Introduction to Cooperatives - American Bar … October 21, 2011 1 Introduction to Cooperatives Tyrus H. Thompson (Ty) Chief Member Counsel National Rural Electric Cooperative Association

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Introduction to Cooperatives

Tyrus H. Thompson (Ty)Chief Member Counsel

National Rural Electric Cooperative Association703-907-5855, [email protected]

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Overview

• What is a Cooperative– Cooperative Definition– Cooperative Principles

• Types of Cooperatives– General Classifications– Tax Classifications

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Overview

• Puget Sound Plywood, Inc. v. Commissioner, 44 T.C. 305 (1965), acq. 1966-2 C.B. 6 (1966)– Leading case and often cited by IRS

• The Organization and Operation of Cooperatives (4th ed. 1970)– Israel Packel– A leading legal treatise

• International Co-operative Alliance– International cooperative association

The leading case addressing cooperatives under federal tax law is Puget Sound Plywood, Inc. v. Commissioner, 44 T.C. 305 (1965), acq. 1966-2 C.B. 6 (1966). See, e.g., Bot v. Commissioner, 118 T.C. 138 (2002); Thwaites Terrace House Owners Corp. v. Commissioner, 72 T.C.M. (CCH) 578 (1996); Trump Village Section 3, Inc. v. Commissioner, 69 T.C.M. (CCH) 2985 (1995); and Buckeye Countrymark, Inc. v. Commissioner, 103 T.C. 547 (1994).

A leading legal treatise addressing cooperatives is The Organization and Operation of Cooperatives (4th ed. 1970) written by Israel Packel.

The International Co-operative Alliance is “an independent, non-governmental association which unites, represents and serves co-operatives worldwide. Founded in 1895, ICA has 221 member organisations from 87countries active in all sectors of the economy. Together these co-operatives represent more than 800 million individuals worldwide.” Seehttp://www.ica.coop/al-ica/.

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What is a Cooperative

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Cooperative Definition

• Puget Sound Plywood, Inc.– “A cooperative is an organization established by

individuals to provide themselves with goods and services or to produce and dispose of the products of their labor. The means of production and distribution are those owned in common and the earnings revert to the members, not on the basis of their investment in the enterprise but in proportion to their patronage or personal participation in it.”

As noted in Puget Sound Plywood, Inc., “A cooperative is an organization established by individuals to provide themselves with goods and services or to produce and dispose of the products of their labor. The means of production and distribution are those owned in common and the earnings revert to the members, not on the basis of their investment in the enterprise but in proportion to their patronage or personal participation in it.” Puget Sound Plywood, Inc. v. Commissioner, 44 T.C. 305, 306 (1965), acq. 1966-2 C.B. 6 (1966) (emphasis original).

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• The Organization and Operation of Cooperatives– “A cooperative can be defined for practical

purposes as a democratic association of persons organized to furnish themselves an economic service under a plan that eliminates entrepreneur profit and that provides for substantial equality in ownership and control.”

As Mr. Packel explains, “A cooperative can be defined for practical purposes as a democratic association of persons organized to furnish themselves an economic service under a plan that eliminates entrepreneur profit and that provides for substantial equality in ownership and control.” Israel Packel, The Organization and Operation of Cooperatives 2 (4th ed. 1970).

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• International Co-operative Alliance– “A co-operative is an autonomous

association of persons united voluntarily to meet their common economic, social, and cultural needs and aspirations through a jointly-owned and democratically-controlled enterprise.”

As defined by the International Co-operative Alliance, “A co-operative is an autonomous association of persons united voluntarily to meet their common economic, social, and cultural needs and aspirations through a jointly-owned and democratically-controlled enterprise.” Statement on the Co-operative Identity, available at http://www.ica.coop/coop/principles.html.

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Cooperative Principles

• Puget Sound Plywood, Inc.– Subordination of capital– Democratic member control– Operation at cost

As held in Puget Sound Plywood, Inc. v. Commissioner, the cooperative principles are subordination of capital, democratic member control; and operation at cost. Puget Sound Plywood, Inc. v. Commissioner, 44 T.C. 305, 308 (1965), acq. 1966-2 C.B. 6 (1966).

