketed their products through the cooperative. A second ground was that petitioner declared dividends in 1958 and 1959 in excess of 8 percent per annum on the value of the consideration for which the stock was issued.

During fiscal year 1958 only about 45 percent of the shareholders delivered any butterfat to petitioner. These shareholders owned approximately 72 percent of petitioner's outstanding stock. During fiscal year 1959 only about 43 percent of the shareholders delivered any butterfat to petitioner. These shareholders owned approximately 70 percent of petitioner's outstanding stock. The remaining shareholders either had discontinued dairy production or preferred to sell their butterfat to companies such as Safeway, Borden, and Foremost.

Recently the Court of Appeals for the Eighth Circuit has stated that this Court is on sound ground in concluding that section 521(b) requires current patronage by shareholder-producers of the cooperative. Co-Operative Grain & Supply Co. v. Commissioner, 407 F.2d 1158 (C.A. 8, 1969), remanding for further proceedings a Memorandum Opinion of this Court. 1969 U.S. Tax Ct. LEXIS 111">*129 The Court of Appeals for the Eighth Circuit remanded the case to afford the taxpayer an opportunity to produce additional evidence on the question of current patronage. In the case at 52 T.C. 457">*465 bar, we have considered as shareholder-producers only those patrons who delivered some butterfat to petitioner during 1958 and 1959. ²

Section 521 does not define the term "substantially all." For purposes of the instant case, we do not deem it necessary to decide exactly what percentage will be sufficient for purposes of section 521. In any event, we do not think that 70 or 72 percent is enough under the facts in this case to constitute "substantially all."

Since 1969 U.S. Tax Ct. LEXIS 111">*130 we agree with respondent on his first ground that petitioner was not exempt from Federal income taxes for the years in issue, we need not decide whether respondent was also correct on his second ground.

Since petitioner was not exempt from Federal income taxes for its fiscal years 1958 and 1959, we must decide the character for tax purposes of certain amounts capitalized by petitioner in those years.

On June 25, 1958, petitioner's board of directors resolved that the sum of $ 1 per share for each share of stock outstanding as of June 30, 1958, be transferred from undistributed income for fiscal year 1958 to the stated capital account. The directors further resolved that the total remaining undistributed income be distributed to patron-shareholders on a per-pound butterfat basis on butterfat shipped to petitioner during fiscal year 1958. An identical motion was carried with respect to fiscal year 1959 except that the amount transferred to stated capital was $ 1.12 per share.

Petitioner's position is that the capitalizations of $ 1 and $ 1.12 per share were patronage dividends to the extent paid to shareholder-patrons and interest payments to the extent paid to nonpatron shareholders.

If 1969 U.S. Tax Ct. LEXIS 111">*131 the amounts capitalized were patronage dividends, they would properly be an item in the cost of goods sold of petitioner. As such, they would be a deduction from gross sales. Although this principle is not based on any provision of the Code, the courts and administrative rulings have long recognized it. ³ The theory is that such dividends are in reality rebates or refunds upon business transacted by the corporation with its shareholders. Since the corporation is under an obligation to make the refunds, the corporation need not initially include the amounts in gross income. Clover Farm Stores Corporation, 17 T.C. 1265">17 T.C. 1265 (1952), acq. 1952-1 C.B. 1.

An allocation of earnings by a cooperative to its patrons will not 52 T.C. 457">*466 qualify as a true patronage dividend unless three requirements are met. The first one is that the allocation must be made pursuant to a legal obligation which existed at the time the participating patrons transacted their business with the cooperative. The second requirement is that the allocation must be made out 1969 U.S. Tax Ct. LEXIS 111">*132 of profits or income realized from transactions with the particular patrons for whose benefit the allocation was made. The third requirement is that the allocation of earnings must be made ratably to the particular patrons whose patronage created the income from which the allocated refund was made. Farmers Cooperative Co., 33 T.C. 266">33 T.C. 266 (1959), reversed on other grounds 288 F.2d 315 (C.A. 8, 1961).

We have limited the scope of our inquiry to the first and third requirements. The amounts of $ 1 and $ 1.12 per share transferred to stated capital met neither of these requirements.

As regards the first requirement, petitioner has produced no evidence that the amounts in issue were credited to shareholders pursuant to a legal obligation arising from the delivery of butterfat to petitioner. At the trial the general manager of petitioner testified:

Q. Did this stock dividend require a declaration of the board of directors?

Q. Was there any agreement or understanding between the Petaluma Co-Op and its shareholders that a stock dividend would be made in any particular year?

