*202 Decision will be entered for the petitioner.
Petitioner, organized in 1912 under the general corporation law of California, always has carried on its business as a co-operative wholesale dealer in hardware selling only to its stockholder-members who own equal amounts of stock. No dividends have ever been paid on petitioner's stock. It was understood and agreed between petitioner and each prospective stockholder at the time stock was purchased that all of petitioner's annual net earnings would be distributed to the stockholder-members in proportion to the purchases of each. In each year, patronage refunds were paid to the members in certificates representing their shares of annual profits over costs and operating expenses, which shares were credited on petitioner's books to each member. The certificates were redeemed by petitioner in cash during 5 years after issuance. Held, that the patronage refunds so paid, in certificates, were paid under legal obligation to and contracts with petitioner's members, and that the amount thereof is subject to exclusion in computing the net income of petitioner subject to tax.
*76 The Commissioner determined deficiencies in income tax for the fiscal years ended on August 31, 1946, 1947, 1948, and 1949, and a deficiency in excess profits tax for the fiscal year ended August 31, 1946, in the following amounts:
| Year ended August 31 | Income tax | Excess profits |
| tax | ||
| 1946 | $ 40,585.18 | $ 31,046.07 |
| 1947 | 36,666.42 | |
| 1948 | 31,927.63 | |
| 1949 | 23,029.41 | |
| Total | $ 132,208.64 | $ 31,046.07 |
*204 The sole issue is whether petitioner properly can exclude from income for each taxable year the entire amount of its net income after all expenses, which represents its profit in each year upon business done with its members, which was credited each year to its members and petitioner asserts belonged to its members as commissions or patronage refunds. The petitioner contends that determinations of deficiencies for the fiscal years ended August 31, 1946 and 1947, are barred by the statute of limitations and that the provisions of section 275 (c) of the 1939 Code do not apply.
FINDINGS OF FACT.
The stipulated facts are found as stipulated; the stipulation and annexed exhibits are incorporated herein by reference.
The petitioner was incorporated on September 17, 1912, under the general corporation laws of California under the name, Hardware Merchants Syndicate, which name was changed to Southwest Hardware Company in 1925. Its place of business is located in Los Angeles, California. It keeps its books and files its returns on an accrual basis for a fiscal year ending on August 31.
Petitioner filed income tax returns for the taxable years with the collector of internal revenue for the*205 sixth district of California. No excess profits tax return was filed for the year ended August 31, 1946. The income tax returns for the taxable years were filed on November 15, 1946, October 28, 1947, November 15, 1948, and November 9, 1949, respectively. The statutory notice of deficiencies was mailed on July 29, 1952. The petitioner did not consent to waive the provisions of section 275 (a) of the 1939 Code before or after the time prescribed *77 therein with respect to its returns for the years ended August 31, 1946 and 1947.
During the taxable years the petitioner was engaged in the business of wholesaling hardware and like products in competition with other wholesalers. However, at all times it has sold merchandise only to its member dealers who are its stockholders. Petitioner's members are selected retail hardware dealers in southwestern California. Petitioner describes itself on its income tax returns as a co-operative wholesale hardware company.
During the taxable years, petitioner's outstanding stock consisted of one class of common stock, only, having a par value of 80 cents per share. Each stockholder owned 1,250 shares having a total par value of $ 1,000. *206 Each of petitioner's directors was the record owner of 1 share. The number of stockholders and directors, and the total par value of all of the outstanding stock at the end of each of the taxable years were as follows:
| Year ended August 31 | Directors | Stockholders | Issued stock |
| 1946 | 7 | 93 | $ 93,005.60 |
| 1947 | 7 | 95 | 95,005.60 |
| 1948 | 9 | 102 | 102,007.20 |
| 1949 | 9 | 102 | 102,007.20 |
Petitioner was organized to operate as a hardware buying syndicate without profit to itself.
