Cooperatives: A Tool for Community Economic Development
A. Financial Structure of Cooperatives
Earlier sections of this Manual discussed what makes a cooperative distinct
from other types of businesses. A review of some of the key operating
principles of co-ops will illustrate how these differences are related
to cooperative financing.
2. User-benefit principle
3. User-control principle
4. Limited return on equity
1. Member Equity
Recall that a cooperative is initiated by a group of people who share a mutual need, and who start a business designed to meet that need. In order to cover the co-op’s start-up costs, each member of the group contributes some money (often in the form of capital stock). The money that members invest in the co-op is known as member equity.
Member equity represents the members ownership interests in the assets of the company. As risk capital, it is subject to loss. Member equity is used to purchase equipment, supplies, inventory, and any other assets the co-op needs to get up and running.
If the members of a co-op are unable to generate sufficient funds to cover all of the assets needed, they usually seek a loan. Although co-ops can borrow money from the same lending institutions as other businesses, many co-ops have found that it is helpful to approach a bank that is familiar with cooperatives. Most banks require that the members contribute at least 50% of the total funds needed by the co-op. Members should have a financial stake in the cooperative, evidenced by their investment in it.
Owners, as providers of equity capital, take the business risks and
enjoy the profits of their success; they should be the major contributors
of capital. The level of equity invested by the owners signals to the banker
the commitment of the owners to both the concept and the company.
2. Allocation of Equity
Member equity is recorded on the cooperative’s books in two different ways. Allocated equity is designated (or allocated) to individual member accounts in proportion to their use of the co-op. Unallocated equity is not assigned to each member’s account, but is left in a general fund. Most co-ops use unallocated equity to build a capital base and to use as a cushion from operating losses.
The requirement that each member’s business with the co-op be tracked
and their allocated equity account be adjusted to reflect their activities
place additional burdens on cooperative accounting. Thus, it is vital
that the co-op obtain the services of qualified and experienced co-op accountants.
3. Sources of Member Equity
Not all member equity comes from direct investment as described above.
In fact, there are three primary sources of member equity:
The first is direct investment. New cooperatives usually obtain direct investments from their members, often in the form of capital stock shares. These shares are evidence of the members’ investment and carry with them all membership and voting rights. With established cooperatives, new members are usually required to make a similar purchase of capital stock or membership certificates, which entitles them to membership and voting rights.
The purchase of one or more shares of common stock is usually the first investment a new memmemb makes in a cooperative. This stock purchase entitles the member to voting rights in the co-op, usually on a one-member, one-vote basis. Non-cooperative businesses pay dividends on stock based on the number of shares owned, but in cooperatives, stock dividends are limited by state law (8% in WI).
The second source of member equity, retained earnings, is another way to generate equity after a co-op is up and running. When a co-op makes a profit on its operations, a portion of those profits (also called net earnings or net income) are usually distributed to the members on the basis of the amount of business they do with the co-op, and a portion is retained by the co-op as an investment in the business.
Many co-ops pay part of their net income (usually 20%) in cash to their members (more about this below under patronage refunds), and retain the remaining funds for future capital needs. These retains are allocated to each member’s account, although some co-ops also keep a portion of the net income as unallocated reserves.
Thus, retained earnings are simply the co-op’s profits that are kept by the co-op in order to build it for the future. Conversely, if the co-op loses money, that loss must be absorbed by the members, in Many co-ops design a program to repay the equity of members who no longer use the co-op due to retirement or relocation. Some co-ops have a revolving equity redemption program in which the oldest equity on the books is paid out regardless of whether the members are still active or not. In most cases, the shares are bought back from the member at par or book value, whichever is less.
The third source of member equity, per unit retains, are used primarily
by farm marketing cooperatives. The co-op retains deductions from
the sale proceeds of each member’s goods through the co-op. These
per unit retains are calculated either as a percent of sales dollars or
as a unit of weight or volume. One advantage of this type of equity
is that it is not dependent on the co-op’s net income as are retained earnings.
4. Equity from Non-members
Thus far, we have discussed only the types of equity that are generated
from members. Outside investors often don’t consider co-ops to be
good investments, for several reasons: Earnings are distributed on
the basis of patronage, not on the basis of the amount of investment; return
on investment is limited, usually by state law; stock in co-ops cannot
be traded on the stock market and does not increase in value over time;
and control of the co-op is usually one-member,
Clearly, an investor who is concerned primarily with making a profit on his or her investment would not find a traditional co-op attractive.
However, there are a few mechanisms by which non-members may invest in cooperatives. The primary one is preferred stock.
Most co-op bylaws allow cooperatives to issue preferred stock, which does not provide voting rights. Dividends on preferred stock are paid out before any payments are made to common stockholders. Thus, the sale of preferred stock can be an effective way to attract non-member investors if the co-op desires to do so.
Other methods for cooperatives to build equity from non-members include
retained income generated through day to day business conducted with non-members
and per unit retains on the sale of goods produced by non-members.
5. Equity Redemption
Allocated member equity is considered temporary capital, thus cooperatives
have an obligation to eventually repay equity to their members. Although
failure to redeem equity is considered an injustice to members, the co-op
board of directors must have the authority to
Equity redemption programs are intended to promote the cooperative principle of having co-ops owned and controlled by current members. However, they also complicate the management of the co-op’s capital, and must be done judiciously in order to prevent any adverse financial impact on the co-op. The board of directors and the management must ensure that the co-op is adequately capitalized at all times.
