Abstract

Nonqualified Notices:

An Alternative for Distributing Cooperative Earnings

Jeffrey S. Royer and Roger A. Wissman

Agricultural Economists

Cooperative Services Division

Agricultural Cooperative Service

U.S. Department of Agriculture

Nonqualified written notices of allocation and per-unit retain certificates

offer alternative means for distributing cooperative earnings and allocating

patron equity that may have advantages over the methods used by most

farmer cooperatives. Nonqualified written notices can be used to delay

patron taxes and income and to avoid negative cash flows due to tax.

Nonqualified notices also offer cooperatives an additional tool for managing

taxes and handling losses. This report defines nonqualified written notices of

allocation and per-unit retain certificates, illustrates the application of

nonqualified notices, and discusses the extent of their use by U.S. farmer

cooperatives. A computer cash flow analysis of qualified and nonqualified

patronage refund distributions is conducted to identify characteristics of

cooperatives and patrons that would benefit from using nonqualified notices.

A number of additional features are discussed, including tax management,

equity, and accounting considerations, the use of nonqualified notices in

federated systems, factors limiting their use, and steps cooperatives should

take in initiating their use.

Key Words: Cooperatives, finance, taxation, patronage refunds, equity

retirement, nonqualified written notices of allocation.

ACS Research Report No. 80

September 1989
Preface

Maintaining an adequate supply of equity capital for financing assets

and growth is a continual challenge for most business organizations. This is

especially true for farmer cooperatives, which are organizations owned by

their patrons and which employ unique methods for obtaining equity

investments based on patronage.

The methods of equity investment used by most cooperatives place a

direct burden on their patron-owners. Retained patronage refunds and perunit capital retains reduce the proceeds patrons receive from business

transactions with their cooperative. In addition, Federal tax law usually

assigns the tax responsibility for patronage refund and per-unit capital retain

allocations to the patron.

Recent financial difficulties in the agricultural economy have affected

both farmer cooperatives and their patrons and have refocused attention on

cooperative equity capitalization methods. Because of financial pressures,

many patrons have expressed interest in reducing the tax burden on their

equity investments.

Nonqualified written notices of allocation and per-unit retain certificates

offer alternative means for distributing cooperative earnings and allocating

patron equity that may have advantages over the methods used by most

cooperatives. Nonqualified written notices of allocation can be used to delay

patron taxes and income and avoid negative patron cash flows due to tax.

Nonqualified notices also offer cooperatives an additional tool for managing

taxes and handling losses.

This report is intended for cooperative managers and directors

interested in examining alternative equity capitalization methods as well as

accountants, attorneys, extension workers, and others who advise

cooperatives on financial and tax matters. The report defines nonqualified

written notices of allocation and per-unit retain certificates, illustrates the

application of nonqualified notices, and discusses the extent of their use by

U.S. farmer cooperatives. A computer cash flow analysis of qualified and

nonqualified patronage refund distributions is conducted to identify

characteristics of cooperatives and patrons that would benefit from using

nonqualified notices. A number of additional features are discussed,

including tax management, equity, and accounting considerations, the use of

nonqualified notices in federated systems, factors limiting their use, and steps

cooperatives should take in initiating their use.

In preparing this report, we benefited from the knowledge and

experience of many people. We would like to express our sincere

appreciation to the following, who provided us with comments useful in

improving this report: James R. Baarda and Charles A. Kraenzle of the

Agricultural Cooperative Service; Richard L. Cisne of Hudson, Cisne,

Keeling-Culp & Company, certified public accountants; J. Gary McDavid of

McDermott, Will & Emery, attorneys at law; and Lee F. Schrader of the

Department of Agricultural Economics, Purdue University. Because of the

evolving nature of this technical subject and conflicting ideas on some
uncertain aspects of it, the contents of this report should not be construed as

representing the opinions of these individuals.

We also would like to thank Robert E. Lee, director of services of the

Kansas Farmers Service Association and former chairman of the National

Council of Farmer Cooperatives’ Legal, Tax, and Accounting Committee

subcommittee on problems regarding issuance and redemption of

nonqualified written notices, for reviewing the report and providing useful

materials and John A. Leeti, treasurer, Knouse Foods Cooperative, for an

insightful interview.
Contents

HIGHLIGHTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .V

I. INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . 1

II. DEFINITION AND USE OF NONQUALIFIED WRITTEN NOTICES

AND RETAIN CERTIFICATES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2

Taxation of Cooperative Earnings Distributions.. ...................................2

Patronage Refunds ........................................................................3

Other Distributions of Income ....................................................... .4

Per-Unit Capital Retains ................................................................ 4

Numerical Comparison ..........................................................................5

Choosing Allocation Method ................................................................. 7

Extent of Use ........................................................................................ 7

Summary ............................................................................................... 9

III. CASH FLOW COMPARISONS OF QUALIFIED AND

NONQUALIFIED PATRONAGE REFUND DISTRIBUTIONS . . . . . . . . . . . . . . 10

Method of Analysis .............................................................................. 11

Impacts on Cooperative and Patrons ................................................. .l 1

Present-Value Analysis ................................................................ 13

Cooperative Income Tax and Equity Retirement ................................. 13

Impact on Individual Patrons ............................................................... 18

Effect of Parameter Changes ..............................................................21

Patron Marginal Tax Rate ............................................................21

Discount Rate ..............................................................................21

Percentage Cash Patronage Refunds ........................................ .24

Cooperative Size ........................................................................ .24

Cooperative Marginal Tax Rate .................................................. .26

Rate of Return ............................................................................. 27

Rate of Growth ............................................................................ 29

Tax Reform Act of 1986.. .................................................................... .33

Summary............................................................................................. 35

IV. TAX MANAGEMENT CONSIDERATIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37

Comparative Cooperative and Patron Tax Rates.. ............................. .37

Flexibility in Issuing and Redeeming Nonqualified Notices.. .............. .39

Tax Planning After Financial Losses .................................................. .40

Responding to Tax Law Changes .......................................................40

Individual Choice of Allocation Method ...............................................42

Limits to Tax Management Flexibility ................................................. .43

Equity Retirement Plans ............................................................. .43

State Taxes ..................................................................................44

. . .

III
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .44

V. SPECIAL PROBLEMS ASSOCIATED WITH NONQUALIFIED

NOTICES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45 .

Accounting for Nonqualified Notices in Financial Statements ........... ..4 5

Classification of Equity Types..................................................... .45

Equity Accounts of Issuing Cooperative ..................................... .46

Income Reporting by Recipients .................................................. 47

Use of Nonqualified Notices in Federated Systems ............................ 48

Base Capital Plans ..................................................................... .51

Other Methods ............................................................................ .52

Equitable Treatment of Members ........................................................ 52

Potential for Changing Financing Relationships.. ............................... .54

Factors Limiting Use ........................................................................... 54

Lack of Experience ...................................................................... 55

Delayed Consequences of Redemption ..................................... .55

Summary.. .......................................................................................... .56

VI. CONCLUSIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57

GLOSSARY OF COOPERATIVE TAX TERMS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .60
Highlights

Nonqualified written notices of allocation and per-unit retain certificates

offer alternative means for distributing cooperative earnings and allocating

patron equity that may have advantages over the methods used by most

farmer cooperatives. Some patrons, particularly those with high tax rates,

may wish to delay receiving income and therefore would prefer receiving

nonqualified distributions. Cooperatives can use nonqualified written notices

of allocation to avoid negative cash flows to these patrons resulting from tax

on qualified notices. Nonqualified notices also offer cooperatives an

additional tool for managing taxes and handling losses.

Although this tool has been available to cooperatives since enactment of

subchapter T of the Internal Revenue Code in 1962, nonqualified notices

account for a small proportion of total patronage distributions. Data on the

100 largest U.S. farmer cooperatives suggest there has been an increase in

the use of nonqualified notices in recent years, but large cooperatives

probably have used these notices more than small cooperatives because

large cooperatives have had better access to information about them.

A comparative analysis of patron cash flows suggests that neither the

qualified nor the nonqualified method of distributing patronage refunds is

clearly superior to the other. Patron cash flows are sensitive to changes in

several factors, and which method of distributing patronage refunds results in

the greatest cash flow to patrons depends on the level of each of these

parameters.

Two critical factors affecting cash flow from qualified and nonqualified

notices are the cooperative and patron marginal tax rates. If the cooperative

marginal tax rate is less than the patron rate, the nominal value of total

patron cash flow from nonqualified notices is greatest because cash drains

on the cooperative system from taxes on nonqualified notices are less than

for qualified distributions. The present value of total patron cash flow

generally is greatest for nonqualified notices if the cooperative faces low

marginal tax rates and patrons face high marginal rates. Increases in the

patron marginal tax rate generally decrease the comparative present value of

qualified distributions because the increased cash drain from patron income

tax on the distributions occurs early and weighs heavily in present-value

computations.

If the cooperative tax rate is relatively low, the cash drain the

cooperative faces from issuing nonqualified notices may be less than from

distributing patronage refunds in cash and qualified notices, and the

cooperative can accelerate equity revolvement. However, increases in

cooperative taxable income resulting from growth produce higher tax rates

due to the generally progressive corporate tax rate structure. Higher rates

increase the cash drain on the cooperative, thereby decreasing equity

retirement and patron cash flow. Cooperative size plays a part in that larger

cooperatives generally will face higher tax rates sooner.

What type of cooperatives and patrons can benefit from using

nonqualified notices? Basically, cooperatives with low tax rates and patrons
with high tax rates. If patron tax rates are high relative to the cooperative

rate, nonqualified notices will provide patrons greater cash flows than

qualified distributions. Patrons with high tax rates are those most affected by

cash drains from income tax on qualified distributions. Therefore, they may

prefer receiving nonqualified notices to receiving cash patronage refunds and

paying income tax on qualified notices. Nonqualified notices also may

provide these patrons with a means of deferring taxable income from

patronage until after they have retired and face lower tax rates.

Because of the generally progressive corporate income tax rate

structure, patrons of small cooperatives are more likely to benefit from the

use of nonqualified notices. Large taxable incomes due to size and growth

increase the marginal tax rate faced by the cooperative and reduce the cash

flow to patrons from nonqualified notices. Large cooperatives probably

cannot do much to reduce the corporate tax rates they face although those

with high rates of return can reduce taxable income by accelerating equity

retirement. Although new, lower corporate tax rates may have reduced the

cash drain on many cooperatives from issuing nonqualified notices, others

may be hurt by the elimination of investment tax credit. This credit was more

valuable to patrons of cooperatives issuing nonqualified notices, especially

those cooperatives facing high marginal tax rates.

Because of timing differences in the tax treatment of patronage refund

distributions, nonqualified notices may provide higher present values of

patron after-tax cash flow in many situations where qualified distributions

result in higher nominal values. One reason cooperatives have used

nonqualified notices so little may be that managers and boards of directors

have not considered present values in making distribution decisions.

Whether an individual cooperative and its patrons can benefit from

issuing nonqualified notices depends on specific circumstances. In general,

current tax rates do not favor one allocation method over the other.

Nevertheless, cooperatives may find they can use nonqualified notices

effectively in responding to various income and tax situations, including

extraordinary occurrences such as losses or changes in the tax law.

Cooperatives have flexibility in issuing and redeeming nonqualified

notices. A cooperative can include authorization for issuing both qualified

and nonqualified notices in its bylaws. Then it can make the choice whether

or not to issue nonqualified notices on a yearly basis according to the

situation it faces each year. If conditions are such that patrons have high tax

rates relative to the cooperative, it may choose to issue nonqualified notices

that year. A cooperative also can choose to issue both qualified and

nonqualified notices in the same year.

A cooperative likewise may time the redemption of nonqualified notices

according to income and tax considerations. The rules for computing the tax

deduction for redemption of nonqualified notices can contribute to this

flexibility.

Financial needs, the limited occurrence of specific tax situations, and the
requirements of a cooperative’s equity capitalization and retirement program

can restrict the tax management flexibility from issuing and redeeming

nonqualified written notices of allocation. A cooperative policy designed to

minimize income tax can disrupt the smooth operation of an equity program.

Sudden changes made to meet special circumstances can create costs in

terms of patron understanding and good will. However, if a cooperative is in

a difficult financial situation, disruption of the existing financing system and

implementation of a temporary system may be an acceptable means of

obtaining tax benefits.

Cooperatives that issue nonqualified notices may face unique problems

because of the notices’ tax treatment. The income reporting and tax

recapture characteristics of nonqualified notices necessitate unique

accounting methods for both cooperatives issuing nonqualified notices and

recipients.

A transfer of earnings through a federated system to producer patrons

generally cannot be made as easily with nonqualified notices as with qualified

notices. A cooperative that receives nonqualified written notices of allocation

from another cooperative faces both theoretical and practical questions

concerning how the notices should be reported and handled. The recipient

cooperative must decide how and when to acknowledge the nonqualified

notices as income and how to account for these notices in a manner that

provides information understandable by its members and others. A

cooperative receiving nonqualified notices also must decide how to transfer

this income to its members in a manner that is acceptable to them and that

satisfies its patronage agreements and Federal income tax rules.

Simple methods of transferring nonqualified patronage refund

distributions between cooperative levels may be possible, but lack of

experience in this area is an impediment. For cooperatives that transfer

patronage refunds between cooperative levels and want secure procedures

for preserving single-tax treatment, qualified written notices of allocation, and

not nonqualified notices, appear to be the more conservative choice.

Maintaining equitable financing becomes more difficult as cooperatives

adopt more complex financing plans and members become more diverse in

character. This difficulty is compounded if a cooperative uses two methods

for allocating and redeeming equity. Although either qualified or nonqualified

notices can provide the basis for an equitable financing system, use of both

allocation methods can introduce inequities if there are inconsistencies in

how individual members or allocations are treated.

Two factors that limit the use of nonqualified notices are a general lack

of experience with them and the delayed tax consequences of their

redemption. Qualified notices have been used widely for more than 25 years.

Prior to enactment of subchapter T of the Internal Revenue Code,

cooperatives generally followed tax procedures similar to current procedures

for qualified notices except for the cash distribution requirement. Since then,

cooperatives and their patrons have incorporated the cash patronage refund

vii
and patron income reporting requirements into their operating routines. In

addition, cooperative literature and legal precedents have firmly established

the procedures for issuing and redeeming qualified written notices of

allocation and per-unit retain certificates.

Cooperatives also may be discouraged from issuing nonqualified notices

because the final tax consequences to the cooperative and its patrons are

not determined until the notices are redeemed in cash, perhaps many years

after they are issued. Between the time when a nonqualified notice is issued

and the time it is redeemed, the business environment of a cooperative or

legislative changes can affect the benefits from redeeming nonqualified

notices.

It may be prudent for a cooperative to include nonqualified notices in its

financial planning to ensure it has the flexibility to meet future situations

optimally. However, a cooperative should take several steps before issuing

nonqualified written notices of allocation. It should review its bylaws and

relevant State income tax laws to determine if the use of nonqualified notices

is compatible with them and if any potential tax problems may arise. It should

review its financing and equity retirement methods to ensure that the use of

nonqualified notices will not cause unforeseen complications. It also should

review the expectations and experience of members to determine what

member relations and education steps need to be taken.

. . . VIII
Nonqualified Notices

An Alternative for Distributing Cooperative Earnings

Jeffrey S. Royer and Roger A. Wissman

Agricultural Economists

I. INTRODUCTION

Farmer cooperatives are unique business

enterprises organized to benefit their patrons by

providing farm supplies and services and

marketing farm products at cost. Most farmer

cooperatives operate at cost by returning margins

to patrons in proportion to each patron’s volume

of business. These cooperatives rely heavily on

retained patronage refunds and per-unit capital

retains to supply equity capital necessary for

financing.

Retained patronage refunds are margins

allocated to patrons but retained by a cooperative

as equity capital. The cooperative uses these

funds to provide working capital and finance

capital assets. The cooperative returns these

funds to patrons as they are replaced with other

allocations through a revolving fund or other

equity capitalization plan. Per-unit capital retains

are equity investments in a cooperative made by

patrons based on volume of products marketed

through the cooperative and withheld from sales

proceeds. These funds also are returned to

patrons as they are replaced.

Federal tax treatment of farmer cooperatives

generally provides for patronage refunds and

per-unit capital retains to be taxed once, at either

the cooperative or patron level. This treatment

was detailed in 1962 with enactment of

subchapter T of the Internal Revenue Code.

Subchapter T defines the tax treatment of most

cooperatives and the conditions under which a

cooperative deducts certain patronage refund and

per-unit capital retain distributions in

determining its Federal taxable income. The

patron to whom a distribution is made must

agree to include both the cash and noncash

portions in current ordinary income if it is to

qualify for deduction from the cooperative’s

income. Noncash allocations that meet the

conditions for deduction are represented by

qualified written notices of allocation or per-unit

retain certificates. This is the method of

allocating patron equity normally used by most

cooperatives.

Subchapter T also specifies a second type of

allocation represented by nonqualified written

notices of allocation or per-unit retain certificates.

Patrons do not agree to accept nonqualified

written notices or retain certificates as current

ordinary income. Therefore, they do not qualify

for deduction from the cooperative’s taxable

income. However, a cooperative can deduct

amounts it pays in redemption of nonqualified

notices or retain certificates. A patron who

receives cash in redemption of a nonqualified

notice or retain certificate includes the amount in

taxable income.

Nonqualified written notices of allocation

and per-unit retain certificates offer farmer

cooperatives alternative means for distributing

cooperative earnings and allocating patron equity

that may have advantages over qualified written

notices and retain certificates in some situations.

Because patrons do not recognize nonqualified

notices until they are redeemed in cash, they can

be used to prevent negative patron cash flows

due to tax on qualified notices. Some patrons,

especially those in high tax brackets, may wish to

delay receiving income and therefore would

prefer nonqualified notices. Nonqualified notices

also offer cooperatives an additional tool for

managing taxes and handling losses.

Shortly after enactment of subchapter T,

accountants and others began writing about and

planning for use of nonqualified written notices

of allocation and per-unit retain certificates.

Many cooperatives made changes in their bylaws

necessary to permit nonqualified notices and
retain certificates without understanding their

potential uses. 1 After more than a quarter

century, only a small proportion of farmer

cooperatives in the United States have used

nonqualified notices.

This report examines the use of nonqualified

written notices of allocation and per-unit retain

certificates, as defined in the Internal Revenue

Code. In chapter 2, nonqualified written notices

of allocation and per-unit retain certificates are

described in detail and the use of nonqualified

notices is illustrated. Then possible advantages

to cooperatives and their patrons from using

nonqualified notices are discussed and comments

are made on the extent of their current use by

U.S. farmer cooperatives.

In chapter 3, results of a computer cash flow

analysis of qualified and nonqualified patronage

refund distributions are reported. Through this

discussion, characteristics of cooperatives and

patrons that would benefit from using

nonqualified notices are identified. In chapter 4,

the tax factors that should be taken into account

by cooperatives considering use of nonqualified

notices are discussed more thoroughly. Some of

the factors that may limit the use of nonqualified

notices in managing taxes also are discussed.

Special problems associated with

nonqualified notices are explored in chapter 5.

These include accounting for nonqualified

notices in financial statements, distributing

income in a federated system using nonqualified

notices, issues of equitable treatment of patrons

that may arise among cooperatives using

nonqualified notices, how the financial

relationships between a cooperative and its

patrons may be changed due to a switch to

nonqualified notices, and some factors that may

limit use of nonqualified notices. Finally, in

chapter 6, the findings of this report are

summarized briefly and steps cooperatives

should take in initiating the use of nonqualified

notices are outlined.

1 John E. Thomas and Kenneth R. Nilsestuen,

“Advance Planning for Redemption of Nonqualified

Allocations and Retains,” Cooperative Accountant, Spring

1980, p. 34.

II. DEFINITION AND USE OF NONQUALIFIED

WRITTEN NOTICES AND RETAIN

CERilFlCATES

Taxation of Cooperative Earnings Distributions

Qualified and nonqualified written notices

of allocation and per-unit retain certificates are

defined in subchapter T of the Internal Revenue

Code. Subchapter T, which consists of sections

1381-88 of the code, defines the tax treatment of

most cooperatives. Specifically, it applies to “any

corporation operating on a cooperative basis”

except mutual savings banks, mutual insurance

companies, and cooperatives engaged in

furnishing electric energy or telephone service to

rural areas.

