55Lie co_ops 101

Fluwl Elhnsssp&g- An Introduction to

Cooperatives
Abstract

This report provides a comprehensive summary of basic

information on the cooperative way of organizing and operating a

business. It covers the nature and extent of the use of cooperatives, compares cooperatives to other business structures,

explains the roles various people play in a cooperative, and

discusses equity accumulation and income taxation. The purpose

is to make available, in a single report, the information someone

would need to acquire a general understanding of how

cooperatives function.

Keywords: Cooperative, Business, Finance, Structure, Tax

Co-ops 101: An Introduction to Cooperatives

Donald A. Frederick, Program Leader

Law, Policy & Governance

Cooperative Resources Management Division

Rural Business-Cooperative Service

U.S. Department of Agriculture

Cooperative Information Report 55

April 1997, Slightly revised June 1997
Preface

Welcome to the dynamic world of cooperation--people working

together to solve common problems and seize exciting

opportunities. Cooperatives are business entities that people use

to provide themselves with goods and services.

This booklet introduces you to the attributes that distinguish a

cooperative from other ways to organize and conduct a business.

Its purpose is to help you understand what makes a cooperative

unique. It contains a great deal of information to absorb. Use it

as a reference and refer to it when specific pro-blems arise. Over

time, you will learn more about cooperatives and your experience

with them should be more rewarding.

The author gratefully acknowledges the cooperation of the

National Society of Accountants for Cooperatives (NSAC) in

simplifying the preparation of this report. NSAC allowed me to

base parts of this publication on material I had written earlier for

Welcome to Cooperatives, an NSAC booklet designed to

introduce accountants, financial, and tax professionals to

cooperatives. This saved me the time and effort of reworking the

presentation of some basis concepts that everyone associated

with cooperatives should understand. This is consistent with the

concept of sharing knowledge freely that should be a cornerstone

of cooperative education.
Contents

Paae

Chapter 1. A Historical Perspective . . . . . . . . . . . . . . . . . . 2

Chapter 2. Cooperative Principles and Practices . . . . . . . 5

Cooperative Principles ........................... 5

The User-Benefits Principle ..................... 5

The User-Owner Principle ...................... 5

The User-Control Principle ..................... 5

Related Practices ............................... 6

The Patronage Refund System .................. 6

Limited Return on Equity Capital ................. 7

Cooperation Among Cooperatives ............... 7

Chapter 3. Cooperatives in the Community . . . . . . . . . . . . 8

Financial Cooperatives ........................... 8

Consumer Service Cooperatives ................... 9

Business Cooperatives ........................... 9

Farmer Cooperatives ........................... 10

Chapter 4. Benefits of Cooperation . . . . . . . . . . . . . . . . . 12

Chapter 5. Business Organizations . . . . . . . . . . . . . . . . . 15

Individually Owned Business ..................... 15

Partnership ................................... 16

General Business Corporation .................... 16

Limited Liability Company ........................ 18

Cooperative ................................... 18

Chapter 6. Classifying Cooperatives by Structure . . . . . 20

Geographic Territory Served ..................... 20

Governance System ............................ 20

Functions Performed ........................... 21
Paue

Chapter 7. People . . . . , . . . . . . . . . . , . . . . . . . . . . . . . . . . 24

Members ..................................... 24

Directors ..................................... 26

Officers.. .................................. 28

Board Committees ........................... 29

Managers .................................... 29

Employees ................................... 30

Chapter 8. Sources of Equity . . . . . . . . . . . . . . . . . . . . . . . 32

Direct Investment .............................. 32

Retained Margins .............................. 34

Per-Unit Capital Retains ......................... 35

Nonmember/Nonpatronage Earnings ............... 35

Chapter 9. Financial and Tax Planning . . . . . . . . . . . . . . . 36

Cash Refunds ................................. 37

Qualified Retains .............................. 37

Nonqualified Retains ............................ 39

Unallocated Reserves ........................... 40

Chapter 10. Equity Management . , . . . . . . . . . . . . . . . . . . 41

Revolving Fund Plan ............................ 41

Special Plans ................................. 42

Base Capital Plan .............................. 43

Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44

Endnotes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
co-op 101

An Introduction to Cooperatives

There is no universally accepted definition of a cooperative.

In general, a cooperative is a business owned and democratically

controlled by the people who use its services and whose benefits

are derived and distributed equitably on the basis of use. The

user-owners are called members. They benefit in two ways from

the cooperative, in proportion to the use they make of it. First, the

more they use the cooperative, the more service they receive.

Second, earnings are allocated to members based on the amount

of business they do with the cooperative.

In many ways, cooperatives resemble other businesses. They

have similar physical facilities, perform similar functions and

must follow sound business practices. They are usually incorporated under state law by filing articles of incorporation,

granting them the right to do business. The organizers draw up

bylaws and other necessary legal papers. Members elect a board

of directors. The board sets policy and hires a manager to run the

day-to-day operations.

But in some ways, cooperatives are distinctly different from

other businesses. These differences are found in the cooperative’s

purpose, its ownership and control, and how benefits are

distributed. They are reflected in cooperative principles that

explain the unique aspects of doing business on a cooperative

basis.
Chapter 1. A Historical Perspective’

In one sense, cooperation is probably as old as civilization.

Early people had to learn to work together to meet their common

needs, or perish. The Pilgrims who settled at Plymouth, MA,

jointly cleared fields abandoned by the Indians, broke up the soil,

and planted and cared for their corn. After the harvest, celebrated

with the Indians in 1621 with a Thanksgiving feast, the corn was

shared equally among the settlers.

Legend suggests that the initial structured cooperative

business in the United States was the Philadelphia Contributionship for the Insurance of Houses from Loss by Fire, a mutual fire

insurance company established in 1752. This association’s

reputation is likely based on two factors. First, Benjamin Franklin

was the organizer. Second, the business has been conducted so

efficiently over the years that it is still operating today.

In the early 18OOs, cooperative businesses appeared on

several fronts. In Britain, cooperatives were formed as a tool to

deal with the depressed economic and social conditions related to

the struggles with Napoleon and industrialization. In the United

States, farmers began to process their milk into cheese on a

cooperative basis in diverse places such as Goshen, CT, and Lake

Mills, WI.

Writers sometimes trace the origin of cooperatives from the

Rochdale Equitable Pioneers’ Society, an urban, consumer

cooperative organized in England in 1844. It sold consumer

goods such as food and clothing to persons unhappy with the

merchants in the community.

While neither the first nor most successful early cooperative,

the Rochdale Society developed an active outreach program,

encouraging and assisting others to form cooperatives. It also

prepared a written list of practices and policies that seemed

consistent with success of such efforts. This list became one of the

first sets of cooperative principles, characteristics that distinguish

cooperatives from noncooperative businesses.

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Open membership

One member, one vote

Cash trading
l Membership education

l Political and religious neutrality

l No unusual risk assumption

l Limitation on the number of shares owned

l Limited interest on stock

l Goods sold at regular retail prices

l Net margins distributed according to patronage

The Grange, founded in 1867, quickly became the major

thrust behind agricultural and rural cooperatives in America. In

1874, a Grange representative went to Europe to gather

information about cooperatives. In 1875, the Grange published a

set of rules for the organization of cooperative stores, based on the

Rochdale principles.

Local granges organized stores to serve their rural members.

They sold groceries and clothing as well as general farm supplies,

hardware and agricultural implements. Granges in the South

marketed cotton. Those in Iowa operated grain elevators. In

Kentucky, they sponsored warehouses for receiving and handling

tobacco. California Granges exported wheat and marketed wool.

As the country recovered from the depression of the 187Os,

fewer Granges were organized and many cooperatives went out

of business, but the impact of the Grange cooperative movement

survives. It demonstrated that the Rochdale type of cooperative,

which handled goods at prevailing prices and distributed net

savings according to use, offered a sound basis for cooperative

efforts in America.

