Farmers Co-op. Co. v. C.I.R.

• Citation: 822 F.2d 774
• Decision Date: 01 July 1987
• Docket Number: No. 86-1831,86-1831
• Parties: -5249, 87-2 USTC P 9404 FARMERS COOPERATIVE COMPANY (Successor-in-Name to Farmers Co-op Oil Company), Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Appellee.
• Court: United States Courts of Appeals. United States Court of Appeals (8th Circuit)

Page 774

822 F.2d 774

60 A.F.T.R.2d 87-5249, 87-2 USTC P 9404

FARMERS COOPERATIVE COMPANY (Successor-in-Name to Farmers

Co-op Oil Company), Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Appellee.

No. 86-1831.

United States Court of Appeals,

Eighth Circuit.

Submitted Feb. 11, 1987.

Decided July 1, 1987.

Robert C. Guenzel, Lincoln, Neb., for appellant.

Kenneth Greene, Dept. of Justice, Washington, D.C., for appellee.

Before HEANEY and McMILLIAN, Circuit Judges, and WOODS, ^* District Judge.

HEANEY, Circuit Judge.

Farmers Cooperative Company (Farmers) appeals a decision of the tax court, 85 T.C. 601, that it did not qualify as an exempt cooperative association under Section 521 of the Internal Revenue Code, 26 U.S.C. Sec. 521 (hereinafter section 521), during the 1977 and 1978 tax years because substantially all of its capital stock was not owned by producers who market their products or purchase their supplies through Farmers. We affirm in part, reverse in part, and remand to the tax court.

Farmers is a cooperative incorporated under the laws of the State of Nebraska with its principal office in Platte Center, Nebraska. It is an association organized and operated as a cooperative to market the products of its farmer members and others and to sell supplies to members and others. During the tax years relevant to this case, Farmers' authorized capital stock consisted of 40,000 shares of $12.50 par value common stock. Each shareholder of the common stock was entitled to only one vote regardless of the number of shares owned. In addition to the capital stock, Farmers carried certificates of participation and equity credits on its books. Neither the certificates nor the credits entitled the holder to vote or otherwise participate in the management of Farmers.

Beginning in 1956, the Internal Revenue Service (IRS) recognized Farmers as an exempt cooperative under section 521. In March 1982, however, the IRS notified Farmers of its determination to revoke its exemption for all tax years beginning on or after October 1, 1976. The IRS stated that it did so because it believed Farmers had not adequately limited the ownership of "substantially all" of its capital stock to producers who patronized the cooperative during the tax year as required by section 521(b)(2). On July 2, 1982, Farmers filed a petition for redetermination with the Tax Court. The Tax Court held that, on the basis of the facts stipulated, Farmers did not qualify as a tax-exempt farmers' cooperative

during the tax years at issue. Farmers appeals.

ANALYSIS

Section 521 provides a tax exemption for qualifying farmers' cooperatives. In order to qualify for the exemption a cooperative must be "organized and operated on a cooperative basis * * * for the purpose of marketing the products of members or other producers * * * or * * * for the purpose of purchasing supplies and equipment for the use of members or other persons." 26 U.S.C. Sec. 521(b)(1). In addition, if the cooperative issues capital stock, it is not entitled to the exemption unless "substantially all such stock (other than nonvoting preferred stock, the owners of which are not entitled or permitted to participate, directly or indirectly, in the profits of the [cooperative], upon dissolution or otherwise, beyond the fixed dividends) is owned by producers who market their products or purchase their supplies and equipment through the [cooperative]." ¹ 26 U.S.C. Sec. 521(b)(2).

The exemption allowed by section 521 is over and above the exemption allowed for other nonqualifying cooperatives. Even nonexempt farmers' cooperatives can deduct from gross income amounts collected from patrons and allocated and distributed to patrons out of the net earnings of the cooperative. See 26 U.S.C. Sec. 1382(b). Exempt cooperatives may, in addition, deduct amounts paid during the tax year as dividends on capital stock and earnings paid to patrons, on a patronage basis, derived from nonpatron sources. See 26 U.S.C. Sec. 1382(c).

