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Editorial 8 MIN READ

The cooperative, revisited: what TCJA broke, what Congress fixed, and where worker co-ops sit in 2019

The grain glitch, the replacement §199A(g), and the state-by-state drift since 2017

The Editors
Staff, Incorporator.org
8 min read Updated
Contents 6 sections
  1. What the Tax Cuts and Jobs Act originally did
  2. The fix: P.L. 115-141 and a new §199A(g)
  3. Subchapter T itself has not changed
  4. Worker cooperatives and the Main Street Act
  5. What this means if you are forming in 2019
  6. Sources

or about twelve weeks in early 2018, a farmer selling corn to a cooperative got a materially larger federal deduction than a farmer selling the same corn to Cargill. That was the grain glitch, and the fact that Congress noticed and fixed it inside a fiscal-year appropriations bill is the most interesting thing that has happened to cooperative taxation in a generation.

Twenty months after our June 2017 piece on the cooperative, the federal tax geography around Subchapter T has been redrawn and the statutes at the state level have kept drifting in the direction of outside capital and worker ownership. The entity itself, governed by IRC §§ 1381 through 1388, is the same machine. The incentives bolted on around it are not.

What the Tax Cuts and Jobs Act originally did

The Tax Cuts and Jobs Act, P.L. 115-97, signed December 22, 2017, repealed the Domestic Production Activities Deduction at IRC § 199, which agricultural cooperatives and their patrons had used since 2004 to deduct 9 percent of qualified production income. In its place, the statute created IRC § 199A, the 20-percent pass-through deduction, and tucked into it a subsection (g) designed to preserve a DPAD-like benefit for specified agricultural and horticultural cooperatives.

The version of § 199A(g) enacted in December 2017 did not preserve the old math. It allowed a farmer who sold commodities to a cooperative to deduct 20 percent of gross payments received from that cooperative, subject to a taxable-income limit, rather than 20 percent of qualified business income net of cost of goods sold. A farmer selling to a non-cooperative buyer (an independent grain elevator, a private ethanol plant, an out-of-state processor) got the ordinary § 199A(a) deduction, which is 20 percent of QBI after costs. On a bushel where the farmer had, say, $4 of gross revenue against $3.50 of input cost, the co-op channel produced a deduction on the full $4; the non-co-op channel produced a deduction on the 50 cents of margin. The arithmetic is not subtle.

This was almost certainly a drafting error rather than a policy choice. The conference agreement was assembled quickly, the agricultural provisions were lifted from an earlier Senate amendment by Senators Hoeven and Thune intended to approximate the old DPAD, and the gross-versus-net distinction was not surfaced until after enactment. The National Grain and Feed Association, representing non-cooperative grain handlers, flagged it publicly in the first week of January 2018 and argued that private elevators would be driven out of business in weeks if the provision stood. The commodity press started calling it the grain glitch almost immediately.

The fix: P.L. 115-141 and a new §199A(g)

Congress repealed the original § 199A(g) retroactive to January 1, 2018, as part of Division T of the Consolidated Appropriations Act, 2018, P.L. 115-141, signed March 23, 2018. In its place, Congress enacted a new § 199A(g) that reconstructs something close to the old DPAD, but only for specified agricultural and horticultural cooperatives, not for other cooperatives and not for the patrons directly.

Under the replacement § 199A(g), a specified ag co-op computes a deduction equal to 9 percent of the lesser of its qualified production activities income or its taxable income, capped at 50 percent of W-2 wages paid by the co-op during the year with respect to the qualified production activities. The mechanics are parallel to the repealed § 199: the same W-2 wage limit, the same definition of qualified production activities income in § 199A(g)(3), the same domestic-production requirement. The co-op may pass through the deduction to patrons via a written notice analogous to the old § 199 pass-through, and the patron may deduct the passed-through amount, subject to the taxable-income limit in § 199A(g)(2)(B).

Patrons who also receive qualified business income from the co-op (for example, qualified per-unit retained allocations or patronage dividends) must then reduce their own § 199A(a) deduction by the lesser of 9 percent of the QBI attributable to co-op business or 50 percent of the W-2 wages allocable to that business. That reduction is the statute's way of preventing double-dipping. It is also where most of the 2018 practitioner confusion has lived, because the interaction between the co-op's § 199A(g) pass-through and the patron's § 199A(a) deduction on the same revenue stream is structurally complicated and the IRS has not issued final regulations as of this writing. Proposed regulations under § 199A were published at 83 Fed. Reg. 40884 on August 16, 2018; they do not address the cooperative provisions, which the preamble states will be reserved for a separate guidance project.

The practical upshot for 2018 returns, which are being prepared now, is that the old DPAD-equivalent is back, the gross-payment windfall is gone, and farmers choosing between co-op and non-co-op buyers face the same after-tax math they did before TCJA. That is, roughly, the outcome the original conferees seem to have intended.

