Alternative Method of Distributing Cooperative Patronage Dividends Can Provide Benefits
Jeffrey S. Royer
Maintaining adequate equity capital for financing assets and growth is a continual challenge for most businesses. This is especially true for cooperatives, which are organizations that rely on unique methods for obtaining equity investments. For many Nebraska cooperatives, the most important source of equity is retained patronage dividends allocated to members. Although patronage dividends are based on savings to members from business done with their cooperative, the method most Nebraska cooperatives use to distribute these dividends places a direct financial burden on members. This stems from the federal tax laws, which require either the cooperative or its members to pay income tax on patronage dividends distributed to members, whether or not these dividends are paid entirely in cash.
Consider a cooperative that pays 20 percent cash patronage dividends. The 80 percent noncash portion is retained by the cooperative to provide equity capital. Presumably, the cooperative will redeem these retained dividends in cash once they are replaced by future allocations. Members usually accept the tax responsibility for both cash and noncash patronage dividends. For a member in the 31-percent federal tax bracket, this means that every $100 in patronage dividends will incur $31 in tax even though the member receives only $20 of the dividends in cash. This cash drain is even greater when state income tax and federal self-employment tax are considered. Some cooperatives pay a higher percentage of dividends in cash to avoid placing their members in this negative cash flow situation. However, other cooperatives may be unable to pay higher cash patronage dividends because of low earnings, increasing capital needs, or pressures to redeem equities.
Many members, directors, and managers may be surprised to learn that there is an alternative to the way most cooperatives distribute patronage dividends. It is called a nonqualified written notice of allocation. Most cooperatives distribute noncash patronage dividends as qualified written notices of allocation. A written notice of allocation is any capital stock, revolving fund certificate, retain certificate, certificate of indebtedness, letter of advice, or other written notice that discloses to the recipient the amount allocated to the individual and the portion of the allocation that is a patronage dividend.
In determining taxable income, a cooperative does not take into account patronage dividends paid in cash, qualified written notices of allocation, or other property with respect to patronage occurring during the tax year. The cooperative must pay the dividends within eight and a half months after the close of the tax year. In addition, to qualify a written notice of allocation for exclusion, the cooperative must pay at least 20 percent of the patronage dividend in cash, and the recipient must consent to have the noncash portion treated as if it had been received in cash. By consenting to have the retained portion treated this way, the patron agrees to include the total dividend in gross income for the year it is received. The patron can give this consent by agreeing in writing or by endorsing and cashing a check on which a statement indicating consent is printed. Often cooperatives obtain consent by a bylaw that provides that membership in the cooperative constitutes consent.
A notice becomes a "nonqualified" written notice of allocation if the cooperative does not obtain patron consent or if it does not pay at least 20 percent of the patronage dividend in cash. Nonqualified notices are not excluded from the cooperative's taxable income. However, a cooperative receives a deduction for payments made in the redemption of nonqualified notices of patronage dividends. Patrons who receive nonqualified notices do not recognize them as income but include in gross income payments received in the redemption of such notices.
Because members do not recognize nonqualified notices for tax purposes until they are redeemed in cash, a cooperative can use the notices to avoid negative member cash flows due to tax. Although there is no cash requirement for issuing nonqualified notices, the cooperative incurs a cash drain from tax. However, this drain could be less than what would result from making a qualified distribution.
The effective tax rates of both cooperatives and members vary from year to year, depending in part on business success and investment decisions. To minimize taxes, both cooperatives and members need to recognize income in years when their tax rates are lowest. Members with high tax rates may wish to delay receiving income and prefer nonqualified notices. Those with low tax rates may prefer qualified distributions because they are paid partly in cash.
Take a farmer in the 31-percent tax bracket who expects to retire within a few years. Assume the farmer is a member of a cooperative with a ten-year revolving fund and will be in the 15-percent tax bracket once retired. This farmer may prefer to receive patronage dividends as nonqualified notices. If the farmer were to receive a $1,000 dividend in qualified form, the dividend would be taxed at the farmer's current rate, and the farmer would pay $310 in tax. On the other hand, if the farmer were to receive the dividend as a nonqualified notice, the notice would be taxed when redeemed in cash, after the farmer has retired. Thus it would be taxed at the lower rate, and the farmer would pay only $150 in tax.
Some cooperatives may find they can use nonqualified notices effectively in responding to various income and tax situations, including extraordinary occurrences such as losses. By including authorization for issuing both qualified and nonqualified notices in its bylaws, a cooperative can decide on a yearly basis whether to issue nonqualified notices, depending on its current income and tax situation. Cooperatives can also time the redemption of nonqualified notices according to income and tax considerations.
Another option is to allow members to choose individually each year whether to accept a patronage dividend in qualified or nonqualified form. This option takes into account the differences in income and tax situations among members and allows them to choose the type of distribution that best suits their needs.
For additional information about nonqualified notices, see Nonqualified Notices: An Alternative for Distributing Cooperative Earnings, ACS Research Report 80, by Jeffrey S. Royer and Roger A. Wissman, which can be obtained from USDA's Rural Business-Cooperative Service. Call 202-720-6483 or visit their website at www.rurdev.usda.gov/rbs/coops/csdir.htm.
From Cornhusker Economics, Aug. 5, 1998.