Midland Cooperative Wholesale v. Commissioner , 44 B.T.A. 824 ( 1941 )

MIDLAND COOPERATIVE WHOLESALE, A CO-OPERATIVE ASSOCIATION, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Midland Cooperative Wholesale v. Commissioner

Docket No. 100612.

United States Board of Tax Appeals

44 B.T.A. 824; 1941 BTA LEXIS 1269;

June 26, 1941, Promulgated

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1. A cooperative association, by appropriate resolution of its board of directors, accrued upon its books its earnings, less taxes, interest on its paid-up capital, and an addition to its permanent surplus. A portion of the amounts so accrued was paid over to the members in cash and the remainder was placed in a reserve account. The earnings were all allocated to the members upon the basis of the business transacted by them. No additional corporate action was required to make the amounts, credited to the members, but not withdrawn, available to them. Held, that the amounts credited to the members represented rebates upon the business transacted by them and should not be included in computing the income tax of the cooperative association. Cooperative Oil Association, Inc. v. Commissioner, 115 Fed.(2d) 666, distinguished.

2. The state law under which petitioner was incorporated and petitioner's bylaws limit the amount of interest which may be paid upon its capital stock. Held that such provisions do not constitute a written contract executed by the corporation expressly dealing with the payment of dividends or entitle it to the credit specified in section 26(c) of the Revenue Act of 1936. Helvering v. Northwest Steel Rolling Mills, Inc.,311 U.S. 46">311 U.S. 46; Crane-Johnson Co. v. Helvering,311 U.S. 54">311 U.S. 54.

E. J. Pearlove, Esq., and Benjamin Drake, Esq., for the petitioner.

H. A. Melville, Esq., for the respondent.

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MELLOT

This proceeding involves the following deficiencies:

	Income tax	Excess profits tax
1936	$2,322.88	$468.81
1937	8,553.00	1,455.27

Petitioner claims that there have been overpayments in its income tax for the year 1936 in the amount of $1,487.23 and for the year 1937 in the amount of $177.23.

The issues are: (1) Are the amounts credited to a "Patrons' Equity Reserve Account" for the years 1936 and 1937 in the respective amounts of $5,000 and $29,336.72 deductible from petitioner's gross income? (2) Is petitioner entitled to credits aggregating $18,017.33 for 1936 and $28,051.41 for 1937 under section 26(c)(1) of the Revenue Act of 1936 in computing the surtax on its undistributed profits?

FINDINGS OF FACT.

The petitioner is a cooperative association, incorporated under the laws of the State of Minnesota. Its principal office is located in Minneapolis, Minnesota, and it is authorized to transact business in both Minnesota and Wisconsin. Its returns for the taxable years were filed with the collector of internal revenue for the district of Minnesota.

Under petitioner's charter it has broad powers to conduct a wholesale business on the cooperative plan for buying, selling, and distributing such commodities as are required in the business of operating and maintaining gasoline service stations. It acts as purchasing agent for its members and contracts for petroleum products, automobile accessories and supplies, and other forms of merchandise necessary in the operation of such business. Any cooperative association may become a member by complying with petitioner's articles of incorporation and bylaws and becoming the owner of at least one share of common stock. During the taxable years approximately 180 cooperatives organized under the laws of Minnesota or Wisconsin were stockholders in and members of petitioner and more than 99 percent of all business transacted by petitioner was done with its members.

The territory in which petitioner operates is divided into 10 districts. Each district holds quarterly meetings at which matters relating to petitioner are presented for consideration and such action as the district deems proper. Each district is represented upon petitioner's board by one director.

Petitioner's authorized capital stock is $250,000, divided into 1,300 shares of preferred of a par value of $100 and 1,200 shares of common of a par value of $100. Dividends on preferred stock are payable when declared by the directors out of earnings, but they can not exceed 5 percent of the par value of such stock and are not cumulative. They are payable before any dividends may be paid on the common stock. The preferred stock may be issued to, and held by, any bona fide cooperative organization or member thereof. It can not at any time exceed the outstanding common stock.

