What is a Cooperative?

There is no single definition of a cooperative. Here is one definition of the term:

“A cooperative is an organization established for the purpose of purchasing and marketing the products of its members, i.e., shareholders, and/or procuring supplies for resale to the members, whose profits are distributed to the members (in the form of patronage dividends), not on the basis of the members’ equity investment in the cooperative, but in proportion to their patronage of it, i.e., the amount of business that each member transacts with it. In a workers’ cooperative, the members jointly manufacture a product and share in the profits of the enterprise based on the amount of labor they contribute.”

(Carla Neeley Freitag, Taxation of Cooperatives, 744 BNA Tax Management Portfolio § I, 1 (2d ed. 2008).

The definition of cooperative varies depending on whether you are looking at it from the perspective of a cooperative enthusiast, a corporate lawyer, or a tax lawyer.  A cooperative enthusiast would probably say that ANY organization that is committed to and practices cooperative principles is a cooperative.  However, a corporate lawyer would probably say that a cooperative must be formed under a cooperative statute.  And a tax lawyer would say it doesn’t matter what statute it’s formed under as long as it “operates cooperatively” as that term is defined in tax law.

It is clear that an organization may be formed under almost any kind of a state statute and still follow cooperative principles.  However, most states have one or more statutes specifically designed for cooperatives.  In many states, an organization that is not formed under a cooperative statute may not use the word cooperative in its name.

From a tax law perspective, cooperatives are entitled to various beneficial tax treatments (under Subchapter T for regular cooperatives, Section 521 for agricultural cooperatives, and Section 501(c)(12) for tax-exempt cooperatives).  To be eligible for these, it does not matter if the entity is formed under a particular statute but rather whether it meets the tax law definition of “operating on a cooperative basis.”

The Internal Revenue Code and Regulations do not define what it means to “operate on a cooperative basis.”  This has been tested by the courts.  The leading case is Puget Sound Plywood v. Commissioner, 44 T.C. 305, 307-308 (1965), in which the court said that “operating on a cooperative basis” means (1) democratic control by the members, (2) operation at cost, and (3) subordination of capital.  Democratic control means that a cooperative is governed by its members on a one-member-one-vote basis.  Operation at cost means that any money left over (beyond a reasonable reserve) after expenses are paid is returned back to the members.  Subordination of capital means that returns to investors must be limited.

How Cooperatives Manifest

Cooperatives manifest in a variety of ways. The term “cooperative” can refer either to a specific type of business entity recognized under the law or to the internal governance structure of an organization.

Cooperatives, as a legal entity

Cooperative” may refer to a specific type of corporation, recognized under the law. The legal requirements for forming a cooperative corporation vary from state to state. In California, cooperatives generally form as a corporation under the California Consumer Cooperative Corporation statute. The rules governing this type of corporation are found in the California Corporations Code provisions beginning with section 12200. In California, you cannot legally have the word “cooperative” in your name, unless you have formed under this statute.

Cooperatives, as a legal structure

Many organizations operate like cooperatives, but, for a variety of reasons, chose an entity other than a cooperative corporation. For example, some cooperatives form as Limited Liability Companies (LLCs) or Nonprofit Mutual Benefit Corporations, and incorporate cooperative principles and practices into their Articles of Organization, Articles of Incorporation, Operating Agreement, and/or Bylaws.

Cooperatives, as a set of practices and values

Some organizations or groups call themselves “cooperatives,” without having formed a cooperative corporation, or for that matter, without having formed an independent legal entity at all. For example, a group of tenants might create a housing cooperative, simply by adopting highly participatory and democratic ways of operating. Similarly, workers at a non-profit organization or fiscally sponsored project, may elect to operate through cooperative, democratic principles, such as one-person one-vote. This type of cooperative organization may or may not have the other cooperative attributes of joint ownership and cooperative distribution of earnings, described above.

Cooperatives, as a tax category

The seminal Tax Court case Puget Sound Plywood, Inc. v. Commissioner (44 T.C. 305, 308 (1965) set forth three core factors of cooperative associations on the basis of the Rochdale Principles. They are generally accepted as a framework for determining whether an organization is operating on a cooperative basis within the meaning of the tax code.(See also: Jimmy Kroger, The New Frontier: Tax Implications of Limited Cooperative Associations, Fed. B.A. Sec. Tax’n Rep., Summer 2009, at 4, 10.)

  1. “‘Subordination of capital, both as regards control over the cooperative undertaking, and as regards the ownership of the pecuniary benefits arising therefrom;
  2. Democratic control by the worker-members themselves; and
  3. The vesting in and the allocation among the worker-members of all fruits and increases arising from their cooperative endeavor (i.e., the excess of the operating revenues over the costs incurred in generating those revenues), in proportion to the worker-members’ active participation in the cooperative endeavor.”(Puget Sound Plywood, Inc. v. C. I. R., 44 T.C. 305, 308 (T.C. 1965) acq., 1966-2 C.B. 3 (1966).)

 Cooperative Principles

The International Cooperative Alliance’s Cooperative Principles (derived from the Rochdale Principles) are:

(1)        Voluntary and Open Membership

Cooperatives are voluntary organizations, open to all persons able to use their services and willing to accept the responsibilities of membership, without gender, social, racial, political or religious discrimination.