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• Subordination of capital– Control by members and not nonmember

equity investors (members elect board of directors and officers)

– Ownership of pecuniary benefits by members and not nonmember equity investors (limitations on dividends and returns on capital)

In general, subordination of capital means that a cooperative is controlled, and its pecuniary benefits are owned, by the cooperative’s members, instead of by nonmember shareholders or other nonmember equity investors. Puget Sound Plywood, Inc. v. Commissioner, 44 T.C. 305, 308-09 (1965), acq. 1966-2 C.B. 6 (1966).

Unlike a business corporation that is oriented toward shareholders, a cooperative is oriented toward members. Puget Sound Plywood, Inc. at 309. Members “control” a cooperative by electing boards of directors and officers. Puget Sound Plywood, Inc. at 308. Members “own” a cooperative’s pecuniary benefits through limitations on dividends or returns on capital invested by nonmember shareholders and equity investors. Puget Sound Plywood, Inc. at 308.

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• Democratic member control– Widely-based participatory democracy– Members exercise franchise of equal

strength– Periodically hold member meetings

In 1972, the United States Court of Appeals for the Fifth Circuit noted that a cooperative must operate “according to a model of a widely-based participatory democracy in which all the members are able to exercise a franchise of equal strength.” Etter Grain Company, Inc. v. United States, 462 F.2d 259, 263 (5th Cir. 1972). A cooperative satisfies democratic control by periodically holding “democratically conducted meetings.” Puget Sound Plywood, Inc. v. Commissioner, 44 T.C. 305, 308 (1965), acq. 1966-2 C.B. 6 (1966).

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• Operation at cost– Cooperative organized for purpose of

rendering economic services– No gain to cooperative or members

In general, the “concept of operation at cost simply means that a cooperative [is] organized for the purpose of rendering economic services, without gain to itself, to shareholders or to members who own and control it.”Buckeye Power, Inc. v. United States, 38 Fed. Cl. 154, 161 (1997); Kingfisher Coop. Elev. Ass’n v. Commissioner, 84 T.C. 600, 616 (1985); andFord-Iroquois FS, Inc. v. Commissioner, 74 T.C. 1213, 1219 (1980).

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• The Organization and Operation of Cooperatives– Substantially equal member control/ownership– Members use cooperative’s services– Prohibited or limited transfer of ownership interests– No or limited return on capital investments– Economic benefits are substantially equal or based on

patronage– Members are not generally personally liable– Member death or withdrawal does not terminate cooperative– Cooperative services primarily for member use

Mr. Packel explains, “Generally, and the word is emphasized very deliberately, a cooperative has the following characteristics:

- Control and ownership of each member is substantially equal;- Members are limited to those who will avail themselves of the services furnished by the association;- Transfer of ownership interests is prohibited or limited;- Capital investment receives either no return or a limited return;- Economic benefits pass to the members on a substantially equal basis or on the basis of their patronage of the association;- Members are not personally liable for obligations of the association in the absence of a direct undertaking or authorization by them;- Death, bankruptcy or withdrawal of one or more members does not terminate the association; and- Services of the association are furnished primarily for the use of the members.”

Israel Packel, The Organization and Operation of Cooperatives 4-5 (4th ed. 1970).

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• International Co-operative Alliance– Voluntary and Open Membership– Democratic Member Control– Member Economic Participation– Autonomy and Independence– Education, Training, and Information– Cooperation among Cooperatives– Concern for Community

According to the International Co-operative Alliance, “The co-operative principles are guidelines by which co-operatives put their values into practice.

1st Principle: Voluntary and Open Membership Co-operatives are voluntary organisations, open to all persons able to use their services and willing to accept the responsibilities of membership, without gender, social, racial, political or religious discrimination.

2nd Principle: Democratic Member Control Co-operatives are democratic organisations controlled by their members, who actively participate in setting their policies and making decisions. Men and women serving as elected representatives are accountable to the membership. In primary co-operatives members have equal voting rights (one member, one vote) and co-operatives at other levels are also organised in a democratic manner.

