INCOME TAX TREATMENT OF COOPERATIVES: …

INCOME TAX TREATMENT OF COOPERATIVES: Distributions, Retains,

Redemptions, and Patrons' Taxation Cooperative Information Report 44, Part 3

2005 Edition

Donald A. Frederick

Abstract

INCOME TAX TREATMENT OF COOPERATIVES: Distributions, Retains, Redemptions and Patrons' Taxation 2005 Edition

Donald A. Frederick Program Leader, Law, Policy & Governance

Cooperative tax rules are a logical combination of the unique attributes of a cooperative and the income tax scheme in the Internal Revenue Code. The single tax principle is applied to earnings from business conducted on a cooperative basis in recognition of the unique relationship between the members and their cooperative associations. Cooperatives have been granted a certain degree of flexibility in their financial and tax planning and should exercise their options effectively to maximize benefits for members.

Key words: Cooperative, equity, income, patronage, per-unit retain, tax

Cooperative Information Report 44, Part 3

April 2005

Preface1

The correlation between cooperative finance and taxation involves several elements of the cooperative/patron relationship. Earnings are allocated to patrons on the basis of the amount of business they do with the cooperative, not to investors on the basis of equity ownership. Tax law recognizes that cooperative margins are allocated directly to patrons and permits cooperatives to pass through those earnings to patrons much as a partnership passes through its earnings to its partners.

To accommodate the unique association between a cooperative and its patrons, the Internal Revenue Code (Code) has special and sometimes complex rules creating a single tax on cooperative margins. Part II of this series described the patronage refund, the basic vehicle for cooperatives to distribute margins to patrons and for patrons to provide equity capital-through retained patronage refunds--to their cooperative. This report examines the additional elements of the cooperative/patron relationship. It covers how patronage refunds are distributed to patrons, how the per-unit retain operates as another tool of equity accumulation for marketing cooperatives, the operation and tax treatment of methods cooperatives use to redeem outstanding equity, and looks specifically at how various patronage financing developments are taxed at the patron level.

1 This report does not represent official policy of the U.S. Department of Agriculture, the Internal Revenue Service, the U.S. Department of the Treasury, or any other government agency. This publication is presented only to provide information to persons interested in the tax treatment of cooperatives.

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Highlights

The linchpin of cooperative equity accumulation is the patronage refund. A patronage refund is a distribution from a cooperative to a patron, based on the amount of business done with or for that patron, out of net earnings from business with or for all patrons. The payment can be made in money or as a distribution of equity or debt capital in the cooperative.

The Internal Revenue Code (Code) provides that if timely payment is made, the underlying earnings of the cooperative are only subject to a single Federal income tax. If the patronage refund is "qualified" according to procedures in the Code, the tax obligation is immediately passed through to the patrons. If the refund is "nonqualified," the tax obligation falls on the cooperative until the equity is redeemed. Then the tax burden passes through to the patron.

Marketing cooperatives have another method of distributing funds and accumulating patronage-based capital that also qualifies for single tax treatment. The per-unit retain is a distribution based on the volume or value of product marketed through the cooperative by the patron. Per-unit retains can be issued as capital certificates, permitting the cooperative to retain the underlying funds as equity and debt financing. Retains are taxed much like patronage refunds, including the option to issue qualified or nonqualified retain certificates.

Although equity accumulation is one of the biggest challenges facing cooperatives, each year many associations redeem part of their patronage-based capital. Equity redemption frequently focuses on the oldest allocations in the cooperative. Redeeming the oldest equities, particularly those of persons no longer patronizing the cooperative, implements the cooperative principle that financing should come from persons currently benefitting from the cooperative's services. Tax consequences for the cooperative and the patron at the time of redemption are determined by the nature of the allocation and whether the redemption is for the full face amount of the original equity distribution.

With few exceptions--notably when members purchase nondepreciable personal and household goods from their cooperative--the earnings on all cooperative business activity are

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subject to Federal income taxation. Ultimately, if not immediately, that tax burden falls on the patron. The timing and extent of that tax burden depend on the way those earnings are distributed. Some cooperative distributions from nonpatronage sources and patronage-based funds not distributed according to specific rules in the Code may be taxable to the patron even though a tax was already paid by the cooperative.

The American Jobs Creation Act of 2004 created a new tax pass-through deduction and two pass-through energy-related credits that give cooperatives new flexibility in allocating tax benefits between the cooperative and its patrons.

The characteristics of payments from a patron to a cooperative are important in determining if they are deductible business expenses or nondeductible contributions to capital.

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