The ownership of common stock is limited to cooperative organizations and such stock is to be paid for in cash or out of patronage dividends. Patronage dividends are credited toward the purchase price of common stock until there is one share for every fifty members of the constituent company. Each holder of common stock is limited to one vote. Interest (dividends) on common stock is payable at the rate of not to exceed 5 percent and is noncumulative. Shares of common stock are transferable only by and with the consent of petitioner.

Petitioner's bylaws provide that its annual meeting shall be held on the second Tuesday of June of each year at its principal place of business. Each member association is entitled to one basic vote and one additional vote for each $50,000 worth of business or fraction thereof transacted by it with petitioner during the preceding fiscal year in excess of the first $25,000. The board of directors is authorized to manage the business and affairs of the association and to make all necessary rules and regulations not inconsistent with law or with the bylaws for the guidance of the officers, agents and employees.

Article VII of the bylaws reads as follows:

The net income of the association, except such amounts as are required to be set aside as a reserve fund, or permanent surplus, or may be set aside by vote of the stockholders, available for distribution among members or patrons, or both, as the case may be, and as may be prescribed by the bylaws, shall be distributed only on the basis of patronage.

There shall be no discrimination as between non-members and member patrons in the payment of patronage dividends or in any other manner. The amount of patronage dividend which shall be due to such non-member patrons shall be credited to their individual accounts and when such credits shall equal the value of a share of stock, a share of stock shall be issued to such non-member patron and he shall thereafter be entitled to the benefits of membership as a stockholder in such association if he is otherwise qualified and eligible for membership therein, and shall assume the responsibilities and obligations attached to such membership as set forth in the articles of incorporation and bylaws of this association.

The amount returned, if any, to the patrons at the close of each fiscal period shall be the gross returns from the sales, less the following deductions.

a. For current operating expenses.

b. For maintenance fund to be used in payment of taxes, insurance, interest and similar maintenance expenses; also for a reasonable reserve for depreciation of the physical property of the association.

c. At least ten per cent (10%) of the annual net income shall be set aside as a permanent surplus until such reserves shall equal the paid up capital.

d. An educational fund of two per cent (2%) of the annual net income shall be set aside to promote cooperative education.

e. For dividends on capital stock.

Under the Minnesota law (P7, ch. 382, Laws of 1919, as amended by ch. 23 of the Laws of 1919 and ch. 326 of the Laws of 1923) distribution of the undivided surplus of a cooperative association is required to be made annually on the basis of patronage. The directors are required to present to the stockholders at their annual meeting a report covering the operations of the association during the preceding fiscal year, together with a financial statement of its resources and liabilities which "shall indicate the amount of undivided surplus available for distribution as patronage refund." Interest on the paid-up capital may be paid only when the net income of the association for the previous fiscal year is sufficient and the directors may not at any time authorize the payment of more than 6 percent per annum on the paid-up capital stock.

Petitioner's "gross income" for the year 1936, as such term is defined by the Minnesota statutes, supra, was $71,574.36. Pursuant to appropriate resolution of the board of directors interest upon the paid-up capital stock at the rate of 5 percent and amounting to $4,413.26 was authorized and paid and a reserve was set up for income tax in the amount of $3,560. At a regular monthly meeting of the board of directors held on December 18, 1936, it was resolved that $10,000 be set up in permanent surplus, $5,000 be allocated to "Patrons' Equity Account," and the balance of the net earnings be available for distribution. On December 31, 1936, a $5,000 credit was made by petitioner to an account in its general ledger entitled "Patrons' Equity Reserve."

In the latter part of May 1937 petitioner allocated its earnings available for distribution to its members on the basis of the business transacted by them, the allocation including both the remaining net earnings aggregating $48,601.10 and the $5,000 in the "Patrons' Equity Reserve" account. It was ascertained that each patron was entitled to receive in cash .1769 times the net profit on its sales and to have set aside for its benefit on the books of the association a portion of the $5,000 placed in the reserve equivalent to .01824 times the net profit on its sales. The first mentioned amounts, aggregating $48,601.10, were paid to the patrons and the last mentioned amounts, aggregating $5,000, were credited to them on petitioner's books. At the annual meeting of the association held on the 8th and 9th of June 1937, the action of the board of directors with relation to the disposition of the 1936 earnings was approved. During December 1937 a form letter was sent to each member patron advising it as to the amount of credit which had been made to its account in connection with the "Patrons' Equity Reserve."

