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Form F.

R.

511(a)

TO_______ Mr. Lindholm
EROM______ Governor Eccle s

REMARKS:

I will appreciate it if you will go over
this letter and its two enclostores, and
let me have your views on them, particular­
ly on the point where he says "I cannot
see the difference between the earnings
of a co-op corporation and that of a private
tax paying organization11.
I will also appreciate your drafting a
reply for ray signature.

GOVERNOR ECCLES* OFFICE



0

N a t i o n a l Ta x E

q u a l it y

A

s s o c ia t io n

INCORPORATED

2 3 1 SO UTH

LA S A L L E S T R E E T

Chicago 4
GARNER M .LESTER
PRESIDENT

SETH

October 16, 1950

MARSHALL

C H A I R M A N OF T HE
EXECUTIVE COMMITTEE

VERNON SCOTT
VICE P R E S I D E N T

Mr. Marriner Eccles
Federal Reserve Board
Washington, D. C.
Dear Mr. Eccles:
This organization is very much interested in the state­
ments attributed to you which appear in the Chicago
Tribune as a result of your recent speech before the
Cooperative League of the United States.
There are a number of points mentioned in this publi­
city on which we would very much appreciate an ex­
tension of your views and we would, therefore, welcome
an opportunity for such a discussion with you.
After many years of careful research and legal study,
we have arrived at definite conclusions about this matter,
which are set out in the enclosed studies.
We hope that you will take the time to read these state­
ments and I have asked Mr. Vernon Scott, Vice-President
of our organization, to seek an appointment with you so
that these questions may be discussed.
Sincerely,

GML
ep




G. M. Lester

October 20, 1950.

Mr. G. M. Lester, President,
National lax Equality Association, Inc.,

231 South La Salle Street,
Chicago 4, Illinois.
Dear Hr. Lesters
I appreciated receiving your letter of October 16,
relative to my recent speech before the Cooperative League of
the United States and a copy of the studies your association
has made on taxing cooperatives.
I have not yet had time to go over the studies as I
am trying to get my desk cleared yrior to leaving for the Vest
this weekend. 1 am sure I will find them interesting. During
my absence I am having one of our Research men go over your
studies and give me his comments on it.
I will be glad to see your Mr. Vernon Scott some
time the latter part of November or the first part of December
when I expect to be back in Washington.
tyy address before the Cooperative League was ex­
temporaneous andj tnerefore, I do not have a written copy of
it. However, I do have a press release covering it with the
exception of what I said about taxing cooperatives. Thinking
you may be interested in seeing it I am enclosing a copy of the
release herewith.
Sincerely yours,

M. S. iccles.
Enclosure

VEsdls




How
cooperatives

ESCAPE
the

INCOME
TAX
N ational Tax Equality Association
231 South LaSalle Street • Chicago 4




A condensed statement about the
Federal income tax
exemption of
cooperative corporations,
its effect
and
the remedy.




How Cooperatives
Escape the Income Tax
The income-tax escape of cooperatives, mu-

tf~\ and other tax-exempt organizations and
ifL-iutions which are engaged in business activ­
ities in competition with taxpaying companies
has created a two-fold problem that seriously
affects the American economy:
1. Taxpaying concerns, in their competition
with tax-exempt competitors, are forced to
operate under the disadvantage of a Federal in­
come tax that ranged as high as 80 per cent
during World War II, has recently been 38 per
cent, now increased to 45 per cent and is about
to rise again to wartime levels.
2. The Treasury is losing more than $1 Bil­
lion a year of highly needed revenue.
Current changes in the law tax the business
earning of colleges, charities and labor unions,
but continue the tax freedom of cooperatives,
mutuals, building and loan associations and
Government owned corporations.
The simple justice of tax equality demands
that these must also be taxed.
LA R G EST T A X ESCAPE
Among the tax-avoiders, cooperatives have
grown most rapidly and their tax advantage de­
r i v e s the Treasury of the largest amount of
\ jbnue.
They were first legally exempted in 1916,
three years after the Federal income tax amend­
ment was adopted.
At that time, the tax rate was only one per
cent, the cooperative volume of business was
small, and the exemption was specifically lim­
ited to the marketing agents of farm groups.
In the next ten years, however, the character
and extent of the exemption changed almost
completely. In a series of amendments, pro­
moted by cooperatives and spurred on in many
instances by Treasury rulings that far exceeded
the law, the exemption was extended to pur­
1



chasing co-ops; the agency requirement was
abolished; co-ops were permitted to become
corporations, enjoying all the benefits of a
corporate entity, and encouraged to become
monopolies; they were allowed to set up re­
serves; they were given the right to do bu si^ ^
with 50 per cent of non-members without Ibsing their tax privilege.
EN O RM O U S ADVANTAGE
As the income tax rate increased the ad­
vantage of tax avoidance became greater. In
1942, at the beginning of World War II, Mr.
A. G. Black, then Governor of the Farm Credit
Administration, was able to say with great
accuracy that “...when taxes are absorbing a
large part of the earnings of private business,
the cooperative form of business really provides
an enormous advantage!’
In the four war years, the cooperatives prac­
tically doubled their volume of business—from
$5.4 billion in 1942 to $10.5 billion in 1945.
In the next four years, the co-op volume of
business again nearly doubled—to more than
$18 billion in 1949.
Largely, this stupendous growth is the result
of tax exemption, which has permitted the ultra­
rapid accumulation of capital and reserves out
of untaxed earnings, and the consequent in­
creases of facilities, often through the buying
out of taxpaying competitors.
TW O AVENUES O F ESCA PE
There are two ways by which cooperative
corporations are able to escape Federal income
taxes. Approximately half of all the farmers
marketing and purchasing cooperatives obtain
total exemption from income taxes by qualify­
ing for tax exemption under Section 101 (12)
of the Internal Revenue Code. This section
provides an absolute and outright exemption
from filing regular income tax returns and
from paying Federal income taxes to those
farmers cooperatives which meet the require­
ments of the section.

