"Operating on a cooperative basis:" Plywood, now and forever

The difference between an article and an indefinite article in English usage -- "a" versus "the" -- cannot possibly be the lynchpin of cooperative law in the U.S.  Thus I respectfully dissent from something I heard one of the presenters say at last month's Cooperative Professionals Conference, sponsored by the National Cooperative Business Association (NCBA) and held in Minneapolis.

We are, of course, talking about Subchapter T of the Internal Revenue Code (26 U.S.C. sections 1381-1388, for those keeping score).  Subchapter T is the center of the universe when it comes to cooperative law in the U.S. for two reasons:  (1) there is no universally accepted definition of "cooperative" as a matter of state law, and it's state law that governs the properties of business entities and (2) avoiding federal income taxation is what every business entity in the U.S. strives to do and co-ops are no exception.

Under Subchapter T, cooperatives can avoid the so-called double taxation of corporate earnings -- once as income tax paid by the corporate entity and once again as income tax paid by individuals upon the receipt of dividends.  (As an aside, please do not be freaked out by my equating co-ops with corporate entities.  Incorporation is a generic term and refers to the legal recognition of a business entity separate from its owners, who therefore cannot in most circumstances be personally liable for the obligations of the entity.  Cooperatives benefit from limited liability as much as Whole Foods or Monsanto do.)  The mechanism for doing so is laudably flexible but also rather convoluted, as anyone familiar with qualifying and non-qualifying patronage allocations can testify.

For present purposes, we can leave the convolutions aside and focus on the key requirement of Subchapter T.  To take advantage of its provisions, a business entity must be "operating on a cooperative basis."  That's what section 1381(a) of subchapter T says about it.  (Yes, I know there are exceptions, having to do with agricultural co-ops, electric and telephone co-ops and cooperatively organized financial institutions like credit unions.  So don't write in about that, okay?)

But what the heck does "operating on a cooperative basis" mean?  Congress did not define the phrase, which is mighty vague.

One thing we know "operating on a cooperative basis" does not mean is "incorporated under state law as a cooperative." Lots of limited liability companies (LLCs) -- a type of entity that is not technically a cooperative as a matter of state law, but whose attributes are sufficiently flexible to allow for operating on a cooperative basis -- are filing Subchapter T tax returns.

As every good student of administrative law knows, when Congress drafts an ambiguous statute it falls to the agency administering the statute to resolve the ambiguities.  The Internal Revenue Service has gazillions of pages of "Treasury regs" for this purpose (since the IRS is technically part of the U.S. Department of the Treasury), and there is also the U.S. Tax Court, which straddles the executive and judicial branches of government (as a so-called Article 1 court, a reference to Article 1 of the U.S. Constitution as opposed to Article 3, which establishes the independent judicial branch of government).  The U.S. Tax Court has the authority to supersede interpretations of the Internal Revenue Code by the IRS.  And in this instance, it is the U.S. Tax Court that has provided what is generally regarded as the definitive interpretation of "operating on a cooperative basis."

Back in 1965, just three years after Congress adopted Subchapter T, the U.S. Tax Court decided Puget Sound Plywood, Inc. v. Commissioner of Internal Revenue, 44 T.C. 305 (1965), and in the process offered these three essential attributes of "operating on a cooperative basis," with specific reference to the Rochdale Pioneers whose co-op founded in 1844 is generally regarded as the mother of all modern co-ops:

"(1) Subordination of capital, both as regards control over the cooperative undertaking, and as regards the ownership of the pecuniary benefits arising therefrom;

(2) democratic control by the [members] themselves; and

(3) the vesting in and the allocation among the worker-members of all fruits and increases arising from their cooperative endeavor (i.e., the excess of the operating revenues over the costs incurred in generating those revenues), in proportion to the [members'] active participation in the cooperative endeavor."

And there it has stood, for a half-century.

So it was a bit startling to be at the National Cooperative Business Association's 2015 Cooperative Professionals' Conference in Minneapolis back in November and hear one of the presenters suggest that maybe we're not really stuck with the tripartite standard articulated in the Puget Sound Plywood case.  According to this presenter, Subchapter T refers not to "operating on the cooperative basis" but to "operating on a cooperative basis" -- ergo, the Rochdale-inspired standard endorsed by the Tax Court in 1965 might not be the only rubric that would qualify an organization for Subchapter T tax treatment.

This is unpersuasive for three distinct reasons.

The first has to do with a key principle of statutory interpretation.  Since at least 1917, when the U.S. Supreme Court decided Caminetti v. United States, 242 U.S. 470 (1917) (holding that one could indeed be prosecuted under the federal "White Slave Traffic Act of 1910" for transporting a woman from Sacramento to Reno, thus crossing state lines, for purposes of causing her to become one's "concubine and mistress," even if no financial transaction was involved), it has been axiomatic that federal statutes must be interpreted so as to apply the plain meaning of the words employed by Congress. "Operating on the cooperative basis" is simply not the way anyone uses the word "basis" in England and there is no reason to assume Congress would have done so if it had meant to telegraph that there is only one way to operate on a "cooperative basis."

The second has to do with the famous principle articulated in Chevron, USA v. Natural Resources Defense Council, 467 U.S. 837 (1984), to the effect that when Congress drafts an ambiguous statute it is appropriate to defer to an agency's reasonable interpretation of that statute.  Assuming that "operating on a cooperative basis" is the sort of ambiguous phrase that Congress wrote with the expectation that the appropriate agency (here, the IRS) would pinpoint a more precise meaning, the IRS has long since done so by acceding rather than challenging the definition adopted by the Tax Court in Puget Sound Plywood.

The third and most important reason that Puget Sound Plywood describes the only possible definition of "operating on a cooperative basis" is that the Tax Court understood something important:  that dividing surplus according to patronage was not just an attribute of the cooperative the Rochdale Pioneers started in 1844.  It's the reason their co-op succeeded where those that came before it failed.  One often hears that Rochdale was the first cooperative, but that's wrong.  It was the first cooperative to endure.  While the patronage rule is only one of the three criteria articulated in Puget Sound Plywood, limitation on return is elsewhere enshrined in Subchapter T and I have never heard anyone seriously argue that one-member-one-vote is not an essential attribute of a cooperative -- or, if you prefer, the cooperative.

Thus the essential holding in Puget Sound Plywood is enshrined on the back of my business card.  I intend it to remain there.