Cooperatives – An Overview

Background

Farming is a unique industry, where often times individual farmers cannot consistently and reliably control the price they receive for their agricultural products or the price they pay for the inputs needed to produce those goods. This allows external factors to dictate the cost of many farm operations, which leaves individual farmers without a significant leverage over their markets and susceptible to failing to respond to unexpected factors such as food borne illness outbreaks, high or low market demands, or natural disasters.

As a result, many farmers enter into cooperatives (co-ops) so that they can enhance their economic market power. A co-op is a legal business entity created under state law that is owned and operated for the purpose of benefiting those individuals who use its services. In other words, co-ops allow similar businesses to associate together in order to gain leverage over a market that they might not have access to as individual businesses. One of the most prominent examples of farmer co-ops in the US is in the dairy industry. Dairy farmers typically have little-to-no control over the cost of their milk to consumers; meanwhile dairy farmers are managing a consistently producing, extremely perishable food product with fluctuating market demands. Dairy co-ops serve to ensure that farmers can consistently sell all their milk by helping distribute (and sometimes process) that dairy to be sold to consumers.

A farmer co-op can take many forms and serve different functions depending on market demands. A co-op can provide loans to farmers, supply information pertinent to agricultural production, sell inputs necessary to agricultural production, bargain on behalf of its members, provide transportation services, or market agricultural products for its members.  For more information on Business Organizations, including cooperatives, visit the Business Organizations Reading Room.

Cooperative Principles

Although cooperatives share similarities with other types of business entities, such as corporations, they are a unique and distinct form of business entity. The following characteristics are principles generally, but not always, associated with a traditional farmer co-op: (1) it is owned and democratically controlled by the individuals that use its services; (2) the returns that its members receive on their individual financial investments into the co-op are limited; (3) it is financed mostly by its members and those who use the co-op; and (4) it distributes net margins to its members in proportion to their use of the co-op.

An individual (person or business entity) can become a member of a co-op by satisfying that co-op’s membership requirements. Typically, this requirement includes an upfront investment. Once the individual has satisfied the membership requirements, it is entitled to voting privileges. Many states have enacted statutes requiring co-op members to adhere to the one member, one vote principle, regardless of how much a member utilizes the co-op or has invested into it. Occasionally, a co-op may allow an individual member more than one vote. However, state laws usually restrict that member’s increased voting power to no more than a small percentage (typically three percent) of the total number of qualified votes in the co-op.

Another principle to cooperatives is that they provide a limited return on investment capital to its members because they are not designed to be for-profit investment enterprises.  Most states have enacted statutes that limit the amount a co-op can return to members annually. Although this limit can differ from one state to another, the Capper-Volstead Act, 7 U.S.C. §§ 291-292, establishes that this return may never exceed more than eight percent to cooperative members.

Statutes Applicable to Cooperatives

Farmer cooperatives are affected by an array of statutes that do not apply to regular business corporations. In addition to state statutes governing incorporation, attention must be given to the special treatment of farmer co-ops under antitrust laws, provisions of the Internal Revenue Code (IRC) governing taxation of cooperatives, and to the status of cooperative financial instruments under state and federal securities laws. These and other federal and state statutes apply to the co-op’s formation as well as its ongoing operation.

Antitrust Laws

The Capper-Volstead Act is perhaps the most important statute relating to the formation and operation of farmer co-ops because the Act provides farmers with unique protections. The Capper-Volstead Act amended the Clayton Act to exempt co-ops of agricultural producers from federal antitrust laws.

A farmer co-op must meet certain eligibility requirements to receive the immunity from antitrust laws provided by the Capper-Volstead Act. First, the co-op must be comprised of “[p]ersons engaged in the production of agricultural products as farmers, planters, ranchmen, dairymen, nut or fruit growers . . . .” 7 U.S.C. § 291. The co-op must also be operated for the mutual benefit of all its members.  Moreover, the cooperative must either (1) not allow any of its members more than one vote, regardless of the member’s ownership interest, or (2) not pay dividends on stocks or other membership capital to its members in an amount greater than eight percent annually.

Tax Laws

The Internal Revenue Code (IRC) Subchapter T allows cooperatives to exclude certain items from its gross income through a series of “deductions.” I.R.C. §§ 1381-1388. This special tax status reflects the view of Congress that co-ops are designed to operate at cost and that “profits” belong to its members. For a farmer co-op to have the basic benefits of Subchapter T, it must be “operating on a cooperative basis.” A farmer co-op that meets the requirements of Subchapter T does not include the following in its gross income: patronage refunds and per-unit retains paid in money, other qualified property, qualified written notices of allocation, qualified per-unit retain certificates or qualified written notices of allocation. I.R.C. § 1382(b)(1),(3). Patrons are taxed on such distributions, including any amounts paid in the form of equity in the co-op.

