Cooperative vs. Corporation – A different choice for new organizations

Cooperative vs. Corporation – A different choice for new organizations[1]

By Fred L. Somers, Jr., P.C.[2]

 When starting a new or reorganizing an existing business, owners are usually confronted with the choices of a corporation, limited liability company, sole proprietorship, or one of the various forms of partnership.[3] The traditional text and online sources for educating lawyers and entrepreneurs typically omit the option of forming a cooperative.

Yet, cooperatives have been around for a long time. In practice, they are largely concentrated in agricultural, utility, and specialized industry endeavors. However, many and successful cooperatives exist in the broader commercial context. Ace Hardware is but one of many examples. Retailer cooperatives have been particularly successful among groceries, pharmacies, and hardware stores.[4] Also, cooperatives are popular within the health care industry.

There exist producer, consumer, worker, and other cooperative classifications. Producer cooperatives operate for the benefit of the members in their capacity as producers. Their function may be either the marketing or processing of goods produced individually (as in fishermen’s or farmers’ marketing associations, or associations which make butter or cheese from farm products received from farmer members), or the marketing of goods processed or produced collectively (as in the so-called workers’ cooperative). Consumer cooperative organizations operate for the benefit of the members in their capacity as individual consumers [5]

Recently, there has been revitalization internationally of cooperatives. We submit a case may be made why cooperatives if they continue to strengthen and multiply may reduce the tension between capital and labor, and that between lesser economically privileged citizens and those enjoying a high economic living under capitalism. 

Distinguishing Cooperative Features. So how do cooperatives differ from the run of the mill organizations? The distinguishing feature of cooperatives as opposed to other organizational forms, is they are user-owned, user-controlled entities that distribute benefits based on use.[6] These features may be considered the three bedrock principles of cooperatives.

. . . [A] cooperative principle is an underlying doctrine or tenet that defines or identifies a distinctive characteristic. It clearly sets the cooperative apart from other businesses. (And as [John] Milton said, “A good principle, not rightly understood, may prove as harmful as a bad principle.”)[7]

For example, the principle of “user-controlled” is often cited as “one member, one vote”. That is, member-owners of a cooperative corporation should have one vote no matter how much money they have invested in stock or how much they patronize the organization. The “one member one vote” principle may be characterized as “democratic control”.  However, a more enlightened interpretation of “user-controlled” may be “member control”. We submit it more accurately describes today’s cooperatives than “democratic control.” Member control recognizes that members can control a cooperative either through one vote per member or through a voting system that relates to the size of the patronage each member does with the cooperative.[8]  “Member control” more accurately is expositive of a principle inherent in cooperatives than “democratic control”.

Other organizations and resources cite additional “cooperative principles”. One is the “seven principles” consisting of: voluntary and open membership, democratic member control, member economic participation, autonomy and independence, education, training, and information, and cooperation among cooperatives.[9] Important is the principle of education and training. Our experience tells us when promoted to leadership positions in cooperatives, the new leaders are sometimes not sufficiently prepared in the nuances and groundings of cooperative operations. This unpreparedness leads to unnecessary mistakes in governance and the risk of losing tax and other benefits of the cooperative over other types of organizations.

Yet another resource espouses fourteen principles, including unity, cooperation, honesty, and neutrality, i.e., membership is open to all, irrespective of religion, caste, political affiliation, and beliefs.[10] Depending upon the laws of the jurisdiction within which the cooperative is operating, and the applicable tax law there may be other requirements (as distinguished from principles) that dictate conformity. However, in the absence of a state law mandating the cooperative be open to all, we find limitation of eligibility for membership to a particular ethnic or other attributes can be a strengthening and cohesion of member interrelationships and economic benefit.

There is a difference in the basic objectives of cooperatives from capitalistic companies. The basic objective of a cooperative organization is to provide essential services for the benefit of its mem­bers. A capitalistic company is a business organization with the objective of earning profit for its shareholders or members.[11] This difference does not mean e.g., a cooperative may not be a corporation in form. Some states require cooperatives to exist as corporations.[12] However, in these instances, return on invested capital is subordinated to distributions to participating member patrons.

Various choices exist depending partially upon the state in which the business is to be organized or operate.  Traditional cooperative members are often in the same industry and have common economic interests that may involve joint marketing, purchasing of supplies, or the providing of services or all three functions.[13] The traditional cooperative is authorized by state statute in a substantial majority of the states.[14] In states not providing for business cooperatives outside of specified industries, other forms of entity structure are available to include cooperative features. For example, a limited liability company (LLC) may be structured to provide cooperative tax treatment and distribution rights.

