Conversions of Businesses into Cooperatives
March 30, 2022
Questions & Answers on Conversions to Cooperatives
Bulletin 1: Choice of Entity
This bulletin is the first in a series of Q&As on converting a business to a cooperative. The series is intended to answer questions from an individual who wants to convert the individual’s business into a worker, multi-stakeholder or other type of cooperative. It is also intended to address questions from community businesspeople who would like to preserve a business in their area and run it as a cooperative. This first bulletin answers questions on the entity options available for businesses and provides details about why cooperatives can be a good choice for running a business. Future Q&As will provide information on the mechanics and financing of the conversion; cooperative governance issues; and securities, tax, antitrust, and employment considerations. This bulletin, and those forthcoming, provide information, not legal advice. When organizing a cooperative, interested parties are advised to consult with an attorney who is knowledgeable regarding cooperative law in the state where the cooperative will be organized.
Q: I want to preserve a community business. How can I keep it going?
Q: I would like to retire, but I would like my business to continue. Is there a way that my employees can keep the business going?
A: You can form a cooperative.
Cooperatives are a great way to do business because they can preserve community businesses and benefit their owner/members:
- Individuals with limited resources can pool their funds in a cooperative and purchase an existing business.
- Members who own the cooperative have democratic control over the entity; they have the power to elect the board of directors (the individuals who govern the cooperative) and vote on cooperative initiatives.
- Members receive financial benefits that are equitably distributed based on use or patronage of the cooperative.
- While a corporation’s board of directors is obligated to focus on maximizing profits for shareholders, a cooperative’s board focuses on purposes that benefit its members and the community:
- A cooperative’s directors owe their fiduciary duty to the members.
- Cooperatives are particularly adept at filling market gaps that a firm motivated primarily by profit would ignore; broadband, electric, rural grocery, and rural farmer cooperatives are examples of businesses that fill community needs that would otherwise go unmet.
- Most cooperative profits go to the members who use the cooperative in the form of patronage distributions.
- Investment returns on cooperative stock are strictly limited. This so-called “subordination of capital” provides a disincentive for nonlocal investors to buy cooperative stock. As a result, cooperative profits are more likely to stay in the local community.
- Cooperatives are resilient during a downturn:
- Members have the power and the flexibility to decide how to handle the ups and downs of the business cycle including accepting lower patronage distributions or wages rather than laying off workers.
- Worker/members in worker cooperatives are as productive or more productive than those employed by businesses that they do not own.
- A cooperative operating under the rules of Subchapter T of the Internal Revenue Code (IRC or Code) is eligible to receive special, flexible tax treatment under Federal law and some states’ laws. For the most part, a cooperative is a “pass through entity,” and most of its income is taxed once---to the member. The Code recognizes that cooperatives are not focused on maximizing profits for investors but instead provide their services at cost so long as profits are distributed to the member/patron on the basis of business done by the member with the cooperative. Certain tax planning strategies allow income to be taxed at the cooperative level during a time when members have a higher tax rate. Later, perhaps when the member has retired and is subject to a lower tax rate, the patronage can be distributed to the member and the cooperative can take a deduction for tax it paid on the income in the past. A future bulletin will go into greater detail on how cooperatives are taxed.
- Farmer cooperatives may qualify for special legal treatment:
- A farmer cooperative meeting certain requirements is eligible for limited antitrust protection under the Capper Volstead Act. A future bulletin will go into greater detail about how the Capper Volstead antitrust provision works.
- In addition to the special tax treatment enjoyed by regular “subchapter T” cooperatives, farmer cooperatives that qualify under Internal Revenue Code section 521 receives additional tax benefits (explained in a later bulletin).
- As with other corporate entities, cooperatives provide a liability shield. Members’ personal assets generally are not at risk if the cooperative suffers a loss; the loss is limited to the member’s investment in the cooperative.
- Cooperatives can operate in several ways:
- Worker cooperatives are owned and controlled by the worker/members who receive payment in the form of patronage based on a formula agreed upon.
- With consumer cooperatives, members band together to be able to purchase better and cheaper goods and services. Examples include credit unions, grocery, housing, childcare, and electric cooperatives.