Cooperation flourished during the three decades from 1890

to 1920. As many as 14,000 farmer cooperatives were operating

by the end of the period. Cooperative growth was fueled by the

wave of other farmer movements and farm organizations

sweeping the country, such as the American Society of Equity,

National Farmers Union, and the American Farm Bureau

Federation. They were engaged in marketing virtually every farm

crop and furnishing supplies and services to their producermembers. Many of today’s major farmer cooperatives were

formed during this period.

The following decades have seen farmer cooperatives

develop their own financial institutions through the Farm Credit

System. Nonagricultural cooperatives likewise developed the

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National Cooperative Bank. With help from the Rural Electrification Administration, rural residents used cooperatives to bring

electric and telephone services to their towns and farms. The rural

electics formed the National Rural Electric Cooperative Finance

Corporation (CFC) as a supplemental source of financing.

Some cooperatives have become larger, partially in response

to growing concentration among their competitors and the firms

their members must deal with. They have adopted modern

management techniques and sophisticated processing, distribution and marketing methods.

Today rural and urban residents use cooperatives to acquire

consumer services such as housing, credit and other financial

services (through credit unions), groceries, education and

telecommunications. Franchisees, governmental units, hardware

and grocery stores, florists and numerous other businesses use

cooperatives to market their products and secure the supplies

they need at competitive prices.

Cooperatives remain a major component of the food and

agriculture industry, but now they are available to help people

provide services for themselves in virtually all segments of the

economy.
Chapter 2. Cooperative Principles and Practices2

Cooperative Principles

Various writers over the past century have analyzed and

observed the application of cooperative principles. Although

slight differences in terminology appear on the various lists, three

principles emerge as being widely recognized and practiced.

These principles are more than just good practices, policies or

common sense. They distinguish a cooperative from other kinds

of business. They are also recognized in state and federal statutes

and regulations as criteria for a business to qualify as a

cooperative.

The User-Benefits Principle

Members unite in a cooperative to get services otherwise not

available, to get quality supplies at the right time, to have access

to markets or for other mutually beneficial reasons. Acting together gives members the advantage of economies of size and

bargaining power. They benefit from having these services available, in proportion to the use they make of them.

Members also benefit by sharing the earnings on business

conducted on a cooperative basis. When cooperatives generate

margins from efficient operations and add value to products,

these earnings are returned to members in proportion to their use

of the cooperative. Without the cooperative, these funds would

go to other middlemen or processors.

The User-Owner Principle

The people who use a cooperative own it. As they own the

assets, the members have the obligation to provide financing in

accordance with use to keep the cooperative in business and

permit it to grow. Accumulating adequate equity is a major

challenge facing many cooperatives. How this task is accomplished is discussed later.

The User-Control Principle

As owners, a cooperative’s members control its activities.

This control is exercised through voting at annual and other

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membership meetings, and indirectly through those members

elected to the board of directors. Members, in most instances,

have one vote regardless of the amount of equity they own or

how much they patronize the organization.

In some instances, high-volume users may receive one or

more additional votes based on their patronage. Equitable voting

is assured, often by limiting the number of additional votes any

one member can cast. This protects the democratic control of the

membership as a whole.

Only members can vote to elect directors and to approve

proposed major legal and structural changes to the organization.

The member-users select leaders and have the authority to make

sure the cooperative provides the services they want. This keeps

the cooperative focused on serving the members, rather than

earning profits for outside investors or other objectives.

Related Practices

Certain business practices have developed that implement

and facilitate these basic principles. They further differentiate a

cooperative from other forms of doing business.

The Patronage Refund System

While cooperatives strive to return earnings to members, this

can’t be done on a transaction-by-transaction basis. Rather,

cooperatives usually charge market prices for supplies and

services furnished to members and competitive prices for

products delivered for further processing and marketing.

Normally, this allows them to generate sufficient income to cover

costs and meet continuing needs for operating capital.

After the fiscal year is over, a cooperative computes its

earnings on business conducted on a cooperative basis. Those

earnings are returned to the patrons--as cash and/or equity

allocations--on the basis of how much business each patron did

with the cooperative during the year. These distributions are

called patronage refunds.

For example, if a cooperative has earnings from business

conducted on a cooperative basis of $20,000 for the year, and Ms.

Jones does 2 percent of the business with the cooperative, she

receives a patronage refund of $400 ($20,000 x .02).
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.

Limited Return on Equity Capital

Members form a cooperative to get a service--source of

supplies, market for products or performance of specialized

functions--not a monetary return on capital investment.

Many cooperatives don’t pay any dividends on capital.

Others pay a modest return, in line with state and federal statutes

that bar substantial payments.

Limiting returns on equity supports the principle of

distributing benefits proportional to use. It also discourages

outsiders from trying to wrest control of a cooperative from its

members and operate it as a profit-generating concern for the

benefit of stockholders.

Cooperation Among Cooperatives

Many cooperatives, especially local associations, are too small

to gather the resources needed to provide all the services their

members want. By working with other cooperatives--through

federated cooperatives, joint ventures, marketing agencies in

common, and informal networks--they pool personnel and other

assets to provide such services and programs on a collaborative

basis at lower cost.

This permits members of local cooperatives to participate in

owning and managing fertilizer plants, food manufacturing

facilities, power plants, national financial institutions, wholesale

grocery and hardware distribution programs, and so forth.

Benefits flow back through the local cooperatives to the individual

members.

These principles and practices have survived and flourished

through 150 years of continuous evolution in the business world.

They remain the foundation that supports the distinctive

cooperative method of doing business.
Chapter 3. Cooperatives in the Community3

While cooperatives are often most closely identified with

agriculture, they are found working effectively to meet people’s

needs in all sectors of American life. The National Cooperative

Business Association reports that in the United States a network

of 47,000 cooperatives directly serve 100 million people -- nearly

40 percent of the population. Here are some examples and facts

and figures about cooperatives in your community.

Financial Cooperatives

The largest single segment of the cooperative industry is

credit unions. The roughly 12,600 credit unions in the United

States have more than $280 billion is assets and almost 65 million

members. Building on their base of member savings and

consumer loans and home mortgages, credit unions now offer

additional services to their members including credit cards,

automated teller machines, tax-deferred retirement accounts and

certificates of deposit.

Created in 1916, the cooperative Farm Credit System is the

nation’s oldest and largest financial cooperative. It provides real

estate loans, operating loans, home mortgage loans, crop

insurance and various other financial services to more than

500,000 farmer, small-town resident and cooperative borrowers.

Annually it loans more than $50 billion to its members, 25 percent

of all money loaned to U.S. agriculture.

One element of the Farm Credit System is CoBank, ACB and

the St. Paul Bank for Cooperatives. They provide about 80

percent of the money farmer cooperatives borrow each year.

They have about $11 billion in outstanding loans to farmer and

rural utility cooperatives and water and waste disposal systems.

CoBank has become an important financier of exports of U.S. farm

products as it broadens its role of making credit available to

enhance farm and rural income.

Since 1969, the National Rural Utilities Cooperative Finance

Corporation (CFC) has been a valuable source of financing for

rural electric and telephone cooperatives. With $5.7 billion in

assets and almost $13 billion in loan commitments, CFC

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supplements funding provided by USDA’s Rural Utilities Service

and provides business services to its borrowers.

In a short period of time, the National Cooperative Bank

(NCB) has become an important financial institution for America’s

housing, business and consumer cooperatives. Chartered by

Congress in 1978 and private since 1982, NCB has originated

more than $2.4 billion in loans to nearly 1,000 cooperatives

throughout the country. NCB has become a leader in providing

development funding for new, non-agricultural cooperatives and

in devising methods of attracting outside capital to leverage its

investments.

Consumer Service Cooperatives

America has about 1 million units of cooperative housing,

nearly 600,000 of them in New York City. New units are being

developed in many other areas including senior citizen

communities, trailer parks, low-income complexes, and student

housing near college campuses.

Millions of Americans receive basic medical care through

cooperatively organized health care providers. Health maintenance organizations (HMO’s) serve more than 1 million people

coast-to-coast and will likely be an increasingly important part of

the health care system in the years ahead. In several major citiesSeattle, Minneapolis, Memphis, Sacramento, Salt Lake City and

Detroit--companies have formed cooperative health alliances to

purchase health care for their employees.