Subchapter T defines the conditions under

which a cooperative deducts certain patronage

refund and per-unit capital retain allocations in

determining its Federal taxable income. One

condition for deduction is that the patron to

whom an allocation is made must agree to

include it in taxable income. Allocations patrons

agree to include in taxable income according to

the conditions specified in subchapter T

“qualify” for deduction from the cooperative’s

taxable income and are represented by qualified

written notices of allocation or per-unit retain

certificates. Allocations patrons do not agree to

include are represented by nonqualified written

notices of allocation or per-unit retain certificates

so long as they meet certain conditions.

Nonqualified written notices and retain

certificates are not deducted from the

cooperative’s taxable income for the year they are

made. When the cooperative redeems the

allocations in cash, it deducts amounts paid in

redemption from its taxable income. Patrons

receiving amounts paid in redemption of

nonqualified notices and retain certificates

include the amounts in their taxable incomes.

Qualified and nonqualified written notices

of allocation and per-unit retain certificates

represent allocations of patronage refunds or perunit capital retains. Both of these terms have

specific meanings with respect to subchapter T.

Some allocations commonly thought of as being

2
patronage refunds do not meet the requirements

of the code. As such, they are not represented by

qualified or nonqualified written notices of

allocation.

Patronage Refunds

A patronage refind is an amount paid a

patron from the net margins of a cooperative on

the basis of quantity or value of business done

with or for patrons under a preexisting legal

obligation.2 A patronage refund does not include

amounts paid a patron based on earnings from

business not done with or for patrons. It also

does not include amounts paid a member based

on earnings from business with nonmember

patrons to whom smaller amounts are paid for

substantially identical transactions. Although the

Internal Revenue Code uses the term patronage

dividends, patronage refunds is used in this

report to avoid confusion with dividends paid on

capital stock.

In determining taxable income, a cooperative

may deduct from its income any patronage

refunds paid in cash, qualified written notices of

allocation, or other property with respect to

patronage occurring during the tax year. The

cooperative must pay a patronage refund during

the payment period for the tax year to make it

eligible for deduction. The payment period begins

the 1st day of the tax year and ends on the 15th

day of the 9th month after the close of the tax

year. Allocations made to patrons after the 20

1 /Zmonth payment period do not qualify as

patronage refunds and must be included in the

cooperative’s taxable income. Distributions paid

in cash to patrons after the payment period also

must be included in the patrons’ taxable incomes.

A written notice of allocation is any capital

stock, revolving fund certificate, retain certificate,

certificate of indebtedness, letter of advice, or

other written notice that discloses to the recipient

the amount allocated to the patron and the

portion of the allocation that is a patronage

2 For convenience, definitions of all tax terms are

presented in a glossary at the end of this report.

refund. A written notice of allocation that

qualifies for deduction from a cooperative’s

taxable income is called a qualified written notice

of allocation.

To qualify a written notice of allocation for

deduction, a cooperative must pay at least 20

percent of the patronage refund in cash or by

qualified check. In addition, the patron must

either have the opportunity to obtain the total

refund in cash within 90 days after the allocation

is made or consent in one of three ways to have

the noncash portion treated as if it had been

received in cash and reinvested by the patron in

the cooperative.

By consenting to have the retained portion of

the refund treated as if it had been paid in cash,

the patron agrees to include the stated dollar or

face amount of the total refund as ordinary

income earned during the year in which it was

received. The patron may do this by: (1)

agreeing in writing; (2) joining or continuing as a

member of the cooperative (so long as the

cooperative has a bylaw adopted after October

16,1962, providing that membership constitutes

such consent and members have received written

notification and a copy of this bylaw); or (3)

endorsing and cashing a qualified check.

A qualified check is a check or other

instrument that is redeemable in cash and paid as

part of a patronage refund. Imprinted on the

instrument is a statement that endorsing and

cashing it constitutes patron consent to include in

taxable income, as provided in Federal income tax

laws, the stated dollar amount of the written

notice of allocation that also is part of the

patronage refund.

A cooperative cannot deduct a patronage

refund allocation from its taxable income unless

all requirements for qualified status are met. If

the cooperative does not receive patron consent

or if it does not pay at least 20 percent of a

patronage refund in cash, the allocation is not

considered a qualified allocation. However, if the

allocation is made before the end of the

cooperative’s payment period and otherwise

meets the definition of a patronage refund, it is

considered a nonqualified written notice of

allocution. Nonqualified allocations are included

3
in the cooperative’s taxable income and are not

taxable income for patrons when received.

There is no requirement that 20 percent of

nonqualified patronage refund distributions be

paid in cash. If a distribution includes both cash

and a nonqualified allocation, the cash portion is

included in the patron’s taxable income and is

deductible from the cooperative’s income.

Although a cooperative cannot deduct

nonqualified written notices of allocation from

current income for the year the notices are

issued, it can deduct redemptions of nonqualified

notices. When nonqualified notices are

redeemed in cash or other property, the

cooperative deducts the payments to patrons

from its income, and a patron who receives a

redemption includes the amount of the payment

received in taxable income.

The cooperative’s tax in the year a notice is

redeemed is the lesser of either: (1) the tax for

the current year after deducting the redemption

from current income or (2) the tax for the current

year without the deduction less the reduction in

tax that would have occurred in prior years if the

allocation originally had been paid in cash or

issued as a qualified written notice. If the

reduction in prior years’ tax is greater than the

current year’s tax without the deduction, the

cooperative receives a refund. Determination of

the reduction in prior years’ tax can be complex,

particularly if it involves losses or redemptions

of notices issued in more than one year.

Other Distributions of Income

Patronage refunds do not include payments

to patrons from nonpatronage income, which is

incidental income that is not directly related to

the marketing, purchasing, or service activities of

a cooperative and merely enhances the

cooperative’s overall profitability. This income

may include rents received, investment revenues,

gains on the sale or exchange of depreciable

property and capital assets, and amounts from

business done with the Federal Government.

Nonpatronage income also includes income from

business done with or for nonmembers but not

distributed to them.

Likewise, patronage refunds do not include

distributions of patronage income that do not

meet the definition of patronage refunds in

subchapter T of the Internal Revenue Code. For

example, payments made to patrons from

patronage income by a cooperative without a

preexisting legal obligation to make such

distributions are not considered patronage

refunds.

Neither distributions of nonpatronage

income nor distributions of patronage income

that do not meet the definition of a patronage

refund are represented by qualified or

nonqualified written notices of allocation.

Distributions of nonpatronage income generally

are not deducted from cooperative taxable

income unless the cooperative holds section 521

tax status. Patrons receiving distributions of

nonpatronage income must include the

distributions in their taxable incomes.

Distributions of patronage income that do not

meet the definition of patronage refunds are

included in both cooperative and patron taxable

income.

Per-Unit Capital Retains

A per-unit capital retain is an investment in a

cooperative made by a patron based on the dollar

value or physical volume of products marketed

through the cooperative. Cooperatives withhold

per-unit capital retains according to a bylaw

provision or membership agreement that

authorizes the cooperative to make a specified

deduction for capital purposes from proceeds

due members or cash advances. These retains

should be distinguished from deductions

authorized to cover operating expenses. Per-unit

capital retains do not depend on cooperative net

margins.

Per-unit capital retains are allocated to

patrons and taxed in a manner similar to

patronage refund allocations. Cooperatives

notify individual patrons of per-unit capital

retain allocations by giving them per-unit retain

certificates. A per-unit retain certificate is any

written notice that discloses to the recipient the

dollar amount of a per-unit retain allocation

4
made by the cooperative.

Recipients of per-unit retain certificates may

consent to include the amount of the retains in

their taxable incomes by agreeing in writing or by

joining or retaining membership in a cooperative

with a bylaw agreement. A cooperative must

issue a certificate before 8 l/2 months after the

close of the tax year to deduct the certificate from

its taxable income.

If the recipient agrees to include a per-unit

retain certificate in taxable income, the certificate

is a qualified per-unit retain certificate and the

cooperative deducts the amount of the certificate

from its income in determining taxable income.

The principal difference between tax treatment of

qualified per-unit retain certificates and qualified

written notices of allocation (patronage refunds)

is that the Internal Revenue Code recognizes perunit capital retains as fundamentally different in

concept and therefore does not require that 20

percent be paid back to patrons in cash.

If the patron does not agree to take a perunit retain certificate into account but the

certificate otherwise meets the requirements of

the code, it is a nonqualified per-unit retain

certificate. The cooperative cannot deduct the

value of the certificate in determining taxable

income. However, cooperatives redeeming

nonqualified per-unit retain certificates can

deduct the amount of the redemptions in a

manner similar to the redemption of nonqualified

written notices of allocation.

Numerical Comparison

The differences between qualified and

nonqualified written notices of allocation are

demonstrated in table 1. This table was

constructed specifically to show potential benefits

from using nonqualified notices, and its results

depend on two important assumptions. First,

there is a decrease in the marginal tax rate of

patrons between the years the notices are issued

and redeemed. This could occur if a substantial

number of patrons retire before redemption or if

there is a reduction in Federal income tax rates.

Second, the cooperative has $125,000 in other

taxable income in the year of redemption.

Equally valid comparisons under different

assumptions could yield much different results.

In this example, the cooperative earns

$100,000 in net margins the year the allocations

are made. If the cooperative chooses to distribute

its net margins in qualified form, it must pay at

least 20 percent in cash. All net margins are

deductible from Federal taxable income, and the

cooperative pays no tax. If the cooperative pays

20 percent cash patronage refunds, its net cash

flow is $80,000.

On the other hand, patrons who receive

qualified distributions include the entire amount

in their taxable incomes. If they are in the 28-

percent marginal tax bracket, they collectively

pay $28,000 in income tax on the distributions.

This exceeds the $20,000 they receive in cash

patronage refunds. Thus, they incur a negative

cash flow of $8,000 due to the qualified written

notices of allocation.

In the year the cooperative redeems the

qualified written notices of allocation, it incurs a

cash drain of $80,000, and patrons receive an

$80,000 cash flow. There are no tax consequences

to either the cooperative or patrons.

If the cooperative chooses to distribute its

net income as nonqualified written notices of

allocation, it does not pay cash patronage

refunds. However, it includes the notices in its

taxable income and pays $22,250 in corporate

income tax. The cooperative’s cash drain is

$2,250 greater than it would have been if the

cooperative had distributed its net income in

qualified form and paid 20 percent in cash.

Patrons who receive the nonqualified written

notices do not include the allocations in their

taxable incomes. They pay no Federal income tax

on the allocations and do not incur the negative

cash flow that results from qualified

distributions. Because patrons’ marginal tax rates

in this example are higher than the cooperative’s,

nonqualified written notices of allocation result in

a lower total cash drain on the cooperative and its

patrons than do qualified distributions.

When the cooperative redeems the

nonqualified written notices of allocation, it earns

an income tax deduction. The cooperative would

save $22,500 in tax by recomputing its tax for the

year in which the allocations were made as if it

5
originally had distributed them in qualified form. savings to the cooperative. Therefore, it is the

The cooperative currently has $125,000 in taxable method used, and cash drain from the

income and ordinarily would pay $30,750 in redemption is $73,000.

income tax. If it deducts the redemption of Patrons who receive the redemptions must

nonqualified written notices from its current include the amounts in their taxable incomes.

taxable income, it would reduce its tax by Because patrons now are in the 15-percent tax

$27,000. This method results in the greatest tax bracket, their income tax on the redemptions is

Table l-Comparison of qualified and nonqualified written notices of allocation

Item

Year of allocation

Qualified written Nonqualified written

notices of allocation notices of allocation

Cooperative:

Net margins

Cash patronage refunds (20%)

Federal income tax (22.25%)

100,000

(20,000)

0

Cash flow 80,000

Patrons:

Cash patronage refunds (20%)

Federal income tax (28%)

Cash flow

20,000 0

(28,000) 0

Dollars

100,000

(22,25i)

77,750

(8,000) 0

Year of redemption

Cooperative:

Equity redemption

Income tax refund (27%)

Cash flow

(80,000) (100,000)

0 27,000

(80,000) (73,000)

Patrons:

Equity redemption

Federal income tax (15%)

Cash flow

80,000 100,000

0 (15,000)

80,000 85,000

Net cash flow - both years

Cooperative: 0 4,750

Patrons: 72,000 85,000

Total 72,000 89,750

6
only about half what it would have been if they

had been taxed in the year of allocation. Their net

cash flow is $85,000.

In this example, total cooperative and patron

cash flow for the two years is greatest for

nonqualified written notices of allocation. This

results from the ability of patrons to defer tax on

their allocations until they are in a lower tax

bracket and to the cooperative’s ability to reduce

income that would have been taxed at a higher

rate. Not all situations would produce this result.

Choosing Allocation Method

The effective tax rates of both cooperatives

and patrons may vary from year to year,

depending on business success and investment

decisions, among other factors. To minimize

taxes, both cooperatives and patrons should

attempt to recognize income in years in which

their effective tax rates are lowest. Patrons with

low tax rates may prefer receiving qualified

distributions because they are paid in part in

cash.

Some patrons, particularly those with high

tax rates, may wish to delay receiving income and

therefore would prefer receiving nonqualified

notices. Cooperatives also can use nonqualified

allocations to avoid negative patron cash flows to

these patrons due to tax on qualified

distributions.

Cooperatives have some flexibility in using

nonqualified notices to manage their taxes.

Nonqualified notices are more attractive to

cooperatives during years in which other taxable

income is low. A decision to issue nonqualified

notices when taxable income is great would result

in a larger cash drain due to tax. Likewise, the

amount of other taxable income can influence the

decision on when to redeem nonqualified notices.

The deduction for redeeming nonqualified

notices is most useful in conserving cash flow

during years when taxable income is high. Once

a cooperative begins redeeming nonqualified

notices issued earlier, this deduction can be used

to reduce the cooperative’s current tax liability

based on the current year’s allocations of

nonqualified notices.

Extent of Use

Data on the 100 largest U.S. farmer

coopera tives3 suggest that there has been an

increase in the use of nonqualified notices in

recent years although they still account for a

small proportion of total patronage distributions.

Figure 1 shows the proportion of patronage

distributions the 100 largest cooperatives

reported making in nonqualified form between

1976 and 1987. Figure 2 shows the number of the

100 largest cooperatives that reported making

nonqualified distributions.

Examination of these cooperatives’ annual

reports indicates these figures overstate the

importance of nonqualified written notices of

allocation. The reports showed some large

cooperatives distribute nonpatronage income to

members on a patronage basis and consider these

distributions to be “nonqualified” because they

do not qualify for deduction from the

cooperative’s taxable income. Most of the

distributions represented in figures 1 and 2 are

nonqualified written notices of allocation

although it is impossible to determine the precise

amounts from the annual reports.

Figures 1 and 2 indicate there generally has

been an increase in the use of nonqualified

notices although there also has been considerable

variation in the number and proportion from year

to year.4 The increase can be attributed to a

number of factors. Some cooperatives with large

numbers of high-income patrons have changed to

nonqualified notices to shift taxable income away

from members. Other cooperatives have issued

nonqualified notices only in certain years as a

means of best managing the tax consequences of

3 Donald R. Davidson and Michael D. Kane, Top

100 Cooperatives, 1986 Financial Profile (Washington,

D.C.: USDA ACS Res. Rep. 71, Apr. 1988), p. 20, and

Farmer Cooperatives, selected monthly issues. The 100

largest cooperatives generally account for over 50

percent of total sales and assets.

4 The large decrease in the proportion of patronage

distributions made in nonqualified form in 1987 is due

in part to the fact that the three cooperatives that made

the largest nonqualified distributions in 1986 made no

nonqualified distributions in 1987.

7
Figure l-Proportion of Patronage Distributions Made in Nonqualified Form

by 100 Largest U.S. Farmer Cooperatives, 1976-87

Percent

1 12.5

1976 1980 1981 1982 1983 1984 1985 1986 1987

Figure 2-Number of Cooperatives Among 100 Largest U.S. Farmer Cooperatives Making

Nonqualified Distributions, 1976-87

Number

10

5

0

1976 1980 1981 1982 1983 1984 1985 1986 1987

8
unusual investment or income situations. These

include cooperatives that made extraordinarily

large capital investments in a particular year and

used nonqualified notices to increase taxable

income for absorbing investment tax credit. They

also include cooperatives that have used

strategies centered on nonqualified notices to

conserve cash flow during loss years.

Large cooperatives probably have used

nonqualified notices more than small

cooperatives because they have had greater

resources and better access to information about

them. However, data comparisons are

inconclusive. The most recent data on

nonqualified notices to include small

cooperatives came from the 1976 Agricultural

Cooperative Service financial profile study.5 This

study reported financial and operating data for

5,795 U.S. farmer marketing and supply

cooperatives of all sizes.

It showed that 166, or 3 percent, of the 5,127

cooperatives reporting net margins in fiscal years

ending in 1976 allocated patronage refunds in

nonqualified form. Only 0.5 percent of net

margins were distributed in nonqualified form.

In contrast, 83 percent of net margins were

distributed as cash or qualified notices. A total of

538 of 5,795 cooperatives had equity on their

balance sheets from nonqualified allocations at

the close of fiscal 1976.

A total of 115 of the 166 cooperatives issuing

nonqualified notices held section 521 Federal

income tax status. Ninety-four of these

cooperatives reported substantial farm supply

activities. These 94 cooperatives represented 57

percent of all cooperatives issuing nonqualified

notices. Of the cooperatives with net margins,

they represented only 3 percent of those with

substantial farm supply activities and 4 percent

with section 521 status.

These data suggest many nonqualified

notices resulted from failure of section 521 farm

supply cooperatives to acquire nonmember

consent to include patronage refund allocations in

5 Nelda Griffin et al., The Changing Financial

Structure of Farmer Coupedives (Washington, D.C.:

USDA ESCS Farm. Coop. Res. Rep. 17, Mar. 1980).

their taxable incomes. Cooperatives wishing to

qualify for section 521 tax status must distribute

patronage refunds to nonmember patrons in the

same manner as members. To treat patronage

refund distributions as qualified, they also must

acquire consent of both members and

nonmembers to include the allocations in their

current ordinary gross incomes. A cooperative

may acquire this consent from members by

including in its bylaws a provision stating that

membership constitutes such consent. The

cooperative must rely on nonmembers to agree to

this consent in writing or by endorsing and

cashing a qualified check. If the cooperative does

not receive such consent from a nonmember for

an allocation that otherwise meets the conditions

for a treatment as a qualified written notice of

allocation, it is treated as a nonqualified written

notice of allocation.

This situation is less common among

cooperatives without section 521 tax status

because many of them do not distribute

patronage refunds to nonmembers. It also is less

common among marketing cooperatives because

marketing rights often are tied to membership.

Summary

Nonqualified written notices of allocation

and per-unit retain certificates offer farmer

cooperatives alternative means for distributing

cooperative earnings and allocating patron equity

that may have advantages over qualified written

notices and retain certificates in some situations.

Some patrons, particularly those with high tax

rates, may wish to delay receiving income and

therefore would prefer receiving nonqualified

notices. Cooperatives can use nonqualified

notices to avoid negative cash flows to patrons

due to tax on qualified distributions.

Nonqualified notices also offer cooperatives an

additional tool for managing taxes and handling

losses.

Although this tool has been available to

cooperatives since enactment of subchapter T of

the Internal Revenue Code in 1962, nonqualified

notices account for a small proportion of total

patronage distributions. Data on the 100 largest

9
U.S. farmer cooperatives suggest there has been

an increase in the use of nonqualified notices in

recent years. However, large cooperatives

probably have used nonqualified notices more

than small cooperatives because they have had

better access to information about them.

In the following chapter, the results of a

comparative analysis of patron cash flows from

qualified and nonqualified distributions of

patronage refunds are reported. Throughout this

discussion, characteristics of cooperatives and

patrons that would benefit from using

nonqualified notices are identified. Among other

results, it is concluded that the benefits from

using nonqualified notices may be at least as

great for small cooperatives as they are for large

cooperatives.

III. CASH FLOW COMPARISONS OF

QUALIFIED AND NONQUALIFIED

PATRONAGE REFUND DISTRIBUTIONS

The principal objective of this chapter is to

identify characteristics of cooperatives and

patrons that affect the benefit received from

using nonqualified written notices of allocation.

This is accomplished by comparing patron cash

flows from qualified and nonqualified patronage

refund distributions for different size

cooperatives and under different rates of return,

growth, and taxes. These cash flows are

generated by a computer simulation model built

to represent the cash flow and tax relationships

of a cooperative and its patrons.

First, results of a base simulation are used to

demonstrate the differences between qualified

and nonqualified notices and the cash flow

relationships between the cooperative and its

patrons. Second, information from this

simulation is used to focus on the relationship

between the cooperative and an individual

patron. Third, cooperative size and the rates of

return, growth, and taxes are changed one at a

time to isolate the effects of each of these factors.

