Cooperative Information Report 55
Co-ops 101: An Introduction to Cooperatives
Abstract
This report provides a comprehensive summary of basic information
on the cooperative way of organizing and operating a business. It covers the nature and
extent of the use of cooperatives, compares cooperatives to other business structures,
explains the roles various people play in a cooperative, and discusses equity accumulation
and income taxation. The purpose is to make available, in a single report, the information
someone would need to acquire a general understanding of how cooperatives function.
Keywords: Cooperative, Business, Finance,
Structure, Tax
Co-ops 101: An Introduction to Cooperatives
Donald A. Frederick, Program Leader
Law, Policy & Governance
Cooperative Resources Management Division
Rural Business-Cooperative Service
U.S. Department of Agriculture
Cooperative Information Report 55
April 1997, Slightly revised June 1997
Preface
Welcome to the dynamic world of cooperation--people working
together to solve common problems and seize exciting opportunities. Cooperatives are
business entities that people use to provide themselves with goods and services.
This booklet introduces you to the attributes that distinguish a
cooperative from other ways to organize and conduct a business. Its purpose is to help you
understand what makes a cooperative unique. It contains a great deal of information to
absorb. Use it as a reference and refer to it when specific problems arise. Over time, you
will learn more about cooperatives and your experience with them should be more rewarding.
The author gratefully acknowledges the cooperation of the
National Society of Accountants for Cooperatives (NSAC) in simplifying the preparation of
this report. NSAC allowed me to base parts of this publication on material I had written
earlier for Welcome to Cooperatives, an NSAC booklet designed to introduce
accountants, financial, and tax professionals to cooperatives. This saved me the time and
effort of reworking the presentation of some basis concepts that everyone associated with
cooperatives should understand. This is consistent with the concept of sharing knowledge
freely that should be a cornerstone of cooperative education.
Contents
Introduction
Chapter 1. A Historical Perspective
Chapter 2. Cooperative Principles and
Practices
Cooperative Principles
The User-Benefits
Principle
The User-Owner
Principle
The User-Control
Principle
Related Practices
The Patronage Refund
System
Limited Return on
Equity Capital
Cooperation Among
Cooperatives
Chapter 3. Cooperatives in the Community
Financial Cooperatives
Consumer Service Cooperatives
Business Cooperatives
Farmer Cooperatives
Chapter 4. Benefits of Cooperation
Chapter 5. Business Organizations
Individually Owned
Business
Partnership
General Business Corporation
Limited Liability Company
Cooperative
Chapter 6. Classifying Cooperatives by
Structure
Geographic Territory Served
Governance System
Functions Performed
Chapter 7. People
Members
Directors
Officers
Board Committees
Managers
Employees
Chapter 8. Sources of Equity
Direct
Investment
Retained Margins
Per-Unit Capital Retains
Nonmember/Nonpatronage Earnings
Chapter 9. Financial and Tax Planning
Cash
Refunds
Qualified Retains
Nonqualified Retains
Unallocated Reserves
Chapter 10. Equity Management
Revolving Fund Plan
Special Plans
Base Capital Plan
Conclusion
Endnotes
Co-op 101
An Introduction to Cooperatives
There is no universally accepted definition of a
cooperative. In general, a cooperative is a business owned and democratically controlled
by the people who use its services and whose benefits are derived and distributed
equitably on the basis of use. The user-owners are called members. They benefit in two
ways from the cooperative, in proportion to the use they make of it. First, the more they
use the cooperative, the more service they receive. Second, earnings are allocated to
members based on the amount of business they do with the cooperative.
In many ways, cooperatives resemble other businesses. They
have similar physical facilities, perform similar functions and must follow sound business
practices. They are usually incorporated- under state law by filing articles of
incorporation, granting them the right to do business. The organizers draw up bylaws and
other necessary legal papers. Members elect a board of directors. The board sets policy
and hires a manager to run the day-to-day operations.
But in some ways, cooperatives are distinctly different
from other businesses. These differences are found in the cooperative's purpose, its
ownership and control, and how benefits are distributed. They are reflected in cooperative
principles that explain the unique aspects of doing business on a cooperative basis.
Table of Contents
Chapter 1.
A Historical Perspective(1)
In one sense, cooperation is probably as old as civilization.
Early people had to learn to work together to meet their common needs, or perish. The
Pilgrims who settled at Plymouth, MA, jointly cleared fields abandoned by the Indians,
broke up the soil, and planted and cared for their corn. After the harvest, celebrated
with the Indians in 1621 with a Thanksgiving feast, the corn was shared equally among the
settlers.
Legend suggests that the initial structured
cooperative business in the United States was the Philadelphia Contribution-ship for the
Insurance of Houses from Loss by Fire, a mutual fire insurance company established in
1752. This association's reputation is likely based on two factors. First, Benjamin
Franklin was the organizer. Second, the business has been conducted so efficiently over
the years that it is still operating today.
In the early 1800s, cooperative businesses
appeared on several fronts. In Britain, cooperatives were formed as a tool to deal with
the depressed economic and social conditions related to the struggles with Napoleon and
industrialization. In the United States, farmers began to process their milk into cheese
on a cooperative basis in diverse places such as Goshen, CT, and Lake Mills, WI.
Writers sometimes trace the origin of
cooperatives from the Rochdale Equitable Pioneers' Society, an urban, consumer cooperative
organized in England in 1844. It sold consumer goods such as food and clothing to persons
unhappy with the merchants in the community.
While neither the first nor most successful
early cooperative, the Rochdale Society developed an active outreach program, encouraging
and assisting others to form cooperatives. It also prepared a written list of practices
and policies that seemed consistent with success of such efforts. This list became one of
the first sets of cooperative principles, characteristics that distinguish cooperatives
from noncooperative businesses.
![](cdblball.gif) |
Open membership |
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One member, one vote |
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Cash trading |
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Membership education |
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Political and religious neutrality |
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No unusual risk assumption |
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Limitation on the number of shares
owned |
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Limited interest on stock |
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Goods sold at regular retail prices |
![](cdblball.gif) |
Net margins distributed according to
patronage |
The Grange, founded in
1867, quickly became the major thrust behind agricultural and rural cooperatives in
America. In 1874, a Grange representative went to Europe to gather information about
cooperatives. In 1875, the Grange published a set of rules for the organization of
cooperative stores, based on the Rochdale principles.
Local granges organized stores to serve their
rural members. They sold groceries and clothing as well as general farm supplies, hardware
and agricultural implements. Granges in the South marketed cotton. Those in Iowa operated
grain elevators. In Kentucky, they sponsored warehouses for receiving and handling
tobacco. California Granges exported wheat and marketed wool.
As the country recovered from the depression of
the 1870s, fewer Granges were organized and many cooperatives went out of business, but
the impact of the Grange cooperative movement survives. It demonstrated that the Rochdale
type of cooperative, which handled goods at prevailing prices and distributed net savings
according to use, offered a sound basis for cooperative efforts in America.
Cooperation flourished during the three decades
from 1890 to 1920. As many as 14,000 farmer cooperatives were operating by the end of the
period. Cooperative growth was fueled by the wave of other farmer movements and farm
organizations sweeping the country, such as the American Society of Equity, National
Farmers Union, and the American Farm Bureau Federation. They were engaged in marketing
virtually every farm crop and furnishing supplies and services to their producer-members.
Many of today's major farmer cooperatives were formed during this period.
The following decades have seen farmer
cooperatives develop their own financial institutions through the Farm Credit System.
Nonagricultural cooperatives likewise developed the National Cooperative Bank. With help
from the Rural Electrification Administration, rural residents used cooperatives to bring
electric and telephone services to their towns and farms. The rural electrics formed the
National Rural Electric Cooperative Finance Corporation (CFC) as a supplemental source of
financing.