3rd Principle: Member Economic Participation Members contribute equitably to, and democratically control, the capital of their co-operative. At least part of that capital is usually the common property of the co-operative. Members usually receive limited compensation, if any, on capital subscribed as a condition of membership. Members allocate surpluses for any or all of the following purposes: developing their co-operative, possibly by setting up reserves, part of which at least would be indivisible; benefiting members in proportion to their transactions with the co-operative; and supporting other activities approved by the membership.

4th Principle: Autonomy and Independence Co-operatives are autonomous, self-help organisations controlled by their members. If they enter to agreements with other organisations, including governments, or raise capital from external sources, they do so on terms that ensure democratic control by their members and maintain their co-operative autonomy.

5th Principle: Education, Training and Information Co-operatives provide education and training for their members, elected representatives, managers, and employees so they can contribute effectively to the development of their co-operatives. They inform the general public - particularly young people and opinion leaders - about the nature and benefits of co-operation.

6th Principle: Co-operation among Co-operatives Co-operatives serve their members most effectively and strengthen the co-operative movement by working together through local, national, regional and international structures.

7th Principle: Concern for Community Co-operatives work for the sustainable development of their communities through policies approved by their members.”

Statement on the Co-operative Identity, available at http://www.ica.coop/coop/principles.html.

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Types of Cooperatives

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General Classifications

• Puget Sound Plywood, Inc.– “Cooperatives may be divided roughly into

consumer cooperatives and producer cooperatives”

• Consumer cooperative– Operates for the benefit of members in

their capacity as consumers

As noted in Puget Sound Plywood, Inc., “Cooperatives may be divided roughly into consumer cooperatives and producer cooperatives. Consumer [cooperative] organizations operate for the benefit of the members in their capacity as individual consumers. Producer [cooperative] organizations operate for the benefit of the members in their capacity as producers. Their function may be either the marketing or processing of goods produced individually (as in fishermen's or farmers' marketing associations, or associations which make butter or cheese from farm products received from farmer members), or the marketing of goods processed or produced collectively (as in the so-called workers' [cooperative] productive associations operating factories or mills).” Puget Sound Plywood, Inc. v. Commissioner, 44 T.C. 305, 306-07 (1965), acq. 1966-2 C.B. 6 (1966).

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• Producer cooperative– Operates for the benefit of members in

their capacity as producers• Producer cooperative

– Marketing or processing goods produced individually (e.g., farmers’ cooperative)

– Marketing goods processed or produced collectively (e.g., workers’ cooperative)

As noted in Puget Sound Plywood, Inc., “Cooperatives may be divided roughly into consumer cooperatives and producer cooperatives. Consumer [cooperative] organizations operate for the benefit of the members in their capacity as individual consumers. Producer [cooperative] organizations operate for the benefit of the members in their capacity as producers. Their function may be either the marketing or processing of goods produced individually (as in fishermen's or farmers' marketing associations, or associations which make butter or cheese from farm products received from farmer members), or the marketing of goods processed or produced collectively (as in the so-called workers' [cooperative] productive associations operating factories or mills).” Puget Sound Plywood, Inc. v. Commissioner, 44 T.C. 305, 306-07 (1965), acq. 1966-2 C.B. 6 (1966).

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• The Organization and Operation of Cooperatives– “The functions performed by cooperatives in the economic life of a

community can be practically without limit”• Functional classifications

– Consumer cooperatives (consumer stores; housing cooperatives; condominiums; electric, telephone, and other utility cooperatives; health cooperatives)

– Marketing cooperatives– Business purchasing cooperatives– Workers’ productive cooperatives– Financial cooperatives– Insurance cooperatives– Labor unions– Trade associations– Self-help cooperatives

Mr. Packel notes, “The functions performed by cooperatives in the economic life of a community can be practically without limit. Literally and figuratively, cooperatives exist to serve members from birth to death, i.e., maternity facilities to funeral services.” Mr. Packel notes the following functional classifications of cooperatives:

- Consumer cooperatives (consumer stores; housing cooperatives; condominiums; electric, telephone, and other utility cooperatives; health cooperatives);- Marketing cooperatives;- Business purchasing cooperatives;- Workers’ productive cooperatives;- Financial cooperatives;- Insurance cooperatives;- Labor unions;- Trade associations; and- Self-help cooperatives.