Child care cooperatives are meeting the needs of families

where the parent(s) are employed and want affordable,

supportive care for their young children while working. These

centers can be organized by parents on their own, by a single

employer, or by a consortium of businesses providing a single

center for the group. More than 50,000 families use cooperative

day care centers daily.

Business Cooperatives

More than 15,000 independent grocery stores rely on

cooperative grocery wholesalers for identity, brand names, and

buying power they need to compete with the chains and the

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discounters. Members also receive training and financing.

Several cooperative grocery wholesalers are multi-billion dollar

firms rivaling the largest farmer cooperatives in sales and assets.

Restaurant supply purchasing cooperatives save money and

provide quality products for franchisees of such noted fast-food

chains as KFC (Kentucky Fried Chicken), Dunkin’ Donuts, Arby’s,

Taco Bell, Burger King, Popeye’s and Church’s. Besides their

bottom line impact, purchasing cooperatives also offer another,

less tangible benefit; they help to build trust among franchisers

and franchisees, particularly on pricing issues.

Cooperatively owned hardware wholesalers supply virtually

all of the independent hardware stores in the United States. As

huge warehouse chains spread across the nation, the independents are relying more and more on Cotter and Company (True

Value), Ace Hardware and other cooperatives for products,

promotions and education to remain viable businesses.

Cooperatives are leaders in other major industries including

outdoor goods and services (Recreational Equipment Inc.),

lodging (Best Western), carpeting (Carpet One), insurance, natural

foods, hospital and pharmacy supply, and collegiate bookstores.

Farmer Cooperatives4

In the agricultural sector, USDA’s Cooperative Services’

survey of farmer cooperatives for calendar year 1995 reported

4,006 cooperatives in operation. Of these associations, 2,074

primarily marketed farm products; 1,458 handled primarily farm

production supplies; and 474 provided services related to

marketing or purchasing activities.

Marketing cooperatives handle, process and sell cotton, dairy

products, fruits and vegetables, grains and oilseeds, livestock and

poultry, nuts, rice, sugar and other agricultural commodities.

Farm supply cooperatives provide farm chemicals, feed, fertilizer,

petroleum products, seed and other input items to producers.

Farm service cooperatives operate cotton gins, provide trucking

and artificial insemination services and store and dry products.

In 1995, farmer cooperatives had more than 3.7 million

members (many farmers belong to more than one cooperative)

and a total gross business volume of $112.2 billion. Total net

earnings (considering losses) were $2.36 billion. Combined assets

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of the group totaled $40.3 billion and liabilities were $23.6 billion,

leaving member equity of $16.7 billion.

Another important cooperative activity in rural areas is

furnishing electric power. Nearly 1,000 rural electric cooperatives

operate more than half of the electrical lines in America,

providing electricity to more than 25 million people in 46 States.

Sixty of these are called generation and transmission cooperatives

(G&Ts) because they generate and transmit electricity to meet the

power needs of the other cooperatives that distribute electricity to

the people.

Telecommunications services to rural areas are also provided

by cooperatives. Telephone cooperatives serve 1.2 million people

in 31 States. The National Rural Telecommunications Cooperative, owned by almost 800 rural electric and telephone systems,

makes satellite television available to rural areas not served by

cable companies. Cooperatives may be the on-ramp for rural

residents wishing to travel the information highway.

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Chapter 4. Benefits of Cooperation5

People buy stock in a non-cooperative business to make

money on their investment. The more of the company you own,

the more benefits (stock appreciation and dividends) you will

realize if the business succeeds.

The benefits of being a cooperative member differ in two

ways. First, the advantages are more numerous. Second, they are

distributed on the basis of how much use you make of the

cooperative, rather than your equity stake. Here are some

benefits of cooperative membership and how they relate to use.

1. Access to quality supplies and services at reasonable

cost. By banding together and purchasing business supplies and

services as a group, individuals offset the market power

advantage of firms providing those supplies. You can gain access

to volume discounts and negotiate from a position of greater

strength for better delivery terms, credit terms, and other

arrangements. Suppliers will be more willing to discuss

customizing products and services to meet your specifications if

the purchasing group provides them sufficient volume to justify

the extra time and expense.

The larger the group purchasing supplies and services

through the cooperative, the greater the potential for savings.

And the more each individual member uses the supply operation,

the more he or she may save over doing business elsewhere.

Another option for cooperative members is to manufacture

their own supplies and hire experts directly to provide essential

services. This gives members even more reliable sources of

supply and greater control over the types of products available,

the cost, and the quality of the services received.

2. Increased clout in the marketplace. Marketing on a cooperative basis, like purchasing supplies and services, permits

members to combine their strength while maintaining their status

as independent business people. They can lower distribution

costs, conduct joint product promotion, and develop the ability to

deliver their products in the amounts and types that will attract

better offers from purchasers.

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A special Federal law, the Capper-Volstead Act, provides a

limited exemption from antitrust liability for marketing

agricultural products on a cooperative basis. Under this law,

farmers can agree on the prices they will accept for their products

and other terms of sale.

Through cooperative marketing, members can share

information and negotiate with buyers from a position of greater

strength and security. They can also develop processing facilities

by themselves or as part of a joint venture with other cooperative

or non-cooperative firms.

A cooperative can also serve as a vehicle for people selling

goods and services to work with their customers to promote

industry research, reduce regulatory burdens, and develop

markets for their products. The cooperative can help create a

“win-win” situation for the entire industry, a business environment where both producers and buyers have more income.

3. Share in the earnings. Some people talk about noncooperative firms operating “for profit” while cooperatives

operate “at cost.” This isn’t totally accurate. Most cooperatives

generate earnings. They differ from non-cooperative firms in how

they allocate and distribute their earnings.

A non-cooperative firm retains its earnings for its own

account, or perhaps pays part of them out to shareholders as

dividends, based on the amount of stock each investor owns. In

a cooperative, earnings are usually allocated among the members

on the basis of the amount of business each did with the

cooperative during the year. Remember the example of a

cooperative that has net earnings of $20,000 during the year and

conducts 2 percent of its business with Ms. Jones. She is allocated

$400 of those earnings ($20,000 x .02).

Typically, Ms. Jones would receive her allocation, called a

patronage refund, partly in cash and the remainder as an addition

to her equity account in the cooperative. Permitting their

cooperative to accumulate retained patronage refunds is a relatively easy and painless way for members to help finance

activities and growth. Also, if certain rules in the Internal

Revenue Code are followed, the cooperative may deduct both the

cash payouts and the retained patronage refunds from its taxable

income. This makes cooperative earnings particularly valuable.

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4. Political action. Growers, small business owners, and

other rural residents have to realize that no one gives you a

favorable law or regulatory ruling just because you think you

deserve it. You have to build your case and argue your point

convincingly.

A cooperative gives people a means to organize for effective

political action. They can meet to develop priorities and

strategies. They can send representatives to meet with legislators

and regulators. These persons will have more influence because

they will be speaking for many, not just for themselves.

They can also form coalitions with other groups having

similar views on issues. The larger the voice calling for a specific

action, the more likely that the system will respond with the

policy you desire.

5. Local economy enhanced and protected. Having its

businesses owned and controlled on a cooperative basis helps

your entire community. Cooperatives generate jobs and salaries

for local residents. They pay taxes that help finance schools,

hospitals, and other community services,

When a business is a cooperative, your town is less likely to

lose those jobs and taxes. A business owned by one person, or a

subsidiary of a big company, can easily be moved to another

community. When many local people share the ownership of a

cooperative, no individual or company can take it from your area

or simply close it. Only the membership as a whole can make

such decisions.

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Chapter 5. Business Organizations’

In the United States, historically there are three basic

categories of private business firms-individually owned, partnerships and corporations. Cooperatives are a type of corporation.

Recently, most States have approved a new business structure,

the limited liability company. This section explains the similarities and differences between cooperatives and the other

business forms.

Individually Owned Businesses

The individually owned business is the oldest and most common form. One person owns, controls and conducts the business.

