Subchapter T: The Most Common Tax Status for Co-ops
The Subchapter T designation is designed specifically to address the unique nature of cooperative income. It allows a co-op to pay taxes only on the income earned after worker-owners have been paid out. This can reduce the co-op’s tax burden substantially. There are some very specific rules about how this can be applied, so it’s important to understand how the designation treats income and payouts to worker-owners.
Why might a cooperative choose Subchapter C?
Subchapter T allows “any corporation operating on a cooperative basis” to deduct from their gross taxable income the amount they pay in qualifying patronage refunds. Earnings in a regular corporation are double-taxed, meaning that the corporation pays income tax on the net earnings, and then the shareholders (owners) pay income tax when they receive dividends on those earnings. In contrast, under Subchapter T allows a cooperative to avoid some of the traditional corporate double-tax. Assuming the cooperative meets all the requirements of “operating on a cooperative basis” set forth in the Code (explained below), patronage dividends (sometimes called “patronage refunds”) are generally tax-deductible for the cooperative if at least 20% of each patronage dividend is paid out in cash. Of course, the members must pay income tax on the total patronage dividend they receive regardless of whether it is paid in cash or as an allocation in the member’s capital account (that’s why at least 20% must be paid out in cash each year – so members can pay their taxes!).
Businesses must operate as a co-op to qualify for the Subchapter T tax status
Subchapter T tax status only applies to a business that is “operating on a cooperative basis”. So what does this mean?
The Puget Sound Plywood case became the leading case on which the IRS relied for the definition of “operating on a cooperative basis.” The court listed three guiding principles:
- Decisions and control are typically based on the principle of “one member, one vote” rather than “one share, one vote.” This means that each member, regardless of their investment or capital contribution, has an equal say in the cooperative’s decision-making process.
- Democratic control by the worker-members.
- The benefits and profits generated from their collective efforts are distributed among the worker-members. This distribution is based on how actively they participate in the cooperative, meaning that those who contribute more to the cooperative’s work receive a proportionately larger share of the benefits.
Courts have clarified that characteristics of cooperatives mentioned outside of the tax code are not strict requirements for tax deductions, but rather for clarification purposes.
One important characteristic is the amount of business a cooperative does with its members compared to non-members. Initially, the IRS required cooperatives to conduct more than 50% of their business with members to be considered operating on a cooperative basis. However, a court ruling in the Conway County Farmers Ass’n case disagreed with this requirement, stating that Congress did not include a specific quantitative threshold for non-member business. As a result in 1985, the IRS changed its position and no longer considers a business to be non-cooperative solely based on doing less than 50% of its business with members. The IRS takes into account various factors and considers the specific circumstances and nature of the business. The IRS follows the principles established in the Puget Sound Plywood case as a guide in making this determination. In other words, the IRS looks at the overall context and characteristics of the business to decide if it meets the criteria to be classified as a cooperative, rather than relying solely on a specific percentage of business conducted with members.
What is a qualifying patronage dividend?
Like stated above, Subchapter T allows a cooperative to deduct from their gross taxable income the amount they pay in qualifying patronage refunds.
There are specific rules defining tax-deductible distributions.To be considered a “qualifying patronage refund” in a worker cooperative, a patronage refund must:
- Be paid to the co-op member on the basis of the quantity or value of business done with the member (typically, the hours the member worked for the co-op).
- Be distributed under a pre-existing obligation of the co-op to pay that amount.
- Be calculated based on earnings derived from the co-op’s business done with its members.
Only income earned from the patronage of members can be distributed as patronage dividends. This means that only income generated from transactions with cooperative members qualifies to be shared as patronage dividends.
In the case of a worker cooperative that has both worker-owners and regular employees, courts have established guidelines to determine how a business can determine the proportion of its income that comes from work performed by members compared to non-members. These guidelines help the cooperative identify the specific portion of their earnings that can be attributed to the work done by cooperative members.
Distributions to worker-members are tax deductible
Initially, the IRS stated that dividends given to members based on their work in a cooperative were not considered true patronage dividends. According to a ruling in 1961, for a dividend to be deductible, it had to be either an additional payment for goods sold through the cooperative or a reduction in the purchase price of supplies and equipment bought by the member through the cooperative.
However, the courts disagreed with this IRS ruling. In a case called Linnton Plywood Ass’n v. United States, the court decided that worker cooperatives could deduct dividends from their overall income, just like other cooperatives. This decision was further supported by the U.S. Tax Court in the Puget Sound Plywood, Inc. v. Commissioner case, which concluded that worker cooperatives operating in accordance with Subchapter T could deduct their patronage dividends from federal taxes.
Eventually, the IRS acknowledged the court rulings and issued Revenue Ruling 71-439 in 1971, confirming that distributions to members based on hours worked are indeed patronage dividends. This ruling was a significant development as it opened the door for many future worker cooperatives and provided a solid tax foundation for the increasing popularity of this business structure. Worker cooperatives were officially recognized, in terms of taxation, as part of the broader group of non-exempt cooperatives, without any particular distinction or special treatment.
How to avoid “double tax” when converting your business to a co-op
If your business can meet the requirements of Subchapter T after conversion, the business can avoid some of the traditional corporate “double-tax.” Even if your state does not offer a cooperative corporation statute, a corporation’s articles and bylaws can probably be amended to meet your cooperative goals (by adding provisions regarding membership, democratic governance, distribution of profits, and, if relevant, protections for existing shareholders). The articles and bylaws should also be made to correspond with the requirements of Subchapter T (the IRS designation for cooperatives) as well as the relevant state cooperative law. Assuming the cooperative meets all the requirements set forth in the Code, patronage dividends are generally tax-deductible for the cooperative if at least 20% of each patronage dividend is paid out in cash.
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