United States Department of Agriculture

Agricultural Cooperative Service

Cooperative Information Report Number 9

What Are

Patronage

Refunds?
Cooperative Information Report 9

Revised January 1985

Reprinted June 1993
What Are

Patronage

Refunds ?

Donald A.

A t torney

Frederick

Gene Ingalsbe, retired

Director

Informa tion and Educa tion Staff

Patronage refunds 

cooperative form of business.

thing distinctive about the

The phrase is a tipoff to what a cooperative is, how it

operates, and the special relationship between it and its

owners.

What a Cooperative Is

A cooperative is a business

people using its services.

owned and controlled by the

That brief definition doesn’t cover all the variations and

complexities of cooperatives. But it captures the central

difference between a cooperative and other businesses. In

the cooperative, the owners and the users are the same

people; they are the members.

Key operating principles of cooperatives are:

l Service at cost-The purpose of a cooperative is to provide

a service to its user-owners at the lowest possible cost,

rather than generate a profit for investors. However, the

cooperative must generate income suffkient to cover

operating expenses and meet continuing capital needs.

0 Financial obligation and beneji’ts proportional to useBenefits are distributed according to use rather than on

the amount of investment. Therefore, it follows that

members are obligated to provide financing in proportion to the use that produced those benefits.

l Democratic control-The Rochdale pioneers formed their

cooperative as individuals and exercised control through

one-member one-vote. Subsequently, we’ve labeled that

concept democratic control. Our political democratic
process allows also for representative or proportional

voting. A few cooperatives, applying that concept, use

proportional voting based on use,

l Limited return on equity capital--The overriding value of

the cooperative to its owners is in the services provided.

Limiting the return on equity capital is a mechanism to

support distribution of benefits according to use.

Important cooperative practices are:

l Continuing member education-Keeping owners educated

on what’s going on is an important practice for any

business. It is particularly vital for members to understand

what their cooperative is and how it operates for at least

two major reasons: (1) The democratic control principle,

exercised through majority rule, requires that the entire

ownership be informed to assure enlightened

decisionmaking; and (2) because cooperatives are not as

numerous as other types of business, the cooperative form

of business does not receive much attention in business

and economic courses of our education system. Therefore,

each cooperative must be the educational institution for

itself.

l Operations on a soundflnancial basis-A cooperative must

be viewed as a business and must have flexibility to adjust

to the changing business climate.

l Cooperation among cooperatives-Cooperatives need to

work together to hold member production input costs to a

minimum and market member products efficiently to meet

the requirements of their customers.

Patronage Refund Importance

Patronage refunds are directly related to key principles and

important practices, and the responsibilities the

cooperative and its owners have to each other.

The purpose of a cooperative is to provide a service to its

member-users at the lowest possible cost, rather than

generate a profit for investors. However, service at cost

doesn’t mean the cooperative operates that way on a daily

basis. It doesn’t for at least two good reasons: (1) it doesn’t

know exactly what its costs are on a daily basis; and (2) as a

business in the private enterprise system, the prices it pays

2

a
for products purchased an

fluctuate with the market.

d receives for goods sold

Once a year, a formal accounting determines the

cooperative’s income and expenses. Income remaining

after deducting all expenses (net margin) is then

distributed in proportion to patronage. The income in

excess of expenses generated by the members’ use of their

business is thus refunded to them. This income returned or

refunded is called a patronage refund. The patronage

refund is one measure of the key operating principle that

ownership benefits are generally in proportion to use.

The patronage refund is an important source of financing

for cooperatives. Members usually elect to leave a portion

of the refund in the cooperative to help keep its operations

on a sound financial basis. The retained portion of the

patronage refund is allocated to the member’s equity

account and paid out at a later date.

The special nature and purpose of a cooperative places the

responsibility to finance the business on its member-users.

Benefits are tied to use. Those benefits do not enhance the

value of shares of stock or other equity capital. Therefore,

the incentives that cause persons to invest in stock of other

corporations are not present in cooperative stock.

Consequently, members of the cooperative must provide

most of its equity capital, either by direct investment or

through retained patronage allocations.

The cooperative has a responsibility, acting collectively for

members, to develop a financing and ownership transfer

plan that’s equitable to members individually and that is in

keeping with cooperative principles. As members use the

cooperative, they assume the basic responsibility of

providing capital according to their use. When patronage

terminates so does the financing responsibility. Unless the

cooperative adopts a systematic plan to redeem equities, an

increasing amount of capital will be held by inactive

members. Such a situation can lead to less participation by

members in their cooperative’s affairs and conflicting

objectives.

Financing the cooperative through reinvestment of

patronage refunds is a simple and straightforward way for

members to carry out their obligation to finance according

to use. Equity redemption serves to keep the cooperative’s

ownership in the hands of current users.

- 3
Terminology Key to Understanding

The important key to understanding what a cooperative is

and how it operates is knowing those words and terms that

are distinctive to the cooperative form of business. Some

terms, though used in other business types, have special

meaning in a cooperative. A glossary of basic terms to

better understand a cooperative follows:

Allocation: Patron’s share

or obligation for its loss.

of the coope rative’s net margin,

Cooperatives typically commingle products of members for

marketing and purchase supplies in bulk for resale. These

activities generate margins and per-unit retains on a

continuous basis. Cooperatives allocate (recognize the

ownership of> these funds to patrons according to their use

of the cooperative.