Israel Packel, The Organization and Operation of Cooperatives 10-23 (4th ed. 1970).

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• International Co-operative Alliance– “The co-operative model of enterprise can be applied to any

business activity”• Economic sectors

– Agriculture and fisheries– Consumer and financial services– Housing and production (worker’s co-operatives)– Child-care, health, and social care– Funeral– Music and sports– Education– Utilities (electricity, water, gas, etc.)– Transportation (taxis, buses, etc.)

According to the International Co-operative Alliance, “The co-operative model of enterprise can be applied to any business activity. They exist in traditional economic sectors such as agriculture, fisheries, consumer and financial services, housing, and production (workers' co-operatives). However, co-operative activity spans to large number of sectors and activities including car-sharing child-care, health and social care, funeral, orchestras and philharmonics, schools, sports, tourism, utilities (electricity, water, gas, etc.), and transport (taxis, buses, etc).”

What is a co-operative?, available at http://www.ica.coop/coop/index.html#types.

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Tax Classifications

• Internal Revenue Code § 521– A farmers’ cooperative is exempt from taxation, except as

otherwise provided in part I of subchapter T• Farmers', fruit growers', or like associations

organized and operated on a cooperative basis for the purpose of:– “Marketing the products of members or other producers, and

turning back to them the proceeds of sales, less the necessary marketing expenses, on the basis of either the quantity or the value of the products furnished by them,” or

– “Purchasing supplies and equipment for the use of members or other persons, and turning over such supplies and equipment to them at actual cost, plus necessary expenses.”

§ 521. Exemption of farmers' cooperatives from tax.

(a) Exemption from tax. A farmers' cooperative organization described in subsection (b)(1) shall be exempt from taxation under this subtitle except as otherwise provided in part I of subchapter T (sec. 1381 and following). Notwithstanding part I ofsubchapter T (sec. 1381 and following), such an organization shall be considered an organization exempt from income taxes for purposes of any law which refers to organizations exempt from income taxes.

(b) Applicable rules.

(1) Exempt farmers' cooperatives. The farmers' cooperatives exempt from taxation to the extent provided in subsection (a) are farmers', fruit growers', or like associations organized and operated on a cooperative basis (A) for the purpose of marketing the products of members or other producers, and turning back to them the proceeds of sales, less the necessary marketing expenses, on the basis of either the quantity or the value of the products furnished by them, or (B) for the purpose of purchasing supplies and equipment for the use of members or other persons, and turning over such supplies and equipment to them at actual cost, plus necessary expenses.

(2) Organizations having capital stock. Exemption shall not be denied any such association because it has capital stock, if the dividend rate of such stock is fixed at not to exceed the legal rate of interest in the State of incorporation or 8 percent per annum, whichever is greater, on the value of the consideration for which the stock was issued, and if substantially all such stock (other than nonvoting preferred stock, the owners of which are not entitled or permitted to participate, directly or indirectly, in the profits of the association, upon dissolution or otherwise, beyond the fixed dividends) is owned by producers who market their products or purchase their supplies and equipment through the association.

(3) Organizations maintaining reserve. Exemption shall not be denied any such association because there is accumulated and maintained by it a reserve required by State law or a reasonable reserve for any necessary purpose.

(4) Transactions with nonmembers. Exemption shall not be denied any such association which markets the products of nonmembers in an amount the value of which does not exceed the value of the products marketed for members, or which purchases supplies and equipment for nonmembers in an amount the value of which does not exceed the value of the supplies and equipment purchased for members, provided the value of the purchases made for persons who are neither members nor producers does not exceed 15 percent of the value of all its purchases.

(5) Business for the United States. Business done for the United States or any of its agencies shall be disregarded in determining the right to exemption under this section.

(6) Netting of losses. Exemption shall not be denied any such association because such association computes its net earnings for purposes of determining any amount available for distribution to patrons in the manner described in paragraph (1) of section 1388(j).

(7) Cross reference. For treatment of value-added processing involving animals, see section 1388(k).