Finally, the effects of the Tax Reform Act of 1986

on patron distribution choices are summarized.

Because cooperatives are financially diverse,

no attempt was made in this analysis to choose

values representative of a specific type of

cooperative. Instead, reasonable values clearly

demonstrating important concepts and

relationships were chosen. This analysis is not

intended to apply specifically to individual

cooperatives. Results for an individual

cooperative will depend on the variables for that

firm. This chapter also does not analyze the

differences between qualified and nonqualified

per-unit retain certificates. However, an analysis

of per-unit capital retains would be similar, and

many of the conclusions derived here are

applicable to them.

This chapter includes a detailed discussion

of the cash flow and tax relationships of

cooperatives and their patrons. Although

readers interested in understanding these

relationships will find this material useful, others

10
may wish to move directly to the summary

section of the chapter.

Method of Analysis

This analysis uses a computer simulation

model that generates annual cash flow and tax

data for a cooperative and its patrons, given

preselected values of six important factors: (1)

percentage qualified patronage refund

distributions paid in cash, (2) average patron

marginal personal income tax rate, (3) rate of

return to cooperative equity, (4) rate of growth in

cooperative equity, (5) average patron discount

rate, and (6) cooperative’s initial equity.

The model is based on a first-in/first-out

revolving fund plan6 and focuses on the internal

financing decisions of the cooperative. No

attention is given to debt financing, and the

cooperative is assumed to maintain a fixed

debt/equity ratio and rate of return to equity. In

the model, each year equity allocated during the

year is added to the revolving fund to be

redeemed in turn. Equity redeemed during the

year is the residual of net margins less cash

patronage refunds, income tax, and planned

equity growth. Nonqualified nctices redeemed

are determined according to the corporate tax rate

schedule and the tax deduction for redemptions.7

The model assumes the revolving fund is

fully operational at the start of a simulation. The

initial revolving period and prior years’ retained

patronage refund allocations are based on the

values selected for the percentage cash patronage

6According to Phillip E Brown and David Volkin,

Equity Redemption Practices of Agricultural Cooperatives

(Washington, D.C.: USDA FCS Res. Rep. 41, Apr. 1977),

p. 8,90 percent of all cooperatives with systematic plans

for redeeming equity used the revolving fund plan.

7 Because net margins are strictly increasing in this

model, deducting the redemption of nonqualified

notices from current taxable income always results in

the greatest tax savings and therefore is the method

used. Existence of two methods of calculating tax

savings implies flexibility in tax management that is not

explored here but discussed in the next chapter.

refunds, rate of return to equity, and rate of

growth in equity. Once the simulation begins,

subsequent operation of the revolving fund is

determined according to the cooperative’s ability

to redeem equity given current net margins and

cash flows.

The simulation model generates data for two

practices: (1) distributing cooperative net

margins to patrons in the form of cash and

qualified written notices of allocation and (2)

distributing cooperative net margins to patrons in

the form of nonqualified written notices of

allocation. In analyzing the nonqualified

practice, it is assumed the cooperative previously

has distributed patronage refunds in cash and

qualified written notices and is switching to

issuing nonqualified notices.

This is done for two reasons. First, this

situation is the most relevant because most

cooperatives currently distribute patronage

refunds in cash and qualified notices. Use of

nonqualified notices would require a switch from

qualified notices. Second, this situation is useful

in analyzing an important stage in implementing

a practice of distributing nonqualified notices.

That is the period during which the cooperative is

issuing nonqualified notices while retiring

previous allocations of qualified notices. This

period could cause financial strain on a

cooperative because the cooperative must pay tax

on nonqualified notices it issues but does not yet

receive tax benefits from redeeming nonqualified

notices.

Impacts on Cooperative and Patrons

Table 2 presents results of the base

simulation for a 50-year period in both nominal

and present values. These values were used in

generating the simulation: (1) percentage

qualified patronage refund distributions paid in

cash, 20 percent; (2) average patron marginal tax

rate, 28 percent; (3) rate of return to cooperative

equity, 15 percent; (4) rate of growth in

cooperative equity, 7.5 percent; (5) average patron

discount rate, 10 percent; and (6) initial

cooperative equity capital, $100,000. Corporate

tax rates are those currently effective since the

11
Tax Reform Act of 1986.8

The cooperative earned a total of $7.2

million in net margins during the simulation

period under both plans. Twenty percent of net

margins in the qualified plan were distributed to

patrons as cash patronage refunds. Remaining

net margins were allocated as qualified written

notices and placed into the revolving fund. In

the nonqualified plan, all net margins were

allocated as nonqualified written notices.

One-half of net margins went into equity

growth in both plans. Net margins remaining

after paying income tax and cash patronage

refunds were used to retire patron equity. The

8 For the current Federal corporate tax rates, as

well as those before July 1,1987, see table 8 in the

following chapter. State tax is ignored in this analysis.

cooperative retired approximately $2.2 million of

patron equity in both plans. The cooperative

with the nonqualified plan redeemed $100,000 of

qualified notices (its initial equity) issued prior to

the switch to nonqualified notices.

The cooperative with the nonqualified plan

generated a tax liability of $1.4 million because it

issued nonqualified notices for which there is no

tax deduction until redemption. Tax paid by the

cooperative was about the same as the cash drain

that resulted from cash patronage refunds in the

qualified plan.

Patron tax liability was greatest in the

qualified plan. Patrons received $7.2 million in

taxable income, $5.1 million more than in the

nonqualified plan. The difference in tax liability

is a result of the timing difference in tax

treatment. Because cash and qualified noncash

patronage refunds are taxed at the patron level

Table P-Comparison of quallfled and nonquallfled plans, IO-year slmulatlonsa

Item

Cooperative:

Cash patronage refunds

Patronage refund allocations

Net margins

Nominal values Present values

Qualified Nonqualified Qualified Nonqualified

plan plan plan plan

Dollars

1,447,589.86 0 81,983.63 0

5,790,359.41 7,237,949.27 327,934.52 409,918.15

7,237,949.27 7,237,949.27 409,918.15 409,918.15

Equity growth 3,818,974.70 3,618,974.70 204,959.08 204,959.08

Patron equity retired:

Qualified notices

Nonqualified notices

Total

2,171,384.71 100,000.00 122,975.45 51,578.Ol

0 2,092,430.13 0 95,221.03

2,171,384.71 2,192,430.13 122,975.45 146,799.04

Taxable income 0 5,145,519.14 0 314,697.12

Tax paid 0 1,426,544.51 0 58,160.04

Patrons:

Taxable income

Tax paid

After-tax cash flow

7,237,949.27 2,092,430.13 409,918.15 95,221.03

2,026,625.80 585,880.44 104,342.80 24,238.08

1,592,348.77 1,606,549.69 100,616.28 122,560.96

aPercentage cash patronage refunds in qualified plan = .20; patron marginal tax rate = .28; rate of return = .15; rate of growth = ,075; discount rate = .lO; initial equity = $100,000.

12
when issued, patron tax liability for the qualified

plan in table 2 reflects all allocations made during

the simulation. Nonqualified notices are not

taxed at the patron level until redeemed. Thus, a

substantial portion of the distributions made in

the nonqualified plan was not recognized as

taxable income during the simulation. This effect

was increased by the growth in cooperative

equity.

The $1.6 million patron after-tax cash flow in

the qualified plan (cash patronage refunds and

patron equity retired less patron income tax paid)

was $14,201 less than in the nonqualified plan.

This was due primarily to the difference in tax

liability. Although under the qualified plan

patrons received $1.4 million in cash patronage

refunds, they paid personal income tax on the

entire distributions, including noncash patronage

refund allocations. Patrons in the nonqualified

plan paid tax only on equity retired by the

cooperative.

Present-Value Analysis

Nominal analysis of cash flow is limited

because it does not take into account timing

differences. Cash received during early years of

the simulation would have been more valuable to

patrons than cash received later. This is because

patrons could have reinvested the cash and

earned a return on it while waiting for later cash

receipts. Present-value analysis properly takes

into account timing differences and converts

nominal cash flows occurring during different

years into equivalent amounts called present

values. This is done by discounting future cash

flows over the period patrons must wait for the

cash using a rate that reflects the return they

could have earned if they had received the cash

during the first year of the simulation and

reinvested it.

When the nominal values in this example are

converted to present values, nonqualified notices

compare even more favorably under the

simulation conditions. Figure 3 shows the annual

cash flows to patrons in the two plans. Cash

flows in the nonqualified plan exceed those in the

qualified plan until year 39. Because the cash

flows in the nonqualified plan are greatest during

the first 38 years of the simulation, they weigh

more heavily in the present-value calculations.

As a result, the present value of total patron aftertax cash flow is $21,945 more in the nonqualified

plan. This amounts to a 22-percent difference,

compared with a 0.9-percent difference in

nominal values.

The greater cash flow in the nonqualified

plan during the early years of the simulation is

due primarily to timing differences in equity

retirement, as shown in figure 4. Total equity

retired in the nonqualified plan (both qualified

and/or nonqualified notices) exceeds that in the

qualified plan through year 38. After that, equity

retired is greatest in the qualified plan, primarily

because of a slowdown in equity retirement in the

nonqualified plan due to increases in the

cooperative’s tax rate. (This effect is explored in

more detail in the next section.) Because the

cooperative with the nonqualified plan redeems

more equity early in the simulation, the present

value of equity retired is greater than in the

qualified plan.

Although both the nominal and present

values of patron after-tax cash flow are greatest

for the nonqualified plan in this example, neither

method of distributing patronage refunds is

clearly superior to the other. Patron cash flows

are sensitive to changes in several variables,

including patron and cooperative income tax

rates and the cooperative’s rate of return, rate of

growth, and size. Analysis reported later in this

chapter measures the sensitivity of patron aftertax cash flow to changes in these parameters for

both the qualified and nonqualified plans. The

method of distributing patronage refunds that

yields the highest cash flows depends on the

levels of all parameters.

Cooperative Income Tax and Equity Retirement

An important factor in determining patron

cash flow in the nonqualified plan is the

cooperative marginal income tax rate. As

cooperative taxable income grows, the marginal

tax rate facing the cooperative usually increases

according to the generally progressive corporate

tax rate structure. This increases the cash drain

on the cooperative and reduces funds available

13
Figure 3-Patron After-Tax Cash Flows

$ thousand

80

60

llllllllmllll Nonqualified plan

0

0 10 20 30 40 50

Year

$ thousand

Present value

O0 10 20 30 40 50

Year

14
Figure 4-Equity Retirement

$ thousand

200 -

20 30 40 50

Year

$ thousand

Present value

i

:

c

I

Qualified allocations

retired in qualified

plan

Qualified allocations

retired in

nonqualified plan

Nonqualified

allocations retired in

nonqualified plan

20 30

Year

15
for retiring patron equity.

Two factors directly affect cooperative

taxable income in this model: cooperative net

margins and nonqualified notices retired. There

are several determinants of cooperative net

margins, but assuming a constant rate of return,

net margins increase as cooperative size increases

due to growth. Thus, cooperative taxable income

generally would increase as net margins grow,

but this effect is mitigated by redemption of

nonqualified notices deductible from taxable

income.

Both factors, net margins and nonqualified

notices retired, are represented in figure 5. Net

margins grow at the rate of 7.5 percent per

annum, the same rate as equity, given a constant

15-percent rate of return. At first, the cooperative

redeems only qualified notices issued prior to

year 1 (figure 4). In year 13, the cooperative

begins to redeem nonqualified notices and

taxable income is reduced. Both net margins and

nonqualified notices retired increase through the

rest of the simulation, but it is not until year 20

that taxable income exceeds its level in year 12.

Figure 6 shows the cooperative’s average tax

rate, which is 15 percent for the first 25 years.

During this period, the cooperative faces the

minimum marginal tax rate because its taxable

income is less than $50,000. The cooperative’s net

margins increase during the simulation, but

redemption of nonqualified notices, beginning in

year 13, reduces taxable income to less than $50,000

until year 26. At that point, the cooperative faces

the 25-percent marginal tax rate, and the average

tax rate begins to climb. It continues climbing until

year 48, when the cooperative faces a flat tax rate of

34 percent. From year 32 onward, income tax paid

by the cooperative with the nonqualified plan

exceeds the cash drain from cash patronage refunds

in the qualified plan. Thus, the cooperative with

the nonqualified plan is relatively less able to retire

equity.

The ability of the cooperative to redeem

equity is manifested by the length of the

revolving period. The revolving period in the

qualified plan is 14 years throughout the

simulation. Initially, the revolving period in the

nonqualified plan, shown in figure 7, also is 14

Figure 5-Cooperative Taxable Income, Nonqualified Plan

$ thousand

Year

16
Figure 6-Cooperative Average Tax Rate, Nonqualified Plan

Percent

40

io

20 30

Year

Figure 7--Revolving Period, Nonqualified Plan

Mmber of years

201

20 30 40 50

Year

17
years. However, when the cooperative switches

to issuing nonqualified notices, the cash drain

from income tax is at first less than the drain

from paying 20-percent cash patronage refunds.

This allows the cooperative to accelerate equity

retirement. By year 4, the revolving period falls

to 13 years. It remains 13 years until year 36,

when the increased cash drain due to higher

average tax rates results in longer revolving

periods. By year 50, the revolving period

increases to 17 years.

Because of the relatively small size of the

cooperative in this example, the cooperative faces

a low average tax rate when it begins issuing

nonqualified notices. Although the cooperative

at first does not receive a deduction from

redeeming nonqualified notices issued in prior

years, the cash drain from taxes still is lower than

from paying 20-percent cash patronage refunds,

as evidenced by the decrease in the revolving

period. Larger cooperatives facing higher

marginal tax rates will suffer larger cash drains,

as will be shown in the section of this chapter on

cooperative size.

Impact on Individual Patrons

The effect of the cooperative’s choice of

allocation method on an individual patron’s cash

flow is represented by table 3. It is assumed the

patron farms for 35 years and is responsible for

1 percent of the cooperative’s total patronage

while farming. Although these values are

somewhat arbitrary, the analysis based on them

demonstrates clearly the cash flow relationships

between a cooperative and a patron, and the

principles demonstrated by the analysis are

largely independent of the values used.

The relationship between the cooperative

and patron is separated into three periods in

table 3: (1) the investment period, (2) the growth

period, and (3) the disinvestment period. The

investment period starts when the patron begins

doing business with the cooperative and ends

when the cooperative begins redeeming the

patron’s equity. During this period, the patron

invests equity in the cooperative but does not

receive cash from the cooperative (in the

nonqualified case) or may be subject to a cash

drain from income tax (in the qualified case).

Thus, the investment period may be a period of

low or negative cash flows.

The growth period starts when the

cooperative begins redeeming the patron’s equity

and ends when the patron quits doing business

with the cooperative. During this period, the

patron continues to invest equity in the

cooperative. This investment generally increases

as the patron’s business with the cooperative

grows. This period usually results in higher cash

Table 3-Comparison of qualified and nonqualified plans from lndlvidual patron perspective

Plan

and

period

Qualified plan:

Investment period

Growth period

Disinvestment period

Total

Nonqualified plan:

Investment period

Growth period

Disinvestment period

Total

Length Cash Patronage Patron Patron Patron Present value Average

of patronage refund equity taxable after-tax of after-tax revolving

period refunds allocations retired income cash flow cash flow period

Years __-____-____-_____________ Do//ars _ _ - _ _ _ _ - _ _ _ _ . _ _ _ _ _ _ _ _ _ _ _ _ _ Years

14 700.98 2,803.91 0 3,504.89 (280.39) (90.06) 14.0

21 3,926.57 15706.28 5,889.85 19,632.85 4,319.22 408.75 14.0

14 0 0 12,620.34 0 12,620.34 215.97 14.0

49 4,627.55 18,510.19 18,510.19 23,137.74 16,659.17 534.66 14.0

13 0 3,120.83 0 0 0 0 13.2

22 0 20,016.91 7,740.16 7,740.16 5,572.91 525.26 13.0

17 0 0 15,397.58 15,397.58 11,086.26 174.02 15.4

52 0 239137.74 233137.74 23,137.74 16,659.17 699.28 13.8

18
flows because equity retirement offsets the

negative tax impacts.

The disinvestment period begins when the

patron quits doing business with the cooperative

and ends when the cooperative retires the last of

the patron’s equity. This period results in

positive cash flows from the cooperative because

tax liabilities on the redemption of qualified

notices have been met previously and tax

liabilities on the redemption of nonqualified

notices are less than the amounts redeemed.

Figure 8 illustrates individual patron cash

flows in the qualified and nonqualified plans. In

the qualified plan, the patron investment period

is equal to the 14-year revolving cycle. During

the investment period, the patron incurs a

negative cash flow from investing equity in the

cooperative. Cash patronage refunds do not

offset the cash drain due to patron income tax on

the cash and noncash patronage refunds. This

negative cash flow grows throughout the period

as patronage refunds increase. Total cash drain

during the investment period is $280.

In year 15, the cooperative redeems

patronage refund allocations issued to the patron

in year 1, marking the start of the growth period.

Redemption of prior years’ equities offsets the

negative cash flow from income tax on current

years’ allocations. Thus, cash flow is positive

during the growth period.

The disinvestment period begins in year 36,

after the patron quits doing business with the

cooperative. During this period, redemption of

the patron’s equity continues, but there are no

current allocations on which the patron must pay

tax. Also, there are no tax consequences to the

cash redemptions of equity. The disinvestment

period extends for one revolving period. In year

49, the cooperative revolves the last of the

patron’s equity.

The patron investment period is 13 years in

the nonqualified plan, during which the patron’s

cash flow is zero. The patron receives no cash

patronage refunds or equity redemption, but

neither does the patron incur a tax liability. Thus,

although the patron receives no cash benefits

from the cooperative, the negative cash flow

arising in the qualified plan is avoided.

The growth period extends from year 14

through year 35. During this period, the patron

continues to receive noncash patronage refund

allocations as well as redemption of previous

years’ allocations. Although the patron must pay

income tax on nonqualified notices redeemed, the

cash redemptions ensure a positive cash flow.

In fact, cash flow during the growth period

generally is greater than in the qualified plan due

to a shorter revolving period. The average

revolving cycle during the growth period is 13

years in the nonqualified plan and 14 years in the

qualified plan. Total equity retirement during the

patron’s active farming career is $7,740 in the

nonqualified plan and $5,890 in the qualified

plan.

The disinvestment period in the

nonqualified plan begins in year 36 and lasts for

17 years, 3 years longer than in the qualified plan.

This is because of the longer revolving period in

the nonqualified plan due to the high marginal

tax rates faced by the cooperative. The

cooperative retires $15,398 patron equity during

this period, $2,777 more than in the qualified

plan. However, average annual patron cash flow

is less than in the qualified plan due to the longer

revolving period and the patron tax liability on

the retirement of nonqualified notices.

Overall patron cash flow is the same for both

plans. The nonqualified plan yields the highest

cash flow during the patron’s active farming

career, both during the investment and growth

periods, but the qualified plan provides the

greatest cash flow during the disinvestment

period.

Results of the nonqualified plan are superior

from a present-value perspective. Present value

of total patron cash flow is $699, about 31 percent

greater than in the qualified plan. This is because

the nonqualified plan yields higher present

values early in the patron’s career, during the

investment period, when the qualified plan yields

negative cash flows, and during the growth

period. Thus, in this case, the nonqualified plan

is superior from the individual patron

perspective. It avoids negative cash flows during

the investment period and yields a higher overall

present value of after-tax cash flow.

19
Figure 84ndividual Patron After-Tax Cash Flows

-50 +

0 10 20 30

Year

40 50 60

$ thousand

4%

Present value

:

.

I

:

,...L...... 9-G

-1 ’

0 10 20 30

Year

60

Qualified plan

Nonqualified plan,

28-percent postretirement tax rate

Nonqualified plan,

1 5-percent postretirement tax rate

20
The nonqualified plan performs even better

if an adjustment is made to the postretirement

patron tax rate to reflect lower taxable income

common to many retirees. If the 2%percent

patron marginal tax rate is replaced by a 15-

percent rate during the disinvestment period, the

after-tax cash flow for the period increases $2,002

to $13,088. Total patron cash flow increases 12

percent to $18,661. The present value of total

patron cash flow increases to $727, about 36

percent greater than in the qualified plan.

Effect of Parameter Changes

Effects of parameter changes on patron aftertax cash flow are summarized in table 4 for

selected values of several important parameters.