A. Never. This was not determined until the last meeting -- the last board meeting in June.

Q. So that there 1969 U.S. Tax Ct. LEXIS 111">*133 was no enforceable obligation on the part of Petaluma Co-Operative to make a stock dividend?

Regarding the third requirement, the amounts in issue were credited only to shareholders of record at the end of each fiscal year. Shareholders who had already sold their shares were not entitled to a rebate on the basis of earnings during the fiscal year. Moreover, as to those shareholders who did receive credits for the amounts in issue, the allocation was not in proportion to the amount of butterfat sold by each shareholder to petitioner. Accordingly, we conclude that the amounts of $ 1 and $ 1.12 per share which petitioner transferred to stated capital were not patronage dividends. Peoples Gin Co. v. Commissioners, 118 F.2d 72 (C.A. 5, 1941), affirming 41 B.T.A. 343">41 B.T.A. 343 (1940).

The position of petitioner that the amounts capitalized were interest payments to the extent paid to nonpatron shareholders is without merit. As noted above, there is no evidence in the record that petitioner was ever liable for such amounts prior to the dates of the resolutions by the board of directors.

The final issue presented is whether petitioner was entitled in fiscal years 1958 and 1959 to deductions 1969 U.S. Tax Ct. LEXIS 111">*134 for additions to its reserve for bad 52 T.C. 457">*467 debts. The amounts of these additions were $ 19,757.51 in 1958 and $ 55,778.39 in 1959.

Section 166(c) allows a deduction for a reasonable addition to a reserve for bad debts. Such deduction is in lieu of deducting debts which become worthless within the taxable year. Section 166(c) grants the Commissioner discretion in determining the amounts of reasonable additions to the reserve for bad debts. The Commissioner will be overruled only where there is a clear showing of abuse of discretion. Though the taxpayer's approach might be more philosophically accurate, such accuracy does not show an abuse of discretion by the Commissioner. United States v. Haskel Engineering & Supply Co., 380 F.2d 786 (C.A. 9, 1967).

The ultimate question is whether petitioner's reserve at June 30 of each year was adequate to cover the expected worthlessness on outstanding notes and accounts receivable. If the reserve was adequate without any addition, no deduction is allowable for an addition to the reserve in that taxable year. Roanoke Vending Exchange, Inc., 40 T.C. 735">40 T.C. 735 (1963).

Petitioner urges that the Commissioner's determination was arbitrary and amounted to an abuse 1969 U.S. Tax Ct. LEXIS 111">*135 of his discretion. Furthermore, petitioner contends that its additions to the reserve were reasonable because they were needed to cover the expected worthlessness of the substantial amounts which Piers owed petitioner. ⁴

The respondent considered the following factors in reaching his decision resulting in the disallowance of petitioner's additions to its reserve for bad debts. For instance, petitioner consistently acted as though it did not anticipate losses on its accounts with Piers. Petitioner's sales to Piers increased from $ 408,422 in 1957 to $ 503,262 in 1958. In 1959 its sales to Piers were $ 471,326. Piers' payments to petitioner were $ 402,136 in 1958 and $ 468,435 in 1959. Although these payments were insufficient to cover Piers' purchases in those years or to reduce balances on outstanding amounts due, petitioner never seriously considered discontinuance of milk sales to Piers. Nor has petitioner ever considered enforced collection 1969 U.S. Tax Ct. LEXIS 111">*136 of its receivables.

In view of the factors weighted by the Commissioner at the time of his determination, we do not think he was arbitrary or committed an abuse of his discretion.

We have considered Calavo, Inc. v. Commissioner, 304 F.2d 650 (C.A. 9, 1962), reversing and remanding a Memorandum Opinion of this Court. The Court of Appeals for the Ninth Circuit stated that 52 T.C. 457">*468 Commissioner had exercised his discretion under an erroneous conception that the circumstances particularly affecting a specific debt must be completely disregarded in determining the reasonableness of additions to reserve.

The instant case is distinguishable from Calavo, Inc. In the case at bar the Commissioner did take into consideration the circumstances specifically affecting the Piers debt in determining what should be a reasonable addition to petitioner's bad debt reserve.

Decision will be entered for the respondent.