Patronage Dividends: A Primer


Should your cooperative consider patronage dividends to owners? If you are already issuing patronage dividends, is your cooperative following the rules? If your cooperative receives patronage dividends from other cooperatives, do you understand what the rules are?

Patronage dividends represent a unique opportunity for retail food cooperatives to avoid taxation at any level on some or all of the cooperative’s earnings. The tax laws allow patronage dividends to your individual members to be exempt from taxation. Since these are deductible by the cooperative and not taxable to members, the patronage dividend amount is not taxed at either level. While there are potential under-capitalization problems if a cooperative distributes 100 percent of the patronage dividend, avoidance of taxation is a significant advantage to patronage refunds for retail food cooperatives.

Patronage dividends originated with the Rochdale Society cooperative principles that included “net margins distributed according to patronage.” Since cooperatives had a long history prior to the enactment of the U.S. income tax laws, cooperatives were accommodated in the tax code. The Internal Revenue Service (IRS) rules formalize the procedures that result in a tax deduction. These rules treat a cooperative as having the option of operating as a pass-through entity where profits are considered an overcharge to be returned to patrons.

Subchapter T

The IRS rules for patronage dividends are outlined in Subchapter T of the Internal Revenue Code. The five code sections comprising Subchapter T are: * 1381-what is a cooperative under Subchapter T? * 1382-how are income and patronage dividends calculated? * 1383-what is nonqualified patronage? * 1385-how are patrons taxed on the dividend? * 1388-what do the terms mean?

These rules apply to non-exempt cooperatives. There are exempt cooperatives, normally only agricultural, which must apply for exempt status and follow somewhat different rules. All cooperative accountants and their outside accounting advisors should be familiar with Subchapter T, even if the cooperative only receives patronage dividends from other cooperatives. Accountants should also utilize the accounting guidance available in the American Institute of CPAs (AICPA) Audit and Accounting Guide, Agricultural Producers and Agricultural Cooperatives. Additional information on accounting and tax issues is available by joining the National Society of Accountants for Cooperatives ( Your accountant on staff and your outside advisor should both be members of NSAC in order to keep up on cooperative tax and financial issues.

Subchapter T lays out three basic criteria for patronage dividends. To be deductible the patronage dividend must be paid:

  1. “on the basis of quantity or value of business done with or for such patron,
  2. “under an obligation of such organization to pay such amount, which obligation existed before the organization received the amount paid, and
  3. “which is determined by reference to the net earnings of the organization from business done with or for its patrons.”

Item 1 requires the cooperative to specify the basis for calculating patronage. For a consumer-owned cooperative it will be sales. For a worker-owned cooperative it will be hours worked by workers or dollars paid to workers. We will use consumer-owned cooperatives in the examples below. The patronage dividend must be proportionally allocated based on business done with everyone, including non-members.

Item 2 requires that the cooperative operate under a pre-existing obligation to pay patronage dividends. This is normally part of the bylaws but may also be in the form of a written agreement with the members. State law normally allows a board of directors to determine that some or all of income be set aside as a reserve not to be paid out as patronage. This tempers the pre-existing obligation. But patronage dividends are not allowed if there was not an obligation established at the beginning of the tax year from which patronage is paid. Part of establishing the obligation is informing members that they may receive a patronage dividend. This is one reason cooperatives should distribute their bylaws to new members. Be sure you consult a qualified attorney on the precise wording of your bylaws, since they must be in accordance with the IRS rules and with applicable state laws.

Item 3 specifies that the base for patronage is net income. The IRS prefers taxable income as the patronage base. This is what most cooperatives use, although book income may also be used. The basis for patronage should be used consistently and should be specified in the bylaws.

Determine amount eligible for patronage dividend

The starting place in allocating patronage is to determine net income for tax or for book purposes. Using this, most cooperatives simply apply a percentage of sales to members and to non-members to determine the net income generated by members (patronage income) and the net income generated by non-members (non-patronage income). A more detailed analysis might allocate revenue and expense items such as member discounts, member only sales, advertising, member communications, and non-member mark-ups to the appropriate member or non-member calculation of net income. The member (patronage) net income is then allocated to each member based on the percentage of that member’s purchases of total member purchases. The non-member (non-patronage) net income is not allocated to members and will potentially be subject to taxation.

The practical method of determining the patronage allocation to each member is to download the annual sales by member from your point of sale system to a spreadsheet. This can then be sorted from largest to smallest. A ratio of each member’s sales to all sales is then an easy calculation, as is multiplying this percentage times net income to calculate the amount of patronage that could be allocated to each member. A mail merge can then be used to generate the actual notices to members of their patronage. Most cooperatives apply a minimum dividend amount that they will process. For instance, anyone who would receive under $2 could be cut out of further processing. This does mean that the cooperative will pay tax on those earnings of members who would have received under $2.

The board will determine the actual dividend payout. The maximum dividend amount will be the net income earned from members. The dividend may be paid out with a minimum of 20 percent either as cash or as a store certificate, with the balance being held by the cooperative as equity in the name of the member.

Qualified notices

In order for the cooperative to retain part of the patronage dividend, members must receive a qualified notice of allocation. This notice indicates that by cashing their check, or using their certificate, they also accept the non-cash portion retained by the cooperative. This notice must specify a deadline to cash the check/certificate of at least 90 days after issuance. The IRS allows the cooperative, through the issuance of a qualified notice of allocation, to deduct the non-cash portion of the patronage dividend.

