Updated: Nov 11, 2020
By Kelly Nuckolls
The article is not a substitute for legal or financial advice. See here for the site’s reposting policy.
The new federal tax law has stirred up a lot of interest among farmers who are now hoping to join or create their own cooperative associations. The new federal tax law provides a significant tax deduction that could benefit some farmers who are members of cooperatives. However, there are a number of things every farmer should consider before forming or joining a cooperative. Farm operations each have unique financial situations, and whether or not you should form an entity like a cooperative association depends on a number of factors, not just one section of the tax code.
If the new federal tax deduction for “qualified cooperative dividends” is the sole reason you are considering joining or creating a cooperative, you should first discuss the tax benefits with an accountant. The new federal tax law’s deduction for qualified cooperative dividends may or may not save you money. You probably want to ask your accountant:
How much money will the new federal tax law’s deduction for qualified cooperative dividends save me on my federal taxes?
Will selling my products as a cooperative member save or cost me money on my state and local income taxes?
Even if the new deduction will save me thousands, will that amount be more than the costs of starting and running a cooperative?
There are a few other questions to consider. If you are creating a cooperative with other farmers, have they asked their accountants about the benefits or possible costs for their operations? Will the cooperative be able to sell products at a high enough price compared to the amount individual farmers would receive from selling products on their own? Also, the federal tax deduction for qualified cooperative dividends is only available from 2018 through 2025. Will you need to change business entities and dissolve the cooperative after 2025? How much will it cost to change business entities if this is the case?
Farmers should also consider that the federal qualified cooperative dividends deduction may disappear sooner than 2025. Reports have stated that an amendment to change the qualified cooperative dividends deduction will likely pass in the next budget bill, which must be passed before March 23rd to avoid a government shutdown. The Internal Revenue Service can also issue rules this year or in the future that could include restrictions on who can receive this deduction.
Even so, the tax savings that could exist for a cooperative, along with the other benefits of joining a cooperative, can still be a smart financial decision. Before the new federal tax law, a deduction existed for income from cooperatives, which may have been financially beneficial for some farm operations. This past deduction is actually the proposed amendment to the current tax code that would change the current qualified cooperative dividends deduction. Cooperatives also could improve members’ bargaining power, resulting in lower costs for services and products. For example, a cooperative may purchase a large amount of seed at a discounted price, passing on those savings to its members.
Even if the new federal law’s cooperative tax benefits are soon changed, there are still a number of reasons joining cooperative may be beneficial for your farm operation. Yet, there are also situations where joining or creating a cooperative may not be financially or logistically possible. There are several items that you should consider before joining or creating a cooperative:
What requirements must be met for a member farmer to receive the new federal tax law’s qualified cooperative dividends deduction? Farmer cooperatives are one of a few types of cooperatives that are eligible for this deduction. There are several requirements an organization must meet to be considered a farmer cooperative under federal tax law:
The organization must be a farmers’ or fruit growers’ association. This means that members should be growers or producers.
The organization must operate “on a cooperative basis,” meaning each member has only one vote, regardless of the amount invested or how many stocks owned.
The cooperative must be organized for either: 1) the purpose of marketing the members’ and other producers’ products in a way that returns the proceeds of those sales minus the marketing costs to those member and nonmember producers based on the value of that product; or 2) to purchase supplies and equipment for the use of the members or nonmembers, only charging the actual costs for the items plus the cooperative’s necessary expenses for acquiring the products.
If the cooperative is incorporated with capital stock, the amount of money the stock pays its shareholders each year cannot exceed the greater percentage of either: 8% each year; or if one exists, the state law’s limit, which in Maryland is 12%.
If the cooperative has capital stock, all stocks (except some stock without voting power) must be owned by producers who market products or purchase supplies through the cooperative.
The cooperative cannot market or purchase more than 50% of products for nonmembers. If the cooperative makes purchases, it cannot make more than 15% of its purchases for individuals who are not members and not farmers or ranchers.
Any financial reserve can only be one required by state law or for a necessary purpose.
A patronage dividend, which is the member’s payment from the cooperative based on: 1) the cooperative’s net earnings; 2) the total business that member did with the cooperative, and 3) the cooperative’s legal obligation to make that payment (such as through a contract with that member). For example, if the cooperative has made a profit of $500,000 for a year, and John has a contract with the cooperative to market and sale his agricultural products, and the sale of John’s products totaled 10% of the cooperatives total business that year, the cooperative would give John a patronage dividend payment of $50,000;
A per-unit retain allocation, or a fixed amount paid to a member, regardless of the cooperative’s profit, according to an agreement between the cooperative and the member (i.e. a contract); or
A qualified written notice of allocation, which is a combination of a patronage dividend with other financing considerations. At least 20% of the patronage dividend must be paid in money or by a qualified check, and it must meet other very specific requirements.
Will you be able to structure your cooperative to meet the above requirements?
Who will keep up with the recordkeeping requirements? Detailed records must be kept, including all business transactions with members and nonmembers and all payments and distributions made. Would it be beneficial to hire an outside advisor, like an accountant, to help maintain these requirements?
Will the one vote per member policy cause any member conflicts or disagreements?
Will the cash flow requirements of this qualified cooperative dividends deduction be a concern for some farmer members? There are only three very specific types of payments that can be made to members that qualify for this deduction, and there are also limits on incorporated cooperative’s dividend payments.
How will the cooperative be financed? How much money will the cooperative need to get started? Will your cooperative have stock purchases or membership fees? How much is each member able to contribute? The U.S. Department of Agriculture’s Rural Development grants for cooperatives may be available to help with some initial costs. Is there enough money within the cooperative to purchase all of the members’ products on an annual basis? Would members be able to sell to another business for a larger profit, even considering the federal tax law changes?
What business activities would the cooperative partake in: marketing, purchasing, or both? A cooperative that markets and purchases on behalf of members could provide opportunities to save money. A purchasing cooperative’s ability to provide farmer members with lower costs for services and products might make the initial investment in the cooperative worth it, even if the marketing side of the cooperative is no longer as beneficial if the federal tax law changes later on.
Have you developed a business, marketing, and sales plan for your marketing cooperative? Who will be the key personnel running the cooperative? Should you hire someone to provide financial data that could increase sales? How much you will spend on an attorney and accountant? What other professionals will you need, such as a marketing specialist or graphic designer to brand and market your products? The cooperative must also have sufficient volume to operate as a business and should consider what facilities may be needed and / or equipment. Who will the cooperative sell to and when will products be delivered? Where will the business be located?
Will you incorporate your cooperative? Incorporating your cooperative could provide members with protection from potential legal liabilities related to their operations. In Maryland, an agricultural cooperative cannot use the term “cooperative” in their name without incorporating; but incorporating m