2


In order to qualify for this exemption from
filing returns or paying income taxes, the co­
operative corporations must conform to the
following requirements:
\

Basically, the organization must be a bona fide
Jm ers’, fruit growers’, or like association, organ­
ized and operated on a true cooperative basis.
( 2 ) All o f the voting membership, or voting stock,
must be owned by bona fide producers of agricul­
tural products, who market their products or pur­
chase their supplies through the cooperative.
(3 ) I f organized on a capital-stock basis, dividends
thereon shall not exceed 8 percent per annum on the
consideration for which the shares were issued, or
the legal rate o f interest of the State of incorpora­
tion.
(4 ) The volume of business done with non-mem­
bers must not exceed the volume of business done
with members, and, as to purchasing activities, the
volume o f purchases made for non-members, who
are not farmers, shall not exceed 15 percent of the
total volume.
(5 ) In the payment and crediting of patronage re­
funds, all patrons must be treated alike, whether
they be members or non-members. Absolutely no
preferential treatment can be given a member pa­
tron over a non-member patron in the distribution
or crediting o f patronage refunds.
(6 ) Reserves, if any, shall be limited to those re­
quired by State law, or such as are reasonable and
for any necessary purpose.

(7 ) Records shall be kept to show the patronage
refunds and credits o f all member and non-member
patrons, and, also, the interest of each member or
non-member in retained reserves or assets o f the
^ Jssociation.

The statute further provides that substantially
all of the voting stock must be owned by pro­
ducers of agricultural products, who market
their products or purchase their supplies and
equipment through the association. Preferred
stock may be owned by non-producers, with
the proviso that preferred shareholders shall
not participate in the assets or profits of the
cooperative in excess of the par value of the
preferred shares, plus accrued and unpaid
dividends.
Corporations qualifying for complete tax ex­
emption are called “tax-exempt cooperatives!’



3

An example of this type is Southern States Co­
operative of Richmond, Virginia, which does
business in a five-state area; operates through
seven subsidiary corporations, 107 retail stores,
10 freezer plants and 27 petroleum co-ops; has
assets of $18,800,000; made $1,865,000 p r f j
in 1949; has never paid Federal income tax.
“ N O N -EX EM PT ” CO-OPS
That half of the farmers cooperative corpora­
tions which does not operate in accordance
with the statute, the wholesale industrial co­
operatives, the urban consumers cooperatives,
and all other types of cooperatives which fall
outside the statute are classified as “non-exempt
cooperatives!’ They file income tax returns and
make the claim that they pay income taxes just
as private corporations do. The fact of the mat­
ter is, however, that they pay little or none of
the income taxes that an ordinary corporation
would pay. They are able to avoid all or nearly
all of their Federal income taxes because of a
tax loophole set up in the law by Treasury
rulings.
The Cooperative Grange-League-Federation
Exchange of Ithaca, New York, and the Con­
sumers Cooperative Association of Kansas City
are examples of big cooperatives that have given
up their total exemption and are now paying
some tax, though by no means as much as
regular corporations pay on the same p r o ^ J
D IFFE R E N C E A PPEARS
A cooperative corporation carries on its busi­
ness operations in the same manner as any other
business corporation. At the end of its fiscal
year it determines its net profits and out of them
sets aside sums for capital reserves and pays
dividends of not more than 8 per cent on out­
standing capital stock. The difference between
a cooperative corporation and ordinary corpo­
ration appears at this point. The regular cor­
poration can pay any amount it pleases as
dividends on outstanding capital stock. The
cooperative corporation in accordance with

4


charter provisions, or its by-laws, or the agree­
ment which it has entered into with its mem­
bers, pays limited dividends on its capital stock
and is obligated to distribute the remainder of
jKprofits to its patrons in a manner proporf pil to the amount of business they have done
with it.
The Treasury Department with what has
been called in Congress and the courts “great
liberality” allows cooperative corporations to
deduct or exclude from their taxable income
the amounts thereof that are allocated or dis­
tributed as a dividend on patronage in accord­
ance with the provisions of their charter, by­
laws or contracts. No law passed by the Con­
gress allows the deduction or exclusion of pat­
ronage dividends from the taxable income of a
cooperative corporation, however, the Treasury
Department justifies its failure to tax this in­
come upon the ground that it represents a
rebate or an additional cost of goods sold.
In 1937, a Treasury ruling referred to as
G.C.M. 17895, C.B. 1937-1 p. 56 was promul­
gated which sets forth the attitude of the Treas­
ury Department:
“So-called patronage dividends have long been rec­
ognized by the Bureau to be rebates on purchases
made in the case o f a cooperative purchasing organ­
ization, or an additional cost of goods sold in case
of a cooperative marketing organization, when paid
^ \ v i t h respect to purchases made by, or sales made on
account o f the distributees. For purposes of admin­
istration o f the Federal income tax laws, such dis­
tributions have been treated as deductions in deter­
mining the taxable net income of the distributing
cooperative organization. Such distributions, how­
ever, when made pursuant to a proir agreement be­
tween the cooperative organization and its patrons
are more properly to be treated as exclusions from
gross income of the cooperative organization. (I.T.
1499; S.M. 2595; G.C.M . 12393.) It follows, there­
fore, that such patronage dividends, rebates, or re­
funds due patrons of a cooperative organization are
not profits of the cooperative organization notwith­
standing the amount due such patrons cannot be
determined until after the closing of the books of
the cooperative organization for a particular taxable
period ”




5

Because of this Treasury practice, income tax
must be paid by a non-exempt cooperative only
on such small amounts as are paid in dividends
on stock and on reserves which are retained
without being allocated to patrons. It is, there­
fore, the general practice of non-exempt
city co-ops to pay out practically all profits m
tax-free patronage dividends.
NO BASIS IN FACT
Since it is corporate net income which, when
distributed on a patronage basis, gives rise to
the “patronage dividends^ the Treasury posi­
tion has no basis in fact. Dividends on capital
stock are paid out of profits first and only when
there are profits left over can the cooperative
corporation distribute them as patronage divi­
dends. The refusal of the Treasury to recognize
patronage dividends as profits has no rational
justification. An examination of the operations
of a cooperative shows that patronage dividends
are distributions of over-all profits which arise
from all the business transactions entered into
by the corporation. Sometimes these profits
arise from transactions wholly unrelated to
business done by members, such as bringing in
oil wells, or selling facilities for a large capital
gain, or receiving rents from the storage of
government wheat
T A X -F R E E EXPANSION
^
The reason for the tremendous growth
cooperative corporations is that they are able
to expand on tax-free income. Cooperative
leaders claim this is not the case because Sec­
tion 101 (12) of the Internal Revenue Code
requires cooperatives to turn back to their mem­
bers all net proceeds remaining after setting up
reserves. The Treasury Department rulings
allow only those profits to escape taxes which
are distributed as patronage dividends. If co­
operative corporations are required to return
net proceeds to their members or to distribute
profits as patronage dividends, how can they
retain them for business purposes?