Limited Cooperative Associations. More recently, “hybrid”, “new generation” and limited cooperatives have been authorized by several states to enable businesses to escape the relatively rigid configurations and requirements of some of the traditional cooperative statutes. Especially we find attractive the limited cooperative, (“LCA”), enacted by at least 10 states plus the District of Columbia. These limited cooperatives in general are patterned after the Uniform Limited Cooperative Association Act.[15]

bLCAs differ from traditional cooperatives in that a member of an LCA does not need to be a patron. In a traditional cooperative, to be a member you are required to participate as a patron of the enterprise.  By allowing non-patron investors to become members, LCAs have more flexibility and capacity to generate financing than the traditional cooperative.[16] LCAs can entice investors with voting rights. Investor-members also receive revenue allocations proportionate to the ratio of their investments to those of other investors.[17]

Unlike traditional cooperatives, in which start-up expenses are minimal and growth is financed through members’ retained earnings, permanent equity to fund LCA start-up and growth is financed through the sale of either delivery or purchase rights or obligations. LCAs may use, multi-stakeholder revenue-based financing[18] mechanisms to raise capital, offering investors a return of up to a multiple of 1-5x the original investment, or a fixed percentage of profit for a fixed duration of time.  Once the cap is reached, the shares are treated as automatically repurchased. These instruments are sometimes called demand dividends.[19]

These flexible LCA financial tools are to be contrasted with traditional and mature cooperatives which tend to finance operations and growth using a preferred share that earns a target, non-cumulative, non-guaranteed dividend over a minimum holding period of between five to ten years.

Alternatively, LCAs with a mature financial history may offer an equity buyback, also known as equity redemption. Instead of taking money out of the business through revenue-share distributions, investors buy shares and hold them until the company is profitable enough.

Taxation. There are several income tax regimes available for cooperatives. IRC 501(c)(12) provides federal income tax exemption for benevolent life insurance associations of a purely local character, mutual ditch or irrigation companies, mutual or cooperative telephone companies, electric companies, or “like organizations”.[20] The purpose of an I.R.C. 501(c)(12) organization is to provide certain services to its members at the lowest possible cost. To qualify for and maintain exemption under I.R.C. 501(c)(12), a cooperative must receive 85 percent or more of its income each year from members. The income must be collected solely to meet the cooperative’s losses and expenses.

Congress also provided special tax rules for three other kinds of cooperatives.  These are “Subchapter T” cooperatives and farmers’ cooperatives. Subchapter T cooperatives are governed by I.R.C. sections 1381-1388. These cooperatives may conduct any kind of business. Their members or patrons can include individuals or organizations. Subchapter T cooperatives are not exempt from federal income tax. Rather, their earnings are taxed at either the cooperative level or member-patron level, or both. A subchapter T cooperative must usually pay tax on patronage source earnings it retains. It can deduct patronage-source earnings it distributes to its member-patrons from its gross income. Only patronage-source earnings are eligible for deduction by the cooperative, and they constitute taxable income to member-patrons who receive them. The cooperative is subject to tax on its net non-patronage source earnings, and patrons are subject to tax on distributions of non-patronage income.[21]

Farmer cooperatives are governed by I.R.C. § 521. Farmers’ cooperative organizations are exempt from taxation to the extent provided in subsection 521. Farmers’, fruit growers’, or like associations are organized and operated on a cooperative basis (A) to market the products of members or other producers, and turning back to them the proceeds of sales, less the necessary marketing expenses, based on either the quantity or the value of the products furnished by them, or (B) to purchase supplies and equipment for the use of members or other persons, and turning over such supplies and equipment to them at actual cost, plus necessary expenses.[22]

Finally, there is I.R.C § 216 Cooperative Housing Corporations. However, it has been held a taxpayer was a cooperative under subchapter T because it was a section 216 cooperative housing corporation.[23]

Each of these tax regimes has both similar and unique requirements. We shall focus here on Subchapter T cooperatives as I.R.C. 501(c)(12) is of limited application and most strict in its requirements. Other extensive resources address farmers’ cooperatives’ requirements.[24] We do not address cooperative housing corporations separately as noted they are governed also by Subchapter T.[25] Further, the cooperatives we have personally dealt with are addressed under Subchapter T.