Unless otherwise indicated, the following

discussion is written exclusively in terms of

present-value analysis although table 4 also

presents nominal results.

Patron Marginal Tax Rate

The effect of changes in the average patron

marginal tax rate is shown in figure 9. At low

patron tax rates, qualified distributions provide

patrons higher present values of after-tax cash

flow than nonqualified notices. Nonqualified

notices provide the highest present values at high

patron rates. Increases in the patron marginal

income tax rate reduce the present value of

patron after-tax cash flows in both the qualified

and nonqualified plans but generally affect the

qualified plan more. Because qualified patronage

refund distributions are taxed at the patron level

when allocated, the cash drain occurs early and

weighs heavily in present-value computations.

Because nonqualified notices are taxed when

redeemed, the tax consequences occur later and

weigh less in present values.

value at a zero discount rate) in the nonqualified

plan is 0.9 percent greater than in the qualified

plan. When the discount rate is 10 percent, the

present value of patron after-tax cash flow in the

nonqualified plan is 22 percent greater than in the

qualified plan.

This effect is due to the timing of cash flows.

The nonqualified plan provides patrons greater

nominal cash flows in early years of the

simulation (years 1 through 38) due to earlier

equity retirement and avoidance of negative cash

flows from patron income tax on qualified

distributions. The qualified plan results in

greater cash flows in later years (year 39 onward)

because of a slowdown in equity retirement in the

nonqualified plan due to the increased cash drain

from higher cooperative tax rates. As the

discount rate is increased, later cash flows weigh

increasingly less in the present-value calculation.

As discount rates are increased beyond 20

percent in this example, the relative attractiveness

of nonqualified notices diminishes somewhat.

However, only at extremely high discount rates

do qualified distributions provide the greatest

present value of patron after-tax cash flow.9

Because of the timing of cash flows, the

present value of patron after-tax cash flow in the

nonqualified plan is comparatively greater than

the nominal value. Generally, whichever

allocation method provides patrons the earliest

cash flows will result in the greatest present

value. In some cases, qualified distributions may

provide patrons greater cash flows during early

years. This may be due to high cooperative

marginal tax rates, a situation that will be

discussed in later sections of this chapter.

Discount Rate

Increasing the patron discount rate decreases

the present value of patron after-tax cash flows in

both the qualified and nonqualified plans, as

shown in figure 10. At first, increases in the

discount rate improve the relative attractiveness

of nonqualified notices. The nominal value of

patron after-tax cash flow (equivalent to present

9This is because the patron tax liability due to

receipt of a qualified patronage refund distribution is

met within the following year and thus is discounted

over one year more than the cash portion of the

patronage refund. At very high discount rates (above 86

percent), only the first several years weigh significantly

in the present-value calculation and the positive cash

flow from cash patronage refunds outweighs the tax

liability.

21
Table 4-Effects of parameter changes on patron after-tax cash flows, 50-year simulations

Item

Nominal values Present values

Qualified Nonqualified Qualified Nonqualified

plan plan plan plan

Base simulationa 1592.35 1,606.55 100.62 122.56

Patron marginal tax rate:

0

.15

.28

.33

.50

3,618.97 2,192.43 204.96 146.80

2,533.28 1,878.57 149.06 133.81

1592.35 1,606.55 100.62 122.56

1,230.45 1,501.93 81.98 118.23

0 1,146.22 18.63 103.52

Discount rate:

.05

.lO

.15

.20

.25

1,592.35

1,592.35

1,592.35

1,592.35

1,592.35

Cooperative size:b

.5x

lx

1.5x

2x

4x

6x

8x

10x

796.17 950.60 50.31 64.41

1,592.35 1,606.55 100.62 122.56

2,388.52 2,233.58 150.92 176.90

3,184.70 2,856.97 201.23 227.17

6,369.40 5,286.06 402.47 380.40

9,554.09 7,696.38 603.70 499.15

12,738.79 10,137.22 804.93 615.90

15,923.49 12.611.13 1,006.16 738.77

Rate of return:

.lO

.15

.20

.25

.30

.35

.40

C C C C

1592.35 1,606.55 100.62 122.56

3,329.45 3,343.66 202.47 225.97

5,066.56 5,080.77 304.33 328.68

6,803.67 6,817.87 406.19 431.06

8,540.78 8,554.98 508.05 533.30

10,277.89 10,292.09 609.91 635.41

Rate of growth:

0

.Ol

.02

.03

.04

.05

.06

.07

.08

.09

.lO

540.00 632.35 110.87 119.12

631.74 656.89 111.54 120.98

744.30 785.46 112.14 123.04

879.82 946.86 112.52 125.30

1,038.14 1,146.83 112.45 127.61

1,214.22 1,385.53 111.56 129.82

1,393.61 1,592.80 109.22 130.60

17544.81 1,652.07 104.42 127.00

1,606.56 1,511.09 95.53 115.91

1,467.15 1,086.81 79.98 93.90

C C C C

1,606.55 314.03 348.71

1,606.55 100.62 122.56

1,606.55 49.54 62.89

1,606.55 31.87 40.47

1,606.55 23.64 29.51

1,000 dollars

aParameter values presented rn table 2.

bExpressed as proportion of rnrtral equity rn base srmulatron.

'Compansons are not presented because nonqualrfred method IS Infeasible at this level given other parameter values.

22
Figure 9-Comparison of Patron After-Tax Cash Flows for Selected Patron Marginal Tax Rates

Present value ($ thousand)

300

200

100

0

Patron marginal tax rate (percent)

Qualified plan

q Nonqualified plan

Figure 1 O-Comparison of Patron After-Tax Cash Flows for Selected Patron Discount Rates

Present value ($ thousand)

300

200

100

0

5 10 15 20 25

Patron discount rate (percent)

Qualified plan

Nonqualified plan

23
Percentage Cash Patronage Refunds

The percentage patronage refunds paid in

cash affects the length of the revolving period in

the qualified plan, as shown in figure 11.

However, it does not affect the present value of

total patron after-tax cash flow. Thus, it does not

affect the relative attractiveness of the qualified

and nonqualified methods to patrons as a group.

This is because increasing cash patronage refunds

decreases funds available for equity retirement

by the same amount. Neither affects the cash

drain due to patron income tax.

This is illustrated in table 5. Cash patronage

refunds and patron equity retired sum to $3,619

regardless of the percentage patronage refunds

paid in cash. Patron tax paid also is constant.

Thus, both the nominal and present values of

total after-tax cash flow are the same across all

levels.

This does not imply that individual patrons

will not have preferences with regard to

patronage refund distributions. Furthermore, an

individual patron’s preferences may change over

time. For example, young patrons in the

investment stage of their careers may prefer to

receive high cash patronage refunds at the

expense of a long revolving cycle. This

preference may be supportable from both a cash

flow and present-value point of view. However,

once these patrons retire from farming and enter

the disinvestment period, they may prefer rapid

revolvement of equity. It may be difficult for a

cooperative to define the best policy for dealing

with two groups with such opposing interests.

Nonetheless, both the nominal and present

values of total cash flow to patrons will be the

same regardless of the level of cash patronage

refunds the cooperative chooses.

Cooperative Size

In this analysis, cooperative size, as

measured by initial equity, has a significant effect

on whether qualified or nonqualified

distributions provide patrons with the largest

present value. As shown in figure 12,

nonqualified notices provide the greatest patron

after-tax present value for small cooperatives. At

greater amounts of initial equity, qualified

distributions provide the largest present values.

The improved relative performance of qualified

distributions as size increases is due to the higher

marginal tax rates faced by the cooperative with

Table 5-Cash flows corresponding to selected levels of cash patronage refunds, qualified plan, 50.year slmulatlons

Percentage

cash

patronage

refunds

Cash Patron Patron Patron

patronage equity tax after-tax

refunds retired pald cash flow

2 0 1,447.59

2 5 1,809.49

3 0 2,171.39

3 5 2,533.29

4 0 2,895.19

4 5 3,257.08

Nominal values (1,000 dollars)

2,171.39 2,026.63

1,809.49 2,026.63

1,447.59 2,026.63

1,085.69 2,026.63

723.79 2,026.63

361.90 2,026.63

1,592.35

1,592.35

1592.35

1,592.35

1,592.35

1592.35

2 0 81.98

2 5 102.48

3 0 122.98

3 5 143.47

4 0 163.97

4 5 184.46

Present values (1,000 dollars)

122.98 104.34

102.48 104.34

81.98 104.34

61.49 104.34

40.99 104.34

20.50 104.34

100.62

100.62

100.62

100.62

100.62

100.62

24
Figure ll--Revolving Period for Selected Levels of Cash Patronage Refunds

Number of years

30

20

10

0

25 30 35 40

Patronage refunds paid in cash (percent)

45

Figure 1 P-Comparison of Patron After-Tax Cash Flows for Selected Cooperative Sizes

Present value ($ thousand)

800

600

400

200

n

Qualified plan

Nonqualified plan

150 200 400 600

Initial net worth ($ thousand)

25
the nonqualified plan. By assuming a constant

rate of return to equity, taxable income and the

marginal tax rate increase as size is increased. As

the marginal tax rate increases, revolvement of

equity is retarded and cash flow to patrons

decreases.

A comparison of the average tax rates of two

cooperatives distributing patronage refunds in

nonqualified form is shown in figure 13. The

smaller cooperative, which has $100,000 initial

equity, is able to keep its average tax rate at 15

percent during the first 25 years of the

simulation. Then growth in taxable income

gradually increases the average tax rate until it

reaches 34 percent in year 48. The larger

cooperative, which has $1 million initial equity, is

unable to take advantage of low tax rates because

of its larger taxable income. Its average tax rate

begins at 27.8 percent and climbs to 34 percent by

year 12. As a result, the average length of its

revolving period is 18.8 years, compared with

13.7 years for the smaller cooperative.

Cooperative Marginal Tax Rate

Analysis of cooperative size yields

interesting results regarding the cooperative tax

rate. However, that analysis does not look

specifically at the impact of the cooperative tax

rate. The effects of the cooperative tax rate are

obscured by the fact that the simulations may

involve several marginal tax rates as the

cooperative’s taxable income progresses up the

corporate tax rate structure.

Table 6 presents results of an analysis of the

effect of the cooperative’s marginal tax rate. This

analysis was conducted by assuming that for each

simulation there was only one marginal tax rate

and bracket. Thus, the analysis is a simplification

of the tax situation facing a cooperative because it

ignores the progressivity of the corporate tax rate

structure and does not distinguish between

marginal and average tax rates. Nevertheless, it

provides useful information on the relationship

between the cooperative tax rate and patron aftertax cash flows.

Figure 13-Comparison of Average Tax Rates for Small and Large Cooperatives

Percent

40

30

20

$100,000

initial net worth

$1 ,ooo,ooo

initial net worth

Year

26
Table 6 shows the nominal and present

values of patron after-tax cash flows for both

qualified and nonqualified plans under five

patron and four cooperative tax rates. Because

the cooperative with the qualified plan does not

pay corporate income tax, performance of that

plan is independent of the cooperative tax rate.

When the cooperative and patron tax rates

are the same, the cash drains on the cooperative

system are equal and patrons receive the same

annual cash flow from both plans. The

nonqualified plan yields a smaller nominal

patron after-tax cash flow than the qualified plan

whenever the marginal tax rate of the cooperative

exceeds the patron rate and provides a higher

nominal value whenever the cooperative tax rate

is less than the patron rate. Thus, in nominal

terms, qualified distributions provide patrons

with the highest after-tax cash flows when the

cooperative tax rate is high and the patron tax

rate is low. Nonqualified notices provide patrons

with the highest nominal cash flows when the

cooperative tax rate is low and the patron rate is

high. The same result holds for present values

although present values for the nonqualified plan

are comparatively lower than nominal values.10

Figure 14 shows the present value of patron

after-tax cash flows for both the qualified and

nonqualified plans for four cooperative tax rates,

assuming a patron tax rate of 28 percent. The

present value of cash flow in the qualified plan is

independent of the cooperative tax rate. At Oand 15-percent cooperative tax rates, the present

value of cash flow in the nonqualified plan is

higher. At 34- and 39-percent cooperative tax

rates, it is lower.

Rate of Return

Increasing the cooperative’s rate of return to

equity appears to be relatively neutral in its effect

on the present values from qualified and

nonqualified distributions, as shown in figure 15.

10 The present values of cash flows from qualified

distributions are greater than those from nonqualified

distributions because the patron tax liability from

receipt of a qualified patronage refund distribution is

met within the following year and is discounted over

one year more than the cooperative tax liability due to

allocation of nonqualified notices.

Table 6-Effects of patron and cooperative tax rates on patron after-tax cash flows, SO-year simulations

Patron

tax rate

(percent)

0

Nominal value

Present value

15

Nominal value

Present value

28

Nominal value

Present value

33

Nominal value

Present value

50

Nominal value

Present value

Qualified

plan

3,618.97

204.96

2,533.28

149.06

1,592.35

100.62

1,230.45

81.98

0

18.63

0

3,618.97

204.96

3,091.13

185.09

2,633.66

167.87

2,457.71

161.25

1,859.49

138.73

Nonqualified plan

Cooperative tax rate (percent)

15 34

7,000 dollars

2,962.69 1,703.14

159.69 81.45

2,533.28 1,462.67

144.95 75.09

2,161.13 1,254.26

132.17 69.57

2,018.OO 1,174.10

127.25 67.45

1,531.34 901.57

110.55 60.24

39

1,241.27

56.21

1,070.08

52.32

921.71

48.95

864.65

47.66

670.63

43.25

27
Figure 14-Comparison of Patron After-Tax Cash Flows for Selected Cooperative Tax Rates

15 34

Cooperative tax rate (percent)

Qualified plan

q Nonqualified plan

Figure l!bComparison of Patron After-Tax Cash Flows for Selected Cooperative Rates of Return

Present value ($ thousand)

800

600

400

200

0

15 20 25 30 35 40

Qualified plan

Nonqualified plan

,

Cooperative rate of return (percent)

28
As the rate of return increases, the present value

of patron after-tax cash flow increases by about

the same amount in both plans.

This differs from results for cooperative size

and rate of growth. Increases in these

parameters, like the rate of return, increase net

margins. However, they also increase cooperative

taxable income in the nonqualified plan. At some

point, the increased cash drain due to the

progressive corporate tax structure reduces the

comparative attractiveness of nonqualified

notices.

When the rate of return is increased, net

margins also increase. However, an increased

rate of return allows the cooperative to accelerate

the redemption of nonqualified notices issued in

prior years. This lowers cooperative taxable

income and delays the progressive increase in

marginal tax rates. Cooperatives with higher

rates of return are able to deduct redemptions of

nonqualified notices earlier and reduce a larger

proportion of taxable income. Once the

cooperative begins redeeming nonqualified

notices, its average tax rates generally are less

than or equal to those at lower rates of return.

Comparison of figure 16, which shows net

margins and taxable income for a 40-percent rate

of return, with figure 5, which is for a 15-percent

rate of return, demonstrates that a cooperative

with a higher return is able to reduce a greater

proportion of its taxable income. A cooperative

earning a 40-percent rate of return begins

redeeming nonqualified notices 9 years earlier

and maintains a shorter average revolving period,

4.1 years, compared with 13.7 years for a

cooperative with a 15-percent return. By

reducing its taxable income through redeeming a

greater amount of nonqualified notices, the

cooperative with the 40-percent rate of return is

able to maintain the same average tax rates as the

other cooperative, shown in figure 6.

Rate of Growth

The effect of the cooperative’s rate of equity

growth on the present values from qualified and

nonqualified distributions is complex. As shown

in figure 17, increases in the rate of growth first

increase and then decrease the present value of

patron after-tax cash flows for both qualified and

&W’e 16--Cooperative Taxable Income, Jo-Percent Rate of Return

$ thousand

400 *

Year

- Net margins

1.1~~ Taxable income

29
nonqualified distributions. The relative

attractiveness of nonqualified notices also

increases and decreases as the rate of growth

increases.

These results are based on a number of

interrelated factors. Increases in the rate of

growth have two effects on patron cash flows.

One, current patron cash flow is decreased

because cooperative cash flow is diverted from

equity retirement to equity growth. Two, an

increased growth rate increases future equity and

therefore future net margins. Thus, future patron

cash flows may increase because of higher cash

patronage refunds and/or equity retirement.

For cooperatives that issue nonqualified

notices, the situation is complicated by the

generally progressive corporate tax structure,

which can cause a relative decline in after-tax

cash flows in later years. As the rate of growth

increases, equity and net margins increase.

Without a corresponding increase in the rate of

return to equity, cooperative taxable income and

the average tax rate increase. At some point, the

resulting cash drain may be so great that the

cooperative is unable to revolve equity.11

The distribution of cash flow in the qualified

plan is’shown in figure 18 for three rates of

growth. At a zero rate of growth, cash flow is

constant throughout the simulation. Net margins

do not grow, and the length of the revolving

period is 9 years throughout. Thus, cash

patronage refunds, income tax, and equity

retirement remain the same from year to year.

If the rate of growth is increased to 7.5

percent, the revolving period increases to 14

years and proportionately less equity is retired at

the start of the simulation. However, net margins

and cash patronage refunds grow throughout the

simulation. The net effect is that total patron

cash flows are less in early years of the

simulation but greater during later years. Total

patron cash flow increases substantially, but

i* This analysis is sensitive to the length of the

simulation period. Longer simulation periods will favor

higher rates of growth because more of the deferred

cash flow will fall within the simulation period.

Figure 17-Comparison of Patron After-Tax Cash Flows for Selected Cooperative Rates of Growth

Present value ($ thousand)

q Qualified plan

q Nonqualified plan

0

0 1 2 3 4 5 6 7 8 9

Rate of cooperative growth (percent)

30
Figure 18-Patron After-Tax Cash Flows for Three Cooperative Rates of Growth, Qualified Plan

$ thousand

125

25

30 40 50

Year

$ thousand

Present value

0 percent rate of

cooperative growth

7.5 percent rate of

cooperative growth

9 percent rate of

cooperative growth

30

Year

31
Figure 19-Patron After-Tax Cash Flows for Three Cooperative Rates of Growth,

Nonqualified Plan

$ thousand

20 30 40 50

Year

$ thousand

12

10

Present value

8

6.-- f

l

““N.,,___

2-.------

0,

0

0 percent rate of

cooperative growth

7.5 percent rate of

cooperative growth

9 percent rate of

cooperative growth

20 30

Year

32
when the cash flows are discounted, the increase

in later cash flows does not compensate for the

decrease in early cash flows, and the present

value of total patron cash flow decreases.

If the rate of growth is increased to 9 percent,

the revolving period increases to 17 years.

Decreased equity retirement further lowers early

cash flows. Later cash flows are greater than for

zero growth but not greater than for a 7.5-percent

rate of growth until late in the simulation. Total

patron cash flows decrease, and the present value

of total patron cash flow is substantially lower.

The distribution of cash flow in the

nonqualified plan is shown in figure 19 for the

same rates of growth. At a zero rate of growth,

the length of the revolving period falls from 9

years to 8 years in year 6. Cash flow drops

slightly because of patron tax liabilities on the

redemption of nonqualified notices, beginning in

year 8.

When the rate of growth is increased to 7.5

percent, the average revolving period increases

from 8.1 years to 13.7 years and proportionately

less equity is retired in the early years of the

simulation. Net margins grow throughout the

simulation, and both the nominal and present

values of total patron cash flow increase.

If the rate of growth is increased to 9 percent,

the average revolving period climbs to 17.7 years.

Decreased equity retirement in the early years is

not offset by increased cash flow in later years

because of the increased average tax rates due to

higher cooperative taxable income (figure 20).

Thus, both the nominal and present values of

total patron cash flow decrease. At a lo-percent

rate of growth, the tax effect is important enough

that the cooperative eventually cannot revolve

equity.

Tax Reform Act of 1986

Recent changes in the Internal Revenue Code

due to the Tax Reform Act of 1986 should be of

interest to cooperatives that issue nonqualified

notices or have considered issuing them. The Tax

Reform Act included three changes relevant to

the preceding analysis: (1) reduction of

individual tax rates and number of brackets, (2)

Figure PO-Cooperative Average Tax Rate for Three Rates of Growth, Nonqualified Plan

Percent

mmamm~~ 0 percent rate of

cooperative growth

7.5 percent rate of

cooperative growth

9 percent rate of

cooperative growth

30 40 50

Year

33
reduction of corporate tax rates and number of

brackets, and (3) elimination of investment tax

credit. The effect of changing the individual

marginal tax rate is discussed in an earlier

section of this chapter. In general, reductions in

personal tax rates make qualified patronage

refund distributions relatively more attractive to

patrons.

