The Taxation of a Subchapter T Cooperative

A cooperative is a business model where an organization is owned and operated by its members for their collective benefit. This structure is governed by Subchapter T of the Internal Revenue Code, sections 1381 through 1388, which provides a unique tax framework. The principles of Subchapter T apply to any corporation that operates as a cooperative, regardless of its formal organization under state law. This means a business structured as a standard corporation or an LLC taxed as a corporation can qualify if its operations align with cooperative principles.

Qualifying as a Cooperative for Tax Purposes

To be treated as a cooperative for federal tax purposes, an entity must operate on a “cooperative basis.” While the Internal Revenue Code does not provide a rigid definition of this term, its meaning has been established through IRS rulings and court decisions. These interpretations have pointed to three principles that must be present in the cooperative’s operations.

The first principle is the subordination of capital. This concept requires that the return on capital investment is limited. In a cooperative, the focus is on providing services to members at the lowest possible cost, not on generating profits for investors, so dividends paid on member equity are restricted to a modest, fixed rate.

Democratic control by members is the second guiding principle. This is most commonly achieved through a one-member, one-vote system, where each member has an equal say in the governance of the cooperative, regardless of their level of investment or business volume. This structure reinforces the idea that the organization exists to serve its patrons rather than outside investors.

The final principle is the allocation of earnings to members based on their patronage. This means that the net margins generated from business conducted with or for the members are returned to them in proportion to their individual business volume with the cooperative. This practice ensures that the financial benefits of the cooperative flow back to those who created them through their participation.

Cooperative Tax Treatment and Distributions

The tax treatment for a cooperative under Subchapter T allows for single taxation on income generated from member business. Unlike a standard C corporation, which is taxed on its income and whose shareholders are taxed on dividends, a cooperative deducts certain distributions made to its patrons. This effectively passes the income and associated tax obligation to the members and is reported on Form 1120-C, the U.S. Income Tax Return for Cooperative Associations.

A distinction is made between patronage-sourced and nonpatronage-sourced income. Patronage income is generated from business conducted directly with or for the cooperative’s patrons, like marketing members’ products or selling supplies to them. Nonpatronage-sourced income comes from activities not directly related to the cooperative’s primary purpose, such as investment income or rent from non-member activities. This income is fully taxable to the cooperative at standard corporate income tax rates.

The primary tool for distributing patronage income is the patronage dividend. This is an amount paid to a patron based on the quantity or value of business done with the cooperative and is determined by the net earnings from that business. To be deductible, these dividends must be paid out within 8 ½ months after the close of the tax year and can be in the form of cash, property, or written notices of allocation.

Another deductible distribution is the per-unit retain allocation. These allocations are not based on net earnings but are fixed amounts based on the volume of products marketed for a patron. For example, a marketing cooperative might retain a set amount per bushel of grain delivered by a member. This method allows cooperatives to raise equity even in years with low or no profits and is only available for marketing operations.

Patron Taxation and Consent

When a cooperative distributes its patronage-sourced income, the tax obligation shifts to the patron. Members must include the value of patronage dividends and per-unit retain allocations in their gross income for the year they are received. The cooperative reports these distributions to patrons and the IRS on Form 1099-PATR.

Distributions can be made in cash, property, or through non-cash “written notices of allocation.” These notices represent a member’s equity in the cooperative, which the cooperative retains for its capital needs. For the cooperative to deduct the full face value of these non-cash distributions, they must be “qualified” written notices of allocation, which requires patron consent.

A patron must agree to take the stated dollar amount of the written notice into their income in the current year. This consent can be given in one of three ways:

• The member can provide direct written consent to the cooperative.
• The cooperative’s bylaws can state that membership itself constitutes consent.
• The patron can cash a “qualified check” for at least 20% of the total patronage dividend, which is accompanied by a statement that cashing it signifies consent.

The requirement that at least 20% of a qualified patronage dividend be paid in cash helps provide the patron with funds to pay the income tax liability on the entire distribution. If a patron does not provide consent, the distribution is a “nonqualified” written notice of allocation. The cooperative cannot deduct the amount until it is redeemed for cash, and the patron does not include it in income until that redemption occurs.

Handling Cooperative Net Operating Losses

When a cooperative experiences a net operating loss (NOL), the tax treatment differs from that of partnerships or S corporations. Losses generated from patronage activities are not passed through to the individual patrons; the cooperative entity itself is responsible for absorbing these losses. When handling a patronage NOL, the cooperative uses carryforward provisions to apply the loss against its own taxable income in future years.

A patronage loss can be carried forward indefinitely to offset future patronage income. Losses from nonpatronage sources, such as investment activities, are treated separately and follow the standard corporate NOL rules. A cooperative is not required to use losses from nonpatronage business to offset income from patronage business. A cooperative’s net operating loss deduction does not reduce its earnings available for paying patronage dividends in the year the deduction is taken.