Farm Service Co-op. v. C. I. R.

• Decision Date: 19 May 1980
• Docket Number: No. 78-1754,78-1754
• Citation: 619 F.2d 718
• Parties: 80-1 USTC P 9352 FARM SERVICE COOPERATIVE, Appellee, v. COMMISSIONER OF INTERNAL REVENUE, Appellant, National Council of Farmer Cooperatives, Amicus.
• Court: U.S. Court of Appeals — Eighth Circuit

Page 718

619 F.2d 718

80-1 USTC P 9352

FARM SERVICE COOPERATIVE, Appellee, v. COMMISSIONER OF INTERNAL REVENUE, Appellant,

National Council of Farmer Cooperatives, Amicus.

No. 78-1754.

United States Court of Appeals,

Eighth Circuit.

Submitted May 15, 1979.

Decided April 11, 1980.

Rehearing Denied May 19, 1980.

Leonard J. Henzke, Jr., Atty., Tax Div., Dept. of Justice, Washington, D. C., for appellant; M. Carr Ferguson, Asst. Atty. Gen., Gilbert E. Andrews, Atty., Tax Div., Dept. of Justice, Washington, D. C., on brief.

B. Harvey Hill, Jr., Alston, Miller & Gaines, Atlanta, Ga., for appellee; Sidney O. Smith, Jr., Franklin R. Nix, and Michael G. Wasserman, Atlanta, Ga., on brief.

Donald E. Graham, Washington, D. C., and Arthur E. Bryan, Jr., McDermott, Will & Emery, Chicago, Ill., for amicus, National Council of Farmer Cooperatives.

Before BRIGHT and McMILLIAN, Circuit Judges, and DEVITT, Chief District Judge. ^*

BRIGHT, Circuit Judge.

The Commissioner of Internal Revenue (Commissioner) appeals from a decision of the United States Tax Court in favor of Farm Service Cooperative (taxpayer). ¹ The Tax Court determined that taxpayer, a nonexempt farm cooperative, ² could offset losses suffered in patronage activities against its taxable income. For the reasons set forth below, we conclude that this determination was erroneous. Accordingly, we reverse.

1. Background.

Taxpayer is an agricultural cooperative incorporated under the laws of Arkansas, with its principal place of business in Fayetteville. During the years in question, taxpayer divided its business activities into four categories: a broiler pool, a turkey pool, a regular pool, and taxable activity. ³ The regular pool was a supply operation; taxpayer owned four stores that sold mostly farm supplies to cooperative members (patrons) and nonmembers alike. ⁴ Taxable activity encompassed various sources of taxable income, including gains from the sale of taxpayer's property, dividends on taxpayer-owned stock, the cancellation of outstanding dividend checks payable to former patrons who could not be located, and other miscellaneous items of cooperative income.

The broiler and turkey pools engaged in hatching, growing, and marketing chickens and turkeys, respectively. It is the broiler pool that chiefly concerns us here. Taxpayer owned hatcheries where eggs were hatched and baby chicks were raised until twenty-four hours old. At that point, taxpayer transported the chicks to approved grower-members, who contracted to care for the chicks until they were of marketable size (about eight weeks). During this time taxpayer supplied feed, medical care, and supervision, while grower-members supplied housing, fuel, equipment, and services. When the chickens became mature, taxpayer picked them up and delivered them to its processing plant.

At the time of pickup, taxpayer paid its grower-members according to a formula that took into account the delivery weight of the chickens (less that of any chickens condemned by the U. S. Department of Agriculture), current market prices, and the efficiency with which chicken feed had been converted into meat. The contracts between taxpayer and grower-members also provided for a minimum payment, irrespective of variations in wholesale market prices. Taxpayer characterizes these grower payments as cash "per-unit retain allocations." See I.R.C. § 1388(f). ⁵

Broilers sell on a highly volatile market; as a result, growing and marketing broilers can be a risky venture. The broiler pool earned reasonable profits in some years, but it sustained significant losses in others. Most of taxpayer's earnings on broiler sales in profitable years were returned to pool members as patronage dividends and deducted from taxpayer's gross income pursuant to I.R.C. § 1382(b). ⁶ A substantial portion of the dividends (approximately eighty percent) were in the form of "qualified written notices of allocation." ⁷ These notices of allocation were considered to be paid out to the members and hence taxable to them upon issue, even though taxpayer actually retained the funds and added them to a reserve account maintained for the broiler pool. By 1971 this account held $448,744.

