Taxation of Cooperatives Under Subchapter T
By Tax practitioners are familiar with Subchapter C (C corporations), Subchapter K (partnerships), and Subchapter S (S corporations) but are generally less familiar with Subchapter T (§§ 1381-1388), which governs the taxation of cooperatives.
A cooperative is an association otherwise taxable as a C corporation that markets, purchases, or performs business functions for its patrons on a cooperative basis. The means of production and distribution are owned in common. The earnings revert to the members in proportion to their patronage (i.e., in proportion to the amount of business each member transactions with it). The predominant features of a cooperative are: (i) subordination of capital, (ii) democratic control, and (iii) proportionate allocation of profits. Cooperatives developed as a legal concept in 19th century England. In the United States, cooperatives were exempted from taxation as far back as 1916. The policy behind such exemption is cooperatives, unlike traditional corporations, are merely agents or conduits of their patrons so income should flow directly to patrons rather than being taxed to the cooperative.
When Subchapter T was enacted as part of the Revenue Act of 1962, it established two types of cooperatives: (1) farmers cooperatives (known as exempt cooperatives) and (2) other types of cooperatives (known as nonexempt cooperatives). Sections 521(a) and 1381(a)(1) provide a farmers’ cooperative is exempt from income taxation to the extent provided in Subchapter T. Section 521(b)(1) defines a farmers’ cooperative to mean “farmers,’ fruit growers,’ or like associations organized and operated on a cooperative basis (A) for the purpose of marketing the products of members or other producers . . . or (B) for the purpose of purchasing supplies and equipment for the use of members or other persons . . . .” Section 1381(a)(2) clarifies Subchapter T also applies to any other corporation that is operated on a cooperative basis.
Subchapter T allows cooperatives that otherwise would be subject to taxation as a C corporation to exempt certain income via a deduction for dividends paid to its patrons. For exempt cooperatives, all dividends regardless of the source of the income, result in a deduction effectively eliminating all tax at the corporate level. For nonexempt cooperatives, however, a deduction is provided for dividends made to patrons that are patronage sourced but not for dividends of income from nonpatronage sources. Patronage sourced income is income (i) arising out of earnings of the cooperative from business done with or for its patrons, (ii) paid on the basis of the quantity or value of business done with or for the patron, (iii) based on an obligation of the cooperative to pay such amount, and (iv) determined by reference to the net earnings of the cooperative from business done with or for the patrons. Section 1388(a) makes clear the term “patronage divided” does not include “any amount paid to a patron to the extent that . . . such amount is out of earnings other than from business done with or for the patrons.” Thus, for nonexempt cooperatives, there is a requirement to allocate income of the cooperative between patronage sourced and nonpatronage sourced income. To the extent income is nonpatronage sourced, it is taxed at the corporate level in the same manner as any other C corporation.
John G. Hodnette is an attorney with Fox Rothschild, LLP in Charlotte.