CHALLENGES ARISING FROM LEGAL
RESTRICTIONS ON COOPERATIVES
© Mark J. Hanson
Lindquist & Vennum PLLP
Minneapolis, Minnesota
612-371-3545
mhanson@lindquist.com
Presentation for
Agricultural and Food Cooperatives
In Rural Development
Washington D.C.
June 17, 2004
1898447v1
PRESENTATION OVERVIEW
•
The purpose of this presentation is to look at various federal laws
which impede the development of cooperatives in their different forms
in the agribusiness industry in which producers and marketers of farm
products are patrons.
•
Federal law institutionalized the cooperative structure in the 1920’s
when about 30% (32 million) of the people lived on the nation’s 6.5
million farms, a small percentage of the agricultural products were
processed, and horses were more common on farms than tractors.
The commodity marketing, income model focus of federal cooperative
structure is limited as a tool for farmers to collectively address
problems and opportunities of the 21st Century.
•
This presentation is biased in that it:
– Advocates cooperatives should be a favored rural development
business structure in which the patrons extract value in addition to
profits from collective action in a common business.
– Focuses on structure from the viewpoint of cooperators.
– Describes impediments to profitable and successful cooperatives.
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THREE PRIMARY TYPES OF
COOPERATIVES HAVE DEVELOPED
1. Traditional Cooperative (T Coop).
•
•
Supply farm inputs; process and market farm products.
Corporate cooperative, taxation under Subchapter T; deduction for
patronage sourced business.
•
Capitalized with patronage equity.
2. New Generation Cooperative (NGC Coop).
•
•
Processing farm products of members.
Corporate cooperative, taxation under Sub T; §521; deduction for
patronage (and §521 nonpatronage) sourced business.
•
Capitalized with direct patron investment.
3. Patron Investment Cooperative (PIC Coop).
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•
•
Process farm products of members and others.
Unincorporated association, taxed under Sub K, pass-through single
tax to members.
Capitalized with patron and investor investment.
M.Hanson L&V 3
FEDERAL INSTITUTIONALIZATION
OF COOPERATIVES
•
Cooperatives were defined about 80 years ago in terms of:
– Structure (corporate).
– Owners (farmers).
– Governance (one vote per member).
– Profit entitlements (patronage).
– Business (primarily with members).
– Benefits (primarily, single level of tax to a corporate
entity) and antitrust exemption (to operate) to
cooperatives to encourage development.
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FEDERAL INSTITUTIONALIZATION OF COOPERATIVES
ANTITRUST, TAX, DEBT FINANCING, FEDERAL REGULATORY, SECURITIES
Capper-Volstead Act the “Magna Charta” of Cooperatives
(7 U.S.C. §§291-292)
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•
•
•
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Adopted in 1922 – narrowly defined farmer cooperative.
Membership of farmer producers may act together.
Association operated for mutual benefit of members “as such
producers.”
One member one vote or not more than 8% return on capital.
Must deal in products of members in greater value than
products of nonmembers.
Intent was to allow farmers to act collectively to market farm
products without antitrust violation or enforcement. Definition of
“Cooperative” has had much broader application. Still important
especially to some fruit and vegetable cooperatives, but for
cooperatives dealing in commodities or where product transfer
is at market price or contracted price generally does not apply.
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FEDERAL INSTITUTIONALIZATION OF COOPERATIVES
ANTITRUST, TAX, DEBT FINANCING, FEDERAL REGULATORY, SECURITIES
Subchapter T – Taxation of Corporate Cooperatives
(Internal Revenue Code §§1381-1388)
•
Deduction of patronage sourced income from taxable income of
cooperative.
•
Cooperative not defined, but patronage sourced business
deduction available only to corporations operating on a
“cooperative basis.”
•
Three principles (Puget Sound Plywood):
1. Democratic control (one member, one vote or voting based on
patronage but not capital).
2. Profits allocated on the basis of patronage (not on invested capital).
3. Subordination of capital (interests in equity subordinated to
patronage).
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FEDERAL INSTITUTIONALIZATION OF COOPERATIVES
ANTITRUST, TAX, DEBT FINANCING, FEDERAL REGULATORY, SECURITIES
Section 521 Exempt Corporate Cooperative (Internal Revenue Code § 521(b))
Advantages:
• Patronage and nonpatronage sourced income deducted from cooperative corporate
taxation as certified by IRS.
• Dividends (not to exceed 8%) on capital stock deducted from cooperative taxable
income.
