*55 Decision will be entered under Rule 50.
The patronage dividends paid by petitioner, a cooperative, to its members in certificates of interest in a fund representing its excess of gross receipts from member products sold over operating expenses and segregated on its books as a "Reserve for Members' Equity," held not to have been paid in the exercise of discretion by its directors but under a fixed and legal obligation under the provisions of its charter, bylaws, and contracts with its members and, as such, subject to exclusion in computing its net income subject to tax. United Cooperatives, Inc., 4 T. C. 93, followed.
*688 Respondent has determined deficiencies in income, excess profits and declared value excess-profits taxes for the fiscal years ended June 30, 1943 and 1944, respectively, together with penalties, as follows:
| 10 per cent | |||
| Year ended | Kind of tax | Deficiency | penalty |
| 6-30-43 | Excess profits | $ 6,485.57 | |
| Income | 949.26 | $ 94.92 | |
| 6-30-44 | Excess profits | 1,356.63 | 135.66 |
| Declared value excess-profits | 9.21 | .92 |
Petitioner pleads only one error as to the determination for each year. This is the addition to reported income of amounts in each year representing that portion of the profits of petitioner in each year upon business done by it for members, which petitioner asserts was distributed to such members as patronage dividends.
*689 Certain of the facts were stipulated and are so found. Other facts were established by evidence presented at the hearing.
FINDINGS OF FACT.
The petitioner was organized and incorporated in 1933 under chapter 48, Acts of the General Assembly of the Commonwealth of Virginia, known as the Virginia "Cooperative Marketing Act," and at all times material hereto it operated pursuant to the provisions of that act. Since incorporation*57 it has conducted its business of processing and marketing milk and other dairy products on a cooperative basis within the State of Virginia, its principal office being at Denbigh, Warwick County, Virginia. Its Federal tax returns for the taxable years here involved were filed with the collector of internal revenue at Richmond, Virginia.
Petitioner's certificate of incorporation does not provide for the issuance of stock. The provision is that "the property rights and interests of the members in the association shall be in proportion to the amount of business done by them through the association as evidenced by the certificates of interest issued and outstanding in the name of each member, as recorded in the books of association; provided, however, each member shall be entitled to one and only one vote." Upon its organization the petitioner duly adopted the bylaws under which it has operated since that time. These bylaws provide that in each year any surplus earnings remaining after payment of expenses and which have accrued from business done for its members shall be determined, and that in any year in which the surplus amounts to $ 100 or more, the petitioner shall issue to each*58 member a certificate of interest showing the equity of such member in surplus funds accumulated on business done for him during the prior year. Such certificates are payable to the respective members whenever, as determined by the board of directors, the revolving fund represented by the accumulation of earnings has reached proportions in excess of the corporate needs for working capital, at which time the oldest outstanding certificate shall be paid in total amount to be determined by the board of directors. The bylaws further provide that certificates of interest may also be issued, by a majority vote of the full board of directors, to members to cover payment for milk routes turned over to petitioner, including building materials, equipment, labor, and other things.
Petitioner, since its organization, has entered into similar contracts with all of its members. By this contract the member agrees to sell to petitioner the milk or cream produced by him, to be processed and sold by petitioner, the member agreeing that petitioner may retain from the proceeds of such sale the amounts necessary to meet operating and maintenance expenses or to provide reserves to be used *690 for*59 any proper purposes of petitioner. The member further agrees to the conditions of the articles of incorporation and the bylaws of petitioner.
In the taxable years 1943 and 1944, petitioner purchased milk from various sources. Approximately 37 per cent of its milk was furnished to it by members in each of those years. The balance of the milk which it handled was purchased from other sources, including milk distributors in other states, petitioner being called on for much larger quantities of milk than its members ordinarily supplied, in order to satisfy the demands at nearby military and other armed forces camps.
In the taxable years petitioner paid to each supplier with which it dealt in the State of Virginia, whether members of the association or others, the unit price of milk set by the State Milk Commission of Virginia. When milk was purchased outside the State of Virginia, petitioner paid the regulated milk price which applied, fixed by the state or Federal Government. Petitioner pooled the milk purchased, processed it and sold it at the prevailing regulated market price.
At the end of each of the fiscal years here involved, petitioner determined the entire revenue received*60 by it from the sale of milk and deducted therefrom the amount paid by it to members and others for the purchase of the milk, together with all other costs and expenses. It then computed the portion of the net revenue so determined which was attributable to the sale of milk processed for members, by applying to said net revenue the percentage ratio that purchases from members bore to total milk purchases, to wit: 37.09 per cent for the fiscal year 1943 and 37.86 per cent for the fiscal year 1944. These calculations, together with the annual accounting statement, were prepared by an auditor employed in the Division of Markets of the Department of Agriculture and Immigration of the Commonwealth of Virginia. For the taxable fiscal year ended June 30, 1943, the portion of the net revenues attributable to purchases from members was determined to be $ 6,722.44, and for the fiscal year ended June 30, 1944, such portion was determined to be $ 4,327.96. These amounts were, at the close of these years, set up on the books of petitioner under the heading "Reserve for Members' Equity."
