U.S. Department of Agriculture

Rural Business and Cooperative

Development Service

Ag Box 3250

Washington, D.C. 20250-3250

The Cooperative Services program of USDA’s

Rural Business and Cooperative Development

Service 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 Cooperative Services staff (1 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. Cooperative Services publishes

research and educational materials and monthly

issues Farmer Cooperatives magazine.

The U.S. Department of Agriculture (USDA) prohibits

discrimination in its programs on the basis of race,

color, national origin, sex, religion, age, disability,

political beliefs and marital or familial status. (Not all

prohibited bases apply to all programs.) Persons with

disabilities who require alternative means of communication of program information (braille, large print,

audio-tape, etc.) should contact the USDA Office of

Communications at (202) 720-7808 (TDD). To file a

complaint, write the Secretary of Agriculture, U.S.

Department of Agriculture, Washington, DC 20250, or

call (202) 720-7327 (voice) or (202) 720-I 127 (TDD).

USDA is an equal employment opportunity employer.

Cooperative Information Report 23

Issued September 1984, Revised May 1995

Supersedes “Handling Net Margins Under Federal Tax

Laws,” FCS Information Report 39, issued in 1979.
Tax Treatment of Cooperatives

Donald A. Frederick

Attorney

A cooperative is a business that is owned, financed, and

controlled by the people who use its services. Earnings are

allocated and distributed to members based on patronage,

rather than to investors based on equity. The Internal

Revenue Code (Code) recognizes the pass-through nature

of a cooperative by providing for the single Federal income

taxation of earnings generated on business conducted on a

cooperative basis. This pamphlet explains how cooperatives are taxed and some tax plamring options available to

cooperative members.

Cooperatives Pay Taxes

Cooperatives have the same rights and responsibilities as

other American businesses, including the obligation to pay

taxes. Cooperatives, like other businesses, pay significant

taxes.

First, cooperatives pay the special taxes assessed all

businesses. These include real estate and personal property

taxes, sales taxes, employment taxes (to finance social

security, unemployment compensation and workers’

compensation benefits), gasoline and diesel fuel taxes,

license fees, motor vehicle registration fees, and excise

taxes on utility services.

Second, cooperatives and their owners pay a single income

tax on margins, usually at the owner level. This is the same

tax treatment applied to most U.S. businesses, As table 1

shows, of the five common structures of American business, only investor-general corporations have their margins

taxed at both the business entity and individual owner

levels. And only 12 percent of American businesses are

operated as investor-general corporations,

Most business taxes are applied uniformly to all affected

taxpayers, including cooperatives. Therefore, they will not

be mentioned further in this pamphlet.

Certain aspects of income taxation are unique to each form

of business. While some variations exist, most States with

income taxes generally follow the Federal model in taxing

cooperative margins.

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Table l--Income tax treatment by business type

Business Type

Times net margin

subject to tax Level

Proprietorship . . . . . . . . . . . . . . . . . . . . . . . 1

Partnership . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

Corporations:

Investor-General . . . . . . . . . . . . . . . . . 2

Investor-Subchapter S . . . . . . . . . 1

Cooperative-Subchapter T . ..l

Owner

Owners

Corporation

Owners

Owners

Owners

Federal Income Taxes

The central feature of cooperatives’ Federal income tax

liability is that net margins are not taxable income to both

the cooperative and the patron if they are distributed or

allocated to patrons on the basis of business done with the

cooperative according to certain well-defined rules. The

Code recognizes cooperatives’ operating principle of

providing services at cost. Therefore, refunds of net margins to patrons on a patronage basis are subject to Federal

income tax only once. This treatment is available to any

business choosing to refund net margins in the same way.

Rules cooperatives and patrons must follow to be eligible

for this tax treatment are in Subchapter T of the Code.

Subchapter T contains a definition of a patronage refimd.

Unfortunately, the Code uses the term “patronage dividend”

instead of “patronage refund.” The more common terminology “patronage refund” is used in this pamphlet, to avoid

confusion with regular dividends on stock.

Subchapter T defines a patronage refund as “An amount

paid to a patron by an organization..

