What Is a Patronage Purchase and How Does It Work?

A patronage purchase is a financial concept specific to cooperative organizations, representing a portion of the cooperative’s earnings returned to its members. This return is based on the volume of business a member conducts with the cooperative. Unlike traditional corporate dividends, which are distributions based on investment or ownership, a patronage purchase is a refund or rebate on transactions. It reflects the cooperative’s structure, returning profits from member business to members.

Understanding the Cooperative Model

A cooperative operates as an autonomous association, owned and democratically controlled by its members. Members pool resources to meet common economic, social, or cultural needs through their jointly owned enterprise. This structure contrasts with traditional for-profit corporations, which aim to maximize returns for shareholders.

The purpose of a cooperative is to serve its members, not to generate profits for external investors. Decisions are often made on a “one member, one vote” basis, regardless of capital contributed. This member-centric approach means surplus earnings from member business are returned to members, forming the basis of patronage as members contribute to the cooperative’s surplus by conducting business.

Mechanics of Patronage Allocations

Patronage is allocated proportionally to the business a member conducts with the cooperative, ensuring those who utilize it more receive a larger share of allocated earnings. Cooperatives are obligated to pay these patronage dividends based on a pre-existing agreement, often outlined in their bylaws. Patronage allocations can take several forms:

Cash patronage refunds are direct cash payments to members, providing an immediate financial benefit.
Qualified written notices of allocation represent a non-cash distribution, often as equity. To be “qualified” under tax law, the cooperative must pay at least 20% of the total patronage allocation in cash or by qualified check.
Non-qualified written notices of allocation are also non-cash allocations, but they differ significantly in their tax treatment. This distinction provides cooperatives with flexibility in how they manage and distribute earnings to their members.

Tax Implications for Cooperative Members

Patronage refunds are considered taxable income to the cooperative member. These refunds are viewed as a reduction in the cost of goods or services purchased, or an increase in the price of products sold. Tax treatment varies by allocation type:

Cash patronage refunds are taxable in the year they are received by the member.
Qualified written notices of allocation are taxable to the member in the year they are received; the stated dollar amount is taxable even if not all received in cash. When a member includes this amount in their income, their tax basis in the cooperative’s equity increases by that amount.
Non-qualified written notices of allocation are not taxable to the member until they are redeemed for cash. The member’s tax basis does not increase upon receipt of a non-qualified notice.

Members receive IRS Form 1099-PATR from the cooperative, reporting patronage dividends. However, patronage dividends for personal, living, or family items are excludable from gross income.

Tax Implications for the Cooperative

Cooperatives operate under a “single-tax” principle, which aims to tax cooperative earnings only once, either at the cooperative level or at the member level. This distinguishes cooperatives from traditional corporations, where earnings can be taxed at the corporate level and again when distributed as dividends to shareholders.

Qualified patronage allocations, including both cash payments and qualified written notices of allocation, are deductible by the cooperative when distributed. This allows the cooperative to avoid corporate-level taxation on earnings distributed as qualified patronage. This encourages cooperatives to return earnings to their members, aligning with their purpose of operating at cost for their patrons.

Non-qualified written notices of allocation are not deductible by the cooperative until they are redeemed for cash. The cooperative pays tax on earnings represented by non-qualified notices in the year allocated, with a deduction taken later when paid out in cash. The ability to deduct qualified patronage distributions is a feature of cooperative taxation, enabling the cooperative structure to serve its member-owners.