University of Wisconsin Center for Cooperatives
Tax Treatment of Cooperatives

Issued September 1984, Reprinted January 1990
United States Department of Agriculture 
Agricultural Cooperative Service
Cooperative Information Report 23

by Donald A. Frederick

Farmers, like other Americans in business, are dedicated to individual initiative and the private enterprise system. But individual family farmers often have little economic power when dealing with large sellers of farm supplies and purchasers of commodities. So they have formed cooperatives to gain the advantages of group action and some of the benefits of modern business corporations while maintaining control "down on the farm." Farmers' cooperatives play an important role in our free enterprise agriculture.

Cooperatives Pay Taxes

Cooperatives have the same rights and responsibilities as other American businesses, including the obligation to pay taxes. Cooperatives, like other businesses, pay significant taxes.

First, cooperatives pay the special taxes assessed all businesses. These include real and personal property taxes, sales taxes, employment taxes (to finance social security, unemployment compensation and workers' compensation benefits), gasoline and diesel fuel taxes, license fees, motor vehicle registration fees, and excise taxes on telephone, power, and other utility services.

Second, cooperatives and their owners pay a single income tax on margins, usually at the owner level. This is the same tax treatment applied to most U.S. businesses. As table I shows, of the five common structures of American business, only investor-general corporations have their margins taxed at both the business entity and individual owner levels. And only 12 percent of American businesses are operated as investor-general corporations.

Most business taxes are applied uniformly to all affected taxpayers, including cooperatives. Therefore, they will not be mentioned further in this pamphlet.

Certain aspects of income taxation are unique to each form of business. While some variations exist, most States with income taxes generally follow the Federal model in taxing cooperative margins.

 Table 1—Tax treatment by business type
Business Type
Times net margin
subject to tax
Corp. Owners
Investor-Subchapter S
Cooperative-Subchapter T

Federal Income Taxes

The central feature of cooperatives' Federal income tax liability is that net margins are not taxable income to both the cooperative and the patron if they are distributed or allocated to patrons on the basis of business done with the cooperative according to certain well-defined rules. The Internal Revenue Code recognizes cooperatives' operating principle of providing services at cost. Therefore, refunds of net margins to patrons on a patronage basis are subject to Federal income tax only once. This treatment is available to any business choosing to refund net margins in the same way. Rules cooperatives and patrons must follow to be eligible for this tax treatment are found in Subchapter T of the Internal Revenue Code.

Subchapter T contains a definition of a patronage refund. Unfortunately, the Code uses the term "patronage dividend" instead of "patronage refund," but to avoid confusion and reflect more common terminology "patronage refund" is used in this pamphlet.

Subchapter T defines a patronage refund as "An amount paid to a patron by an organization...

1. On the basis of 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 of the organization from business done with or for its patrons."

The Subchapter T definition includes several key requirements that will be clarified and emphasized.

First, the definition refers to amounts paid to a "patron" rather than a "member." Some cooperatives only conduct business with or for members, others deal with persons who are members and nonmembers. The farmer-owners of a cooperative with nonmember business have the choice of whether to make patronage refunds to nonmember users of the cooperative.

Second, one of the critical characteristics that distinguishes a business operating on a cooperative basis from other businesses is the requirement that distribution of net margins is based on the "quantity or value of business done with or for such patron." Distributions to patrons not made in proportion to business done with the cooperative cannot qualify as patronage refunds. For example, dividends paid on capital stock are not patronage refunds because they are made in proportion to the amount of stock owned rather than the amount of business done with the cooperative. This standard implements the cooperative's central objective of distributing financial benefits to patrons based on their use of the cooperative's services rather than on the basis of their investment in the cooperative's capital structure.

Third, the cooperative must have an obligation to pay net margins to patrons, and the obligation must exist before a patronage transaction takes place. Both the cooperative and its patrons have knowledge prior to any transaction that net margins from the transaction will be paid in whole or in I part as a patronage refund. The preexisting legal obligation I must be in enforceable written form. It can be included in a cooperative's bylaws, articles of incorporation, marketing
agreement, sales receipts, or other written contract obligating the cooperative to make the payments. If a State law makes patronage refunds mandatory, that law also is considered a valid obligation.