1. On the basis of quantity or value of business done

with or for such patron,

2. Under an obligation of such organization to pay such

amount which obligation existed before the organization

received the amount so paid, and

3. Which is determined by reference to the net earnings

of the organization from business done with or for its

patrons.”

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For example, if a cooperative has a margin of $2,000 for

the year, and Ms. Jones does 10 percent of the business

with the cooperative, then she receives a patronage refund

of $200 ($2,000 x . IO). This allows the cooperative to

return margins to members on an annual basis, consistent

with standard accounting conventions and without regard

to how much was earned on each transaction.

The Subchapter T definition includes several key

requirements.

First, the definition refers to amounts paid to a “patron”

rather than a “member.” Some cooperatives only conduct

business with or for members, while others deal with both

members and nonmembers. The members of a cooperative with nonmember business have the choice of whether

to make patronage refunds to nonmember users.

Second, the critical characteristic that distinguishes a

business operating on a cooperative basis is the requirement that distribution of net margins is based on the

“quantity or value of business done with or for such

patron.” Distributions to patrons not made in proportion to

business done with the cooperative cannot qualify as

patronage refunds. For example, dividends paid on capital

stock are not patronage refunds because they are made in

proportion to the amount of stock owned rather than the

amount of business done with the cooperative. This standard implements the cooperative’s central objective of

distributing financial benefits to patrons based on their use

of the cooperative’s services rather than on the basis of

their investment in its capital structure.

Third, the cooperative must have an obligation to pay net

margins to patrons, and the obligation must exist before a

patronage transaction takes place. Both the cooperative and

its patrons know prior to any transaction that net margins

from the transaction will be paid in whole or in part as a

patronage refund. The preexisting legal obligation must be

in enforceable written form. It can be included in a cooperative’s bylaws, articles of incorporation, marketing agreement, sales receipts, or other written contract obligating the

cooperative to make the payments. If a State law makes

patronage refunds mandatory, that law also is considered a

valid obligation.

Fourth, patronage refunds are distributions of net margins

derived from business with or for patrons. The Treasury

Department regulations define net earnings (net margins)
as “the excess of amounts retained (or assessed) by the

organization to cover expenses or other items over the

amount of such expenses or other items.” Patronage

refunds can come only from business done with or for

patrons. Income a cooperative may receive from business

unrelated to patronage cannot be included in patronage

refunds under definitions of the Internal Revenue Code.’

Written Notices of Allocation

A cooperative has several options in distributing its patronage refunds and taking advantage of the tax treatment

available under Subchapter T. It may simply pay out all of

its earnings in cash. This is usually done by cooperatives

that do not need to generate additional capital, or those

whose members finance by other methods.

The most popular method of distributing patronage refunds

is to pay out part of the refund in cash and part in a noncash form called a “written notice of allocation,” Funds

represented by a written notice of allocation are retained by

the cooperative, not as profit, but as a capital investment by

the patron in the cooperative. The tax code permits the

notice to be in a variety of forms so long as it is in writing

and informs the patron of the total amount allocated to him

or her on the books of the cooperative and the portion that

is a patronage refund.

Members determine how much of the cooperative’s net

margins are to be retained in the cooperative to meet its

capital needs. The written notice of allocation is evidence

of a patron’s share of that investment. This method of

tVmancing helps the association comply with the cooperative principle of obtaining financing from current patrons

on the basis of their use of the cooperative.

A cash refund is deductible by the cooperative in the year

the funds being returned were earned and is taxable income

to the patron in the year received. Members and their

cooperative have two alternative tax treatments available

‘Dividends paid on capital stock and patronage-based

refunds of nonpatronage income are eligible for single tax

treatment if a cooperative meets the requirements of section 521

of the Internal Revenue Code. A review of 52 1 status is beyond

the scope of this pamphlet. A thorough discussion of section 521

can be found in LegalPhases ofFarmer Cooperatives, FCS

Information 100, beginning at page 381.

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for retained funds evidenced by written notices of allocation. Specific tax treatment will depend on whether a

written notice of allocation is “qualified” or “nonqualified.”