Some cooperatives have become larger, partially
in response to growing concentration among their competitors and the firms their members
must deal with. They have adopted modern management techniques and sophisticated
processing, distribution and marketing methods.
Today rural and urban residents use
cooperatives to acquire consumer services such as housing, credit and other financial
services (through credit unions), groceries, education and telecommunications.
Franchisees, governmental units, hardware and grocery stores, florists and numerous other
businesses use cooperatives to market their products and secure the supplies they need at
competitive prices.
Cooperatives remain a major component of the
food and agriculture industry, but now they are available to help people provide services
for themselves in virtually all segments of the economy.
Table
of Contents
Chapter 2.
Cooperative Principles and Practices(2)
Cooperative Principles
Various writers over
the past century have analyzed and observed the application of cooperative principles.
Although slight differences in terminology appear on the various lists, three principles
emerge as being widely recognized and practiced.
These principles are more than just good
practices, policies or common sense. They distinguish a cooperative from other kinds of
business. They are also recognized in state and federal statutes and regulations as
criteria for a business to qualify as a cooperative.
The User-Benefits Principle
Members unite in a
cooperative to get services otherwise not available, to get quality supplies at the right
time, to have access to markets or for other mutually beneficial reasons. Acting together
gives members the advantage of economies of size and bargaining power. They benefit from
having these services avail-able, in proportion to the use they make of them.
Members also benefit by sharing the earnings on
business conducted on a cooperative basis. When cooperatives generate margins from
efficient operations and add value to products, these earnings are returned to members in
proportion to their use of the cooperative. Without the cooperative, these funds would go
to other middlemen or processors.
The User-Owner Principle
The people who use a
cooperative own it. As they own the assets, the members have the obligation to provide
financing in accordance with use to keep the cooperative in business and permit it to
grow. Accumulating adequate equity is a major challenge facing many cooperatives. How this
task is accomplished is discussed later.
The User-Control Principle
As owners, a
cooperative's members control its activities. This control is exercised through voting at
annual and other membership meetings, and indirectly through those members elected to the
board of directors. Members, in most instances, have one vote regardless of the amount of
equity they own or how much they patronize the organization.
In some instances, high-volume users may
receive one or more additional votes based on their patronage. Equitable voting is
assured, often by limiting the number of additional votes any one member can cast. This
protects the democratic control of the membership as a whole.
Only members can vote to elect directors and to
approve proposed major legal and structural changes to the organization. The member-users
select leaders and have the authority to make sure the cooperative provides the services
they want. This keeps the cooperative focused on serving the members, rather than earning
profits for outside investors or other objectives.
Related Practices
Certain business practices have developed that implement and
facilitate these basic principles. They further differentiate a cooperative from other
forms of doing business.
The Patronage Refund System
While cooperatives
strive to return earnings to members, this can't be done on a transaction-by-transaction
basis. Rather, cooperatives usually charge market prices for supplies and services
furnished to members and competitive prices for products delivered for further processing
and marketing. Normally, this allows them to generate sufficient income to cover costs and
meet continuing needs for operating capital.
After the fiscal year is over, a cooperative
computes its earnings on business conducted on a cooperative basis. Those earnings are
returned to the patrons--as cash and/or equity allocations--on the basis of how much
business each patron did with the cooperative during the year. These distributions are
called patronage refunds.
For example, if a cooperative has earnings from
business conducted on a cooperative basis of $20,000 for the year, and Ms. Jones does 2
percent of the business with the cooperative, she receives a patronage refund of $400
($20,000 x .02).
This allows the cooperative to return margins
to members on an annual basis, consistent with standard accounting conventions and without
regard to how much was earned on each transaction.
Limited Return on Equity Capital
Members form a
cooperative to get a service--source of supplies, market for products or performance of
specialized functions--not a monetary return on capital investment.
Many cooperatives don't pay any dividends on
capital. Others pay a modest return, in line with state and federal statutes that bar
substantial payments.
Limiting returns on equity supports the
principle of distributing benefits proportional to use. It also discourages outsiders from
trying to wrest control of a cooperative from its members and operate it as a
profit-generating concern for the benefit of stockholders.
Cooperation Among Cooperatives
Many cooperatives,
especially local associations, are too small to gather the resources needed to provide all
the services their members want. By working with other cooperatives--through federated
cooperatives, joint ventures, marketing agencies in common, and informal networks--they
pool personnel and other assets to provide such services and programs on a collaborative
basis at lower cost.
This permits members of local cooperatives to
participate in owning and managing fertilizer plants, food manufacturing facilities, power
plants, national financial institutions, wholesale grocery and hardware distribution
programs, and so forth. Benefits flow back through the local cooperatives to the
individual members.
These principles and practices have survived
and flourished through 150 years of continuous evolution in the business world. They
remain the foundation that supports the distinctive cooperative method of doing business.
Table of Contents
Chapter 3.
Cooperatives in the Community(3)
While cooperatives are
often most closely identified with agriculture, they are found working effectively to meet
people's needs in all sectors of American life. The National Cooperative Business
Association reports that in the United States a network of 47,000 cooperatives directly
serve 100 million people -- nearly 40 percent of the population. Here are some examples
and facts and figures about cooperatives in your community.
Financial Cooperatives
The largest single
segment of the cooperative industry is credit unions. The roughly 12,600
credit unions in the United States have more than $280 billion is assets and almost 65
million members. Building on their base of member savings and consumer loans and home
mortgages, credit unions now offer additional services to their members including credit
cards, automated teller machines, tax-deferred retirement accounts and certificates of
deposit.
Created in 1916, the cooperative Farm
Credit System is the nation's oldest and largest financial cooperative. It
provides real estate loans, operating loans, home mortgage loans, crop insurance and
various other financial services to more than 500,000 farmer, small-town resident and
cooperative borrowers. Annually it loans more than $50 billion to its members, 25 percent
of all money loaned to U.S. agriculture.
One element of the Farm Credit System is CoBank,
ACB and the St. Paul Bank for Cooperatives. They provide about
80 percent of the money farmer cooperatives borrow each year. They have about $11 billion
in outstanding loans to farmer and rural utility cooperatives and water and waste disposal
systems. CoBank has become an important financier of exports of U.S. farm products as it
broadens its role of making credit available to enhance farm and rural income.
Since 1969, the National Rural Utilities
Cooperative Finance Corporation (CFC) has been a valuable source of
financing for rural electric and telephone cooperatives. With $5.7 billion in assets and
almost $13 billion in loan commitments, CFC supplements funding provided by USDA's Rural
Utilities Service and provides business services to its borrowers.
In a short period of time, the National
Cooperative Bank (NCB) has become an important financial institution for
America's housing, business and consumer cooperatives. Chartered by Congress in 1978 and
private since 1982, NCB has originated more than $2.4 billion in loans to nearly 1,000
cooperatives throughout the country. NCB has become a leader in providing development
funding for new, non-agricultural cooperatives and in devising methods of attracting
outside capital to leverage its investments.
Consumer Service Cooperatives
America has about 1
million units of cooperative housing, nearly 600,000 of them in New York
City. New units are being developed in many other areas including senior citizen
communities, trailer parks, low-income complexes, and student housing near college
campuses.
Millions of Americans receive basic medical
care through cooperatively organized health care providers. Health
maintenance organizations (HMO's) serve more than 1 million people coast-to-coast and will
likely be an increasingly important part of the health care system in the years ahead. In
several major cities--Seattle, Minneapolis, Memphis, Sacramento, Salt Lake City and
Detroit--companies have formed cooperative health alliances to purchase health care for
their employees.
Child care
cooperatives are meeting the needs of families where the parent(s) are employed and want
affordable, supportive care for their young children while working. These centers can be
organized by parents on their own, by a single employer, or by a consortium of businesses
providing a single center for the group. More than 50,000 families use cooperative day
care centers daily.