Fourth, patronage refunds are distributions of net margins derived from business with or for patrons. The Treasury Department regulations define net earnings (net margins) as "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." Patronage refunds can come only from business done with or for patrons. Income a cooperative may receive from business unrelated to patronage cannot be included in patronage refunds under definitions of the Internal Revenue Code.1 Examples of nonpatronage income include items such as a cooperative's rental income, interest income, and capital gains.

Written Notices of Allocation

A cooperative has several options in distributing its patronage refunds and taking advantage of the tax treatment available under Subchapter T. It may simply pay out all of its earnings in cash. This is usually done by cooperatives that do not need to generate additional capital, or those whose members finance by other methods.

The most popular method of distributing patronage refunds is to pay out part of the refund in cash and part in a noncash form called a "written notice of allocation." Funds represented by a written notice of allocation are retained by the cooperative, not as profit, but as a capital investment by the patron in the cooperative. The tax code permits the notice to be in a variety of forms so long as it is in writing and informs the patron of the total amount allocated to him or her on the books of the cooperative and the portion that is a patronage refund.

Members determine how much of the cooperative's net margins are to be retained in the cooperative to meet its capital needs. The written notice of allocation is evidence of a patron's share of that investment. This method of financing helps the association comply with the cooperative prin-ciple of obtaining financing from current patrons on the basis of their use of the cooperative.

A cash refund is deductible by the cooperative in the year the funds being returned were earned and is taxable income to the patron in the year received. Members and their cooperative have two alternative tax treatments avail able for retained funds evidenced by written notices of allocation. Specific tax treatment will depend on whether a written notice of allocation is "qualified" or "nonqualified."

"Qualified" and "Nonqualified"

If a cooperative elects to meet the specific requirements of the Code to "qualify" written notices of allocation, funds represented by qualified written notices are treated just like a cash patronage refund for tax purposes. That is, the cooperative deducts the entire amount from its taxable income in the year the funds are earned, and the patron includes the entire amount in his or her income in the year the written notice is received. (A cooperative is allowed 8-1/2 months from the end of its tax year to complete its tax returns and make its patronage distributions.)

The requirements to qualify a written notice of allocation are:

1. The written notice of allocation must be part of a patronage refund package of which 20 percent or more is paid in money or qualified check, and either

2a. The patron has the option of redeeming the written notice of allocation at face value for cash within 90 days of issuance, or 2b. The patron has consented to include the face value of the written notice in his or her taxable income.

As used above the term "money" includes both cash and a regular bank check. A "qualified check" is a specially prepared bank check that can be used to establish a patron's consent to include the noncash portion of a patronage refund in his or her income for tax purposes.

A patron can "consent" to include the face value of the written notice of allocation in taxable income in any one of three ways:

1. By joining a cooperative whose bylaw clearly states membership in the cooperative constitutes such consent, provided the patron is given a copy of the bylaw and a written statement of its purpose. This is the most common method of establishing consent.

2. By signing and furnishing a written consent to the cooperative before the end of the taxable year in which the patronage occurs. The consent must be revocable. Unless it provides otherwise, a written consent remains in effect for all subsequent years until it is revoked.

3. By endorsing and cashing a qualified check. A "qualified check" is one carrying a clearly printed statement that endorsement and cashing of the check constitutes consent by the patron to take into account, as provided in the Federal income tax laws, the stated amount of any written notices of allocation that are paid as part of the patronage refund of which the check is also a part.

A cooperative may elect not to meet all the requirements to qualify a written notice of allocation. For example, it may pay less than 20 percent of the patronage refund in money or qualified check, or it may not have its patrons consent to take the face amount of the refund into account for tax purposes. A written notice that for any reason does not meet the requisites for qualified status is called "nonqualified."

A cooperative that issues nonqualified written notices of allocation must include the face amount of the notice in its taxable income for the year the covered funds are earned and pay tax on these funds at regular corporate income tax rates.

The patron receiving a nonqualified written notice of allocation does not pay an immediate tax on the funds it represents. However, when the cooperative pays out the money represented by the nonqualified notice to the patron, the money received is taxable income to the patron in the year received, and the cooperative deducts the amount paid from income in the year paid according to formulas established in the Code.

