Understanding Cooperatives: Income Tax Treatment of Cooperatives1 Cooperative Information Report 45, Section 8

vehicle registration fees, and excise taxes Benjamin Franklin, who among his on telephone, power, and other utility ser- other accomplishments helped vices. United States Also, no cooperative is exempt from Department of establish a successful insurance Federal income taxation and filing Federal Agriculture cooperative, wrote shortly before his income tax forms. Most states with a cor- Rural Development porate income tax generally follow the Fed- own demise, “Our Constitution is in eral rules. Rural Business actual operation; everything appears The relationship of cooperative income and Cooperative tax treatment to that of other business Service to promise that it will last; but in this forms is set out in table 1. Of the five com- world nothing is certain but death mon types of business structures in this January 1995 country, only investor-general corporations and taxes.” pay income tax at both the business and owner levels. And only 12 percent of Ameri- can businesses are investor-general corpo- Fortunately, the Constitution has endured, rations. but so have taxes. Taxes are a factor in the Most rules governing cooperative planning of every individual and business. income tax treatment are found in sub- Like other businesses, cooperatives pay chapter T of the Internal Revenue Code, taxes. This report is to help persons asso- sections 1381-1388. Subchapter T recog- ciated with cooperatives (1) understand nizes that the objective of business con- cooperative income tax treatment, (2) avoid ducted on a cooperative basis is not to fundamental mistakes that cost money and generate earnings for the cooperative, but may lead to an expensive and disruptive to increase the income of the members. audit or assessment by the Internal Rev- Thus, net margins on business with or for enue Service, and (3) use tax planning patrons are subject to Federal income tax options that may increase the benefits only once, at either the cooperative or the members receive from their cooperative. TABLE 1—Tax Treatment by Business Type Cooperatives Are Not Exempt from Business type Times Earnings Level 1 Taxation This report does not represent Taxed official policy of the U.S. Depart- Cooperatives usually pay all the special Proprietorship 1 Owner ment of Agriculture, the Internal Revenue Service, the U.S. De- taxes levied on businesses. These include Partnership 1 Owner partment of the Treasury, or any real and personal property taxes, sales Corporations: other government agency. This taxes, employment taxes (to fund social Investor-General 2 Corporation/Owner pulication is presented only to provide information to persons security, unemployment compensation, and S Corporation 1 Owner interested in the tax treatment of workers’ compensation benefits), gasoline cooperatives. Cooperative 1 Owner and diesel fuel taxes, license fees, motor % 1 user level, but not both. Only this patron- portion of a patronage refund is deductible age-sourced income is eligible for single by the cooperative in the year the margin tax treatment. With certain exceptions, being returned was earned. It is taxable income from nonpatronage sources is sub- income to the patron in the year received. ject to tax at the cooperative level when In the example, if Ms. Jones received her earned and at the recipient level when paid entire patronage refund in cash, the coop- out to members or others. erative would deduct the $100 from taxable This single tax treatment is not limited to income for the tax year in which the busi- farmer cooperatives. With certain excep- ness occurred that generated the $100 in tions, any business that chooses to “oper- margins. Ms. Jones would include the $100 ate on a cooperative basis” is eligible for in the taxable income of the year in which tax treatment under Subchapter T. she received the $100 refund.

Patronage Refunds Written Notices of Allocation Single tax treatment is accomplished by Members usually authorize their coopera- permitting a cooperative to deduct patron- tive to retain at least a portion of their age refunds distributed according to rules patronage refunds each year as additions in Subchapter T. A patronage refund is: to equity capital. u an amount paid by a cooperative to a To protect single tax status for retained patron, margins, the cooperative must, within u based on the quantity or value of busi- 81/2 months after the close of its tax year ness done with or for the patron, and send each patron a written statement u derived from the cooperative’s earnings reporting the amount of that patron’s from business done with or for all patrons, patronage refund for the year. This state- usually referred to as the cooperative’s ment is called a written notice of allocation. margins. For example, if 10 percent of a coopera- Qualified Notices tive’s business is with or for Ms. Jones, and Two optional tax treatments are available the cooperative has a total net margin for for patronage refunds distributed as written Patron the year of $1,000, then Ms. Jones receives notices of allocation. The type of written a patronage refund of $100 ($1,000 x 10%). notice of allocation used determines which tax treatment applies. Payment Options, If a cooperative meets the subchapter T Tax Treatment requirements to “qualify” its written notices A cooperative has three options when dis- of allocation, the notice is treated just like a tributing patronage refunds—cash, quali- cash patronage refund for tax purposes. fied written notices of allocation, and The cooperative deducts the amount allo- nonqualified written notices of allocation. cated from its taxable income in the year Tax treatment is one of the factors to con- earned, and the patron includes the entire sider in deciding which option(s) to use. amount in income in the year the notice is received. Cash The requirements to “qualify” a written A cooperative may pay out some or all of notice of allocation are: its margins to patrons in cash. The cash