Tax laws require allocations retained by the cooperative be

evidenced by a document issued to the patron by the

cooperative. A document reporting a dollar amount

allocated to the patron and the portion thereof that

constitutes a patronage refund is called a written notice of

allocation, one reporting per-unit retains is a per-unit retain

certijka te.

If the allocation and the document are structured to comply

with specific requirements of the Internal Revenue Code,

they are qualicfied. The cooperative deducts the amount of

the patronage refund or per-unit retain from taxable

income and the patron agrees to include it in taxable

income as if it had all been paid in cash. The principal

requirement for qualification is consent by the patron to

include the total amount of the patronage refund or perunit retain in taxable income. Also, the cooperative must

pay at least 20 percent of any covered patronage refund in

cash.’

Allocations and documents not so structured are

nonqualzfied. The cooperative pays tax on these monies in

the year obtained. When a nonqualified allocation is

redeemed, the cooperative deducts the allocation from

taxable income and the patron includes it in taxable income

in the year of redemption.

'See Coope rative Information Report 23, “Tax Treatment of

Cooperatives,” Agricultural Cooperative Service, U.S.

Department of Agriculture.
Centralized, Federated, Mixed-Structure Cooperatives. In a

centralizedcooperative, producers themselves belong

directly to the cooperative and make up the entire

membership. In afederatedcooperative, other cooperatives

are the direct members. A mixed structure cooperative has

both producers and other cooperatives as direct members.

Democratic Control: Members, by majority vote, determine

how their cooperative will operate. Decisions can be

reached on the basis of one-member, one-vote or through

proportional voting based on patronage.

Equity Redemption: The payment of cash or other property

to return previously invested funds. A revolvingfund plan is

a system of equity redemption where the earliest

investments are redeemed first, on a reasonably regular

schedule.

Member: A person or organization joining

and agreeing to abi.de by the conditions of

a cooperative

bership.

Member Equity The capital investment of each member in

the cooperative. Such investments are usually in the form

of cash, retained patronage refunds, and per-unit retains.

Net Margin: Total income from all sources minus expenses.

Patron: A person who uses the services of a cooperative

and agrees to share the margins in proportion to use. A

patron can be either a member or a nonmember of the

cooperative, an individual or another business.

Patronage Refund: A payment from a cooperative to a

patron from net margins based on quantity or value of

business done with or for the patron.

The refund may be in cash and/or in the form of a

document evidencing the patron’s decision to have the

cooperative retain the refund as an investment by the

patron. Patronage refunds may be paid only to members,

or to both member and nonmember users.

The term “refund” is appropriate to emphasize the

cooperative’s service orientation. When a margin occurs in

the performance of a service, regardless of the source -

reduction in cost, underpayment for product, or enhanced

value from processing - it belongs to the user and is

5
refunded on the basis of patronage. This action is required

for t he cooperati ve to fulfill the principle of service at cost.

A patronage refund should not be confused with a dividend

on capital stock. A dividendis a distribution to a

shareholder based on investment or ownership. A

patronage refund is a distribution based on use.

Per-Unit Retain: A deduction by the cooperative from the

proceeds of sale based on the value or quantity of products

marketed for the patron.

Patronage refunds and per-unit retains are sometimes

confused. Patronage refunds are based on net margins

generated during the year. Per-unit retains are based on the

number, or dollar value, of units marketed.

Pooling An averaging process wherein producers who

market a commodity through a cooperative during a fixed

period of time agree to share expenses and returns

associated with that commodity handled during the period

on a pro rata basis.

Section 521 Cooperative: A cooperative that meets specific

requirements of section 521 of the Internal Revenue Code

and has received written authority from IRS to use this tax

section. Only agricultural cooperatives can qualify for

section 521 status. Such a cooperative is not totally exempt

from taxation. It can, in addition to other lawful

deductions, deduct from taxable income dividends paid on

capital stock and nonpatronage income distributed on a

patronage basis.
Other Publications

Farmer Cooperative Publications. Gene Ingulsbe CIR 4.

Revised 1992. 59 pp.

Tax Treatment of Cooperatives. Donald A. Frederick. CIR

23. Revised 1984. 12 pp.

Cooperative Principles and Legal Foundations. Martin A.

Abrahamsen, J. Warren Mather, James R. Baarda, and

James Kelly. CIR 1, Sec. 1. 1977. 26 pp.

Equity Redemption Guide. Jeffrey S. Royer and Gene

Ingalsbe. CIR 31.1983.12 pp.

Federal Income Taxes, Part II-Legal Phases of Farmer

Cooperatives. Morrison Neely. FCS Inf. 100. May 1976.

126 pp.

Income Tax Treatment of Cooperatives CIR 44, Sec. 1 and 2.

For copies, write Agricultural Cooperative Service, U.S.

Department of Agriculture, Washington, D.C., 20250.