Cooperative Tax Developments Co-op Professionals Conference Presented by: Bruce Mayer, CPA May 31, 2019

Topics Entity Choice Member capital accounts Sweat Equity

Entity Choice Cooperative Corporation – Subchapter T Internal Revenue Code (IRC) Sections 1381-1388 Is a subset of C-Corporations Partnership – Subchapter K Internal Revenue Code (IRC) Sections 701-777 S-Corporation – Subchapter S Internal Revenue Code (IRC) Sections 1361-1379 Tax Exempt – Subchapter F Internal Revenue Code (IRC) Sections 501-530

Entity Choice What is a co-op anyway? IRS and accounting definition: One member- One vote Allocate profits based on business done with the co-operative No statutory definition The IRS only recognizes Subchapter T entities as cooperatives Everything else is meeting co-op principles through choices in organizing documents allowable under their chosen entity Chart comparing entities https://www.wegnercpas.com/taxation-comparison/

Entity Choice Cooperative Corporation – Subchapter T Usually incorporated, whether as a co-op or not Can be an LLC that elects to be taxed as a corporation Elect corporate taxation with Form 8832 File before effective date or within 75 days after For January 1, 2019 effective date file by March 15, 2019 Cannot go back to partnership taxation once corporate taxation is elected

Entity Choice Cooperative Corporation – Subchapter T (continued) More formal entity – has it’s own existence Owners generally paid with W-2 Depends on qualification as employee or independent contractor No draws Either corporate dividend or return of capital or W-2 wage or reimbursement of business expenses Or patronage dividend

Entity Choice Cooperative Corporation – Subchapter T (continued) Double taxation only on corporate dividends Patronage dividends are deductible Tax paid by the co-operative or by patrons Tax form 1120-C The profit allocations, patronage dividends, may be subject to self employment tax Can retain income in the name of the co-op Permanent capital belonging to co-op Accessed through losses or on dissolution

Entity Choice Cooperative Corporation – Subchapter T (continued) When operating in multiple states only the Co-op files returns in all states Owners with W-2s subject to all rules and taxes imposed by state where they work Unemployment Worker’s compensation Exempt or non-exempt employee Minimum wage, overtime

Entity Choice Partnership – Subchapter K More open and informal entity Can be LLC, partnership, or an informal association Only LLCs can elect corporate taxation More open and informal entity Pass through entity where all activity is allocated to owners All tax characteristics pass through to members Tax form: 1065 Allocation reporting form: Schedule K-1 of Form 1065

Entity Choice Partnership – Subchapter K (continued) Taxes paid by owners through allocation of income Partnership generally does not pay income taxes The profit allocations are subject to self employment tax All equity is allocated to owners Partnership cannot retain any income No permanent reserves Can revolve former owner equity slowly

Entity Choice Partnership – Subchapter K (continued) Owners paid with draws and guaranteed payments No W-2s regardless of meeting definition of an employee Owners not subject to employee rules or taxes Non-owners are subject to employee or independent contractor rules Probationary members may be employees If so, employee rules and taxes apply

Entity Choice Partnership – Subchapter K (continued) Governed by operating agreement IRS will not recognize partnership as a co-op To call the entity a co-op: One member – one vote Allocate profits based on business done with the co-op Operating agreements are flexible Allow voting and profit allocation to be independent of ownership percentage Allocation must not be based on tax avoidance

Entity Choice Partnership – Subchapter K (continued) Operating in multiple states the partnership files in each state and allocates income to all owners in each state May result in owners filing personal income taxes in each state

Half Way Still on entity choice Through Co-op Corporations and Partnerships Still have: Subchapter S and exempt groups Member capital accounts Sweat equity

Entity Choice S-Corporation – Subchapter S Is a hybrid of corporation and partnership taxation Not many co-ops use this Possible for small groups

Entity Choice Corporation – Subchapter S (continued) Usually incorporated Corporations elect S status by filing Form 2553 File before effective date or within 75 days after For January 1, 2019 effective date file by March 15, 2019 Can be an LLC that elects to be taxed as a corporation and then elects treatment as an S-corporation

Entity Choice Corporation – Subchapter S (continued) Owners generally paid with W-2 Depends on qualification as employee or independent contractor There can be draws Double taxation only on corporate dividends

Entity Choice Corporation – Subchapter S (continued) Tax paid by income allocated to owners Tax Form 1120-S Income allocation reported on Schedule K-1 of Form 1120-S The profit allocations are not subject to self employment tax But W-2 wage must be fair compensation for services All equity is allocated to owners Partnership cannot retain any income No permanent reserves Can revolve former owner equity slowly

Entity Choice Corporation – Subchapter S (continued) S-corporation rules are very strict Profit allocation must exactly follow ownership percentage This is where operating as a co-op can be challenging If equal ownership and all owners work equal amounts the allocation of profits agrees to allocation based on business done with the co-op Otherwise need to use a bonus system to emulate allocation based business done with the co-op

Entity Choice Corporation – Subchapter S (continued) Operating in multiple states the S-corporation files in each state and allocates income to all owners in each state May result in owners filing personal income taxes in each state Owners with W-2s subject to all rules and taxes imposed by state where they work Unemployment Worker’s compensation Exempt or non-exempt employee Minimum wage, overtime

Entity Choice Tax Exempt Most are 501(c)(3) charitable organizations Some have tried other tax exempt co-op approaches 501(c)(4) – Social Welfare 501(c)(5) – Labor organizations 501(c)(6) – Business League 501(c)(7) – Social Club Most do not qualify due to focus on members

Entity Choice Tax Exempt Generally housing Student Senior Low-income Must have public purpose and not allocating profits to members

Entity Choice So which one? How do they want to operate? Legal Tax Conversion

Member Capital Accounts Tax law dictates capital accounts Co-op corporations – typical equity composition Preferred shares – owners or investors Common shares - owners Retained patronage dividends – patrons Retained earnings – co-op

Member Capital Accounts Co-op corporations (continued) Retained patronage dividends must be allocated to patrons By name By year Identify if it was qualified or non-qualified patronage dividend This is the non-cash portion of patronage dividends

Member Capital Accounts Partnership Member equity – invested equity Member equity – allocated profits or losses S-corporation Common shares – invested equity

Sweat Equity Awarding equity for services triggers immediate taxation Founding members New members Example founding members given credit for low paid years by assigning equity of $5,000 each Must report as income in year assigned

Sweat Equity Assignment of equity falls into deferred compensation rules If qualifying contract is not used it is immediately taxable To qualify there must be a risk of forfeiture Co-op can use other means to award work such as higher compensation or bonuses But any plan promising future benefit may fall into deferred compensation rules

Co-op Taxes and Accounting Ask The Accountant

Thank you for participating! Bruce Mayer, MBA, CPA 608-442-1939 bruce.mayer@wegnercpas.com https://www.wegnercpas.com/industries/cooperatives/