For-profit cooperative corporations and limited liability companies electing to be taxed as associations are given special treatment respecting federal taxation. They may reduce their tax exposure by issuing what are known as “patronage dividends” to patrons of the cooperative. The term “patronage dividend” means an amount paid to a patron by an organization (1) based on the quantity or value of business done with or for such patron, (2) under an obligation of such organization to pay such amount, which obligation existed before the organization received the amount so paid, and (3) which is determined by reference to the net earnings (a/k/a “net margins”) of the organization from business done with or for its patrons.[26]

Patronage dividends do not include an amount paid to a patron by a cooperative to the extent that such amount is paid out of earnings not derived from business done with or for patrons.[27] Thus, e.g., if the cooperative pays out earnings derived from business with other organizations or non-patrons, the earnings are usually excluded from being included as patronage dividends. However, there are exceptions to this rule. Also, amounts paid to a patron by a cooperative are not eligible to be classified as patronage dividends to the extent that such amounts are fixed without reference to the net earnings of the cooperative organization from business done with or for its patrons.[28] For example, if the cooperative pays an 8% return to patrons on capital stock, the 8% return does not qualify as a patronage dividend.

The term “net earnings” include the excess of amounts retained (or assessed) by the organization to cover expenses or other items over the amount of such expenses or other items but shall not be reduced by any taxes imposed by subtitle A of the Code, but shall be reduced by dividends paid on capital stock or other proprietary capital interests.[29]

A cooperative may deduct the amount of the patronage dividends that it issues in a particular tax year from its gross income in that year.[30] As a result, this income is not taxed at the entity level.

Each patron shall include in gross income—(1) the amount of any patronage dividend which is paid in money, a qualified written notice of allocation, or other property (except a nonqualified written notice of allocation), and which is received by the patron during the taxable year from the cooperative.

So what are “qualified” and “non-qualified” allocations? A “qualified” allocation occurs when at least 20% of the total patronage refund is being delivered to the patron in cash or by a check drawn on a bank and the patron has been notified in writing and agreed in advance to the retention of a portion of the otherwise distributable allocation of net margin. The notice of retention shall be provided at any time within a period beginning on the date such written notice of allocation is paid and ending not earlier than 90 days from such date, but only if the patron receives written notice of the right of redemption at the time the patron receives such written notice of allocation. To be effective, the written notice of the right of redemption referred to in the preceding sentence shall be given separately to each patron.[31]

Note the patron is required to consent to a qualified allocation. The consent may be evidenced by the patron signing and furnishing a written consent to the cooperative revocable by the patron at any time.

A “nonqualified” allocation occurs when the cooperative isn’t required to pay any portion of the patronage refund in cash or by a check drawn on a bank to the patron.

If the net margin is fully allocated and distributed in cash or by a check drawn on a bank to the patrons, the patrons incur income tax recognition for the amount they received. If a portion of the net margin is retained as a qualified allocation then the retained portion is added to the patron’s capital account and taxed to the patron.

bIf the portion of the net margin is retained as a nonqualified allocation, then the cooperative recognizes income for tax purposes for the allocation for the year in which retained. The patron does not recognize income in the year retained. However, in a later year when the retainage is distributed in cash, the patron will recognize income and the cooperative will receive a tax deduction. If a nonqualified allocation is made, the cooperative is not required to make any cash distribution in the year of allocation.

Summary. Business consultants or professional advisors are not usually oriented towards cooperatives as they are towards the more conventional organizations. Admittedly, conforming to the strictures of cooperative organization to achieve favorable tax and other results is an educational process. However, if the objectives of the new organization and its constituencies are more consonant with the cooperative form of entity than they are with a “C” or “S” corporation or a limited liability company without electing association status, then the organizer should favorably consider the cooperative or LCA structure.

[1] This blog is designed for general information only. The information presented at this site should not be construed to be formal legal advice or the formation of a lawyer/client relationship. The author of this blog is not certified by any state agencies or boards of legal specialization. This blog may constitute attorney advertising in some jurisdictions.

[2] The author is an Atlanta Ga. area attorney with a concentration on trade association, private club, cooperative, limited liability, and small business formation, organization and governance. . See www.somerslawfirm.org.

[3] There are several different types of partnerships. Also, the option of sole proprietorship exists but doesn’t afford the immunity from personal liability for actions taken by owners, shareholders, members, directors and officers on behalf of or for the benefit of the entity afforded by the other choices.

[4] Autry and Hall, “The Law of Cooperatives”©, page 19 (American Bar Association Business Law Section 2009) [Hereafter “Autry”]

[5] Puget Sound Plywood, Inc v. Commissioner, 44 T.C. 305 at 307 (1965). This case is considered by many as the

seminal case respecting cooperative taxation.

