*2270 EXEMPT CORPORATIONS - FARMERS' SELLING AND PURCHASING ASSOCIATION. - Petitioner furnished its members supplies at cost and marketed the perishable produce of its 400 members and returned to them the average price received by it less freight, brokerage fees if sold on consignment, and 5 per cent commission which, with interest on bank deposits, constituted its gross receipts. Out of said receipts petitioner paid all necessary expenses and the net receipts were used as follows: 10 per cent dividends paid on all of its capital stock; $3,000 added to surplus, one-half of the balance also added to surplus and the remainder set aside for refunds to all members on the basis of the value of produce sold for them, respectively. During 1923 and 1924, the refunds constituted a very small portion of petitioner's net receipts. Only a portion of petitioner's members held stock and the dividends were in excess of the legal rate of interest in South Carolina. Held that the Commissioner's regulations applicable to section 231(11) of the 1921 and 1924 Acts, are reasonable and sound and that during 1923 and 1924, petitioner failed to comply with the said provisions of the revenue acts and regulations. *2271
*1028 The respondent has determined against this petitioner deficiencies in the amounts of $165.50 and $456.30 for the fiscal years ended September 30, 1923, and 1924, respectively.
*1029 At the hearing petitioner waived all issues raised by the pleadings except one, namely, whether it is exempt from taxation under section 231(11) of the Revenue Acts of 1921 and 1924.
FINDINGS OF FACT.
The South Carolina Produce Association was organized in February, 1915, under the general corporation statutes of South Carolina. Its principal office is at Meggett, S.C., and since its organization it has been engaged in marketing its members' perishable produce and purchasing supplies for its members.
The authorized capital stock of petitioner was and is $20,000, divided into $10,000 voting common stock of 1,000 shares of the par value of $10 each, and $10,000 limited nonvoting stock of 1,000 shares of the par value of $10 each. The by-laws restricted the issuance and transfer of the voting stock to 1 share to each 10 acres of land actually under cultivation. *2272 The nonvoting stock was limited to not more than 100 shares to any one person, but there were no limitations as to acreage and occupation. Those restrictions have been observed and enforced and the nonvoting common stock has been issued only to those engaged in cultivating land. During 1923 and 1924 there were 60 stockholders owning from 1 to 140 shares of petitioner's voting stock and 12 stockholders owning from 40 to 100 shares of limited nonvoting stock. The stockholders were practically the same in both years and all of the nonvoting stockholders, except one during 1923, held voting stock.
The petitioner's by-laws provide that any farmer not a stockholder, may, by payment of a fee of $1, secure a certificate of shipping privilege, which entitles him to all privileges and benefits of the association except the right to vote and participate in dividends and the corporation's surplus and assets. During the years 1923 and 1924 there were about 340 such certificate holders and 60 stockholders, all being regarded as members under the by-laws so far as shipping and purchasing privileges were concerned.
The by-laws required all members, both stockholders and certificate holders, *2273 to market all of their produce through petitioner's organization except produce sold for local consumption. The petitioner charged all of its members a commission of 5 per cent on sales, which was its only source of income, except for interest on its bank deposits, during the years in question.
The petitioner maintained at its own expense private telephone lines to its members for the purpose of advising them as to market conditions and receiving information as to the amount of produce to be marketed in any one day. After the members delivered their produce to petitioner it was inspected, graded, and pooled. *1030 Petitioner's sales were made either f.o.b. shipping point or on consignment and petitioner made the collections and stood any losses incurred from bad accounts. Each day petitioner pooled the sales for that day made at various points; deducted freight, and brokerage fees if sold on consignment; averaged the net proceeds; and paid to each member such average price less 5 per cent commission for the amount of produce furnished by him for that shipment. That practice was followed as to each separate kind and grade of produce shipped on any one day, so that while*2274 the market prices might vary at different points at which produce of one kind and grade were sold, each member contributing produce to those shipments would receive the same average prices. Petitioner's gross sales amounted to between $1,500,000 and $2,000,000 during 1923 and 1924. Petitioner did not buy or sell any produce for its own account during 1923 and 1924, although its general manager had the authority under article 3, section 8, of the by-laws to buy produce from persons who were not stockholders or members of the company, to protect the market and/or to make good his quotations when sales exceeded the available supply of the members' produce.