Business Cooperatives
More than 15,000
independent grocery stores rely on cooperative grocery wholesalers for
identity, brand names, and buying power they need to compete with the chains and the
discounters. Members also receive training and financing. Several cooperative grocery
wholesalers are multi-billion dollar firms rivaling the largest farmer cooperatives in
sales and assets.
Restaurant supply
purchasing cooperatives save money and provide quality products for franchisees
of such noted fast-food chains as KFC (Kentucky Fried Chicken), Dunkin' Donuts, Arby's,
Taco Bell, Burger King, Popeye's and Church's. Besides their bottom line impact,
purchasing cooperatives also offer another, less tangible benefit; they help to build
trust among franchisers and franchisees, particularly on pricing issues.
Cooperatively owned hardware
wholesalers supply virtually all of the independent hardware stores in the United
States. As huge warehouse chains spread across the nation, the independents are relying
more and more on Cotter and Company (True Value), Ace Hardware and other cooperatives for
products, promotions and education to remain viable businesses.
Cooperatives are leaders in other major
industries including outdoor goods and services (Recreational Equipment Inc.), lodging
(Best Western), carpeting (Carpet One), insurance, natural foods, hospital and pharmacy
supply, and collegiate bookstores.
Farmer Cooperatives(4)
In the agricultural
sector, USDA's Cooperative Services' survey of farmer cooperatives for calendar year 1995
reported 4,006 cooperatives in operation. Of these associations, 2,074 primarily marketed
farm products; 1,458 handled primarily farm production supplies; and 474 provided services
related to marketing or purchasing activities.
Marketing cooperatives handle, process and sell
cotton, dairy products, fruits and vegetables, grains and oilseeds, livestock and poultry,
nuts, rice, sugar and other agricultural commodities. Farm supply cooperatives provide
farm chemicals, feed, fertilizer, petroleum products, seed and other input items to
producers. Farm service cooperatives operate cotton gins, provide trucking and artificial
insemination services and store and dry products.
In 1995, farmer cooperatives had more than 3.7
million members (many farmers belong to more than one cooperative) and a total gross
business volume of $112.2 billion. Total net earnings (considering losses) were $2.36
billion. Combined assets of the group totaled $40.3 billion and liabilities were $23.6
billion, leaving member equity of $16.7 billion.
Another important cooperative activity in rural
areas is furnishing electric power. Nearly 1,000 rural electric cooperatives operate more
than half of the electrical lines in America, providing electricity to more than 25
million people in 46 States. Sixty of these are called generation and transmission
cooperatives (G&Ts) because they generate and transmit electricity to meet the power
needs of the other cooperatives that distribute electricity to the people.
Telecommunications services to rural areas are
also provided by cooperatives. Telephone cooperatives serve 1.2 million people in 31
States. The National Rural Telecommunications Cooperative, owned by almost 800 rural
electric and telephone systems, makes satellite television available to rural areas not
served by cable companies. Cooperatives may be the on-ramp for rural residents wishing to
travel the information highway.
Table of Contents
Chapter 4. Benefits of Cooperation (5)
People buy stock in a non-cooperative business to make money on their investment. The more
of the company you own, the more benefits (stock appreciation and dividends) you will
realize if the business succeeds.
The benefits of being a cooperative member
differ in two ways. First, the advantages are more numerous. Second, they are distributed
on the basis of how much use you make of the cooperative, rather than your equity stake.
Here are some benefits of cooperative membership and how they relate to use.
1. Access to quality supplies and services at reasonable cost. By banding together and
purchasing business supplies and services as a group, individuals offset the market power
advantage of firms providing those supplies. You can gain access to volume discounts and
negotiate from a position of greater strength for better delivery terms, credit terms, and
other arrangements. Suppliers will be more willing to discuss customizing products and
services to meet your specifications if the purchasing group provides them sufficient
volume to justify the extra time and expense.
The larger the group purchasing supplies and
services through the cooperative, the greater the potential for savings. And the more each
individual member uses the supply operation, the more he or she may save over doing
business elsewhere.
Another option for cooperative members is to
manufacture their own supplies and hire experts directly to provide essential services.
This gives members even more reliable sources of supply and greater control over the types
of products available, the cost, and the quality of the services received.
2. Increased clout in the marketplace. Marketing on a cooperative basis, like purchasing
supplies and services, permits members to combine their strength while maintaining their
status as independent business people. They can lower distribution costs, conduct joint
product promotion, and develop the ability to deliver their products in the amounts and
types that will attract better offers from purchasers.
A special Federal law, the Capper-Volstead Act,
provides a limited exemption from antitrust liability for marketing agricultural products
on a cooperative basis. Under this law, farmers can agree on the prices they will accept
for their products and other terms of sale.
Through cooperative marketing, members can
share information and negotiate with buyers from a position of greater strength and
security. They can also develop processing facilities by themselves or as part of a joint
venture with other cooperative or non-cooperative firms.
A cooperative can also serve as a vehicle for
people selling goods and services to work with their customers to promote industry
research, reduce regulatory burdens, and develop markets for their products. The
cooperative can help create a "win-win" situation for the entire industry, a
business environment where both producers and buyers have more income.
3. Share in the earnings. Some people talk about non-cooperative firms operating "for
profit" while cooperatives operate "at cost." This isn't totally accurate.
Most cooperatives generate earnings. They differ from non-cooperative firms in how they
allocate and distribute their earnings.
A non-cooperative firm retains its earnings for
its own account, or perhaps pays part of them out to shareholders as dividends, based on
the amount of stock each investor owns. In a cooperative, earnings are usually allocated
among the members on the basis of the amount of business each did with the cooperative
during the year. Remember the example of a cooperative that has net earnings of $20,000
during the year and conducts 2 percent of its business with Ms. Jones. She is allocated
$400 of those earnings ($20,000 x .02).
Typically, Ms. Jones would receive her
allocation, called a patronage refund, partly in cash and the remainder as an addition to
her equity account in the cooperative. Permitting their cooperative to accumulate retained
patronage refunds is a relatively easy and painless way for members to help finance
activities and growth. Also, if certain rules in the Internal Revenue Code are followed,
the cooperative may deduct both the cash payouts and the retained patronage refunds from
its taxable income. This makes cooperative earnings particularly valuable.
4. Political action. Growers, small business owners, and other rural residents have to
realize that no one gives you a favorable law or regulatory ruling just because you think
you deserve it. You have to build your case and argue your point convincingly.
A cooperative gives people a means to organize
for effective political action. They can meet to develop priorities and strategies. They
can send representatives to meet with legislators and regulators. These persons will have
more influence because they will be speaking for many, not just for themselves.
They can also form coalitions with other groups
having similar views on issues. The larger the voice calling for a specific action, the
more likely that the system will respond with the policy you desire.
5. Local economy enhanced and protected. Having its businesses owned and controlled on a
cooperative basis helps your entire community. Cooperatives generate jobs and salaries for
local residents. They pay taxes that help finance schools, hospitals, and other community
services.
When a business is a cooperative, your town is
less likely to lose those jobs and taxes. A business owned by one person, or a subsidiary
of a big company, can easily be moved to another community. When many local people share
the ownership of a cooperative, no individual or company can take it from your area or
simply close it. Only the membership as a whole can make such decisions.
Table of Contents
Chapter 5.
Business Organizations (6)
In the United States,
historically there are three basic categories of private business firms--individually
owned, partner-ships and corporations. Cooperatives are a type of corporation. Recently,
most States have approved a new business structure, the limited liability company. This
section explains the similarities and differences between cooperatives and the other
business forms.
Individually Owned Businesses
The individually owned
business is the oldest and most common form. One person owns, controls and conducts the
business. Characteristics of individually owned businesses include:
Control.
