The Section 199 Deduction and Patronage Calculations

By Phil Kenkel, Bill Fitzwater Cooperative Chair, Oklahoma State University.

There is generally a gap between tax-based net income and book-based net income. While the IRS prefers to use taxable income as the patronage base, cooperatives can calculate patronage on either a tax or a book basis. Patronage refunds originated with the Rochdale principles, which stated “net margins distributed according to patronage.” This concept is reflected in Subchapter T of the IRS tax code, which lays out three basic criteria for patronage refunds. To be exempt from taxation at the cooperative level, patronage refunds must be paid:

  • On the basis of quantity or value of business done with or for such patron.
  • Under an obligation of such organization to pay such amount, which obligation existed before the organization received the amount paid.
  • Which is determined by reference to the net earnings of the organization from business done with or for its patrons.”

The first criteria requires patronage distribution be proportional to the patron’s business volume. The second criteria require the cooperative to establish an obligation, typically as part of the bylaws, which specifies that earnings will be distributed to members. This agreement can allow the board to set aside some or all of net earnings as a reserve and allow the earnings to be distributed in the form of qualified or nonqualified stock. The third criteria requires that patronage refunds be based on net earnings and that the cooperative define the basis for net earnings calculations and use it consistently.

Most cooperatives base patronage refunds on a tax basis. A simplistic description of these calculations is that the cooperative calculates earnings considering that patronage refunds are excluded from income and then distributes those earnings in proportion to business volume. A cooperative calculating patronage on a book basis would base their calculations on book net earnings. Because of the gap between tax and book accounting, patronage refund calculations would differ across the two methods. Tax conventions for depreciation could increase expense (relative to book) and reduce patronage while conventions for other expenses such as bad debt, meals and entertainment, and deferred compensation could result in tax-based earnings and patronage exceeding book-based calculations.

The Section 199 Domestic Production Activities Deduction (DPAD) presents an interesting wrinkle in the debate over tax versus book patronage. A cooperative using the DPAD can reduce or eliminate its taxable income. The question then arises as to whether it also reduced the net earnings used as the basis for patronage. This relates to the language in the bylaws where the cooperative defines the procedures for calculating and distributing patronage refunds.

Most cooperatives are likely to continue to prefer to calculate patronage on a tax basis. In many cases, the bylaw description of patronage refund procedures is sufficiently vague to allow the cooperative to reduce taxable net income through the DPAD without eliminating the “net earnings,” which are used as the patronage base. Your cooperative’s tax and legal advisors are the best source of guidance on that issue. If your board concludes that the bylaw language needs to be cleaned up, it might be a good time to discuss whether you want to cover any of the other items such as bad debt reserve or deferred compensation that impact patronage calculations.

For more information, see Patronage Dividends: A Primer by Cooperative Grocer magazine.