Per-Unit Retains

Members usually have alternative methods of meeting their obligation to finance their cooperative. They may make out-of-pocket investments, such as buying a membership or shares of stock. They may leave a portion of their patronage refund in the cooperative, as previously described. Patrons of marketing cooperatives may also invest in their cooperative by authorizing it to deduct a portion of the proceeds of sale, based on the dollar value or physical volume of products marketed through that cooperative. This method of financing is called "per-unit retains."

Tax treatment of per-unit retains generally parallels that of patronage refunds. A cooperative is required to pay tax currently on its per-unit retains unless they are evidenced by certificates "qualified" under the law. The patron is required to include the face value of a qualified per-unit retain in his or her income for tax purposes in the year received. The certificate is qualified only if the patron consents to include the face amount of the certificate in current income. If the patron receives a nonqualified certificate, the amount evidenced is not reported as income until the money it represents is paid to the patron. Because per-unit retains are deducted from payments for products there is no cash distribution rule similar to the 20-percent requirement to qualify a written notice of allocation.

Patronage refunds and per-unit retains are often confused. The main distinction is that patronage refunds are based on net margins while per-unit retains are based on the amount of business conducted without regard to margins.

Tax Planning Alternatives

The tax treatment available to businesses operated on a cooperative basis is a simple concept-a cooperative operates at cost, so it has no true income to tax. However, as the earlier sections of this pamphlet indicate, when that concept is melded into our complex Federal income tax system it also becomes quite complex.

Careful tax planning is as important for farmers and their cooperatives as it is for all other individuals and businesses. This is especially true when patronage refunds are involved, because almost every decision will have significant tax consequences for both the cooperative and its farmer-patrons. Here is a brief summary of some of the choices available:

1. How to finance the cooperative. Members may supply equity capital through out-of-pocket investments, patronage refunds, or per-unit retains. Initial investments to start a cooperative usually come from the members. When the cooperative generates margins, retained patronage refunds generally become the principal source of capital. Only a limited number of cooperatives use per-unit  retains. A combination of these methods is permissible. The role each is to play in capital formation should be planned.

2. Who is to receive patronage refunds. A cooperative may pay patronage refunds to all users or only to member-users. If margins on nonmember business are not returned to nonmember users on a patronage basis, then the cooperative pays corporate income taxes on this money.

3. Whether to "qualify" its paper. Most cooperatives "qualify" their written notices of allocation (and per-unit retain certificates) because members find it to their advantage to accept immediate tax liability for their investment in their cooperative, and thereby give the cooperative the easiest possible access to needed financing. It is permissible to qualify part of an allocation and not the remainder. The extent to which nonqualified allocations are made generally depends on the cash needs and tax rates confronting both the members and the cooperative at the time of allocation.

4. How to "qualify." The vast majority of cooperatives use a bylaw provision to obtain the necessary consent to qualify their allocations to members. The required explanation can be provided at the time the producer files application for membership, and the pre-existing legal obligation to conduct business on a patronage basis is established. A separate written consent is usually obtained from nonmembers if their business is to be conducted on a patronage basis. Bylaws only bind members, so bylaw consent is not available for nonmember business. Qualifed checks can be issued only as part of a patronage refund, and are rarely used because of the uncertainty over whether patrons will cash them.

5. How to redeem old patronage paper. If current patrons are to meet their obligation to finance the cooperative, then written notices of allocation and per-unit retain certificates that have been on the books of the cooperative for many years should be paid off. The redemption schedule should not be so rigid that it interferes with the cooperative's efforts to raise needed capital. However, the existence of some kind of formal redemption program is clearly compatible with cooperative principles.

Member-patrons of each agricultural cooperative must collectively decide which alternatives best fit their needs and the operation of their cooperative.

1Dividends paid on capital stock and patronage-based refunds of nonpatronage income are eligible for single tax treatment if a cooperative meets the requirements of Section 521 of the Internal Revenue Code. A review of 521 status is beyond the scope of this pamphlet. A thorough discussion of section 521 can he found in Legal Phases of Farmer Cooperatives, FCS Infor mation loo, beginning at page 381.

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