How Cooperative Taxation Works for Businesses and Members

A cooperative is a distinct form of business organization owned and operated for the mutual benefit of its members rather than for the profit of outside investors. Members pool their resources to achieve common economic goals, such as marketing goods, purchasing supplies, or obtaining services. Because this structure is centered on member benefit, any surplus generated by the cooperative’s operations is returned to the members themselves.

This operational model is recognized within the U.S. tax code, which provides a specialized framework for cooperatives. The tax rules are designed to accommodate the principle of returning net earnings to patrons, which directly influences how the entity and its members are taxed. This structure acknowledges that the cooperative acts as an extension of its members’ own business activities.

Qualifying Under Subchapter T

For a business to be taxed as a cooperative, it must adhere to the requirements outlined in Subchapter T of the Internal Revenue Code. This tax treatment is available to any corporation or limited liability company that elects to be taxed as a corporation, provided it operates on a cooperative basis. An entity’s qualification is determined by its method of operation, not just its legal incorporation status.

Three core principles define operating on a cooperative basis. The first is the subordination of capital, which requires that the primary purpose of the entity is to benefit its member-patrons through their participation, not to generate a return on capital investment. The second principle is democratic control, demonstrated by a “one member, one vote” governance structure. The third is the equitable allocation of financial benefits, meaning earnings are distributed to members in proportion to their business activity with the cooperative.

A requirement for cooperative tax treatment is the existence of a “pre-existing legal obligation.” This means the cooperative must be legally bound, through its bylaws or member agreements, to return to its patrons any net earnings generated from business done with them. This obligation must be in place before the income is earned, establishing that the earnings are held for the benefit of its patrons.

The tax code distinguishes between exempt and nonexempt cooperatives. Most cooperatives are classified as nonexempt and are subject to the general rules of Subchapter T, which is the focus of this article.

Calculating Cooperative Taxable Income

A cooperative’s tax liability is determined by its ability to deduct distributions to its members, which prevents the double taxation common to corporations. Cooperatives report their financial activity on Form 1120-C, U.S. Income Tax Return for Cooperative Associations. This form is designed for the income allocation and deduction methods available under Subchapter T.

A primary step in the tax calculation is the separation of income into two categories: patronage-sourced and nonpatronage-sourced. Nonpatronage income is derived from activities not directly related to the cooperative’s primary function, such as investment earnings or business with nonmembers. This income is taxed at the standard federal corporate income tax rate of 21 percent.

Patronage-sourced income consists of net earnings from business conducted with or for patrons. From this income, a cooperative can make distributions that qualify for the patronage dividend deduction under IRC Section 1382. This allows the cooperative to subtract the value of qualifying patronage dividends from its taxable income.

To be deductible, a patronage dividend must be allocated based on the quantity or value of business the patron conducted with the cooperative, paid from net earnings derived from that patronage business, and distributed under the pre-existing legal obligation. These distributions can be made in cash, other property, or qualified written notices of allocation.

A written notice of allocation is a document informing a patron of their share of the net earnings that the cooperative is retaining as capital. For this notice to be “qualified” and its stated value deductible by the cooperative, two conditions must be met. The patron must consent to include the stated amount of the notice in their own taxable income, and the cooperative must pay at least 20 percent of the total patronage dividend in cash. The payment period for these distributions extends to the 15th day of the ninth month after the cooperative’s tax year ends.

Tax Treatment of Member Distributions

The tax obligations of a cooperative are directly linked to the tax responsibilities of its members. When a cooperative takes a deduction for a patronage dividend, the responsibility for paying tax on that income shifts to the member who receives it. This structure ensures that the earnings from patronage business are taxed once, either at the cooperative level if retained or at the member level when distributed.

Members receive information about their distributions on Form 1099-PATR, Taxable Distributions Received From Cooperatives. The cooperative is required to issue this form to any person who has been paid at least $10 in patronage dividends during the year. The form details the total distributions the member received, which must be reported as income on the member’s tax return.

The amounts reported on Form 1099-PATR reflect the various ways a cooperative can distribute its earnings. Box 1 of the form shows the total patronage dividends, which includes cash payments and the stated dollar amount of qualified written notices of allocation. Even though a member may only receive a portion of their dividend in cash, they are required to report the full value of the distribution, including the amount retained by the cooperative as equity, as taxable income.

The form also reports other types of distributions, such as per-unit retain allocations, which are payments based on the volume of products marketed through the cooperative. These can be paid in cash or qualified per-unit retain certificates. The information on Form 1099-PATR provides a complete picture of the taxable income the member must recognize.