The ability of exempt cooperatives to deduct nonpatronage income allocated to patrons on a patronage basis has often been used by cooperatives to allocate income from government grain storage to their patrons, distributing the minimum amount required in cash and carrying the remainder on its books as a credit. Although this arrangement requires patrons to recognize their full allocation for federal tax purposes, the "flow through" arrangement has enabled cooperatives to accumulate sufficient capital to build grain storage and handling facilities not otherwise possible if the nonpatronage income were taxed at the cooperative level. See Affidavit of Stanley A. Wells, Exhibit 123 pp. 27-28. Such facilities allow the cooperative to exercise greater bargaining power on behalf of member farmers by giving them the power to make larger purchases and sales and to better control the timing of such purchases and sales. Thus, the exemption is one method by which Congress sought to enhance the bargaining power of small farming operations. See Liberty Warehouse Co. v. Burely Tobacco Growers' Co-operative Marketing Association, 276 U.S. 71, 92-96, 48 S.Ct. 291, 295-96, 72 L.Ed. 473 (1928).

In limiting the exemption, however, Congress sought to benefit only the members of the cooperative, not the cooperative as a business entity. Accordingly, Congress granted the exemption only to those cooperatives in which "[a]dvantages * * * accrue to a member of a cooperative * * * primarily because of his patronage with the association and not because of any financial investment he may have made therein." Co-operative Grain & Supply Co. v. Commissioner, 407 F.2d 1158 (8th Cir.1969) (quoting Paul, The Justifiability of the Policy of Exempting Farmers' Marketing and Purchasing Cooperative Organizations from Federal Income Taxes, 29 Minn.L.Rev. 343, 344 (1945)).

It is to this end that section 521 requires a farmers' cooperative to limit the ownership of "substantially all" of its capital stock to producers who market their products or purchase their supplies through the cooperative. The degree to which a cooperative must limit ownership of its capital stock in order to qualify for the exemption, however, is not defined in the Internal Revenue Code or the regulations. ² In Co-operative In deciding whether a farmers' cooperative meets the "substantially all" test of section 521(b)(2) of the Code, all of the capital stock of the cooperative (other than nonvoting preferred) must be counted. Once all of the capital stock has been counted, at least 85 percent of such capital stock should be held by producers before it can be said that the "substantially all" test of section 521(b)(2) of the Code has been satisfied.

Grain & Supply Co. v. Commissioner, 407 F.2d 1158, 1164 (8th Cir.1969), Judge Matthes, speaking for this Court, held that qualification for the exemption requires substantially all of the shareholder producers to patronize the cooperative on a current basis. In addition, the Court in Co-operative Grain & Supply Co. urged the IRS to promulgate regulations clarifying the requirements of section 521(b)(2). After Co-operative Grain & Supply Co., the IRS issued a revenue ruling stating:

Rev.Rul. 73-248, 1973-1 C.B. 295.

This Court has since upheld the 85% test as a reasonable interpretation of the "substantially all" requirement of section 521. See West Central Cooperative v. United States, 758 F.2d 1269, 1271 (8th Cir.1985).

In this case, we do not understand Farmers to challenge the 85% test in the revenue ruling. Instead, Farmers challenges the manner in which it was applied. In particular, it argues that two groups were treated erroneously: (1) those who, by sufficiently patronizing the cooperative, became entitled to a share of capital stock during the tax year (Farmers contends that those in this group should have been counted as shareholders for the tax year in which they became entitled to the stock); ³ and (2) those who did not patronize Farmers during the tax year (Farmers argues that those in this group should not have been counted as shareholders).

The consequences of accepting Farmers contentions with respect to each group and each tax year are important. For tax year 1977, the IRS contends that Farmers had 670 shareholders, 568 or 84.78% of whom patronized it during the tax year. Alternatively, Farmers argues that if those who became entitled to a share of capital stock during the 1977 tax year are counted as shareholders (and by definition patrons) it would have had 702 shareholders, 600 or 85.47% of whom patronized it during the year.

For tax year 1978, Farmers' argument with respect to those who became entitled to a share is less helpful. The IRS contends that during tax year 1978, Farmers had 698 shareholders, 576 or 82.52% of whom patronized it. Accepting Farmers' argument as to those who became entitled to a share during the tax year, Farmers would have 731 shareholders, 609 or 83.31% of whom patronized it during the tax year.

Of course, accepting Farmers contention that those who failed to patronize it during the tax year automatically ceased to be shareholders results in 100% of Farmers' shareholders being patrons during the tax year because nonpatrons automatically become nonshareholders. Thus, Farmers would be entitled to the exemption for both tax years at issue.

In support of its argument as to the first group, Farmers contends that under general corporate law principles the right to a share of stock accrues upon performance of the necessary prerequisites (in this case sufficient patronage during the year). Thus, since Farmers could not and has not denied a share of stock to one who became entitled to it, any formalities required for issuance of the share should be irrelevant and the patron counted as a shareholder for the year in which the right to it accrued.

In support of its argument as to the second group, Farmers cites the Court to its by-laws which state: "Only...