The owner is responsible for management, makes all the major operational decisions
an sets the business policies
Capital. The owner supplies the equity and is responsible for all debts.
Earnings. Profits belong to the owner.
Taxes.
Profits are taxed once, as income of the owner.
Life.
The life of the individually owned business is tied to the one owner. It continues until
the owner sells the business, retires or dies. At that point the
business is either taken over by a new owner or discontinued.
Many farms are
operated as individually owned businesses. Other examples of business commonly operated by
an individual owner include service stations, hardware stores, restaurants, flower shops
and dry cleaners.
Partnerships
Partnerships consist
of two or more people who jointly own, control and operate a business. The
responsibilities of each are usually based on a partnership agreement. Characteristics of
partnerships include:
Control. Partners usually share management and make
policy decisions by mutual agreement or majority vote. Some agreements provide for senior
partners whose votes may carry greater degrees of weight.
Capital.
Partners provide the equity capital. Usually, each partner is personally liable, up to the
value of all the property he or she owns (both within and outside the partnership), for
the debts of the partnership. Some partnerships have "limited" partners, who
relinquish any voice in managing the business in exchange for a limit on their personal
liability.
Earnings. Profits (or losses) are shared by the partners
in accordance with the terms of the partnership agreement. This is usually determined by
the amount of capital invested and the nature of the work performed by each partner.
Taxes.
Earnings are taxed once, as income of the partners.
Life.
The life of the partnership as a business is deter-mined by the partners, but if one dies
or leaves the organization, it often must be dissolved and a new partnership formed.
Some farms are owned
and operated on a partnership basis. Other examples include law and accounting firms,
insurance and real estate companies. Partnerships may operate an auto repair firm, store
and any other business.
General Business Corporations
Most businesses that
have more than a small number of owners are organized as corporations. Corporations are
legal entities, authorized by law to act much like an individual person. A corporation has
the right to provide services, own property, borrow money, enter into contracts and is
liable for its own debts.
A general business corporation operates as a
profit-making enterprise for its investors, who are also referred to as stock-holders.
Most of the major companies in America operate as general business corporations. Their
characteristics include:
Control.
Management is controlled by a board of directors and officers who are elected by the
stockholders. Each stockholder usually has as many votes as the number of shares of voting
stock he/she owns. Business decisions and policy are made by the board and officers. The
directors have no obligation to use the firm's products or services and may have no
contact with the firm outside of board meetings.
Capital.
Equity is raised by selling shares of stock to investors for their profit-making
potential. The corporation is responsible for its own debts. If the business fails, each
owner of stock can lose only the amount invested.
Earnings.
Profits are distributed to stockholders as dividends according to the number of shares of
stock owned or used to expand the business. The timing and amount of such dividend
distributions are decided by the board of directors.
Taxes.
Earnings are taxed twice, as income of the corporation when earned and as income of the
stockholders when distributed as dividends.
Life.
A corporation enjoys a continuing existence, regardless of changes that may occur in the
ranks of its shareholder owners.
Examples of investor-oriented corporations are
large department stores, chain grocery stores, regional banks, automobile manufacturers
and much of the communications industry.
Limited Liability Company
A new form of business
gaining widespread attention is the limited liability company (LLC). It combines the
single-tax treatment of a partnership and the limited personal liability of owners of a
corporation. Characteristics of an LLC include:
Control.
The owners, called members as in a cooperative, may share management and make policy
decisions by mutual agreement or majority vote, or turn the management over to nonmembers.
The operating agreement among the members determines voting rights of each member.
Capital.
Members usually provide the equity capital. Liability of the members is usually limited to
their investment in the corporation.
Earnings.
Profits (or losses) are shared by the members in accordance with the terms of the
operating agreement. This is usually based on the amount of capital invested and the
nature of the work performed by each member.
Taxes.
The Treasury Department assumes an LLC wants to be taxed as a partnership. However, an LLC
has the option to elect to be taxed as a general business corporation.
Life.
An LLC may have a perpetual existence, or the members may chose to be governed by the
partnership rules.
The LLC is still
developing as a business structure. It is already proving a useful vehicle for organizing
joint ventures among established corporations, including those involving cooperative and
noncooperative firms. Whether it can be used to organize a number of individuals, who may
want the flexibility to join and leave the venture at will, is undetermined at this time.
Cooperative
A cooperative is also
a state-chartered business, organized and operating as a corporation under applicable
state laws. Cooperative attributes are:
Control.
Management is controlled by a board of directors who are elected by the members. One
unique feature of a cooperative is that each member usually has only one vote in selecting
directors, regardless of the amount of equity that member has in the cooperative. Another
is that all or most of the directors must be members of the cooperative. Thus, the leaders
are regular users of the firm's products or services.
Capital.
Equity comes from the members, rather than outside investors. It is obtained by direct
contributions through membership fees or sale of stock, by agreement with members to
withhold a portion of net income based on patronage, or through retention of a portion of
sales proceeds for each unit of product marketed. If a cooperative fails, the liability of
each member is limited to the amount he/she has invested.
Earnings.
Earnings (or losses) on business conducted on a cooperative basis, often called margins,
are allocated to the members on the basis of the use they made of the cooperative during
the year, not on the basis of equity held. The allocations may be distributed in cash or
retained as additional equity. Members usually receive a combination of cash and an
allocation of equity.
Taxes.
Earnings from business with members are taxed once, either as income of the corporation
when earned or as income of the members when allocated to them.
Life.
A cooperative usually has a perpetual existence. Members can routinely join or resign
without disrupting ongoing operations.
Examples of businesses
that operate as cooperatives include agricultural marketing, purchasing and service
organizations; credit unions; health care providers and multi-unit housing facilities.
Table of Contents
Chapter 6. Classifying
Cooperatives by Structure
Cooperatives are
regularly described by a number of classification schemes. The more important ways to
categorize are by the geographical territory served, the governance system and the
functions they perform.
Geographic Territory Served
One factor determining
cooperative structure is the size of the area served. Cooperatives are loosely categorized
as local, super local, regional, national and international.
Local
cooperatives operate in a relatively small geographic area, typically a single county or
an area within a radius of 10 to 30 miles. They usually have only one or two facilities,
from which to serve members.
Super local
cooperatives operate in two or more counties, often with several branch facilities.
Regional
cooperatives serve an area comprising numerous counties, an entire State or a number of
States.
National
cooperatives serve a major portion or most of the United States.
International
cooperatives operate in more than one country, with headquarters in the United States or
another country.
Governance System
Cooperatives can also
be classified based on membership structure, as centralized, federated or mixed.
Centralized
cooperatives have individuals and business entities (including partnerships and family
corporations) as members. Virtually all locals and super locals are centralized. Regional,
national, and international cooperatives may also be centralized.
A centralized cooperative has one central
office, one board of directors elected by its members, and a manager (chief executive
officer) who supervises all operations. Business may be conducted through numerous branch
stores or offices staffed by employees responsible to the central management team.
Federated
cooperatives have other cooperatives as their members. Each member of a federated is a
separate cooperative that owns a membership share entitling it to voting rights in the
affairs of the federated. Local cooperatives commonly form federateds to perform
activities too complex and expensive for them to do individually, such as manufacturing
production supplies, tapping major financial markets, and marketing on a national or
worldwide scale.
Each member of a federated typically has its
own board of directors, manager, employees and facilities to serve its members. The
federated has its own hired management and staff and a board of directors elected by and
representing its member cooperatives.
Mixed
cooperatives have both individuals and other cooperatives as members, who are usually
given voting rights representative of their own membership.
Functions Performed
Cooperatives may
perform one or more of three core functions: marketing products, purchasing supplies and
providing services.
Marketing
cooperatives assist members maximize the return they receive for goods they produce. Most
cooperative marketing activity involves either agricultural products or those of producers
in related industries such as forestry, aquaculture and horticulture. New marketing
ventures are developing in such diverse industries as handicrafts, professional services
and information technology.