Additional analysis was conducted to

demonstrate the effects of the new corporate tax

rates and elimination of investment credit.

Results of this analysis do not invalidate the

conclusions of the analysis previously discussed.

Instead, this analysis was conducted to

demonstrate specific effects of the Tax Reform Act

of 1986. The results are presented in table 7 for the

base cooperative used in the previous simulations

and a cooperative 10 times larger. The larger

cooperative was used to study the effect of lower

corporate tax rates on a cooperative currently

facing high marginal tax rates.

The new corporate tax rate schedule affects

only the nonqualified plan. Lower rates increase

cash flow available for equity retirement and,

therefore, both nominal and present values of

patron after-tax cash flow. The effect of reduced

rates is greatest for the larger cooperative. The

new rates double the nominal value of patron

after-tax cash flow. The present value increases

by 63 percent.

Loss of investment credit lowers patron

after-tax cash flow in both plans but has a greater

impact in the nonqualified plan, particularly for

the larger cooperative. This is because

Table 7-Effects of Tax Reform Act of 1988 on patron after-tax cash flows, 50.year simulations

Item

Nominal values Present values

Qualified Nonqualified Qualified Nonqualified

plan plan plan plan

1,000 dollars

Base cooperative?

Before tax law changes

New corporate rates only

Elimination of investment

credit only

New corporate rates and

elimination of investment

credit

2,050.75 1,660.97 124.22 133.48

2,050.75 1,945.21 124.22 139.13

1,809.49 1,349.16 111.80 118.61

1,809.49 1,669.32 111.80 125.16

Large cooperative:b

Before tax law changes

New corporate rates only

Elimination of investment

credit only

New corporate rates and

elimination of investment

credit

20,507.52 7,867.43 1,242.18 554.53

20,507.52 15,836.58 1,242.18 905.52

18,094.87 4,489.61 1,117.96 381 .OO

18,094.87 13,094.93 1,117.96 751.87

aPatron margmal lax rate = .25; initial annual Investment and replacement of capital assets qualifying for investment tax credit = $5,000. All other parameters

equal to levels rndrcated In table 2. Annual investment and replacement of capital assets qualifying for investment tax credit assumed to grow at same rate as

net worth.

blnitral net worth and property quallfyrng for Investment tax credit increased to 10 times that of base cooperative.

34
investment credit is more valuable to a

cooperative the higher its marginal tax rate.12

The combination of reduced corporate

income tax rates and elimination of investment

credit decreases nominal and present values of

patron after-tax cash flow in the qualified plan. It

increases nominal patron cash flow for both

cooperatives in the nonqualified plan. It also

increases the present value for the larger

cooperative. However, the present value for the

larger cooperative still is substantially lower than

in the qualified plan.

The net effect of the Tax Reform Act of 1986

on individual cooperatives will depend on the

relative importance of the decrease in tax rates

and loss of investment tax credit. Lower personal

tax rates will make qualified patronage refund

distributions more attractive to patrons. Lower

corporate tax rates generally will make

nonqualified notices more attractive, but this

effect will be at least partially offset by the loss of

investment credit.

Summary

The preceding analysis suggests that neither

the qualified nor nonqualified method of

distributing patronage refunds is clearly superior

to the other. Patron cash flows are sensitive to

changes in several factors, and which method of

distributing patronage refunds results in the

greatest cash flow to patrons depends on the level

of each of these parameters.

Two critical factors affecting cash flow from

12 For an analysis of investment tax credit under

the old corporate tax rates, see Jeffrey S. Royer, “Cash

Flow Comparisons of Qualified and Nonqualified

Allocations of Cooperative Patronage Refunds,”

AgCxdturnl Finance Review 47 
cooperative taxable income and delays the

progressive increase in marginal tax rates.

The percentage patronage refunds paid in

cash affects the length of the revolving period in

the qualified plan. It does not affect the present

value of total after-tax cash flow and the relative

attractiveness of the qualified and nonqualified

methods. However, this does not imply that

individual patrons do not have preferences with

regard to patronage refund distributions.

Patrons in the early stages of their careers may

prefer to receive high cash patronage refunds at

the expense of a long revolving cycle. However,

once these patrons retire from farming, they may

prefer rapid revolvement of equity.

What type of cooperatives and patrons can

benefit from using nonqualified notices?

Basically, cooperatives with low tax rates and

patrons with high tax rates. If patron tax rates

are high relative to the cooperative rate,

nonqualified notices will provide patrons greater

cash flows than qualified distributions. Patrons

with’high tax rates are those most affected by

cash drains from income tax on qualified

patronage refund distributions. Therefore, they

may prefer receiving nonqualified notices to

receiving cash patronage refunds and paying

income tax on qualified notices. Nonqualified

notices also may provide these patrons with a

means of deferring taxable income from

patronage until after they have retired and face

lower tax rates.

The comparative benefits these patrons

receive from nonqualified notices may be

improved if the patrons have high discount rates.

Because increases in the patron discount rate

favor the allocation method that provides the

earliest cash flows, patrons with high discount

rates may have an additional reason for

preferring nonqualified notices. In particular,

farmers with large incomes and high-yielding

opportunities for investment outside the

cooperative may find nonqualified notices

attractive.

Because of the generally progressive

corporate income tax rate structure, patrons of

small cooperatives are more likely to benefit from

the use of nonqualified notices. Large taxable

incomes due to size and growth increase the

marginal tax rate faced by the cooperative and

reduce the cash flow to patrons from

nonqualified notices. Large cooperatives

probably cannot do much to reduce the corporate

tax rates they face although those with high rates

of return can reduce taxable income by

accelerating equity retirement. Although new,

lower corporate tax rates may have reduced the

cash drain on many cooperatives from issuing

nonqualified notices, others may be hurt by the

elimination of investment tax credit. This credit

was more valuable to patrons of cooperatives

issuing nonqualified notices, especially those

cooperatives facing high marginal tax rates.

Because of timing differences in the tax

treatment of patronage refunds, nonqualified

notices may provide higher present values of

patron after-tax cash flow in many situations where

qualified distributions result in higher nominal

values. One reason cooperatives have used

nonqualified notices so little may be that managers

and boards of directors have not considered present

values in making distribution decisions.

36
IV. TAX MANAGEMENT CONSIDERATIONS

The previous chapter identified

characteristics of cooperatives and patrons that

could benefit from using nonqualified notices.

That analysis was based on the values of several

important factors, including cooperative and

patron tax rates. Although these factors were

varied to examine patron benefits from qualified

and nonqualified patronage refund distributions

under a broad range of parameter values, the

results cannot be used to determine whether a

specific cooperative should use nonqualified

notices.

Whether an individual cooperative and its

patrons can benefit from issuing nonqualified

notices depends on the unique environment faced

by the cooperative and on situations that change

from year to year. In reality, no cooperative

operates under stable income relationships and

uniform patron characteristics such as those

assumed in the preceding analysis. Net margins

generally vary from year to year, and cooperative

patrons face various income and tax situations.

Even tax laws and other institutional factors are

subject to frequent change.

This chapter discusses more thoroughly the

factors that should be taken into account by

cooperatives considering use of nonqualified

notices. In doing so, it focuses on some unique

situations in which nonqualified notices can be

used for the benefit of a cooperative and its

patrons. The chapter begins with a discussion of

the use of nonqualified notices in managing

cooperative and patron taxes. It ends with a

discussion of some factors that may limit the use

of nonqualified notices in managing taxes. Other

factors that may discourage the use of

nonqualified notices are discussed in the next

chapter.

Comparative Cooperative and Patron Tax Rates

Generally, if a cooperative’s income tax rate

is lower than its patrons’ tax rates, the

cooperative can reduce the tax paid on a

patronage refund distribution by issuing

nonqualified notices and paying the tax itself.

Conversely, if patrons’ tax rates are lower, the

combined taxes of the cooperative and patrons

will be lowest if the cooperative distributes the

patronage refunds in qualified form and patrons

pay the tax.

Table 8 summarizes the major features of the

Federal income tax laws before and after passage

of the Tax Reform Act of 1986.13 The act lowered

tax rates and reduced the number of tax brackets

for both cooperatives and patrons. It also

eliminated investment tax credit. Prior to 1986,

businesses could earn tax credits on investments

in certain depreciable or amortizable property.

Such credits not used by a cooperative in the year

earned were allocated to patrons in a manner

similar to patronage refunds.

Under the current tax law, there may not be

much difference between cooperative and patron

income tax rates. The current corporate tax rate

for incomes above $75,000 is 34 percent. For

incomes between $100,000 and $335,000, there is a

5-percent surcharge, which is intended to phase

out the benefit of the 15-percent rate applied to

the first $75,000 of income. Thus, nonqualified

notices issued by most cooperatives would be

taxed at a 34-percent rate. Only small

cooperatives with less than $75,000 annual

earnings would be taxed at the 15-percent rate.

Meanwhile, the current (1989) income tax

rate for single individuals with incomes of over

$18,550 is 28 percent. For incomes between

$44,900 and $93,130, single individuals must pay

a 5-percent surcharge designed to phase out the

benefit of the 15-percent rate applied to the first

$18,550 income. The surcharge is extended to

additional income up to $11,200 to reduce the

benefit of the $2,000 personal exemption. The 28-

percent income tax rate applies to incomes above

$30,950 for married couples filing jointly. The 5-

13 Although most of the basic features of the old

tax law still existed in 1986,1985 is used in table 8 to
Table O---Major features of Federal tax laws before and after lax Reform Act of 1988

Tax on -

1985

Tax year

1988

Corporations Tax rates:

15% to $25,000,

between $1 ,OOO,OOO and

$1,405,000.

Tax rates:

15% to $50,000,

25% to $75,000,

34% thereafter;

5% surcharge on income

between $100,000 and

$335,000.

Investment credit:

Up to 10% credit on qualifying property; maximum

allowable credit in any

year was $25,000 plus 90% of

tax liability over $25,000;

credit not used by cooperatives in year earned was

allocated to patrons.

No investment credit.

Single individuals 15 tax brackets with 50%

maximum rate on income

over 585,130.

Tax rates:

15% to 517,850,

28% thereafter;

5% surcharge on income

between 543,150 and 589,560;

5% surcharge on additional

income up to 510,920 for

personal exemption.

Married couples

filing jointly

15 tax brackets with 50%

maximum rate on income

over 5169,020.

Tax rates:

15% to $29,750,

28% thereafter;

5% surcharge on income

between 571,900 and 5149,250;

5% surcharge on additional

income up to $10,920 for

each personal exemption.

Self-employment

income

Net rate of 11.8% for income Net rate of 13.02% for income

to $39,600. to 545,000.

percent surcharge for married couples filing

jointly applies to incomes between $74,850 and

$155,320 plus additional income of up to $11,200

for each personal exemption claimed. Thus,

cooperative patrons can have marginal income

tax rates of 15,28, or 33 percent.

Farmer patrons also are subject to Federal

self-employment tax if they operate their own

farms, whether on land they own or lease from

someone else, or are sharefarmers who produce

38
agricultural or horticultural commodities for the

owner or tenant of land in exchange for a share of

the commodities. Ordinarily, a farmer’s income

subject to self-employment tax is equal to net

farm profit adjusted for certain income items and

deductions. Taxable patronage refunds from

cooperatives are among those items usually

included in farmers’ self-employment income.

Currently, the first $48,000 of a farmer’s selfemployment income is subject to tax at a net rate

of 13.02 percent.

Thus, most patrons are subject to combined

income and self-employment taxes on qualified

patronage refund distributions and redemptions

of nonqualified notices at effective rates from 28

to 41 percent, compared with the 34-percent rate

cooperatives would pay on most nonqualified

patronage refund distributions. Whether a

cooperative or its patrons will have the lowest

effective tax rate will depend on specific

circumstances, including current income and

other temporal influences.14

Certainly, there are situations in which

patrons can benefit most often from their

cooperatives’ issuing nonqualified notices. Take,

for example, a group of farmers who usually are

in the highest individual or corporate tax bracket

and form a small cooperative to provide

themselves specialized services. If the

cooperative’s income is taxed at the lower

corporate rate, its rate will be lower than its

members’ rates and nonqualified notices will

produce the lowest overall taxes.

Of course, this is a special situation. In most

cases, cooperative patrons will have a range of

incomes, not all in the highest or lowest tax

brackets. In addition, most patrons belong to

cooperatives that are large enough to have their

incomes taxed at the 34-percent corporate tax

rate. In general, current tax rates do not favor

one allocation method over the other.

14 Because of the diversity of State income tax

rates, they are ignored in this discussion. However,

they should be taken into consideration in tax

management decisions.

Flexibility in Issuing and Redeeming

Nonqualified Notices

The preceding discussion of comparative

cooperative and patron tax rates ignores the

flexibility cooperatives have in issuing and

redeeming nonqualified notices. The choice to

issue nonqualified notices is not a once-and-for-all

decision. A cooperative can include authorization

for issuing both qualified and nonqualified notices

in its bylaws with the idea each may be useful

under certain conditions. Then it can make the

choice whether to issue nonqualified notices on a

yearly basis according to the situation it and its

patrons face each year. If conditions in a given

year are such that patrons have high tax rates

relative to the cooperative, it may choose to issue

nonqualified notices that year. A cooperative also

can choose to issue both qualified and

nonqualified notices in the same year.

A cooperative likewise may time the

redemption of nonqualified notices according to

income and tax considerations. The rules for

computing the tax deduction for redemption of

nonqualified notices can contribute to this

flexibility. Generally, redemption of prior years’

nonqualified notices is most valuable to a

cooperative in years when its tax rate is high

because the current tax rate can be used to

determine the deduction. However, even if the

current tax rate is not high, the cooperative’s

deduction will equal, at a minimum, the

difference between the tax it paid in the year the

notices were issued and what it would have paid

if it had issued them in qualified form. Of course,

the cooperative should take its patrons’ current

tax rates into consideration also.

Cooperatives with stable tax rates may not

find the flexibility in issuing and redeeming

nonqualified notices very valuable. Because the

Tax Reform Act of 1986 reduced tax rates and the

number of brackets, changes in a cooperative’s

income from one year to another may not result

in a change in its tax rate. Thus, this flexibility

may not be as valuable as it was prior to the act.

However, cooperatives may find they can use

nonqualified notices effectively in responding to

extraordinary occurrences such as losses or

changes in the tax law itself.

39
Tax Planning After Financial Losses

A cooperative that suffers an operating loss

may be able to benefit from issuing nonqualified

notices to absorb some of the loss. Under section

172 of the Internal Revenue Code, most

corporations can elect to carry an operating loss

backward 3 years or forward 15 years to deduct it

from taxable income earned during those years.

If the loss is carried back, the corporation can

request a refund for tax already paid. If the loss

exceeds total taxable income for the 3 years, the

balance of the loss can be carried forward 15

years.15

If a cooperative has issued nonqualified

notices in prior years, it already may have

taxable income available for absorbing the loss

and generating an income tax refund. However,

even if a cooperative previously has issued

qualified notices and has no past taxable income

for absorbing the loss, it may be able to begin

issuing nonqualified notices to increase taxable

income for absorbing the loss in the future.

Although the cooperative would not receive a tax

refund, there would be no income tax on the

taxable income from nonqualified notices offset

by the loss carried forward. Thus, the

cooperative would conserve cash flow by issuing

nonqualified notices and avoiding the cash drain

that would have occurred if it had distributed net

margins to patrons in qualified form and paid a

portion of them in cash.

A similar technique was applied during the

loss year itself by a cooperative that determines

patronage refunds on a departmental basis and

suffered an operating loss in one department

while earning net margins in another. The

cooperative distributed nonqualified notices to

the patrons who were allocated patronage

15 Loss treatment under section 172 of the Internal

Revenue Code currently is under challenge by the

Internal Revenue Service (IRS) for cooperatives

operating without section 521 tax status. The IRS

contends that these cooperatives are subject to the loss

handling rules in section 277, which applies to certain

membership organizations. Under section 277,

organizations cannot carry losses backward but may

carry them forward to other tax years.

refunds. The losses in the other department were

used to offset the taxable income resulting from

the notices, thus freeing the cooperative of any

tax liability. As a result, the cooperative had a

lower cash drain than if it had distributed

qualified notices and paid 20 percent of

patronage refunds in cash.

In both situations, patrons who earn net

margins still would receive their full share of

patronage refunds. Each year’s or department’s

accounting would be maintained separately, and

only the tax responsibilities would be combined.

Thus, the principal impact on patrons would be

that patronage refunds that otherwise would

have been distributed in qualified form would be

distributed as nonqualified notices.

These strategies may require conceptual

definition to reconcile the cooperative’s tax

accounting methods with the methods used to

calculate patronage refunds. If the application of

one department’s loss against another

department’s taxable income (created because

patronage refunds based on the department’s net

margins are distributed as nonqualified written

notices of allocation) is viewed as only a year-end

calculation to determine the cooperative’s total

taxable income, it will not affect the allocation of

losses and net margins to patrons of the respective

departments. The nonqualified notices represent

patronage refunds based on the net margins

generated by the department with margins.

However, if the loss application to the

margin generating department affects the net

margins available for allocation to patrons (if

methods used to determine patronage refunds

follow tax accounting calculations), the

patronage refunds upon which the nonqualified

notices are based are reduced. Cooperatives that

issue nonqualified notices for patronage refunds

based on net margins unreduced by the loss

application could face difficulties upon

redemption.

Responding to Tax Law Changes

Cooperatives have been able to use

nonqualified notices to produce positive benefits

from tax law changes. Within the past several

40
years, two revisions of the Internal Revenue Code

have had important impacts on the tax

management strategies available to cooperatives.

The Revenue Act of 1978 changed investment tax

credit rules for cooperatives, allowing many

cooperatives to use this credit effectively for the

first time. The Tax Reform Act of 1986

substantially revised the Internal Revenue Code,

reducing tax rates and eliminating investment

credit for all businesses, among other things.16

Prior to the Revenue Act of 1978, for a

cooperative, the value of an investment in

property qualifying for investment credit and the

amount of credit allowable in a given year, were

reduced by multiplying them by the ratio of the

cooperative’s taxable income to its total income,

including deductions from taxable income

allowed under the Internal Revenue Code.

Because most cooperatives generally distributed

nearly all their income in deductible form, this

rule substantively excluded them from effectively

using investment credit.

The Revenue Act of 1978 eliminated this rule

and specified that credits not used by a

cooperative in the year earned were to be

allocated to patrons in a manner similar to

patronage refunds. Although cooperatives

issuing nonqualified notices could have benefited

from investment credit under the old rules,17 the

increased availability of investment credit for

cooperatives drew new attention to the

usefulness of nonqualified written notices as a tax

planning tool.18

Although many cooperatives decided to pass

the credit they earned through to patrons, some

cooperatives used nonqualified notices to

increase taxable income with which to absorb the

credit at the cooperative level. This may have

been a desirable strategy for several reasons.

First, investment credit was more valuable when

applied at the cooperative level and at high tax

rates.19 Second, this strategy avoided the

increased administrative costs of allocating the

credit and applying it to individual tax forms as

well as potential problems from recapture.20

Finally, in cases of unusually large investments in

property with long useful lives, cooperatives that

did not allocate the credit to current patrons

could pass the benefit to those who financed the

property through decreased borrowing costs

made possible by absorption of the credit.

More recently, the lower corporate tax rates

resulting from the Tax Reform Act of 1986

reduced the possibility of cooperatives’ benefiting

from redeeming nonqualified notices at a higher

tax rate than that at which they were issued.

However, lower patron tax rates still provided

some cooperatives that had issued nonqualified

notices in prior years a chance to reduce patron

taxes, as illustrated in the following example.

The use of nonqualified notices by a grocery

wholesaling cooperativez* demonstrates several

important tax considerations. The membership of

this cooperative is composed of independently

I6 One author suggests that a cooperative

anticipating an alternative minimum tax liability under

the new tax rules may be able to reduce or avoid the tax

by issuing nonqualified written notices. See Barry E.

Jencik, “Tax Reform and Cooperatives: Selected

Issues-Part II,” Cooperative Accountant, Fall 1987, pp.

41-42.

r7 Because nonqualified written notices of

allocation are included in taxable income, some

cooperatives issued them to increase their allowable

investment credit according to William E. Lazzeri, “New

Tax Law Gives Coops and Their Patrons Full Benefit of

Investment Tax Credits,” Cooperative Accountant, Winter

1978, p. 52.