6


The answer is that it is not necessary for the
avoidance of income taxes that the distribution
of corporate income on a patronage basis be
made in cash; it is sufficient if the money is al­
located to the patrons on the books of the corr f ^ i o n and the corporation keeps the money
foi Expansion purposes. Payments may also be
made in stock, scrip, or other evidence of
equity which does not require an actual distri­
bution of cash.
Many big cooperative corporations have car­
ried on a pyramidical accumulation of untaxed
earnings for years until they have become dom­
inant m their industries. As they grow they buy
out their large ,and small competitors taking
them off the tax rolls too and paying for them
with .money that other xmporations would be
required to use for income tax purposes.
FA L SE CO M PRO M ISES
Frequently a compromise solution to the
co-op tax controversy is put forward whereby
cooperative corporations would be subject to
Federal income taxes cm all retained earnings
and profits except those distributed as cash
patronage dividends. Such a proposal is mean­
ingless as far as it accomplishes real tax equal­
ity. In fact, such a compromise or any si m alar
to it would offer no solution at all in most in­
stances and very little in others. In other words,
i^ s not a compromise, but rather is a fallacious
^ £ r o a c h both in prinicple and as to practical
result.
The Treasury department, itself, in a study
of this oft-proposed “compromise” stated:

“...A requirement that non-cash distribu­
tions o f patronage dividends be included in the
income o f cooperative associations, while cash
dividends were excluded , would not prevent
cooperatives from building up substantial
amounts o f capital out o f earnings not taxed to
the associationV
The reason is that the courts and the Treas­
ury are disposed to rule that the issuance of
such things as “scrip,” certificates of indebted
7


ness, stock, or merely credit entries on the
books of the cooperatives are the same as a dis­
tribution of cash and the reinvestment thereof
by the recipient. Hence, under such a “com­
promise” the cooperative would merely issue
such items in lieu of actual money to pa^^y
and keep the cash, tax-free, for any purpose To
which it desired to put it. In fact, many coopera­
tives follow this identical practice today under
present laws and regulations. The “compro­
mise” would not affect them and most other
co-ops could follow the same plan with little or
no difficulty. Cooperative spokesmen agree that
such a law would have little or no effect on their
present ability to escape income taxes.
N O T A B LE E X A M P L E S
A notable example of the way cooperative
corporations expand on tax-free income is
found in the Farmers Union Grain Terminal
Association. This cooperative corporation be­
gan operations in 1938 with $30,000 of cap­
ital. During the ten succeeding years it in­
creased its net worth to a total of $17,012,313
or 566 times its original capital. Practically all
of this increase in net worth was built up
through the retention of untaxed earnings.
In its process of growth it has bought out one
big line elevator company and it now owns
lumber yards, a flour mill, feed mills and other
enterprises on whose earnings no income
is paid.
V
Other big co-ops, too, have bought out large
and small competitors, paying for them out of
tax-free earnings and taking them off the tax
rolls in the process. And numerous concerns
have voluntarily shifted from taxpaying status
to cooperative tax-free status—admittedly for
the sole purpose of avoiding taxes.
*

*

*

In the case of the Consumers Cooperative
Association of North Kansas City, Missouri,
net worth grew from $251,849 at the close of
1935 to $7,321,867 at the close of 1945. Again,

8


most of the increase in net worth was built up
out of retained earnings that escaped Federal
income taxes.
During the four years of World War II, co­
operatives did a total volume of business
a ^ ^ n tin g to nearly $ 33 ,000,000,000 escaped
Federal income tax of about $855,200,000 fig­
ured at regular rates.
AMOUNT O F T A X ESC A PE
Much of this $855 million of unpaid income
tax, along with a major proportion of the taxfree profits themselves, was retained in the co­
operatives’ businesses by the simple device of
issuing scrip or allocating book credits to pa­
trons in place of money. That’s how cooperative
business has grown so fast.
Profits from their present volume of busi­
ness are estimated at about $875,000,000 a
year, on which the Federal income tax would
be about $320,000,000 at the regular corpo­
rate rates of 21 to 35 percent.
(Add $50,000,000 or more to the find the
co-ops’ tax liability under the new rates of the
first war-time tax bill.)
CO -O P B U SIN ESS VOLUM E
In 1948, cooperative business volume
reached a total of nearly $17 billion, as follows:
Farmers Marketing Co-ops at local lev el.. .$6,989,919,500
Farmers Purchasing Co-ops at local lev el.. 1,858,080,000
Manufacturing Co-ops ..................................... 1,296,231,926
#*%Dlesale Co-ops .............................................. 1,296,231,927
V^Amission Business ........................................ 3,752,471,978
Consumer Cooperatives ............. ..................... 1,020,740,100
Retailer-owned Cooperatives........................
595,400,000
$16,809,075,431

To promote the ideology of cooperation and
to protect the various statutory advantages that
have been secured, several big and powerful
organizations have been set up, skillful at­
torneys and lobbyists are employed, the assist­
ance of the farm bloc in Congress has been
wooed and won, political strength has been
developed all the way from the Nation’s Capital
to the grassroots, and a language of economic
doubletalk has been created to confuse the
issue.