Petitioner's "gross income" for the year 1937 as such term is defined by the Minnesota statutes is not shown. Its earnings, after the payment of interest, income tax, and kindred items, were $58,673.43. At the regular monthly meeting of petitioner's board of directors held on November 22 and 23, 1937, it was resolved that petitioner "present at the district meetings for approval of the delegates that 50% of the earnings for 1937 be put in patrons' equity reserve and that the other 50% be applied to patrons' common or preferred stock, based on patronage." Another motion was adopted at this meeting of the board providing that if the contemplated action should not meet with the approval of the delegates to the district meetings then "the management be instructed to set up 50% of the earnings for 1937 in permanent surplus and 50% in common and preferred stock, based on patronage." All of the ten districts, during the month of December 1937, adopted resolutions approving the plan or contemplated action of paying 50 percent of the earnings to the patron members in cash and putting the other 50 percent of the earnings in the "Patrons' Equity Reserve" account. Thereupon, following an audit of petitioner's books and as of December 31, 1937, petitioner set aside in its "Patrons' Equity Reserve" account $29,336.72.

During the early months of 1938 petitioner allocated its earnings available for distribution to its members on the basis of business transacted by them, the allocation including both the $29,336.71 payable in cash and the $29,336.72 in the "Patrons' Equity Reserve" account. It was ascertained that each patron was entitled to receive in cash .008 times the grand total of the net business transacted with it and to have set aside on the books of the association, as its share of the reserve, an additional amount equivalent to .008 times the grand total of the net business transacted with it. The first mentioned amounts, aggregating $29,336.71, were paid to the patrons and the last mentioned, aggregating $29,336.72, were credited to them on petitioner's books. At the annual meeting of the association held on June 14, 1938, the action of the board of directors with relation to the disposition of the 1937 earnings was approved.

At the annual meeting on June 14, 1938, the following new bylaw was adopted:

ARTICLE VIII (Certificates of Patrons' Equity Reserve)

Certificates of Patrons' Equity of the Association reserve may be issued to patrons to evidence the patrons' interest in such earnings of the association, which have been distributed on the basis of patronage and have been annually determined by the Board of Directors or members to be withheld in the assets of the association until such time as the Board of Directors in their discretion may decide to redeem.

Such certificates of Patrons' Equity Reserve may contain the following provisions:

A. They must be redeemed in order of priority both as to date and number.

B. Must be subject to Articles of Incorporation and By-Laws.

C. Interest may be paid at the discretion of the Board of Directors but Rate of Interest may not exceed 4 per cent.

D. Notice of intention to redeem any certificate must be mailed to each holder, and interest, if any paid, will cease to accrue from date of notice.

E. The Association may deposit in trust in any reliable bank or trust company any or all funds provided for redemption of such certificates to be delivered thereto for redemption.

F. In case of liquidation, winding-up or dissolution, such certificates shall be paid only after all corporate liabilities (including the liabilities arising from the issuance of Preferred Stock by this association, by [but] excluding its liability arising from the issuance of Common Stock) have been paid in full.

On or about December 23, 1938, a form letter was sent to each member patron, advising it of the amount of its credit to the patrons' equity reserve account for the year 1937, and also setting forth the amount of the previous credit for the year 1936. The form letter is as follows:

At the annual meeting of the Midland Cooperative Wholesale held in Minneapolis, Minnesota, June 13-14, 1938, the following resolution pertaining to the distribution of the 1937 net earnings was adopted:

"WHEREAS, at the December 1937 Quarterly Meetings of all ten districts of the Midland Cooperative Wholesale approved a resolution of the Midland Board of Directors providing for the disposition of the net earnings for 1937;

"THEREFORE, BE IT RESOLVED, that the Board's recommendation be and hereby is adopted by this Twelfth Annual Meeting of the Midland Cooperative Wholesale; viz., that fifty (50) percent of the net earnings be placed in Patrons' Equity Reserve, and the other fifty (50) percent be applied toward patrons' common and preferred stock on the basis of patronage."

