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Editorial 8 MIN READ

The cooperative, in June 2017: when one-member-one-vote is the right legal form

Patronage dividends under Subchapter T, Capper-Volstead protection for farmers, and a worker-co-op movement that finally has a statute built for it

The Editors
Staff, Incorporator.org
8 min read Updated
Contents 6 sections
  1. Formation mechanics vary by state and by flavor
  2. Subchapter T is the whole federal tax story
  3. Capper-Volstead and the agricultural carve-out
  4. Governance, capital, and the exit problem
  5. When the form actually fits
  6. Sources

cooperative is the entity you pick when the owners are the users — the farmers who deliver the milk, the shoppers who buy the groceries, the workers who do the work — and you want the tax code and the governance rules to reflect that. Everything else follows from that sentence.

The form has three dominant flavors in the United States: agricultural producer co-ops, consumer co-ops (grocery, utility, credit union), and worker co-ops. They share a federal tax chapter and a set of governance habits, and almost nothing else. A farmer in Wisconsin forming a marketing co-op and a group of house cleaners in Oakland forming a worker co-op are using the same word for two different legal machines.

Formation mechanics vary by state and by flavor

There is no federal cooperative statute of general application. You incorporate under a state cooperative act, which means reading the right one. Wisconsin's is Chapter 185 (Cooperatives) with a newer Chapter 193 added in 2006 for unincorporated cooperative associations that want flexible equity structures. Minnesota has Chapter 308A (the traditional cooperative association) and Chapter 308B (the cooperative association act, enacted in 2003 to allow outside investor members, patterned on the Iowa model). California's Corporations Code Part 2 of Division 3 — sections 12200 through 12704 — governs consumer cooperative corporations, and Part 3 (sections 13200 through 13632) governs the Consumer Cooperative Corporation Law itself.

The Uniform Limited Cooperative Association Act, finalized by the Uniform Law Commission in 2007 and amended in 2013, is the modern template. It authorizes two classes of members — patron members and investor members — and lets the co-op allocate voting power and profit distributions between them within statutory floors that preserve patron control. As of mid-2017 it has been enacted in roughly a dozen states, including Colorado, Utah, Oklahoma, Nebraska, Iowa, Kentucky, Tennessee, and the District of Columbia. It is the statute to pick when you want outside capital without giving up the cooperative tax treatment or the one-member-one-vote culture.

For worker cooperatives specifically, California enacted AB 816 (the Worker Cooperative Act) in 2015, which added Article 3 to the Corporations Code governing worker-cooperative corporations and allows up to $1,000 per member per year in community-investor contributions without triggering securities registration. It is, as of June 2017, the most explicit worker-co-op statute in the country. New York, Massachusetts, and Ohio have active conversions happening under their general cooperative or business corporation acts, but without the same tailored provisions.

The mechanics at the counter look like any other entity filing: a short organizing document (articles of incorporation or articles of organization), a registered agent, and a filing fee that in most states runs in the low hundreds of dollars. What you spend time on is the bylaws, because the bylaws are where cooperative identity actually lives: the definition of patronage, the allocation formula, the redemption schedule for member equity, and the dissolution clause that determines what happens to any residual assets. Most state statutes require the bylaws to do this work; the statute itself is skeletal.

Subchapter T is the whole federal tax story

Cooperatives that "operate on a cooperative basis" are taxed under Subchapter T of the Internal Revenue Code, IRC §§ 1381 through 1388. The mechanism is the patronage dividend. Under IRC § 1382(b), a cooperative deducts from its gross income amounts paid to patrons as patronage dividends, provided those amounts are paid out of net earnings from business done with or for patrons and allocated on the basis of quantity or value of business each patron did with the co-op. The patron then reports the patronage dividend as income under IRC § 1385. Net result: the earnings are taxed once, at the patron level, not at both the co-op and the member level the way a C-corp distribution is.

Two details matter. First, the co-op can pay the dividend partly in cash and partly in a written notice of allocation — a paper IOU representing equity retained by the co-op — and still get the deduction, as long as at least 20 percent of the dividend is in cash (IRC § 1388(c)). The retained equity is what capitalizes most traditional co-ops. Second, the allocation must be made under a pre-existing obligation — in the articles, the bylaws, or a member agreement — that existed before the patron did the business. Retroactive bonuses do not qualify.