1s Fred E. Beaver and Myron J. Fleck, “The New

Tax Planning Environment for Cooperative

Organizations under the Revenue Act of 1978,”

Cooperative Accountant, Winter 1978, pp. 28-49.

19 See Royer, “Cash Flow Comparisons,” 11.

2s If a business disposed of property qualifying for

investment tax credit before the end of the property’s

useful life, the credit had to be recomputed according to

how long the property was held. If the recomputed

credit was less than the original, the business incurred a

tax liability equal to the difference. According to the

investment credit rules for cooperatives, a cooperative

had to pay back this recaptured credit even if the credit

had been allocated to patrons.

21 Walter L. Grant, “Nonqualified Notices of

Allocation and the Tax Reform Act of 1986,” Cooperative

Accountant, Summer 1987, pp. 58-62.

41
owned and operated grocery stores, substantially

all of which are corporations. The cooperative

was formed more than 40 years ago to use the

combined purchasing power of the stores to

obtain volume discounts similar to those of chain

stores and avoid duplication of effort in certain

business activities.

Member stores provided equity capital

through retained patronage refunds. The

cooperative paid 25 percent of patronage refunds

in cash and issued 75 percent as qualified written

notices of allocation. As the member stores grew,

most began reaching the 46-percent maximum

corporate income tax rate. As a result, they were

experiencing substantial cash drains from tax on

qualified patronage refund distributions.

To alleviate this problem, in 1981 the

cooperative began issuing part of patronage

refunds in nonqualified form. The members still

received 25 percent in cash, but the remainder

was issued as nonqualified written notices of

allocation. Thus, the members were relieved

from paying tax on all but the cash portion of

refunds. The cooperative assumed the tax

responsibility for the noncash portion, but this

allowed it to effectively utilize tax credits, much

of which was lost previously.

This policy was used for 5 years. During

that period, members amassed a substantial

amount of equity in the cooperative. The

cooperative paid tax on nonqualified notices at

the 46-percent rate. Income tax, which the

cooperative expected to have refunded when it

redeemed the nonqualified notices, was recorded

on the balance sheet in an asset account called

deferred income tax benefits.

When the Tax Reform Act of 1986 reduced

the top corporate income tax rate from 46 percent

to 34 percent, the cooperative at first thought it

faced a significant write-down of a large asset

account. However, after reviewing the tax rules

for redemption of nonqualified notices, it

discovered it still was entitled to a tax benefit

equal to the tax paid on the notices in the years

they were issued.

Review of the tax rules also clarified the fact

that members would be taxed at their current

rates when they received cash redemption of the

nonqualified notices. The cooperative

recognized that if it redeemed the nonqualified

notices, members could benefit from the newly

reduced tax rates. Investigation into the income

situation of its members revealed many members

had effective tax rates considerably lower than

the maximum and some members had losses.

After careful consideration, the cooperative

decided to redeem the nonqualified notices,

financing this action with a line of credit and the

tax refund. Its principal purpose was to allow its

members to benefit from the reduction in tax

rates in case tax rates might be increased again in

the future. It also wanted to provide members

cash flow for expansion, reduce its large deferred

tax benefit asset, and substantially lower the

amount of equity held by members.

Because of the elimination of investment

credit and reduction of the tax rates faced by

members, the cooperative no longer viewed

nonqualified notices as attractive as in the past.

It also was concerned that members might lose

from deferring tax liability on patronage refunds

if tax rates were increased in the future.

Therefore, the members agreed to accept

patronage refunds 25 percent in cash and 75

percent in qualified written notices of allocation

until the line of credit was retired in 2 years. At

that point, the cooperative planned on increasing

cash patronage refunds to 40 percent to ensure

members a positive cash flow.

Although the cooperative in this example

acted to avoid loss of the patron tax benefit from

any future increase in tax rates, such an increase

would bring about new opportunities for tax

savings by cooperatives currently issuing

nonqualified notices. Because of the rules for

computing the tax deduction for redemption of

nonqualified notices, an increase in corporate tax

rates, for example, would allow cooperatives

having issued nonqualified notices under the

current low rates to deduct redemptions at the

higher rates.

Individual Choice of Allocation Method

As an alternative to planning for its patrons’

taxes, a cooperative might consider allowing

patrons each year to choose individually which

type of allocation they are to receive. Such a plan

42
takes into consideration the differences in income

and tax situations among patrons and allows

them to choose the allocation form that best suits

their needs. This plan could substantially

complicate financial planning if patron

preferences change considerably from year to

year because cooperative cash flow would

depend on the relative amounts of cash patronage

refunds and income tax paid. The marginal tax

rate faced by the cooperative could vary from

year to year depending on the amount of

nonqualified notices chosen by patrons but could

be low if enough patrons accepted patronage

refunds as qualified.

One fruit processing cooperative has had

such a plan for several years. Each year members

individually specify which type of allocation they

are to receive. Although the cooperative places

no restrictions on the members’ choices and does

not know what type of allocations it is to make

until after members have made their choices, the

plan has operated smoothly and the mix of

allocations issued by the cooperative has

remained fairly constant through the years.

Although the cooperative has members with a

variety of sizes and incomes, there does not appear

to be a strong relationship between these factors

and the type of allocation chosen by members. A

more important factor seems to be a member’s

plans for retirement. Members often begin

choosing to receive allocations in nonqualified

form within a few years of retirement.

Patron tax savings could be an important

incentive for a cooperative to adopt such a plan.

To do so, however, the cooperative must have

flexibility to accommodate patron choices. In

addition, it should set the level of cash patronage

refunds for qualified distributions so the choices

offered patrons are roughly equivalent in terms of

their cash flow impact on the cooperative.

Limits to Tax Management Flexibility

Financial needs, the limited occurrence of

specific tax situations, and the requirements of a

cooperative’s equity capitalization and retirement

program can restrict the tax management

flexibility from issuing and redeeming

nonqualified written notices of allocation. Equity

retirement depends on the financial plans and

operating results of the cooperative. Tax

considerations may influence equity retirement

decisions but probably will play a secondary role

to other financial factors.

Patrons will understand the cooperative’s

equity program better if it is operated in a

systematic and consistent manner. They also will

place a greater value on their equities and

membership in the cooperative if they have

accurate expectations of when the cooperative

will redeem their equities. A cooperative policy

designed to minimize income tax can disrupt the

smooth operation of an equity program. Sudden

changes made to meet special circumstances can

create costs in terms of patron understanding and

good will. Redeeming one type of equity

allocation in preference over the other for tax

purposes also can benefit one group of patrons

over others, causing discord and problems of

fairness. Thus, concerns about maintaining

equitable treatment of patrons may impose limits

on tax management practices.

If a cooperative is in a difficult financial

situation, disruption of the existing financing

system and implementation of a temporary

system may be an acceptable means of obtaining

tax benefits. The board of directors should

consider all alternatives in situations that threaten

the existence of the cooperative. In these cases,

nonqualified notices may provide some options

qualified distributions do not.

Equity Retirement Plans

The equity retirement plan a cooperative uses

can limit its tax management flexibility and

complicate its tax calculations for years it redeems

nonqualified written notices of allocation. When

nonqualified notices are redeemed, the

cooperative’s tax is based on a comparison of the

benefits from deducting the notices from the

current year’s income and those from recomputing

prior years’ taxes as if the notices originally had

been distributed in qualified form. Under some

equity retirement plans, the cooperative frequently

will redeem equities issued in more than one year.

Thus, recomputation of prior years’ taxes can be

complex.

43
Tax management flexibility may be limited

because the cooperative cannot recompute prior

years’ taxes based on a single tax rate. If prior

years’ taxes were based on a single rate, the rate

might be expected to be higher than the current

year’s rate from time to time. Thus,

recomputation of prior years’ taxes occasionally

would result in a greater tax savings than

deducting the redeemed nonqualified notices

from current taxable income. However, if prior

years’ taxes are based on a variety of rates, some

high and some low, the benefit resulting from

this blend may more frequently be less than that

from deducting the redeemed notices from

current income. Thus, the cooperative may lose

some of the benefit of basing its tax on

recomputation of prior years’ taxes.

Under the revolving fund plan, which is the

most common systematic equity retirement plan,

equities are redeemed in the order in which they

are issued. Usually in a given year, only notices

issued in one or two previous years are redeemed.

Thus, the prior years’ tax recomputation is

relatively simple, and the cooperative often can

base its tax management decisions on knowledge

of a single prior year’s tax rate.

Other equity retirement plans frequently

redeem allocations issued over a number of

years. For example, cooperatives that settle

estates could redeem many years’ allocations in a

year, depending on the number of deaths and the

number of years the deceased members were

active patrons. Obviously, recomputation of

prior years’ taxes would be complex and the

cooperative would not have an opportunity for

an active tax management policy under this type

of program. Base capital and percentage-of-allequities plans also could involve redemptions of

allocations made over several years.

If a cooperative’s tax rate is constant from

year to year, the two alternative methods of

determining the tax benefit would yield similar

results. Thus, the loss in tax management

flexibility would not be important.

State Taxes

States with income taxes generally follow

the basic provisions of Federal tax rules with

respect to issuing and redeeming qualified

written notices of allocation. However, not all

States have included provisions for treating

nonqualified notices. Thus, cooperatives must

review how nonqualified notices are treated in

their individual States. If a cooperative’s State

does not have provisions for nonqualified

notices, the cooperative may not be able to take a

tax deduction for redemption of nonqualified

notices in computing its State income tax.

Summary

Whether an individual cooperative and its

patrons can benefit from issuing nonquaiified

notices depends on the unique environment

faced by the cooperative and on situations that

change from year to year. Generally, if a

cooperative’s income tax rate is lower than its

patrons’ rates, it can reduce the tax paid on a

patronage refund distribution by issuing

nonqualified notices and paying the tax.

Conversely, if patrons’ tax rates are lower, the

combined taxes of the cooperative and patrons

will be lowest if the cooperative distributes

patronage refunds in qualified form.

Under the current tax law, there may not be

much difference between cooperative and patron

income tax rates. Most patrons are subject to

combined Federal income and self-employment

taxes on qualified patronage refund distributions

and redemptions of nonqualified notices at

effective rates from 28 to 41 percent, compared

with the 34-percent rate cooperatives would pay

on most nonqualified notices. Whether a

cooperative or its patrons will have the lowest

effective tax rate will depend on specific

circumstances. In general, current tax rates do

not favor one allocation method over the other.

Nevertheless, cooperatives may find they can use

nonqualified notices effectively in responding to

various income and tax situations, including

extraordinary occurrences such as losses or

changes in the tax law.

Cooperatives have flexibility in issuing and

redeeming nonqualified notices. A cooperative

can include authorization for issuing both

qualified and nonqualified notices in its bylaws.

Then it can make the choice whether or not to

44
issue nonqualified notices on a yearly basis

according to the situation it faces each year. If

conditions are such that patrons have high tax

rates relative to the cooperative, it may choose to

issue nonqualified notices that year. A

cooperative also can choose to issue both

qualified and nonqualified notices in the same

year.

A cooperative likewise may time the

redemption of nonqualified notices according to

income and tax considerations. The rules for

computing the tax deduction for redemption of

nonqualified notices can contribute to this

flexibility. Generally, redemption of prior.years’

nonqualified notices is most valuable to a

cooperative in years when its tax rate is high

because the current tax rate can be used to

determine the deduction.

As an alternative to planning for its patrons’

taxes, a cooperative might consider allowing

patrons each year to choose individually which

type of allocation they are to receive. Such a plan

takes into consideration the differences in income

and tax situations among patrons and allows

patrons to choose the allocation form that best

suits their needs. This plan could substantially

complicate financial planning if patron

preferences change considerably from year to

year.

Financial needs, the limited occurrence of

specific tax situations, and the requirements of a

cooperative’s equity capitalization and retirement

program can restrict the tax management

flexibility from issuing and redeeming

nonqualified written notices of allocation. A

cooperative policy designed to minimize income

tax can disrupt the smooth operation of an equity

program. Sudden changes made to meet special

circumstances can create costs in terms of patron

understanding and good will. However, if a

cooperative is in a difficult financial situation,

disruption of the existing financing system and

implementation of a temporary system may be an

acceptable means of obtaining tax benefits.

V. SPECIAL PROBLEMS ASSOCIATED WITH

NONQUALIFIED NOTICES

Cooperatives that issue nonqualified notices

may face some unique problems because of the

notices’ tax treatment. This chapter discusses

some of these problems. First, it discusses

accounting for nonqualified notices in financial

statements and distributing income in a federated

system using nonqualified notices. Next, it

explores some issues of equitable treatment of

patrons that may arise among cooperatives using

nonqualified notices. Then it discusses how the

financial relationships between cooperatives and

their patrons may change due to a switch to

nonqualified notices. Finally, it explores some of

the factors that may limit use of nonqualified

notices.

Accounting for Nonqualified Notlces In Financial

Statements

Cooperatives use a number of financing

methods, and the net worth sections of

cooperative balance sheets contain various classes

of stock, other types of allocated equity, and

unallocated equity. The use of nonqualified

written notices of allocation adds another element

to cooperative financial statements and may make

it more difficult for patrons to understand how

their cooperative is financed. Patron

understanding and acceptance is essential to the

success of any financing method.

Classification of Equity Types

The information about nonqualified notices

contained in financial statements varies and

probably is still evolving. Cooperatives that issue

both qualified and nonqualified notices usually

use different terms for them. In some cases, the

terms “qualified” and “nonqualified” are used, as

in “qualified” and “nonqualified capital credits.”

Other cooperatives use different terms for each

but do not use the adjectives “qualified” and

“nonqualified.”

More than a casual glance at a cooperative’s

equity accounts is needed to determine if

45
nonqualified notices are present. The financial

statements reviewed in this study did not always

identify nonqualified notices, especially in years

in which nonqualified notices were neither

issued nor redeemed. In one case, a cooperative

included nonqualified notices in “retained

earnings” with funds from other sources. Notes

to the financial statements explained

nonqualified notices, but the allocations were not

identified separately.

The term “nonqualified” is used in some

financial reports to refer generally to

distributions of net margins that do not qualify

for deduction from the cooperative’s taxable

income under subchapter T of the Internal

Revenue Code. An example is the distribution of

nonpatronage income to members by a

cooperative that does not hold section 521 tax

status. Such distributions “do not qualify” for

deduction from the cooperative’s taxable income,

but they do not meet the restrictive use of the

term “nonqualified” used in the Internal Revenue

Code and in this report to mean “nonqualified

written notices of allocation.” The loose use of

the word “nonqualified” to indicate something

other than nonqualified written notices of

allocation can be confusing.

Equify Accounts of Issuing Cooperative

The income reporting and tax recapture

characteristics of nonqualified notices necessitate

unique accounting methods for both cooperatives

issuing nonqualified notices and recipients.

Cooperatives issuing nonqualified notices

account for the tax recapture feature in different

ways. The following examples are based on

annual reports of cooperatives that have issued

nonqualified notices. They assume a cooperative

with $100,000 in net margins.

Method 2: Net margins before tax are

allocated to patrons as nonqualified written

notices. This amount appears in the net worth

section of the balance sheet. Income tax paid on

the notices is listed as a noncurrent asset because

the cooperative expects the tax to be refunded

when the notices are redeemed.

Balance Sheet 1

Cash

Future tax benefit

AS!Xk

$77,750

22,250

Total Assets $100,000

Liabilities and Net Worth

Nonqualified equity allocations $100,000

Total Liabilities and Net Worth $100,000

In an informal survey of accountants serving

cooperatives who had issued or had considered

issuing nonqualified notices, the consensus was

that this method should be used.22 It shows

explicitly the amount of nonqualified notices and

the tax benefit that will occur when the notices are

redeemed. However, some analysts consider this

method to overstate the value of assets and net

worth. They think the tax refund from redemption

of nonqualified notices should be discounted to

reflect the restrictions on its realization?

22 John J. Blair, “Issuance and Redemption of

Nonqualified Written Notices of Allocation,” paper

presented at tax seminar, 44th annual meeting of the

National Society of Accountants for Cooperatives,

Norfolk, Va., Aug. 13,1979.

23 New accounting standards could prohibit

cooperatives from using this method. Statement of

Financial Accounting Standards No. 96, “Accounting for

Income Taxes,” which is effective for fiscal years

beginning after December 15,1988, stipulates that tax

benefits arising from an event are not included in

financial statements until the event itself is recognized.

See Financial Standards Accounting Board, Original

Pronouncements: July 2973-June I,2988 (Homewood, Ill.:

Irwin, 1988), pp. 1089-1159. A strong argument exists

for allowing cooperatives to continue recognizing the

tax benefit from redemption of nonqualified written

notices as an asset according to “1988 Subcommittee

Report on Effective Use and Problems of Nonqualified

Patronage Dividends and/or Per-Unit Retains,” Reports

of Subcommittees of the Legal, Tax, and Accounting

Committee (Washington, D.C.: National Council of

Farmer Cooperatives), p. 23. The audit and accounting

guide for agricultural producers and cooperatives

issued Oct. 9,1987, by the American Institute of

Certified Public Accountants also contains provisions

for deferred income tax accounting.

46
Method 2: Net margins before tax are

allocated as nonqualified written notices.

However, the future tax benefit from redeeming

the notices is not listed as an asset. Nonqualified

notices are listed at face value, but tax paid on

them is subtracted from them in listing total net

worth. Thus, this method is more conservative

than the first because assets and net worth are

reduced by the amount of tax paid.

Balance Sheet 2

Cash

Total Assets

ASS&S

$77,750

$77,750

Liabilities and Net Worth

Nonqualified equity allocations

Less: Tax paid

Total Liabilities and Net Worth

$100,000

(22,250)

$77,750

Method 3: Net margins after tax are

allocated as nonqualified written notices. This is

the simplest method of accounting for

nonqualified notices, and it has some intuitive

appeal because tax is paid on net margins and the

residual is allocated to patrons. This method

does not take tax recapture into consideration.

Assets and net worth are valued at the same

amount as under the second method.

Balance Sheet 3

Cash

Total Assets

AS.%%

$77,750

$77.750

Liabilities and Net Worth

Nonqualified equity allocations $77,750

Total Liabilities and Net Worth $77,750

The biggest drawback of this method is that

not all of available net margins are allocated to

patrons. Thus, when the nonqualified notices are

redeemed, only the taxes applicable to them can

be recaptured. In this example, tax recapture is

$14,685, which is $7,565 less than in the other two

examples. This $7,565 represents an important

cost to the cooperative from using this method.

Income Reporting by Recipients

The required method of reporting income for

Federal income tax returns will not necessarily be

the same as prescribed by standard accounting

practices. Federal income tax rules and standard

accounting practices have different purposes and

have different methods of reporting for some

transactions. Federal tax rules specify the

deductions allowable from income and by their

nature do not allow flexibility. Under the tax

return reporting method, patrons receiving

nonqualified notices do not recognize them as

income until they are redeemed in cash. Under

this method, a nonqualified notice is not recorded

as an asset on the patron’s balance sheet.

An alternative accounting view includes

nonqualified notices as income. This income is

included with income from all other sources, and

the notices are included on the balance sheet with

other investments. Under this method, income

reported on Federal tax returns is lower than

income reported on the cooperative’s financial

statements because the tax return income does

not include the nonqualified notices received.

Examples can be found of cooperatives using

each of these accounting methods for their

financial statements.

The purpose of the accounting statements of

cooperatives and their patrons is to provide

useful information to management, membership,

and financial institutions. To effectively provide

information, statements should be prepared

consistently from year to year. Within the range

of acceptable accounting practices, business

organizations have some discretion in the

practices they follow. The expected time of

redemption of nonqualified notices could

influence a cooperative in its choice of a reporting

method. If the cooperative expects to redeem

nonqualified notices within a short time period, it

may choose to recognize the expected tax benefit

from the redemption. If it does not expect to

redeem the notices within a short time, it may

decide to report income and equity on a net basis.

The size of nonqualified allocations also may

47
influence the amount of information that users of

the financial statements need.

Financial statements are accompanied by

notes that explain the accounting practices used

and provide other information. Because of the

characteristics and limited use of nonqualified

notices, these notes can be an important device in

explaining nonqualified notices.

Use of Nonqualified Notices

in Federated Systems

Some cooperatives, particularly farm supply

and grain cooperatives, are organized into

multilevel federated structures. Large federated

cooperatives generally have many member

cooperatives. Their members can cover several

States and include cooperatives with

memberships in other federated cooperatives.

