Date: June 22,1999

Primary Author: D.Scott Beane, CPA

Topic:Issues relating to Taxation of Subchapter T Cooperatives

Question:

What are some considerations relating to organizing an entity as a cooperative under Subchapter T of the Internal Revenue Code of 1986?

Answer:

In general, Cooperatives are governed under Subchapter T of the Internal Revenue Code of 1986 which comprises Sections 1381 - 1388 inclusive. The rules in these sections also relate to exempt Farmers' Cooperatives organized under Section 521.

Cooperatives may or may not be organized as such under state law. They can also be corporations or limited liability companies under the "Business Statutes" of State laws. Subchapter T essentially acts as a default: The entity may be a "cooperative" for federal tax purposes even though it is organized under a state business corporation or trade association statute.

"Cooperative" is a "touchy-feely" term. By definition (included in Section 1388), it has certain characteristics - - - Ownership is vested in "Patrons" rather than stockholders who receive Patronage dividends which are allowed as a deduction if certain rules met. (See below.)  However, it would appear that if rules are not adhered to, that cooperative will not "benefit" from the deduction.

Subchapter T appears on the surface to be deceptively simple, but minute variations in practices of cooperatives and theoritical concepts of the IRS result in a complex and often contradictory body of published and private rulings. In PLR 8009114, a membership cooperative which was so organized proposed to change its form to a business corporation, but also wanted to operate on a cooperative basis. The IRS also allowed this change under Section 365(a)(1)(F) . . . "mere change of identity."

1. A general qualification for a cooperative classification involves two criterion:
 

a. Ownership of the cooperative is vested in the persons who are patrons of the cooperative, rather than in investor stockholders. This does not mean that all patrons must have an ownership interest.

Those with ownership interest only receive one vote regardless of their level of patronage.

b. Cooperatives return their earnings only to their patrons in proportion to their patronage.


2. To avoid tax, the entity pays qualified patronage dividends [including per unit retained allocations and redemptions of previously distributed non-qualified written notices of allocation].

3. In general, the entity will be taxed like an ordinary corporation with respect to non-patronage - source income, but like a partnership with respect to patronage - source income. However, losses do not pass through.

4. The Cooperative if organized as a corporation files a regular Form 1120.

5. One of the most troubling areas of cooperative taxation is a requirement to identify the specific earnings as "patronage - sourced" in associating those earnings with a proper group of patrons. This shouldn't be a problem if you are only dealing with patrons.

6. Patron dividends must be distributed within 8½ months after the close of your tax year.

7. If the entity will be dealing with non-patrons it must isolate those sales and calculate its net taxable income separately for those non-patrons. Hence, if 100% of the taxable income from patrons is distributed, there will still be a tax on the non-patron earnings.

8. It is possible to obtain a deduction for dividends paid, when in fact, patrons receive 80% of the dividends in the form of a qualified written notice of allocation which is redeemable at a future date. However, the patrons have to include the entire dividend, even though not paid, in their incomes. Formal rules for such consents are required.

9. In order to assure net operating loss carry-overs, it is recommended that the articles and by-laws include specific references to such. The IRS has argued that on a theoretical basis, cooperatives should never have an NOL because patrons would be assessed to cover the shortfall.

The preceding discussion is not intended to be all inclusive or comprehensive. You should consult with your CPA before proceeding with organizing an entity such as a cooperative under Subchapter T.  In some cases, better choices will be available.


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