Should Everyone CO-OP-erate? (article)
Update: Shortly after publication of this article, new legislation was enacted to provide a correction for the “grain glitch” referenced in our original article. Also as a result of the new legislation, the potential loophole we discussed for non-farm cooperatives is no longer possible. Following is the original version of our article.
The frenzied pace with which Congress delivered the most significant tax reform legislation since 1986 (TCJA) resulted in numerous potential drafting errors. This expediency is also starting to reveal a number of legislative oversights. Whether intended or not, a significant planning opportunity was created for certain types of businesses structured as cooperatives. Cooperative businesses engaging in activities that ordinarily are disqualified from the new 20 percent deduction for qualified business income (QBI) may get the deduction after all, while traditional business structures do not. And cooperatives are fairly simple and straightforward to establish.
One highly visible provision of the new QBI deduction rules is an increased amount available to certain farmers who sell their products to agricultural cooperatives. Gross sales to agricultural cooperatives were made eligible for the QBI deduction under the TCJA, while identical business conducted with traditional entities is entitled to a QBI deduction that is based only on net income. A revision to this so-called “grain glitch” is being negotiated presently in Congress, and is one example of the oversights in the TCJA. However, it is not clear that fixing the grain glitch will address a larger loophole apparent in the QBI deduction rules for non-farm cooperatives.
This potential loophole is a byproduct of the favorable treatment Congress desired for cooperatives under the QBI deduction rules. Before discussing the way this works and how businesses may benefit, it is important to briefly explore how cooperatives are taxed.
Taxation of Cooperatives
While a full explanation of cooperative taxation is beyond the scope of this article, the hallmark of a cooperative is the operation of business on a cooperative basis, which includes the following characteristics:
- Subordination of stock rights to member rights with regard to control and profits;
- Democratic level of control among the members; and
- Allocation of profits among patrons proportionate to the quantity or value of business contributed by such patrons, with required personal involvement (through production or use) over the product sold by the cooperative.
The Code does not define patron; however, the regulations describe a patron as “any person with or for whom the cooperative association does business on a cooperative basis, whether a member or a nonmember of the cooperative association ....” So a patron is someone who shares in the cooperative’s earnings based upon the amount of business he does with the cooperative – his “patronage.”
A member is generally regarded as a person who has the right to vote on issues decided by the membership. The same person can be both a “member” and a “patron,” and this is often the case. That being said, the cooperative must conduct business with members on a patronage basis. The standard for business with nonmembers depends on the type of cooperative. Farm cooperatives must also conduct business with nonmembers on a patronage basis, but non-farm (nonexempt) cooperatives may conduct business on a patronage or nonpatronage basis with nonmembers. Hence, a patron of a farm cooperative always includes members and nonmembers, while a patron of a non-farm cooperative includes members but not necessarily nonmembers.
Generally cooperatives are taxed as C corporations; however, cooperatives are allowed to deduct distributions to patrons from taxable income, so-called “patronage dividends.” While patronage dividends are taxable to their recipients, this treatment eliminates much of the double taxation that occurs with a traditional C corporation, and has not changed as a result of the TCJA. Deductions for patronage dividends are available for farm and non-farm cooperatives. Non-farm (nonexempt) cooperatives cannot claim a deduction for dividends paid to members from non-patronage sources (transactions with nonmembers), but otherwise remain eligible for the general tax treatment of cooperatives and the deduction for dividends paid from patronage income.
The patronage dividend is payable upon the basis of the quantity or value of business done by the cooperative for each patron, and is not based upon each patron’s ownership interest if he/she is also a member. For example, if four member/patrons each contribute 25 percent to the net earnings of the cooperative, then 25 percent of the total patronage dividend paid must be allocated to each patron (even if the four patrons are not each 25 percent members). For non-farm cooperatives, the deductible patronage dividend also must be paid only out of the earnings or income from business done with or for its patrons.
