A cooperative is owned by the people who use it, and it returns its margins to them in proportion to that use. Farm supply and marketing cooperatives, rural electric and telephone cooperatives, purchasing cooperatives and consumer cooperatives all share the mechanic. For the auditor, the unusual part is that earnings are not simply retained or paid out. They are allocated to members, and the form of the allocation decides the tax result, the equity presentation and the cash the cooperative owes.
What a patronage dividend is
Section 1388(a) of the Internal Revenue Code defines a patronage dividend as an amount paid to a patron that is based on business done with or for the patron, is paid under an obligation that existed before the cooperative received the amounts, and is determined by reference to the net earnings of the cooperative from business done with or for its patrons. Each element is an audit target: the bylaws or contract that created the obligation, the basis for allocation, and the earnings pool.
Cooperatives pay part of the dividend in cash and retain the rest as equity, communicated through a written notice of allocation: capital stock, a revolving fund certificate, a retain certificate or another written notice stating the dollar amount allocated and the part that is a patronage dividend (section 1388(b)).
Qualified and nonqualified notices
The difference changes who pays tax and when.
- A qualified written notice can be redeemed in cash at its stated dollar amount for at least 90 days after payment, with notice of that right, or the patron consents to take it into account at its stated dollar amount (section 1388(c)).
- If a notice is paid as part of a patronage dividend, at least 20 percent of the dividend must be paid in money or by qualified check, or the notice is not qualified (section 1388(c)(1)).
- A nonqualified notice fails those tests.
Consequences, from the statute:
- The cooperative leaves out of its taxable income amounts paid as patronage dividends in money, qualified notices or other property during the payment period. Redemptions of nonqualified notices are also deductible when paid (section 1382(b)).
- The patron includes patronage dividends paid in money or qualified notices in income. A nonqualified notice has a zero basis to the patron, and gain on its disposition up to the stated value is ordinary income (section 1385).
- When a cooperative redeems a nonqualified notice, section 1383 sets a special tax computation, with the tax computed as the lesser of two alternatives.
Per-unit retains. A per-unit retain allocation is tied to products marketed for a patron and set by agreement, not by net earnings (section 1388(f)). A qualified per-unit retain certificate needs the recipient's written agreement or membership under a bylaw adopted after November 13, 1966 (section 1388(h)).
Nonpatronage income. Section 1382(c) allows deductions for dividends on capital stock and for payments on a patronage basis of earnings from business done for the United States government or from other nonpatronage sources. The earnings pool therefore needs a split between patronage and nonpatronage. Where the cooperative is a farmers' marketing association under the Capper-Volstead Act, the statute requires it to operate for the mutual benefit of members as producers, and to either give one vote per member or limit dividends on capital to 8 percent a year. It also may not handle nonmember products in a greater dollar value than member products (7 U.S.C. 291).
Equity presentation and risk areas
Retained patronage becomes member equity, often in a revolving fund redeemed on an age-based or board-discretion schedule. Equity splits into allocated amounts held in member accounts and unallocated reserves.
- Patronage versus nonpatronage split. Misclassified income changes the deduction.
- Allocation accuracy. Member patronage data by pool and by year, and the unit used to allocate.
- Qualified status. Consent documents, the 20 percent cash test and the 90-day redemption feature for each notice.
- Board declaration. When allocations are declared and whether the payable is recorded in the correct period.
- Revolving fund redemptions. Board resolutions, order of redemption, and any estate or hardship redemptions. Mandatory redemption obligations need a liability classification assessment. See liabilities versus equity.
- Member and nonmember business. Eligibility rules tied to the governing statute.
- Related parties. Board members and directors are also patrons. See related party transactions.
- Marketing pools. Marketing pools that stay open across years need a patronage year rule (section 1382(e)).
Audit procedures
- Read the articles, bylaws and marketing agreements. Identify the pre-existing obligation to allocate and the allocation unit.
- Reconcile total net earnings to the patronage and nonpatronage pools, and test the nonpatronage items.
- Recompute allocations for a sample of members using pool data, and agree to the allocation notices sent.
- Test cash and noncash components, and recompute the 20 percent test.
- Agree equity rollforward by year of allocation: opening, allocated, redeemed, closing, to member subledger and general ledger.
- Trace redemptions to board minutes and cash disbursements.
- Test the patronage refund payable at year-end and subsequent payment.
- Evaluate the tax provision for deduction taken and any deferred tax on nonqualified allocations.
Worked example
Example: A supply cooperative has $1,000,000 of net margin from member business and $100,000 of nonmember profit. The board declares the $1,000,000 as a patronage dividend: $300,000 in cash and $700,000 as qualified written notices of allocation redeemable in cash at stated amount for 90 days.
- The cash share is 30 percent, above the 20 percent minimum.
- The cooperative deducts $1,000,000 for the patronage dividend.
- The $100,000 of nonmember profit is nonpatronage and taxed, unless allocated on a patronage basis to patrons.
Suppose the notices were issued without the written 90-day cash right and without member consent. They are nonqualified. The deduction for the $700,000 is denied until redemption, the cooperative recomputes tax, and the audit adjustment is a deferred tax asset or a current tax payable, depending on timing.
PBC items to request
- Articles, bylaws, membership and marketing agreements
- Board minutes declaring patronage and equity redemptions
- Patronage allocation workpaper by member and pool
- Written notices, consent forms and Form 1099-PATR files
- Equity rollforward and member subledger
- Revolving fund policy and redemption schedule
- Tax return workpapers for patronage and nonpatronage income
See the PBC list guide.
Red flags
- Allocations that do not total to declared patronage earnings
- Retained amounts not backed by a pre-existing obligation
- Cash share close to the minimum every year
- Redemptions to directors ahead of other members
- Nonpatronage income shrinking while margins grow
Sources
- 26 U.S.C. 1388, definitions (Cornell Legal Information Institute): https://www.law.cornell.edu/uscode/text/26/1388
- 26 U.S.C. 1382, taxable income of cooperatives: https://www.law.cornell.edu/uscode/text/26/1382
- 26 U.S.C. 1385, amounts includible in patrons' gross income: https://www.law.cornell.edu/uscode/text/26/1385
- 26 U.S.C. 1383, computation of tax where cooperative redeems nonqualified written notices: https://www.law.cornell.edu/uscode/text/26/1383
- 7 U.S.C. 291, Capper-Volstead Act: https://www.law.cornell.edu/uscode/text/7/291
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