Legal Considerations When Forming a Cooperative

Do I need to incorporate the business as a cooperative?
No. Many states have cooperative incorporation laws that may or may not be appropriate for the cooperative you are forming. Cooperatives can also be incorporated as nonprofit corporations or general business corporations under the laws of many states (including ever-popular Delaware). Some cooperatives even operate informally without being incorporated at all.

If I incorporate a cooperative as a nonprofit corporation or a general business corporation, how is it still a cooperative?
State or federal government can confer some benefits, or impose some restrictions, on your business depending on how you incorporate, but only the members of your cooperative determine whether your business is operating as a cooperative or not. This depends on how your bylaws are written and how the members govern and operate the business, not on how it is incorporated.

OK, then how do I ensure that our business is a cooperative?
When your cooperative is forming, the prospective members of the cooperative need to discuss how the business will be governed and run. The group will need to draft bylaws and/or other governing documents (e.g. articles of incorporation, membership agreements - see link to "Things to Know about the Bylaws and Articles of Incorporation") that state how the business is structured. The business should be operated according to the seven universally agreed-upon cooperative principles (see link to ICA Principles) in order to operate as a cooperative. The business must be owned and democratically controlled by its members with the members receiving benefits in proportion to their patronage of the business.

Are there any tax advantages to operating as a cooperative?
Yes. In general, the federal government and state governments recognize the way that cooperative operate and tax them accordingly. Cooperatives generally do not pay income tax on surplus earnings that are refunded to members. Under Subchapter T of the federal tax code, these distributions are called "patronage dividends". The members, however, must include these refunds in their taxable income.

When a business is "operating on a cooperative basis", according to federal rules, the cooperative may deduct "patronage dividends" from its taxable income. Patronage dividends are the refunds "paid to a patron 1) on the basis of quantity or value of business done with or for such patron, 2) under an obligation of such organization to pay such amount, which obligation existed before the organization received the amount so paid, and 3) which is determined by reference to the net earnings of the organization from business done with or for its patrons." The "preexisting legal obligation" rule requires that some formal obligation exist in writing to pay out patronage dividends. This obligation can be found in the cooperative's bylaws or the membership agreement.

Because of the way some cooperatives operate, they are tax-exempt under federal and state law. These include credit unions and rural utility cooperatives. Credit unions operate under tight restrictions imposed by federal and state law and put all earnings made by their businesses back into the business to deliver more benefits for their members. Rural utility cooperatives also operate under tight restrictions that federal and state governments impose in order for them to claim tax-exempt status. Rural utility cooperatives may distribute "capital credits" to their members when surplus earnings are made.

How can cooperatives raise equity capital from its members?
Subchapter T allows cooperatives to retain patronage dividends and allocate them to the patrons' equity accounts with the cooperative through "written notices of allocation." If the equity is qualified as defined in the code, the cooperative can deduct the amount of allocations from its taxable income in that same year. Patrons include the amount allocated in their taxable income in the year they receive the qualified written notices of allocation. Subchapter T requires that at least 20 percent of the patrons' patronage dividends be paid out in cash in order for the allocation to be qualified. The cooperative can retain up to 80 percent as equity investments without owing tax on those investments.

Cooperatives can choose to delay the pass-through by retaining patronage dividends as nonqualified investments. The cooperative can retain any amount of the patronage dividends and take the amount into its taxable income for the year. When the patronage dividends are later redeemed in cash by the patrons, the cooperative can deduct the amount from its taxable income for the year of redemption.

Legal Advice
People seriously considering a cooperative venture should seek the advice of an attorney familiar with cooperatives. The articles of incorporation and bylaws should be specific to the new cooperative and not be merely copied from a model provided by another cooperative. An attorney can also provide advice on the particular requirements of the state in which the cooperative plans to incorporate.