unit vi. income taxation of co-ops. much confusion about the income taxation of co-ops exists....

Unit VI.

Income Taxation of

Co-ops

Much confusion about the income taxation of co-ops exists.

Example Misconception:“These super co-ops (22 largest) virtually escape all Federal income taxation. Unless the Co-op tax and antitrust laws are revised, we will continue to see in ever increasing numbers, co-op expansion into the competitive market place. The tax-base erosion by the tax-favored, if not the tax-free, co-ops is particularly upsetting in light of the present economy. Now is the time for Congress to end the co-op use of tax-free capital for competitive marketplace intrusion.”

(Nat’l Tax Equality Assoc., 1980)

Much confusion about the income taxation of co-ops exists.

Reality:

These 22 co-ops paid $68 million Federal income taxes in 1980. Their tax rate as a percent of earnings was nearly 15 percent which was larger than for many large non co-op firms in the U.S.

How a Co-op’s Earnings are Taxed Depends Primarily on:

1. The source of those earnings.a. Patronageb. Nonpatronage*

2. The distribution (or use) of those earnings.a. Retained earnings (unallocated)b. Allocated patronage refunds

1. Qualified2. Nonqualified

c. Stock dividends*

3. The co-op’s ‘tax status’ (521 or non-521) for items denoted with a * above.

Taxation laws determine how co-op earnings are taxed.

Example situation:

Recently, Sioux Honey Assn. had net earnings of $10 million and yet paid income taxes of only $30,000. Why didn’t the co-op pay more taxes?

Taxation laws determine how patronage refunds are taxed.

Example situation:

• Suppose you receive a $1,000 patronage refund of which $200 is cash and $800 is noncash.

• How much of this do you include in your taxable income for the year?

• How much of this can the co-op deduct from its taxable income for the year?

Overview of Co-op Earnings for Tax Purposes

Total Co-op Earnings

Nonpatronage Earnings* Patronage Earnings

Retained Allocated Allocated Retained

Qualified Refunds/Distribution

Nonqualified Refunds/Distribution Dividends*

Cash Noncash

Some Basics of Co-op Income Taxation

1. Co-ops are NOT automatically exempt from income taxes.

2. Patronage refunds are generally subject to ‘single’ taxation.

3. To be taxed like a co-op, firms can organize and operate as a co-op.

Qualified Patronage Refunds1. Must be based on patronizing the co-op2. Must be a pre-existing obligation to pay3. Must be allocated correctly:

a. Within 8.5 months after the end of the co-op’s fiscal year

b. At least 20% in cash(noncash = written notice of allocation including

stocks and certificates)

c. Noncash portion must be:1. Redeemable in cash within 90 days OR2. Distributed to patrons with their ‘consent’

Obtaining Patron Consent

1. Letter from Patron

2. Bylaw Consent

3. Cash a Qualified Check

Taxation of QUALIFIED Patronage Refunds

Year of Issuance

Member: Pays tax on entire amount

including cash and noncash

amounts

Co-op: Claims entire amount as a

deduction from its taxable income

Taxation of QUALIFIED Patronage Refunds

Year of Redemption

Member: No additional tax is due (already

paid income tax on it)

Co-op: Cannot claim as a deduction

(did previously when issued)

• $1000 Qualified Pat. Ref., TAXATION– => $200 Cash, $800 Non cash

• Year of ISSUANCE– Member reports $1000 taxable income– Co-op deducts $1000 from taxable income

• Year of REDEMPTION– Co-op pays and member receives $800 cash– Co-op and member do NOT report this on tax

return

Taxation of NONQUALIFIED Patronage Refunds

Year of Issuance

Member: Pays tax on cash portion only

Co-op: Deducts cash portion from its

taxable income; pays tax on

noncash portion

Taxation of NONQUALIFIED Patronage Refunds

Year of Redemption

(of previous noncash allocation)

Member: Pays tax on cash received

Co-op: Deducts amount paid out in cash

from taxable income for either the

year of redemption (co-op has its

choice; the co-op should opt for

the greatest tax savings) or year of issuance.

• $1000 Non Qualified Pat. Ref., TAXATION

• Year of ISSUANCE– Member reports $0 taxable income– Co-op reports $1000 taxable income

• Year of REDEMPTION– Member reports $1000 taxable income– Co-op claims $1000 as tax-deductible

expense

Which is Best – Qualified or Non Qualified?

• Look at after-tax net cash flows:– Year of issuance member– + Year of issuance co-op– + Year of redemption member– + Year of redemption co-op

_____________________________

= Total Net Cash Flow

(May want to discount redemption yr NCF’s)

Which is Best – Qualified or Unqualified?

The co-op should choose that form which results in the combined taxes of both the co-op and patrons being minimized. Nonqualified allocations would likely accomplish this better if patron income tax rates are currently relatively high (expected to be lower in the future) and if co-op income tax rates are currently relatively low (expected to be higher in the future). Qualified allocations would likely be preferred if the opposite were true.

Taxation of Unallocated or Retained Co-op Earnings

Co-op: Pays tax on entire amount

retained (just as other businesses

do)

Member: No tax impact

• Taxation of per-unit capital retains = same as patronage refunds except there is no 20% cash refund requirement

Key 521 Co-op Requirements(about 25% of top 100 Ag Co-ops)

1. At least 85% co-op stock owned by ‘active’ members.

2. At least 50% of total business volume and 85% of supply business volume must be done with ‘members’.

3. Must treat members and nonmembers alike regarding pricing and patronage refunds.

521 vs Non-521 Co-op Taxation

• Nonpatronage Earnings Received– 521: Taxable to patrons if allocated– Non-521: Taxable to co-op

• Stock Dividends Paid– 521: Taxable to patrons only– Non-521: Taxable to patrons and co-op

Nonpatronage Earnings

= Incidental income that is not directly

related to the marketing, purchasing,

or service activities of a co-op

Examples:1. Rent

2. Interest Income

3. Capital Gains

4. Sales to Fed. Government

5. Dividends Received

Factors that Would Favor 521 Tax Status

1. Substantial Stock Dividends

2. Very Little Nonmember Patronage

3. Substantial Nonpatronage Income

4. High Co-op Tax Bracket

5. Exemption from Federal Security Registration

Alternatives for Allocating Losses

1. To unallocated reserves.

2. To current patrons in proportion to patronage (or equity)

a. Reduce deferred equity

b. Collect cash (deduct from proceeds: bill directly)

3. Carry forward

Local Cooperative Losses May:

1. Reduce a member’s equity

2. Increase a member’s after-tax net cash flow if allocated to the member

• Regional co-op losses, when allocated to a local, are ‘paper’ expenses for the local that lower the local’s net earnings (taxable income)

Net Cash Flow Impacts of Regional Co-op Losses

Allocated Not Allocated

Local Co-op (100% qualified)

Local savings 20,000 20,000

- Loss allocation 10,000 0

Net Income 10,000 20,000

Cash Pat. Refs. 2,000 4,000

Net Cash Flow 18,000 16,000

Patron (10% Share)

Oth. Taxable Inc. 30,000 30,000

Cash pat. Ref. 200 400

Noncash Pat. Ref. 800 1,600

Taxes (t = .3) 9,300 9,600

Net Cash Flow 20,900 20,800

Regional Cooperative Losses May Drastically Reduce a Local’s:

1. Equity

2. Earnings

Yet increase a local’s:

1. Net Cash Flow