On the basis of the above action we have set aside as a credit to your account in the Patrons' Equity Reserve -

for the year 1937 the amount of	$ ;
for the year 1936 the amount of	$ ;
total amount set aside in the Patrons' Equity Reserve	$ .

The amount due you in the Patrons' Equity Reserve may be issued to you in the form of certificates as provided in Article VIII of the Midland CooperativeWholesale By-Laws.

At the time of the hearing most of the amounts which had been credited by petitioner to its members in connection with the patrons' equity reserve were still held by it. In 1939 one of its members was liquidated and in 1940 one was placed in receivership. In each instance request was made that petitioner apply the amount which had been credited to the member against its indebtedness to petitioner. This was done after approval by petitioner's board of directors. Inthe first instance petitioner was thus enabled to collect $1.06 and in the second, $91.99. The remaining amounts credited to the members as shown above are still held by petitioner.

Petitioner's books are kept and its returns are filed on the accrual, as distinguished from the cash, basis.

OPINION.

MELLOTT: The Commissioner determined that the amounts credited by petitioner to its members and held in its "Patrons' Equity Reserve"account are not deductible from its gross income for the taxable years. Whether this determination is or is not correct is the first issue to be determined.

Both parties recognize that there is no specific statutory provision for the deduction of patronage dividends from the gross income of a cooperative association. The Treasury Department, however, as pointed out in Fruit Growers Supply Co.,21 B.T.A. 315">21 B.T.A. 315, 326; affd.,56 Fed.(2d) 90, with "great liberality", has allowed such deductions "to the end that substantial justice may be done to an association which is engaged in cooperative marketing or purchasing work but which may not be exempt from taxation." The justification for the ruling rests upon the fact that the so-called dividends are in reality rebates upon the business transacted by the association with its members rather than true income to the association.

Respondent, in determining the deficiency, correctly allowed the deduction of the amounts paid in cash by petitioner to its members, based upon the business transacted by them in each year, though payment was not made of such amounts until the following year. Heconcedes that a definite liability to make such payments - clearly a prerequisite to their deduction - arose during the taxable years. HomeBuilders Shipping Association,8 B.T.A. 903">8 B.T.A. 903; Anamosa FarmersCreamery Co.,13 B.T.A. 907">13 B.T.A. 907; Farmers Union Cooperative Association,13 B.T.A. 969">13 B.T.A. 969; Farmers Union State Exchange,30 B.T.A.1051, 1066.

As to the amounts credited by petitioner to its members upon its books and not paid over to them during the following year respondent takes a different position. Pointing to some of the corporate records received in evidence, especially the minutes of the directors' meetings and the minutes of the annual meetings, he argues that they show petitioner was in need of working capital and that the members recognized the necessity of either borrowing it or raising it among themselves; that this could be, and was, accomplished by the members leaving a substantial portion of their dividends with petitioner; that the so-called reserve was not a true reserve, but an allocation of a part of petitioner's undivided surplus made in the hope of avoiding income tax; that setting aside a portion of its income in such an account "was contrary to, or at least not provided for by, the state law, petitioner's Articles of Incorporation and its by laws"; and that additional corporate action is required to be taken before petitioner becomes under any liability to pay to its members the amounts set aside.

The evidence does indicate that petitioner was in need of working capital and that the membership desired to aid it in getting out of debt by leaving a portion of their dividends with it. It is also true that at least petitioner's directors knew all earnings placed in "permanent surplus" would be included in its gross income in computing the amount of its income tax. The motive of petitioner and its members does not seem to be very material to the present controversy. It is important to determine, however, whether the action taken was in violation of state law or charter provisions and whether additional corporate action is required before petitioner is under any definite liability to make payment; so these questions will now be considered.

