Businesses pay a variety of state and federal taxes. This section will focus on federal income, employment taxes and calculating tax deductible patronage-sourced income.
Federal income tax rules for co-ops
Cooperatives can receive special tax treatment under Subchapter T of the Internal Revenue Code. “C” corporations face double-taxation, which means that the corporation gets taxed on their earnings at the corporate level, and then, when it pays dividends to its shareholders, the shareholders have to pay tax on those dividends. In contrast, Subchapter T allows a cooperative to avoid double-taxation on some of its earnings, if those earnings are paid out to members as patronage dividends, so long as the cooperative meets the requirements set forth in the Code and at least 20% of each patronage dividend is paid out in cash. This is because patronage dividends are considered a tax-deductible business expense for the cooperative.
Federal income tax rules for individual co-op members
Each member will pay tax on the patronage dividend distributed or allocated to the member. Note that the member must pay income tax on the entire patronage dividend, even if some of it was only received in the form of a written notice of allocation, rather than as a cash pay-out. Refer to this article from Wegner CPAs for more information.
If a member receives half of their patronage payment in cash and the other half in a written notice of allocation, that member will need to pay taxes on both payments. Since they are paying taxes on all of it now, when the money from the written notice of allocation is paid to them over the next few years, they will not have to pay tax on it again.
Calculating tax deductible patronage-sourced income (T Corp)
The Cooperative will need to calculate its net revenue by taking its earnings and subtracting any expenses. Then the Cooperative will need to calculate how much of its earnings it will keep in the Cooperative’s Collective Account and how much of it will be paid to Members as Patronage Dividends.
Each Cooperative will decide on what percentage of its earnings it wants to keep in a Collective Account in order to build a financial reserve to help cover ongoing and future operating costs. The amount of earnings that is put in a Collective Account and not paid out to Members is called retained earnings. The Cooperative will need to pay taxes on its retained earnings.
Once a portion of the net revenue is put into the Collective Account as retained earnings, the remainder of the earnings will be split amongst the members, this payment is referred to as patronage dividends. The amount each member receives as patronage dividends will most likely depend on how many hours they each worked. Patronage dividends can be paid out to members in cash and/or written notices of allocation. As a reminder, each member will need to pay taxes on both the earnings they received in cash and the ones they received as written notices of allocation. Please consult with an experienced accountant to discuss patronage and distributions for your cooperative.
Subchapter T and Federal Income Tax
Subchapter T allows a cooperative to avoid double-taxation on some of its earnings, if those earnings are paid out as patronage dividends. This is because patronage refunds are considered a tax-deductible business expense for the cooperative. Each member will pay tax on the patronage dividend distributed or allocated to the member.. Note that the member must pay income tax on the entire patronage dividend, even if some of it was only received in the form of a written notice of allocation, rather than as a cash pay-out.
To take advantage of Subchapter T, a cooperative has to meet the requirements outlined in the relevant part of the Internal Revenue Code, 26 U.S.C. § 1388. For patronage dividends to be tax-deductible, two of the more important requirements are:
- that at least 20% of the Patronage Dividend gets paid out in cash/check within 8.5 months of the end of the fiscal year; and
- each member of the co-op receives a “qualified” written notice of allocation for the noncash portion of the Patronage Dividend.
Another note on CA taxes: cooperatives also have to pay either the CA Corporation Franchise Tax (state income tax), which is based on its taxable income, or the $800 CA Minimum Franchise Tax, whichever amount is greater. However, in its first taxable year, a cooperative is not subject to the CA Minimum Franchise Tax (although it does still have to pay the Corporation Franchise Tax, even if it’s less than $800).
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