Most federated cooperatives distribute

patronage refunds in the form of cash and

qualified written notices of allocation. Member

cooperatives that receive qualified patronage

refund distributions from their federated

cooperative take them into their incomes and, in

turn, can reallocate them as patronage refunds to

their producer patrons.

Cooperatives usually pay patronage refunds

according to a bylaw agreement that requires the

organization to distribute its net margins on a

patronage basis. These agreements are central to

the cooperative method of operation. The bylaws

usually allow the board of directors the power to

determine annual patronage refund distributions

according to the cooperative’s operating results.

Cooperatives usually follow accounting

practices that keep their financial statement

income and tax return income before patronage

refund deductions close together. Most

cooperatives base patronage refunds on the

amount available for distribution from their tax

return. Some bylaws specifically state that

patronage refunds will be determined according

to the same accounting procedures used in

preparing the Federal tax return.

The following schedule summarizes the

flow of income in a federated system when

qualified written notices of allocation are issued

by the federated cooperative.

Schedule 1:

Flow of Qualified Income

in a Federated System

Year 1: Earnings occur at federated

cooperative. Cooperative distributes earnings as

cash and qualified written notices of allocation

after close of its tax year.

Year 2: Member cooperative receives

qualified distribution and includes it in income.

After close of tax year, member cooperative

allocates cash and qualified notices to its

producer patrons based on local earnings and

qualified distribution received from federated

cooperative.

Year 3: Producer patrons receive qualified

distributions and include them in their taxable

income.

The final recipients, producer members, bear

the final income tax responsibility. The noncash

allocations of the federated cooperative are

included in its net worth, are held as an

investment in the federated cooperative by the

member cooperative and included in its net

worth, and are represented by equity certificates

in the member cooperative held by producer

members. In the complete system, there is a

pyramid effect as the federated cooperative’s

earnings are reported at each subsequent level.

Differences in associations’ accounting years

and the time between the end of the accounting

year and issuance of patronage refunds increase

the time between when earnings occur and when

patronage refunds are issued to the final

recipient. Cooperatives have 8 l/2 months after

the end of their accounting year to issue

patronage refunds. Therefore, qualified notices

from one year’s earnings probably will be

included in the cooperative’s members’ income

for the following year. The federated system has

been criticized for this time lag, especially when

several levels of federation exist. However, this

delay is generally accepted as reasonable, a

position that has been supported by court

decisions.

48
A transfer of earnings through a federated

system to producer patrons generally cannot be

made as easily using nonqualified written notices

of allocation. A cooperative that receives

nonqualified written notices of allocation from

another cooperative faces both theoretical and

practical questions concerning how the notices

should be reported and handled. The recipient

cooperative must decide how and when to

acknowledge the nonqualified notices as income

and how to account for these notices in a manner

that provides information understandable by its

members and others. A cooperative receiving

nonqualified notices also must decide how to

transfer this income to its members in a manner

that is acceptable to them and that satisfies its

patronage agreements and the Federal income tax

rules that determine whether single-tax treatment

of the patronage distributions is allowed.

The following schedule summarizes the flow

of income in a federated system when

nonqualified written notices of allocation are

issued according to the federated cooperative’s

tax return.

Schedule 2:

Flow of Nonqualified Income

in a Federated System

(Tax Return Method)

Year 2: Earnings occur at federated

cooperative. Cooperative issues nonqualified

written notices of allocation after close of its tax

year.

Year 2: Member cooperative receives

nonqualified notice but does not include it in

income.

Year Federated Cooperative Redeems Notices:

Member cooperative receives cash redemption of

notice and includes it in current year’s income.

After close of year, member cooperative

distributes income to producer patrons based on

current patronage.

Under this method, accounting practices

follow the tax treatment of the notices. Member

cooperatives do not include nonqualified notices

in their income or in distributions to producer

members when they receive the notices. Instead,

this is done when the notices are later redeemed

by the federated cooperative. Tax responsibility

for the nonqualified notices is met by the

federated cooperative until the notices are

redeemed.

Because nonqualified notices are not taken

into income for tax purposes by the recipient

until they are redeemed, a notice received by a

member cooperative from a federated cooperative

cannot simply be reissued as another patronage

refund. The receipt of nonqualified notices does

not produce tax return income from which

patronage refunds can be issued. The net

margins of the federated cooperative distributed

as nonqualified notices are shown only in the

financial statements of the federated cooperative.

Thus, repeated accounting for the net margins of

the federated cooperative does not occur.

Treating nonqualified notices in the same

manner on tax returns and the financial

statements provided to members makes the

allocation process straightforward and easy to

understand. However, there can be difficulties

with this practice. Because patronage refunds are

based on current patronage, income received

from the redemption of nonqualified notices and

distributed as patronage refunds will not

necessarily be distributed to the patrons who

were responsible for the patronage upon which

the original income was based. This can create an

inequitable situation, particularly when

considerable time has elapsed between issuing

and redeeming the nonqualified notices. In

addition, strict interpretation of the definition of

patronage refunds, which are based on net

earnings done with or for patrons, may imply

that these distributions do not qualify for singletax treatment under the Internal Revenue Code.

Accountants following standard accounting

procedures also could question why nonqualified

notices are not included in the member

cooperatives’ income. It may seem inconsistent

from an accountant’s view to include qualified

notices but exclude nonqualified notices. Some

cooperative accountants maintain that patronage

refunds are not necessarily tied to the

conventions established by Federal tax rules.

49
As an alternative approach, a member

cooperative could take nonqualified notices into

income reported on its financial statements when

they are received. Under this method, nonqualified notices would be included as investments on the member cooperative’s balance sheet

and as income in determining its net margins.

Federal income tax still would be based on net

margins determined according to tax rules.

The following schedule summarizes the

flow of income in a federated system when the

member cooperative includes the receipt of

nonqualified written notices of allocation in the

income it reports on its financial statements. Two

alternatives are examined. Under the first, the

member cooperative allocates the income from

nonqualified notices to patrons according to their

patronage during the year the federated

cooperative redeems the notices. Under the

second alternative, the member cooperative

allocates this income to the patrons upon whose

patronage the original income was based.

Schedule 3:

Flow of Nonqualified Income

in a Federated System

(Financial Statement Method)

Year 2: Earnings occur at federated

cooperative. Cooperative issues nonqualified

written notices of allocation after close of its tax

year.

Year 2: Member cooperative receives

nonqualified notice and excludes it from income

on tax return but includes it in income on

financial statement.

Alternative A: Member cooperative does

not allocate income from nonqualified

notice from federated cooperative but

includes income on financial statement as

retained earnings.

Alternative B: Member cooperative

allocates book credits to producer patrons

for income from nonqualified notice from

federated cooperative based on current

year’s patronage.

Year Federated Cooperative Redeems Notices:

Redemption of notices is included in member

cooperative’s tax return income.

Alternative A: Retained earnings account

is reduced as funds from redemption are

allocated to producer patrons according

to current year’s patronage.

Alternative B: Funds from redemption are

allocated to producer patrons according

to patronage in year 2.

Under alternative A, the member

cooperative includes the nonqualified notice

received from the federated cooperative in the

income it reports on its financial statements.

Otherwise, there are no differences between this

alternative and the tax return method

summarized in schedule 2. The member

cooperative does not allocate income to its

patrons until the federated cooperative redeems

the notice. Then the allocations are made to

producer patrons according to current year’s

patronage, as under the tax return method.

Alternative B differs in that the member

cooperative assigns the nonqualified notice it

receives to its producer patrons on its records.

This allocation process matches the federated

cooperative’s allocation to the patronage of

producer patrons in the member cooperative in a

manner similar to what would have occurred if

qualified notices had been issued. Because the

member cooperative allocates its federa ted

earnings to producer patrons in proportion to

patronage in the year it receives the nonqualified

notice, this allocation process appears to follow

the traditional intent of cooperative practices and

is consistent with income tracing for federated

cooperatives suggested by the Internal Revenue

Service (IRS) under some circumstances.

However, it also may not fit the precise wording

of patronage refunds included in the tax code

because it does not assign earnings reported on

the tax return to current patrons.

The size of the nonqualified notice and the

expected equity redemption practices of the

federated cooperative issuing nonqualified

notices may influence member cooperatives’

50
decisions. If the patronage refund from the

federated cooperative is large relative to a

member cooperative’s net margins from its own

operations, how the nonqualified notice is

handled has an important effect on the member

cooperative’s reported net margins. For many

grain and farm supply cooperatives, patronage

refunds from their federated cooperatives can be

as large as the net margins earned locally.

Member cooperatives have individual

financing plans that may not work well with

nonqualified notices issued by the federated

cooperative. If close ties exist between the

federated cooperative and its members, the

federated financing plan can be coordinated with

that of members. However, because of the

number of organizations and variety of financing

systems involved, the federated cooperative may

be limited in how programs can be coordinated.

Some member cooperatives receive a major

portion of their net margins from patronage

refunds distributed by the federated cooperative.

A shift to nonqualified notices by the federated

cooperative could require major adjustments in

member operations and expectations. Because

issuing and redeeming nonqualified notices can be

complicated within a federated system and most

member cooperatives may not have experience

with them, the member cooperatives may resist the

introduction of a major change in the federated

cooperative’s practices. Thus, from a member

relations perspective, federated cooperatives could

find it easier to use a financing plan that matches

the plans of their members.

Base Capital Plans

A base capital plan may provide member

cooperatives a method for matching nonqualified

patronage refund distributions from a federated

cooperative to the patronage attributable to their

producer patrons in the year the refunds were

earned. This use of a base capital plan is based on

the long-term stable relationships federated

cooperatives usually share with their member

cooperatives. Because of these relationships, a

federated cooperative may be able to use a base

capital plan to make most adjustments to the

equity accounts of its member cooperatives by

varying cash patronage refunds and without

redeeming equities. By not redeeming the

nonqualified notices allocated to member

cooperatives, the federated cooperative can benefit

from using nonqualified notices while sparing

member cooperatives the difficulties of allocating

income from the notices to their patrons.

Generally, a member cooperative’s patronage

and share of the responsibility for financing a

federated cooperative do not change greatly from

year to year. In addition, federated cooperatives

do not need to redeem the equities of retired

patrons and estates as do cooperatives that

directly serve producers. However, to ensure

each member is financing its fair share, a

federated cooperative needs some method for

adjusting the equity accounts of its member

cooperatives. Equity adjustments also are needed

for when member cooperatives go out of business

or merge. The generally stable relationships

between a federated cooperative and its members

make the base capital plan a good choice for an

equity redemption plan.

Under a base capital plan, each member’s

equity requirement is readjusted annually

according to the cooperative’s capital needs and

the proportion of the cooperative’s total

patronage attributable to the member during a

moving base period, usually the last 3 to 10 years.

Underinvested members, or members whose

capital investments are less than their equity

requirements, continue to provide direct

investments, retained patronage refunds, or perunit capital retains. Overinvested members may

begin to receive at least partial redemption of

excess investments. For these members,

additional investment either is no longer required

or is reduced.24

Total equity redeemed in a base capital plan

may be substantially less than in other financing

plans because the base capital plan is based on

adjustments to individual members’ equity

accounts instead of redemption of equity

24 For a detailed description of the base capital

plan, as well as other equity retirement plans, see David

W. Cobia et al., Equity Redemption: Issues and

Alternatives for Farmer Cooperatives (Washington, D.C.:

USDA ACS Res. Rep. 23, Oct. 1982), pp. 16-41.

51
allocations. In other plans, equity is redeemed

regardless of the investment status of individual

members. In a base capital plan, equity allocated

to a member generally is not redeemed if the

member does not meet its equity requirement.

As a result, lower levels of equity redemption

generally occur and adjustments among

members can be made largely by varying

individual levels of cash patronage refunds.

If a federated cooperative issues

nonqualified written notices and operates a base

capital plan, nonqualified notices can be used to

build up an underinvested member cooperative’s

equity investment. No cash would flow from the

federated cooperative through the underinvested

member to its patrons.

The federated cooperative would have two

choices for paying cash benefits to member

cooperatives that meet their equity requirements.

It could redeem nonqualified notices held by

them, or it could pay current patronage refunds

in cash. Because both redemptions of

nonqualified notices and cash payments of

patronage refunds are deducted from the

federa ted cooperative’s taxable income, these

options generally would be identical with respect

to the tax and cash flow burdens on the

cooperative.

Both options also would result in the same

cash flow to member cooperatives. In both cases,

the income would be taken into member

cooperatives’ current taxable incomes. The

difference is that income passed to member

cooperatives as cash patronage refunds is based

on current business whereas income from the

redemption of nonqualified notices is based on

business conducted earlier. Because cash

patronage refunds are based on current business,

this method would avoid the difficulties of

allocating income from earlier business to current

producers.

By paying cash patronage refunds, the

federated cooperative would not receive the tax

benefits from redemption of nonqualified notices.

As a consequence, there would be a buildup of

unused tax benefits as the amount of

nonqualified allocations grows. However, the tax

burden on the federated cooperative and its

members would not necessarily be greater than

from making qualified patronage refund

distributions. The federated cooperative can

issue nonqualified notices to its members and

pay the tax on the equity it retains or make

qualified distributions and pass cash through to

its members that they can use to pay the tax.

Because both the federated cooperative and its

members are taxed at the corporate rate, the cash

drain due to tax would be about the same

regardless of which cooperative pays the tax.25

Other Methods

A member cooperative could explore other

methods of matching nonqualified patronage

refund distributions from a federated cooperative

to its producer patrons. Nonqualified per-unit

retain certificates might be used to make such an

assignment. If the member cooperative could

construct an agreement for retaining an amount

equal to the nonqualified notice it receives from

the federated cooperative, the income from the

nonqualified notice could be used to meet the

retain requirements of individual producers and

the allocations could be passed through the

member cooperative to the producers. However,

it would be important for the cooperative to

conduct a careful review of the relevant tax rules

and accompanying risks before attempting to

implement any unusual allocation method such

as this.

Equitable Treatment of Members

Ideally, the burden of financing a

cooperative should be borne equitably among

members so the equity each member provides is

proportionate to that member’s use of the

25 See Cobia et al., Equity Redemption, pp. 199-200,

for an example of a federated cooperative with a base

capital plan that generally does not redeem equity but

pays varying levels of cash patronage refunds according

to the proportion of the equity base each member

cooperative has met. Although this plan uses qualified

notices, it demonstrates how a base capital plan can

operate without redeeming equity.

52
cooperative. Cooperative equity progrdms

generally are designed with this in mind, but in

practice this goal is difficult to achieve, partly

because cooperative net margins and investment

outlays vary from year to year. Nonetheless,

operating on a cooperative basis implies that, at a

minimum, members should be treated in an equal

manner with respect to allocation and redemption

of patronage refunds and per-unit capital retains.

Maintaining equitable financing becomes

more difficult as cooperatives adopt more

complex financing plans and members become

more diverse in character. This difficulty is

compounded if a cooperative uses two methods

for allocating and redeeming equity. Although

either qualified or nonqualified notices can

provide the basis for an equitable financing

system, use of both allocation methods can

introduce inequities if there are inconsistencies in

how individual members or allocations are

treated.

Inconsistencies in treatment can occur if the

proportion of allocations held in nonqualified

form varies among members and qualified and

nonqualified notices are redeemed according to

different schedules. Members will hold varying

proportions of their allocations as nonqualified

notices if the cooperative allows them to

individually select the type of allocation they

receive. Because individual members generally

are not responsible for the same share of the

cooperative’s business from year to year, this

situation also may occur if the cooperative varies

the type of allocations it issues based on its

current income and tax situation.

When members hold varying proportions of

nonqualified notices, the cooperative can avoid

inequities by redeeming qualified and

nonqualified notices according to the same

schedule. It is particularly important that this be

done if members are allowed to choose

individually the form of their allocations, unless

an understanding to the contrary exists before

they make their choices. When the cooperative

redeems both types of allocations according to the

same schedule, it forgoes the ability to time the

redemption of nonqualified notices to maximize

tax savings. There also is no guarantee that the

fairness of the plan will not change because of

delays or suspensions in the redemption schedule

brought about by financial reverses or changes in

condition.

If a cooperative issues the same proportion

of nonqualified notices year after year, all

members will have similar holdings of qualified

and nonqualified notices. The cooperative loses

flexibility in adjusting the proportion to meet its

current situation. However, it is able to choose

whether to redeem qualified or nonqualified

notices according to current conditions without

creating serious equity problems.

An examination of cooperatives that have

issued nonqualified notices generally did not

reveal instances in which there were differences

between the type of allocations received by

different member groups. Only when members

were allowed to choose the type of allocation they

received were there differences. The review did

indicate that in cooperatives having issued both

qualified and nonqualified notices, nonqualified

notices frequently were treated differently in the

cooperatives’ financing plans.

Although there were examples in which

qualified and nonqualified notices played similar

roles, qualified notices were more likely than

nonqualified notices to be revolved by

cooperatives operating revolving fund plans. In

some examples, nonqualified notices were

assigned to nonrevolving reserve funds. In these

cases, both cooperatives and members may have

had different expectations about the revolvement

of nonqualified notices because of the different

tax treatment these allocations receive.

Two cooperatives had issued nonqualified

notices because of special situations and

established a revolving period for nonqualified

notices shorter than that for qualified notices.

Use of nonqualified notices was considered

temporary and not expected to become an

ongoing part of the cooperatives’ financing plans.

Several cooperatives that issued

nonqualified notices operated base capital plans.

In some cases, nonqualified notices were included

in members’ equity bases. However, there were

other cases in which these allocations were not

included. Such treatment would detract from the

53
purpose of the base capital plan if the role of

nonqualified notices were to grow.

Cooperatives may be able to use

nonqualified notices to improve the fairness of

their financing plans in some situations. For

instance, in the past when a cooperative earned

investment tax credit from an unusually large

investment in property with a long useful life,

use of nonqualified notices to absorb the credit

may have been a more equitable alternative than

allocating it to current members. By using the

credit, the cooperative might have been able to

reduce borrowing necessary for the investment.

Reduced future borrowing costs would have

more directly benefited those members burdened

with financing the investment.

Distributing patronage refunds as

nonqualified written notices could help eliminate

an equity problem common to many cooperatives

making qualified distributions of patronage

refunds. In these cooperatives, there often are

conflicts between active members who prefer to

have the cooperative pay a high percentage of

patronage refunds in cash and former members

who prefer rapid revolvement of equity. These

conflicts may be difficult to reconcile because there

may ba frequent shifts in consensus as active

members retire and individual preferences change.

Exclusive use of nonqualified notices to

distribute patronage refunds could eliminate the

need for a cooperative to pay cash patronage

refunds and allow its management to focus on

effectively achieving a single equity objective all

members could support throughout their

careers-timely revolvement of equities.

Although this strategy might not remove all

pressures for high cash patronage refunds, it

could reduce them by eliminating the need of

patrons for cash to meet their tax liabilities.

Potential for Changing Financing Relationships

Nonqualified notices have potential for

altering the financial relationships between

cooperatives and their patrons. The relationship

between a cooperative and its patrons can range

from close and almost interdependent to distant

and more like that between a supplier and

customer. Because the overall relationship

between a cooperative and its patrons depends

on many factors, including financing methods,

marketing contracts, member relations programs,

and personal contacts between patrons and

employees, the use of nonqualified notices will

not by itself define the nature of this relationship.

However, use of nonqualified notices may

change patron involvement in providing the

cooperative equity capital, thereby contributing

to change in the overall relationship.

If a cooperative is financed through

operations with noncash patronage refund

allocations, patrons have an important role in

providing equity capital. However, when

patronage refunds are distributed in qualified

form, patrons play a more active role than when

nonqualified notices are used. By agreeing to

accept qualified notices in their taxable incomes,

patrons finance their cooperative in a manner

similar to direct equity investment. They also

make an important contribution by paying the

tax, reducing their cooperative’s tax liability, and

allowing the cooperative to retain more equity.

When nonqualified notices are used, patrons

provide equity to the cooperative, but in a

passive manner. Patrons receive written notices

of allocation, but no action is required and the

cooperative pays the income tax. Management

and patrons may regard nonqualified notices less

like an investment by patrons and more like

retained earnings. In the cooperatives examined

in this study, nonqualified notices were less

likely than qualified allocations to be revolved or

be included in patron equity bases.

Factors Limiting Use

Although nonqualified notices were created

by the same Federal legislation as qualified

notices, relatively few cooperatives currently use

them and the proportion of patronage refunds

and per-unit capital retains issued in

nonqualified form is small. Two factors that limit

the use of nonqualified notices are a general lack

of experience with them and the delayed tax

consequences of their redemption.