“Qualified” and “Nonqualified”

If a cooperative chooses to meet the specific requirements

of the Code to “qualify” written notices of allocation, funds

represented by qualified written notices are treated just like

a cash patronage refund for tax purposes. The cooperative

deducts the entire amount from its taxable income in the

year the funds are earned and the patron includes the entire

amount in his or her income in the year the written notice is

received. (A cooperative is allowed 8- l/2 months from the

end of its tax year to complete its tax returns and make its

patronage distributions.)

An example illustrates how this works for a typical marketing cooperative. The cooperative pays the patron $600

for his crop at the time of delivery. It costs the cooperative

$300 to market the crop. The cooperative sells the crop for

$1,000.

The resulting margin of $100 is returned to the patron as a

patronage refund. The patron receives a total payment of

$700 for the crop, a $600 advance at the time of delivery

and a $100 patronage refund.

Example of Tax Treatment of Cooperative and Patron

Qualified Retained Equity

Cooperative Patron

Expenses

Crop

Other

Total

$600

$900

Income

Crop $600

Income $1000

Margin $100 Refund $100

Taxable income 0 Taxable Income $700

When the cooperative figures its taxable Income, it can

deduct the initial payment for the crop ($600) its other

expenses of marketing the crop ($300), and the patronage

refund ($100). Thus, it ends up with no taxable income.
The patron includes both the initial payment ($600) and

the patronage refund ($100) in taxable income, for a total

of $700.

The requirements to quality a written notice of allocation

are:

1. The written notice of allocation must be part of a

patronage refund package of which 20 percent or more is

paid in money or qualified check, and either

2a. The patron has the option of redeeming the written

notice of allocation at face value for cash within 90 days of

issuance, or

’

2b. The patron has consented to include the face value

of the written notice in his or her taxable income.

,

The term “money” includes both cash and a regular bank

check. A “qualified check” is a specially prepared bank

check that can be used to establish a patron’s consent to

include the noncash portion of a patronage refund in his or

her income for tax purposes.

A patron can “consent” to include the face value of the

written notice of allocation in taxable income in any one of

three ways:

1. By joining a cooperative whose bylaws clearly state

that membership in the cooperative constitutes such consent, provided the patron is given a copy of the bylaw and a

written statement of its purpose. This is the most common

method of establishing consent.

2. By signing and furnishing a written consent to the

cooperative before the end of the taxable year in which the

patronage occurs. The consent must be revocable. Unless it

provides otherwise, a written consent remains in effect for

all subsequent years until it is revoked.

3. By endorsing and cashing a qualified check. A

“qualified check” carries a clearly printed statement that

endorsing and cashing the check constitutes consent by the

patron to take into account, as provided in the Federal

income tax laws, the stated amount of any written notices

of allocation that are paid as part of the patronage refund of

which the check is also a part.

A cooperative may elect not to meet all the requirements to

qualify a written notice of allocation. For example, it may

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pay less than 20 percent of the patronage refund in money

or qualified check, or it may not have its patrons consent to

take the face amount of the refund into account for tax

purposes. If a written notice does not meet the requisites

for qualified status, it is called “nonqualified.”

A cooperative that issues nonqualified written notices of

allocation must include the face amount of the notice in its

taxable income for the year the covered funds are earned

and pay tax on these funds at regular corporate income tax

rates.

The patron receiving a nonqualitied written notice of allocation does not pay an immediate tax on the funds it

represents. However, when the cooperative pays out the

money represented by the nonqualified notice to the patron,

the money received is taxable income to the patron in the

year received. The cooperative deducts the amount paid

from income in the year paid according to formulas established in the Code.

If the cooperative in the earlier example issues its patronage refunds as nonqualified written notices of allocation, it

has taxable income of $100, the amount of the margin. The

patron’s taxable income is $600, the payment for the crop.

Example of Tax Treatment of Cooperative and Patron

Nonqualified Retained Equity

Cooperative Patron

Expenses

Crop

Other

Total

$600

$900

income

Crop $600

income $1000

Margin $100 Refund $100

Taxable Income $100 Taxable Income $600

At some later time, when the nonqual$ed notice is

redeemed, the cooperative will deduct the $100 (or receive

a credit under certain circumstances) and the patron will

report it as income in the year the cash payment is

received.
Thus, the single tax treatment of cooperatives doing business with or for members is complete and consistent with

that accorded other single-tax entities. Income is ultimately

taxed once, at the level of the owner-user of the business.