Characteristics of individually owned businesses include:

Control. The owner is responsible for management, makes

all the major operational decisions and sets the business

policies.

Capital. The owner supplies the equity and is responsible for

all debts.

Earnings. Profits belong to the owner.

Taxes. Profits are taxed once, as income of the owner.

Life. The life of the individually owned business is tied to

the one owner. It continues until the owner sells the

business, retires or dies. At that point the business is either

taken over by a new owner or discontinued.

Many farms are operated as individually owned businesses.

Other examples of business commonly operated by an individual

owner include service stations, hardware stores, restaurants,

flower shops and dry cleaners.

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Partnerships

Partnerships consist of two or more people who jointly own,

control and operate a business. The responsibilities of each are

usually based on a partnership agreement. Characteristics of

partnerships include:

Control. Partners usually share management and make

policy decisions by mutual agreement or majority vote.

Some agreements provide for senior partners whose votes

may carry greater degrees of weight.

Capital. Partners provide the equity capital. Usually, each

partner is personally liable, up to the value of all the property

he or she owns (both within and outside the partnership), for

the debts of the partnership. Some partnerships have

“limited” partners, who relinquish any voice in managing the

business in exchange for a limit on their personal liability.

Earnings. Profits (or losses) are shared by the partners in

accordance with the terms of the partnership agreement.

This is usually determined by the amount of capital invested

and the nature of the work performed by each partner.

Taxes. Earnings are taxed once, as income of the partners.

Life. The life of the partnership as a business is deter-mined

by the partners, but if one dies or leaves the organization, it

often must be dissolved and a new partnership formed.

Some farms are owned and operated on a partnership basis.

Other examples include law and accounting firms, insurance and

real estate companies. Partnerships may operate an auto repair

firm, store and any other business.

General Business Corporations

Most businesses that have more than a small number of

owners are organized as corporations. Corporations are legal

entities, authorized by law to act much like an individual person.

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A corporation has the right to provide services, own property,

borrow money, enter into contracts and is liable for its own debts.

A general business corporation operates as a profit-making

enterprise for its investors, who are also referred to as stockholders. Most of the major companies in America operate as

general business corporations. Their characteristics include:

Examples of investor-oriented corporations are large

department stores, chain grocery stores, regional banks,

automobile manufacturers and much of the communications

industry.

Control. Management is controlled by a board of directors

and officers who are elected by the stockholders. Each

stockholder usually has as many votes as the number of

shares of voting stock he/she owns. Business decisions and

policy are made by the board and officers. The directors

have no obligation to use the firm’s products or services and

may have no contact with the firm outside of board meetings.

Capital. Equity is raised by selling shares of stock to

investors for their profit-making potential. The corporation

is responsible for its own debts. If the business fails, each

owner of stock can lose only the amount invested.

Earnings. Profits are distributed to stockholders as

dividends according to the number of shares of stock owned

or used to expand the business. The timing and amount of

such dividend distributions are decided by the board of

directors.

Taxes. Earnings are taxed twice, as income of the

corporation when earned and as income of the stockholders

when distributed as dividends.

Life. A corporation enjoys a continuing existence, regardless

of changes that may occur in the ranks of its shareholder

owners.

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Limited Liability Company

A new form of business gaining widespread attention is the

limited liability company (LLC). It combines the single-tax

treatment of a partnership and the limited personal liability of

owners of a corporation. Characteristics of an LLC include:

The LLC is still developing as a business structure. It is

already proving a useful vehicle for organizing joint ventures

among established corporations, including those involving

cooperative and noncooperative firms. Whether it can be used to

organize a number of individuals, who may want the flexibility to

join and leave the venture at will, is undetermined at this time.

Cooperative

A cooperative is also a state-chartered business, organized

and operating as a corporation under applicable state laws.

18

Control. The owners, called members as in a cooperative,

may share management and make policy decisions by

mutual agreement or majority vote, or turn the management

over to nonmembers. The operating agreement among the

members determines voting rights of each member.

Capital. Members usually provide the equity capital.

Liability of the members is usually limited to their

investment in the corporation.

Earnings. Profits (or losses) are shared by the members in

accordance with the terms of the operating agreement. This

is usually based on the amount of capital invested and the

nature of the work performed by each member.

Taxes. The Treasury Department assumes an LLC wants to

be taxed as a partnership. However, an LLC has the option

to elect to be taxed as a general business corporation.

Life. An LLC may have a perpetual existence, or the

members may chose to be governed by the partnership rules.
Cooperative attributes are:

Control. Management is controlled by a board of directors

who are elected by the members. One unique feature of a

cooperative is that each member usually has only one vote in

selecting directors, regardless of the amount of equity that

member has in the cooperative. Another is that all or most of

the directors must be members of the cooperative. Thus, the

leaders are regular users of the firm’s products or services.

Capital. Equity comes from the members, rather than

outside investors. It is obtained by direct contributions

through membership fees or sale of stock, by agreement with

members to withhold a portion of net income based on

patronage, or through retention of a portion of sales proceeds

for each unit of product marketed. If a cooperative fails, the

liability of each member is limited to the amount he/she has

invested.

Earnings. Earnings (or losses) on business conducted on a

cooperative basis, often called margins, are allocated to the

members on the basis of the use they made of the cooperative

during the year, not on the basis of equity held. The allocations may be distributed in cash or retained as additional

equity. Members usually receive a combination of cash and

an allocation of equity.

Taxes. Earnings from business with members are taxed once,

either as income of the corporation when earned or as income

of the members when allocated to them.

Life. A cooperative usually has a perpetual existence.

Members can routinely join or resign without disrupting

ongoing operations.

Examples of businesses that operate as cooperatives include

agricultural marketing, purchasing and service organizations;

credit unions; health care providers and multi-unit housing

facilities.

19
Chapter 6. Classifying Cooperatives by Structure

Cooperatives are regularly described by a number of classification schemes. The more important ways to categorize are by

the geographical territory served, the governance system and the

functions they perform.

Geographic Territory Served

One factor determining cooperative structure is the size of the

area served. Cooperatives are loosely categorized as local, super

local, regional, national and international.

Local cooperatives operate in a relatively small geographic

area, typically a single county or an area within a radius of 10 to

30 miles. They usually have only one or two facilities, from which

to serve members.

Super local cooperatives operate in two or more counties,

often with several branch facilities.

Regional cooperatives serve an area comprising numerous

counties, an entire State or a number of States.

National cooperatives serve a major portion or most of the

United States.

International cooperatives operate in more than one country,

with headquarters in the United States or another country.

Governance System

Cooperatives can also be classified based on membership

structure, as centralized, federated or mixed.

Centralized cooperatives have individuals and business

entities (including partnerships and family corporations) as

members. Virtually all locals and super locals are centralized.

20
Regional, national, and international cooperatives may also be

centralized.

A centralized cooperative has one central office, one board of

directors elected by its members, and a manager (chief executive

officer) who supervises all operations. Business may be

conducted through numerous branch stores or offices staffed by

employees responsible to the central management team.

Federated cooperatives have other cooperatives as their

members. Each member of a federated is a separate cooperative

that owns a membership share entitling it to voting rights in the

affairs of the federated. Local cooperatives commonly form

federateds to perform activities too complex and expensive for

them to do individually, such as manufacturing production

supplies, tapping major financial markets, and marketing on a

national or worldwide scale.

Each member of a federated typically has its own board of

directors, manager, employees and facilities to serve its members.

The federated has its own hired management and staff and a

board of directors elected by and representing its member

cooperatives.

Mixed cooperatives have both individuals and other

cooperatives as members, who are usually given voting rights

representative of their own membership.

Functions Performed

Cooperatives may perform one or more of three core

functions: marketing products, purchasing supplies and

providing services.

Marketing cooperatives assist members maximize the return

they receive for goods they produce. Most cooperative marketing

activity involves either agricultural products or those of producers in related industries such as forestry, aquaculture and

horticulture. New marketing ventures are developing in such

diverse industries as handicrafts, professional services and

information technology.

21
Some marketing cooperatives limit their activity to negotiating prices and terms of sale with buyers. Growers of fruits and

vegetables for processing and dairy farmers are primary users of

these cooperatives, called bargaining associations.

