Although most cooperatives take advantage of Subchapter T to reduce their tax liability, sometimes another tax status is more advantageous or appropriate for a cooperative. In the same way that a business can operate on a cooperative basis using any entity type, it likewise is not required to elect Subchapter T, the tax status available for cooperatives, in order to function as a cooperative. However, as noted below, the other options have some drawbacks and may require workarounds for the business to both comply with the tax status requirements and manage its money cooperatively.
A cooperative formed as a corporate entity can choose to be taxed under Subchapter C, Subchapter S, or Subchapter T. An LLC or partnership can choose from Subchapter C, K, S, or T. Subchapter T is discussed here, so this page will discuss the other options.
Subchapter C is the default tax status for corporations, as well as LLCs that elect corporate taxation. Under Subchapter C, net income is taxed at the entity level at the corporate tax rate at both the federal and state level. If the corporation pays dividends to its shareholders, the shareholders must also pay income tax on those dividends. This is known as “double taxation” because the corporation cannot deduct dividends as a business expense, so its income is taxed at both the corporate level and again at the individual level, if distributed to shareholders. This tax liability can be minimized through wages or employee bonuses rather than dividends.
If the company retains most of its net income, it will only be taxed at the corporate level, which could mean a tax savings. Larger corporations have seen a significant tax reduction at the federal level, which is now a flat 21% at the federal level. Previously, the top corporate interest rate was 35%; however, tax rates varied from 15% to 35% depending on the amount of income subject to tax. Small corporations, with taxable income up to $50,000, have seen a tax increase with the tax bill that went into effect in 2018. But for larger corporations with shareholders in upper tax brackets, the marginal rate applicable to the corporate may be lower than the marginal rate which the shareholders would pay.
Why might a cooperative choose Subchapter C?
It is a fairly uncommon tax election for cooperatives. Under Subchapter T, coops can already avoid double taxation and decide whether net income will be taxed at the shareholder level (by allocating patronage dividends to its members) or at the corporate level (by allocating it to a collective account). The primary reason is that patronage dividends in a T Corp might be subject to self-employment tax, which is currently 15.3%. These dividends would be subject to that tax as well as income tax at the individual level. For more information on why that is the case, see this article by a CPA who specializes in cooperative taxation. The instructions to the Form 1040 direct tax payers to report their patronage dividend income on the Schedule C or Schedule C-EZ, which are forms used to report business income, rather than investment income. Income from these schedules is almost always subject to self-employment tax. There is an argument that this income should not be subject to self-employment tax; however, some cooperatives do not want to take the legal risk of not paying. In contrast, it is clear that C Corp dividends are treated as ordinary income.
Dividends under Subchapter S are also treated as ordinary income; S Corps are subject to a number of other restrictions that may be incompatible with a cooperative’s operations, as described below.
On the whole, few cooperatives elect Subchapter C taxation because the overall tax burden is likely higher for most companies than Subchapter T.
LLCs, partnerships, and Limited Cooperative Associations are taxed under Subchapter K by default (although these entities can elect to be taxed as a corporation). Corporate entities cannot elect Sub-K taxation. Subchapter K is also known as “partnership taxation.” Under this tax status, entities are not subject to income tax at the federal level. Rather, income and losses are passed through to the owners, who are subject to self-employment and income tax on all amounts allocated to them, whether distributed in cash or not. States typically do tax LLCs; in California they are subject to a minimum franchise tax of $800/year, plus a tax on gross receipts.
This pass-through tax status allows the entity to avoid double taxation at the federal level. In addition, the 2017 tax bill created a 20% deduction of “qualified business income” from pass-through entities. This essentially means that only 80% of the profits allocated to a member are subject to income tax (the full amount is still subject to self-employment tax, however). The deduction doesn’t apply to guaranteed payments. If the taxpayer has an income over $157,500 (or $315,000 if married filing jointly) then the deduction may be reduced or unavailable depending on the business type, wages paid, and investment property. Incidentally, this 20% deduction also applies to patronage dividends in a Sub-T cooperative.
There are a few important drawbacks to partnership taxation for a cooperative: (1) the cooperative cannot have an unallocated reserve account, because all income, loss, deductions, and gains must be allocated to the owners; (2) owners must pay self-employment tax on all net income allocated to them; (3) the entity must redeem a member’s capital account at departure, including retained working capital allocated to them.
Why might a cooperative choose Subchapter K?
