Innovative Uses of Non-Qualified Stock

Phil Kenkel Bill Ftizwater Cooperative Chair Sub-chapter T of the IRS tax code allows cooperatives which meet certain requirements to deduct retained patronage (stock) distributions. These are called qualified distributions and are the traditional stock distribution used by Oklahoma cooperatives. If the cooperative does not choose to deduct the stock patronage it is a non-qualified distribution which is deductible to the cooperative and taxable to the member in the year it is redeemed. The original argument for qualified distributions was that the corporate tax rate was much higher than the producer’s tax rate so we didn’t want to “park” the tax liability at the cooperative level for the period of time between issuing and redeeming the stock. If we were establishing cooperatives today we would likely use non-qualified distributions because the tax rate differential has shrunk.

At least one regional cooperative uses non-qualified stock in an innovative manner. CoBank uses a base capital plan where a cooperative’s equity is related to their use of the bank (loan volume). Under a base capital plan, equity does not revolve based age of stock but is rather returned when the member’s equity percentage exceeds their usage percentage. CoBank also has goals for permanent equity in their capital structure. As they increased permanent capital they made a decision to do so by issuing non- qualified stock rather than increase unallocated equity. The non-qualified stock is not involved in the base capital plan so it is not intended to revolve. Since it doesn’t revolve the tax implications are identical to retaining funds as unallocated reserves. The advantage of holding permanent capital as non-qualified is that it is linked to a member. If the cooperative (in this case CoBank) was dissolved there is clear ownership of the permanent capital. That is not true for unallocated reserves. Creating permanent capital as non-qualified stock also eliminates the incentives for members to dissolve the cooperative because their collective value (stock and unallocated reserves) far exceeds the value of their stock.

A local cooperative would face more issues in using non-qualified stock as permanent capital. Unlike cooperatives which have indefinite life, producers retire and eventually die. A local cooperative’s could redeem non-qualified under an estate-only plan but it would have all of the planning disadvantages of not systematically retiring the stock. Members might be less concerned about a longer redemption period for non-qualified since they had not pre-paid the tax. Non-qualified stock could serve as more permanent equity for a local cooperative, but not as true permanent capital. Still, semi-permanent non- qualified is one option to consider as we struggle to build and maintain strong balance sheets.

3-9-2012