In addition to marketing the produce grown by its members, petitioner also purchased supplies such as seeds, principally seed potatoes, barrels, baskets, crates, fertilizer, and insecticides for the account of its members, exclusively. Such purchases were made only upon orders from the members to avoid carrying a stock on hand. The actual price of the supplies to petitioner, especially as to seed potatoes, which were purchased in different places at the best obtainable prices, were averaged and each member charged the average*2275 price. The expense, such as traveling expenses, etc., incurred by petitioner in purchasing supplies was not included in the average cost to the members, but was included in petitioner's general operating expenses, which were paid out of the 5 per cent commissions received on sales of its members' produce.
The shipping season ended about July 15 of each year and petitioner closed its books on September 30 of each year. After the payment of all of petitioner's expenses out of the selling charges assessed against its members, the remainder was distributed in accordance with the by-laws, article IX, which was in effect from date of organization until October 26, 1924. A dividend at a fixed rate of 10 per cent was paid on the par value of the total capital stock, both voting and nonvoting; $3,000 was added to surplus and of whatever remained, 50 per cent was also added to surplus and the balance set aside to be "refunded to the loyal shippers of the company," in proportion to the value of produce sold during the year for their respective accounts.
*1031 During the years in question, the legal rate of interest in South Carolina was 7 per cent, and, by written agreement, not*2276 in excess of 8 per cent.
Petitioner's books reflect the following assets and liabilities as disclosed by the balance sheets as of September 30, 1922, 1923, and 1924:
| Sept. 30, 1922 | Sept. 30, 1923 | Sept. 30, 1924 | |
| ASSETS | |||
| Cash | $52,072.19 | $118,187.11 | $96,900.32 |
| Notes receivable | 13,911.82 | 7,874.32 | 5,505.12 |
| Accounts receivable | 4,016.62 | 11,399.57 | 30,069.99 |
| Growers' accounts | 2,411.72 | ||
| Advances to employees | 410.00 | ||
| Inventory of supplies | 5,988.31 | ||
| Cash in closed banks | 74,292.51 | 52,563.13 | 51,072.36 |
| Furniture and fixtures | 2,576.72 | 2,637.28 | 2,916.63 |
| Office equipment | 3,005.15 | 3,275.75 | 3,622.00 |
| Office building | 40,199.62 | 40,199.62 | 40,199.62 |
| Telephone equipment | 6,835.44 | 8,037.10 | 9,791.06 |
| Packing plant | 6,814.35 | 6,814.35 | 6,792.27 |
| Automobile | 512.82 | 454.70 | |
| Hotel equipment | 454.29 | 474.79 | 474.79 |
| Total assets | 213,501.56 | 257,263.02 | 247,798.86 |
| LIABILITIES | |||
| Shippers' refund | 84,790.04 | 114,402.86 | 88,889.39 |
| Notes payable | 10,000.00 | 10,000.00 | 10,000.00 |
| Accounts payable | 6,244.82 | 9,201.13 | 13,453.88 |
| Growers' accounts | 2,777.63 | ||
| Accrued interest shippers | 3,245.93 | ||
| Checks out on closed banks | 1,419.20 | 1,099.38 | |
| Dividend unpaid | 2,000.00 | ||
| Reserve for bad debts | 1,500.00 | 1,500.00 | 1,500.00 |
| Reserve for depreciation | 9,219.10 | 12,576.00 | 16,229.10 |
| Surplus | 75,620.77 | 89,583.03 | 93,381.18 |
| Capital stock | 20,000.00 | 20,000.00 | 20,000.00 |
| Total liabilities | 213,501.56 | 257,263.02 | 247,798.86 |
*2277 The items of cash appearing as assets include refunds due petitioner's members, which are set up among the liabilities as shippers' refunds. Those refunds represent an accumulation since petitioner's organization and are subject to withdrawal upon demand by any member having a refund due. The growers' accounts represented amounts due petitioner from members for supplies and cash advanced. In 1922 the market for cucumbers dropped and petitioner was forced to carry a supply of baskets over for the next season and they are represented by the item of inventory of supplies in the 1922 balance sheet. The office building was used exclusively by petitioner, which owned no other real estate. The telephone equipment was used in petitioner's private system covering a radius of about 50 miles and used by all its members to communicate with petitioner as to market conditions, shipments, and supplies. Petitioner maintained the telephone system without charge to its members. The packing plant was used for packing vegetables for shipment and the hotel equipment was for the accommodation of produce buyers, and extra help during the shipping season, the town of Meggett having very limited lodging*2278 accommodations.
