Although they are for-profit businesses, cooperative corporations can have little to no federal income tax burden depending on how they share their profits with their patrons. This is true even when the cooperative retains most of those earnings and allocates them to patron accounts. Patronage dividends, as defined under Subchapter T of the Internal Revenue Code, are tax-deductible to the cooperative. Patronage dividends must meet a specific definition, however: amounts paid by a cooperative to its patrons on the basis of the quantity or value of business done with or for the patrons, under a pre-existing legal obligation, and based on net earnings from business with or for patrons. Patronage dividends can still be tax-deductible even when up to 80% of the dividend is retained by the cooperative as operating capital.
The “pre-existing legal obligation” language in the statute is vague, and can lead coops to wonder how, when, and in what context they must commit to paying patronage dividends. Does the cooperative have flexibility to decide, at the time of paying dividends, how much to retain and how much to pay in cash? If it has an unallocated or indivisible reserve, does it need to determine the amount that will be allocated to that reserve before the fiscal year begins? How firm does the obligation language need to be, and where should it appear?
As lawyers, we should be able to help clients decide how to balance considerations like their tax bill, their desire for financial flexibility, and their ability to retain earnings that are owned by the cooperative and not allocated to members. Clients will often prefer permissive language around the obligation to pay patronage dividends, so we should watch for that when reviewing draft bylaws, and have a clear explanation for clients to explain why a firm obligation is usually better. At the same time, we should understand what decisions the IRS does allow cooperatives to make at the end of the fiscal year, so as not to commit our clients to unnecessary financial responsibilities.
Basic Requirements for the Pre-existing Obligation
The pre-existing legal obligation requirement is found in the statutory definition of “patronage dividend,” which states that the amount must be paid “under an obligation of such organization to pay such amount, which obligation existed before the organization received the amount so paid.” Below, this article discusses what is meant by the terms “pre-existing” and “legal obligation.” This discussion is limited to nonexempt cooperatives.
The purpose of having a “pre-existing” obligation to make patronage dividends is to establish that income derived from patronage sources is the property of the patrons, not of the cooperative. The obligation is said to be “pre-existing” because it must be made before a patronage transaction takes place. This means that the obligation must exist by the beginning of the tax year. The cooperative therefore does not need to make one static decision about its patronage dividend obligation before it begins operations, but can decide near the end of one fiscal year what (if any) their obligation will be to pay patronage dividends for the following year.
In addition to establishing the obligation before the tax year begins, the cooperative must communicate to its members that they may receive a patronage dividend that year. All members must be made aware of the pre-existing obligation. Coops should be careful to distribute written evidence of this obligation to members as soon as they join the cooperative and at any time the cooperative changes the specifics of its obligation.
- Legal Obligation
The pre-existing obligation must be legally binding. It must not require additional action by the cooperative to make it binding, such as a future declaration by the cooperative. The Regulations require it to be in writing,and it may be included in any of the following:
The cooperative’s bylaws (most common)
- The cooperative’s articles (not recommended, as these are more difficult to amend)
- Membership agreement
- Any other written contract between the coop and its patrons
- State law (if a state statute requires patronage dividends, that will be considered a binding pre-existing obligation)
What Decisions Require a Pre-existing Obligation
Exactly what must the pre-existing obligation require the cooperative to do? The Code describes a patronage dividend as an amount paid to a patron, on a patronage basis, determined by reference to the net earnings from business done with its patrons, by an organization obligated “to pay such amount.”
This has been interpreted to mean that the cooperative must (rather than may) decide to distribute patronage dividends, in order for the patronage dividends to be tax-exempt under Subchapter T. The definition of “patronage” should also be defined.
If the cooperative has multiple classes of patrons or members, it can decide not to issue patronage dividends to all classes, but the cooperative should decide this before the beginning of the tax year. Which classes are entitled to patronage dividends should be indicated in the bylaws or other written agreement. For example, the cooperative can decide that only patrons who are also members are entitled to patronage dividends. In such a case, the cooperative limits the amount of income available to distribute as patronage dividends; amounts paid to a patron out of income earned from other patrons (who receive a smaller dividend or no dividend) is not tax-deductible. Because of the pre-existing obligation rule, the cooperative cannot decide at the end of the year to issue patronage dividends to patrons that it previously decided would not receive them. The obligation to pay those patrons dividends must exist before it receives income from those patrons during the tax year.
The IRS allows the board to have a good amount of discretion on other matters. How the cooperative pays patronage dividends, and even some of the specifics about determining the amount do not need to be decided in advance.
A typical bylaw provision includes the following language. Note that the only requirement is that patronage dividends be paid, to all member patrons, and done so on the basis of patronage:
“[T]he association is obligated to account on a patronage basis to all member patrons on an annual basis for all amounts received from business conducted with members on a patronage basis, over and above the cost of providing such services, making reasonable additions to reserves, and redeeming capital credits. Such allocation shall be on the basis of the volume (dollar value) of product marketed through (purchased from) the association. The association is hereby obligated to pay all such amounts to the patrons in cash or by credits to a capital account of each member patron.”
These bylaws allow the cooperative to retain a “reasonable” portion of the patronage sourced income as unallocated equity, to build up the cooperative’s reserves, and to redeem any capital credits before allocating the remaining net income to member accounts. After these accountings have been made, the cooperative is obligated to allocate the rest to members, and it shall make the allocation on the basis of patronage (dollar value of product marketed through the coop in this case). The provision states that it will be allocated through cash or credits, but does not set parameters for how much will be distributed in each form.
Likewise, the board has discretion to distribute a portion of the patronage-sourced income as dividends on capital (within the limits of the applicable state statute). However, net income that is set aside in unallocated reserves, or paid out to investors, will not be excluded from gross income under Subchapter T and will be subject to corporate tax.
What Decisions Do Not Require a Pre-existing Obligation
The pre-existing obligation does not require the following to be determined in advance, and can be left to the discretion of the board:
- A specific fixed amount or proportion of net earnings to be paid out
- The proportion paid in cash vs. written notices of allocation
- Whether to use qualified or non-qualified written notices of allocation
- The exact proportion to be allocated to reserves before calculating patronage dividends
- How the coop will use any reserved net income
Conclusion: Summary of Best Practices for Coop Attorney
To ensure your client is meeting the “pre-existing obligation” requirement, you should advise that they do the following:
- Include a provision in the bylaws (or other document as noted above) that requires the coop to distribute patronage dividends, if there are any at the end of the year.
- Establish the provision before the beginning of the tax year to which it will apply.
- If the provision is in the coop’s bylaws, distribute the bylaws to new members, and to all members whenever this provision is amended.
- If there are multiple classes of members or patrons that differ in their rights to patronage dividends, specify this in the document containing the language about patronage distributions.
- Recommend allowing board discretion regarding contributions to reserves and payment in cash versus credits (written notices of allocation).
- Comply with any provisions of state law, in addition to federal tax law, that address patronage distributions.