The petitioner, in reporting its income for the taxable years here involved, excluded the aforesaid sums *61 of $ 6,722.44 and $ 4,327.96 from gross income by deducting them from gross sales under the heading "Less: Returns and Allowances." In determining the deficiencies involved in this proceeding, respondent included these sums in petitioner's gross income in each year, which resulted in an increase in each year in these respective amounts in petitioner's net taxable income.
*691 For each of the years here involved, petitioner's board of directors adopted resolutions declaring that the earnings made on member business for the year should be distributable to the members as patronage refunds at the close of the year, based on the audit report.
At the close of each of the taxable years petitioner executed and delivered to each of its members a so-called certificate of interest in the amount of such member's proportionate share in net earnings for the year upon the business done by petitioner with such member, the amounts of these certificates being represented in the total set-up at the close of each year on petitioner's books in the reserve entitled "Reserve for Members' Equity." The certificates so issued to its members by petitioner were in the following form:
Certificate
Number*62
Amount $
Certificate of Interest of the Colony Farms Cooperative Dairy, Inc.
NON NEGOTIABLE
This certifies that has an interest in the Revolving Capital Fund of the Colony Farms Cooperative Dairy, Inc., in the sum of $ for moneys deducted from returns due on milk and dairy products sold the Cooperative, and loaned and advanced unto it, which sum it hereby promises, covenants and agrees to pay the member, or his assigns, when the Board of Directors finds that the Revolving Capital Fund of the Cooperative has accumulated to ample proportions to properly finance the operations of the Cooperative, or in any event upon the dissolution of the Cooperative. The Certificates of Interest of this Cooperative shall be retired in the order in which issued.
The Certificates of Interest issued by this Cooperative are subject and junior to all other obligations thereof.
In witness whereof, the Colony Farms Cooperative Dairy, Inc., has caused this certificate to be executed this day of 194 .
[SEAL]
Colony Farms Cooperative Dairy, Inc.
By
Treasurer
Beginning in June 1946, petitioner commenced paying or liquidating, in the order in which*63 issued, the certificates of interest theretofore issued. In June 1946 it paid outstanding certificates for net proceeds for 1936; in June 1947 the 1937 certificates of interest were liquidated, in 1948 the 1938 certificates, and in 1949 the 1939 certificates. At the hearing of this proceeding, the certificates issued covering the receipts here in question on members' business for 1943 and 1944 had not been liquidated.
During and before the fiscal year ended June 30, 1942, petitioner operated as a tax exempt farmers' cooperative association, within the purview of section 101, paragraph 12, of the Internal Revenue Code, *692 as up to that time its dealings had been, except for a small amount, on behalf of members.
In the fiscal year ended in 1943 and the years following, petitioner abandoned its tax exempt status by reason of the increase in business done for nonmembers. Petitioner has no capital stock, its operations and the building of its plant having been financed with loans from the Baltimore Bank for Cooperatives and from members. The net proceeds of each year were retained, as hereinbefore explained, to insure adequate working capital and to repay capital loans made *64 in connection with the launching of the enterprise.
Notwithstanding the fact that petitioner's returns state that they are made on the basis of cash receipts and disbursements, the parties agree that the records were maintained on the accrual basis of accounting.
OPINION.
By reason of the large amount of business done by petitioner, a cooperative, for its nonmembers, it is not entitled to and does not claim tax immunity. Nor is the question here one of its right to a deduction from gross income in computing net income subject to tax. Our question is its right to exclude from its gross receipts earnings upon business done for or with its members, where, under its charter, bylaws, and marketing contracts with its members, such profits are segregated for return to such members in the form of patronage dividends.
This problem is not new, and has often been before the courts. The accepted rule is that if the cooperative receives these earnings under an existing legal obligation to distribute them to its members, such earnings are not income of the cooperative and consequently are to be excluded in the computation of its gross income.
The determinative fact in establishing this petitioner's*65 right to the exclusion is whether, at the time of its receipt of these earnings, it was under a legal obligation to pay them over to its members as patronage dividends. A thorough analysis and discussion of the principle appears in United Cooperatives, Inc., 4 T.C. 93">4 T. C. 93. It was clearly recognized in that decision that, to be entitled to the exclusion, the cooperative need not have paid the earnings in cash to its members if the agreement under its bylaws and contracts with its members permitted it to retain the cash for its use in the business and to make distribution to the members in the form of stock or other evidence of the extent of their individual participation in the fund.
