Phil Kenkel
Bill Fitzwater Cooperative Chair
Oklahoma State University
The Federated Cooperative Structure
Cooperatives that operate over a large geographic area are commonly referred to as “regional” cooperatives even though they may be national or even international in scope. There are two ownership structures for regional cooperatives. Centralized regional cooperatives are directly owned by producer members. A federated regional cooperative is owned by the local cooperatives that transact business with it. This discussion focuses on the federated category of regional cooperatives.
Local cooperatives conduct business with regional cooperatives and share in the regional’s profits through patronage distributions. Those patronage distributions can be in both cash and retained patronage (equity). The regional retained patronage is typically reflected as an asset on the local cooperative’s balance sheet, commonly termed “investment in cooperatives”. The regional cooperative may redeem the retained patronage into cash at some later point in time. The distributions from the regional cooperative flow into the local cooperative. The local cooperatives makes similar but separate distributions to its producer members. Under the two tiered structure of the federated system, the profit distribution and equity management choices of the regional cooperative are not linked directly to the producer member. Under that structure it is easy to see how regional patronage can have impacts on local cooperatives.
Basics of Cooperative Taxation
Subchapter T of the Internal Revenue Tax Code applies to corporations operating on a cooperative basis. The basic structure of Subchapter T and cooperative taxation is that the cooperative corporation is taxed at the regular corporate rate but is allowed to exclude certain types of patronage refunds and per-unit refunds from its taxable income. Patronage refunds are a distribution from the net income of the cooperative based on the quantity or value of business conducted. Patronage refunds can be distributed in cash or equity. Equity patronage is often termed “retained patronage” since the cooperative is retaining cash by distributing additional equity. Retained patronage can be in the form of qualified equity or non-qualified equity. Qualified retained patronage is tax deductible to the cooperative and becomes taxable income for the member in the year the equity is distributed. Retained patronage can also be distributed as non-qualified equity which is not tax deductible to the cooperative or taxable income for the recipient until the time at which it is redeemed into cash.
Per-unit capital retains are allocated to patrons and taxed in a similar manner as patronage refunds. The difference is that they are based on the volume of business conducted and not on the profits of the cooperative. For example, a cooperative could make a per-unit retain deduction from a member’s commodity payments in a year when the cooperative did not have an operating profit. Cooperatives can also repay equity to members on a per unit basis. That transaction is termed per-unit retain paid in money (PURPIM). In recent years many marketing cooperatives have structured commodity purchases as PURPIMs to maximize their Section 199A deduction.
Regional and local cooperatives can also make non-patronage based distributions to members by paying dividends on equity. Dividends on equity are not patronage since they are based on ownership and not use. Most cooperatives cannot deduct dividend payments from their taxable income as determined under Sub-Chapter T. A cooperative qualifying for Section 521 provisions of Sub-Chapter T (a more restrictive form of cooperative) can deduct dividend payments.
Taxation of Federated Cooperative
Federated cooperatives are taxed under Sub-Chapter T. Just like a local cooperative, the regional cooperative can exclude certain types of profit distributions from its taxable income. The regional cooperative is taxed on any remaining patronage based income and all non-member income at the corporate rate. The regional cooperative can return profits to the local member cooperatives in the form of cash, qualified retained patronage and non-qualified retained patronage. When a regional cooperative distributes cash and qualified retained patronage to a local cooperative those distributions are excluded from the regional’s taxable income and become part of the patronage-sourced total income of the local cooperative for the tax year in which the distribution was received. In order to exclude that distribution from its taxable income the local cooperative must distribute the income in the form of cash or qualified retained patronage to its producer members within 8 ½ months of the close of its tax year. Otherwise the local cooperative must pay taxes on the regional patronage.
A regional cooperative can also distribute profits in the form of non-qualified retained patronage. Non-qualified retained patronage does not create a tax deduction for the regional cooperative or become taxable income for the local cooperative until the year in is redeemed into cash. When a regional cooperative distributes cash and non-qualified retained patronage the local cooperative, only the cash portion is included in the local cooperative’s taxable income. The local cooperative would need to distribute an amount equal to that cash portion in a deductible form (cash and/or qualified retained patronage) if it wanted to avoid paying taxes on the regional patronage. The retained non-qualified patronage distributed by the regional cooperative is not taxable until the redemption year.
When a regional cooperative redeems qualified retained patronage there is no tax effect on either the regional or local cooperative because the tax effects occurred at the time the equity was issued. The transaction reduces the regional’s cooperative’s cash flow and increased the cash flow at the local cooperative level. When a regional cooperative redeems non-qualfied equity it can exclude that amount from its taxable income in the current year. In simple terms, it receives a tax deduction. The non-qualified redemption becomes taxable income for the local cooperative which would need to make an equivalent tax deductible distribution (issue cash patronage or redeem non-qualified equity) to its producer members or be taxed on that income. The redemption of regional non-qualified stock also reduces the regional’s cash flow while providing cash to the local cooperative. The regional cooperative is receiving a tax deduction which partially offsets the cash outflow.
