DocketNumber： Docket No. 8084-93.
Filed Date： 9/11/1995
Status： Non-Precedential
Modified Date： 11/20/2020
*435 Decision will be entered for petitioner.
MEMORANDUM FINDINGS OF FACT AND OPINION
SCOTT,
| Year | Deficiency |
| 1979 | $ 11,217 |
| 1980 | 110,107 |
| 1981 | 156,030 |
| 1982 | 248,083 |
| 1983 | 130,496 |
| 1984 | 133,627 |
These deficiencies result from a determination by respondent that the allowance of loss carrybacks by a predecessor of Farm Credit Services of NorthwestNorth Dakota from 1985 to 1982, 1983, and 1984, thus permitting carrybacks of investment tax credits no longer needed in those years to 1979, 1980, and 1981, was in error.
The issue for decision is whether Production Credit Association of Minot, a production credit association, which was a predecessor of Farm Credit Services of NorthwestNorth Dakota, is prohibited by
FINDINGS OF FACT
Some of the facts have been stipulated and are found accordingly.
At the time of the filing of the petition in this case, Farm Credit Services of NorthwestNorth Dakota (Farm Credit Services) had its principal place of business in Minot, North Dakota.
Farm Credit Services is an agricultural credit association incorporated under the Farm Credit Act of 1971, Pub. L. 92-181, 85 Stat. 583, as amended. It is the result of a merger between the Production Credit Association of Minot (which we will hereinafter refer to as petitioner since it is the one of the merged organizations whose taxes were adjusted) and the Federal Land Bank Association of Northwest North Dakota, which occurred on March 31, 1989.
Petitioner was incorporated on January 17, 1934, as a production credit association pursuant to title II of the Farm Credit Act of 1933, with its stated purpose being, among other things, "to make loans to farmers for general agricultural purposes." *437 At all times relevant to this case petitioner had its principal office in Minot, North Dakota. Petitioner timely filed its Federal income tax returns for the taxable years 1979 through 1984 with the office of the Internal Revenue Service in Ogden, Utah.
During the taxable years at issue, petitioner operated as a production credit association pursuant to the Farm Credit Act of 1971. During the years at issue, petitioner was one of over 400 production credit associations located throughout the United States.
Petitioner operated through a main office located in Minot, North Dakota, and four branch offices located in Williston, Bottineau, Rugby, and Carrington, North Dakota. Petitioner operated through five offices because the territory it served was quite large, necessitating branch offices.
During the taxable year 1985, petitioner had approximately 65 employees.
Beginning October 1, 1985, petitioner and the Federal Land Bank Association of Northwest North Dakota entered into a joint management arrangement. Under that agreement, they shared office space and employees, but each kept its separate corporate identity, and petitioner continued to file separate Federal income tax returns. *438 The purpose of joint management was to achieve greater efficiencies. The Federal Land Bank Association of Northwest North Dakota and petitioner conducted business under the name Farm Credit Services of Minot.
Under the Farm Credit Act of 1971, section 2.15(a), 85 Stat. 601, petitioner was authorized to do the following: make, guarantee, or participate with other lenders in short- and intermediate-term loans and similar financial assistance to (1) bona fide farmers and ranchers and the producers or harvesters of aquatic products, for agricultural purposes and other requirements of such borrowers, (2) rural residents for housing financing in rural areas, under regulations of Farm Credit Administration, and (3) persons furnishing to farmers and ranchers farm-related services directly related to their on-farm operating needs.* * *
Most of petitioner's loans were to farmers for agricultural purposes. Petitioner participated in a few commercial bank loans to farmers. Petitioner made a few loans to persons furnishing farmers with farm-related services that were directly related*439 to their on-farm operating needs.
From 1979 through most of 1985, petitioner lent money to farmers located in a 16-county area in northwest North Dakota. As of December 1, 1985, a 17th North Dakota county, McKenzie, was added to petitioner's service area. Most farming businesses in these counties were conducted as sole proprietorships. Most of the farms in this area were engaged in either small grain production or cow/calf operations. A typical farm in this area was approximately 1,200 acres.