Note that unallocated member equity (equity that is not assigned to
individual member accounts) is considered permanent capital. Thus
many co-ops use unallocated equity to build a capital base which is not
redeemed. It is important that unallocated equity not be allowed
to become too large a portion of the total equity in a cooperative, however.
Since management, not the members, control unallocated equity, such a situation
leads to declining user control in the co-op.
6. Base Capital Plan
Some co-ops use what is called a base capital plan as an alternative to the equity building and equity redemption methods described above. Under such a plan, each member invests equity in proportion to their use of the co-op over a base period of years. This ensures that each member’s investment is in proportion to his or her use. Base equity plans can also be designed to respond effectively to the co-op’s need for capital.
Underinvested members continue to invest over time, using direct investment,
retained patronage, or per unit retains to do so. If a member becomes
overinvested in relation to their use of the co-op, they can receive a
partial refund to correct the balance. As always, the board of directors
should have authority over when and how the co-op may return equity to
7. Patronage Refunds
Patronage refunds are a key mechanism by which cooperatives practice their principles. As noted above, when a co-op makes an annual profit, part of this net income is distributed back to the members in proportion to their use of the co-op during the past year. In effect, such patronage refunds are a demonstration of the cooperative principle of benefits in proportion to use.
About 20% of net income is usually distributed to the members. The remaining income is retained by the co-op in order to ensure a firm capital base for the co-op’s future. However, the co-op allocates the retained portion to each members account. Tax laws require that co-ops notify each member in writing of their patronage refunds and the total amount allocated to the members account.
Reinvestment of patronage refunds is a key way for members to meet their
obligation to provide the capital for the co-op in proportion to their
use of it. It is important that co-op policies on patronage refunds
be communicated to the members effectively. Members need to understand
their role in providing sufficient capital to the co-op so that is able
to grow and thrive. Without sufficient communication on this subject,
members may have unrealistic expectations regarding when and how much patronage
refunds they may receive.
(Material is reprinted with permission of USDA, Donald A. Frederick Attorney)
Farmers, like other Americans in busi-ness, 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. 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. 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.
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 other businesses 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.
Subchapter T defines a patronage refund as "An amount paid to a patron
by an organization...
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 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 principle 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 available for retained funds evidenced by written notices of allocation. Specific tax treatment will depend on whether a written notice of allocation is qualilied’’ 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 81/2 months from the end of its tax year to complete its tax
returns and make its patronage distributions.)
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 lor 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, 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 al1 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 nonqualilied written notices of allocation must include the face amount of the notice in its t.axable income for the year the covered funds are earned and pay tax on these funds at regular corporate income tax rate.
The patron receiving a nonqualilied written notice 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 mount paid from income in the year paid according to formulas established in the Code.
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 qualilied 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 it 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 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. Qualified 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
Member-patrons of each agricultural cooperative must collectively decide which alternatives best fit their needs and the operation of their cooperative.
C. Financing New Generation Cooperatives
This article by Dennis A. Johnson, President and CEO, St. Paul Bank for Cooperatives, is reprinted with permission.
In this article, prepared for Year in Cooperation, a cooperative development magazine published by the Minnesota Association of Cooperatives, Johnson addresses major questions the Bank is asked and major concerns it has in financing new cooperative ventures.
Success stories of new- venture farmer cooperatives prompt many calls to the St. Paul Bank for Cooperatives from would-be founders of cooperatives with visions of a piece of the action. Through the years the Bank has been involved in the start-up of many successful cooperatives and a few-very few-that did not succeed. Those experiences have led us to a set of inescapable truths about financing new cooperative ventures.
While we are a relationship business and our goal is to assist in cooperative
development to the fullest extent feasible, those truths are why we must
sometimes say “no” to financing requests. Lee Estenson who heads the Bank’s
processing and marketing lending team, has developed sort of a cookbook
of risks to be addressed and questions to be answered in financing new-venture
cooperatives. I’m singing notes from Lee’s songsheet as I tell you
what we look for in financing them.
If so, who are your customers? Your competitors? What stands in the way of entering the market? What advantages do you have? What disadvantages? Assuming that your advantages outweigh your dis- advantages, how large is your market?
What is your likely market share? Finally, do you have management qualified
to assess your market niche and develop a marketing strategy or plan and
The next step is to develop marketing, material and a sales approach
for each marketing segment or customer. Finally, you need a customer calling
plan with a timetable of customer calls, a specific marketing approach
for each call and a specific and attainable follow-up schedule.
These are the questions about technology you must be able to answer:
Will your plant use proven equipment brands? Are any new processes
on the horizon that may dramatically affect your profitability? Does
current technology dictate a certain minimum or maximum plant size? Does
your manufacturing process provide end-product flexibility or is it single-purpose?
Is your management qualified to assess the technology and make informed
recommendations regarding processes and brands? Finally, will your proposed
plant be environmentally acceptable?
Have you had third-party verification of design, costs and timetable? Are adequate construction monitoring controls in place to protect both investors and lenders? And do you have management qualified to evaluate contractors and bids and to oversee a complex construction project?
How low can sales prices and/or production levels decline before your
debt servicing, capability is endangered? How high can your expenses,
especially feedstock prices, increase before endangering your debt- service
capacity? Under reasonable operating assumptions, will the project
provide an acceptable return to investors? Is the equity level adequate
to maintain lender support through prolonged periods of financial stress?
And do you have management qualified to run the plant efficiently and produce
Do your best to assess how government policy affects market growth,
market prices, operating permits and costs, and plant profitability.
Then do your best to get a fix on the likelihood that government policy
Then prepare to commit many, many long days to your project.