Although petitioner's articles of incorporation and bylaws do not provide for payment of patronage refunds to members, petitioner has at all times treated earnings above costs and operating expenses as belonging to its members, and it has never paid any dividends on its stock. During the taxable years, and in prior years, the patronage refund, or commission, of each member has been computed on the basis of the ratio of net profit derived from the purchases of each member to total net profit derived from the purchases of all members in a year. Petitioner's method of making patronage refunds has always been based upon resolutions of its member-stockholders which were duly adopted. A method of making patronage*207 refunds was followed before 1930 which proved to be unsatisfactory because it did not work out so that sufficient provision was made to cover petitioner's operating expenses. Therefore in 1930 a new method of allowing patronage refunds, or commissions, was adopted, pursuant to a resolution of the stockholder-members which has been followed ever since. The resolution was adopted by the stockholder-members on October 20, 1930. It is tantamount to a bylaw provision. It provided, in part, as follows:
*78 the member's commission on the gross profits on their purchases [shall] be limited to an amount not to exceed the net income after deducting all expenses not including members' commissions, and * * * members' commission in such profit to be equal to the gross profit on the purchases of all participating members. * * *
Since 1930, at least, records and accounts in petitioner's books have been maintained by which each member's share of annual net profit above expenses and costs has been computed according to the ratio which the profit on each member's purchases during the year bears to the total profit on total sales to all members. The gross profit, or gross commission, on *208 every purchase of a member dealer was stated on the retained copy of each invoice of sales to a member and was entered in the member's account on petititoner's books. At the end of the year, the percentage which petitioner's net earnings bears to the total gross profit on all members' purchases is applied to each member's gross profit for the year, and the result is entered as the member's commission. The total of these commissions, which equals petitioner's net earnings, is entered in an accounts payable control account, "Commissions Due Members."
Petitioner's books do not contain any profit and loss account. Its accounting records for each year show gross sales, net sales after returns and allowances, cost of goods sold to member dealers, operating expenses, miscellaneous expenses, and net profit. All of the net profit of each year's operations is credited at the end of each year to the "Members' Commissions" account. For the taxable years, petitioner's net profit before commissions and the credits to members' commissions were as follows:
| Net profit | Credits to | |
| Year ended August 31 | before | members' |
| commissions | commissions | |
| 1946 | $ 144,279.75 | $ 144,279.75 |
| 1947 | 96,630.75 | 96,630.75 |
| 1948 | 84,153.94 | 84,153.94 |
| 1949 | 60,603.71 | 60,603.71 |
*209 In its income tax returns for the taxable years, the petitioner excluded from "taxable income" the above amounts of the credits to members' commissions, i. e., all of its net profits after all expenses. The Commissioner restored the above amounts to petitioner's taxable income, determining that all of the net profit for each year is taxable to petitioner.
Each member dealer was advised of the amount of its commission for the year and advised that it must be reported in the member's income tax return.
*79 Because petitioner's sales are not made for cash but are made on account, whereas most of its purchases are paid for in cash on delivery, petitioner requires a large fund to carry on buying operations. Its paid-in capital represents a small percentage of its inventory and receivables. In order to avoid borrowing from banks, petitioner's members voted after each of the taxable years, and prior years, to loan their patronage refunds to petitioner at 2 per cent interest so that petitioner could build a fund for operations. Accordingly, in the taxable years, and before, petitioner distributed the patronage refunds to members by means of certificates or receipts, 1 issued serially, *210 in lieu of cash. It has paid the certificates in cash within 5 years from the year of issuance. The receipts are numbered serially; they are signed by petitioner's president and secretary; they bear interest payable semiannually; they are printed; they acknowledge the receipt from the member of a stated sum of money; and they set forth petitioner's agreement with the member-lender to make repayment of the amount stated. The receipts are transferable without restriction. Petitioner first obtained approval from the California Commissioner of Corporations to issue the receipts as "evidences of indebtedness" before each series was distributed to its members.