Production, or operating, loans were short-term loans to finance the cost of raising a crop or feeding livestock. These loans were normally due within 1 year. Production loans were used by farmers to pay for fuel, fertilizer, seed, and other expenses of raising a crop or the costs of feeding livestock. These loans were paid off when the crop or livestock was sold. These loans were typically secured by crops, farm machinery, or livestock.
Term loans were loans to purchase machinery, livestock, or farm-related assets, other than land, with a useful life longer than 1 year for use for agricultural purposes. The maximum length of the term loans that petitioner made was 7 years. Term loans were*440 often secured by the asset purchased.
When a prospective borrower requested a loan, petitioner required that he or she complete an application that asked for detailed financial information. After the application was completed, petitioner analyzed the information contained in the application to determine whether the prospective borrower's anticipated cash-flow would be sufficient for timely repayment of the loan, and whether the available collateral was adequate. Petitioner would then investigate the credit history of the prospective customer to determine the customer's credit-worthiness.
Once petitioner had completed its analysis of the application, it decided whether or not to make the loan. Depending on the size and complexity of the prospective loan, the lending decision was made by either a loan officer, a branch manager, a credit committee, or the Federal Intermediate Credit Bank in St. Paul. Lending decisions were normally made within 1 to 7 days, with decisions on large loans requiring higher levels of review taking longer than decisions on smaller loans that were approved by a loan officer or a branch manager.
When a loan application was declined, the applicant was normally*441 sent a letter informing the applicant that the loan had been declined, stating the reason for the denial and describing the applicant's appeal rights. An applicant had certain appeal rights if the applicant thought that credit had been unfairly denied.
When a loan was approved, a credit officer was responsible for assuring that the correct papers were prepared to document the loan and to perfect petitioner's security interest in any collateral. Petitioner had both a long form and a short form basic loan agreement. Various papers were used to perfect petitioner's security interest in collateral.
When the loan documentation was completed, the loan would be closed and the funds disbursed. Once the loan funds were disbursed, the loan was entered into petitioner's accounting system so that the borrower would be billed when appropriate. A credit officer normally was not actively involved in monitoring a loan after it was made, unless the loan was large or had been identified as a problem loan. The procedures for approving and processing loan renewals were essentially the same as the procedures for new loans, except that the investigation of the borrower's history did not need to be as*442 extensive.
If a borrower missed a payment or petitioner had reason to be concerned about the repayment prospects of the loan, the loan was characterized as a problem loan. For all problem loans, a loan service plan was prepared outlining petitioner's general philosophy with respect to the loan, the condition of the collateral, and a plan for handling the loan so that the loan would eventually be upgraded or repaid. Petitioner sought to work with borrowers to return problem loans to acceptable credit standards.
If it appeared that a problem loan would not eventually be upgraded, but the borrower was cooperating with petitioner, the loan was classified as a workout loan. The objective was to gradually reduce the balance of the workout loan over a 1- to 3-year period.
If it appeared that a problem loan would not eventually be upgraded and the borrower was not cooperating, the loan was classified as a collection loan. The objective of petitioner was to get out of collection loans as quickly as possible using the collection alternatives at its disposal. Any collateral received in a foreclosure was classified as acquired property and sold, sometimes on a contract basis, as part of the*443 loan collection process. Foreclosed property was sold to whoever was willing to buy it. Petitioner pursued collection on loans in default as long as the costs of collection did not outweigh the prospects of recovery.
Petitioner described the activities it engaged in with respect to each loan to ensure collection as "loan servicing". These activities included billing and collecting interest and principal, checking collateral, monitoring the loan, and work-out and collection efforts. Petitioner's loan collection process, loan approval process, loan documentation process, loan processing times, procedures for dealing with troubled loans, and lending practices were, in general, comparable to those of commercial banks making loans to farmers in northwest North Dakota.