Subchapter T itself has not changed

The patronage-dividend mechanism in IRC §§ 1381 through 1388 is unaffected by any of this. A cooperative operating on a cooperative basis still deducts qualified patronage dividends from gross income under § 1382(b), patrons still report those amounts as income under § 1385, the 20-percent cash requirement for qualified written notices of allocation still lives at § 1388(c), and § 521 status still requires Form 1028 and an IRS determination. The vocabulary and the filing cadence are exactly what they were in 2017.

What TCJA did change, indirectly, is the relative appeal of the cooperative tax regime versus the C-corp tax regime. The federal corporate rate fell from 35 percent to 21 percent under § 11(b) as amended. For a co-op that was organized before TCJA on the theory that Subchapter T avoided the old 35-percent corporate layer, the 21-percent layer is a smaller disadvantage. The governance advantages of the cooperative form (one-member-one-vote, patronage allocation, asset lock) are unchanged, but the purely tax-driven case is thinner than it was.

The worker cooperative remains a separate analysis because wages are not patronage under Rev. Rul. 74-567, 1974-2 C.B. 199, and the worker co-op's surplus is the net margin after wages rather than the value of the work itself. A 21-percent corporate rate still sits on top of whatever net margin is retained inside the co-op for reinvestment; only the amounts distributed as patronage avoid the corporate layer.

Worker cooperatives and the Main Street Act

On the policy side, the one federal statute enacted in the past twenty months that moves in the worker-co-op direction is the Main Street Employee Ownership Act, enacted as Title VIII of the John S. McCain National Defense Authorization Act for Fiscal Year 2019, P.L. 115-232, signed August 13, 2018. It directs the Small Business Administration to support employee-ownership transitions, including worker cooperatives and ESOPs, by amending the Small Business Act to let SBA-backed 7(a) loans finance the purchase of a business by its employees through a worker co-op or ESOP, and by requiring Small Business Development Centers to provide employee-ownership technical assistance.

That is useful, if modest. It does not change the tax treatment of worker co-ops and it does not preempt state law. It does give the conversion-to-worker-ownership pathway a federal lending channel it did not previously have, which matters for the baby-boomer business succession wave that the worker-co-op movement has been organizing around since the middle of the decade. The rough policy argument is that several million closely held businesses have owners over 55 and no obvious buyer, and that conversion to employee ownership is cheaper than a liquidation and better than letting the business die on the vine. The federal government now has a modest thumb on that scale.

State activity has continued in a familiar direction. The Uniform Limited Cooperative Association Act, the Uniform Law Commission's two-class patron-and-investor statute from 2007 (amended in 2013), stands at roughly sixteen enactments, with the additions since 2017 adding incremental rather than structural state coverage. New Jersey, Massachusetts, and New York have live legislation or administrative activity aimed at worker-cooperative incentives; California's AB 816, the 2015 Worker Cooperative Act, remains the most explicit worker-co-op statute in the country. There is no federal cooperative statute of general application, and there is no movement toward one.

What this means if you are forming in 2019

For an agricultural producer cooperative, the federal tax treatment is stable again. Subchapter T still governs the single-tax treatment of patronage, § 199A(g) as corrected approximates the old DPAD, the W-2 wage limit is the binding constraint on the co-op's § 199A(g) deduction for most operations, and the patron's reduction under § 199A(b)(7) needs to be modeled before the 2018 return is filed. If the Treasury guidance on the cooperative provisions arrives in the second half of 2019, amended returns may be in order for positions taken aggressively this spring.

For a worker cooperative, the formation analysis is the same as it was in 2017, with one new federal lending channel under the Main Street Act when the co-op is a conversion rather than a greenfield formation. The state statute you pick still matters more than the federal backdrop: California AB 816 remains the most developed, the ULCAA states give you the option of patron-plus-investor capital structure, and in states without either you are forming under the general business-corporation or general-cooperative act and writing the cooperative features into the bylaws.

For a consumer cooperative (grocery, utility, credit union where applicable), none of the 2018 federal changes move the ball. The Capper-Volstead antitrust exemption at 7 U.S.C. § 291 remains agricultural-only; consumer and worker co-ops do not get the collective-action protection that dairy and grain co-ops do, and no legislation proposes to change that.

The open federal question for 2019 is the § 199A cooperative regulations. Treasury reserved the cooperative provisions in the August 2018 proposed regulations and has not committed to a timeline for a separate proposal. Until that guidance is final, cooperatives and their tax preparers are computing § 199A(g) and the patron reduction on the basis of the statutory text, the Senate Finance Committee's floor statements at the time of P.L. 115-141, and a handful of IRS FAQs. That is a thinner base than the DPAD regime ever ran on, and it is the place where the next round of cooperative tax controversy will come from.

Sources

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