- Producers of a similar or complementary good or service may be members of a producer cooperative. Producer cooperatives market the goods or services and may further process the goods. They take advantage of the greater marketing power that they achieve when they combine. Farmer, artists, and architect cooperatives are examples.
- Multi-stakeholder cooperatives are cooperatives owned by two or more types of members. For example, a group of consumers, a group of producers, workers, and/or investors may own a multi-stakeholder cooperative.
Q: What are the different ways businesses can operate?
A: A business can operate as a sole proprietorship, a partnership, a limited liability company, a corporation, a cooperative, or a nonprofit; businesses are organized and regulated under state law but are also subject to Federal regulation.
A sole proprietorship exists when an individual operates a business without asking the state for a special status. The business is not taxed separately from the individual and if someone is injured in connection with the business or if the business incurs a financial debt, the owner is personally responsible.
A partnership is a business run by two or more individuals that is formed under the state’s partnership law. The partners are taxed at the individual level and report their share of the partnership income on their personal tax return. Each partner has unlimited personal liability with respect to the business.
A limited liability company (LLC) is responsible for any business legal liability and may be permitted under state law to have a single member or multiple members who may be individuals, corporations, other LLCs, and/or foreign companies. The default Federal tax treatment of an LLC is as a partnership (if it is owned by more than one member), or as a “disregarded entity” whose income is included in its owner’s tax return if it is owned by one member. However, an LLC may elect to be treated for federal tax purposes as a corporation if it has more than one member and may be treated as a cooperative under Subchapter T of the Internal Revenue Code if it additionally adheres to Subchapter T rules.
A corporation is incorporated under state law and legal responsibility resides at the corporate level. Stockholders own the corporation and generally are not legally liable for the corporation’s actions. A corporation is run by a board of directors. Cooperatives are often a type of corporation but also can be formed as an LLC or a nonprofit entity.
Under Federal tax law, S-corporations or “small business corporations” can pass through company income to shareholders who then report the income on their personal tax returns. To qualify as an S-corporation, the corporation must have only one class of stock, no more than 100 shareholders, and make a special IRS election. Shareholders may be individuals, estates, and certain trusts. Partnerships, corporations, non-resident aliens, financial institutions, insurance companies, and domestic international sales corporations are not permitted to be shareholders.
Under Federal law, income of a C-corporation is subject to “double taxation”: it is taxed at the corporate level when earned then at the shareholder level when distributed as a dividend.
A nonprofit is also organized under state law and enjoys limited liability but must meet certain requirements to achieve Federal tax-exempt status. For example, organizations that operate for religious, charitable, scientific, educational, or certain other purposes qualify as charitable organizations under Internal Revenue Code (IRC) section 501(c)(3). Nonprofits may qualify under other IRC sections, including section 501(c)(12), which provides an exemption for benevolent life insurance associations of a purely local character, mutual ditch or irrigation companies, mutual or cooperative telephone companies, electric companies, and “like organizations.” To qualify for and maintain exemption under section 501(c)(12), a cooperative must receive at least 85 percent of its income each year from members. Many electric and telephone cooperatives operate as cooperatives exempt under section 501(c)(12), but others do not qualify for the exemption because they receive too much income from nonmembers. Cooperatives that perform certain service functions for hospitals and educational institutions may form as nonprofit exempt organizations under IRC section 501(e) and (f), respectively.
Q: What if my state statute only allows a cooperative business to operate for a specific purpose (for example, the statute permits agricultural and/or electric cooperatives but not worker cooperatives, grocery cooperatives, service cooperatives, or cooperatives that operate for some other purposes)?
A: Businesses can: 1. organize under corporate, LLC, or nonprofit statutes and operate as cooperatives, or 2. organize under another state’s cooperative statute.
Some state statutes only permit cooperatives to be organized for narrow purposes. Individuals intending to convert a business that is not an agricultural or an electric business may have to be creative to assure that the converted business operates as a cooperative. A business can organize under the state’s general corporate or limited liability company statute and engage a lawyer to draft articles and bylaws to assure that the entity operates like a cooperative. A business can also organize under a cooperative statute in another state but operate in the state where the business is located. It is important to make use of the services of an attorney who is comfortable operating in both states.