Petitioner did not give its borrowers advice on how to conduct farming operations or how to market crops. Loan officers for petitioner were cautioned not to become involved in the management of the farms of borrowers, but rather to deal with borrowers on an arm's-length basis to avoid jeopardizing petitioner's chances of collection should the borrower default on the loan.
Petitioner actively sought new borrowers. It advertised*444 in local papers and on the radio and television, sought referrals from existing customers and from machinery suppliers, and reviewed the credit bulletins to identify potential customers.
The purpose of the Farm Credit Act of 1971 was to improve income of farmers and ranchers by furnishing sound, adequate, and constructive credit and closely related services to them. In line with this purpose, production credit associations were obligated to set interest rates at the lowest reasonable cost taking into account the cost of funds, necessary income, and expenses.
Petitioner charged interest on its loans at a competitive rate, but not always the lowest rate charged in its area. Its interest rates were generally equal to rates charged by other lending institutions in northwest North Dakota for comparable loans. Petitioner's only compensation for loans was interest charged for the money lent. It had no separate charge for the time spent processing and handling loans. Petitioner's share of the farm production loan market in northwestern North Dakota during the years in issue was between 20 and 25 percent.
Initially petitioner's business was only making loans, but starting in November 1983*445 petitioner offered borrowers the option of financing farm equipment, machinery, and grain storage facilities under a farm equipment lease program. Under the farm equipment lease program, petitioner purchased the farm equipment needed by a farmer and leased it back to the farmer. Petitioner determined whether to enter into a farm equipment lease with a farmer in the same manner it determined whether it would make a term loan to a farmer to purchase equipment which would serve as collateral for the loan. Under the terms of the farm equipment lease, the farmer was entitled to purchase the leased property at the end of the lease term at a percentage of the original equipment cost established at the origination of the lease.
Leases under the farm equipment lease program qualified as farm finance leases for tax purposes under section 168(f)(8) (as in effect at that time) so that petitioner, rather than the farmer, was treated as the owner of the leased property for tax purposes and, thus, was entitled to depreciate the property and to claim any investment tax credit. This tax deduction arrangement enabled petitioner to offer farmers financing on farm equipment at a reduced rate.
In addition*446 to providing loans to farmers, petitioner was authorized by the Farm Credit Act of 1971, section 2.16, 85 Stat. 602, to do the following: provide technical assistance to borrowers, applicants, and members and may make available to them at their option such financial related services appropriate to their on-farm operations as is determined feasible by the board of directors of each district bank, under regulations prescribed by the Farm Credit Administration.
Petitioner's loans to borrowers sometimes required that credit life or key-man insurance be maintained in the amount of the loans to assure repayment in the event of the death of the borrower. Petitioner's loans to borrowers sometimes required that hail or all-risk insurance be purchased to protect petitioner's collateral and to thereby assure repayment. Petitioner offered its borrowers the option of purchasing credit life, hail, or all-risk insurance through insurance programs it sponsored. *447 While petitioner sometimes required that a borrower purchase insurance as a condition of the loan, it did not require that the insurance be purchased through its programs. Petitioner was not the insurer under its programs, but rather it sold insurance offered by several insurance companies.
Petitioner sold credit life insurance only to borrowers. Hail insurance and multiperil insurance were sold to borrowers, to landlords whose tenants were borrowers, and, in a few instances, to borrowers of the Federal Land Bank Association of Northwest North Dakota. Commercial banks lending to farmers in northwest North Dakota offered similar credit life insurance programs, and, depending on their size and their authority, offered similar hail and multiperil insurance programs.
Petitioner, at least from 1979, also offered borrowers an electronic farm recordkeeping system known as "Agrifax", as well as tax planning and preparation assistance. Under the Agrifax system, petitioner would process data provided by farmers and produce standardized farm records for a set fee. The Agrifax system helped farmers prepare records which the farmers could then use in running their businesses. The Agrifax system*448 also produced standardized records which were of assistance to petitioner in monitoring the status of its loans.
Petitioner did not advertise the availability of the Agrifax system to the general public. When a nonborrower used the system, the nonborrower was required to purchase a share of stock or a participation certificate.