The broiler pool sustained significant losses in the fiscal years ending June 30, 1971, and June 30, 1972. In fiscal 1971 broiler pool expenditures (including grower payments) exceeded gross receipts by $572,634.37. During the same period taxpayer realized income from its other activities as follows:

Patronage Income from Turkey

Pool $ 4,088.80

Income from Regular Pool

Patronage--sourced 51,510.37

Nonpatronage--sourced 20,528.75

Taxable Activity 156,497.56

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Total $ 232,625.48

Taxpayer distributed or allocated to its turkey pool members the net patronage income derived from the turkey pool activities. It similarly distributed or allocated to its regular pool members the net patronage income derived from the sale of farm supplies to its regular pool members. After taxpayer had done this, taking the deductions authorized by I.R.C. § 1382(b), there remained $177,026.31 of income subject to taxation. ⁸

Taxpayer reduced its taxable income for fiscal 1971 to zero by setting this $177,026.31 off against part of the $572,634.37 broiler pool deficit. Taxpayer then timely filed Form 1139 requesting refunds for the carryback of $165,469.67 of the remaining broiler pool deficit. Taxpayer also requested a carryback of its unused investment credits for the fiscal years ending June 30, 1970, 1969, and 1968. ⁹ After this offsetting of four years' taxable income, taxpayer allocated the balance of the 1971 broiler pool deficit to its broiler pool reserve account, reducing it from $448,744 to $218,605.61. This change was reflected in the cancellation of $230,138.39 in members' qualified written notices of allocation.

For the fiscal year ending June 30, 1972, the broiler pool's expenditures exceeded broiler pool receipts by $72,040.65. Taxpayer offset the entire amount of this broiler pool deficit against its taxable income for fiscal 1972 (i. e., nonpatronage-sourced income from the regular pool and taxable activity income), leaving taxable income of $5,122 for the year.

The Commissioner disagreed with taxpayer's method of accounting. Specifically, he determined that taxpayer was required to pay tax on all income not allocable to patrons; taxpayer could not use the losses generated by business done with patrons (i. e., the broiler pool deficit) to offset its taxable income. In pertinent part, the Commissioner's notice of deficiency to taxpayer states:

(a) Deductions of $572,634.37 and $72,040.65 claimed for broiler pool losses on your returns for June 30, 1971 and June 30, 1972 are not allowable offsets to current taxable income but are charges against the broiler pool reserve.

(c) As a result of the above adjustments to your return for June 30, 1971, the net operating loss for that year which was carried back to taxable years June 30, 1968, June 30, 1969 and June 30, 1970 and tentatively allowed is eliminated.

Further, since the net operating loss is eliminated, the carryback of unused investment credits to June 30, 1965 and June 30, 1966 from June 30, 1968 and to June 30, 1967 from June 30, 1970 and tentatively allowed are also eliminated.

II. Analysis.

A. The Statutory Scheme: Taxation of Cooperative Income and Patronage Dividends.

By virtue of consistent administrative practice, all cooperatives have been permitted to treat patronage payments as a deduction from gross income (under specified conditions) since 1914. T.D. 1996, 16 Treas.Dec.Int.Rev. 100 (1914); Logan, Federal Income Taxation of Farmers' and Other Cooperatives, 44 Tex.L.Rev. 250, 285-86 (1965). The theory underlying this tax treatment is clear, although stated in various ways: the cooperative is merely an agent for the patron; a patronage dividend constitutes a rebate or price adjustment for the patron; or the money returned in fact always belonged to the patron. See Des Moines County Farm Service Co. v. United States, 324 F.Supp. 1216, 1219 (S.D. Iowa), aff'd per curiam, 448 F.2d 776 (8th Cir. 1971).

The deductibility of patronage dividends first received explicit legislative recognition and approval in the Revenue Act of 1951, ch. 521, § 314(a)(2), 65 Stat. 492 (repealed 1962). See Des Moines County Farm Service Co. v. United States, supra, 324 F.Supp. at 1219. It was generally thought at that time that the earnings of cooperatives would be currently taxable either to the cooperative or to its patrons. Subsequent court decisions, however, held that noncash allocations of patronage dividends, though deductible by the cooperative, were not taxable to the patron.

The enactment of subchapter T, section 17(a) of the Revenue Act of 1962, Pub.L.No.87-834, 76 Stat. 960, was intended to overturn these decisions. S.Rep.No.1881, 87th Cong., 2d Sess., reprinted in (1962) U.S.Code Cong. & Admin.News 3304, 3414. Subchapter T, I.R.C. §§ 1381-88, permits cooperatives to deduct amounts allocated in cash or scrip as patronage dividends, and it makes patrons currently taxable on these patronage dividends to the extent that they arise out of the patrons' business transactions with the cooperative. "Exempt" cooperatives, those satisfying the criteria of I.R.C. § 521(b), may allocate to their patrons and deduct not only earnings derived from patronage activities, but also dividends on capital stock and earnings derived either from business done for the United States or from nonpatronage sources. I.R.C. § 1382(c). See generally Land O'Lakes, Inc. v. United States, 514 F.2d 134 (8th Cir.), cert. denied, 423 U.S. 926, 96 S.Ct. 271, 46 L.Ed.2d 253 (1975); Logan, Federal Income Taxation of Farmers' and Other Cooperatives, 44 Tex.L.Rev. 250 (1965). Nonexempt cooperatives may allocate and deduct only income arising from business done with patrons, and then only under additional conditions specified in I.R.C. § 1388(a). ¹⁰ I.R.C. §...