Subchapter T and How Money Flows Through a Cooperative

Cooperative Money/Tax Basics

Contributions of Capital by the Members

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.  Not all cooperatives require a contribution to capital by members.

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 books of the co-op.  The members’ capital accounts make up the equity of the co-op.  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 his or her capital back until he or she leaves 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 over time.

Distribution of Surplus to the Members

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 board must decide what to do with it.  The options are to (1) keep the money in reserve to cover unforeseen expenses or invest back into the business; (2) distribute the surplus to the members; or (3) do some combination of options 1 and 2.

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.

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 (discussed below).

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 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 member capital accounts to prevent members from becoming frustrated by having capital accounts tied up in the cooperative without any financial return.

Tax Treatment

Earnings in a regular corporation are double-taxed—the corporation pays income tax on the net earnings, and then the shareholders pay income tax when they receive dividends on those earnings.  In contrast, under Subchapter T of the Internal Revenue Code, a cooperative can avoid some of the traditional corporate double-tax. 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.  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.

Limiting Equity in a Cooperative

Many cooperatives intentionally limit the ways in which members may benefit from equity in a business.  In a more conventional business, an owner that sells his/her share back to the company often has a right to be paid market value for that share.  By contrast, when members leave a cooperative, they typically receive only what is in their capital account, without regard to the market value of the business.  Furthermore, cooperative members are almost always prevented from selling their memberships to third parties.

The dissolution and sale provisions of cooperative bylaws also serve to limit equity of current members.  If a worker cooperative starts an ice cream company that becomes wildly successful, it may be somewhat tempting for the worker/owners to sell the business and enjoy a windfall.  To prevent the incentive to sell out, some cooperative bylaws require that, if the business is sold or dissolved, the proceeds must be divided among all current and past members, on the basis of their patronage.  That way, a past member that put in years of service will be rewarded, even if that person is not a member at the time of the sale.  Building in disincentives to sell the business helps the cooperative to maintain its purpose of providing livelihoods to its members, and it helps to keep businesses locally-based and locally-owned.

Furthermore, although there may not be enough precedent in tax court decisions to know this for sure, it is possible that this method of dividing sale proceeds is actually necessary to meeting the Subchapter T requirements.  It follows that if regular earnings must be distributed on the basis of patronage, then so too must a pay-out of equity.  Presumably, every member that has ever worked for a cooperative business contributed to its success and value, and should therefore receive part of that pay-out.

Explanation of How Money Flows Through a Cooperative

How Patronage Works

Amy and Bernardo decide to go into business for themselves. They start Green Commonwealth, a landscaping cooperative to help people create outdoor spaces that showcase colorful native plants. The cooperative has properly complied with relevant securities laws to raise money. In the beginning, it has two members, Amy and Bernardo.

Amy puts in $10,000 and Bernardo puts in $10,000. This is their initial capital contribution. They each have a capital account,which now contain $10,000 (in the sample bylaws, the capital account is also known as Member Account).   Thus, we have:

Amy’s Capital Account/Member Account: $10,000 initial capital contribution       

Bernardo’s Capital Account/Member Account: $10,000 initial capital contribution

Note: The Member Account (capital account) is not a separate bank account for the member. The Member Account includes not only the member’s initial capital contribution, but also his or her shares of the cooperative’s earnings (Patronage Dividends), plus or minus anything else that might affect the balance in the Member Account. Those funds in the Member Account do belong to the member, but they actually sit in the cooperative’s bank account and are accounted for separately. The cooperative’s bylaws provide rules on how and when the member can take out those funds.

Carla then joins as a regular employee. Carla isn’t yet a member and she hasn’t made an initial capital contribution therefore, unlike Amy and Bernardo, Carla has no capital account. Carla does get paid regular wages, like Amy and Bernardo. We will assume that Amy and Bernardo have chosen to treat themselves as employees; however, see the section of this handbook that describes when you do or do not need to treat working cooperative members as employees.

The beautiful gardens are a hit! Green Commonwealth makes a nice profit. What happens now?