54
Lack of Experience

Qualified notices have been used widely for

more than 25 years. Prior to 1962, when

enactment of subchapter T of the Internal

Revenue Code created the requirements for both

qualified and nonqualified notices, cooperatives

generally followed tax procedures similar to

current procedures for qualified notices except for

the cash distribution requirement. Since then,

cooperatives and their patrons have incorporated

the cash patronage refund and patron income

reporting requirements into their operating

routines. In addition, cooperative literature and

legal precedents have firmly established the

procedures for issuing and redeeming qualified

written notices of allocation and per-unit retain

certificates.

Cooperatives and their patrons have not had

as much experience with nonqualified notices,

and only limited literature and legal precedents

relating to them exist. This lack of experience

discourages their use because uncertainties about

their characteristics or the procedures for their

use make planning for them more difficult.

Federal tax forms and instructions for

reporting farm income recognize the existence of

nonqualified notices and discuss reporting

qualified notices as current income and excluding

nonqualified notices. However, if patrons do not

understand the differences between qualified and

nonqualified notices, they may incorrectly report

nonqualified notices as income, thereby losing tax

benefits, or later neglect to report the

redemptions as income.

Because members, managers, cooperative

lenders, and advisors are familiar with qualified

notices, organizers of new cooperatives probably

consider this allocation method first when

planning an equity capitalization program.

Accounting and legal advisors may not present

cooperative organizers with the alternative of

using nonqualified notices at all. Establishing a

new organization involves so many uncertainties

that those involved may resist exploring the

advantages and disadvantages of a financing

method with which they are unfamiliar.

Once a cooperative is established, changing

financing practices can cause disruptions and

issuing nonqualified notices would be a new

experience for most patrons. Thus, unless there

are compelling reasons for changing the present

system, existing procedures probably will

continue to be used.

Delayed Consequences of Redemption

Cooperatives may be discouraged from

issuing nonqualified notices because the final tax

consequences to the cooperative and its patrons

are not determined until the notices are redeemed

in cash, perhaps many years after they are issued,

Calculation of the tax benefit from redeeming

nonqualified notices depends in part on the

cooperative’s operating results and the applicable

tax rates in the year of the redemption, factors

that are far from certain when the notices are

issued. Similarly, tax paid by patrons on the

redemptions depends on their incomes and tax

rates, factors that also are indeterminate.

Between when a nonqualified notice is

issued and redeemed, the business environment

of a cooperative can change. Patronage and

membership change, and the cooperative may

reorganize or merge with other cooperatives.

Financing methods may have changed to

accommodate other factors without thought to

redeeming nonqualified notices. Thus,

redemption of nonqualified notices may occur

under circumstances unanticipated when the

notices were issued. For example, after the

merger of two cooperatives, one of which uses

nonqualified notices, the new organization may

adopt financing methods different from the two

original organizations. Priority may be given to

redeeming patronage refund allocations in a

manner equitable to members of both of the

original cooperatives without regard to

maximizing the benefits from redeeming

nonqualified notices.

Legislative changes also can affect the

benefits from redeeming nonqualified notices.

Tax legislation can affect the consequences of

redeeming nonqualified notices directly, but even

tax changes not directly aimed at cooperatives or

allocation methods can have important impacts

on the benefits from redeeming nonqualified

notices.

55
Changes included in the Tax Reform Act of

1986 are an example. Although the act did not

affect the redemption of nonqualified notices

directly, the elimination of investment tax credit

and reduction of corporate and individual tax

rates included in this act did affect the

consequences of redeeming nonqualified notices.

Under the Federal tax rates in effect before July 1,

1987, redemption of $1 of nonqualified paper

could produce a maximum benefit of 51 cents.

With new tax rates, the maximum benefit from

redeeming nonqualified notices was reduced to

39 cents. Although, at a minimum, a cooperative

can recover the tax it paid on an allocation,

uncertainties make aggressive tax planning

difficult.

Another example of an uncertainty that

affects the decision to issue nonqualified notices

occurred after passage of the Revenue Act of

1978. That act changed investment tax credit

rules for cooperatives, allowing many to use this

credit effectively for the first time. Cooperatives

with taxable income could use investment credit

they earned to pay Federal income tax. Some

cooperatives saw the existence of the credit as a

windfall that could be captured by issuing

nonqualified written notices of allocation. Much

of what was written about this strategy focused

on the cash flow situation of a cooperative and its

patrons in the year the notices were issued, and

little was said about the consequences of

redemption. This may have been because tax

advisors were unsure of these consequences or

had not thought about them.

Technically, cooperatives redeeming

nonqualified notices on which tax was paid using

investment credit could receive a cash refund on

their redemptions. Whether the IRS would,

without challenge, allow a cooperative a cash

refund for the reversal of a tax transaction for

which a credit, and no cash, was used to pay tax

was not known. Nor is it likely to be known

until the situation begins to arise with some

frequency, perhaps years from now. Meanwhile,

cooperatives considering the benefits of this

strategy did not have the benefit of regulations or

tax court rulings on which to base their decisions.

Legislative change affecting cooperative

equity allocations always is a possibility.

However, qualified and nonqualified notices

differ because redemption of qualified notices

produces no tax consequences to either the

cooperative or its patrons. Redemption of

nonqualified notices yields tax consequences to

both the cooperative and patrons, and any

legislative change occurring before the notices

are redeemed can affect these consequences. In

many cases, the period during which changes

that affect redemption of nonqualified notices

could occur may extend for many years.

Summary

Cooperatives that issue nonqualified notices

may face unique problems because of the notices’

tax treatment. The income reporting and tax

recapture characteristics of nonqualified notices

necessitate unique accounting methods for both

cooperatives issuing nonqualified notices and

recipients. Within the range of acceptable

accounting practices, business organizations have

some discretion in the practices they follow.

Considerations such as the expected time of

redemption and the size of nonqualified

allocations may influence a cooperative in its

choice of a reporting method and the information

presented in its financial statements.

A transfer of earnings through a federated

system to producer patrons generally cannot be

made as easily with nonqualified notices as with

qualified notices. A cooperative that receives

nonqualified written notices of allocation from

another cooperative faces both theoretical and

practical questions concerning how the notices

should be reported and handled. The recipient

cooperative must decide how and when to

acknowledge the nonqualified notices as income

and how to account for these notices in a manner

that provides information understandable by its

members and others. A cooperative receiving

nonqualified notices also must decide how to

transfer this income to its members in a manner

that is acceptable to them and that satisfies its

patronage agreements and Federal income tax

rules.

Member cooperatives have individual

56
financing plans that may not work well with

nonqualified notices issued by the federated

cooperative. If close ties exist between the

federated cooperative and its members, the

federated financing plan can be coordinated with

that of members. However, because of the

number of organizations and variety of financing

systems involved, the federated cooperative may

be limited in how programs can be coordinated.

Simple methods of transferring nonqualified

patronage refund distributions between

cooperative levels may be possible, but lack of

experience in this area is an impediment. For

cooperatives that transfer patronage refunds

between cooperative levels and want secure

procedures for preserving single-tax treatment,

qualified written notices of allocation, and not

nonqualified notices, appear to be the more

conservative choice.

Maintaining equitable financing becomes

more difficult as cooperatives adopt more

complex financing plans and members become

more diverse in character. This difficulty is

compounded if a cooperative uses two methods

for allocating and redeeming equity. Although

either qualified or nonqualified notices can

provide the basis for an equitable financing

system, use of both allocation methods can

introduce inequities if there are inconsistencies in

how individual members or allocations are

treated. Inconsistencies in treatment can occur if

the proportion of allocations held in nonqualified

form varies among members and qualified and

nonqualified notices are redeemed according to

different schedules.

Nonqualified notices have potential for

altering the financial relationships between

cooperatives and their patrons. Because the

overall relationship between a cooperative and its

patrons depends on many factors, including

financing methods, marketing contracts, member

relations programs, and personal contacts

between patrons and employees, the use of

nonqualified notices will not by itself define the

nature of this relationship. However, use of

nonqualified notices may change patron

involvement in providing the cooperative equity

capital, thereby contributing to change in the

overall relationship. When nonqualified notices

are used, patrons provide equity to the

cooperative, but in a passive manner.

Management and patrons may regard

nonqualified notices less like an investment by

patrons and more like retained earnings.

Although nonqualified notices were created

by the same Federal legislation as qualified

notices, relatively few cooperatives currently use

them and the proportion of patronage refunds

and per-unit capital retains issued in nonqualified

form is small. Two factors that limit the use of

nonqualified notices are a general lack of

experience with them and the delayed tax

consequences of their redemption.

Cooperatives and their patrons have not had

as much experience with nonqualified notices,

and only limited literature and legal precedents

relating to them exist. This lack of experience

discourages their use because uncertainties about

their characteristics or the procedures for their

use make planning for them more difficult.

Cooperatives may be discouraged from

issuing nonqualified notices because the final tax

consequences to the cooperative and its patrons

are not determined until the notices are redeemed

in cash, perhaps many years after they are issued.

Calculation of the tax benefit from redeeming

nonqualified notices depends in part on the

cooperative’s operating results and the applicable

tax rates in the year of the redemption, factors

that are far from certain when the notices are

issued. Similarly, tax paid by patrons on the

redemptions depends on their incomes and tax

rates, factors that also are indeterminate.

VI. CONCLUSIONS

Nonqualified written notices of allocation

and per-unit retain certificates offer farmer

cooperatives alternative means for distributing

cooperative earnings and allocating patron equity

that may have advantages over qualified written

notices and retain certificates in some situations.

Some patrons, particularly those with high tax

rates, may wish to delay receiving income and

therefore would prefer receiving nonqualified

distributions. Cooperatives can use nonqualified

57
notices to avoid negative patron cash flows to

these patrons resulting from tax on qualified

notices. Nonqualified notices also offer

cooperatives an additional tool for managing

taxes and handling losses.

Although this tool has been available to

cooperatives since enactment of subchapter T of

the Internal Revenue Code in 1962, nonqualified

notices account for a small proportion of total

patronage distributions. Data on the 100 largest

U.S. farmer cooperatives suggest there has been

an increase in the use of nonqualified notices in

recent years, but large cooperatives probably

have used these notices more than small

cooperatives.

The comparative analysis of patron cash

flow conducted earlier in this report suggests

that neither the qualified nor the nonqualified

method of distributing patronage refunds is

clearly superior to the other. Patron cash flows

are sensitive to changes in several factors, and

which method of distributing patronage refunds

results in the greatest cash flow to patrons

depends on the level of each of these parameters.

In general, low individual income tax rates

favor choosing the qualified method. At low

individual rates, patrons avoid negative cash

flows from paying tax on qualified written

notices of allocation without requiring large

cooperative cash drains from paying a high

proportion of patronage refunds in

cash. High individual tax rates and low

corporate rates favor the nonqualified method.

The nonqualified method also may be favored by

tax incentives such as investment tax credit.

Several institutional factors unrelated to tax

rates may support choice of the qualified

method. The great deal of experience

cooperatives and their patrons have with

qualified written notices of allocation and perunit retain certificates certainly contributes to

their wide current use. Qualified written notices

and retain certificates have been used for more

than 25 years. During that time, cooperatives

and their patrons have incorporated the cash

patronage refund and patron income reporting

requirements into their operating routines. In

addition, the accounting and legal procedures for

issuing and redeeming qualified written notices

and retain certificates have been well established.

Patrons pay the income tax on qualified

notices. As a result, the tax responsibility is

settled simply and immediately with no longterm complications or uncertainties. By agreeing

to include qualified notices in their taxable

incomes, patrons also take a more active role in

financing their cooperatives. In the case of perunit capital retains, patron agreement to take the

allocations into account relieves the cooperative

from a tax drain.

Qualified notices also work well within

federated systems. There are minimal delays in

the flow of patronage refunds from the federated

cooperative to its member cooperatives, and

there are no conflicts or uncertainties with regard

to the distribution of income to current and

former patrons.

In general, qualified notices work well with

all types of equity accumulation and redemption

plans. On the other hand, nonqualified notices

require simple and flexible financial

arrangements that allow adjustments in equity

accumulation and redemption to be made easily.

Cooperatives may find they can use nonqualified

notices effectively in responding to extraordinary

occurrences or large fluctuations in operating

results that necessitate major adjustments in their

financing methods.

Qualified and nonqualified notices should

not be viewed as mutually exclusive alternatives.

A cooperative can include authorization for

issuing both types of allocations in its bylaws

with the idea that each may be useful under

certain conditions. Then it has the flexibility to

choose whether or not to issue nonqualified

notices on a yearly basis according to the

situation each year.

Although current individual and corporate

tax rates do not favor one type of allocation over

the other, future changes in tax rates or credits

could alter this situation. In addition, a

cooperative could experience special situations

such as operating losses. Thus, it may be

prudent for a cooperative to review its bylaws

and include nonqualified notices in its financial

planning to ensure it has the flexibility to meet

58
future situations optimally.

However, a cooperative should take several

steps before issuing nonqualified written notices

of allocation. It should review its bylaws and

relevant State income tax laws to determine if the

use of nonqualified notices is compatible with

them and if any potential tax problems may arise.

It should review its financing and equity

retirement methods to ensure that the use of

nonqualified notices will not cause unforeseen

complications. It also should review the

expectations and experience of members to

determine what member relations and education

steps need to be taken.

Although the board of directors often is

given discretion in administering a cooperative’s

financing plan, specific provisions may need to be

added to the bylaws if the cooperative wants to

begin issuing nonqualified written notices of

allocation. Bylaws usually include provisions

declaring the rights of different equity classes,

requiring members to consent to include qualified

written notices in their taxable incomes,

authorizing the cooperative to issue and redeem

patronage refund or per-unit capital retain

allocations, and describing operation of the

equity retirement or base capital plan.

Amendments to the bylaws may need to specify

the rights of nonqualified notices in relation to

other equity classes and their role in the equity

retirement or base capital plan. Nonqualified

notices are not covered by the consent provisions

for qualified distributions, and the amended

bylaws need to be clear about which allocations

are covered.

State income tax treatment generally follows

Federal procedures for issuing and redeeming

qualified written notices of allocation. However,

not all States have included procedures for

nonqualified written notices in their tax

regulations. Thus, cooperatives must review how

nonqualified notices are treated in their

individual States. If a cooperative’s State has not

included procedures for nonqualified notices in

its regulations, the cooperative may not be able to

deduct the redemption of nonqualified written

notices from its State taxable income.

Financing plans can be complicated by the

use of nonqualified written notices of allocation

or the existence of two distribution methods.

Similarly, the use of nonqualified notices can be

complicated by certain financing plans. For

example, calculation of the tax benefit from

redemption of nonqualified notices can be

complicated by equity retirement plans that in

any tax year may redeem equity allocations

issued during more than one prior year. A

cooperative should review its financial plan to

determine if issuing nonqualified written notices

of allocation will seriously complicate operation

of the plan, its tax calculations, or the equitable

treatment of its patrons.

Because the income and tax situation of a

cooperative’s members will vary from one group

to another, the expected benefits of receiving

nonqualified written notices of allocation also

will generally differ. The cooperative should

review the expectations and experience of its

members to determine what member relations

and education steps need to be taken. For an

allocation program to be successful, members

must clearly understand the mechanics of

nonqualified notices, appreciate the expected

benefits to the cooperative and themselves, and

perceive the program as operating in an equitable

manner. Because patrons generally have not had

much experience with nonqualified notices, they

may require educational assistance in

understanding how nonqualified written notices

are issued and redeemed and how they are

reported as income on tax forms. The benefits of

using nonqualified notices certainly should be

weighed against any loss in patron good will or

understanding that may arise from a disruption

of the systematic and consistent operation of the

current program or an increase in its complexity.

In summary, the tax treatment of

nonqualified notices is different from that of

qualified notices. Under some conditions,

cooperatives and patrons could benefit from

considering nonqualified notices. The benefits of

nonqualified notices require flexibility by

cooperatives and understanding by patrons.

59
GLOSSARY OF COOPERATIVE TAX TERMS

Nonpatronage income: Incidental income that is

not directly related to the marketing, purchasing,

or service activities of a cooperative and merely

enhances the cooperative’s overall profitability.

It may include rents received, investment

revenues, gains on the sale or exchange of

depreciable property and capital assets, and

amounts from business done with the Federal

Government. Nonpatronage income also

includes income from business done with or for

nonmembers but not distributed to them.

Nonqualified per-unit retain certificate: A per-unit

retain certificate that the recipient does not

consent to include in taxable income and thereby

does not qualify for deduction from the

cooperative’s taxable income. Cash redemptions

of nonqualified per-unit retain certificates are

included in the recipient’s income and are

deducted from the cooperative’s income.

Nonqualified written notice of allocution: A written

notice of allocation that the recipient does not

consent to include in taxable income and thereby

does not qualify for deduction from the

cooperative’s taxable income. Cash redemptions

of nonqualified allocations are included in the

recipient’s income and are deducted from the

coopera live’s income.

Patronage refund: An amount paid a patron from

the net margins of a cooperative on the basis of

quantity or value of business done with or for

patrons under a preexisting legal obligation. A

patronage refund does not include amounts paid

a patron based on earnings from business not

done with or for patrons or amounts paid a

member based on earnings from business with

nonmembers to whom smaller amounts are paid

for substantially identical transactions. Called

patronage dividend in the Internal Revenue

Code.

Payment period: The period during which a

patronage refund or per-unit capital retain must

be distributed to be considered as such under

subchapter T of the Internal Revenue Code. The

period begins the 1st day of the tax year and ends

on the 15th day of the 9th month after the close of

the tax year.

Per-unit capital retain: An investment in a

cooperative made by a patron based on the dollar

value or physical volume of products marketed

through the cooperative and withheld according

to a bylaw provision or membership agreement

that authorizes the cooperative to make a

specified deduction for capital purposes from

proceeds due members or cash advances. These

retains should be distinguished from deductions

authorized to cover operating expenses.

Per-unit retain certificate: Any written notice that

discloses to the recipient the dollar amount of a

per-unit retain allocation made by the

cooperative.

Qualified check: A check or other instrument that

is redeemable in cash and paid as part of a

patronage refund. Imprinted on the instrument

is a statement that endorsing and cashing it

constitutes patron consent to include in taxable

income the stated dollar amount of the written

notice of allocation that also is part of the

patronage refund.

Qualified per-unit retain certificate: A per-unit

retain certificate that the recipient consents to

include in taxable income and thereby qualifies

for deduction from the cooperative’s taxable

income under conditions specified in

subchapter T of the Internal Revenue Code.

Qualified written notice of allocution: A written

notice of allocation that the recipient consents to

include in taxable income and thereby qualifies

for deduction from the cooperative’s taxable

income under conditions specified in subchapter

T of the Internal Revenue Code. At least 20

percent of the patronage refund of which the

notice is a part must be paid in cash.

Section 522: Section of the Internal Revenue Code

that exempts cooperatives that meet certain

60
requirements from including in taxable income

dividends paid on capital stock and nonpatronage

income distributed to patrons on a patronage basis.

Subchapter T: Sections 1381-88 of the Internal

Revenue Code, which define the tax treatment of

any corporation operating on a cooperative basis

except mutual savings banks, mutual insurance

companies, and cooperatives engaged in

furnishing electric energy or telephone service to

rural areas.

Written notice @allocation: Any capital stock,

revolving fund certificate, retain certificate,

certificate of indebtedness, letter of advice, or

other written notice that discloses to the recipient

the amount allocated to the patron by the

cooperative and the portion of the allocation that

is a patronage refund.

61
U.S. Department of Agriculture

Agricultural Cooperative Service

P.O. Box 96576

Washington, D.C. 20090-6576

Agricultural Cooperative Service (ACS) provides research, management, and

educational assistance to cooperatives to strengthen the economic position of farmers

and other rural residents. It works directly with cooperative leaders and Federal and

State agencies to improve organization, leadership, and operation of cooperatives and

to give guidance to further development.

The agency (1) helps farmers and other rural residents develop cooperatives to obtain

supplies and services at lower cost and to get better prices for products they sell; (2)

advises rural residents on developing existing resources through cooperative action to

enhance rural living; (3) helps cooperatives improve services and operating efficiency;

(4) informs members, directors, employees, and the public on how cooperatives work

and benefit their members and their communities; and (5) encourages international

cooperative programs.

ACS publishes research and educational materials and issues Farmer Cooperatives

magazine. All programs and activities are conducted on a nondiscriminatory basis,

without regard to race, creed, color, sex, age, marital status, handicap, or national

origin.