9


Cooperative leaders use this, double talk in
order to justify their unfair tax privileges to the
public. We have seen how profits are “distri­
buted” by keeping the profits in the corporation
and making book entries allocating th enito
patrons. Similarly when a co-op leader
about the profits of a cooperative, they are
likely to be very low because he has excluded
therefrom the profits that have been distributed
as dividends on patronage. Co-ops like to con­
ceal the fact that they are escaping income taxes
by calling their profits “savings” “net margins”
“rebates” “price adjustments” “over-deposits”
and other terms which camouflage the fact that
their corporate profits are unfairly escaping
income taxes.
Most cooperatives are corporations because
of the protection that corporate set-up gives to
officers and members. For tax purposes—and
for tax purposes only—they like to call them­
selves “partnerships” which they are not.
In the first place, they have none of the per­
sonal liabilities of a partnership. In the second
place, a cooperative corporation is a corpora­
tion and it would be most unfair if such corpo­
rations were enabled to avoid corporate income
taxes and only be taxed on a partnership basis.
However, they have tax advantages over part­
nerships too.
The opinion of the staff of tax experts of
Congressional Joint Committee was explaiireSr
in a report to the House Ways and Means Com­
mittee during consideration of the current tax
bill as follows:
“ Cooperatives now have a tax advantage over both
corporations and partnerships. M oreover, this ad­
vantage is not merely due to the fact that corporate
earnings paid out as dividends are subject to double
tax. A tax must be paid by a corporation on earn­
ings retained for expansion, and even though there
is no double tax involved in these particular earn­
ings so long as they are retained, the tax that is paid
decreases the funds available for expansion are
likely to be depleted by the amount of the tax which
the partners must pay. on these earnings. In the case
o f the cooperatives, however, this is not the case”

10



F A L S E JU S T IF IC A T IO N
Cooperative leaders frequently attempt to
justify their tax privileges upon the ground
that their corporations act merely as agents for
their members. This claim has no foundation in
fa^jEooperative corporations make no attempt
to act as mere agents. They buy and sell for
their own account, not that of principals. They
commingle transactions, take title in their own
name, buy from and sell to members and non­
members, make purchases, sales and other de­
cisions without consulting members. They do
not account to each member for the profit and
loss incurred in carrying out particular business
and they are not reimbursed by their members
for losses incurred. In other words, they act in
the same manner as any other corporation.
Cooperative leaders claim that by anticipa­
tory arrangements and contracts, their corpo­
rations have a legal obligation to turn over
their profits to their members and that, there­
fore, it would not be constitutional to tax their
income to them. They conveniently overlook, in
their argument, the fact that the Supreme Court
of the United States had held time and time
again that income taxes cannot be escaped by
“anticipatory arrangements and contracts how­
ever skillfully devised!’
The cooperative statement that “we pay all
taxes” applies generally to local taxes, but
CZBts payment of Federal taxes on all income
and at full rates. In states that have state net
income taxes, they escape these also.
T A X W IL L NOT D E S T R O Y
Paying full Federal income taxes would not
destroy any cooperative, any more than it de­
stroys competing businesses.
Neither NTEA nor any other organization
seeking tax equality aims or desires to “kill the
cooperative movement!’ The sole objective is
tax equality.
In the opinion of eminent tax attorneys, in­
cluding Mr. Randolph E. Paul for the Farmers
Union Grain Terminal Association, it would

11


not be unconstitutional to impose income tax
on the earnings of cooperatives.
In order to correct the present tax injustice,
two things will have to be done: First, it will be
necessary to repeal Section 101 (1 2 ) and 101
(1 3 ) of the Internal Revenue Code be<#|p
these sections grant absolute tax-exemption to
cooperatives and corporations organized by
them to finance co-op corporations. Second, it
will be necessary to close the tax loopholes
created by Treasury rulings. This can be done
by a law making it clear that cooperative corpo­
rations are to be taxed like other corporations
on their full income, including that part of their
income which is subsequently distributed as a
dividend on patronage. H. R. 5064 which was
filed by Congressman Noah Mason of Illinois
would bring about tax equality by accomplish­
ing these two steps.
This is the only way by which tax equality
can be brought about. Any so-called com­
promise, such as the “cash dividend” com­
promise previously outlined, is utterly mean­
ingless.
Probably the chief reason why Congress has
failed so far to close the cooperative tax loop­
hole and end this obvious injustice is politics.
Three decades of co-ops lobbyists have ca­
joled and threatened the members of Congress,
demanding their continued support of tax ex­
emption as the price of the farm vote.
1 }
Only recently has it been disclosed that co-op
political power is actually exceedingly thin.
Testifying before the Senate Finance Com­
mittee in opposition to the Treasury requested
withholding tax on patronage dividends, Mr.
Karl D. Loos, attorney for three big co-op
groups, presented his own careful calculation of
929.000 payments of patronage dividends.
Of these, 563,000 were for less than $1 and
285.000 were between $1 and $10. In other
words, 91.4 percent of these payments were
for less than $ 10 .
Further, Mr. Loos revealed that the recipients
12



of the 8.6 percent of patronage dividends
amounting to more than $10 collected 76 per­
cent of the profits paid out by the co-ops.
Economically, it is interesting to learn that
so large a part of the profits of cooperative
by^pss is paid to so very few members.
Politically, it is highly significant that the
great number of farmer-voters get so very little
value from cooperative membership, and that
the chief beneficiaries of the system are so few
in number as to be politically impotent.
It is evident that no Congressman has much
to fear from threats of cooperative reprisal!
CO -O PS ESCAPED T A X IN
TW O W ORLD W ARS

*

*

*

IT M U ST NOT H A PPEN AGAIN
The cooperatives were given their first tax
exemption just before the U. S. went into
World War I.
They made their biggest gains in World War
II, when they paid little or no tax on earnings
while other corporations were paying up to 80
percent.