Under IRC § 521, further exclusions from gross income are available to farmer co-op in addition to those available under Subchapter T if the co-op elects to meet additional requirements. Specifically, amounts paid as dividends on capital stock during the taxable year are excluded. The same is true for certain distributions of earnings from business with the United States or nonpatronage sources.  I.R.C. § 1382(c)(2)(A).  With these additional exclusions, a § 521 co-op is likely to have little, if any, taxable income.

Securities Laws

Generally, equity and debt instruments issued by cooperatives are not considered “securities” for purposes of federal and state securities laws. State securities laws, often called “blue sky” laws, may also apply to farmer co-operatives.  Both coverage and requirements of these laws vary considerably from state to state.

Types of Farmer Cooperatives

There are three main categories of farmer cooperatives: supply, marketing, and service. A supply co-op is designed to furnish inputs necessary for agricultural production, such as fertilizers and pesticides. Supply co-ops purchase these inputs in bulk to enjoy the lowest possible prices and then sells directly to its members at a lower cost than if the farmer had purchased it on its own. A marketing co-op assists its members in the marketing of their agricultural products. It may either purchase its members’ agricultural products at the prevailing market price or act as a pooling agency that holds goods until a more beneficial price can be obtained. A service co-op provides services to its members, such as artificial insemination, housing, or transportation. A co-op can fall into any one or a combination of these three categories. Most farmer co-ops are either supply or marketing co-ops, or a combination of the two. For instance, dairy co-ops are primarily marketing co-ops.

“Value-added” cooperatives (sometimes referred to as “new generation”) are distinguished from traditional co-ops because they convert a raw agricultural product, such as wheat, into a further processed product, such as bagels. Although value-added co-ops are not new, they have become more popular in recent years, largely due to “the desire to develop new value-added products and to gain access to an increased share of the consumers’ food dollar.” Andrea Harris et al., New Generation Cooperatives and Cooperative Theory, 11 J. of Cooperatives 15, 15 (1996). Although value-added co-ops incorporate many of the principles and functions associated with traditional co-ops, they can differ significantly. For example, value-added co-ops require its members to make an initial investment that is directly proportional to the degree that member will use the co-op. As a result, the initial investment required by value-added co-ops can be substantially higher than the investment needed in traditional farmer co-ops.

Cooperative Formation and Financing

The first major step in forming a cooperative is filing all required legal documents, such as the articles of incorporation. Co-ops, like all other business entities, must incorporate under state law. Many states have enacted statutes specifically governing agricultural co-ops. In all other states, a co-op can be formed under that state’s general business corporation statute. The co-op’s founding members must adopt and ratify bylaws, a legally enforceable set of rules that establish the rights and obligations of the co-op’s members. Sometimes the articles of incorporation establish members’ rights and obligations.

Once a co-op is established, its members must elect a board of directors. Typically, the board of directors are members of that co-op. The board of directors supervises and handles most business matters. Some states have enacted statutes that determine responsibilities of the board of directors. One of the important responsibilities of the board of directors is to select the individual who will serve as the co-op’s manager or chief executive officer.

A critical step in co-op formation and operation is acquiring the necessary capital.  As noted above, one of the main principles associated with a co-op is that individuals invest into the co-op to become a member. Regardless of whether that investment is one time or reoccurring, it often provides a substantial amount of finances for the co-ops. If a co-op only requires an initial investment, it must consider alternative sources of income to continue operating on a long-term basis and during months when its cash flow will be limited. While membership investment is the hallmark principle of co-op, it is not a legal requirement for co-op formation. Thus, some co-ops might not require any investments for members to join.

Generally, a co-op finances itself through direct investment, patronage income, or nonpatronage income. Common methods of direct investment are charging a membership fee, selling membership stock, and selling preferred stock. The amount charged for a membership fee or stock is usually relatively small. As noted earlier, however, the price of stock in a value-added co-op may be much higher. A patron is anyone that uses the co-op’s services. Patronage income is any income that the co-op incurs from a patron using the co-op’s services. This broad definition includes “invisible income” from members who are working for the co-op but do not get paid. Patronage income is often the most significant source of financing for a farmer co-op. Nonpatronage income is income that does not derive from business transactions with or for members of the co-op. Nonpatronage income is subject to double taxation, like most corporations.

A co-op can obtain patronage income through the use of per-unit retains or written notices of allocation. A per-unit retain is an assessed sum based on the value or quantity of units of an agricultural product handled by the co-op for a member. It is treated as an equity investment in the co-op by that member. Per-unit retains are the less preferred option of patronage source income and are used predominantly in marketing co-ops.

A co-op not only obtains patronage income to use as capital, but it must also return a certain portion of its net margins—the bulk of which typically derives from patronage source income—to its members each year in order to enjoy certain tax benefits. Essentially, co-ops must refund members for their investment when the co-op incurs a profit. The amount of the patronage refund is determined by the net income of a co-op in proportion to the member’s patronage to the co-op. Patronage refunds are distributed annually, either in cash to the member or are used as further investment in the co-op by the member.