Other marketing associations assemble member production

into large quantities for sale to further processors, wholesalers or

retailers. This first-handler role is common for cooperatives of

grain growers and producers of fruits and vegetables for the fresh

produce market.

Other such associations add further value to member

production by processing or manufacturing member products

into other, more valuable products. These may serve as

ingredients in further processed products or be sold to

institutional buyers and restaurants for their direct use, to grocery

chains for resale as private label products, or to brand-name

companies for resale under their brand. Cooperatives that

process dairy products, fruits, vegetables, grains, fish, and lumber

exemplify these value-added processing activities.

Still others put member products right on the grocery store

shelf under their own brand name. Land O’Lakes, Sunkist, Ocean

Spray, Welch, Tree Top and Knouse Foods are examples of

cooperatives with established brands.

Marketing cooperatives enable members to extend control of

their products--and realize additional margins--through processing, distribution and sale.

Purchasing cooperatives were first used by farmers to gain

access to affordable, quality production supplies such as feed,

fuel, fertilizer and seed. These early efforts often became

businesses having full-time managers and warehouses to handle

other production supplies and services such as farm chemicals,

animal health products, fencing, building supplies, construction

contracting, automotive accessories, etc.

Many local purchasing cooperatives have affiliated with

other such organizations, often through regional and national

federated cooperatives. These efforts reduce member costs and

strengthen their purchasing power through direct ownership of

large-scale facilities such as petroleum refineries; phosphate,

potash, and nitrogen manufacturing plants; feed mills; research

facilities and laboratories.

22
Today many nonfarm businesses have developed supply

purchasing cooperatives to gain access to the same volume

discounts and quality control assurances long available to

farmers. These include hardware stores, independent grocery

stores and fast food restaurant franchisees. Many have developed

private labels, such as Shurfine Foods, or recognized brand names

such as Ace Hardware, True Value and Servistar.

Service cooperatives were also developed to serve farmers.

Some of these services are farm-specific, such as recommending

and applying fertilizer, lime, or pesticides; animal feed processing; and crop harvesting. Others are general in nature, such

as credit through the Farm Credit System, electricity through

rural electric cooperatives and communications service through

rural telephone cooperatives.

Nonagricultural service cooperatives are also flourishing.

Credit unions and the National Cooperative Bank provide credit

on a cooperative basis to nonfarm individuals and cooperatives.

School systems, health care providers, and insurance buyers are

among the general public segments making use of service

cooperatives.

23
Chapter 7. People’

Because a cooperative is owned and controlled by the people

who use its services, the various persons affiliated with a

cooperative must work even more closely together than in a

noncooperative firm. Customer service and satisfaction are the

driving forces behind a cooperative, not maximizing bottom-line

return to investors. These take on a highly personal tone when

the owners and directors, in their role as users, have regular

contact with management and staff.

Cooperatives depend on a coordinated team consisting of

four elements - members-owners, board of directors, the manager

and other responsible employees. Each part of the team has its

own distinctive duties. Success is based on intelligent and active

cooperation and each group carrying its load.

Members

Members are the foundation of the cooperative. They organized it. Their needs are the reason for its existence. Their

support, through patronage and capital investment, keeps it

economically healthy. And their changing requirements shape

the cooperative’s future.

Statutory law and the basic legal documents of a cooperative

--articles of incorporation, bylaws, and contracts between the

cooperative and its members--give the members the tools to

control the cooperative and the duty to use those tools for their

mutual benefit. Legal rights and responsibilities of cooperative

members normally include:

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To adopt and amend the articles of incorporation and

bylaws.

To elect and, if necessary, remove directors.

To decide whether to dissolve, merge or consolidate the

cooperative or form a joint venture with other cooperative or

noncooperative firms.
l To make sure officers, directors and other agents comply

with laws applicable to the cooperative and with its articles

of incorporation, bylaws and membership contracts.

Members also have general responsibilities toward their

cooperative. Unlike the passive investor in a general business

corporation, the member-owner-user of a cooperative must

patronize and guide the venture for it to succeed. Employees and

advisers need to understand these member obligations and help

members fulfill them.

1. Patronize the cooperative. Members must make a conscious decision to be committed to the cooperative, even when

short-term prices or services may be better elsewhere. If members

don’t want to use the cooperative, the need for it must be

reexamined.

2. Be informed about the cooperative. To carry out their

other duties, members must know what the cooperative is about;

what it can do for them; its purpose, objectives, policies; and the

issues it faces. They can obtain information through annual

meetings, reports and newsletters, and from talking to the

manager, staff, directors and other members. To effectively

exercise their right of ownership, a member needs a good

understanding of the present situation and projected future

operations.

3. Be conscientious when selecting and evaluating directors. Although the cooperative is a user-owner, democratically

controlled form of business, members can’t make all the decisions

directly. They select from among their peers individuals with the

best judgment and business management skills to represent them

in management affairs as the cooperative’s board of directors.

Loyalty, integrity, the ability to make wise business decisions and

willingness to serve are necessary characteristics for board

members.

4. Provide necessary capital. Members must provide the

equity financing their cooperative needs for acquiring inventory,

facilities, services and working capital. This is done initially

25
through the purchase of stock or a membership. It continues by

permitting the cooperative to retain a portion of the earnings

allocated to each member and through the collection of per-unit

retains from checks to members for the proceeds of sale from

marketing member products.

If the cooperative loses money, members have the same

obligation to share those losses as they do the earnings.

5. Evaluate performance of the cooperative. Members

should examine the annual report and observe whether the

cooperative is meeting their needs. If they are dissatisfied with

cooperative performance, they should share their concerns with

the directors. They should also express support for things the

cooperative is doing well. Directors can’t effectively represent the

members if they don’t know the members’ true feelings.

Directors

Directors in a cooperative occupy a key position between

members and hired management. They are both users of its services and representatives of other members who depend on those

same services.

Acting as a group, directors set the objectives for the cooperative and make decisions that set the course the cooperative will

follow in achieving those objectives. These broad managerial

decisions include:

Hire a competent manager, determine the salary, outline the

duties and authority of the position and formally review

his/her performance at least annually.

Adopt broad, general policies to guide the manager. Topics

covered might include credit limits to patrons, expenditures

that need prior board approval and general personnel

regulations.

Develop and adopt long-range business strategies.

26
l Require written monthly financial reports and operating

statements for board meetings to be informed of adverse as

well as favorable operations.

l Direct the manager to prepare, before the close of each year,

an operating budget for the next fiscal year for board

approval. This budget should estimate the volume of sales

and gross income of various items to be handled, the

expenses by account classifications and the net income

expected. This constitutes necessary forward planning by the

board and management. The budget should be reviewed at

intervals throughout the year to determine the trends of the

business.

l Employ a qualified auditor to make an independent audit at

least once each year to determine the accuracy of the financial

records. An audit is the primary method the board uses to

verify the financial condition of the cooperative. Many

successful cooperatives also use the audit report to evaluate

the effectiveness of the policies and budget, performance of

the manager and gain insight into the effect of past decisions

and the need for new ones.

l With the aid of the manager, plan and conduct the annual

meeting to keep the membership informed about the status

of their business, including operations, finances and policies.

l Determine the patronage refund allocation and per-unit

retain level. Factors to consider include legal requirements,

member needs and desires for cash refunds, the desirability

of providing money to retire old equities, and current and

future capital needs.

l Assure competent legal counsel is available.

l Keep a complete record of the board’s actions.

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A cooperative director should not expect to receive special

favors from the manager or employees, and a director does not:

l Act independently on matters that should be decided by the

entire board. Individual directors have no authority outside

of board meetings.

l Represent special interests, factions or political entities.

Directors are elected to oversee the business activities of the

cooperative, not serve as an agent of these groups.

In carrying out their responsibilities, directors serve much

like trustees, charged with a legal obligation to protect the assets

of the members. Directors who act outside the parameters of the

law or don’t exercise due care in their decisionmaking can be

personally liable for the harm they cause the members, the

cooperative or third parties.