Some marketing cooperatives limit their
activity to negotiating prices and terms of sale with buyers. Growers of fruits and
vegetables for processing and dairy farmers are primary users of these cooperatives,
called bargaining associations.
Other marketing associations assemble member
production into large quantities for sale to further processors, wholesalers or retailers.
This first-handler role is common for cooperatives of grain growers and producers of
fruits and vegetables for the fresh produce market.
Other such associations add further value to
member production by processing or manufacturing member products into other, more valuable
products. These may serve as ingredients in further processed products or be sold to
institutional buyers and restaurants for their direct use, to grocery chains for resale as
private label products, or to brand-name companies for resale under their brand.
Cooperatives that process dairy products, fruits, vegetables, grains, fish, and lumber
exemplify these value-added processing activities.
Still others put member products right on the grocery store shelf under
their own brand name. Land O'Lakes, Sunkist, Ocean Spray, Welch, Tree Top and Knouse Foods
are examples of cooperatives with established brands.
Marketing cooperatives enable members to extend control of their
products--and realize additional margins--through processing, distribution and sale.
Purchasing cooperatives were first
used by farmers to gain access to affordable, quality production supplies such as feed,
fuel, fertilizer and seed. These early efforts often became businesses having full-time
managers and warehouses to handle other production supplies and services such as farm
chemicals, animal health products, fencing, building supplies, construction contracting,
automotive accessories, etc.
Many local purchasing cooperatives have affiliated with other such
organizations, often through regional and national federated cooperatives. These efforts
reduce member costs and strengthen their purchasing power through direct ownership of
large-scale facilities such as petroleum refineries; phosphate, potash, and nitrogen
manufacturing plants; feed mills; research facilities and laboratories.
Today many nonfarm businesses have developed supply purchasing
cooperatives to gain access to the same volume discounts and quality control assurances
long available to farmers. These include hardware stores, independent grocery stores and
fast food restaurant franchisees. Many have developed private labels, such as Shurfine
Foods, or recognized brand names such as Ace Hardware, True Value and Servistar.
Service cooperatives were also
developed to serve farmers. Some of these services are farm-specific, such as recommending
and applying fertilizer, lime, or pesticides; animal feed processing; and crop harvesting.
Others are general in nature, such as credit through the Farm Credit System, electricity
through rural electric cooperatives and communications service through rural telephone
cooperatives.
Nonagricultural service cooperatives are also flourishing. Credit
unions and the National Cooperative Bank provide credit on a cooperative basis to nonfarm
individuals and cooperatives. School systems, health care providers, and insurance buyers
are among the general public segments making use of service cooperatives.
Table of Contents
Chapter 7.
People (7)
Because a cooperative
is owned and controlled by the people who use its services, the various persons affiliated
with a cooperative must work even more closely together than in a noncooperative firm.
Customer service and satisfaction are the driving forces behind a cooperative, not
maximizing bottom-line return to investors. These take on a highly personal tone when the
owners and directors, in their role as users, have regular contact with management and
staff.
Cooperatives depend on a coordinated team
consisting of four elements -- members-owners, board of directors, the manager and other
responsible employees. Each part of the team has its own distinctive duties. Success is
based on intelligent and active cooperation and each group carrying its load.
Members
Members are the
foundation of the cooperative. They organized it. Their needs are the reason for its
existence. Their support, through patronage and capital investment, keeps it economically
healthy. And their changing requirements shape the cooperative's future.
Statutory law and the basic legal documents of
a cooperative --articles of incorporation, bylaws, and contracts between the cooperative
and its members--give the members the tools to control the cooperative and the duty to use
those tools for their mutual benefit. Legal rights and responsibilities of cooperative
members normally include:
To
adopt and amend the articles of incorporation and bylaws.
To
elect and, if necessary, remove directors.
To
decide whether to dissolve, merge or consolidate the cooperative or form a joint venture
with other cooperative or noncooperative firms.
To
make sure officers, directors and other agents comply with laws applicable to the
cooperative and with its articles of incorporation, bylaws and membership contracts.
Members also have general responsibilities toward their
cooperative. Unlike the passive investor in a general business corporation, the
member-owner-user of a cooperative must patronize and guide the venture for it to succeed.
Employees and advisers need to understand these member obligations and help members
fulfill them.
1. Patronize the cooperative.
Members must make a conscious decision to be committed to the cooperative, even when
short-term prices or services may be better elsewhere. If members don't want to use the
cooperative, the need for it must be reexamined.
2. Be informed about the cooperative. To
carry out their other duties, members must know what the cooperative is about; what it can
do for them; its purpose, objectives, policies; and the issues it faces. They can obtain
information through annual meetings, reports and newsletters, and from talking to the
manager, staff, directors and other members. To effectively exercise their right of
ownership, a member needs a good understanding of the present situation and projected
future operations.
3. Be conscientious when selecting and
evaluating directors. Although the cooperative is a user-owner, democratically
controlled form of business, members can't make all the decisions directly. They select
from among their peers individuals with the best judgment and business management skills
to represent them in management affairs as the cooperative's board of directors. Loyalty,
integrity, the ability to make wise business decisions and willingness to serve are
necessary characteristics for board members.
4. Provide necessary capital.
Members must provide the equity financing their cooperative needs for acquiring inventory,
facilities, services and working capital. This is done initially through the purchase of
stock or a membership. It continues by permitting the cooperative to retain a portion of
the earnings allocated to each member and through the collection of per-unit retains from
checks to members for the proceeds of sale from marketing member products.
If the cooperative loses money, members have the same obligation to
share those losses as they do the earnings.
5. Evaluate performance of the
cooperative. Members should examine the annual report and observe whether the
cooperative is meeting their needs. If they are dissatisfied with cooperative performance,
they should share their concerns with the directors. They should also express support for
things the cooperative is doing well. Directors can't effectively represent the members if
they don't know the members' true feelings.
Directors
Directors in a
cooperative occupy a key position between members and hired management. They are both
users of its services and representatives of other members who depend on those same
services.
Acting as a group, directors set the objectives
for the cooperative and make decisions that set the course the cooperative will follow in
achieving those objectives. These broad managerial decisions include:
Hire
a competent manager, determine the salary, outline the duties and authority of the
position and formally review his/her performance at least annually.
Adopt broad, general
policies to guide the manager. Topics covered might include credit limits to patrons,
expenditures that need prior board approval and general personnel regulation.
Develop
and adopt long-range business strategies.
Require
written monthly financial reports and operating statements for board meetings to be
informed of adverse as well as favorable operations.
Direct
the manager to prepare, before the close of each year, an operating budget for the next
fiscal year for board approval. This budget should estimate the volume of sales and gross
income of various items to be handled, the expenses by account classifications and the net
income expected. This constitutes necessary forward planning by the board and management.
The budget should be reviewed at intervals throughout the year to determine the trends of
the business.
Employ
a qualified auditor to make an independent audit at least once each year to determine the
accuracy of the financial records. An audit is the primary method the board uses to verify
the financial condition of the cooperative. Many successful cooperatives also use the
audit report to evaluate the effectiveness of the policies and budget, performance of the
manager and gain insight into the effect of past decisions and the need for new ones.
With
the aid of the manager, plan and conduct the annual meeting to keep the membership
informed about the status of their business, including operations, finances and policies.
Determine
the patronage refund allocation and per-unit retain level. Factors to consider include
legal requirements, member needs and desires for cash refunds, the desirability of
providing money to retire old equities, and current and future capital needs.
Assure
competent legal counsel is available.
Keep
a complete record of the board's actions.
A cooperative director should not expect to
receive special favors from the manager or employees, and a director does not:
Act
independently on matters that should be decided by the entire board. Individual directors
have no authority outside of board meetings.