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Tax Classifications

• Internal Revenue Code § 501(c)(12)(A)– “Mutual or cooperative telephone

companies, or like organizations” are exempt from taxation

– “But only if 85 percent or more of the income consists of amounts collected from members for the sole purpose of meeting losses and expenses”

§ 501. Exemption from tax on corporations, certain trusts, etc.

(a) Exemption from taxation. An organization described in subsection (c) or (d) or section 401(a) shall be exempt from taxation under this subtitle unless such exemption is denied under section 502 or 503. …

(c) List of exempt organizations. The following organizations are referred to in subsection (a): …

(12) (A) Benevolent life insurance associations of a purely local character, mutual ditch or irrigation companies, mutual or cooperative telephone companies, or like organizations; but only if 85 percent or more of the income consists of amounts collected from members for the sole purpose of meeting losses and expenses.

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Tax Classifications

• Internal Revenue Code Subtitle A, Chapter 1, Subchapter T (“Cooperatives and Their Patrons”)– Part I (“Tax Treatment of Cooperatives”) –

sections 1381-83– Part II (“Tax Treatment by Patrons of Patronage

Dividends and Per-Unit Retain Allocations”) –section 1385

– Part III (“Definitions; Special Rules”) – section 1388

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Tax Classifications

• Internal Revenue Code § 1381 – Subchapter T, Part I applies to:– Farmers’ cooperatives exempt from tax under §

521 and– “Any corporation operating on a cooperative basis

other than an organization” which is: (1) exempt from tax; (2) subject to subchapter H (mutual savings banks, etc.) or L (insurance companies); or (3) “engaged in furnishing electric energy, or providing telephone service, to persons in rural areas”

§ 1381. Organizations to which part applies.

(a) In general. This part shall apply to –

(1) any organization exempt from tax under section 521 (relating to exemption of farmers' cooperatives from tax), and

(2) any corporation operating on a cooperative basis other than an organization –

(A) which is exempt from tax under this chapter,(B) which is subject to the provisions of –

(i) part II of subchapter H (relating to mutual savings banks, etc.), or(ii) subchapter L (relating to insurance companies), or

(C) which is engaged in furnishing electric energy, or providing telephone service, to persons in rural areas.

(b) Tax on certain farmers' cooperatives. An organization described in subsection (a)(1) shall be subject to the taxes imposed by section 11 or 1201.

(c) Cross reference. For treatment of income from load loss transactions of organizations described in subsection (a)(2)(C), see section 501(c)(12)(H).

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Tax Classifications

• Nonexempt rural electric and telephone cooperatives– “These will continue to be treated the same

as under present law”– Subchapter T doesn’t control, but indicates

position of Internal Revenue Service and courts on cooperative taxation issues

As explained by the Senate Committee on Finance and the House ofRepresentatives Committee on Ways and Means in their reports accompanying the bill enacting Subchapter T, Subchapter T “does not apply to presently taxable organizations which are engaged in furnishing electric energy, or providing telephone service, to persons in rural areas. These will continue to be treated the same as under present law.” S. Rep. No. 87-1881 (1962), reprinted in 1962 U.S.C.C.A.N. 3304, 3416 & 1962-3 C.B. 707, 819; and H.R. Rep. No. 87-1447 (1962), reprinted in 1962-3 C.B. 405, 483; see also Rev. Rul. 83-135, 1983-2 C.B. 149.

Although Subchapter T deviated in some ways from the case law existing before 1962, “in many ways … [it] codified the law that existed prior to 1962.” See, e.g., Priv. Ltr. Ruls. 200314002 (Dec. 4, 2002); 200239029 (Sept. 27, 2002); 200206044 (Nov. 9, 2001); & 200152035 (Oct. 2. 2001). Since its enactment, most of the legal developments regarding the taxation of cooperatives have occurred under Subchapter T. Id. Accordingly, while the cases and rulings interpreting Subchapter T do not control the taxation of nonexempt rural electric and telephone cooperatives, they indicate the position of the Service and the courts on many issues controlling the taxation of these cooperatives. Id.

Introduction to Cooperatives - American Bar … October 21, 2011 1 Introduction to Cooperatives Tyrus H. Thompson (Ty) Chief Member Counsel National Rural Electric Cooperative Association

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