Green Commonwealth earns $150,000 from their landscaping services. It spent $105,000 to buy materials, pay wages to Amy, Bernardo, and Carla, buy insurance, etc. Green Commonwealth earned net revenue of $45,000 ($150,000 – $105,000 = $45,000). As members of Green Commonwealth, Amy and Bernardo are entitled to a share of this net revenue. But how do we know how much they get?

First, look at how many hours everyone worked that year and figure out how much of that $45,000 was attributable to members’ labor (work done by Amy and Bernardo) and how much was attributable to non-members’ labor (work done by Carla).

Members Hours Worked     

Amy: 1200 hours

Bernardo: 1800 hours

Total Member Hours: 3000


Non-Members Hours Worked

Carla: 1500 hours

Total: 1500 hours

Total Member and Non-Member Hours: 4500

3000 Member Hours/4500 Total Hours = 2/3

1500 Non-Member Hours/4500 Total Hours = 1/3

2/3 of the $45,000 was attributable to the hours of work that Amy and Bernardo, the members, did (member labor). This is what the bylaws call a $30,000 Surplus.

1/3 of the $45,000 (or $15,000) was attributable to the hours of work that Carla, the non-member, did (non-member labor). This is what the bylaws call a $15,000 Profit.

Like most businesses, Green Commonwealth wants to build a financial reserve to help cover ongoing and also future operating costs. When drafting their bylaws, they decided one way to build their financial reserve was by agreeing to put some of the net revenue (in this case, some of the $45,000) 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 Green Commonwealth’s bank account. However, it does not belong to any one individual Member, but to Green Commonwealth itself.

In the bylaws (see Section 7.3 of the sample “Bylaws of Green Commonwealth Cooperative, Inc.”), they agreed to allocate 100% of Profit (i.e., the net revenue that was attributable to non-member labor) to the Collective Account. So they put the $15,000 Profit into the Collective Account as retained earnings. Retained earnings are the earnings that Green Commonwealth does not pay out. Note that the cooperative will need to pay tax on the retained Profits; see the tax section below.

Okay. So far, so good. What else do the bylaws say?

In Section 7.3 of their bylaws, they agreed that “[a]ny Surplus shall be credited to the Collective Account as necessary to bring the year’s contribution to the Collective Account up to 25% of the year’s combined Profit/Surplus. All other Surplus shall be paid as Patronage Dividends in direct proportion to Patronage during the fiscal year.” Fortunately, Green Commonwealth has already allocated 33% of the combined Profit/Surplus to the Collective Account, thanks to the large amount of earnings attributed to non-member labor. Thus, no additional funds are required to be put into the Collective Account to bring it up to 25%.

Now that they’ve put enough retained earnings into the Collective Account, let’s figure out how Amy and Bernardo will get their shares of the year’s earnings (Patronage Dividends).

The amount of Patronage Dividends each Member gets is based on how much patronage each of them had that year. 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.

We know from the previous table that Amy worked 1200 hours and Bernardo worked 1800 hours.

Now, let’s do the math:

Amy’s Hours/Total Member Hours = 1200/3000 = 2/5

Bernardo’s Hours/Total Members Hours = 1800/3000 = 3/5

2/5 of the $30,000 Surplus = $12,000 in Patronage Dividends to Amy

3/5 of the $30,000 Surplus = $18,000 in Patronage Dividends to Bernardo

Amy gets $12,000 in Patronage Dividends. Does this mean she gets a $12,000 check to take home with her?

Do they get it all back in cash? Well, let’s look at the bylaws again!  Section 7.4 of the bylaws says that Patronage Dividends get paid to their members “50% in cash and 50% as written notices of allocation.” When a Member receives a written notice of allocation for a specified amount, that amount goes into his or her Member Account as a credit which will be paid out in cash sometime in the future, according to what the bylaws provide for.