Q: What if my state allows cooperative businesses to organize under more than one cooperative statute?
A: If your business has the choice of organizing as a corporate-type cooperative or an LLC-type cooperative you need to consider your specific circumstances to determine which form of business will work better for you.
More traditional state cooperative statutes permit the formation of a cooperative that technically is a corporation. Some states additionally have cooperative association statutes that allow the formation of an entity that is similar to a limited liability company (LLC). Both of these entities are governed by a board of directors elected by members. From a tax standpoint, Treasury regulations permit a cooperative association (the type of cooperative that resembles an LLC) to elect to be treated as a corporation for Federal tax purposes and get beneficial Subchapter T treatment of patronage distributions to cooperative members. Further, unlike a sole proprietorship or a partnership, a cooperative formed under either statute shields members from liability from actions of the cooperative. The cooperative formed under the more traditional corporate model may benefit from the existence of more court cases interpreting legal situations involving corporate cooperatives. Further, other states may be better set up to accommodate the corporate cooperative doing business in their jurisdiction. However, cooperative association statutes offer certain flexibilities that may make them the preferred option. For example, some have provisions that make it easier to finance the cooperative by allowing non-patron equity members. Some permit multiple membership classes with different distribution and voting rights, allowing for the operation of a multistakeholder cooperative.
Q: What if I have several different groups who are interested in being members of the cooperative?
A: A multistakeholder statute may be a good option if different groups want to participate in the cooperative. Alternatively, each group can form its own cooperative and participate together in a joint venture.
In some situations, different groups may be interested in operating a cooperative together. For example, a food hub may operate as a cooperative with farmers, consumers, investors, and workers each making up a separate membership class. Additional member classes could include owners, suppliers, lenders, clients, volunteers, and other community members
The concern with a multistakeholder cooperative is that the different interests of each group will lead either to failure of the cooperative or to one group dominating the organization. Some anecdotal experience suggests that member commitment to the overarching goals of the cooperative often helps to overcome class differences. Additionally, board discussions regarding differences among the member classes may result in improving the overall operation of the cooperative.
The individual who drafts the articles and bylaws of the multistakeholder cooperative should consider carefully the number of board representatives from each group so that the rights and responsibilities of membership are balanced fairly. A multistakeholder cooperative that anticipates potential conflicts and puts in place processes for effective communication and consensus building makes it easier for the board of directors to effectively manage the organization, engage in strategic planning, and decide how to distribute patronage fairly. It is important for members as a whole to feel that they are participating in the governance of the cooperative. When the governance rules are not working effectively, members should feel that they can work together to change them.
One problem that board members of multistakeholder cooperatives may face is the conflict between their fiduciary responsibility to the cooperative and their responsibility to the class of members who elected them. Different classes of individuals who would like to engage in a project together always have the option of forming separate cooperatives that engage in a joint venture.
Q: Are there other ways to operate as a cooperative?
A: Yes. If you will acquire most of your funds through donations from private donors or the government and you will not distribute profits to members, you may want to organize as a nonprofit or mutual benefit corporation then draft operating documents that include cooperative principles.
A typical cooperative is a for-profit business owned by its member/patrons who receive the cooperative’s profits in the form of patronage refunds or distributions. Specific state statutes under which cooperatives form may say that cooperatives are “nonprofit,” but in fact this description may refer to how the cooperative itself is a pass-through entity that, for the most part, distributes profits to members. While typical cooperatives may retain and be taxed on some income, the members own the assets of the cooperative and ultimately will receive and be taxed on the retained funds that have been allocated to their accounts. If the cooperative is dissolved, the members receive the cooperative’s assets after the creditors have been paid. Since a cooperative is a for-profit business, it may have an easier time getting access to loans.
