Cooperatives – An Overview

Background

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.  Thus, farmers often form cooperatives so that they can enhance their economic market power.  Although there is no universally accepted definition, a cooperative can be defined as a legal business entity created under state law that is owned and operated for the purpose of benefiting those individuals who use its services.  A farmer cooperative can serve one or more functions including but not limited to providing loans to farmers, supplying information pertinent to agricultural production, selling inputs necessary to agricultural production, bargaining on behalf of its members, providing transportation services, and marketing 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, they are a unique and distinct form of business entity.  The following characteristics are principles generally, but not always, associated with a traditional farmer cooperative: (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 cooperative are limited; (3) it is financed mostly by its members and those who use the cooperative; and (4) it distributes net margins to its members in proportion to their use of the cooperative.

Contained within the principle that a cooperative is owned and democratically controlled by its member-users is the notion that each member is permitted one vote, regardless of how much a member uses the cooperative or the amount of money he invested into the cooperative.  A member of a cooperative is generally defined as a person, which can be an individual or an entity, who has satisfied the membership requirements for a cooperative and is entitled to voting privileges.  Many states have enacted statutes requiring that cooperatives adhere to the one member, one vote principle.  In some instances, however, an individual member is allowed to exercise more voting power than is allowed under that principle, but the member’s increased voting power is usually limited by state law to no more than a small percentage, typically three percent, of the total number of qualified votes in the cooperative.

The principle that cooperatives provide a limited return on investment capital to its members is based on the notion that cooperatives are not designed to be for-profit investment enterprises.  Most states have enacted statutes that limit the amount of return a member may receive from a cooperative to eight percent, although the amount can differ from one state to another.  The Capper-Volstead Act, 7 U.S.C. §§ 291-292, establishes a maximum limit of eight percent on returns to cooperative members.

Types of Farmer Cooperatives

It is difficult to list all the “types” of farmer cooperatives that exist because cooperatives serve a variety of functions and purposes.  Traditionally there are three basic categories of farmer cooperatives:  supply, marketing, and service.  A supply cooperative is designed to furnish inputs necessary for agricultural production, such as fertilizers and pesticides.  It purchases inputs at the lowest possible cost by making bulk purchases and then sells the inputs to its members and nonmember patrons at a lower price.  A marketing cooperative 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 cooperative provides services to its members, such as artificial insemination, housing, or transportation.   A cooperative can fall into any one or a combination of these three categories.  Most farmer cooperatives are either supply or marketing cooperatives, or a combination of the two.

“Value-added” cooperatives (sometimes referred to as “new generation” cooperatives) are distinguished from traditional cooperatives because they convert a raw agricultural product, such as wheat, into a further processed product, such as bagels.  Although value-added cooperatives 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 cooperatives incorporate many of the characteristics and functions associated with traditional cooperatives, they differ in significant ways.  For example, value-added cooperatives require its members to make an initial investment that is in direct proportion to the degree they will use the cooperative.  The initial investment required by value-added cooperatives is much more substantial than the investment needed in traditional farmer cooperatives.

Cooperative Formation and Financing

The first major step in forming a cooperative is the filing of legal documents required for incorporation.  Cooperatives are usually incorporated under state law in accordance with either the state’s statute governing agricultural cooperatives or in accordance with the state’s general business corporation statute.  Thus, a cooperative is not necessarily required to be organized under a state cooperative statute in order to operate as a cooperative.  The cooperative must also adopt and ratify bylaws, a legally enforceable set of rules that establish the rights and obligations of the cooperative’s members.  The articles of incorporation may sometimes set forth some of the members’ rights and obligations.

A board of directors must also be elected by a cooperative’s members.  The members of the board are usually members of the cooperative.  The board of directors supervises and handles the business matters for the cooperative.  At least some of the responsibilities of the board of directors are usually set forth under state law and can vary from state to state.  One of the important responsibilities of the board of directors is to select the individual who will serve as the cooperative’s manager or chief executive officer.

A critical step in cooperative formation and operation is acquiring the necessary capital.  As noted above, one of the basic principles associated with a cooperative is that a cooperative is typically financed almost entirely by its members.  A cooperative must consider how it will be financed because it must have not only a sufficient initial investment to begin operating but must also maintain adequate capital to continue operating on a long-term basis-including months when its cash flow will be limited.  It should be noted that member financing of a cooperative is not a legal requirement for cooperative formation.

In general terms, a cooperative can obtain financing from three sources:  direct investment, patronage income, and nonpatronage income.  Direct investment is not dependent on the actual operation of the cooperative.  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 cooperative may be much higher.  Patronage income results from a cooperative’s doing business with members on a cooperative basis and is often the most significant source of financing for a farmer cooperative.  Nonpatronage income is income to the cooperative that does not derive from business transactions with or for members of the cooperative.

The use of patronage income as a source of capital is intricately linked to the cooperative’s returning of its net margins, if any, to its members.  A cooperative not only retains patronage income for 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.  Patronage income is obtained through the use of either per-unit retains or written notices of allocation.

A per-unit retain is a sum that is assessed on the value or quantity of units of an agricultural product handled by the cooperative for a member and is treated as an equity investment in the cooperative by that member.  Per-unit retains are the less preferred option of patronage source income and are used more prevalently in marketing cooperatives.

A patronage refund is the net income of a cooperative that is allocated to a patron, in accordance with a prior existing agreement between the cooperative and the member, and is in proportion to the member’s patronage to the cooperative.  Patronage refunds are distributed annually either in cash to the member or are used as an investment in the cooperative by the member.

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 cooperatives 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 are relevant not only at the formation of a farmer cooperative, but its ongoing operation.

Antitrust Laws

The Capper-Volstead Act is perhaps the most important statute relating to the formation and operation of farmer cooperatives because most farmer cooperatives could not exist without the protections it provides.  The Capper-Volstead Act amended the Clayton Act to exempt from federal antitrust laws both stock and nonstock cooperatives composed of producers.

A farmer cooperative must meet certain eligibility requirements to receive the immunity from antitrust laws provided by the Capper-Volstead Act.  First, the cooperative 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 cooperative must not deal in the products of its nonmembers in an amount that exceeds the value of the products it handles for its members.  The cooperative must also be operated for the mutual benefit of 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 gross income through a series of “deductions.”  I.R.C. §§ 1381-1388.  This special tax status reflects the view of Congress that cooperatives are designed to operate at cost and that “profits” belong to its members.  For a farmer cooperative to have the basic benefits of Subchapter T, it must be “operating on a cooperative basis.”  A farmer cooperative that meets the requirements of Subchapter T does not include in its gross income patronage refunds and per-unit retains paid in money, other qualified property, or by 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 those amounts paid in the form of equity in the cooperative.

Under IRC § 521, further exclusions from gross income are available to farmer cooperatives in addition to those available under Subchapter T that elect 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 cooperative 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 cooperatives.  Both coverage and requirements vary considerably from state to state.