For a fee, petitioner prepared tax returns. When returns were prepared for a nonborrower, the nonborrower was required to purchase a share of stock or a participation certificate.
During the years at issue, petitioner had approximately 450 to 550 customers of Agrifax and approximately 250 to 450 tax return preparation customers. Petitioner ceased offering Agrifax and tax return preparation in 1985 when the key individual involved in this activity left petitioner and went into business for himself.
Petitioner's principal business activity was making loans to farmers. During the years at issue, petitioner had over 2,000 borrowers each year, and its average loan volume exceeded $ 120 million annually. Interest earned on loans was $ 16,569,600 in 1984. Agrifax income and tax service income were $ 200,588 and $ 95,380, respectively, in 1984.
In 1984, credit*449 life insurance gross premiums collected totaled $ 429,000 and credit life insurance income was $ 109,050. In 1984, hail insurance gross premiums collected totaled $ 2,200,000, all-risk insurance gross premiums collected totaled $ 480,428, and hail and all-risk insurance income totaled $ 602,702. In 1983, 23 leases were closed totaling approximately $ 1 million, and, in 1984, 54 leases were closed totaling approximately $ 1.5 million.
Petitioner was organized with capital stock. During the years relevant to this case, petitioner had issued and outstanding shares of class A nonvoting stock (through 1980), shares of class B voting stock, and participation certificates. Petitioner had authority to issue class C preferred stock, but no shares of class C preferred stock were issued or outstanding during the years here relevant.
Petitioner had authority to pay dividends on its outstanding shares of both class A nonvoting stock and class B voting stock, and on participation certificates. Petitioner paid dividends on shares of class A nonvoting stock for the years 1978 through 1980.
Petitioner's bylaws provided for the payment of patronage dividends to borrowers, if prior to the start of*450 a fiscal year the board of directors adopted a resolution obligating petitioner to pay patronage dividends. The board of directors never adopted such a resolution, and petitioner never paid a patronage dividend.
During each of the years at issue, petitioner filed Forms 1120, U.S. Corporation Income Tax Returns. Petitioner did not claim any special tax status, and it paid tax on its taxable income each year as an ordinary corporate taxpayer.
Petitioner was not exempt from income taxes under subchapter F or any other provision of the Internal Revenue Code. Petitioner was not a "corporation operating on a cooperative basis" within the meaning of section 1381(a)(2), and was not subject to and did not receive the benefits of subchapter T. Petitioner was not a social club.
In the mideighties, petitioner experienced a significant deterioration in the quality of its loans. This decline culminated in substantial loan losses in 1985 and 1986, which petitioner deducted as worthless debts resulting in net operating losses in 1985 and 1986. The deterioration in the quality of petitioner's loans was primarily the result of a weakening of the farm economy during the mideighties, which made it*451 difficult or impossible for many of its borrowers to make payments when their loans became due. Farm income dropped, and the value of farm assets fell during this period.
During the mideighties, commercial lenders to farmers in northwest North Dakota suffered losses similar to those suffered by petitioner.
The production credit associations in the district in which petitioner was located and the St. Paul Federal Intermediate Credit Bank collectively incurred net losses of $ 159.7 million and $ 100.3 million in 1985 and 1986, respectively. The Federal land bank associations in the district in which petitioner was located and the Federal Land Bank of St. Paul collectively incurred net losses of $ 335.8 million in 1985 and $ 433 million in 1986.
The losses incurred by petitioner were not intentionally generated by petitioner for tax or other reasons. They did not result from pricing loans or interest on loans below market. Borrowers from petitioner who were able to repay their loans did not benefit from the losses incurred by petitioner from bad loans, while the farmers whose loans were written off often lost all that they had invested in farming.
Petitioner conducted its business*452 in essentially the same manner in 1985 as it had in prior years. The farmers whose loans gave rise to the loan losses in 1985 were the type of borrowers, and some were borrowers, with whom petitioner had done business for a number of years.
