Chapter 9: Cooperative Fundamentals

Cooperatives are for-profit businesses that are governed on the principle of one member, one vote. Each member gets an equal vote, regardless of the ownership percentage breakdown in the business. Most cooperatives start when a group of people come together with a shared need. They devise a strategy or solution, and then pool their resources to implement it. The cooperative is organized to serve its members, for example by offering discounts or leveraging special services. Profits are distributed based on each member’s participation or usage rate in the cooperative rather than percentage of ownership. This makes it very different from a C corporation, where both voting and profit distribution to shareholders for the most part must be based on ownership percentage. This chapter highlights the various types and central characteristics of the cooperative entity and presents basic legal considerations involved in creating and maintaining one.

General Concept	Cooperative Terminology
Name	“Farm Name Cooperative” (or abbreviations “co-op” or “CP”)
Owners/investors are called	“Members”
Persons who make management decisions are called	The “Board of Directors” is responsible for making key decisions; the “Officers” (optional) are responsible for the day-to-day management
Creation document is called	“Articles of Incorporation”
Organizing document is called	“Bylaws”
An owner’s investment in the company is called	“Member Investment”
An ownership share is called	“Membership”
A payment of the company’s profits to the owners is called	“Patronage Dividend” or “Patronage Refund”
Is there personal liability?	Limited to each member’s investment so long as best business practices are upheld
How many participants can you have?	At least two people, can be other business entities
Are different ownership classes allowed?	Allowed
Is an EIN required?	Required
Who files the federal tax return?	It depends on the type of earnings. For all earnings a cooperative makes from transacting business with and for its members (i.e. patrons), the income passes through to the individual members for tax purposes. The members report this income as a patronage refund on their individual tax return and pay taxes at the dividend tax rate. For earnings that the cooperative makes from transacting business with and for non-members, the cooperative must report earnings on its own tax return, Form 1120-C, which are taxed at the corporate tax rate.

Cooperative Origins and Types

Cooperatives have been around for hundreds of years; their origin is rooted in agricultural ventures. The first cooperatives were created in Europe in the 17th century when farmers pooled their resources together to more efficiently grow food. The first documented consumer cooperative was a retail store in England in the mid-1700s that sold butter, oatmeal, sugar, flour and candles to its members at a discount. Here in the United States, the cooperative model has a long history, including the Grange, which also has its roots in farming.

The types of cooperatives vary based on the particular resources, services or products they provide and who the members are. An agricultural cooperative, also known as a farmers’ co-op, is a cooperative where farmers pool their activities or production resources together. For example, a family farm may be too small to afford expensive farm equipment or machinery that they only use rarely. A group of local farmers may decide to get together to form a farm equipment cooperative that purchases the necessary equipment for all the members to share. Each member invests some money to pay for the equipment, and in return they get the privilege to use all the equipment owned by the cooperative.

Another type of cooperative would be a service cooperative, such as a distribution and marketing cooperative. A farm doesn’t always have the means or the time to deliver its produce to the market, or to advertise or market its products to the general public. So, the distribution and marketing cooperative could act as an integrator, collecting the output from farmer members and then coordinating the distribution and marketing of the farmers’ products. The cooperative could even manufacture some value-added products. Such a cooperative would include both farmer members (producers) and worker members (i.e., distributors, marketers, manufacturers). Again, the cooperative would divvy up any profits at year’s end and distribute them to the members based on their inputs to the cooperative.

A cooperative could also be made up partly or entirely of consumer members. An example of this is the local food co-op. Such cooperatives typically offer their members or patrons a discount on the products they sell. At year’s end, the food co-op directors could decide to refund or distribute any profits made to the members based on their usage or purchases at the local food co-op.

These are just some examples of how the cooperative model works in reality, particularly in the context of sustainable food and farming. The possibilities are endless, really. Overall, cooperatives provide a vehicle to help farmers and other community members leverage a solution to their individual needs by joining forces. For example, institutional buyers may be more willing to purchase from and even provide better terms to local farmers that are part of a larger cooperative than if they are each out on their own. This can help the farmers involved reach a broader market, which can result in increased profits for all farmers involved, as well as make more local produce available in the local marketplace.