In each of the taxable years, except 1948, petitioner made cash payments to its members in partial redemption of the outstanding receipts, or certificates. The amounts of the cash payments in each*211 year were determined by petitioner's directors, depending upon petitioner's need for working capital and its ability to pay cash to members.
After the close of each of the taxable years, all of the net profit of petitioner above cost of merchandise and operating expenses was credited to the members' commissions account in petitioner's books in the amounts set forth in the following schedule; and petitioner issued, after authorization by its member-stockholders, 2 per cent receipts for the commissions in the amounts set forth in the following schedule, both amounts being equal:
| Net profit | Receipts | |
| Year ended August 31 | credited to | issued to |
| members | members | |
| 1946 | $ 144,279.75 | $ 144,279.75 |
| 1947 | 96,630.75 | 96,630.75 |
| 1948 | 84,153.94 | 84,153.94 |
| 1949 | 60,603.71 | 60,603.71 |
In its balance sheets for each of the taxable years, petitioner carried as deferred liabilities, members' commissions -- current year -- the amounts set forth above. The amount of the receipts outstanding at *80 the end of each taxable year was carried as a deferred liability, also.
Petitioner made cash payments on the outstanding 2 per cent receipts during the fiscal years ending August 31, 1946, *212 1947, and 1949, in the amounts of $ 242.21, $ 42,818.66, and $ 56,241.85, respectively. It made cash payments on the receipts during the fiscal years ended August 31, 1950, 1951, and 1952 in the amounts of $ 54,497.85, $ 60,992.38, and $ 70,321.19, respectively. Also, it paid 2 per cent interest every year on the outstanding receipts.
At the end of the fiscal years ended August 31, 1946, 1947, 1948, and 1949, the total amounts of outstanding 2 per cent receipts were as follows:
| August 31, 1946 | $ 352,840.88 |
| August 31, 1947 | 406,652.97 |
| August 31, 1948 | 490,806.91 |
| August 31, 1949 | 495,168.77 |
The above amounts at the end of each fiscal year comprised the member commissions for each current year plus the unpaid balances of a series of receipts for the commissions of members for 4 prior years as the following detailed breakdown illustrates:
| Unpaid receipts for year ended August 31, 1942 | $ 42,818.66 |
| Unpaid receipts for year ended August 31, 1943 | 50,435.41 |
| Unpaid receipts for year ended August 31, 1944 | 53,558.52 |
| Unpaid receipts for year ended August 31, 1945 | 61,748.54 |
| Unpaid receipts for year ended August 31, 1946 | 144,279.75 |
| Outstanding receipts as of August 31, 1946 | $ 352,840.88 |
*213 Petitioner's annual applications to the California Commissioner of Corporations for permission to issue the certificates, as well as its applications to the commissioner to sell stock, stated that the petitioner operated without profit to itself, that its operations result in extra savings to its members, and that membership in petitioner entitled the member to commissions in direct proportion to the gross profit earned by petitioner on the member's purchases. Petitioner's annual financial statements state that members are entitled to commissions in amounts directly proportional to the gross profit earned by petitioner on their purchases, subject to the provision that total commissions to all members are not to exceed petitioner's net earnings, i. e., gross receipts less cost of goods and operating expenses.
The transfer of stock of petitioner is restricted by bylaw, and no transfer may be made by a stockholder unless the proposed transferee is first approved by a majority vote of the board of directors. If a proposed transferee of outstanding stock is disapproved by the board, the petitioner can repurchase stock, or select a satisfactory transferee who will pay cash for the stock.
*214 *81 New stockholders give petitioner a written option to repurchase their stock at cost, but such option can be exercised by petitioner only at the direction of its board. The purpose of such option is to enable petitioner to be rid of members who prove to be undesirable. It is stated in the written option that the option does not include any commissions, or accrued patronage refunds, it being understood that the stockholder remains the owner of commissions on his purchases which have accrued while he has been a stockholder.