2 u The written notice must be part of a Nonqualified Notices patronage refund package of which 20 per- A cooperative may elect not to meet all the cent or more is paid in cash, and requirements to qualify a written notice of u The patrons must have consented to allocation. For example, it might pay less include the face value of the notice in their than 20 percent of the patronage refund in taxable income. money or it might not have its patrons con- The patron “consent” requirement is sat- sent to include the face value of the notice isfied in one of three ways: in taxable income. u By being a member of a cooperative A written notice that for any reason does with a bylaw that clearly states membership not meet the requisites for qualified status is in the cooperative constitutes such con- called a “nonqualified written notice of allo- sent. The member must receive a copy of cation.” the bylaw and a written statement of its A cooperative that issues nonqualified purpose. written notices of allocation must include u By signing a written consent form before the face amount of such notices in its tax- the end of the taxable year in which the able income for the year the covered funds patronage occurs. are earned and pay tax on these funds at u By endorsing and cashing a “qualified regular corporate income tax rates. When check.” A qualified check is a specially pre- the cooperative pays out the money repre- pared bank check which, if endorsed and sented by the nonqualified notices to the cashed, establishes patron consent to patrons (i.e., redeems them), the coopera- include the entire refund in taxable income. tive can recover the tax paid in the year Most cooperatives have a bylaw making issued, according to formulas established in consent automatic with membership. Subchapter T. Because bylaws only bind members, a The patron receiving a nonqualified separate written consent must be obtained notice pays no immediate tax on the funds from nonmember patrons for their consent it represents.Notice When the cooperative of to be effective. Qualified checks are rarely redeems a nonqualified notice, the money used because of the uncertainty over when received by theAllocation patron is taxable income to and whether patrons will cash them. the patron in the year received. Using the earlier example, if Ms. Jones Again referring to the example, if the received a qualified written notice of alloca- cooperative issued a nonqualified written tion reporting her patronage refund, the notice of allocation as a patronage refund cooperative could deduct both the amount to Ms. Jones, the cooperative would report of cash refunded to Ms. Jones (must be at the $100 face value of the nonqualified least 20 percent of the refund) and the notice as income in the year it was earned. noncash portion of her patronage refund in Ms. Jones has no immediate tax liability for the year the underlying margin was earned. the refund. When the cooperative pays Ms. Ms. Jones must report the entire refund Jones $100 in money to redeem the non- ($100) as income in the year received, qualified notice of allocation, the coopera- even though the cooperative might retain tive recovers the tax it paid at the time the up to 80 percent of the funds. notice was issued. Ms. Jones reports the $100 as income for the tax year in which she received the funds.

3 The extent to which a cooperative pays If a per-unit retain does not meet the its patronage refunds in cash, or in qualified requirements for qualified status, the written or nonqualified written notices of allocation, notice is called a “nonqualified” per-unit is a matter within the discretion of the board retain certificate. The cooperative includes of directors. Tax and financial advisers are the face value of the certificate in current often consulted before the decision is taxable income and recovers the tax paid at made. the time of redemption. The patron does not report the retained amount as income Per-Unit Retains until the nonqualified certificate is Members of marketing cooperatives have redeemed by the cooperative. an alternative method of providing patronage-based financing. They may authorize Section 521 Cooperatives the cooperative to deduct a portion of the Farmer cooperatives meeting certain tests proceeds of sale, based on dollar value or set out in section 521 of the Internal Rev- physical volume of products marketed enue Code may, in addition to patronage through the cooperative. This method of refunds and per-unit retains, deduct divi- financing is called “per-unit retains.” dends on stock and income from business Tax treatment of per-unit retains generally with the United States and other nonpatron- parallels that of patronage refunds. To qual- age income distributed to patrons on a ify for single tax treatment the cooperative patronage basis. must, within 8 1/2 months of the end of its tax year, either refund the per-unit retain in Filing and Forms cash or provide the patron with a written As mentioned earlier, all cooperatives must notice that discloses to the recipient the file annual Federal income tax returns, even dollar amount retained. That notice is called if they have no taxable income. a per-unit retain certificate. u Farmer cooperatives file form 990-C. If patrons consent to include the face u Other cooperatives file form 1120. value of the certificates in current income, u Other forms to be filed may include the the retained funds are deductible by the various form 1099’s to report distributions To see this and cooperative in the year the funds were paid as interest, stock dividends, patronage other USDA coop- acquired and must be included in taxable refunds and per-unit retains (both cash and erative publica- income by the patrons in the year they noncash). n tions online, visit: received the required written notice, now http://www.rurdev. referred to as a “qualified” per-unit retain usda.gov/rbs/pub/ certificate. cooprpts.htm This circular is one of a continuing series that provides training information and presentations for education To order hard cop- resource persons who may or may not be familiar with the cooperative form of business. This series provides the ies, e-mail: basic background material they need and in a form that can be readily adapted, with limited preparation time, to a lecture or other presentation. coopinfo@wdc. The U.S. Department of Agriculture (USDA) prohibits discrimination in all of its programs and activities on the basis usda.gov of race, color, national origin, age, disability, and where applicable, sex, marital status, familial status, parental or telephone: status, religion, sexual orientation, political beliefs, genetic information, reprisal, or because all or part of an individual's income is derived from any public assistance program. (Not all prohibited bases apply to all programs.) 1-800-670-6553. Persons with disabilities who require alternative means for communication of program information (Braille, large print, audiotape, etc.) should contact USDA's TARGET Center at (202) 720-2600 (voice and TDD).

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