This article explores how cooperatives distribute money differently from conventional businesses, focusing on key concepts such as member equity accounts, funding collective accounts with retained earnings, patronage dividends, and profit-sharing distributions to members. We provide a comprehensive guide to understanding these mechanisms, specifically for cooperatives taxed under IRS Subchapter T.
Understanding equity accounts: Contributions of Capital by the Members
Equity capital is the money supplied by the owners of a business, which is used towards financing the various needs of the business.
When members join a co-op, they usually make an initial capital contribution and/or pay a fee. A fee is usually non-refundable, whereas a capital contribution (sometimes called a “buy-in”) becomes the member’s capital in the cooperative, which the member can get paid back to them at certain defined points in time. Not all cooperatives require members to pay a fee or a capital contribution to become a member.
When members make a capital contribution, this amount of money becomes the starting balance in the member’s capital account. The capital account is not literally a separate bank account, but is accounted for separately on the financial records (the “books”) of the co-op. The members’ capital accounts make up the equity of the co-op. Each member account includes not only the member’s initial capital contribution, but also their portions of the cooperative’s earnings (“patronage dividends”), plus or minus anything else that might affect the balance in the member account. The co-op has rules about how and when the members can get the contents of their capital accounts back out of the co-op. Usually, a member does not get their capital back until they leave the co-op. Often when the member leaves the co-op, the balance in the capital account converts to a loan from the departing member to the co-op, which the co-op then pays back to the departing member over time.
Funding the collective account (retained earnings)
At the end of each accounting period (usually the fiscal year), the cooperative’s accountant determines whether there is any surplus (money left over after expenses.) If there is any surplus, the co-op must decide what to do with it. The co-op’s governing document sets out the options (e.g., the bylaws or operating agreement). The options are to:
- keep the money in reserve (retain the earnings) to cover unforeseen expenses or invest back into the business;
- distribute the surplus to the members; or
- do some combination of options 1 and 2.
Retained earnings are the earnings that a cooperative does not pay out to its members. Like most businesses, cooperatives should build a financial reserve to help cover ongoing and also future operating costs. When drafting bylaws, a cooperative should decide how to build their financial reserve by agreeing to put some amount of the net revenue into their Collective Account before putting the rest into the individual Member Accounts (in the form of patronage dividends). The Collective Account sits with the Member Accounts in the cooperative’s bank account. However, the Collective Account does not belong to any one individual Member, but to the cooperative itself.
In the context of a California worker cooperative, an Indivisible Reserves Account is an internal account with funds derived from non-patronage-sourced income, that will not be distributed to members, and that must, upon dissolution, be allocated to a cooperative development organization identified in the cooperative’s articles of incorporation or bylaws.
Note that the cooperative will need to pay tax on the retained Profits; see the tax section below.
Funding member accounts (Patronage Dividends)
Unlike in a regular corporation, the surplus is distributed not based on ownership interest but on patronage. So, for example, in a producer cooperative, if one member delivered 30 pounds of broccoli to be marketed through the cooperative and another member delivered 10 pounds of broccoli during the same period, the first member would receive three times as much of the surplus as the second member.
In a worker cooperative, patronage is measured by the work done for the cooperative. In most worker cooperatives, it is calculated based on how many hours each Member worked relative to each other. Thus, Patronage Dividends are calculated by dividing up the Surplus at the end of the fiscal year.
The co-op can choose to pay the entire patronage dividend in cash, or it may simply allocate all or a portion of the dividend to the members’ capital accounts using a “Written Notice of Allocation” (WNA), which is defined in Subchapter T of the Internal Revenue Code. The use of WNAs allows the co-op to retain more cash within the co-op. The co-op sets policy as to when members may withdraw these funds as cash from their capital accounts. One common practice is to redeem WNAs on a rolling basis to prevent long-time members from accumulating very large capital accounts. Some co-ops pay interest on the balance in the members’ capital accounts to prevent members from becoming frustrated by having capital accounts tied up in the cooperative without any financial return.
If some of the patronage is sourced from non-members, the cooperative will have to calculate what percentage of its total revenue is attributable to member patronage. Only surplus attributable to member patronage may be distributed to members if the cooperative wants to get the tax benefits related to patronage distributions.
Distributing member payments: Profit Sharing in Cooperatives
Both the LLC and the Cooperative Corporation allow for worker-owners to share in the profits of the business. Members of a worker cooperative share in the surplus revenue that was derived from patronage activities each year, which most worker cooperatives measure based on the number of hours each member works. The more “patronage” you have (for example, the more hours you work), the greater the profit-share to which you are entitled. Either an LLC or a cooperative corporation could also include other factors such as “job creation” or a “founder’s multiplier” to vary profit distribution based on what is perceived to have been the value of the worker-owner’s contribution for the year.
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