(2)        Democratic Member Control

Cooperatives are democratic organizations controlled by their members, who actively participate in setting policies and making decisions. Men and women serve as elected representatives and are accountable to the members. In primary cooperatives members have equal voting rights (one member, one vote).

(3)        Member Economic Participation

Members contribute equitably to, and democratically control, the capital of their cooperative. At least part of that capital is usually the common property of the cooperative. Members usually receive limited compensation, if any, on capital invested as a condition of membership. Members allocate surpluses for any or all of the following purposes: developing their cooperative, possibly by setting up reserves, part of which at least would be indivisible; benefiting members in proportion to their work for the cooperative; and supporting other activities approved by the membership.

(4)        Autonomy and Independence

Cooperatives are autonomous, self-help organizations controlled by their members. If they enter into agreements with other organizations, including governments, or raise capital from external sources, they do so on terms that ensure democratic control by their members and maintaining their cooperative autonomy.

(5)        Education, Training and Information

Cooperatives provide education and training for their members, elected representatives, managers, and employees so they can contribute effectively to the development of their cooperatives. They inform the general public – particularly young people and opinion leaders – about the nature and benefits of cooperation.

(6)        Cooperation among Cooperatives

Cooperatives serve their members most effectively and strengthen the cooperative movement by working together through local, national, regional and international structures.

(7)        Concern for Community

Cooperatives work for the sustainable development of their communities through policies approved by their members.

Cooperative Members and Patrons

The users of the services that the cooperative offers are known as “patrons.”  Cooperatives can be formed for many different purposes and by many different types of patrons.  Cooperatives are formed by consumers, producers, workers, and sometimes by a combination of those groups.  “Patronage” is the term that describes how the patrons use the cooperative.  So, for example, the patronage of a consumer cooperative is the purchase of goods from the cooperative; patronage of a producer cooperative is the transfer of goods to the cooperative to be marketed by the cooperative; patronage of a worker cooperative is the work performed for the cooperative.  There is a great deal of flexibility for cooperatives to define patronage and how it is measured.  For example, one worker cooperative might define patronage as the number of hours worked in a fiscal year while another might define patronage as the amount of money earned by a worker in a fiscal year.

Bread cooperative example:  Here’s an example to help explain what patronage is in different types of cooperatives.  The phrase “bread cooperative” can mean many different things, depending on the relationship between the members and the cooperative.  It can be:

  • A consumer cooperative:  The member/owners are people that enjoy eating bread and they have formed a cooperative to purchase bread collectively and obtain bulk discounts.  A member’s patronage is measured by how much bread he/she buys from the cooperative.
  • A producer cooperative: The member/owners are individual home bread bakers that have formed a cooperative to jointly market their breads. The cooperative may, for example, operate stands at various farmers markets.  A member’s patronage is measured by how much bread he/she sells to the cooperative.
  • A worker cooperative: The member/owners are workers in a single bakery.  A member’s patronage is measured by how much time he/she spends working for the cooperative or by the value of the work he/she contributes to the cooperative.

Not all of the cooperative’s patrons are necessarily members.  For example, REI, the cooperative recreational equipment retailer, is open to the public and anyone that shops there is a patron, but only some people that shop there are members.  Generally, it is up to the cooperative members and/or board to decide which patrons will be admitted as members.  Cooperative members get various benefits such as the right to share in excess revenues, discounts on products, invitations to member-only events, etc.  The exact benefits of membership are generally up to the cooperative to decide.  For example, most cooperatives distribute any excess revenues to their members at the end of a fiscal year.  However, some cooperatives (mostly food cooperatives with hundreds or thousands of members) have decided that it would be too onerous to make cash distributions and therefore choose to provide other benefits such as product discounts. (The National Cooperative Grocers Association is a great resource for cooperative grocery stores.)

Technical Resource List
Author: Center for Cooperatives, University of California
Overview: This ten page article provides a list of accountants, attorneys and board advisors who specialize in the field of cooperatives. It categories cooperatives into: Arts & Crafts, Agricultural, Business and Other Shared Services, Consumer (Nat’l Food and Grocery), Consumer (Service and Retail), Credit Unions, Forestry, Funeral & Memorial, Housing, Preschool & Childcare, Utility, and Worker. Includes the individual and organization name, address, phone number, and e-mail.

Cooperatives: Principles and Practices in the 21st Century
Authors: Kimberly A. Zeuli and Robert Cropp
Publisher: Cooperative Extension of the University of Wisconsin
Date of Publication: 2004
Overview: A booklet on cooperative history (international and domestic), classification, business structures, officers, personnel, communications, finances, formation, and overall benefits and limitations.

Perceptions of Cooperatives: What They Mean to California’s Cooperative Leaders
Authors: Study conducted by Kim Coontz, Jenni James, Mahlon Lang, Lee Ruth, Jerome Siebert, Karen Spatz
Publisher: University of California
Date of Publication: 1995
Overview: A study of how cooperatives are viewed by the public, by growers, and policy makers.

Research on the Economic Impact of Cooperatives
Authors: Project Principal Investigators Steven Deller, Ann Hoyt, Brent Hueth, Reka Sundaram-Stukel
Publisher: University of Wisconsin Center for Cooperatives
Date of Publication: 2009
Overview: This report describes the impact of cooperatives on the US economy and provides a census of cooperatives across sectors.

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