*1032 At the close of the fiscal year 1922, petitioner had $74,292.51 in three banks which had been closed, but during 1923 and 1924 dividends were paid and the amount of loss sustained has not yet been determined. The item of notes payable represented amounts due banks and accounts payable represented current unpaid bills. The petitioner met all bad accounts resulting from sales and maintained a reserve for bad debts.
Petitioner had an established line of credit amounting to $300,000 with banks, $50,000 to $100,000 with fertilizer companies, and $100,000 with companies selling shipping crates and packages. All purchases of seed potatoes had to be paid for in cash.
Although claiming tax exemption, petitioner filed returns for the fiscal years ended September 30, 1923, and 1924, and respondent has determined the following as to those years:
| 1923 | 1924 | |
| Net income | $15,286.25 | $11,187.11 |
| Correct tax liability | 1,660.78 | 1,148.39 |
| Previously assessed | 1,495.28 | 692.09 |
| Deficiency in tax | 165.50 | 456.30 |
On October 7, 1924, petitioner amended its by-laws, article IX, to provide that at the close of each fiscal year, after payment*2279 of all expenses and losses incident to the year's operations and a dividend at a fixed rate equal to the legal rate of interest in South Carolina (7%), and after adding $5,000 to surplus, one-fourth of the remainder of receipts shall be added to surplus and the remaining three-fourths, shall be retained in the treasury for five years as a reserve for depreciation and losses and at the end of that period shall be refunded with interest to those who were shippers during the year such amount was retained as an addition to surplus.
Respondent denied petitioner's claim that it was exempt from taxation for the fiscal years ended September 30, 1923 and 1924, for the reason that the dividends paid in those years were in excess of the legal rate of interest in South Carolina, and that a large surplus was maintained.
OPINION.
TRUSSELL: The petitioner was organized under the general corporation statutes of South Carolina as a cooperative association, for the purpose of marketing its members' perishable produce and purchasing supplies for the use of its members. Petitioner acted as sales agent for its 400 members, who delivered their produce at the association's headquarters at Meggett, *2280 where the produce was graded and pooled. Petitioner obtained the best prices possible *1033 in various markets, made the shipments and collections, and made good any losses sustained through the failure of purchasers to pay. The prices obtained and the freight and brokerage fees, if any, differed as to portions of any one day's shipment of one kind and grade of produce, but each member received the average price for the quantity of produce furnished, less the 5 per cent charge made by petitioner. The petitioner did not buy or sell any produce for its own account nor did it handle any produce for nonmembers during the years in question, although its general manager had the authority to do so under article 3, section 8 of the by-laws of the corporation.
The petitioner also operated as purchasing agent for its members, exclusively. It purchased only on orders and carried no stock on hand. Each member paid the average price per unit for the supplies ordered by him, and petitioner made no charge for the service and did not add to the cost the expense incurred by it in making the purchases.
The petitioner's only source of income during 1923 and 1924 was the 5 per cent commission*2281 charged on the sales of its members' produce and interest on its bank deposits. During those two years petitioner's income was in excess of all the necessary operating expenses incurred in the sale of produce and the purchase of supplies for its members. Out of the net receipts petitioner paid each year the fixed dividend rate of 10 per cent on the par value of its total capital stock and added $3,000 to surplus and, of the balance, 50 per cent was also added to surplus, while the remainder was set aside for refunds to all of the loyal shippers in proportion to the value of the produce sold during the year for their respective accounts.
The only issue is whether petitioner is exempt from taxation for its fiscal years ended September 30, 1923 and 1924, under the provisions of section 231(11) of the Revenue Acts of 1921 and 1924, which are identical and are as follows:
SEC. 231. That the following organizations shall be exempt from taxation under this title -
* * *
(11) Farmers', fruit growers', or like associations, organized and operated as sales agents for the purpose of marketing the products of members and turning back to them the proceeds of sales, less the necessary*2282 selling expenses, on the basis of the quantity of produce furnished by them; or organized and operated as purchasing agents for the purpose of purchasing supplies and equipment for the use of members and turning over such supplies and equipment to such members at actual cost, plus necessary expenses.