Why don’t Amy and Bernardo get it all back in cash?  Green Commonwealth needs a certain amount of cash on hand for operating expenses, and the funds that are in the Collective Account (retained earnings, etc.) may not be enough to run the business day to day. By paying part of the Patronage Dividends as written notices of allocation, Green Commonwealth will help ensure that it has enough cash on hand to pay for things like rent, salaries, landscaping supplies, etc. In return, Green Commonwealth might pay a modest interest rate on the Member Accounts (under 15%).

So Amy and Bernardo get their Patronage Dividends as follows:

$6,000 cash and $6,000 written notice of allocation for Amy

$9,000 cash and $9,000 written notice of allocation for Bernardo

 And here’s how their Member Accounts look now:

Amy’s Capital Account/Member Account

$10,000 initial capital contribution

$6,000 written notice of allocation

Total: $16,000


Bernardo’s Capital Account/Member Account

$10,000 initial capital contribution

$9,000 written notice of allocation

Total: $19,000

(Carla doesn’t get any Patronage Dividends because she isn’t a Member. She only gets her regular salary.)

Amy and Bernardo are pretty happy. Green Commonwealth had a great year and they both received a good chunk of profits in cash–$6,000 for Amy and $9,000 for Bernardo. Their Member Accounts are looking healthy too–$6,000 written notice of allocation added to Amy’s Member Account and $9,000 written notice of allocation to Bernardo’s Member Account.

Paying Taxes

Businesses pay a variety of state and federal taxes. Besides state and federal income tax and employment taxes, they pay excise taxes, unemployment insurance and temporary disability taxes, etc. For purposes of this discussion, we focus on federal income and employment taxes. Taxation is complicated, and cooperative taxation is even more complicated. You should consult with an experienced tax attorney who specializes in cooperative taxation.

 Subchapter T and Federal Income Tax

Cooperatives can receive special tax treatment under Subchapter T of the Internal Revenue Code. Regular 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 as patronage refunds (known in this scenario as Patronage Dividends). This is because patronage refunds are considered a tax-deductible business expense for the cooperative. In the case of Green Commonwealth, it will pay some tax, because 33% of the earnings were attributable to non-member labor and were therefore not paid out as patronage refunds.

Each member will pay tax on the patronage dividend distributed or allocated to him/her. 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. So, Amy must pay income tax on her $12,000 patronage dividend, even though she received $6,000 of it in cash and $6,000 of it as written notice of allocation. Since she is paying taxes on all of it now, when the additional $6000 is paid to her over the next few years, she will not have to pay tax on it again.

To take advantage of Subchapter T, Green Commonwealth has to meet the requirements outlined in the relevant part of the Internal Revenue Code, 26 U.S.C. § 1388. For the patronage refunds/Patronage Dividends to be tax-deductible, two of the more important requirements are (1) 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 (2) 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: Green Commonwealth also has 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, Green Commonwealth 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).

Employment and self-employment tax

Besides paying income tax based on what a business earns, a business must pay employment taxes based on the wages it pays to its employees. As discussed above, Green Commonwealth pays wages to employees. Carla is an employee, and Amy and Bernardo, as members of the worker cooperative, have also chosen to treat themselves as employees. Therefore, Green Commonwealth has to pay employment tax on those wages. Employment taxes include Medicare, Social Security, and unemployment insurance.

If you are self-employed, you pay self-employment tax (Medicare and Social Security) based on your self-employment income. The IRS defines self-employment income as the income that an individual earns from a trade or business carried on by that individual.

As we will see in the next chapter, Green Commonwealth has to pay employment taxes on the wages it paid to Amy, Bernardo, and Carla. What about the Patronage Dividends it paid to Amy and Bernardo? Would these coop members have to pay self-employment tax on the Patronage Dividends? Would Green Commonwealth have to pay employment tax on the Patronage Dividends?

