Taxation of Cooperatives and "Patronage Dividends"

For-profit cooperative corporations are given special treatment with respect to federal taxation. Although they are generally taxed as normal corporations, they can reduce their tax exposure by issuing what are known as “patronage dividends” to patrons of the cooperative.

A “patronage dividend” is essentially a refund issued to those who purchase goods or services from a cooperative, and is calculated based upon the amount that each patron spends at the cooperative in a given taxable year. 26 U.S.C. § 1388(a). When filing its federal tax returns, a cooperative may deduct the amount of the patronage dividends that it issues in a particular tax year from its gross income in that year. 26 U.S.C. § 1382(b). As a result, this income is not taxed at the corporate level. Certain patronage dividends may also be deducted on the personal tax returns of the patrons who receive them. 26 U.S.C. § 1385(b).

“Patronage dividends” are distinct from the more familiar “stock dividends” that a corporation pays to its shareholders in an amount proportional to their respective ownership of the corporation. Although a for-profit journalism cooperative usually can have shareholders and can issue stock dividends to them, there is no federal tax deduction at either the corporate or individual level for stock dividends. 26 U.S.C. § 1388(a). Thus, it is infrequent that a cooperative will issue stock dividends as opposed to patronage dividends.

For that reason, purchase of shares in a cooperative is usually less a personal investment strategy and more an investment in the community. This is emphasized by the fact that, under most state cooperative laws, shareholders in a cooperative receive only a single vote in the management of the business regardless of the number of shares they own.

In order to qualify for the federal tax deduction, patronage dividends must, under 26 U.S.C. § 1388(a), meet the following two criteria:

  • Each patronage dividend must be calculated based upon the basis of the quantity or value of business done by the cooperative with or for each patron, with reference to the net earnings of the organization from business done with or for its patrons.

o       In order to be deductible by the cooperative, the amount that a particular patron receives as a patronage dividend must reflect the relative contribution of that patron to the net earnings of the cooperative from “business done with or for its patrons.” In many circumstances, the patronage dividend is calculated as a percentage of each patron’s individual purchases made during the tax year, but other calculations may be possible.

o       Qualifying patronage dividends cannot be paid out of earnings or income other than from “business done with or for its patrons.” Therefore, a patronage dividend will generally not be tax-deductible if it is made out of the capital contributions of shareholders, donations to the cooperative, or sources of revenue other than business with or for the cooperative’s patrons.

o       However, if a cooperative earns income through secondary activities that are integrally intertwined with its ordinary functions and are commercially reasonable, those activities might constitute business “for” or on behalf of its patrons and the income might be available for distribution as a patronage dividend. See Cotter & Co. v. U.S., 765 F.2d 1102 (Fed. Cir. 1985) (rental income from lease of warehouse space and interest income from commercial paper and certificates of deposit held to have resulted from business conducted on behalf of patrons).

o       Identifying income that can be distributed as a patronage dividend and calculating those dividends in a manner that qualifies for the federal tax deduction can be very complex, and you are advised to seek the assistance of a tax attorney or other tax professional when determining how to calculate the amount that each patron receives.

  • The cooperative must have obligated itself to issue a patronage dividend before the cooperative receives the income out of which it pays the dividend.

o       A cooperative cannot use a patronage dividend to reduce its tax exposure on income earned prior to deciding to issue the dividend. Thus, a cooperative cannot wait to decide to issue a patronage dividend until after it sees how much it has earned for the year.

o       Usually, this issue can be avoided by building the obligation to pay patronage dividends into the bylaws or articles of incorporation of the cooperative during its formation.

In general, cooperatives are not required (by federal law, at least) to issue patronage dividends to all patrons, and can define classes of patrons who receive more or less than one another, or nothing at all. These classes can be based on purchase of a “membership,” residency in a particular geographic area, or other criteria (so long as the criteria do not violate anti-discrimination laws). Some cooperatives only issue patronage dividends to patrons who are also shareholders; thus, a capital investment in the cooperative might be a prerequisite to receipt of a patronage-based refund. 

However, if you create different classes of patrons that receive different patronage dividends, it will limit the amount of distributed income that can be deducted by the cooperative. The cooperative may not deduct from its income any dividend paid to a patron out of income earned from other patrons who receive a smaller refund or no refund.  26 U.S.C. § 1388(a). In other words, if a cooperative earns 5% of its net business income from patrons who are eligible to receive a patronage dividend and 95% from other patrons that are ineligible, the cooperative can distribute a maximum of 5% of its net income as a qualifying patronage dividend and must pay taxes on the remaining 95% (regardless of what the cooperative does with that other 95%). This rule prevents a cooperative from using patronage dividends to funnel all of its profits to a select class of individuals while simultaneously claiming a tax benefit.

The federal Internal Revenue Code also contains provisions allowing cooperatives to issue "qualified written notices of allocation"  (such as shares of stock, certificates of indebtedness, or other redeemable notes) as patronage dividends in lieu of cash. 26 U.S.C. § 1382(b).  These provisions are complex, and may require advance consent from the patron receiving such alternative compensation. Again, determining how to fulfill the cooperative’s obligation to issue patronage dividends can be very complex, and you are advised to seek the assistance of a tax attorney or other tax professional when making these decisions.

Note that state (as opposed to federal) taxation of cooperatives varies from state to state. You are advised to contact the Department of Revenue in the state where you are considering forming a cooperative to determine how taxes are handled there.

Note: The information contained on this page is meant for general, information purposes only, and CMLP makes no claim as to comprehensiveness or accuracy of the information. Because of the complexity of tax issues associated with starting any business, you are encouraged to consult with a tax attorney and/or accountant to ensure compliance with federal, state, and local tax requirements. The CMLP is not a substitute for individualized legal advice, especially not individualized tax advice.


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