Represent
special interests, factions or political entities. Directors are elected to oversee the
business activities of the cooperative, not serve as an agent of these groups.
In carrying out their
responsibilities, directors serve much like trustees, charged with a legal obligation to
protect the assets of the members. Directors who act outside the parameters of the law or
don't exercise due care in their decisionmaking can be personally liable for the harm they
cause the members, the cooperative or third parties.
Officers
The board usually
elects the cooperative's officers shortly after the annual membership meeting. Each
officer has specific duties as detailed in the cooperative's bylaws.
The
president presides at all meetings and watches over the association's affairs, serving as
the main communication link between hired management and the other directors and members.
The
vice president, in the absence or disability of the president, performs the duties of the
president.
The
secretary keeps a complete record of all meetings of the board of directors and general
membership and also is the official custodian of the cooperative's seal, bylaws, and
membership records.
The
treasurer oversees the bookkeeping and accounts to ensure accuracy and proper handling and
also is responsible for presenting periodic financial reports.
Board Committees
The board's work may be divided among special or permanent
committees, each dealing with a phase of the association's operations, such as finance,
purchasing, merchandising, and others.
Each committee studies the problems in its
particular field and makes recommendations to the board of directors. In some instances,
committees may be given certain powers to act for the board, subject to review by the
entire board.
Large associations may select an executive
committee to perform general management and oversight duties as authorized by the board.
Managers
Success of a
cooperative largely depends on good board/ manager relationships. The working relationship
between board and general manager requires respect and an understanding of each other's
responsibilities.
The board of directors decides what the
cooperative will do; the general manager and immediate staff decide how it can best be
done--subject to board review--so as to achieve the basic objective of serving members
effectively.
The manager is selected by the board and
accountable to it for his/her actions. The manager should therefore not be a part of the
board. The manager should, however, attend all board meetings and be an active, nonvoting
participant.
The manager controls the ongoing activity of
the cooperative. Responsibilities of the general manager include:
Supervise
and coordinate, under board direction, the business activities of the co-op by managing
the people, capital, and physical resources.
Hire,
train, supervise, and set compensation for employees. The manager also needs to review
their performance and train, reassign, or replace those employees not meeting acceptable
performance levels.
Oversee
the detailed operations of the cooperative, within policies established by the board of
directors, such as purchasing inventory and selling commodities, maintaining the general
appearance of the co-op, and making sure employees respond to member needs.
Maintain,
and revise as necessary, an adequate bookkeeping and accounting system; develop for board
approval a financial budget annually; prepare proper financial reports regularly for board
review; and present a report of the cooperative's operational highlights to the membership
at the annual meeting.
Furnish
information needed for long-range planning. This will bring matters, such as fixed asset
additions or revisions, to the board's attention for review.
Represent
the cooperative and portray a positive image to members and others in the community.
Encourage
membership and active patronage.
Communicate
developments at the cooperative to members.
Keep
current on local, State, and Federal legislative and regulatory developments affecting
cooperatives.
Employees
In many ways, working
for a cooperative is similar to doing the same job at a noncooperative firm. But special
features of a cooperative--the role of the member-owner as user and the emphasis on
service over bottom-line numbers--place unique obligations on the employees.
1. Understand
the purpose and objectives of the cooperative. Employees need to know how
cooperatives are different from other methods of doing business. By understanding
cooperative purposes, objectives, operations and their role as employees, they can
help improve member relations, the cooperative's image and the general public's
understanding of cooperatives.
2. Fully
perform duties. In many cooperatives, like other business firms, the largest
operating expense is for personnel. While the cooperative has responsibility for
recruiting and providing training, the employee is responsible for using these
opportunities to provide the best possible service to members.
3. Understand
the relationship to member-owners. All employees have a responsibility to
maintain a high level of customer satisfaction and good relations between the cooperative
organization and its member-users. Immediate feedback from members should be encouraged to
keep the manager informed of problems, needs and customer satisfaction.
The employee role is particularly important in
larger cooperatives. The only cooperative employees that members may encounter regularly,
from annual meeting to annual meeting, may be the individual pumping the gas, the cashier,
the person answering the telephone, the truck driver picking up their milk or delivering a
product. To the average member, they are the voice of the cooperative.
4. Favorably represent the cooperative. Employees help build the
cooperative's image as they serve members and the community--both on and off the
cooperative's premises. Employees should keep the premises clean and attractive; make sure
equipment and service tools are operating; serve members pleasantly, promptly, and in the
order promised and take an extra step to give members satisfactory service.
Employees, like their manager, can be community
boosters by taking part in religious, school or community affairs. Their efforts can
positively affect the cooperative image held by members, the general public and other
businesses.
Table of Contents
Chapter 8.
Sources of Equity (8)
One of the greatest
challenges facing cooperatives is raising equity capital. Because cooperatives pass
earnings through to users on a patronage basis, they cannot attract equity from outside
sources to the same extent as investor-owned businesses.
Cooperatives are not alone. Sole
proprietorships, partnerships and closely held corporations face similar problems
acquiring equity. Their equity capital usually is provided by the owners or acquired via
retained earnings.
Only a single tax is placed on their income, to
help overcome the capital accumulation problem. Earnings of investor-owned corporations
are subject to taxation twice, once at the corporate level when earned and again at the
ownership level if and when distributed as dividends. Owner(s) of a sole proprietorship,
partnership, limited liability company or cooperative can generally reduce tax liability
at the firm level if they meet specific Internal Revenue Code (Code) requirements. A
greater portion of income is therefore available for reinvestment in the business.
The three primary ways members provide equity
to their cooperative are direct investment, retained margins, and per-unit capital
retains. Cooperatives may also acquire equity by retaining earnings on nonmember,
nonpatronage business. This section explains the nature of each source of equity.
Direct Investment
Direct investment
refers to cash purchases of membership certificates, common and preferred stock or other
forms of equity.
Most cooperatives require a member to make a
direct payment when joining the cooperative. In return, the member receives a membership
certificate in a nonstock cooperative or a share of common stock in a stock cooperative.
The certificate or share of stock usually conveys to the owner the right to vote on
matters submitted for decision to the cooperative membership and the owner is generally
referred to as a member of the cooperative.
Direct investment by members is often a minor
source of equity to a cooperative. Most cooperatives are trying to retain current members
and attract more members and member business. And members generally prefer the cooperative
to generate its own equity, rather than solicit checks from them. Thus the cost of a
membership certificate or share of common stock is usually modest. Equity that evidences
membership usually does not pay a dividend, if for no other reason than the administrative
expense of issuing a large number of small checks.
Traditionally, direct investment can be a major
source of equity in two instances. Direct investment is often the primary means for a new
cooperative to acquire equity capital. Once the cooperative is functioning, it then can
accumulate additional equity from operating funds in the form of retained earnings or
per-unit retains.
Some cooperatives also acquire equity by
selling nonvoting stock or equity certificates to members and nonmembers. This nonvoting
equity usually pays a limited dividend as an inducement for persons to invest in the
cooperative.
A resurgence in
cooperative value-added processing of commodities is being fueled by a system of direct
investment, called transferable delivery rights. Members who wish to
share in the benefits from the value-added processing are required to provide necessary
up-front capital by purchasing long-term delivery rights in the cooperative. These
delivery rights entitle and obligate the member to deliver to the cooperative all of the
production from specified acreage or specific quantities of product (so many tons or
bushels). The purchase of delivery rights assures members of a long-term "home"
for their production and provides an opportunity to share in the benefits of value-added
processing based on their patronage.
