Thursday, November 02, 2006

Preferential Tax Treatment for Agricultural Cooperatives

GrainAgricultural cooperatives can claim tax deductions under two provisions of the Internal Revenue Code: Subchapter T and I.R.C. § 521. While agricultural cooperatives do not receive preferential tax treatment under Subchapter T (see prior post), agricultural cooperatives that qualify do receive preferential tax treatment under I.R.C. § 521. Subchapter T applies to all cooperatives, while I.R.C. § 521 applies solely to agricultural cooperatives that are run for the benefit of farmer members.

As previously discussed, the purpose of permitting cooperatives to claim Subchapter T tax deductions is not to promote cooperatives. Instead, the purpose of Subchapter T is to tax solely the gross income generated by cooperatives that can be said to belong to the cooperatives, rather than to the cooperatives' members.

In contrast, the purpose of permitting agricultural cooperatives to claim tax exempt status under I.R.C. § 521 is squarely to promote agricultural cooperatives that benefit farmer members. In Co-operative Grain & Supply Co. v. Commissioner, 407 F.2d 1158 (8th Cir. 1969), the court explained the purpose of I.R.C. § 521's tax exemption:
[Agricultural cooperatives] were organized primarily for the purpose of helping individual farmers to better their bargaining position in the sale of their products and the purchase of their supplies. In granting favorable tax treatment to certain farmer cooperatives Congress recognized their contribution to the agricultural community. Justification for bestowing upon them tax exempt status is based upon the policy that a strong and prosperous agriculture is necessary for the national welfare.

It must be kept in mind that the policy behind [I.R.C. § 521's] tax exemption is not to benefit the cooperative as a business organization, but to benefit its member-producers.

The fundamental characteristic of an agricultural cooperative is that it is operated for the mutual benefit of its members as producers - not as stockholders. Advantages which accrue to a member of a cooperative accrue primarily because of his patronage with the association and not because of any financial investment he may have made therein.

It logically follows that the primary purpose of the cooperatives - to give farmers a better bargaining position in the marketplace - cannot be accomplished unless the farmers patronize the association . . . .
Co-operative Grain & Supply Co. v. Commissioner, 407 F.2d 1158 (8th Cir. 1969).

The requirements to claim Subchapter T tax deductions and the requirements to claim I.R.C. § 521 tax exempt status reflect the distinct purposes of these two provisions. To claim Subchapter T tax deductions, a business must be "operating on a cooperative basis." (To determine whether a business is "operating on a cooperative basis," courts consider whether the business is operating consistently with the three principles articulated in Puget Sound Plywood, Inc. v. Commissioner, 44 T.C. 305, 308 (1965), and consider all facts and circumstances.) Businesses can claim Subchapter T tax deductions if they receive income that they hold "in trust" for members and then repay to members annually in the form of patronage dividends. The requirements to claim I.R.C. § 521 tax exempt status are more stringent. See I.R.C. § 521(b). To claim I.R.C. § 521 tax exempt status, agricultural cooperatives must be managed for the benefit of their farmer members. To this end, to claim I.R.C. § 521 tax exempt status, agricultural cooperatives are required (among other things) to conduct at least 50% in value of their business with farmer members. I.R.C. § 521(b)(4).

I.R.C. § 521's tax exemption for agricultural cooperatives that benefit farmer members raises several questions. Is promoting agricultural cooperatives a wise policy? Does promoting agricultural cooperatives effectively address a market failure by enabling farmers to bargain more effectively with economically powerful agribusinesses? Or, is promoting agricultural cooperatives an economically inefficient policy that increases prices for consumers?

Paul Pomerleau commented on Agricultural Law that it is difficult for agricultural cooperatives to remain financially viable without doing a substantial amount of business with non-members: "It is . . . impossible [for agricultural cooperatives] to respect the 50% rule and everyone knows it" Does Pomerleau's comment suggest that I.R.C. § 521's tax exemption should be extended to agricultural cooperatives that conduct less than 50% of their business with farmers? Do agricultural cooperatives that conduct less than 50% of their business with farmer members benefit society? Or, does Pomerleau's comment suggest that the concept of a business form managed by and for the benefit of farmer members is not economically viable and, consequently, agricultural cooperatives should not be given preferential tax treatment?

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