The nature of petitioner's organization and operations, and of each member's right to commissions, or patronage refunds, was and is explained to each applicant before he purchases petitioner's stock and becomes a member. At all times, it was understood and agreed between petitioner and a prospective member at the time he purchased stock in petitioner that the member would be entitled to a commission or refund of his proportionate share of each year's net earnings based upon his purchases during a year, and that all of petitioner's net earnings would be distributed among and to its members.
Petitioner did not omit from gross income in its returns for the*215 taxable years ended August 31, 1946 and 1947, an amount which was properly includible therein which was in excess of 25 per centum of the gross income stated in the return.
OPINION.
Petitioner is a corporation organized for profit and it does not claim that it is a tax-exempt corporation under section 101 of the 1939 Code. It contends, however, that it is entitled to exclude from its gross income, the earnings upon business done with its members which were credited each year to the members, and were distributed by means of certificates, the 2 per cent receipts.
The only issue to be decided is whether petitioner received, in each taxable year, the earnings in question under an existing contractual obligation to make refunds of them to its members, and whether the members had a right to the patronage refunds founded in a contract, which right did not depend on some corporate action by the petitioner's officers or directors after receipt of earnings. The issue presents the narrow question, only, whether there was a contract between petitioner and its members giving them the right to receive patronage refunds.
There is no specific statutory provision authorizing exclusion of patronage*216 dividends from gross income, but it is established that where a cooperative is obligated to refund to members the profit realized from business transacted with members, it is proper to exclude such profits from taxable income on the theory that they belong to the members and are not income of the cooperative. Clover Farm Stores *82 , 17 T. C. 1265, 1276, 1277; Colony Farms Cooperative Dairy, Inc., 17 T. C. 688, 692; United Cooperatives, Inc., 4 T. C. 93, 106. This rule applies only if the members' rights to patronage refunds existed at the time the members transacted business with the corporation and were not dependent upon any subsequent corporate action. In United Cooperatives, Inc., 4 T. C. 93, 106, the rule is stated in the following way:
However, this practice of excluding patronage dividends from gross income has been limited to those cases in which the right of patrons to such dividends arises by reason of the corporation charter, or bylaws, or some other contract, and does not depend upon some corporate action taken subsequent to*217 its receipt of the money later so distributed, such as the action of the corporation's officers or directors. This limitation recognizes that if the money later distributed to patrons is received by the corporation without a legal obligation existing at the time of its receipt to later distribute it, it must be considered as the gross income of the corporation and, since there is no deduction permitted by statute of the amounts later distributed to patrons, it is taxable as such. * * * [Italics supplied.]
The petitioner concedes that its members derived no rights to patronage refunds from a state statute, cf. Midland Cooperatives Wholesale, 44 B. T. A. 824, or from petitioner's articles of incorporation or bylaws, cf. United Cooperatives, Inc., Colony Farms Cooperative Dairy, Inc., Clover Farms Stores Corporation, and Midland Cooperative Wholesale, supra. Petitioner claims that its members had a contractual right to patronage refunds, and that it was contractually obligated, at the time it sold merchandise to members, to make refunds to members of earnings derived from members' purchases without any subsequent corporate*218 action.
The evidence supports petitioner's contention. Petitioner believed it was legally and contractually obligated, when its members made purchases, to make patronage refunds to its members in proportion to their purchases. In verified statements to and exhibits filed with the California Commissioner of Corporations, the petitioner's officers stated that the petitioner operated without profit to itself, and that membership in the petitioner entitled a member to commissions in direct proportion to the gross profit earned by petitioner on the member's purchases. To the same effect are statements contained in the reports of annual audits of petitioner's books. Petitioner, in fact, has distributed patronage refunds to members at all times. In each of the taxable years, and before, petitioner credited on its books to the members, refunds based on purchases, in amounts which equalled its entire earnings above costs and expenses, and distributed certificates, or 2 per cent receipts, to its members.
The evidence establishes, also, that the stockholder-members understood that petitioner was obligated to make refunds to them of earnings *83 based upon their purchases. One of respondent's*219 witnesses testified as follows:
Q. When you became a stockholder in Southwest Hardware Company, Mr. Fields, was the method of operation of Southwest Hardware Company explained to you by Mr. Izenour?