• Securities issued by §521 cooperative are exempt from registration under Securities Act
§3a(5).
Requirements:
• Producer (farmer) members with one vote per member.
• Profits and liquidation proceeds distributed on basis of patronage to member and
nonmember patrons.
• Dividends on capital limited to 8% (or state judgment rate).
• Operated to market farm products (at least 50% from members) and returning profits to
patrons, or purchasing supplies and equipment (up to 15% nonmember nonproducers)
for farmers on cost plus basis.
No authority for nonfarmer members. Outside capital limited to fixed rate of return of 8%. Restrictions on
patrons, patronage sourced business, and capital limit competitive business operations.
M.Hanson L&V 7
FEDERAL INSTITUTIONALIZATION OF COOPERATIVES
ANTITRUST, TAX, DEBT FINANCING, FEDERAL REGULATORY, SECURITIES
Marketing Act of 1929 (12 U.S.C. §1141)
• Definition of “cooperative” used in other federal laws (12 U.S.C. §1141j)
• Requirements
– Defined as Association in which “farmers act together” similar
to Capper-Volstead Requirements, except one vote per member and
dividends do not exceed 8%, and business with nonmembers is not
greater in value than business with members. Also applies to farm
supply cooperatives.
• Application
– Cooperative bank financing.
– Agricultural Fair Practices Act.
– Securities Act of 1934 Reporting Requirements.
– Cooperative exemption from Perishable Agricultural Commodities Act.
– Cooperative exemption from trucking regulation under the Interstate
Transportation Act.
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FEDERAL INSTITUTIONALIZATION OF COOPERATIVES
ANTITRUST, TAX, DEBT FINANCING, FEDERAL REGULATORY, SECURITIES
Securities Laws
1933 Act (Offer and Sale of Securities)
• §3a(5) offer of §521 cooperative securities exempt from registration.
• Producer farmer members; One vote per member; Dividends on
capital limited to 8%; Distributions based on patronage.
1934 Act (Public Reporting Requirements)
• Required public quarterly and annual reporting.
• Cooperative defined under Marketing Act of 1929; Farmer members;
One vote per member; Dividends on capital limited to 8%; Business
with nonmembers not to exceed business with members.
The narrow definition of cooperatives for purposes of registered offerings
and public reporting requirements deny many cooperatives the Securities
exemptions for registration and reporting to raise new invested capital.
M.Hanson L&V 9
FEDERAL LAW/POLICY IMPACT
ON COOPERATIVES
FEDERAL LAW
1. Prescribes Members:
Farmer or Producer
IMPACT
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•
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Producer membership pool is shrinking
Capital options limited
Liquidity restricted
Restricts aligned industry participants
2. Prescribes Governance:
One Vote Per Member
3. Prescribes Financial Rights:
Distributions Based on
Patronage
•
Discourages Members with large patronage or
potential investment
•
Excludes or deters patron or nonpatron
investment that is not commensurate with
patronage
Patrons need to expand deliverable
production to invest greater amounts
4. Restricts Return on Capital:
Generally Limited to 8% of
Invested Capital
•
5. Limits Corporate Tax Benefit
of Patronage Deduction
•
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Very limited opportunities for investment
capital
8% is deductible in §521, but taxable to
nonexempt cooperatives
Further processing and manufacturing subject
to double tax (~65% state and federal)
Encourages transition or formation of
unincorporated association (PIC Coop or LLC)
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FEDERAL LAW/POLICY IMPACT
ON COOPERATIVES
IMPACT (cont.)
FEDERAL LAW (cont.)
6. Taxes Liquidation Profits as
Ordinary Patronage Income
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Corporation, or PIC Coop, or LLC
Shareholder/Members generally receive capital
gain treatment (potential tax rate difference of
35% vs 15%)
Encourages successful corporate cooperatives
to transition to other business structures
7. Taxes Transition of
Cooperative to PIC Coop or
LLC as Liquidation of Coop
Assets and Recontribution
by Members to New Entity
•
Double tax on unrecognized gain to cooperative
and members with no new gain or cash
•
Makes transition to more efficient tax business
structure expensive
8. Exempts Defined
Cooperatives from
Securities Registration and
Financial Reporting
•
Many cooperatives do not fit definitions
•
Expensive and time consuming securities
registration process designed for publicly traded
corporations is a poor fit for cooperatives
Many start-up businesses choose alternative
business structure, LLC; private placement
offering
•
M.Hanson L&V 11
COOPERATORS AND FARMING
CONTINUES TO CHANGE
• Farming operations – multi-commodity to single
business purpose; land acquired, not inherited way
of life.