Petitioner used the terms "borrower", "stockholder", and "member" to describe its customers. All borrowers, including leasing customers, were required to purchase and own either class B voting stock if they were ranchers or farmers, or participation certificates if they were not farmers or ranchers, in an amount equal to 10 percent of their outstanding loan balance. Participation certificates were issued when loans were made to persons who were not farmers or ranchers who took out loans to furnish farmers farm-related services. When petitioner participated in loans made by commercial banks to farmers, when petitioner sold hail or multi-peril insurance to a landlord or a borrower from the Federal Land Bank Association of Northwest North Dakota, or when petitioner provided Agrifax or tax preparation services for someone who was not a borrower, the customer was required to purchase a participation certificate. Most outstanding participation certificates*453 related to commercial bank loans in which petitioner participated. As a borrower paid off his or her loan from petitioner, the amount originally paid to purchase stock or a participation certificate was returned to him or her. *454 refused a loan because he or she was not a shareholder. In fact, most borrowers did not become stockholders until the loan was approved and made to them. At that time, most of the borrowers purchased their stock with a portion of the borrowed funds.
Only class B stockholders were permitted to vote at members' meetings. Each owner of class B voting stock was entitled to one vote, regardless of the number of shares held. A holder of a participation certificate, who was denominated a member under petitioner's bylaws, had no right to vote at members' meetings.
All class B voting stock of petitioner was owned by either borrowers or lessees. All borrowers, lessees, all persons who purchased insurance through petitioner, and all persons who used Agrifax or had their tax return prepared by petitioner owned either class B voting stock or participation certificates and, thus, were members under petitioner's bylaws.
Petitioner obtained its loan funds from its equity and from borrowing from the Federal Intermediate Credit Bank of St. Paul, 1 of 12 Federal intermediate credit banks nationwide which provided funds to production credit associations. The Federal Intermediate Credit Bank in turn*455 obtained capital by selling bonds in national markets.
On its Federal income tax returns for its taxable years 1979 through 1984, petitioner reported taxable income and total tax paid each year as follows:
| Year | Taxable income | Total tax paid |
| 1979 | $ 562,948.48 | $ 228,244.06 |
| 1980 | 889,375.82 | 364,445.53 |
| 1981 | 988,499.08 | 420,546.18 |
| 1982 | 625,252.00 | 248,583.00 |
| 1983 | 603,542.00 | 130,608.00 |
| 1984 | 673,710.00 | 133,650.00 |
On its tax return for 1985, petitioner reported total income of $ 14,027,238 and total expenses of $ 17,004,075. The expenses it reported were:
| Expense | Amount |
| Compensation of officers | $ 187,707 |
| Salaries and wages | 1,149,326 |
| Bad debts | 3,594,997 |
| Taxes | 123,346 |
| Interest | 10,328,650 |
| Depreciation | 759,138 |
| Advertising | 22,743 |
| Employee benefits | 78,592 |
| Other deductions | 759,576 |
The operating loss incurred by petitioner of $ 2,976,837 during its 1985 taxable year was the result of the bad debt deduction of $ 3,594,997.
Petitioner filed Corporation Applications for Tentative Refund, Forms 1139, with the Internal Revenue Service claiming a carryback of its 1985 net operating loss to its 1982, 1983, and 1984 taxable years and carrybacks of investment*456 tax credits to its 1979, 1980, and 1981 taxable years. The net operating loss carrybacks from 1985 and the claimed refunds were as follows:
| Net operating | Refund | |
| Year | loss carryback | claimed |
| 1982 | $ 625,252 | $ 248,083 |
| 1983 | 603,542 | 130,496 |
| 1984 | 673,710 | 133,627 |
The investment credit carrybacks from 1982, 1983, and 1984 and the claimed refunds were as follows:
| Investment credit carrybacks and | |
| refund claimed resulting | |
| Tax year ended | from carrying back credits |
| 12/31/79 | $ 11,217 |
| 12/31/80 | 110,107 |
| 12/31/81 | 156,030 |
As required by section 6411, the amounts claimed on the Corporation Applications for Tentative Refund, Forms 1139, were refunded to petitioner.