That must not happen again!
This time, cooperatives and all other tax
exempts must share the costs of war by paying
full income tax on all their earnings.
Neither political fears nor economic doubleshould be permitted to continue tax exption for any business.
In the very next tax bill considered by the
Congress the cooperatives must be taxed.
No one can be allowed to make tax-free
profits, especially in wartime!
*

*


13


*

A dd itio n a l copies o f this
booklet are available at
no cost fro m the

N A T I O N A L T A X E Q U A L I T Y ASSOCIATION
231 South LaSalle Street




•

Chicago 4

This file contained a copyright-protected article that has been removed.
The citation for the original is:
Adcock, Albert W. “Patronage Dividends: Income Distribution or Price Adjustment,” Law and
Contemporary Problems, Summer 1948, Vol. 13, No. 3, pp. 505-525.




HOP/ PAKTHi-aSHIPS AHE TAXED

A partnership is not a legal entity separate and distinct from its
partners* The income tax law regards the partners as businessmen who are work­
ing together, each of whom is taxable upon his distributive share of the net
income of the partnership, whether distributed or not,
flection 181 of the Internal Revenue Code states:
"Individuals carrying on business in partnership shall be liable
for income tax only in their individual capacity."
This means that partners are obliged to report as an item of their
income from all sources (partnership and non-partnership) their distributive
share of the net income of the partnership of which they are members. Whether
or not there is actual distribution of profits is immaterial. This process of
taxing the partners of a partnership has been called looking through the fic­
tion of the partnership /Helvering v. Waldridge, CCA 2 (1934) 70 P. (2d) 6$3>
cert, den, 293 U, 53, 59^.
Under present law, partnership income in computed under the same
provisions as those applicable to Individuals, with the following exceptions:
(1)

Capital net gains and losses of the partnership are segregated
fron ordinary net income and carried into the income of the
individual partners. There they are treated in the same manner
as other capital gains and losses of an individual.

(2)

Charitable contributions, etc. of the partnership are not allow­
able in computing partnership income, but each partner deducts
his distributive portion of such contributions in his individual
return.

The general rule for the taxing of partners is to include in comput­
ing the net income of each partner, whether or not. distribution is made to him,
(a)

his distributive share of the net short-term and long-term
capital gain or loss and

(b)

his distributive share of the partnership net income or the
ordinary net loss of the partnership computed as specifically
provided in the statute.

The partners may take the profits in whatever form and manner and in
such proportions as they may agree upon, asaisilng an arm's length agreement. The
statute holds each partner accountable for the tax upon his proportion of the
profit*.




—2 —

The statute foXlowi the general principal of treating a partner's
distributive si are of partnership income on the same basis aa income received
by him individually and of allowing every deduction from partnership income
which he mif:ht take from his individual income, unless the contrary clearly
appears in tho statute /Cralk v, U. S». 31 H. r>upp., 132 (19AO)_7*
Although partnerships ac such ?.re not taxable, a number of special
rales apply to the taxation of the partner thereof. The difficulties in con­
nection with the treatment of partnerships and their members relate sometimes tos
(a) the period in which the partner*s distributive share is to be
included in income
(b)

the complications arising when a partnership is dissolved by
death or otherwise, and

(c)

cas^lications resulting from the use of different methods of
accounting of the partner and its members, as where the part­
nership is on the accrual basin and the partner is on the
cash basis•

If the taxable year of a jiartnership is different from that of a
partner, the share of the firm’s income to bo reported by a member thereof is
based upon the incone of the partnership for any taxable year of the partner­
ship ending within the nomber's taxable year.
*?hen a moatoer of a i>artnership dies, his distributive share of the
income to the date of his death should be included in the return of his income
to the date of his death.
A partner must report his distributive share of tho net income of the
firm, despite tho fact that he any employ an accounting basis (cash receipts)
different from that of the partnership (accrual basis).
Salaries paid to partners are not treated as such but are returned as
part of partnership profits. The same is true of interest on capital contri­
butions.
There are other rules relating to particular situations, but I think
the above are sufficiant to present a picture of how partnerships are treated
under the Internal lievenue Code.
What itelationshlp txrtxeen Individuals Constitutes a Partnership for Tax Purposes
The Code iknd the Revenue Acts, since 1932, define the term ’♦partnership"
as including:




". . . a syndicate group, pool, joint venture, or other unincorporated
organisation, through or by means of which any business, financial
operation, or venture, carried on, and which is not, witldn the

-3 -

raeaning of this title, a trust or estate or n corporation".
/ T . R . C . , fiectian 3797 (a) (2) J .
For purposes of Federal taxation, the Internal Revenue Code makes its
own classifications and prescribes its own standards for qualification as a
"partnership". The tern '’partnership” as used in the statute is not limited to
its common-law cleaning, but is broader in scope anti includes groups not commonly
called partnerships. The statutory definition is not an exclusive definition.
One must explore the common-law, the various uniform partnership laws, and
decisions under the various Revenue Acts, and resolve many virtually irreconcil­
able decisions, ^ho rules of law determining whether a partnership may or does
not exist are in confusion, and factually the existence of a partnership is
often "problematical and difficult to determine" /if. N. Duchanan v. Comm.,
20 BTA, 2107.
There is no one test to apply to determine whether or not a given
association is a partnership; however, the following tests are among those
frequently applied:
1.
The profit-sharing test. There must be a mutual interest in
the profits. In Howard Coombs v. Comm., 20 UTA, 1021, the Board of Tax Appeals
on page 1025 quotes from lieehan v. Valentine, 145 U. f>. 611, as follows: *
"The requisites of a partnership are that the parties must have
joined together to carry an a trade or adventure for their common
benefit, each contributing profit or services, and having a commun­
ity of interests in the profits.”

2m The mutual liability test.
for all the debts of the partnership.