Membership is generally limited to producers
who purchase delivery rights and the cooperative only sells enough delivery rights to
secure the quantity of product it can process efficiently and resell at a profit. The
delivery rights are typically represented by non-dividend bearing, non-voting preferred
stock. The preferred stock (and thus the right to deliver product to the cooperative) are
transferable by the member to other producers, subject to approval by the cooperative's
board of directors. If the cooperative is successful, the only way other producers can
participate is to purchase delivery rights from current members. Thus, members may enjoy
an additional benefit, a gain on the sale of their preferred stock tied to their delivery
rights.
Generally, the tax treatment of direct
investments in a cooperative follows the same rules as a direct investment in an
investor-owned corporation. The payment to the cooperative is a nontaxable event. While
the value of cooperative equity is usually constant, any gain or loss realized by the
equity holder is generally a capital gain or loss.
Cooperative earnings used to pay dividends on
equity are usually subject to taxation at both the cooperative and the recipient levels.
An exception is dividends paid by farmer cooperatives that qualify for so-called
"exempt" status under Code section 521. These cooperatives are allowed to deduct
dividends paid on stock, so they are only taxed once, at the recipient level.
Retained Margins
While cooperatives are
sometimes described as businesses that operate "at cost," few if any can do so
on a day-to-day basis. Rather, cooperatives seek to generate income that exceeds expenses
on an ongoing basis. Then, usually after the close of the fiscal year, they return
earnings from business conducted on a cooperative basis to the persons responsible for the
business generating those earnings, who are called patrons.
These returns, based on the amount of business
each patron does with the cooperative during the year, are called "patronage
dividends" in the Code. This report refers to them as "patronage refunds,"
the term used in cooperative literature. This reduces the likelihood such refunds will be
confused with traditional dividends, which are based on stock ownership rather than the
amount of business conducted with the firm.
The board usually determines how the earnings
will be distributed. All of the earnings may be returned to the patrons as cash patronage
refunds. Or the directors may decide to have the cooperative retain some or all of the
patronage refunds as an equity investment in the cooperative. Single tax treatment is
available only for patronage-sourced earnings that are returned to the patrons as cash or
"other property," or retained under procedures set out in the Code.
Qualifying for the single tax treatment
provided in the Code is discretionary, not mandatory. Earnings not allocated to patrons
are treated just as profits of an investor-owned firm. They are taxable income to the
cooperative when earned and taxed a second time to the recipients when distributed by the
cooperative.
Per-Unit Capital Retains
Cooperatives that
market products produced by their members have a third means of acquiring equity capital,
per-unit capital retains. These are capital investments based on either the number of
physical units handled by the cooperative or on a percentage of sales revenue. Per-unit
retains are deducted from sales proceeds due the members from the cooperative.
As with patronage refunds, per-unit capital
retains returned to patrons as cash or retained by the cooperative, under rules in the
Code, are only subjected to a single income tax.
And again, single tax treatment is
discretionary. A cooperative may place some or all of these retains into an unallocated
reserve, thereby forfeiting access to single tax treatment.
People sometimes blur the distinction between
patronage refunds and per-unit capital retains. Patronage refunds are based on the
earnings of the cooperative; per-unit retains on the volume or value of business done with
the cooperative. Thus, a cooperative can acquire capital, even in a year of limited
margins or a loss, through the use of per-unit capital retains.
Nonmember/Nonpatronage Earnings
Non-tax laws, such as
the Capper-Volstead Act and state cooperative incorporation statutes, frequently require
affected cooperatives to do a majority of their business with members. This still leaves
those associations free to do up to 49 percent of their business with nonmembers on a
noncooperative basis.
Earnings on this business are usually not
eligible for single tax treatment. But the after-tax earnings can be used to build the
equity base of the cooperative to improve its balance sheet and finance services it
provides to members. Again, an exception is made for section 521 cooperatives, which may
deduct nonpatronage income distributed to patrons on a patronage basis.
Table of Contents
Chapter 9.
Financial and Tax Planning
As the following flow
chart illustrates, cooperatives have flexibility in designing an equity accumulation
program to meet their individual needs. An understanding of the alternatives and their tax
treatment is especially important when allocating patronage-based sources of equity,
retained margins, and per-unit retains.
![c55eqty2.gif (6533 bytes)](c55eqty2.gif)
Direct investments
usually are made to purchase membership equity, the membership certificate or a share of
common voting stock.
Nonpatronage income is likewise usually placed
into a single type of account, an unallocated reserve.
Patronage-based sources of equity can be used
for at least four purposes: cash refunds, qualified retained patronage allocations,
nonqualified retained patronage allocations and unallocated reserves.
Cash Refunds
Cooperatives can
distribute their margins and per-unit capital retains as cash refunds to the patrons. Cash
distributions are generally tax deductible by the cooperative in the year earned and
taxable income to the recipient in the year of receipt. Cash refunds do not add to the
equity of the cooperative, but provide an immediate additional return to the patron on his
or her use of the cooperative.
Qualified Retains
Cooperatives can
retain margins and per-unit capital retains and allocate the retained funds to equity
accounts of the patrons, based on the amount of business each patron did with the
cooperative during the year. If the cooperative follows the rules in the Code to
"qualify" the equity, the cooperative deducts the amount of the allocations from
its taxable income in the year the margins and retains were realized.
Patrons include the amount allocated in their
taxable income in the year they receive a required written notice of the allocation. The
retained funds become an equity investment by the patron in the cooperative. An example
illustrates how this works for a typical agricultural marketing cooperative.
The cooperative pays the producer $600 for
his/her crop at the time of delivery. It costs the cooperative $300 to market the crop.
The cooperative sells the crop for $1,000.
The resulting margin of $100 is returned to the
patron as a patronage refund. Thus the patron receives a total payment of $700 for
the crop, a $600 advance at the time of delivery and a $100 patronage refund.
When the cooperative figures its taxable
income, it is allowed to deduct the initial payment for the crop ($600), its other
expenses of marketing the crop ($300), and the patronage refund ($100). Thus, it ends up
with no taxable income. The patron includes both the initial payment ($600) and the
patronage refund ($100) in taxable income, for a total of $700.
TAX TREATMENT OF COOPERATIVE AND PATRON
QUALIFIED RETAINED EQUITY
Cooperative |
|
Patron |
|
Expenses |
|
Income |
|
Crop |
$600 |
Crop |
$600 |
Other |
$300 |
|
|
Total |
$900 |
|
|
Income |
$1000 |
|
|
Margin |
$100 |
Refund |
$100 |
Taxable Income |
0 |
Taxable Income |
$700 |
The Code requires at
least 20 percent of a qualified patronage refund be paid in cash. But the cooperative can
still retain up to 80 percent of its margins without having to pay a tax (at the co-op
level) on any of the patronage refund. There is no 20-percent cash distribution
requirement for qualified per-unit retains, so a cooperative can keep the entire amount
free of tax liability at the co-op level.
The patron must report the entire $100 refund
as taxable income, even though $20 or less may have been paid in cash.
The redemption of qualified equity is a
tax-free event for both the cooperative and the patron, since the tax was paid by the
member when the patronage refund was received.
The tax treatment of qualified retained equity
is similar to the pass-through procedures that provide single tax treatment for
partnerships and other single-tax corporations. But, cooperatives have additional
flexibility not generally available to other pass-through entities.
Nonqualified Retains
Cooperatives may delay
the pass-through of the tax obligation from the cooperative to the patron without
jeopardizing single tax treatment of those moneys.
Any patronage-based allocation not meeting the
requirements of the Code to be "qualified," has "nonqualified" status.
When a nonqualified allocation is made, the cooperative pays corporate income taxes on the
funds retained. The patron has no tax obligation on these funds in the year of allocation.