Officers

The board usually elects the cooperative’s officers shortly

after the annual membership meeting. Each officer has specific

duties as detailed in the cooperative’s bylaws.

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The president presides at all meetings and watches over the

association’s affairs, serving as the main communication link

between hired management and the other directors and

members.

The vice president, in the absence or disability of the

president, performs the duties of the president.

The secretary keeps a complete record of all meetings of the

board of directors and general membership and also is the

official custodian of the cooperative’s seal, bylaws, and

membership records.

The treasurer oversees the bookkeeping and accounts to

ensure accuracy and proper handling and also is responsible

for presenting periodic financial reports.
Board Committees

The board’s work may be divided among special or permanent committees, each dealing with a phase of the association’s

operations, such as finance, purchasing, merchandising, and

others.

Each committee studies the problems in its particular field

and makes recommendations to the board of directors. In some

instances, committees may be given certain powers to act for the

board, subject to review by the entire board.

Large associations may select an executive committee to

perform general management and oversight duties as authorized

by the board.

Managers

Success of a cooperative largely depends on good board/

manager relationships. The working relationship between board

and general manager requires respect and an understanding of

each other’s responsibilities.

The board of directors decides what the cooperative will do;

the general manager and immediate staff decide how it can best

be done--subject to board review--so as to achieve the basic

objective of serving members effectively.

The manager is selected by the board and accountable to it

for his/her actions. The manager should therefore not be a part

of the board. The manager should, however, attend all board

meetings and be an active, nonvoting participant.

The manager controls the ongoing activity of the cooperative.

Responsibilities of the general manager include:

Supervise and coordinate, under board direction, the

business activities of the co-op by managing the people,

capital, and physical resources.

Hire, train, supervise, and set compensation for employees.

The manager also needs to review their performance and

train, reassign, or replace those employees not meeting

acceptable performance levels.

29
Oversee the detailed operations of the cooperative, within

policies established by the board of directors, such as

purchasing inventory and selling commodities, maintaining

the general appearance of the co-op, and making sure

employees respond to member needs.

Maintain, and revise as necessary, an adequate bookkeeping

and accounting system; develop for board approval a

financial budget annually; prepare proper financial reports

regularly for board review; and present a report of the

cooperative’s operational highlights to the membership at the

annual meeting.

Furnish information needed for long-range planning. This

will bring matters, such as fixed asset additions or revisions,

to the board’s attention for review.

Represent the cooperative and portray a positive image to

members and others in the community.

Encourage membership and active patronage.

Communicate developments at the cooperative to members.

Keep current on local, State, and Federal legislative and

regulatory developments affecting cooperatives.

Employees

In many ways, working for a cooperative is similar to doing

the same job at a noncooperative firm. But special features of a

cooperative-the role of the member-owner as user and the

emphasis on service over bottom-line numbers-place unique obligations on the employees.

1. Understand the purpose and objectives of the cooperative. Employees need to know how cooperatives are different

from other methods of doing business. By understanding cooperative purposes, objectives, operations and their role as employees,

30
they can help improve member relations, the cooperative’s image

and the general public’s understanding of cooperatives.

2. Fully perform duties. In many cooperatives, like other

business firms, the largest operating expense is for personnel.

While the cooperative has responsibility for recruiting and

providing training, the employee is responsible for using these

opportunities to provide the best possible service to members.

3. Understand the relationship to member-owners. All

employees have a responsibility to maintain a high level of

customer satisfaction and good relations between the cooperative

organization and its member-users. Immediate feedback from

members should be encouraged to keep the manager informed of

problems, needs and customer satisfaction.

The employee role is particularly important in larger

cooperatives. The only cooperative employees that members may

encounter regularly, from annual meeting to annual meeting, may

be the individual pumping the gas, the cashier, the person

answering the telephone, the truck driver picking up their milk or

delivering a product. To the average member, they are the voice

of the cooperative.

4. Favorably represent the cooperative. Employees help

build the cooperative’s image as they serve members and the

community--both on and off the cooperative’s premises. Employees should keep the premises clean and attractive; make sure

equipment and service tools are operating; serve members

pleasantly, promptly, and in the order promised and take an extra

step to give members satisfactory service.

Employees, like their manager, can be community boosters

by taking part in religious, school or community affairs. Their

efforts can positively affect the cooperative image held by

members, the general public and other businesses.

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Chapter 8. Sources of Equitp

One of the greatest challenges facing cooperatives is raising

equity capital. Because cooperatives pass earnings through to

users on a patronage basis, they cannot attract equity from

outside sources to the same extent as investor-owned businesses.

Cooperatives are not alone. Sole proprietorships, partnerships and closely held corporations face similar problems

acquiring equity. Their equity capital usually is provided by the

owners or acquired via retained earnings.

Only a single tax is placed on their income, to help overcome

the capital accumulation problem. Earnings of investor-owned

corporations are subject to taxation twice, once at the corporate

level when earned and again at the ownership level if and when

distributed as dividends. Owner(s) of a sole proprietorship,

partnership, limited liability company or cooperative can

generally reduce tax liability at the firm level if they meet specific

Internal Revenue Code (Code) requirements. A greater portion

of income is therefore available for reinvestment in the business.

The three primary ways members provide equity to their

cooperative are direct investment, retained margins, and per-unit

capital retains. Cooperatives may also acquire equity by retaining

earnings on nonmember, nonpatronage business. This section

explains the nature of each source of equity.

Direct Investment

Direct investment refers to cash purchases of membership

certificates, common and preferred stock or other forms of equity.

Most cooperatives require a member to make a direct

payment when joining the cooperative. In return, the member

receives a membership certificate in a nonstock cooperative or a

share of common stock in a stock cooperative. The certificate or

share of stock usually conveys to the owner the right to vote on

matters submitted for decision to the cooperative membership

and the owner is generally referred to as a member of the

cooperative.

Direct investment by members is often a minor source of

equity to a cooperative. Most cooperatives are trying to retain

32
current members and attract more members and member

business. And members generally prefer the cooperative to

generate its own equity, rather than solicit checks from them.

Thus the cost of a membership certificate or share of common

stock is usually modest. Equity that evidences membership

usually does not pay a dividend, if for no other reason than the

administrative expense of issuing a large number of small checks.

Traditionally, direct investment can be a major source of

equity in two instances. Direct investment is often the primary

means for a new cooperative to acquire equity capital. Once the

cooperative is functioning, it then can accumulate additional

equity from operating funds in the form of retained earnings or

per-unit retains.

Some cooperatives also acquire equity by selling nonvoting

stock or equity certificates to members and nonmembers. This

nonvoting equity usually pays a limited dividend as an inducement for persons to invest in the cooperative.

A resurgence in cooperative value-added processing of

commodities is being fueled by a system of direct investment,

called transferable delivery rights. Members who wish to share

in the benefits from the value-added processing are required to

provide necessary up-front capital by purchasing long-term

delivery rights in the cooperative. These delivery rights entitle

and obligate the member to deliver to the cooperative all of the

production from specified acreage or specific quantities of

product (so many tons or bushels). The purchase of delivery

rights assures members of a long-term “home” for their

production and provides an opportunity to share in the benefits

of value-added processing based on their patronage.

Membership is generally limited to producers who purchase

delivery rights and the cooperative only sells enough delivery

rights to secure the quantity of product it can process efficiently

and resell at a profit. The delivery rights are typically represented

by non-dividend bearing, non-voting preferred stock. The

preferred stock (and thus the right to deliver product to the

cooperative) are transferable by the member to other producers,

subject to approval by the cooperative’s board of directors. If the

cooperative is successful, the only way other producers can

participate is to purchase delivery rights from current members.

33
Thus, members may enjoy an additional benefit, a gain on the sale

of their preferred stock tied to their delivery rights.

Generally, the tax treatment of direct investments in a

cooperative follows the same rules as a direct investment in an

investor-owned corporation. The payment to the cooperative is

a nontaxable event. While the value of cooperative equity is

usually constant, any gain or loss realized by the equity holder is

generally a capital gain or loss.