Petitioner's articles of incorporation and bylaws follow quite closely the provisions of the Minnesota state law. Both provide for the deduction of operating costs, the setting aside of a reserve for depreciation, and the creation of a reserve against other possible losses. Both require that there be deducted an amount sufficient to pay interest on the paid-up capital of the association. The by laws provide for the payment of interest at not to exceed 5 percent per annum. The state law authorizes the payment of interest at a rate not in excess of 6 percent per annum. There may also be deducted and set aside such amounts as may be required to provide for the erection of new or additional buildings or for additional machinery or equipment. Provision is also made for "creating a reserve for permanent surplus." The balance of the net income, in the language of the state statute, is to "be considered and termed as 'undivided surplus' for such fiscal year and shall be available for distribution among the members of such cooperative association on the basis of patronage." Distribution of the undivided surplus is required to be made annually on the basis of patronage during the preceding fiscal year.

It is true that neither the state law nor petitioner's articles of incorporation and bylaws, at least prior to the annual meeting of 1938, specifically referred to a patrons' reserve account. The "undivided surplus," however, clearly belonged to the members or patrons and, both under the law of the state and under petitioner's bylaws, was required to be distributed to them annually on the basis of patronage. While the setting aside of a portion of such amount is not specifically authorized, there is nothing in the state statute or the bylaws prohibiting such action being taken. We are therefore of the opinion that when petitioner, with the consent and knowledge of its members, set aside a portion of its earnings in a reserve account and allocated it among them, it did not violate any provision of the state law or actin violation of its charter provisions.

The next question is whether additional corporate action is required to be taken before petitioner becomes under a definite liability to pay to its members the amounts set aside to their credit. Petitioner points out that the amounts to be paid forth with to its members in cash and the amounts to be held in reserve were both authorized at the same time and by the adoption of one resolution; that both were allocated to the members at the same time and entered upon the corporate ledger as credits; and that both were computed upon the business transacted with the association. It argues, therefore, that both were properly accrued as liabilities upon its books. We agree with petitioner. In our opinion all necessary steps were taken in the taxable years to obligate petitioner to pay the earnings over to its members. The resolutions of the board of directors recognized that the entire amounts - $53,601 in 1936 and $58,673.43 in 1937 - belonged to the members. The statutes and the bylaws so provide. If any other disposition of such earnings had been made - other than putting them in permanent surplus - the directors would have committed an unlawful act, which under the statutes of Minnesota would have been "cause for the cancellation of the charter." The amounts in question were not put in permanent surplus. They were allocated to the members, though held in reserve. Moreover, though perhaps wholly unnecessarily, the directors sought and secured the approval of the membership at the annual meetings of their action in withholding the portion of the earnings which had been set aside for them, and, in connection with the earnings for 1937, such approval was also secured during the month of December and before the end of the taxable year of the action then contemplated - i.e., that 50 percent be paid in cash at once and 50 percent be placed to the credit of the members and be held in reserve.

Respondent places considerable reliance upon the new by law adopted at the annual meeting in 1938 which, he says, indicates that petitioner was under no definite liability to pay the amounts credited upon its books to its members unless it should choose to do so. Herelies particularly upon the last sentence of the bylaw, which provides that "in case of liquidation, winding up or dissolution, such certificates shall be paid only after all corporate liabilities (including the liabilities arising from the issuance of preferred stock but excluding its liability arising from the issuance of common stock) have been paid in full." This, he says, indicates that unless some definite corporate action is taken prior to the liquidation or dissolution of petitioner, the members will receive the credits which have been made to their respective accounts only in the event all corporate liabilities shall have been paid and all preferred stock redeemed.

Petitioner, in its reply brief, argues that the new bylaw is immaterial to the present issue and that no corporate action taken during a succeeding year can add to, or detract from, the rights and obligations of the petitioner and its members which had come into being by virtue of corporate action previously taken. There is considerable substance to petitioner's argument. We are of the opinion, however, that if the bylaw is to be considered, still it does not have the effect that respondent contends it has. It recognizes that the amounts set aside and credited to the members belong to them, that interest must hence forth be paid, and, in the event of liquidation or dissolution of the cooperative, that the members shall have the rights of general creditors. No additional action is required to be taken by the corporation to create such liability.