TAX TREATMENT OF COOPERATIVE AND PATRON
NONQUALIFIED RETAINED EQUITY
Cooperative |
|
Patron |
|
Expenses |
|
Income |
|
Crop |
$600 |
Crop |
$600 |
Other |
$300 |
|
|
Total |
$900 |
|
|
Income |
$1000 |
|
|
Margin |
$100 |
Refund |
$100 |
Taxable Income |
$100 |
Taxable Income |
$600 |
If the cooperative in
the earlier example issues its patronage refunds as nonqualified written notices of
allocation, it would have taxable income of $100, the amount of the margin. The patron's
taxable income would have been $600, the payment for the crop.
At some later time, when nonqualified
retained equity is redeemed, the cooperative receives a tax benefit based on the tax
paid at the time of allocation. The patron is taxed on the funds received. In the example,
the cooperative would deduct the $100 paid to the patron (or receive a credit under
certain circumstances). The patron would report the $100 as income in the year the cash
payment was received.
Thus the single tax treatment of cooperatives
doing business with or for members is complete and consistent with that accorded other
single-tax entities. Income is ultimately taxed once, at the level of the owner-user of
the business.
Nonqualified allocations have particular appeal
to cooperatives with member-patrons in high marginal tax brackets. If the cooperative uses
qualified allocations, it must make substantial cash payouts or high income patrons may
suffer a negative cash flow on the margins they generate. This occurs when the total tax
owed on the allocation (Federal and State) exceeds the amount of cash paid out as part of
the distribution.
By using nonqualified allocations, no tax is
due from patrons until the allocation is redeemed. Also, there is no 20-percent cash
payout rule for nonqualified allocations.
Unallocated Reserves
Cooperatives can treat
margins just as noncooperative firms treat earnings, by putting them into an unallocated
reserve and paying corporate income tax. Under this approach, single tax treatment is
forfeited. If the funds are later distributed, the recipients must pay a second income
tax.
Cooperatives are free to use a combination of
cash payouts, unallocated reserves, and qualified and nonqualified allocations. This makes
it possible for the leadership to develop a program that reflects the best interests of
the membership.
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Chapter 10.
Equity Management
Another practice
unique to cooperatives is the regular redemption of outstanding equity. Capital
contributions from continuing patrons build as time passes. But the level of patronage
will fall for some members, and others will likely cease using the cooperative at all. A
program of adjusting patronage-based equity requirements on a regular basis matches the
responsibility of financing the cooperative to current use of its services.
Three methods of matching patronage and equity
obligations have achieved general acceptance: revolving fund plans, special plans, and
base capital plans. Although the systems are often viewed as unrelated, they may, in fact,
operate together.
Revolving Fund Plan
"Revolving fund
financing" refers to systems in which patrons make annual capital contributions,
typically through retained patronage refunds or per-unit retain allocations. The
cooperative, in turn, redeems earlier capital contributions on a regular basis. Redemption
is usually on a first-in, first-out basis. The cooperative determines what its total
capital requirements are and the excess is redeemed each year, the earliest or
"oldest" equity being revolved out first.
A revolving fund plan is frequently described
as "systematic" if older equities are retired on a regular basis, usually a
given number of years after they were issued. In a systematic plan, member investment is
related to recent and current use. Newer members usually add equity to their account
during their early years in the cooperative.
The accounts of established members are
adjusted each year to better reflect current patronage. They make new investments based on
current year's patronage and have their earliest year's equity redeemed. The accounts of
former members are commonly paid off during the life of the revolving cycle, usually
beginning the year after they cease patronizing the cooperative.
Redemption is normally dependent on a board of
directors determination that funds for revolvement are available. This insures that there
is room for flexibility if the situation warrants it. For instance, if there is a
shortfall in new equity or a need to increase the cooperative's total equity, equity
requirements can be met by lengthening the revolving cycle (the cooperative keeps equity
for a longer period of time).
This tactic should be used sparingly, as it
deviates from the objective of having current users finance the cooperative. Also, it can
create member relations problems if the members have the expectation that their oldest
equities will be redeemed on a fixed schedule, sometimes without regard for the
cooperative's financial condition.
Special Plans
A special plan is one
in which a specific event or condition, such as a member's death, triggers equity
redemption. The most common events covered are death, retirement or reaching a specified
age. Once the condition is verified, the member's equity may be returned at once or over a
prescribed number of years.
Special plans are often popular with members,
who see redemption of their equity investments supplementing retirement income or their
estates. But special plans can complicate financial planning for the cooperative. One
problem is forecasting how much equity will be redeemed in a given year.
Another difficulty is dealing fairly with
members who are partnerships or corporations and whose business activity or life may
continue well beyond that of individual partners or shareholders. One approach is for the
association to redeem that portion of the member firm's equity equal to the ownership
interest in the firm of the person meeting the special redemption condition. Then the firm
would be expected to make up the difference just as if it had been underinvested by the
amount of the redemption.
Special plans are sometimes combined with
revolving fund or base capital plans.
Base Capital Plan
A "base capital
plan" is a special equity capital management plan. It focuses directly on the current
proportion of capital a patron should have in the cooperative at a particular time, based
on the degree of use. Development of the base capital plan involves several steps.
1. The cooperative
determines its total equity capital needs.
2. The equity capital
needs are allocated among patrons based on the proportion of the cooperative's business
each patron did with the cooperative during a base period, typically the past 3 to 7
years.
3. Each year the
cooperative's equity requirements are re-viewed and adjusted as the board of directors
finds appropriate. Each patron's share of the equity requirement is also adjusted to
reflect (a) any change in the total requirement of the cooperative and (b) any change in
the patron's proportional share in the new base period.
4. Under invested
patrons must add to their equity account, usually through the current year's retained
patronage refunds or per-unit retains, or by direct contribution.
5. Fully invested and
overinvested patrons generally are paid a cash rebate of current year's patronage refunds
and per-unit retain allocations. Overinvested patrons may receive an additional payment in
redemption of their excess share of the equity.
The proportional share
of former patrons will fall each year, reaching zero at the end of the base period
beginning the first year after they cease patronizing the cooperative.
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Conclusion
Cooperation is a very
old concept, with the potential for a very bright future. That potential will only be
realized if the people with an interest in cooperatives make the effort to make them work.
Reading and studying this booklet, and others like it, is an important first step. But
that alone won't make you an expert. Learning about cooperatives can be a life-long
process.
As the world changes, so must cooperatives if
they want to survive and prosper. Members, directors, managers, employees and advisers
must all seek out and take advantage of continuing educational opportunities.
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ENDNOTES
1. This chapter is based primarily on chapters 1
and 2 of Farmers, Cooperatives, and USDA: A History of Agricultural Cooperative
Service, Agricultural Information Bulletin 621 (USDA 1991).
2. This explanation of cooperative principles and
practices was developed by the author for Welcome to Cooperatives, available from
the National Society of Accountants for Cooperatives, Springfield, VA. Welcome to
Cooperatives is particularly appropriate- for educating accounting, financial and tax
professionals with limited knowledge of cooperatives.
3. Most of the material in this chapter is from A
Day in the Life of Cooperative America, a fascinating collection of facts and figures
on cooperatives, sponsored by the National Cooperative Bank, Washington, DC.
4. The first 3 paragraphs of this section are
based on Farmer Cooperative Statistics, 1995, RBS Service Report 52 (USDA 1996).
5. This chapter was written originally for Do
Yourself a Favor: Join a Cooperative, RBS Cooperative Information Report 54 (USDA
1996).
6. Much of this chapter was also prepared by the
author for Welcome to Cooperatives (see note 2, above).
7. This chapter reflects material originally
published in Under-standing Cooperatives, a series of circulars that can be used
individually or collectively for teaching people about cooperatives. RBS Cooperative
Information Report 45, sections 4-6 (USDA 1994).
8. Much of the last 3 chapters was first drafted
for Income Tax Treatment of Cooperatives: Background, RBS Cooperative Information
Report 44, part 1 (USDA 1993), the first in a technical series of reports on Federal
income taxation of cooperatives.
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