Basic Characteristics of the Cooperative

Cooperatives embody democratic and community values

Because cooperatives are governed on the principle of one member, one vote, democracy is a defining characteristic of cooperatives. No member-owner can dominate the decision-making process, no matter how much money that member invests. The cooperative’s fundamental purpose is to meet the needs of its members. The democratic structure helps ensure that all of the members’ needs are being met, not just a select few with the most power or money. In addition, by their nature, cooperatives promote community values such as sharing and collaboration. Cooperatives are formed by a group of people who come together because they share a need and want to work together to resolve it. The democratic- and community-oriented values inherent in the cooperative structure are often appealing to many farmers who want to work within their local community to not only grow a viable business, but to also contribute to a healthier local food system.

Obtaining investor funding may be a challenge

However, because of the one person, one vote principle, cooperatives may struggle to obtain financing through traditional investors. This is because investors typically prefer it when their investment translates into decision-making power— the more they invest, the more control they have. While the one member, one vote principle of cooperatives may be appealing to small farmers and local community members, bigger investors may choose to invest their money in an LLC or C corporation where they can literally buy more power. Farm operations that anticipate needing significant financing from investors should consider this potential challenge before forming a cooperative.

On the other hand, a variety of government-sponsored grant programs are available specifically for certain types of farm-related cooperatives. For example, the USDA Office of Rural Development offers grants for new and existing rural development cooperatives. So in certain situations, cooperatives may present more funding opportunities for farm operations that adopt a cooperative model.

Cooperatives protect member-owners’ personal assets from the business’s liabilities
Like LLCs and C corporations, a cooperative is considered a limited liability business entity. What this means is that the personal assets of the members are protected from the business’s liabilities, to an extent. Let’s say, for example, a farmer-distributor cooperative is made up of about 20 farmer-members who grow local produce and two worker-members who help distribute and market the local produce to institutional buyers in the local community. The cooperative decides to take out a loan to purchase a refrigerated truck so the worker-members can collect and distribute the produce. If the cooperative defaults on this loan, the creditor can only come after the business’s assets, and not the personal assets of each of the members. This includes any capital or equipment that is officially owned by or has been invested in the cooperative. It’s unlikely that a farmer-member would have invested their farmland into such a cooperative, so that farmland would be protected, as it is not an asset of the cooperative. Without the protection of the cooperative entity, a court may determine that the farmers and the workers were operating as a general partnership. If this happens, then each of the farmers’ and workers’ personal assets could potentially be at risk, which could in fact include the farmers’ land.

However, the limited liability protection offered by the cooperative entity is not absolute. Just as for an LLC and a C corporation, to maintain the status and protection granted by a cooperative, the cooperative must observe corporate formalities, avoid mixing personal assets with company assets, provide adequate funding for the business to operate and follow other standards. This means that the cooperative must have a bank account, credit cards and accounting system that is separate from the members’ personal accounts. Also, the business must generally have enough money in its accounts to make due on its debts. If the business starts recklessly spending money and incurring a lot of debt, a court could determine that the entity is undercapitalized and go around it to access the personal assets of the members. The takeaway is that if you go to the trouble of forming a cooperative, or any business entity, be sure to follow through and uphold best business practices by taking steps to treat the cooperative as a separate entity and being careful not to let the entity take on too much debt.

Cooperatives do not substitute for insurance or reduce the likelihood of liabilities
Forming a cooperative, or any business entity, is not a substitute for insurance. Some farmers mistakenly believe creating a business entity of some kind reduces the likelihood of liability. Creating a cooperative does nothing to change the landscape of a farm’s potential liability; it only limits the assets available to satisfy that liability, should it materialize, to business assets. All the farm business’s assets are entirely available to anyone with a successful claim against the cooperative. Good liability insurance provides the farm business with a defense in court and a source of funds to pay out on a court claim if it is successful. Farm Commons strongly urges any farm business, no matter what business entity it adopts, to maintain adequate insurance coverage.