Section 521 co-ops — agricultural cooperatives that meet the requirements of IRC § 521 — get an additional set of deductions under IRC § 1382(c), including the ability to deduct dividends paid on capital stock and certain nonpatronage earnings allocated to patrons. The § 521 status requires, among other things, that substantially all of the co-op's stock be owned by producers and that business done for nonmembers not exceed business done for members. It is elected by filing Form 1028 and obtaining a ruling from the IRS.

For worker cooperatives, the wrinkle is that the IRS has long treated wages as not constituting patronage, which means the surplus available for patronage allocation is what is left after wages — the "net margin" from the work of members as worker-owners. Rev. Rul. 74-567 established that worker co-ops qualify for Subchapter T, and the patronage factor for worker co-ops is hours worked or wages earned, not goods purchased.

Capper-Volstead and the agricultural carve-out

Agricultural cooperatives have a second federal statute that does something the other flavors don't get: a limited exemption from antitrust liability. The Capper-Volstead Act of 1922, codified at 7 U.S.C. § 291, lets "persons engaged in the production of agricultural products" — farmers, planters, ranchers, dairymen, nut or fruit growers — act together in associations to collectively process, prepare for market, handle, and market their products, without running afoul of the Sherman Act, provided the association operates for the mutual benefit of the members and either limits dividends on stock to 8 percent annually or restricts voting to one-member-one-vote.

That is why dairy cooperatives can set prices that would be per-se illegal for any other industry. The exemption has limits — the Supreme Court has policed them, most pointedly in Maryland & Virginia Milk Producers Ass'n v. United States, 362 U.S. 458 (1960), where predatory practices against nonmembers were held outside the protection — but the core grant of collective-bargaining power is intact. The Secretary of Agriculture retains oversight authority under 7 U.S.C. § 292.

Nothing analogous exists for worker or consumer co-ops.

Governance, capital, and the exit problem

In a traditional cooperative the governance rule is one member, one vote, regardless of how much equity the member has in the co-op. That is the feature. It is also the bug from the standpoint of raising outside capital, because equity investors do not typically accept a structure in which their vote is the same as a $100 patron's. The ULCAA solution is two classes: patron members who keep majority control of the board, and investor members who get economic rights proportionate to their investment. A dozen states now permit this. It is the single most important statutory development for cooperatives in the last decade.

Member equity is built through retained patronage — the notices of allocation the co-op issues instead of cash — and is redeemed on a schedule set by the board, often over seven to fifteen years, often only on retirement, death, or the member leaving the co-op. This is the other structural feature that pushes co-ops away from rapid growth: you cannot borrow your way to scale on member equity alone, and outside debt is harder to secure against a balance sheet full of deferred redemption obligations.

On dissolution, most state statutes require that any residual assets, after liabilities and member equity are paid, go to another cooperative or to a charitable purpose. That is the asset-lock that distinguishes a co-op from a close corporation and is the reason a worker co-op cannot simply be sold to a private buyer and the proceeds split among the current workers. If that exit matters to the founders, the cooperative form is the wrong choice.

When the form actually fits

Pick a cooperative when the economics of the business are a relationship between the enterprise and a class of repeat users, and the fairness of the distribution depends on reflecting that use. A farmer-owned processing plant. A grocery where the shoppers want to own the store. A cleaning company where the cleaners want to own the work. The tax treatment is favorable, the governance reflects the ownership, and the form has a century of statute and case law behind it.

Do not pick a cooperative because it sounds more humane than an LLC. The humane part is not free. You give up the option to sell the business, you give up the ability to raise growth capital quickly, and you pick up a compliance load — patronage accounting, 20-percent cash-dividend math, bylaws that actually govern allocation — that most founders underestimate until the first year's tax return.

The thing worth knowing about the co-op form in 2017 is that it has quietly become more usable than it was ten years ago. The ULCAA states, the California worker-co-op statute, and the growing bench of accountants and lawyers who understand Subchapter T have made it realistic to form a cooperative and take outside capital without either violating the tax rules or surrendering patron control. That is new. It is also, still, a minority choice, and for good reasons.

Sources

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