Food cooperatives will normally only use qualified patronage dividends. The non-qualified patronage dividend is non-deductible at the time it is issued but is deductible when cash is paid. The National Cooperative Grocers Association issued non-qualified patronage dividends on 2005 income as a tax-planning tool.

Form of payment

The minimum 20 percent paid out portion of a patronage dividend may be in the form of a store certificate that is redeemable in the store for purchases. You must also allow members to ask for cash if they prefer that option. This is much easier than issuing checks and limits the problems with un-cashed checks. Using a certificate also encourages members to use the dividend on groceries and keep the funds in the cooperative.

Anyone who does not cash a check or use a certificate by the deadline you specify in the written allocation notice gives up his or her claim to the patronage dividend including the non-cash portion. The cooperative will then need to pay tax on the entire patronage allocation to that member. Due to timing and practicality many cooperatives adjust for the unclaimed patronage in the next year, paying the tax at that time.

Some patrons may deliberately not cash their patronage check/certificate, thinking they are making a contribution to the cooperative. One way to encourage cashing the checks/certificates is to set up a donation fund either to the cooperative or as part of the community contributions program of the cooperative. If the person gives the cash portion back, it is taxable to the cooperative in the next year, but the retained portion of equity would still be held in that member’s name and would not be taxed.

Payouts to members from the income of a given tax year must be made no later than 8.5 months after that year-end. This allowable timeframe is called the payment period. The deadline for cashing the check/certificate must be no later than 90 days after the end of the payment period. The IRS is very particular about this and will classify any payment made outside of the allowable payment period as an ordinary corporate dividend-nondeductible for the cooperative and taxable to the recipient. A 1099-DIV would need to be issued to each member. Any non-cash portion held by the cooperative would also not be deductible.

Filing 1099-PATR forms is not required

Food cooperatives should file IRS form 3491 to elect not to issue the 1099-PATR form. Form 3491 is filed in the first year patronage dividends are paid and does not need to be filed again. This exemption is allowed for cooperatives that have at least 85 percent of gross receipts from the sale of “personal, living, or family items.” The tax code allows persons who purchase such items from a cooperative to exclude any patronage dividend from taxable income even if they receive a 1099-PATR. The reasoning is that individuals may not deduct personal use items and therefore any dividend on them is not taxable. Not issuing the 1099-PATR does not relieve members who are required to claim the patronage dividend as income from doing so. Examples of some possible members who should claim a patronage dividend as income are restaurants and day care centers.

One more issue with patronage dividends is the financial statement presentation. There is no definitive requirement for treating patronage as a deduction from income or as an equity transaction similar to corporate dividends. The guidance from the AICPA in the Audit and Accounting Guide mentioned earlier is that patronage is an equity transaction. The reporting examples given in the AICPA Guide follow that format. On the other hand, the CoCoFiSt format uses the income statement treatment.

In considering your cooperative’s treatment, a question to ask is: we are retaining 80 percent of the payment, so why should it be expensed? Showing patronage dividends as an expense reduces net income, which may make your cooperative look weaker to a banker or other evaluator who does not understand cooperatives.

Related issues include the balance sheet presentation of the retained patronage dividend and the policy for eventually paying it out to members. The retained portion of a patronage dividend is equity of the cooperative and should be presented along with retained earnings and member shares in the balance sheet. This retained patronage is only paid out by the decision of the board. Most cooperatives do not return the retained patronage even if a member requests it back. This is also generally the case in agricultural cooperatives.

One advantage food cooperatives have in withholding retained patronage is that almost all members never paid tax on it and already received some cash. This removes the basic fairness argument that agricultural cooperatives must face since their members normally did pay tax on the retained patronage. If your cooperative does plan to revolve back this equity, it should lay out a plan for it. If it does not plan to revolve it back, that should be made clear. Most cooperative members should be receptive to the idea that they get some cash back and the rest is an easy way to avoid paying taxes and keeping the money in the cooperative working for them.

Patronage involves a simple set of rules but you need to actually learn them and keep them in mind so your cooperative can follow the applicable laws and make sound decisions.

Form 1120-C

New for 2006 was a specific IRS income tax form for cooperatives, the 1120-C. This will be mandatory for all cooperatives starting with the 2007 tax form. The primary difference from the 1120 is the addition of Schedule G that specifically requires the allocation of all income and expense items into patronage and non-patronage columns for all cooperatives with over $250,000 in gross receipts. Previously such an allocation was only explicitly required for cooperatives over $10 million in gross receipts. This allocation has always been required for all cooperatives but has generally been ignored by smaller entities.

One result of allocating income in Schedule G is that net operating losses stay segregated by patronage and non-patronage sources. The IRS rules prevent patronage losses from offsetting non-patronage income. This can result in some pitfalls as a cooperative uses up a net operating loss. In loss years the loss is normally not allocated to members, resulting in an accumulation of patronage and non-patronage net operating losses. When the cooperative begins generating a positive net income, it may issue patronage dividends before its patron net operating loss is used. This can result in a situation where it will not be able to use up its patronage net operating loss and will pay more tax on its non-patronage income than would be expected by only looking at the overall net operating loss carry-forward.


Bruce Mayer, MBA, CPA, is a partner in Wegner LLP, CPAs & Consultants in Madison, Wisconsin ([email protected]).

Add comment

Log in or register to post comments