Cooperative earnings used to pay dividends on equity are

usually subject to taxation at both the cooperative and the

recipient levels. An exception is dividends paid by farmer

cooperatives that qualify for so-called “exempt” status under Code

section 521. These cooperatives are allowed to deduct dividends

paid on stock, so they are only taxed once, at the recipient level.

Retained Margins

While cooperatives are sometimes described as businesses

that operate “at cost,” few if any can do so on a day-to-day basis.

Rather, cooperatives seek to generate income that exceeds

expenses on an ongoing basis. Then, usually after the close of the

fiscal year, they return earnings from business conducted on a

cooperative basis to the persons responsible for the business

generating those earnings, who are called patrons.

These returns, based on the amount of business each patron

does with the cooperative during the year, are called “patronage

dividends” in the Code. This report refers to them as “patronage

refunds,” the term used in cooperative literature. This reduces the

likelihood such refunds will be confused with traditional dividends, which are based on stock ownership rather than the

amount of business conducted with the firm.

The board usually determines how the earnings will be

distributed. All of the earnings may be returned to the patrons as

cash patronage refunds. Or the directors may decide to have the

cooperative retain some or all of the patronage refunds as an

equity investment in the cooperative. Single tax treatment is

available only for patronage-sourced earnings that are returned

to the patrons as cash or “other property,” or retained under

procedures set out in the Code.

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Qualifying for the single tax treatment provided in the Code

is discretionary, not mandatory. Earnings not allocated to patrons

are treated just as profits of an investor-owned firm. They are

taxable income to the cooperative when earned and taxed a

second time to the recipients when distributed by the cooperative.

Per-Unit Capital Retains

Cooperatives that market products produced by their

members have a third means of acquiring equity capital, per-unit

capital retains. These are capital investments based on either the

number of physical units handled by the cooperative or on a

percentage of sales revenue. Per-unit retains are deducted from

sales proceeds due the members from the cooperative.

As with patronage refunds, per-unit capital retains returned

to patrons as cash or retained by the cooperative, under rules in

the Code, are only subjected to a single income tax.

And again, single tax treatment is discretionary. A cooperative may place some or all of these retains into an unallocated

reserve, thereby forfeiting access to single tax treatment.

People sometimes blur the distinction between patronage

refunds and per-unit capital retains. Patronage refunds are based

on the earnings of the cooperative; per-unit retains on the volume

or value of business done with the cooperative. Thus, a

cooperative can acquire capital, even in a year of limited margins

or a loss, through the use of per-unit capital retains.

Nonmember/Nonpatronage Earnings

Non-tax laws, such as the Capper-Volstead Act and state

cooperative incorporation statutes, frequently require affected

cooperatives to do a majority of their business with members.

This still leaves those associations free to do up to 49 percent of

their business with nonmembers on a noncooperative basis.

Earnings on this business are usually not eligible for single

tax treatment. But the after-tax earnings can be used to build the

equity base of the cooperative to improve its balance sheet and

finance services it provides to members. Again, an exception is

made for section 521 cooperatives, which may deduct

nonpatronage income distributed to patrons on a patronage basis.

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Chapter 9. Financial and Tax Planning

As the following flow chart illustrates, cooperatives have

flexibility in designing an equity accumulation program to meet

their individual needs. An understanding of the alternatives and

their tax treatment is especially important when allocating

patronage-based sources of equity, retained margins, and per-unit

retains.

SOURCES AND TYPES OF EQUITY

Sources of

Equity

Types of

Equity

36
Direct investments usually are made to purchase membership equity, the membership certificate or a share of common

voting stock.

Nonpatronage income is likewise usually placed into a single

type of account, an unallocated reserve.

Patronage-based sources of equity can be used for at least

four purposes: cash refunds, qualified retained patronage

allocations, nonqualified retained patronage allocations and

unallocated reserves.

Cash Refunds

Cooperatives can distribute their margins and per-unit capital retains as cash refunds to the patrons. Cash distributions are

generally tax deductible by the cooperative in the year earned and

taxable income to the recipient in the year of receipt. Cash

refunds do not add to the equity of the cooperative, but provide

an immediate additional return to the patron on his or her use of

the cooperative.

Qualified Retains

Cooperatives can retain margins and per-unit capital retains

and allocate the retained funds to equity accounts of the patrons,

based on the amount of business each patron did with the

cooperative during the year. If the cooperative follows the rules

in the Code to “qualify” the equity, the cooperative deducts the

amount of the allocations from its taxable income in the year the

margins and retains were realized.

Patrons include the amount allocated in their taxable income

in the year they receive a required written notice of the allocation.

The retained funds become an equity investment by the patron in

the cooperative. An example illustrates how this works for a

typical agricultural marketing cooperative.

The cooperative pays the producer $600 for his/her 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. Thus the patron receives a total payment of

31
$700 for the crop, a $600 advance at the time of delivery and a

$100 patronage refund.

When the cooperative figures its taxable income, it is allowed

to 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.

TAX TREATMENT OF COOPERATIVE AND PATRON

QUALIFIED RETAINED EQUITY

Coooerative Patron

Expenses Income

Crop

Other

$600

$300

Crop $600

Total $900

Income $1000

Margin $100 Refund $100

Taxable Income 0 Taxable Income $700

The Code requires at least 20 percent of a qualified patronage

refund be paid in cash. But the cooperative can still retain up to

80 percent of its margins without having to pay a tax (at the co-op

level) on any of the patronage refund. There is no 20-percent cash

distribution requirement for qualified per-unit retains, so a

cooperative can keep the entire amount free of tax liability at the

co-op level.

The patron must report the entire $100 refund as taxable

income, even though $20 or less may have been paid in cash.

The redemption of qualified equity is a tax-free event for both

the cooperative and the patron, since the tax was paid by the

member when the patronage refund was received.

38
The tax treatment of qualified retained equity is similar to the

pass-through procedures that provide single tax treatment for

partnerships and other single-tax corporations. But, cooperatives

have additional flexibility not generally available to other passthrough entities.

Nonqualified Retains

Cooperatives may delay the pass-through of the tax obligation from the cooperative to the patron without jeopardizing

single tax treatment of those moneys.

Any patronage-based allocation not meeting the requirements of the Code to be “qualified,” has “nonqualified” status.

When a nonqualified allocation is made, the cooperative pays

corporate income taxes on the funds retained. The patron has no

tax obligation on these funds in the year of allocation.

TAX TREATMENT OF COOPERATIVE AND PATRON

NONQUALIFIED RETAINED EQUITY

Coooerative Patron

Expenses Income

Crop

Other

$600

$300

Crop $600

Total $900

Income $1000

Margin $100 Refund $100

Taxable Income $100 Taxable Income $600

If the cooperative in the earlier example issues its patronage

refunds as nonqualified written notices of allocation, it would

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

39
patron’s taxable income would have been $600, the payment for

the crop.

At some later time, when nonqualzjied retained equity is

redeemed, the cooperative receives a tax benefit based on the tax

paid at the time of allocation. The patron is taxed on the funds

received. In the example, the cooperative would deduct the $100

paid to the patron (or receive a credit under certain circumstances). The patron would report the $100 as income in the year

the cash payment was 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.

Nonqualified allocations have particular appeal to

cooperatives with member-patrons in high marginal tax brackets.

If the cooperative uses qualified allocations, it must make

substantial cash payouts or high income patrons may suffer a

negative cash flow on the margins they generate. This occurs

when the total tax owed on the allocation (Federal and State)

exceeds the amount of cash paid out as part of the distribution.

By using nonqualified allocations, no tax is due from patrons

until the allocation is redeemed. Also, there is no 20-percent cash

payout rule for nonqualified allocations.

Unallocated Reserves

Cooperatives can treat margins just as noncooperative firms

treat earnings, by putting them into an unallocated reserve and

paying corporate income tax. Under this approach, single tax

treatment is forfeited. If the funds are later distributed, the

recipients must pay a second income tax.

Cooperatives are free to use a combination of cash payouts,

unallocated reserves, and qualified and nonqualified allocations.

This makes it possible for the leadership to develop a program

that reflects the best interests of the membership.