Tax Basis versus Book Basis
Like other firms, cooperatives can prepare financial statements on either a tax or book basis. In simple terms, book basis statements are structured in accordance with generally accepted accounting principles (GAAP) while tax basis statements are governed by the requirements of the internal revenue service. A cooperative’s net income and patronage calculated on a tax basis can differ from the book basis net income and patronage.
Local Income versus Total Income
A local cooperative’s total net income is the combination of the net income generated from local operations and the patronage received from regional cooperatives. Local cooperatives calculate and distribute patronage based on total income so the regional patronage can impact their decisions on the percentages of cash and retained patronage and the cash flow implications of a given patronage split. Lenders and other analysts focus on local net income when evaluating a cooperative’s performance since the regional patronage is not under the local cooperative’s control. If a local cooperative’s performance is evaluated based on total net income, the regional patronage may mask poor performance in local operations.
Balance Sheet Impact of Regional Patronage
Retained patronage from a regional cooperative (both qualified and non-qualified) is generally shown as an asset on the local cooperative’s balance sheet. The only rationale for not booking the retained patronage as an asset is if it appears unlikely that the regional cooperative will ever redeem it. The cooperative’s auditor is the best source of information on questions as to how to reflect the regional retained patronage on the balance sheet.
Regional patronage is part of the local cooperatives total savings and thus becomes a part of the patronage distribution. As the local cooperative issues retained patronage is it creating additional equity on its balance sheet. A portion of that additional equity is a by-product of the regional patronage. When the cash and equity percentages of the local cooperative match those of the regional cooperative the retained patronage received from the regional is matched by additional local equity created from the local cooperative retained patronage. In that case the regional patronage is also cash flow neutral to the local cooperative since the local cooperative is passing on cash and retained patronage in the same portions as it was received. When the cash and retained equity rates differ, the additional local equity may be lower or higher than the regional retained patronage and the local cooperative’s cash flow may be lower or higher relative to the locally generated cash flow.
Effect of Regional Patronage on Cash Patronage Rates
Regional patronage generally has a cash flow impact to the local cooperative unless the local cooperative and regional cooperative have identical cash and retained patronage percentages. The local cooperative’s board of directors can easily manage cash flow impacts by adjusting their cash patronage rate. If we assume the local cooperative sets their cash patronage rate for their desired cash flow before receiving regional patronage, they should adjust their cash patronage rate up when the regional’s cash patronage rate is above their rate and down when the regional issues a lower portion of cash. In practice, the boards of local cooperatives consider the cooperatives total income, cash flow situation and balance sheet goals when setting cash patronage rates. Most boards would not set a rate based on local operations and then adjust it for regional patronage. Regional patronage is simply one of the factors they consider in selecting the appropriate cash patronage rate.
Revolving Cycle Issues
Under the two tiered federated system the regional cooperative is distributing and redeeming retained patronage (revolving equity) to the local cooperative and the local cooperative is distributing and redeeming retained patronage to the producer members. The local cooperative’s revolving equity is in some sense a blend of retained local profits and retained regional profits. Difference between the revolving cycles of the local and regional cooperatives have implications for the local cooperative’s cash flow. If the local cooperative is redeeming equity more rapidly relative to the regional, their cash flow challenge is increased since they are redeeming regional profits to their members while the regional patronage associated with those profits remains on their balance sheet. Conversely, when the regional cooperative’s revolving cycle is shorter than the local cooperative, the local cooperatives gains cash flow from the regional redemption.
The miss-match between equity redemption is most severe for local cooperatives that revolve equity based on the age of the patron or special situations. The timing of the local cooperative equity redemption under those systems is unlikely to match that of the regional cooperative. Some regional cooperatives also manger equity under a base capital system which matches equity to use. Under a base capital system equity is only redeemed when a member’s share of the total equity exceeds their share of the total use. A growing local cooperative would therefore not receive equity redemption from a regional cooperative that managed equity through a base capital system. The timing of equity redemption of the local and regional cooperatives is unlikely to match if either are on a base capital system.
Segregating Regional Patronage
As a means to alleviate revolving cycle issues some local cooperative segregate the retained patronage issued to their producer member. The member would receive one category of revolving equity reflecting the local cooperative’s retained patronage and another category representing the pass through of retained patronage from the regional cooperative(s). The goal would be to match the redemption of the regional equity category to the time period when the regional cooperative redeemed equity. In practice, segregating regional equity can become somewhat “clunky”. Most local cooperatives are members of multiple regional cooperatives. Completely segregating regional equity would require the local cooperative to issue multiple categories of retained patronage. The local cooperative also has to decide how they will handle the segregated equity if a member dies or in other special situations. The argument against segregating regional equity is that is unnecessary and complex. The cooperative board has discretion in managing equity and they can manage redemption in accordance with their cash flow, balance sheet situation and asset needs.
Issues with Non-qualified Regional Patronage
Historically, both local and regional cooperative distributed retained patronage as non-qualified revolving equity. In recent years, some regional cooperatives have distributed retained patronage in the form on non-qualified equity. This raises some different issues with respect to taxation, cash flow, allocation of the regional patronage to the producer member and recognition on the balance sheet.