The main reason to choose partnership taxation is to avoid employee status. If a startup cooperative cannot afford to pay their members minimum wage and overtime, employment taxes, unemployment insurance, and the like, they might start as a LLC taxed under Subchapter K. Likewise, a cooperative might prefer to avoid employee classification due to the immigration status of the members, or simply to avoid the costs involved with being an employer. For tax purposes, the members would be considered self-employed, and due to this status, they will more likely be able to avoid employee classification for other purposes, assuming they structure the entity’s governance such that the owners are all equal co-owners and managers of the business. Since they will not be on W-2s and instead will be sharing all the profits and losses, they will function more as business partners than as employees. An additional benefit to this tax status is that business losses in the early years of launching the cooperative would “pass through” to the members, allowing them to offset their personal income and pay less tax.
A Sub-K cooperative will need to consider workarounds to the drawbacks of the tax status. For instance, cooperatives generally do not allow worker-owners to profit off of non-owner labor; that is, profits attributable to non-owner employee labor would be allocated to a collective account rather than distributed to members. Under Sub-K, this cannot be done easily. Rather than create a collective account, members can agree to retain earnings attributable to non-members, rather than pay those profits out as cash to the members. However, those profits would still be taxable to the members, and the entity would need to pay them out to the members when they leave or if the cooperative dissolves. To address this, the members could have an agreement to donate such profits back to the entity, or to a nonprofit cooperative developer. But this is a clunky workaround and may not be satisfying to members who have been taxed on profits they do not get to keep.
Generally, partnership tax status is best used temporarily as a cooperative gets off the ground, or when the cooperative has compelling reasons to avoid employee status for its members.
S-Corp status is a popular tax election for many small businesses, because it allows a corporate entity to avoid double taxation and pass through its gains and losses to the shareholders. It also owners of an LLC to be treated as W-2 employees, rather than self-employed partners under the default partnership tax status, while still retaining pass-through tax benefits. S-Corp worker-owners are employees, but the entity generally pays no corporate income tax, and profit distributions would be taxed as ordinary income for the owners, rather than self-employment income like with a Subchapter K business. The S-Corp owners do need to pay themselves a “reasonable” salary, so they do not have complete flexibility with regard to how much is paid as distributions rather than wages.
Subchapter S has the same drawbacks in the context of a cooperative as Subchapter K; primarily, that the entity cannot have an unallocated reserve account. But S-Corps are subject to a number of additional restrictions that make this tax status unworkable for cooperatives in most cases.
The primary difficulty with S-Corp status is that the entity must distribute profits on the basis of a shareholder’s capital investment. Cooperatives, in contrast, are intended to subordinate capital, and to share profits on the basis of member patronage, not their financial investment. Thus, unless members’ patronage is at all times in proportion to their ownership stake in the cooperative, an S-Corp cannot share profits on a cooperative basis. Where this can work is when a cooperative has equal buy-in amounts for all members and all members also work the same number of hours. But since this is often not the case, Subchapter S is often not appropriate for a cooperative.
In addition to this important consideration, the following S-Corp restrictions also may rule out this tax status for some cooperatives:
- S-Corp owners can only be individuals and certain trusts and estates; other legal entities cannot be members.
- It cannot have members who are “nonresident aliens.”
- It cannot have more than 100 shareholders total.
- It can only have one class of stock, meaning that the cooperative cannot have a class of preferred shares. All members and investors must have the same distribution and liquidation rights (however, voting rights can differ). A cooperative that has converted from another entity type using seller financing could inadvertently create a second class of stock under IRS rules.
Why might a cooperative choose Subchapter S?
There are few circumstances where this tax status is recommended for a cooperative, primarily because it prevents sharing profits on the basis of patronage except where patronage is in proportion to members’ ownership stakes. But in a small cooperative where all members intend to invest and work equivalent amounts, it could work, and could potentially be the most tax advantaged status if the IRS continues to instruct taxpayers to report patronage dividends as self-employment income. Another scenario is when an existing S-Corp business is converting to worker ownership. It may be simpler to retain that tax status, and cause fewer tax consequences for the original owner, than to convert to Subchapter T.
Table highlighting Sub-K / Sub-T advantages and disadvantages
As indicated above, cooperatives typically choose between Subchapter T (as a cooperative corporation or LLC) or Subchapter K (as a limited cooperative association or LLC). The following table summarizes the factors a cooperative should consider when making that choice.