Reducing taxes with qualified patronage dividends

Editor: Michael D. Koppel, CPA/PFS/CITP

When a type of entity is chosen for a new company, the method of taxation is often factored into the decision. The entities recognized by the IRS are sole proprietorships, partnerships, corporations (often referred to as C corporations), and corporations formed under Subchapter S (called S corporations). Each choice is available to an owner or shareholder, and each entity is subject to a different taxation regime. While most practitioners are familiar with the rules for C corporations, fewer are familiar with the rules for corporations organized on the cooperative basis, which are subject to Subchapter T of the Internal Revenue Code.

Like other C corporations, cooperative corporations are taxed at the corporate level. Cooperatives, however, enjoy a distinct tax advantage. Cooperative corporations can shield some or all of their net income from taxation by returning it to the patrons (owners) in the form of qualified patronage dividends. Sec. 1388 requires a minimum of 20% of the dividend to be paid out in cash while allowing the entire amount of the dividend to be deducted from taxable income when certain rules are followed. These rules allow the cooperative corporation to avoid double taxation of its dividends to its stockholders.

This is a distinct advantage over the return of profits to owners of a standard corporation, whose dividends are not deducted from the net income taxed at the corporate level. In addition, because the patronage dividend is calculated based on the net income for the year, and the end of the payment period is 8½ months following year end, the taxation of the dividend to the recipient (the patron) can be delayed to the year after the net income was generated. However, because the qualifying payment period begins on the first day of the tax year, the cooperative is allowed to pay patronage payments before the year ends. To qualify for this preferred treatment, the cooperative must follow specific rules regarding the timing, payment, and notification of the dividend.

The first requirement in determining the amount available for a patronage deduction is to determine the portion of the net income that is derived from business done with or for its patrons. Certain items are therefore excluded from the patronage pool. This calculation varies among different types of cooperatives because they interact differently with their members.

Purchasing cooperatives are formed by members that pool their purchasing power and negotiate with suppliers as a group. Producer cooperatives are formed by members that produce goods individually but pool their goods together to receive preferred treatment in (or access to) a market. Worker cooperatives are formed by employees who collectively own the company and work for it. Consumer cooperatives are formed when members pool their collective purchasing power. Rural utility cooperatives are formed by the members receiving the service.

While there are many other forms of cooperatives, all forms decide to what extent nonmembers are permitted to interact with the cooperative. For example, a worker cooperative frequently has employees who are not owners; however, a purchasing cooperative usually does not allow nonmembers to purchase goods through the co-op. Consumer cooperatives, such as REI, an outdoor adventure retailer, often allow nonmembers to shop in their stores.

One well-known example of a producer cooperative is Organic Valley, which is a cooperative of farmers that distribute and market under the Organic Valley brand. A producer co-op usually does not allow nonmembers to have access to the markets through the co-op. This division is important because only the earnings from business done with or for its members is available for the patronage dividend paid to the members. Income that is not sourced from member activities is ineligible for patronage treatment and is taxed at regular corporate tax rates.

Example: A worker co-op has 10 full-time employees. Six of the employee are owners; four are not. The co-op, which uses hours worked as the basis for calculating patronage, has only 60% of the total net income available for a patronage dividend payable to its owners. The remaining 40% of the total net income that is from nonpatronage activity, as well as any portion of the 60% not declared as a qualified patronage dividend, is then taxed as regular corporate earnings.

The second requirement is that the organization be under an obligation, which existed before the organization conducted business with its members, to pay patronage dividends on its net earnings. This obligation is normally fulfilled by the wording of the bylaws and/or by a written agreement with the members.

The third requirement is that the organization must allocate the patronage pool to its members based on the quantity or value of business done with or for those patrons. This is different from a standard corporation, which allocates the dividend based on the owner’s proportion of ownership. Therefore, a worker co-op usually allocates the dividend based on hours worked; a producer co-op allocates it based on amounts produced and sold to (or through) the co-op; a purchasing cooperative allocates it based on the amounts purchased from (or through) the co-op; and a consumer cooperative allocates it based on sales to its members.

Once the amount available for the patronage dividend for each member is determined, the cooperative is then required to provide the appropriate notice to the members of the total dividend and to pay a minimum of 20% of each member’s dividend in cash within 8½ months after year end. The unpaid portion (80% or less of the total) is held by the cooperative in its members’ equity accounts until it is paid to the members at some future date. Sec. 1382 also requires a minimum 90-day period for the members to cash the check. If the requirements are not followed for the “qualified written notice of allocation,” the dividend does not qualify as a patronage dividend deduction on Form 1120C, U.S. Income Tax Return for Cooperative Associations.

The total dividend (retained and paid portions) is generally considered taxable income to the recipient in the year received. Cooperatives generally must provide members to whom they pay patronage dividends of $10 or more a Form 1099-PATR, Taxable Distributions Received From Cooperatives, with a few exceptions. The most common exception is for consumer cooperatives that have 85% of their gross receipts for the preceding tax year, or 85% of their total gross receipts for the preceding three tax years, from retail sales of goods or services that are generally for personal, living, or family use. These cooperatives request an exemption from filing Forms 1099-PATR by filing Form 3491, Consumer Cooperative Exemption Application. Other cooperatives that do not qualify under this exception are required to issue Forms 1099-PATR to all members that receive a patronage dividend over $10 unless, generally, the member is a corporation; a tax-exempt organization, including tax-exempt trusts (health savings accounts, Archer medical spending accounts, and Coverdell education savings accounts); or the United States, a state, a possession of the United States, or the District of Columbia.

EditorNotes

Michael D. Koppel is a retired partner with Gray, Gray & Gray LLP in Canton, Mass.

For additional information about these items, contact Mr. Koppel at 781-407-0300 or mkoppel@gggcpas.com.

Unless otherwise noted, contributors are members of or associated with CPAmerica International.