It is apparent we are of the opinion respondent erred in holding that the amounts credited to the members must be included in petitioner's income. One additional reason for so holding may be given. Petitioner's books were kept upon an accrual, as distinguished from a cash, basis. All events occurred within the taxable years determining the liability of petitioner to its members and the amounts thereof. United States v. Anderson,269 U.S. 422">269 U.S. 422. The fact that the entries could not be made upon petitioner's books until its audit of the year's business was completed is unimportant and does not deprive it of its right to accrue all proper items in closing its books for the year. It accrued upon its books, and showed as accounts payable upon its balance sheet, the amounts credited to its members. This action was in accordance with the corporate resolutions adopted by it in December of each year. The amounts so credited, in our opinion, could have been withdrawn by the members at any time. In at least two instances they were, in effect, withdrawn. As shown in our findings, they were applied by petitioner in liquidation of the members' accounts.

Respondent cites an unpublished memorandum opinion of this Board holding that amounts set aside in an account entitled "Reserve for Working Capital" by a cooperative association organized under the laws of Idaho are not deductible as patronage dividends. Thecited decision has now been affirmed by the Circuit Court of Appealsfor the Ninth Circuit. Cooperative Oil Association, Inc. v. Commissioner, 115 Fed.(2d) 666. An examination of the opinion of the court discloses that the taxpayer, as provided in its bylaws, had set-aside a substantial portion of its earnings "to create a reserve or reserve funds necessary to provide working capital." In the letter to its members it stated that "as rapidly as our reserves accumulate these earnings will be released and disbursed to you as patronage dividends." The reserve established by the taxpayer in the cited case was similar to the "permanent surplus" set aside by petitioner in the instant proceeding rather than to the amounts set aside by it in the patrons' equity reserve account and credited to its members. Additional corporate action was required before it was available to them. This fact distinguishes the cited case from the present.

We are of the opinion and hold that respondent erred in including the amounts in issue in petitioner's income.

Petitioner claims an overpayment for each of the years based upon its present assertion that it should be allowed a credit of $18,017.33for the year 1936 and $28,051.41 for the year 1937 under section 26(c)(1) of the Revenue Act of 1936. The petition alleges that these amounts equal the excess of the adjusted net income over the aggregate of the amounts which petitioner could distribute within the taxable years as dividends (for purposes of the surtax on undistributed profits imposed by section 14 of that act) without violating state statutes and the provision of a written contract executed prior to May 1, 1936.

The returns were not introduced in evidence. The deficiency notice indicates that the credits now sought were not claimed in the returns. The basis upon which they are claimed is that under the laws of Minnesota petitioner was prohibited from paying dividends in excess of 6 percent per annum and under its charter it was prohibited from paying dividends in excess of 5 percent per annum.

Since the filing of briefs the Supreme Court has settled the question now before us. It held that the section relied upon by petitioner "referred to routine contracts dealing with ordinary debts and not to statutory obligations", and that the mere fact that a corporation was prohibited by state law or charter provisions from distributing a portion of its earnings did not entitle it to the credit specified in section 26(c). Helvering v. Northwest Steel Rolling Mills, Inc., 311U.S. 46; Crane-Johnson Co. of North Dakotav. Helvering, 311U.S. 54.

While the cited cases completely dispose of petitioner's contention that it is entitled to the credit specified in section 26(c), there are other equally soned reasons why it can not be allowed. The statute merely limits the amount of interest which may be paid upon the paid-up capital. Such interest, for some purposes, is, no doubt,a dividend; but it is questionable, to say the least, whether a statutoryprovision making specific reference to "interest" could be construed to include "dividends." It is also not inappropriate to point out that petitioner's contention that the "net income" of a corporation is being "distributed", if sustained, would deprive it of the deduction of the amounts paid to its members or allocated to them upon its books; for such deductions may be allowed only upon the theory that the distributions were rebates upon the business of the members rather than income of the association.

Petitioner's claim for the credit it denied. No overpayment in tax has been established.

Other adjustments made by the respondent and not contested by petitioner are approved.

Decision will be entered under Rule 50.