This means that capital contributions, donations, or other sources of income (e.g., transactions with nonmembers) cannot be distributed as deductible patronage dividends. Any income that cannot be offset with a deductible patronage dividend is taxed at the 21 percent corporate tax rate. Regardless, any dividend distributions (including patronage dividends) are taxable to the patron.
QBI Deduction Reexamined
The single level of taxation paired with the TCJA’s reduction in corporate and individual tax rates already makes cooperatives appealing. And this appeal only grows stronger with the addition of the new QBI deduction. In the case of cooperatives, the rules for calculating and claiming the deduction are particularly favorable. The four most important limitations on the QBI deduction do not apply to qualified cooperative dividends, which include patronage dividends:
1. Income: The 20 percent QBI deduction is based upon the gross income a patron receives from a cooperative as a patronage dividend, rather than the net income attributable to ownership in pass-through entities.
2. Specified Trade or Business: The exclusion of any specified service trade or business (which generally restricts the QBI deduction to business activities in fields other than specified personal and professional services businesses) does not apply to qualified cooperative dividends. For a highly compensated professional in a specified service trade or business, such as a doctor or an attorney, this could mean the difference between a 20 percent deduction and no deduction at all.
3. Wages: The QBI deduction on qualified cooperative dividends is not subject to the wage or wage-plus-property limitations that restrict the amount of the QBI deduction available for other businesses.
4. Dividends: The QBI deduction on qualified cooperative dividends is subject to a 100 percent limitation on an individual’s taxable income (excluding capital gains and qualified dividend income), whereas the taxable income limitation for other businesses is 20 percent. This provision conceivably allows an individual to completely eliminate taxable income by the QBI deduction on qualified cooperative dividends.
Returning to the earlier example of the cooperative with four patrons/members, it is possible to show through a simplified example how this entity structure can provide a greater benefit than the traditional pass-through entity structure. For purposes of this illustration, the four patrons/members are attorneys who, prior to forming the cooperative, each independently operated her own practice as an S corporation. Under this structure (prior to forming the cooperative), each earned a salary of $250,000, and had $300,000 in net profits from her practice after expenses. Assume this combined net income of $550,000 places each attorney above the threshold that would allow the QBI deduction despite being in a specified service business, so each attorney is ineligible for any QBI deduction because of her profession.
If, however, the four attorneys form a cooperative and the administrative functions of the attorneys (billing and collecting payment from clients, paying rent, purchasing supplies, marketing, etc.) are assumed by the cooperative, the income of the attorneys is now the income of the cooperative. The cooperative then would distribute as deductible patronage dividends each attorney’s share of income proportionate to the value of work contributed by each attorney. Each attorney will be able to claim the QBI deduction on her respective patronage dividends, and notably, the specified services limitation does not apply. Note that it is the gross patronage dividend that is eligible for the QBI deduction, but in this example, the gross patronage dividend is based on the cooperative’s net profit.
So, further assuming that each attorney’s patronage dividend is $300,000 (representing what had previously been the net profit of each), she will be able to claim a QBI deduction of $60,000. Thus, each attorney’s net income will be $490,000 ($300,000 patronage dividend, $250,000 wages, and $60,000 QBI deduction).
This result is also favorable when compared to each attorney forming her own C corporation. No QBI deduction would be available for any income in that situation, and the double-taxation of income earned by C corporations would further deplete after-tax cash flows for each attorney.
Evaluate Your Options
With proper planning, businesses (particularly specified service trades or businesses otherwise ineligible for the QBI deduction) could preserve or enhance QBI deductions for their owners. There are other factors to consider, such as voting rights, management, and control, as well as the costs of converting an existing entity to a cooperative, before concluding that a cooperative structure is an attractive alternative. Furthermore, this planning idea takes advantage statutory language to reach a result that that may not have been intended by Congress. As such, the vitality of this planning idea may be short-lived if Congress passes technical corrections to the TCJA that clarify its intent. As a result, we strongly recommend that you consult with your tax advisor to consider the implications of these matters. For more information on the interaction of cooperatives with the QBI deduction, please consult your local CBIZ MHM tax professional.
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