40
Chapter 10. Equity Management

Another practice unique to cooperatives is the regular

redemption of outstanding equity. Capital contributions from

continuing patrons build as time passes. But the level of

patronage will fall for some members, and others will likely cease

using the cooperative at all. A program of adjusting patronagebased equity requirements on a regular basis matches the

responsibility of financing the cooperative to current use of its

services.

Three methods of matching patronage and equity obligations

have achieved general acceptance: revolving fund plans, special

plans, and base capital plans. Although the systems are often

viewed as unrelated, they may, in fact, operate together.

Revolving Fund Plan

“Revolving fund financing” refers to systems in which

patrons make annual capital contributions, typically through

retained patronage refunds or per-unit retain allocations. The

cooperative, in turn, redeems earlier capital contributions on a

regular basis. Redemption is usually on a first-in, first-out basis.

The cooperative determines what its total capital requirements are

and the excess is redeemed each year, the earliest or “oldest”

equity being revolved out first.

A revolving fund plan is frequently described as “systematic”

if older equities are retired on a regular basis, usually a given

number of years after they were issued. In a systematic plan,

member investment is related to recent and current use. Newer

members usually add equity to their account during their early

years in the cooperative.

The accounts of established members are adjusted each year

to better reflect current patronage. They make new investments

based on current year’s patronage and have their earliest year’s

equity redeemed. The accounts of former members are

commonly paid off during the life of the revolving cycle, usually

beginning the year after they cease patronizing the cooperative.

Redemption is normally dependent on a board of directors

determination that funds for revolvement are available. This

41
insures that there is room for flexibility if the situation warrants

it. For instance, if there is a shortfall in new equity or a need to

increase the cooperative’s total equity, equity requirements can be

met by lengthening the revolving cycle (the cooperative keeps

equity for a longer period of time).

This tactic should be used sparingly, as it deviates from the

objective of having current users finance the cooperative. Also, it

can create member relations problems if the members have the

expectation that their oldest equities will be redeemed on a fixed

schedule, sometimes without regard for the cooperative’s

financial condition.

Special Plans

A special plan is one in which a specific event or condition,

such as a member’s death, triggers equity redemption. The most

common events covered are death, retirement or reaching a

specified age. Once the condition is verified, the member’s equity

may be returned at once or over a prescribed number of years.

Special plans are often popular with members, who see

redemption of their equity investments supplementing retirement

income or their estates. But special plans can complicate financial

planning for the cooperative. One problem is forecasting how

much equity will be redeemed in a given year.

Another difficulty is dealing fairly with members who are

partnerships or corporations and whose business activity or life

may continue well beyond that of individual partners or

shareholders. One approach is for the association to redeem that

portion of the member firm’s equity equal to the ownership

interest in the firm of the person meeting the special redemption

condition. Then the firm would be expected to make up the

difference just as if it had been underinvested by the amount of

the redemption.

Special plans are sometimes combined with revolving fund

or base capital plans.

42
Base Capital Plan

A “base capital plan” is a special equity capital management

plan. It focuses directly on the current proportion of capital a

patron should have in the cooperative at a particular time, based

on the degree of use. Development of the base capital plan

involves several steps.

1. The cooperative determines its total equity capital needs.

2. The equity capital needs are allocated among patrons

based on the proportion of the cooperative’s business each patron

did with the cooperative during a base period, typically the past

3 to 7 years.

3. Each year the cooperative’s equity requirements are reviewed and adjusted as the board of directors finds appropriate.

Each patron’s share of the equity requirement is also adjusted to

reflect (a) any change in the total requirement of the cooperative

and (b) any change in the patron’s proportional share in the new

base period.

4. Under invested patrons must add to their equity account,

usually through the current year’s retained patronage refunds or

per-unit retains, or by direct contribution.

5. Fully invested and overinvested patrons generally are

paid a cash rebate of current year’s patronage refunds and perunit retain allocations. Overinvested patrons may receive an

additional payment in redemption of their excess share of the

equity.

The proportional share of former patrons will fall each year,

reaching zero at the end of the base period beginning the first

year after they cease patronizing the cooperative.

43
Conclusion

Cooperation is a very old concept, with the potential for a

very bright future. That potential will only be realized if the

people with an interest in cooperatives make the effort to make

them work. Reading and studying this booklet, and others like it,

is an important first step. But that alone won’t make you an

expert. Learning about cooperatives can be a life-long process.

As the world changes, so must cooperatives if they want to

survive and prosper. Members, directors, managers, employees

and advisers must all seek out and take advantage of continuing

educ&onal opportunities.

44
ENDNOTES

1. This chapter is based primarily on chapters 1 and 2 of Farmers,

Cooperatives, and USDA: A Histo y of Agricultural Cooperative

Service, Agricultural Information Bulletin 621 (USDA 1991).

2. This explanation of cooperative principles and practices was

developed by the author for Welcome to Cooperatives, available

from the National Society of Accountants for Cooperatives,

Springfield, VA. Welcome to Cooperatives is particularly appropriate for educating accounting, financial and tax professionals

with limited knowledge of cooperatives.

3. Most of the material in this chapter is from A Day in the Life of

Cooperative America, a fascinating collection of facts and figures on

cooperatives, sponsored by the National Cooperative Bank,

Washington, DC.

4. The first 3 paragraphs of this section are based on Farmer

Cooperative Statistics, 2995, RBS Service Report 52 (USDA 1996).

5. This chapter was written originally for Do Yourselfa Favor: Join

a Cooperative, RBS Cooperative Information Report 54 (USDA

1996).

6. Much of this chapter was also prepared by the author for

Welcome to Cooperatives (see note 2, above).

7. This chapter reflects material originally published in Understanding Cooperatives, a series of circulars that can be used

individually or collectively for teaching people about

cooperatives. RBS Cooperative Information Report 45, sections

4-6 (USDA 1994).

8. Much of the last 3 chapters was first drafted for Income Tax

Treatment of Cooperatives: Background, RBS Cooperative Information Report 44, part 1 (USDA 1993), the first in a technical series

of reports on Federal income taxation of cooperatives.

45
U.S. Department of Agriculture

Rural Buslness_(=ooperative Service

stop 3250

Washington, DC. 2025@3250

Rural Business-Cooperative Service (RBS) provides research, management, and

d_tMi~M &ta~9 to ~&&s iO S!~~IKJUI~II the ea%dRic@ttonoffan-nefs

and 0ihsr rural residents. It works directly wfth cwperative leaders and Federal and

Stai9 KJWCi9S t0 b?pfOV9 OQaRiZSthl, kd933h@, 9Kt C$h?iaibfl 0: WtYpBathS ?Sld t0

give guidance to further development.

The coaperatire segment of RBS (1) helps farmers and other rural residents develcp

Wvp9raiivest0Obt9in.suppbS9rld~ ai lower cost and to get better prwass for

p&u&s they se& (2) advises raad rw on devef@q sxistirrg resorum through

maiive action iO enimmx rurat fiving: (3) hefps -atires improve serylce~ and

operaiing effickncy; (4) informs members, directors, empfoyees. and the pubk on TV

aqkrattfas work and bene6t theix members and !h&r crwuwMq and (5) ertawages

international cooperative programs. RBS also publishes research and educational

materials and issues Rural C~fafives magazine.

The United States Department of Agriculture (USDA) prohtbits discrimination in rts

prcupams on th9 basis o! race. a&r, il&onal origin, sex, retfgkn, age, &ab#ily, lmtikaf

betie!s and marltaf or !amilfaf s!atus. (Not all prohibited bases appty to a4 programs )

Ptisw5 with d&abMes who requke atternat%e means for romwnkat&~ of program

information (Braille, large print, audiotape, etc.) should contact USDA’s 1 ARGE I Center

at 202-72&2600 (votce and I DD).

To tile a complaint, wrife the Secretary of Agriculture. U.S. Uepartment of Agriculture,

Washington, DC. 20750. or call 1 800 245 6340 (voice) or (702) 720 1127 (1 DD).

USDA is an equal employment ~rtunity employer.