Forming a Cooperative

Come up with a shared need and strategy

Forming a cooperative is slightly different than forming any other business entity. Typically, to start up, a group of initial members who share a common need, often referred to as the “charter members,” meet up to strategize on how they can work together to address or resolve that need. For example, a group of farmers may come together to strategize on how best to distribute their produce into institutions or restaurants in the local community. They explore how they can work together so that they all succeed. The initial group comes up with a business plan, which may include an assessment of how feasible the strategy of working together is as well as an analysis of the costs and benefits of doing so. The group could simply work together to implement their strategy in a cooperative way without officially forming a cooperative entity. However, to receive the added benefits and protections of a business entity, the group may decide that it’s in their best interest to file the necessary paperwork in their state to officially form a cooperative entity.

File articles of incorporation

The first step of officially forming a cooperative is to draft and file the articles of incorporation. Once the articles of incorporation are filed with and approved by the state’s business entities agency, most commonly the state’s secretary of state office, the cooperative will officially be recognized and receive all the benefits and privileges of the cooperative business entity. The articles typically require basic information, like the location and purpose of the cooperative, as well as a list of the names and contact information of the charter members. An internet search of “forming a cooperative in [your state]” will most likely get you the information you need. The filing of the articles may also be accompanied by a required fee–usually around $45. Annual fees may also be required. These are all considerations a farm operation should evaluate before deciding what business entity to create, as the registration and annual fees can vary based on both the state and the entity.

Prepare bylaws

Most state cooperative statutes do not actually require a cooperative to create bylaws. However, if no bylaws are in place, then the cooperative must abide by its state’s default statutes, which may or may not be in the best interest of the farm operation. It’s often best to take control of the matter and create your own rules. Basically, the bylaws list membership requirements, duties, responsibilities and other operational procedures that allow your cooperative to run smoothly. While the voting must be based on one member, one vote, other significant issues still need to be addressed.

Create a membership application and agreement

One option is to create both a membership application to recruit new members and a separate membership agreement that members sign once they’ve been approved. However, a well-crafted application could serve both roles. The membership application component asks questions that help vet new members to be sure they share in the cooperative’s mission. It should basically seek out why they want to join, what skills or assets they have to offer and so on. The membership agreement component serves as a legal document to verify the membership and the individual’s commitment to certain obligations. As such, the agreement section should specify rules, roles and responsibilities that members must abide by, as well as outline the rights and privileges that come with membership. For example, the membership agreement should specify that the members must comply with relevant tax laws upon becoming members. It should also specify any investment or fee obligations. Does membership require just a one-time investment or fee, or are annual fees required to maintain membership each year? A copy of the bylaws should be included with the application/ agreement so that each member acknowledges and understands how the cooperative is run. Each member should sign the agreement, and the agreements from all members should be kept in a safe place.

Conduct a charter member meeting and elect directors

During this meeting, charter members should vote to adopt the bylaws. The board of directors should be elected and officers should be designated, in accordance with the bylaws. Be sure to take minutes at this and all official meetings to document what happened. The cooperative is now officially formed.

Implementing Best Business Practices for Your Cooperative

File federal taxes

For-profit cooperative corporations receive some special treatment for federal taxation. Although the cooperative entity is generally taxed as a normal C corporation, it can reduce its tax exposure by issuing what are known as “patronage dividends” (also referred to as “patronage refunds”) to patrons or members of the cooperative. A patronage dividend is basically a refund to the cooperative’s members who purchase goods or services from the cooperative. It is calculated based upon the amount that each patron spends or uses the cooperative in a given tax year. When filing its federal tax returns, a cooperative may deduct the amount of the patronage dividends it issues from its gross income. In effect, this income passes through to the individual members, who must report and pay taxes for it on their individual tax return at the dividend rate. The cooperative itself pays no taxes on these earnings. However, any earnings that the cooperative makes by selling goods or services to non-members must be reported on the cooperative’s income tax return. These earnings will be taxed at the corporate rate.