In contrast, a nonprofit cooperative is incorporated under a state nonprofit statute then applies for tax exempt status with the Federal government and, when required, local governmental entities. A tax-exempt nonprofit must serve a public interest, uses revenue for operating expenses, and dedicates any profits to a charitable purpose. Assets are not distributed to individuals. If the nonprofit is dissolved, the remaining assets are distributed to another nonprofit or a governmental entity. The nonprofit may have paid employees and volunteers. Board members do not receive services from the nonprofit and often are volunteers. A nonprofit has access to certain government funding and tax-deductible private sector donations.
A “membership nonprofit” is a nonprofit with a board that is elected and controlled by members and could operate on a cooperative basis if the operating documents embed cooperative principles. For example, the articles and/or bylaws could specify that the members elect the board on a one member, one vote basis. An example of a business that could operate as a membership nonprofit is a cooperative preschool or an organization devoted to preserving Native American culture. Credit unions and housing cooperatives also operate as nonprofits. If you are considering operating your cooperative as a nonprofit, it is very important to consult with a knowledgeable attorney who is well-versed on how cooperatives and nonprofits operate.
Q: Should I use an Employee Stock Ownership Plan to convert my business?
A: Using an ESOP to convert a business to a worker cooperative may provide tax benefits but is administratively complex.
An exiting owner can transfer ownership to employees by contributing the owner’s stock in the business to an employee stock ownership plan (ESOP). While there are approximately 6,600 ESOPs covering 14 million participants, the typical ESOP is not a worker cooperative; it generally is controlled by management and ownership of the stock is gradually transferred to a qualifying employee all at once after 3 years or gradually over 6 years. The ESOP is managed by a trustee who has fiduciary duties exclusively toward the ESOP participants and beneficiaries. The trustee is tasked with voting the stock in the ESOP, and the ESOP can operate as a cooperative if the trustee is required to vote as instructed by the employees and the employees vote on issues on a one-member, one-vote basis or using some other cooperative voting method. A problem may arise if the trustee’s fiduciary duties conflict with how the trustee has been instructed by the cooperative members to vote.
Tax Benefits of an ESOP
An ESOP is a defined contribution retirement plan qualified under Internal Revenue Code section 401(a). A business forms an ESOP by creating a trust and making tax-deductible (with certain limits) contributions of the business’ stock or funds to purchase the business’ stock. The ESOP can borrow money to buy company stock with the stock serving as collateral. As the company makes deductible contributions to the ESOP to repay the loan, a portion of the stock no longer serves as collateral and is allocated to employees’ accounts in the ESOP.
The deductible payments for interest and principal on the loan can help the business’ cash flow but as employees leave, the business must pay fair market value for their distributed ESOP stock. A C-corporation may also receive deductions for dividends paid on the ESOP shares. These dividends can be passed through to employees or reinvested in the ESOP. Employees are not taxed until they receive distributions from their account, generally when they leave the company or if they receive passed-through dividends.
Administrative Issues
The ESOP must be administered in accordance with the Internal Revenue Code and the Employee Retirement Income Security Act (ERISA) and should be set up by an experienced attorney. The ESOP requires governing documents, a summary plan description, administrative forms, and a determination letter from the Internal Revenue Service that the ESOP is qualified. The fair market value of the stock must be independently appraised when contributed and each year thereafter. The ESOP should employ a third-party recordkeeper to manage employee accounts and prepare the Form 5500 annual return and the summary annual report as required by the IRS. Most conversions involving an ESOP occur with larger companies because of the administrative complexity and expense. For more information on ESOPs, see the IRS’ ESOP page.
Conclusion and Next Bulletin Topics
While there are many reasons to convert an existing business to a cooperative, perhaps one of the most powerful is that cooperatives are resilient. Seventy-six percent of agricultural cooperatives have been in existence for 50 years or more. Resiliency in any economic climate is important and cooperatives are a proven vehicle to weather challenging economic times.
Upcoming bulletin topics in the cooperative conversion Q&A series will address:
- The mechanics and financing of the conversion;
- Cooperative governance issues; and,
- Securities, tax, antitrust, and employment law considerations.
Note: These bulletins provide information, not legal advice. When organizing a cooperative, you are advised to consult with an attorney who is knowledgeable regarding cooperative law in the state where the cooperative will be organized.
Bulletin Link: https://content.govdelivery.com/accounts/USDARD/bulletins/30ff250
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