Kvery partner must be personally liable

3. The mutual agency test. The common-law type of partnership has
been defined as "a business organisation in which every partner possesses full
power and absolute authority to bind all the partners by his acts or contracts
in relation to the business of the firm, in the same manner and to the same
extent as if he held full power of attorney from them (letter from the Treasury
Department dated January 19# 1916).
4* The common contribution teat. A contribution by all partners
concerned of assets to the partnership. This test is of slight value, since
one partner may contribute services only.
5* The service contribution teat. It is customarily for all partners
to contribute services to the partnership. It must be remembered, however, that
there may be Inactive partners.
6. The alienability of interest test. The rights of a partner in
a partnership are determined by a personal contract sand are nan-alienable.
A partnership is a matter of contract but no particular form or con­
tract is necessary to its creation. A partnership may exist without any formal
agreement. It may be oral. In determining whether or not a partnership exists,




-4 -

courts consider evidences of conduct and circumstance and, after a consideration
of all the evidence and all the partnership tests, comes to a decision. Ho
rigid rule is applied. The particular facts are considered in the light of
partnership lav? and a conclusion is reached which may or may not follow precedence.
When does a Partnership become subject to Corporate Income Taxes?
A partnership is taxed like an association or corporation when it
conducts its business so as to obtain for itself the advantages that go \iith that
form of doing business. The main factors to be considered as set out in the lead­
ing case on this subject, Morrissey et al Trustees v. Comm.» 296 U. S. 344 (1935)
are:
1.

Centralized management.

2*

Title to property in trustees or agents with provision for
succession.

3 . Security from termination of association by death of a beneficial
owner*
4*

Facility of transferring the beneficial interests without affecting
the continuity of the enterprise.

5.

Limitation of personal liability.

The limitation of personal liability is particularly important.
A question may be raised about so-called "limited partnerships".
These may be taxed as ordinary partnerships or as corporations, depending on
their character. Heg. 1Q3, Section 19*3797.5 of the Internal Revenue Code states:
"If the organization is not interrupted by the death of a particular
partner or by a ch ange in the ownership or his participating interest,
and if the management of its affairs is centralized in one or more
personn acting in a representative capacity, it is taxable as a cor­
poration"*
An association taxable like a corporation is defined in the regula­
tions as follows:
(Heg. 103, Sec. 19*3797-2)




"The term 'association' is not used in the Internal Revenue Code
in any narrow or technical sense. It includes any organization
created for the transaction of designated affairs, or the attainment
of some object, which, like a corporation, continues notwithstanding
that its members or participants change, and the affairs of which,
like corporate affairs, are conducted by a single individual, a
committee, a board, or some other group, acting in a representative
capacity* It is immaterial whether such organization is created by
an agreement, a declaration of trust, a statute, or otherwise. It
includes a voluntary association, * * * a partnership association,
and any other type of organization (by whatever name known) which
is not, within tho meaning of the Code, a trust or an estate, or

a partnership. * * *"

- 5-

The Morrissey Case, supra., indicates the features which make an
association taxable as a corporation, but it does not indicate hew many of the
attributes are indispensable. From subsequent decisions, it may be gathered
that the question is still one of degree, that one or more of these attributes
may be absent without affecting the determination thnt the organization was
sufficiently analagous to corporate organization to justify the conclusion that
Congress intended that the income of the enterprise should be taxed in the sane
manner as that of a corporation.
The difference between corporations and partnerships must be kept in
mind when determining whether a given bonier line organization is more like a
corporation and co should be taxed as such or, more like a partnership and so
should be taxed as such. In making this decision, the following distinctions
are usually kept in mind by jucges making the decision:
1. A corporation continues until it is dissolved by law arid so the
continuity of its business is a certainty. A partnership is for an agreed term,
within which death may intervene and dissolve the business. Continuity of its
business is uncertain, since death may terminate it.
2. A corporation has an entity separate and distinct from its stock­
holders. xt has the right to sue and be sued and to hold and deal it property
as a separate entity. A partnership has no entity separate from its personnel
and Use individual members of a partnership are responsible for its every activ­
ity.
3. The stockholders of a corporation are exempt from the liabilities
of the corporation. In a partnership, each member is individually liable for
all the obligations of the partnership, notwithstanding agreements to the con­
trary between the partners and regardless of the capital contributions made by
various partners.
4. Stock certificates are ordinarily transferable to strangers. Own­
ership interests are thus very readily transferred. In the partnership, the trans­
fer of a partnership interest affects a new partnership. The consent of the other
partners is necessary plus involved arrangements to provide against the former
members continuing liability for partnership debts.
5. A corporation has groat ease in obtaining; capital by the sale of
stock or bonds. A partnership can secure new and necessary capital only by loan
or by remaking the partnership or upon contributions of its members.
6. A majority of the Board of Directors assures prompt and timely
business action by the corporation. Partnership action is usually dependent
upon the unanimous agreement of its membership, and In addition to material
objectives, problems of disagreements, unity of policy, and difficult personnel
equations may be involved.




—6 —

7. fltock certificates may be used as collateral.
nerships are not ordinarily pledgible for loans or cr«dit.

Interests in part­

8. Stockholders do not directly share in the responsibility of manage­
ment. Investment in a partnership involves responsibility for management and
a participation therein.
9. A corporation is a creature of the state from which its powers are
received. A partnership is a contractual relationship between individuals, with­
in, which the members ordinarily possess the power to do, in business, what in­
dividuals can and usually do in such business.
Applying the above nine teats to a given organization usually re­
solves the question as to how it should be taxed. If it more nearly resembles
a corporation than it coes a partnership, the association itself is regarded as
an entity whose income is subject to tax and that same income is taxed again
in the hands of individuals receiving distributions thereof as dividends.
If the organization is more like a partnership than a corporation,
each member thereof is taxed for his proportionate share in the partnership
income, whether distributed or not. Salaries paid to members are disregarded
and are included in the full income of the partnership to be taxed to the part­
ners individually as if distributed in the proportions fixed by the partnership
contract.




BOARD OF GOVERNORS

or THE
FEDERAL RESERVE SYSTEM

Office Correspondence
. _____ Governor Eooles_____________

From___ R. W. Lindholm_____________

Date November 1, 1950.
Subject; Comments on three enclosures
sent by the National Tax Equality
Association.