Patronage dividends have to abide by very specific requirements. These are set forth in the IRS’ Subchapter T Cooperatives tax code. The IRS requires that patronage refunds be directly associated with the usage or value of business done for that particular patron or member. 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, very complex. Be sure to seek the assistance of a tax attorney or accountant who is familiar with the cooperative tax code when determining how to go about calculating the amount that each member of the cooperative receives each year.

Note too that in general, a cooperative is not required to issue patronage dividends to all its members. It can define classes of members that receive more or less than one another, or nothing at all. For example, these classes can be based on purchasing a “membership,” certain types of members like farmer-members and worker-members, or other criteria. However, this can again complicate matters for tax purposes, so be sure to consult expert advise before designating such classes.

Let’s presume, for the moment, that the issuance of patronage dividends is done correctly. The members who receive patronage dividends from the cooperative must report that income and pay taxes on it through their individual tax return. The cooperative will need to issue a Form 1099-PATR, “Taxable Distributions Received From Cooperatives,” to each member who receives at least $10 in patronage dividends, and to file all the Form 1099-PATRs with the IRS. If the farm operation earns income from selling products or services to non-members, or for whatever reason does not properly follow the protocol for issuing patronage dividends, it must prepare and file Form 1120-C with the IRS and pay taxes on all earnings not reported as patronage dividends. Other forms may be required depending on the farm operation. Don’t forget that the cooperative will need to abide by state tax obligations, which vary from state to state. The best place to seek guidance is through your tax attorney or accountant, or to contact your state’s department of revenue.

Again, determining how to fulfill the cooperative’s tax obligations can be very complex. This section does not serve in any way as tax advice and only outlines the issues and complex nature of cooperative tax law. Farm Commons strongly advises that any farm operation that becomes a cooperative seeks the assistance of a tax attorney or other tax professional when making these decisions.

Again, preparing and filing tax paperwork can be tricky for a cooperative. It’s best to work with an accountant or tax attorney who is familiar with the strict guidelines for cooperatives.

Hold an annual meeting

Most state cooperative statutes require cooperatives to hold an annual meeting. This is the time to review the program and business of the cooperative for the past year, to elect officers and to plan the next year’s activities. The annual meeting should be open to all members and other interested people. Be sure to follow the protocol set forth in your bylaws for sending out the meeting invitation or notice to all members, conducting the meeting and holding votes. The annual meeting agenda will include matters like reading the minutes, presenting annual reports of the business operations, hearing reports of officers and any committees, electing directors, discussing unfinished business and raising new business or issues. Minutes must be taken at the annual meeting and at all other official meetings to officially document what happened, including who was present and what decisions were made. The minutes do not have to be elaborate. They simply have to provide enough detail to show what happened in case an issue or dispute arises.

Follow through with all other requirements to maintain the business entity’s integrity

Like all other formal business entities, the cooperative will have to uphold certain formalities and best practices to maintain the entity’s integrity and protect the members’ personal assets from the business’s liabilities. These include keeping the business’s financial affairs separate from the members’ financial affairs, including maintaining separate bank accounts, credit cards and accounting systems. The cooperative must not recklessly spend money and incur a lot of debt, otherwise courts could determine that the entity is undercapitalized and go around it and access the members’ personal assets to cover the business’s liabilities. The cooperative members must also abide by the bylaws, as these are the ground rules for how the entity is to operate, and must file annual fees, obtain required licenses and so on. Cooperatives are considered a form of a corporation, and they share many similarities in the formalities required for C corporations. The “Implementing Best Business Practices” section in the C corporation chapter (Chapter 5) provides a thorough breakdown of what is required to maintain a corporation’s integrity, which aside from the tax obligations is for all intents and purposes the same for cooperatives. Refer to that section if your farm operation decides to form a cooperative.