A. Yes.Q. What did he tell you about the operation?A. Well, as I recall, in brief, the stockholders comprised the corporation, meaning, I understood it to be the truth, that if you were not a member, possessing stock, you could not buy from Southwest Hardware.
The purpose of the organization was explained to me as follows: That I was to buy as much of the commodities which I could, merchandise, in my store, from them. The reason being that I would be charged jobber's cost, or, as the case might have been, less.
At the end of the year my purchases and all other member purchases were to be aggregated to a total, figured against the total business. A profit was to be arrived at and we were to receive cash checks, -- cash payment for whatever was our percentage.
The evidence establishes that the method for making distribution of patronage refunds to members was definite and clear.
Dealers became members of and made purchases from petitioner in reliance on petitioner's representation to*220 them that petitioner's earnings on their purchases would be distributed in patronage refunds. We are satisfied upon consideration of all of the evidence that there was a binding oral agreement to that effect under which petitioner was contractually obligated to distribute net earnings derived from members' purchases; and that the understanding between petitioner and its members constituted a contract. See, 1 Williston, Contracts, sec. 102, p. 323 (rev. ed. 1936). Such contract did not have to be made in writing. See, Home Builders Shipping Association, 8 B. T. A. 903, 906, 908. It follows, therefore, that net profits derived from members' purchases belonged to the members as a matter of right, and that petitioner was required to distribute such net earnings as commissions, or patronage refunds. Such net earnings could not be transferred to surplus for distribution as dividends, or otherwise accumulated. Petitioner was under a contractual obligation to pay patronage refunds and neither its directors, nor officers, nor general manager had the discretion to determine that the refunds would or would not be made. The evidence is not opposed to this*221 conclusion. The policy of petitioner's directors of making cash refunds to all members at the same time was not in derogation of the members' rights to receive the patronage refunds.
In Clover Farm Stores Corporation, supra, the Commissioner made a similar contention. The taxpayer's articles of incorporation provided that the board of directors could determine what part of "surplus" could be declared as dividends, or for other purposes. Nevertheless, *84 the taxpayer's patrons were found to have a right to patronage refunds under article VIII of its code of regulations to the extent of the excess of the corporation's gross revenues over its expenses and certain other specified items. We said:
Thus, to the extent that article VIII was applicable, the corporation was charged with a liability with respect to the amount involved, and it therefore never did become a part of surplus. The provisions of article VIII were mandatory and neither petitioner's board of directors nor its officers had any discretion to determine whether a refund would or would not be made, and petitioner's general manager could not, as respondent urges, on brief, have decided, *222 with the approval of the directors, that the entire amount of $ 48,805.66 set up on petitioner's books at the end of 1948 as a "patronage refund" be retained by petitioner with no distribution to its stockholder-members in cash, stock or otherwise. * * * [p. 1279]
In this proceeding, the petitioner's obligation to distribute net earning derived from members' purchases is no less binding than was the obligation of the taxpayer in Clover Farm Stores Corporation, supra. Therefore, the net profits in question here never belonged to petitioner and were not its income. Petitioner distributed the entire net earnings of each taxable year by the issuance of the 2 per cent receipts, or certificates which it was obligated to redeem in cash. The stockholders voted to defer the cash payments and took in lieu thereof the 2 per cent notes which petitioner, clearly, was obligated to redeem in cash. Respondent does not contend that the 2 per cent receipts were not notes of petitioner evidencing a legal obligation to pay the face amounts thereof.
It was never contemplated that earnings would be distributed as dividends. Each member's commissions were calculated on*223 the basis of his purchases during the year. Distributions to members were not made in accordance with ownership of stock. Furthermore, the amounts of members' patronage refunds and the members' right to receive them were not dependent upon any action of petitioner's board of directors. Petitioner's entire earnings were distributed to members in accordance with the agreement which petitioner made with them at the time they became members.