The tax analyses prepared for the National Tax Equality
Association, Ino. by Mr. Lester and Mr* Adcock are not a compromise
of the cooperative tax problem such as have been advocated and reached
in a number of countries. The recommendation is that all earnings in­
cluding what is classified as patronage dividends be taxed to the co­
operative in a manner similar to corporate earnings. This "solution”
would undoubtedly raise the maximum amount of revenues from cooperatives
and would eliminate any complaints from corporations that cooperatives
were undertaxed. In doing this, however, it would be necessary to
eliminate consideration of one major difference between cooperatives
and corporations which does exist despite disclaimers; namely, the
portion of cooperative earnings correctly labeled patronage dividends
are paid on the basis of business done with the cooperative while
corporate dividends are paid on the basis of shares of stook owned.
This difference is too fundamental to be exoluded entirely from con­
sideration in writing tax legislation.
As the cooperative movement has developed and corporate tax
rates have increased the tax advantage of the cooperative method of
organizing eooncudc activity has beoome widely recognized as worthy of
attention by businessmen and Government offioials. It, however, is not
the only and more than likely not the largest of existing tax loopholes.
The National Tax Equality Association to live up to the purpose indicated
in its name should also be making studies to show the tax avoidanoe of
insurance ccanpanies, oil companies, educational and charitable eoonomio
activities, and the like.
The position taken in the NTEA literature has the publicity
advantage of being simple and direct — treat patronage dividends as
earnings subjeot to the corporate income tax. It also has the inherent
disadvantage of avoiding complicating realities — of simplifying tax
proposals to increase public appeal.
A preferable approach would be to accept the basic idea of the
cooperative plea that patronage dividends are different from regular
corporate earnings. Then it should be pointed out that the recognition
of this fact does not also necessitate tax exemption of cooperative
earnings not paid out in dividends to patrons, nor does it also follow
that patronage dividends should be tax-exempt if they arise from earnings
on activities not closely associated with purchases or sales made for the
patron. Finally, it oan be emphasized that there is no relationship
between the recognition that patronage dividends should be tax-exempt
and the exemption of dividends paid on cooperative capital stook.




December 6, 1950.

Hr. G. M. Lester, President,
National Tax Equality Association, Inc.,
231 South La Salle Street,
Chicago 4-, Illinois.
Dear Hr, Lester:
In response to your letter of October 16,
relative to a speech which I made before the Coopera­
tive League of the United States, I advised vou in ay
reply of October 20 that I would have one of our Resee rch men go over and give me his concents on the
material which you sent to me.
Our tax man on the staff ha3 gone over the
material and given me a very brief memorandum on your
three studies. Thinking you may be interested in his
comments I am enclosing herewith a copy of his meraorrandum.
Sincerely yours,

M. S. Eccles.

Enclosure
VEfdls




Comment on a Memorandum Prepared for M. S. Eccles

The essential point made in the comment prepared for Mr. Eccles is
that:
“ . . . the portion of cooperative earnings correctly labeled
patronage dividends are paid on the basis of business
done with the cooperative while corporate dividends are
paid on the basis of shares of stock owned. This differ­
ence is too fundamental to be excluded entirely from con­
sideration in writing tax legislation. ”
Is this difference really “ too fundamental’'? It is true the corporate
profits of the cooperative are not distributed on the basis of stock­
holdings; but why should this difference in the pattern of distribution
affect corporate income tax liability? It is a well established law
that:
“ A distribution of profits may be made on a basis other than
stock holdings and still be a dividend distribution” Juneau
Dairy Inc. vs Commissioner 44 B. T. A. 759.
With other corporations the income tax applies to earnings regardless
of the pattern in which they are distributed. They may be put into a
special reserve fund or distributed to stockholders, or put into work­
ing capital, or any number of things.

Under the income tax law, how­

ever, the earning of the profit determines the income tax liability, and
that tax liability is not changed by the subsequent use of the funds.
Why should it be any different with cooperative corporations?

Cooperative spokesmen point out that their payments to members are
made pursuant to a contract and that they call them “ savings” instead




of profits.

The courts, however, say:

“ Payments by a corporation to its shareholders pursuant to a
contract may constitute dividend distributions notwithstand­
ing that they are labeled expenses or something else”
Ingle Coal Corporation vs Commissioner 174F (2d) 569(1949)
In the above case royalty payments were subjected to corporate income
taxes even though royalties are ordinarily deducted as business expen­
ses.

The distribution of corporate dividends to customers rather than stock­
holders would have more significance in the case of cooperative corpor­
ations if the two groups were not substantially the same.

The fact of

the matter is, however, that the profits distributions to the customers
of a cooperative are in the main also distributions to members and
shareholders, because cooperative corporations deal principally with
their members.

The reason the stockholders of a cooperative corpor­

ation do not object to their corporate profits being distributed under
the guise of price adjustment to customers is that the shareholders
are the customers and it makes little difference to them whether the
dividend they receive is on stock ownership or on patronage.

It must be remembered that when members of a cooperative corpora­
tion adopt by-laws directing that the corporate profits be distributed
to them as a dividend on patronage, they are not contracting with a
stranger.

The agreement is made by the shareholders with an entity

of t h e i r own creation, a n organization operated and controlled by
them. They may decide that the corporate profits shall be distributed
to them on s o m e basis other than stock ownership, but that does not



-2 -

alter the fact that the distribution is being made to shareholders; hence
the difference in pattern between distribution of a cooperative corpora­
tion and an ordinary corporation is not as “ fundamental” as it might
seem at first glance.

The memorandum prepared for Mr. Eccles states that a “ profitable
approach” to taxing the income of all corporations alike would be to
continue t o allow the corporation income of cooperatives to escape
federal income taxation when it is distributed as dividends on patron­
age, but to narrow this tax loophole.

The difficulty with this approach

is that after such legislation has been passed, the cooperative corpor­
ations, by exercising a little ingenuity, would still be able to have
their income classified as, tax exempt and would therefore continue to
be unfair competition for fully taxed businesses.