After examination of the returns and the applications for tentative refund described above, respondent issued a notice of deficiency to petitioner determining deficiencies in its Federal income taxes for the years 1979 through 1984 in the amounts of the previously allowed refunds resulting from carrying back the 1985 net operating loss and investment tax credits.
In her notice of deficiency, respondent explained her determination of deficiencies as follows: Under
OPINION
*458 The parties are in agreement that for
Petitioner contends that it was not a "membership organization" within the meaning of
Respondent's position is that petitioner is a "membership*459 organization" within the literal language of
5.
The Committee on Finance of the U.S. Senate enlarged some of the exceptions to the proposed 5. The purpose of the provision is to impose a limitation on the amount of deductions in a taxable year for items which are otherwise allowable as deductions in the case of the organizations and activities to which the provision is applicable, and is not intended to provide for the deduction of any item not otherwise deductible.
The purpose of
None of the decisions in which this Court has considered
*466 In
At least one other court has upheld the applicability of
In the cases that have held that the taxpayer qualified as a membership organization, none involved a taxpayer that offset income of prior years from member activity by a loss carryback. In each instance, the taxpayer had either investment or nonmember income which was used in the same year received to offset a loss from providing goods and services to its members in that year. These holdings are consistent with the policy behind
Petitioner, in disputing that it was a membership organization, first relies on the definition of membership organization from section 456(e)(3). Petitioner argues that
Without addressing many of petitioner's arguments, we conclude that petitioner is not a membership organization for purposes of
Persons who received loans or services from petitioner were designated members by receiving either stock or participation certificates. Members did not receive special loan rates, special treatment in loan processing, or special treatment if their loans became problem loans. An eligible borrower was not refused a loan because he or she was not a shareholder, but was required to become a shareholder upon approval of the loan. The only privilege bestowed upon a nonshareholder member was the right to attend and speak, but not vote, at members' meetings. Class B stockholder borrowers were the only voting "members". In one sense of the word, petitioner generally did not make loans to members but only to nonmembers and, therefore, would not be a "membership organization" that had any substantial transactions with its members. As a loan was paid*470 off, generally the class B stock or participation certificate the borrower was required to purchase was paid off, so that when that person applied to borrow again, he or she was not a member. Therefore, there were no "members" to which petitioner could furnish services or goods at less than cost.
The fact that clearly distinguishes the instant case from the prior cases that have held
Respondent argues that
In the prior cases where we have considered
The legislative history clearly confirms that to broaden the scope of
1. All section references are to the Internal Revenue Code in effect for the years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure, unless otherwise indicated.↩
2. The testimony in the record is that if, as occasionally happened, a class B stockholder wished to remain a stockholder after his or her loan was repaid, he or she could convert his class B stock to class A stock. However, petitioner's records show no class A stock outstanding after 1980.↩
3.
(a) General Rule.--In the case of a social club or other membership organization which is operated primarily to furnish services or goods to members and which is not exempt from taxation, deductions for the taxable year attributable to furnishing services, insurance, goods, or other items of value to members shall be allowed only to the extent of income derived during such year from members or transactions with members (including income derived during such year from institutes and trade shows which are primarily for the education of members). If for any taxable year such deductions exceed such income, the excess shall be treated as a deduction attributable to furnishing services, insurance, goods, or other items of value to members paid or incurred in the succeeding taxable year. The deductions provided by sections 243, 244, and 245 (relating to dividends received by corporations) shall not be allowed to any organization to which this section applies for the taxable year.
(b) Exceptions.--Subsection (a) shall not apply to any organization-- (1) which for the taxable year is subject to taxation under subchapter H or L, (2) which has made an election before October 9, 1969, under section 456(c) or which is affiliated with such an organization, or (3) which for each day of any taxable year is a national securities exchange subject to regulation under the Securities Exchange Act of 1934 or a contract market subject to regulation under the Commodity Exchange Act.↩
4.
5. In
6. For a more detailed discussion of subch. T organizations, see our discussion in
7.
8. In
In