All of the provisions of article 522 of the Commissioner's Regulations 62, pertaining to the 1921 Act, are contained in article 522 of his Regulations 65 of the 1924 Act, which provides:
*1034 ART. 522. Cooperative associations. - (a) Cooperative associations, acting as sales agents for farmers, fruit growers, live-stock growers, dairymen, etc., or engaged in the marketing of farm products, and turning back to the producers the proceeds of the sales of their products, less the necessary operating expenses, on the basis of the produce furnished by them, are exempt from income tax and shall not be required to file returns. Thus cooperative dairy companies which are engaged in collecting milk and disposing of it or the products thereof and distributing the proceeds, less necessary operating expenses, among the producers upon the basis of the quantity of milk or of butter*2283 fat in the milk furnished by such producers, are exempt from the tax. If the proceeds of the business are distributed in any other way than on such a proportionate basis, the association does not meet the requirements of the statute and is not exempt. The accumulation and maintenance of a reasonable reserve for depreciation or possible losses or a reserve required by State statute or a reasonable sinking fund or surplus to provide for the erection of buildings and facilities required in business, or for the purchase and installation of machinery and equipment, or to retire indebtedness incurred for such purposes, will not destroy the exemption. A corporation organized to act as a sales agent for farmers, or to market cooperatively the products of the farm, and having a capital stock on which it pays a dividend not exceeding 8 per cent per annum or not exceeding the legal rate of interest, and in which the voting control is retained by the shareholders who are actual producers, will not for such reasons be denied exemption.
(b) Cooperative associations organized and operated as purchasing agents for farmers, fruit growers, live-stock growers, dairymen, etc., for the purpose*2284 of buying supplies and equipment for their use and turning over such supplies and equipment to them at actual cost, plus necessary operating expenses, are also exempt. The provisions of paragraph (a) relating to a reserve, sinking fund, or surplus, and to capital stock shall apply to associations coming under this paragraph.
In order to be exempt under either (a) or (b) an association must establish that it has no net income for its own account other than that reflected in a reserve, sinking fund, or surplus specifically authorized in paragraph (a). An association acting both as a sales and a purchasing agent is exempt if as to each of its functions it meets the requirements of the statute.
There is no question but that the petitioner comes within the provisions of the said statutes and the regulations with respect to its being a farmers' association organized and operated as a sales agent for the purpose of marketing the products of its members and, also, purchasing supplies for the use of its members, but does it come within the provisions of the statutes and the regulations with respect to the distribution of its net receipts derived from commissions charged*2285 its 400 members and from interest on its bank deposits? We think not.
The above-quoted sections of the Revenue Acts of 1921 and 1924 provide for exemption from taxation and must be strictly construed and the petitioner must establish clearly that during 1923 and 1924 it complied with the provisions of such sections.
We agree with petitioner that the Commissioner may not by regulations destroy or limit the statutory exemption, but we can not agree with petitioner that the above-mentioned regulations have that *1035 effect because they limit the rate of dividends which may be paid on the capital stock of an organization such as petitioner. With respect to the distribution of the receipts of such an organization, the statute merely provides that it turn "back to them [the members] the proceeds of sales, less the necessary selling expenses, on the basis of the quantity of produce furnished by them." The regulations materially enlarge rather than restrict the application of the statutory provisions for tax exemption, for they provide that the accumulation of reasonable reserves and a surplus for buildings and equipment will not destroy exemption and, further, that if a*2286 corporation such as petitioner pays dividends not in excess of the legal rate of interest, it will not for that reason be denied exemption. In effect the regulations permit a distribution of profits not in excess of the legal rate of interest. We are of the opinion that the above regulations are both reasonable and sound, for Congress has adopted and incorporated the major provisions thereof in section 231(12) of the Revenue Act of 1926.
During 1923 and 1924 petitioner's 400 members received or were entitled to receive, as refunds on the basis of the quantity of produce furnished by them, only a very small portion of the petitioner's net receipts, while the balance was added to petitioner's accumulated surplus, out of which it paid 10 per cent dividends on its capital stock, which was held by only a portion of petitioner's members, and those dividends were in excess of the legal rate of interest in South Carolina.
Petitioner contends that the Commissioner has no authority to place a limit upon the price to be paid for the use of capital necessary to operate a legitimate business, but it seems to us that such argument is to the effect that petitioner's 10 per cent dividends*2287 were, or were in the nature of, interest payments. In the case of , in which it was held that dividends paid by the taxpayer did not constitute interest, the Board said:
Dividends upon the capital stock are to be paid only from profits. They are not a charge against the assets of the company, and the Board finds no basis for differentiating such dividends from similar payments upon the stock of any other corporation.
See also ; .
We are of the opinion that during 1923 and 1924 petitioner did not bring itself within sections 231(11) of the Revenue Acts of 1921 and 1924, and the regulations applicable thereto, and that it was not entitled to tax exemption for those years.
Judgment will be entered for the respondent.