On the issue of whether patronage refunds (Patronage Dividends) are subject to self-employment tax, the IRS has gone back and forth. Over the past several years, the IRS audited members of a worker cooperative and told them they had to pay self-employment tax on their patronage refunds. Bay Area tax attorney Greg Wilson fought those cases, asserting that patronage refunds paid by a worker cooperative are not subject to self-employment taxes for several reasons. (See “Taxation of Patronage Dividends from Worker Cooperatives: Are They Subject to Employment Tax?” By Attorney Gregory R. Wilson). Eventually, the IRS agreed and dropped those cases, concluding that patronage refunds from a worker cooperative are not subject to self-employment tax. The IRS said that, in cases where members of a worker cooperative are employees, employees generally do not receive both employment income and self-employment income from the same entity. However, this leads to the possibility that the IRS might conclude that patronage refunds are employee bonuses. If this is true, the worker cooperative may have to pay employment tax on patronage refunds, since employee bonuses are considered employee wages.

Redeeming the Member Account

Amy and Bernardo’s Member Accounts are looking pretty good. But how do they get money out of them? According to Section 7.7 of their bylaws, Green Commonwealth “shall aim to pay out in cash all funds credited to their Member Accounts within three years of the date they were first credited.”  So, three years from now, assuming all is well, Amy and Bernardo will have gotten back all of the $6,000 and $9,000 written notices of allocation as cash. Since they will already have paid taxes on those amounts, they will not need to pay taxes again when they receive the money.

Leaving the Cooperative

When a member leaves a co-op, the amount in his or her capital account becomes a debt that the co-op then pays back to the member over a specified amount of time. Under Section 7.8 of their bylaws, the cooperative would repay the debt, plus interest, within five years after Amy or Bernardo leaves.

Selling/Dissolving the Cooperative

According to their bylaws, if Green Commonwealth is ever sold or dissolves, all proceeds (after paying out Member Accounts and debts) will be distributed to everyone that was ever a member of the cooperative, on the basis of the number of hours each put in. This method of distribution is consistent with the requirement that earnings of cooperatives be distributed to members on the basis of their patronage, and it means that current members will not get an inappropriate bonus. This helps to keep businesses locally owned, because it gives current members a disincentive to vote to sell a business for the purpose of cashing out and getting a lot of money, since proceeds will need to be distributed among past members as well.


Case where court found patronage to be part of wages for the purposes of determining lost wages in a workers compensation payment. 

In the Matter of the Compensation of Virgillia K. Ekdahl, Claimant. SAIF CORPORATION and Burley Design Cooperative, Petitioners, v. Virgillia K. EKDAHL, Respondent., Court of Appeals of Oregon (2000). 170 Or. App. 193

Clayton S. Reynolds, Patronage-Sourced Income: An Expanding Universe, 58 Tax Law. 479 (2005)

The article summarizes developments in the law regarding tax cooperatives, in particular, the distinction between patronage and non-patronage-sourced income, in the wake of Revenue Ruling 69-576, which expanded the types of income that qualify as patronage-sourced. Reviews dividends, lease payments, rebates, capital gains, partnership income, and interest. A very technical piece that non-lawyers will find challenging to understand, but a good primer for those ambitious individuals seeking to master coop tax law on their own.

Jimmy Kroger, The New Frontier: Tax Implications of Limited Cooperative Associations, Fed. B.A. Sec. Tax’n Rep., Summer 2009

This article discusses the history of cooperative associations and their taxation, especially in the context of the Uniform Limited Cooperative Association Act. The author presents the opportunities and challenges for cooperations formed under the Act. Though much of the article focuses on the so-called “new age” agricultural cooperatives that were spawned throughout the Midwest in the 1990s, its background coverage on cooperative tax law is valuable for all cooperatives.

Benson, George W. “Conducting business in the United States through a corporation ‘operating on a cooperative basis’.” The International Tax Journal 37.1 (2011): 31+. LegalTrac. Web. 23 Mar. 2011.

Provides an advanced explanation of the taxation of non-exempt Subchapter T cooperatives, and discusses tax issues when a cooperative has foreign members. Includes a wonderful overview of the taxation of various kinds of cooperatives in the United States, the IRS principles on cooperatives, other characteristics considered by the IRS to determine whether an association is operating on a cooperative basis, and a summary of patronage dividend requirements. The article is geared toward foreign companies seeking to create a joint enterprise in the United States, but the majority of the content is background information about the tax code that is useful for all cooperatives.

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