It is true that there is no provision in petitioner's articles of incorporation or bylaws prescribing the payment of patronage refunds to members. But such provision is made in the stockholders' resolution of October 20, 1930, which has never been amended or rescinded, and under the facts present here, that resolution is tantamount to a bylaw provision. Prior to the resolution of October 20, 1930, similar provision was made under another resolution of the stockholder-members.
Respondent does not rest his determination on the fact that the patronage refunds, or members' commissions, were distributed by *85 means of certificates, i. e., the 2 per cent receipts, or notes; or upon the fact that petitioner's members elected, by vote, to take *224 the notes in lieu of immediate cash refunds. Cf. Colony Farms Cooperative Dairy, Inc., supra, p. 689, and pp. 693, 694. What we said there applies here, namely: The funds represented by the 2 per cent notes were retained by petitioner with the consent of its members and represent loans by each of them to petitioner for working capital at a lower rate of interest than petitioner would have had to pay if it had borrowed from a bank. We held in Colony Farms, supra, p. 694, that "the distribution in the form of certificates of interest effected a distribution of earnings just as effectively as though made in cash, * * *." We do not find any facts in this case, in the record before us, which require reaching a result different from that reached in the Colony Farms case. It is followed here.
Consideration has been given to a few instances where the general manager of petitioner made decisions which amounted to conclusions that a few members had forfeited their rights to patronage refunds. It appears that he believed the members in question had violated their agreements with the petitioner. It may be (a matter we are not*225 called upon to decide) that the general manager acted improperly and outside the scope of his duties. However, the few members so affected had their legal remedies. These instances are de minimis and should not and do not affect our conclusions under the issue before us. Petitioner did not retain the "forfeited" commissions; they went into the patronage refunds which were distributed.
Respondent relies on American Box Shook Export Association, 4 T. C. 758, affd. 156 F. 2d 629. In that case, the association purchased box shook from its twelve member-stockholders for resale. It was alleged that there was an understanding that the association's receipts, in excess of the cost of the box shook plus a reserve for anticipated claims, would be returned to the members. The evidence did not support the taxpayer's contention that the so-called "understanding" constituted an oral contract. For example, it was not shown that the "understanding" was carried out in practice. During the taxable year, the association retained $ 13,317.66 of earnings, apparently for its own use, and distributed only $ 7,559.11 to members. These *226 facts negated the taxpayer's claim that there was an agreement that members were to receive all profits in excess of cost and additions to a reserve. Also, there was evidence that it had been contemplated originally that excess revenue would be distributed by way of dividends on the stock. Although there was an amendment to the bylaws to effect the distribution of excess revenue among the members upon the basis of the dollar value of shipments made by each member, the amendment was never put into effect. Furthermore, the evidence *86 showed that no amounts were distributable to the members without prior action on the part of the directors, as the members understood. That is to say, it was not mandatory that the association make refunds to members, and the association's directors were not without the discretion of determining whether refunds to members would or would not be made. Cf. Clover Farm Stores Corporation, supra, p. 1279. Only about one-third of the earnings of the association were distributed to members. American Box Shook Export Association, supra, is distinguishable on its facts. The evidence in this*227 case is different, and it supports the petitioner's contention that there were oral contracts with its members to make patronage refunds.
It is held that petitioner was under a legal and contractual obligation at the time members made purchases in the taxable years to make refunds of their proportionate shares of gross receipts above costs and operating expenses based upon their respective purchases, and that, accordingly, petitioner is entitled to exclude from its taxable income for each taxable year the amounts of such shares of earnings as were credited to its members and distributed to them by means of the 2 per cent notes called "receipts." Because of this holding, section 275 (c) of the 1939 Code does not apply to the fiscal years ended August 31, 1946 and 1947; deficiencies for those years are barred.
Decision will be entered for the petitioner.
Footnotes
1. These are called "Building Fund Receipts." The title signifies the building of a working fund of capital and does not mean a receipt of funds to construct a building.↩