Here the petitioner was organized as a nonstock corporation under the Virginia Cooperative Marketing Act of 1922. Its charter provides that the property rights and interests of the members shall be in proportion to the amount of business done by them through the *693 cooperative, as evidenced by certificates of interest issued and outstanding in the name of each member as recorded on the books. The bylaws adopted by petitioner include a mandatory provision that at the*66 close of each year the profits arising from member business shall be computed and the amount thereof set aside on the books in a revolving fund, and that a certificate of interest showing the amount of the equity of each member in such fund be delivered to each member, such certificates to be payable when the revolving fund has, in the opinion of the directors, been accumulated to such proportions that certificates may be liquidated in cash without reducing the fund below the amount necessary for the operations of the association. The certificates thus issued are to be liquidated in cash, in the order of their issuance. The obligation of the petitioner to its members is again specifically evidenced by its contract with each member. The arrangement under the charter, bylaws, and membership contracts was meticulously carried out by the petitioner in each year since its organization.
Respondent, upon brief, appears to recognize the fact that petitioner, to be denied exclusion of the earnings in question from gross receipts must have received them without a legal obligation to distribute them to its members. It is argued, however, that upon this record such distributions were only*67 to be made within the discretion of the directors. In support of this argument only one fact is pointed out as indicating that such power was only discretionary. This is the provision in the Virginia statute under which the petitioner was incorporated, that "the association may from time to time issue to each patron a certificate of equity evidencing the patron's interest in any fund, capital investment or other assets of the association. [Emphasis added.]" This argument overlooks the fact that the provision cited is in the enabling act under which the petitioner came into existence, and the section in question is permissive only. It merely allows the corporation the privilege of providing for distributions of certificates of interest within the discretion of its directors. However, the liabilities of the corporation are determined by the obligations to its members specifically assumed by it under its charter, bylaws and contracts with each member.
On this record we have no hesitation in concluding that the petitioner, through its bylaws and by its individual contracts with members, has specifically assumed an obligation to issue to each member a certificate in the amount*68 of his participation in the profits realized upon member business, to segregate such profits on its books, and to liquidate in cash these certificates when the financial needs of the corporation permit such action.
It must be kept in mind that the funds represented by these certificates of interest are retained by the corporation with the consent of *694 its members and represent an investment by each of them in the business to the same extent as if the distribution had been made in cash and the amount in each instance had been repaid by the member to the association for its use as working capital.
That the distributions in the form of certificates of interest effected a distribution of the earnings just as effectively as though made in the form of cash, it is thought, cannot be disputed. We have held such distributions to be taxable income of the individual member. Harbor Plywood Corporation, 158">14 T. C. 158, affd. 187 F. 2d 734; George Bradshaw, 14 T.C. 162">14 T. C. 162.
It is respondent's contention that the facts in the present case are similar to those in Fountain City Cooperative Creamery Association, 9 T.C. 1077">9 T. C. 1077,*69 affd. 172 F.2d 666">172 F. 2d 666, in which we held the taxpayer was not entitled to the exclusion. The facts in that case were that the cooperative was a stock company and the amount of the dividends upon its stock was not subject to limitation. Its directors might, in their discretion, allocate all of the earnings from member business as dividends upon the stock and consequently pay no patronage dividends. In view of this condition, the power thus held by the taxpayer's directors, we held that any action on their part in making a distribution of such earnings to the members was purely discretionary and voluntary and not taken under a legal obligation to so act. The cited case has no application here where the petitioner has no stock and the directors are definitely obligated by its bylaws and individual contracts with its members to segregate at the end of each year on its books the earnings from member business and to issue to each member a certificate evidencing his individual share of such earnings. The absence of this condition in Fountain City Cooperative Creamery Association, supra, was the reason for the conclusion reached *70 by us in that case. The distinction between the two types of cases is illustrated in Peoples Gin Co. v. Commissioner, 118 F. 2d 72, in which the exclusion was denied, the court saying:
This case is different from the cases relied upon by the petitioner. In those cases where the deduction was allowed the obligation to make rebates or refunds was in existence before the profits were earned.
In the present case the obligation to segregate the earnings in a revolving fund and to distribute to the members certificates of interest therein was assumed by the petitioner prior to the receipt of these earnings and did not come about through voluntary action on the part of petitioner's directors after such receipt.
The action of respondent in denying the exclusion is reversed. Since there were certain adjustments by respondent in computing the deficiency that are not put in issue by the petition,
Decision will be entered under Rule 50.