In general, non-qualified regional patronage would be listed as an asset unless the regional cooperative indicated they did not plan to redeem it. One regional cooperative (CoBank) issued non-qualified retained patronage and indicated they had no plans on ever redeeming it. In that case the non-qualified equity was essentially serving as permanent allocated equity. Most local cooperatives did not reflect that retained non-qualified patronage as an asset. That structure was unique to the particular regional cooperative. In general, there is nothing about non-qualified retained patronage that makes it less likely or more likely to be redeemed relative to qualified retained patronage Non-qualified regional equity can certainly represent future value (be an asset) for a local cooperative just as local non-qualified equity can provide future value to the producer member.
The local cooperative’s decision to calculate patronage on a book or tax bases has implications for regional non-qualified retained patronage. When a regional cooperative distributes non-qualified retained patronage, a local cooperative operating on a tax basis would not record that patronage as income until the year it was redeemed since it only becomes taxable income in the redemption year. A local cooperative calculating income and patronage on a book basis would recognize the non-qualified patronage in the year issued. The tax versus book issue is not a factor with cash or qualified retained patronage since that patronage would be reflected as income to a local cooperative in the distribution year under either system.
Non-qualified regional patronage has different tax implications for the local cooperative relative to qualified retained patronage. When the regional cooperative distributes cash and non-qualified equity, only the cash portion effects its taxable income. The local cooperative must pass on the cash portion as cash or qualified equity to avoid taxation. The non-qualified regional patronage is not taxable income for the local cooperative until it is redeemed. Until that time, it is essentially off the books for taxable income. When the regional cooperative redeems non-qualified equity the amount of redemption would be included in the local cooperative’s taxable income. In order to avoid taxation on those funds the local cooperative would need to make a tax deductible refund to the producer members which could be in the from a cash patronage payment or a redemption local non-qualified equity.
As discussed, a local cooperative can address the cash flow impacts of regional patronage by adjusting its cash patronage from the level they would have selected based on local operations. When a regional cooperative distributes cash and non-qualified stock, only the cash portion is relevant for tax basis patronage. From a tax and patronage basis, it is as if the regional cooperative issued 100% cash. If the local cooperative wants to maintain its locally generated cash flow, it would need to increase its cash percentage rate to be cash neutral.
The most complex question relating to regional non-qualified patronage is how the local cooperative should allocate it to the producer member. In terms of operating on a cooperative basis, the best choice for local cooperatives calculating patronage on a tax basis is to make a non-qualified distribution to the producer members. If a co-op is distributing patronage as cash and non-qualified equity, the regional pass-through of non-qualified patronage simply adjusts those percentages. If a cooperative is distributing cash and qualified stock, it must add a supplemental non-qualified distribution to members to reflect the regional pass-through. In either case, the regional non-qualified patronage is allocated and eventually redeemed by the members who helped create it. The increase in the local cooperative’s taxable income from the regional redemption is offset by the deduction they create by redeeming their non-qualified equity. As discussed, there can be cash flow issues in the redemption year if the revolving cycles of the local and regional cooperatives do not match. The mechanics of creating the non-qualified distribution are impacted by whether the local cooperative uses tax based or book based patronage calculations. It can be achieved under either structure.
Another alternative is for the local cooperative to allocate it or distribute it to their members when it is redeemed by the regional. That would involve a cash patronage distribution since it would be illogical to pass through a cash redemption from the regional in the form of qualified equity. The disadvantage to this approach is that it does not match benefits with use. The members who receive the cash allocations are likely not the members doing business when the regional patronage was earned. The advantage of distributing the regional nonqualified as cash patronage in the year the regional redeems it is that it avoids any cash flow issues. As with the first alternative, it is tax neutral to the local cooperative since the taxable income from the regional non-qualified redemption is matched by a tax deductible cash patronage distribution to local members.
The final alternative for the local cooperative is to not allocate the regional non-qualified and instead put it in their permanent equity, retained earnings. Cooperatives should be aware that this reduces the member’s return since they never receive that portion of their member-based profits. The cooperative must also pay taxes on the amount of the regional non-qualified redemption so only the after tax portion is actually retained. For those reasons, cooperative purist would consider the retained earnings approach the least desirable choice. The appropriate level of retained earnings and the desired ratio of allocated equity to total equity are separate issues for the board to consider. There is no logic to linking those decisions to regional patronage.
Final Thoughts
Under the federated cooperative system the local producer is a participating owner in two cooperatives. They are direct owners and patrons of the local cooperative and indirect owners and patrons of the regional cooperative. It is logical to expect that both entities would have an impact on the producer’s cash payments, taxation and equity investment. In terms of understanding the system it is useful to discuss the effects of regional patronage on local cooperatives. In the big picture, those effects are simply part of the process of transferring profit distribution and ownership to the producer member. Board of local cooperatives are overseeing complex diversified firms that are also member-owners of regional cooperatives. In making decisions on profit distribution and equity management they should consider their total income, cash flow needs and balance sheet goals. Regional patronage is simply one factor entering in to that equation.