Subchapter T allows cooperatives to deduct from their gross taxable income the amount they pay in patronage refunds. This tax benefit is available to “any corporation operating on a cooperative basis”, with a few business types specifically excluded; worker cooperatives are not explicitly mentioned.1 This broad language is evidence that Congress intended subchapter T to apply to a wide variety of entities. However, there has been some conflict over the years as to whether patronage in the form of dividends in a worker co-op would qualify for tax exemption under this subchapter, and to what extent. What follows is a brief summary of income tax implications for worker cooperatives as understood from case law and IRS rulings. It is guided by United States Department of Agriculture, Income Tax Treatment of Cooperatives: Background, 13-18 (June 2013), available at http://www.rurdev.usda.gov/supportdocuments/cir44-1.pdf.
Qualifying patronage dividends
Under Subchapter T, a co-op can avoid double taxation of patronage dividends when they (1) are paid to the co-op member on the basis of the quantity or value of business done with the member (typically, the hours the member worked for the co-op)
(2) are distributed under a pre-existing obligation of the co-op to pay that amount, and
(3) are calculated based on earnings derived from the co-op’s business done with its members.2
Distributions to worker-members = tax deductible patronage dividends
The IRS initially ruled that dividends given to members on the basis of work performed were not true patronage dividends. In a 1961 ruling, it held that a deductible dividend must be “either an additional consideration due the patron for goods sold through the association or a reduction in the purchase price of supplies and equipment purchased by the patron through the association.”3
The courts disagreed. In Linnton Plywood Ass’n v. United States, 236 F. Supp. 227 (D.C. Ore. 1964), the court held that worker cooperatives could deduct dividends from their gross income to the same extent as other cooperatives. The U.S. Tax Court followed this holding in Puget Sound Plywood, Inc. v. Commissioner, 44 T.C. 305 (1965), finding that worker co-ops “operating on a cooperative basis” under Subchapter T could deduct their patronage dividends from federal taxation.
The IRS finally acquiesced and issued Revenue Ruling 71-439 in 1971, stating unequivocally that distributions to members based on hours worked are patronage dividends. The ruling “was an enormous development and cleared the way for many future worker cooperatives, and laid a tax law foundation for today’s rising popularity of this entity structure. WCs were officially, taxwise, ‘admitted’ into the larger pool of non-exempt coops, with no particular distinction or special treatment.”4
“Operating on a cooperative basis”
The Puget Sound Plywood case became the leading case on which the IRS relied for the definition of “operating on a cooperative basis.” The court listed three “guiding principles”: “(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.” The court noted that entities with those attributes clearly qualified as “operating on a cooperative basis” under Subchapter T. Subsequent Revenue Rulings took this holding a step further and emphasized that these principles were necessary to a determination that a business was operating on a cooperative basis.
The IRS has, at times, supplemented additional factors used to determine whether an entity is a cooperative; however, in the early 21st century it has emphasized only these three factors from Puget Sound Plywood. Courts have tended to assert that characteristics of co-ops found outside of the Code itself should be cited for clarification but should not be seen as codified requirements for tax deductions.5 For example, the appellate court in CF Industries noted that the obligation to pay patronage dividends, as stated in the Code, was the primary required characteristic for an entity to be considered a cooperative. That court and the Tax Court both emphasized that other descriptions of coopeartive principles and practices should not be considered mandatory for Subchapter T purposes.
Majority member business
One such characteristic was the amount of business a cooperative must do with its members as opposed to nonmembers. The IRS originally required that a cooperative do more than 50% of its business with members in order to be “operating on a cooperative basis”. The court in Conway County Farmers Ass’n v. United States, 588 F.2d 595 (8th Cir. 1978) disagreed, noting that Congress did not include a quantitative requirement to the amount of nonmember business a cooperative conducted. The IRS continued to disallow deduction of dividends by cooperatives doing a majority of business with nonmembers, until the courts issued two more rulings in 1985, reaffirming the Conway County decision and emphasizing the public policy reasons for tax incentives for patronage dividends. Finally the IRS changed its position, stating that it would no longer find that a business was not operating on a cooperative basis solely because it did less than 50% of its business with members. Instead, it would look at all the circumstances and nature of the business, relying on the Puget Sound Plywood principles for determining whether it was operating on a cooperative basis.
For worker cooperatives, this means that a business that includes non-member employees need not attribute more than 50% of its business to worker-members in order to be “operating on a cooperative basis”.
Calculating tax deductible patronage-sourced income
Only “patronage-sourced” income qualifies for distribution as patronage dividends. When a worker cooperative has both worker-owners and employees, courts have considered how a business can identify what proportion of its income is derived from member versus non-member work. In Linnton Plywood Ass’n & Multnomah Plywood Association v. United States (“Multnomah”), 410 F.Supp. 1100 (D.C. Ore. 1976), the court held that a worker cooperative may weigh the value of its member work hours more heavily to account for factors such as members’ higher productivity, ability to work with less supervision, and lower turnover rates. A cooperative may use a reasonable weighting factor to account for this increased value of member work when calculating its patronage dividend exclusion. The weighting formula should be supported by objective evidence of the difference in value of member work hours.
The IRS, however, has not followed this holding. Prior to Multnomah, the Service issued rulings prohibiting such weighting and calling it arbitrary, and it has not changed its position. “[A]ny cooperative attempting to assign weights to hours worked should be ready to defend its position before the IRS.”6 On the other hand, the IRS has proposed an allocation of patronage based on the “value”, rather than quantity, of member work, by reference to the union scale, especially when member and non-member wages differ substantially.7 It is possible that the IRS would today consider other market-based calculations in industries which do not have a union scale.
- I.R.C. section 1381(a)(2). ↩
- I.R.C. section 1388(a) ↩
- Rev. Rul. 61-47, 1961-1 C.B. 193, revoked by Rev. Rul. 71-439, 1971-2 C.B. 321. ↩
- Dmitriy Kustov, Worker Cooperatives and Patronage Dividends, section 1.02, A Look Inside Worker Cooperatives, Lexis Federal Tax Journal Quarterly (Sept. 2012), available at http://www.cooperativefund.org/system/files/WorkerCooperativesAndPatronageDividends.pdf ↩
- See, e.g. CF Industries, Inc. v. Commissioner, 995 F.2d 101 (7th Cir. 1993); Ford-Iroquois FS, Inc. v. Commissioner, 74 T.C. 1213 (1980). ↩
- Kustov, supra note 4, at section 1.04(1)(a). ↩
- Kustov, supra note 4, at section 1.04(1)(a). ↩