- 0O0-

N a t i o n a l Ta x E q u a l i t y A s s o c i a t i o n
I NCORPORATED

231

SOUTH

LASALLE

STREET

C h i c a g o -4
G A R N E R M. L E S T E R

December 12, 1950

PRESIDENT

SETH

MARSHALL

C H A I R M A N OF THE
EXECUTIVE COMMITTEE

VERNON SCOTT
VICE P R E S ID E N T

Mr. M.S. Eccles
Board of Governors
Federal Reserve System
Washington, D.C.
Dear Mr. Eccles:
Thank you very much for your letter of December
6, 1950, enclosing the comments of the tax man
on your staff wi t h respect to the enclosures we
previously sent to you,
I note that the comment states that if the National
Tax Equality Association l i v e d up to its name it
should also be making studies relative to the t a x
disparities of various insurance companies, educa*
tional and charitable economic activities, and the
like. The fact of the matter is that the National
Tax Equality Association has been making such
studies but did not send such material to you inas­
much as our correspondence resulted from a
speech which you made before the Cooperative
League of the United States and these other mat­
ters were not involved.
I asked our general counsel, Mr. A. W. Adcock,
to briefly comment on the comments you sent me
and I am enclosing his memorandum on them. I
think you will be interested in the points he brings
out.
Cordially,

gml
ep



G. M. Lester
President

January 17, 1951

lft% G. M. Lester, President,

National Tax Equality Association,
231 South La Sail# Street,
Chicago h» Illinois*
Dear Ir. Lester*
I sm glad to have tha oosments of your lottor of
Dcccaber 12, 1930, and tha attaohod memorandum prepared by
your general counsel, Mr* A* V* Adcock. It ia useful to
know that you are working on a number of aspects of the tax
equality question in addition to the cooperative problem.
The position taken by Hr* Adoock on the difference
between patronage dividends and investment dividends is a
legal one related to lsbels attached to buaineas distributions*
These points are well taken but the fact remains, even deapite
court deeiaions, that a fundamental econonic difference exists
between dividends based on patronage and dividends based on
investment. However, It is also true that patronage dividends
paid from receipts arising from activities other than the
recipient's patronage and patronage dividends not paid in
cash fall outside the scope of the economic concept of
patronage dividends to which I refer. This difference
should be recognised in tax legislation. I believe that
it should be possible to take account of both sound economic
and legal differences in tax legislation in a practical and
workable fens*




Sincerely youra.

M» 8. fiscles.

N a t i o n a l Ta x E q u a l i t y A s s o c i a t i o n
INCORPORATED

231

SOUTH

LASALLE

STREET

Chicago 4
G A R N E R M. L E S T E R

January 24, 1951

PRESIDENT

SETH

MARSHALL

C H A I R M A N OF T H t
EXECUTIVE COMMITTEE

VERNON SCOTT
VICE P R ES ID EN T

Mr. M.S. Eccles
Board of Governors
Federal Reserve System
Washington, D. C.
Dear Mr. Eccles:
Thank you for your letter of January 17th.
I am deeply appreciative of two things; first, that you
would take the time, busy as you are, to maintain cor­
respondence with me on the subject of tax equality,
and second, 1 am mindful of your open minded attitude.
Attached are two enclosures; one is the article from
the Michigan Law Review by Roswell Magill, former
under secretary of the Treasury, and the other is a
statement by Professor Guthmann of Northwestern
University. Each of these gentlemen cover the points
mentioned in your letter with respect to their belief
that the income of co-ops is the same for tax purposes
as that of any other corporation.
\ I would appreciate it very much, if you do not have the
time to go into this yourself, that you refer it to your
research staff. We would be very much interested in
their views as well as your own, with respect to the
opinions advanced by these gentlemen.
Personally, 1 cannot see any difference between the
earnings of a co-op corporation and that of a private
tax paying organization. I believe the Treasury and
the Courts have ruled time and time again that the tax­
ability of income is determined by the way it is earned
and not by the manner of its distribution.


gml
http://fraser.stlouisfed.org/
ep
Federal Reserve Bank of St. Louis

February 13, 1951*
Hr* G. M* Lester, President,
National Tax Equality Association, Inc.,

231 South La Salle Street,
Chicago h9 Illinois*
Dear Mr* Lesters
Thank you for forwarding to me the discussions of the
desirability of taxing cooperative patronage dividends* Both of
the papers have been carefully prepared and ahov an understanding
of the problems related to the treatment of cooperative patronage
dividends for income taxation purposes* The general conclusion of
both able studies is to substantiate the opinion I previously ex­
pressed} nmoly, that cooperative tax burdens should be increased*
It nay be a desirable practical program in reaching this goal to
advocate taxing cooperative patronage dividend payments at the
regular corporation income tax rate and then compromise vlth the
taxation of only retained earnings and these earnings paid as
dividends on preferred stock* However, in using this approach
it should be fully realised that the foundation of the argument
is open to serious attack*
The basic point of both papers is that the cooperative
arrangement is merely a method of reducing taxable income by selfdealing between related taxpayers* The relationship between a
cooperative and its hundreds and maybe thousands of patrons is
made out to be the same as the relationship between a parent corpo­
ration and its subsidiaries* This is, of course, partially true
but in extending the concept to include cooperatives the same type
of error is being made as i&en the concept of the cash discount is
stretched to include cooperative patronego dividends*
The basic shortcoming of both arguments is that patronage
dividends of a true cooperative arrangement are not adequately de­
scribed by legal rules related to production facilities owned and
controlled by persons who are only incidentally consumers of the
services or produets produced* That is, court decisions and legisla­
tion aimed at explaining and controlling operations of business ftrms
established largely to serve custiera ether than swnera must be
considerably revised to become applicable to firms organised to
provide goods and serviees only to Its owners*




Mr a G. M* Lester

m 2 •*

It is because a true cooperative produces only services
consumed by its owners that patronage dividends are sufficiently
different fro* the income of a corporation, partnership, and
proprietorship to justify different tax treatment* Patronage
dividends are not the same as trade discounts, also, the relation­
ship between a cooperative and its patrons is not the seme as that
between a parent corporation and its subsidiaries or a corporation
and its stockholderso this fact justifies a treatment of cooperative
patronage dividends different from the treatment of regular business
profits, although it does not provide a basis for complete exemption
of cooperative patronage dividends from taxation*
Sincerely yours,

If* S. Socles*

EWLitI