Per-Unit Retains

Members usually have alternative methods of meeting their

obligation to finance their cooperative. They may make

out-of-pocket investments, such as buying a membership

or shares of stock. They may leave a portion of their patronage refund in the cooperative, as previously described.

Patrons of marketing cooperatives may also invest in their

cooperative by authorizing it to deduct a portion of the

proceeds of sale, based on the dollar value or physical

volume of products marketed through that cooperative.

This method of financing is called “per-unit retains.”

Tax treatment of per-unit retains generally parallels that of

patronage refunds. A cooperative is required to pay tax

currently on its per-unit retains unless they are evidenced

by certificates “qualified” under the law. The patron must

include the face value of a qualified per-unit retain in his or

her income for tax purposes in the year received. The certificate is qualified only if the patron consents to include the

face amount of the certificate in current income. Because

per-unit retains are deducted from payments for products,

there is no cash distribution rule similar to the 20-percent

requirement to qualify a written notice of allocation. If a

patron receives a nonqualified per-unit retain, the amount

is not reported as income until the money it represents is

paid to the patron.

Patronage refunds and per-unit retains are often confused.

Patronage refunds are based on net margins while per-unit

retains are based on the amount of business conducted

without regard to margins.

Tax Planning Alternatives

The tax treatment available to businesses operated on a

cooperative basis is a simple concept--a cooperative

operates at cost, so it has no true income to tax. However,

as the earlier sections of this pamphlet indicate, when that

concept is melded into our complex Federal income tax

system, it also becomes quite complex.

Careful tax planning is as important for members and their

cooperatives as it is for other individuals and businesses.

8
This is especially true when patronage refunds are involved, because most decisions will have significant tax

consequences for both the cooperative and its memberpatrons. Here is a brief summary of some of the choices

available:

1. How to finance the cooperative -- Members may

supply equity capital through out-of-pocket investments,

patronage refunds, or per-unit retains. Initial investments to

start a cooperative usually come ti-om the members. When

the cooperative generates margins, retained patronage

refunds generally become the principal source of capital.

Marketing cooperatives may also use per-unit retains. A

combination of these methods is permissible. Cooperatives are encouraged to plan what role each of these

approaches should play in capital formation.

2. Who is to receive patronage refunds -- A cooperative

may pay patronage refunds to all users or only memberusers. If margins on nonmember business are not returned

to nonmember users on a patronage basis, the cooperative

must pay corporate income taxes on this money.

3. Whether to “qualify” its paper -- Most cooperatives

“quality” their written notices of allocation and per-unit

retain certificates because members find it to their advantage to accept immediate tax liability for their investment in

their cooperative, and thereby give the cooperative the

easiest possible access to needed financing. It is permissible to qualify part of an allocation and not the remainder.

The extent to which nonqualified allocations are made

generally depends on the cash needs and tax rates confronting both the members and the cooperative at the time

of allocation.

4. How to “qualify” -- The vast majority of cooperatives

use a bylaw provision to obtain the necessary consent to

qualify their allocations to members. The required explanation can be provided at the time the producer applies for

membership, and the pre-existing legal obligation to conduct business on a patronage basis is established. Bylaws

only bind members, so bylaw consent is not available for

nonmember business. A separate written consent is usually

obtained from nonmembers if their business is to be conducted on a patronage basis. Qualified checks can be

issued only as part of a patronage refund, and are rarely

used because of the uncertainty over whether patrons will

cash them.

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5. How to redeem old patronage paper -- If current patrons are to meet their duty to finance the cooperative, then

written notices of allocation and per-unit retain certificates

that have been on the books of the cooperative for many

years should be redeemed. The redemption schedule

should not be so rigid that it becomes difficult to maintain

adequate levels of capital. However, a formal redemption

program is clearly compatible with cooperative principles.

The member-patrons must collectively decide which alternatives best fit their needs and the operation of their

cooperative.

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