[6] Autry at page 8 paraphrasing Puget Sound Plywood, Inc v. Commissioner, 44 .T.C. 305 (1965); See also  https://www.rd.usda.gov/files/CIR45_2.pdf#:~:text=They%20are%20the%20principles%20that%20continue%20to%20distinguish,u%20Financial%20obligation%20and%20benefits%20propor-tional%20to%20use%3B

[7]https://www.rd.usda.gov/files/CIR45_2.pdf#:~:text=They%20are%20the%20principles%20that%20continue%20to%20distinguish,u%20Financial%20obligation%20and%20benefits%20propor-tional%20to%20use%3B

[8] Id.

[9] For example see https://www.fci.coop/about-us/seven-cooperative-principles/; and https://www.iwdc.coop/why-a-coop/basic-principles-of-a-cooperative

[10] http://bankofinfo.com/principles-of-co-operative-society/

[11] https://www.yourarticlelibrary.com/company/difference-company/difference-between-cooperatives-and-companies/75892

[12] See, e.g., Texas and Arkansas.

[13] McKee and Frederick, “Traditional Cooperative Businesses” (2019) https://cooperatives.extension.org/traditional-cooperative-businesses/

[14] See National Cooperative Business Association Clusa International State Cooperative Statute Library https://ncbaclusa.coop/resources/state-cooperative-statute-library/. The library is a useful reference for individuals who want to quickly access specific provisions in different states’ cooperative laws and also have the ability to compare the provisions with similar provisions in other jurisdictions. the library provides a provision-by-provision description of state laws, with different spreadsheet pages on subjects such as cooperative purpose, powers, formation, articles of incorporation, bylaws, membership, control, directors, officers, patronage, finance, merger, consolidation and dissolution. The library also includes answers to questions on how cooperatives are treated under specific states’ securities, antitrust, escheat and unclaimed property laws. Further, states’ cooperative tax regimes are described, including state law provisions regarding cooperative income tax, franchise taxes, sales taxes, the domestic production credit, and other taxes and exemptions. Id.

[15]  Uniform Limited Cooperative Association Act ©2011, 2013

[17] https://www.dorsey.com/newsresources/publications/client-alerts/2019/07/washington-state-limited-cooperative-association

[18] A company agrees to pay out a % of its top-line sales, usually until its investors achieve some pre-determined return. As an example, company ABC raises $500,000, and in return pays out 3% of its sales until investors have received a total of $1,000,000 in distributions (a 2x return on their $500,000 investment). Tweaks can be made to this basic model, such as (1) including a grace period (e.g. payments only start after a number months/years, or once the company hits a certain revenue threshold), (2) using some profit line instead of revenues (e.g. % of free cashflow, EBITDA etc.), or (3) instead of a revenue-based loan, the same % of revenues can be used to buy shares back from investors at a pre-determined price. See https://transformfinance.org/blog/2018/2/26/dont-go-chasing-unicorns-or-how-to-support-a-more-inclusive-startup-ecosystem

[19] Revenue-based financing is more typically used in the context of later stage businesses.  It turns out that adapting this as a tool for early stage investing often just doesn’t work. [Also,] Simple math tells us is that a revenue share deal would rarely work if a company is trying to raise more than, say, $750,000. Of course, the picture gets even worse (more red cells) if the business was starting from a lower base (e.g. $500,000 in annual sales instead of $750,000) and/or if it were growing at a slower pace (e.g. 50% year over year instead of 80%). In general, for early stage businesses, revenue-based finance really only works if you need a relatively small amount of capital, say $500k or less. https://transformfinance.org/blog/2018/2/26/dont-go-chasing-unicorns-or-how-to-support-a-more-inclusive-startup-ecosystem.

[20] General Survey of I.R.C. 501(c)(12) Seto and Chasin, Cooperatives and Examination of Current Issues,  2002 EO CPE Text –  https://www.irs.gov/pub/irs-tege/eotopice02.pdf

[21] Id.

[22] See https://www.law.cornell.edu/uscode/text/26/521

[23] Park Place, Inc. v. Commissioner, 57 T.C. 767 (1972) cited in Thwaites Terrace House Owners Corp. v. Commissioner, 72 T.C.M. 578 (T.C. 1996)

[24] See, e.g., http://ncfc.org/ and https://farmersmarketlegaltoolkit.org/business-structures/cooperatives/

[25] See end note 25.

[26] 26 U.S.C. § 1388(a)

[27] REG § 1.1388-1(a)(2)

[28] Id.

[29] REG § 1.1388-1(a)(1)(iii)

[30] 26 U.S.C. § 1382(b).

[31] REG § 1.1388-1(c)(3)(i)