• Marginal tax rates of commercial farmers increasing,
cash patronage expectations increasing.
• Liquidity expectations – equity at exit from farming;
revolvement demands increasing; growing amount
of capital held by nonpatrons.
Just 3% of the nation’s farms (70,600 with annual sales of $500,000
or more) produced 62% of the nation’s agricultural products.
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FUTURE PATRONS CONTINUE TO DECLINE
TRADITIONAL COOPERATIVES: Current Patrons Provide the Capital for Ongoing
Business Needs and to Retire the Capital of Former Patrons. WHERE WILL THE
PATRONS COME FROM? WHO WILL REVOLVE FORMER PATRONAGE EQUITY?
FIVE YEAR TREND
% Farm Operators by Age Category
(1987, 1992, 1997, preliminary 2002)
30.0%
Percent
25.0%
-17%
(77,697)
20.0%
-31%
(48,742)
15.0%
1987
1992
1997
2002
10.0%
5.0%
0.0%
le s s 2 5
25 to 34
35 to 44
45 to 54
55 to 64
65 & Over
Age Categories
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FEDERAL SECURITIES LAWS
•
LENGTHY AND EXPENSIVE REGISTRATION PROCESS REQUIRED
TO OFFER SECURITIES UNLESS SECURITIES CAN BE OFFERED
THROUGH A REGISTRATION EXEMPTION.
•
TRENDS TO PRIVATE PLACEMENT EXEMPTION TO ACCREDITED
INVESTORS ($1,000,000 Net Worth or $200,000 Income).
– Only 1% to 5% of farmers likely to meet test.
– Most farm operators excluded from investment/marketing opportunity.
DISTRIBUTION OF HOUSEHOLD INCOME BY FARM SIZE
(Income, Wealth, and the Economic Well-Being of Farm Households/A ER-812)
Farm and Non-Farm Net Worth
Agricultural Income and Finance Outlook / AIS-81 / November 2003
> $1.0 m il
Residential
$321,000$124,000
Accredited Investor
< $250,000 Sales but Farm Income is not
Predominant Component of Total Income
$596,000
$90,000
< $250,000 Sales and Farm Income is
Predominant Component of Total
Income
> $250,000 Sales and Farm Income is
Predominant Component of Total Income
,
Accredited Investor
$1,300,000
Commercial
$0
,
$119,000
$200,000 $400,000 $600,000 $800,000 $1,000,000 $1,200,000 $1,400,000 $1,600,000
Farm Size in Sales
Type of Farm
to $999,999
Other Farms
22,648 Farms (1.1%)
$322,011
35,754 Farms
(1.7%)
$124,683
to $499,999
Accredited Investor Joint With Spouse
77,314 Farms
(3.6%)
$85,685
to $249,999
$56,824
355,366 Farms
(16.5%)
< $50,000
$60,139
1,656,492 Farms
(77.1%)
Dollars of Net Worth
$0
Farm Net Worth
Non-Farm Net Worth
$50,000
$100,000
$150,000
$200,000
$250,000
$300,000
$350,000
Total Household Incom e - 1999
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FOUR STRUCTURE OBJECTIVES FOR
SUCCESSFUL COOPERATIVES
GOAL: STRENGTHEN INCOME/GROWTH BUSINESS MODEL
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Tax Efficiency – Single-level of tax applied to income allocated
to members or entity.
•
Ease of Raising Capital – Securities registration and public
financial reporting requirements commensurate with size and
structure of organization and offering (with proper disclosure, no
registration or reporting unless publicly traded securities).
•
Equity Liquidity – Owners can exit and transfer their ownership
interests when they decide to do so and broad pool of buyers are
eligible to purchase.
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Transition Flexibility – Flexibility to change ownership and
operational structure as competitive business environment
and ownership needs change without tax of unrealized gain
or registration of securities to existing owners.
M.Hanson L&V 15
ALTERNATIVE FEDERAL
POLICY/LAW CONSIDERATIONS
1. Define Cooperative Beneficiaries (Cooperators)
Rather Than Business Structure.
•
A cooperative is an association (which may be a corporate
structure) in which producers of agricultural products control
the governance of the association, receive profits or margins
of the association based on business done for or with the
association as determined and agreed upon by the producer
patrons.
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ALTERNATIVE FEDERAL
POLICY/LAW CONSIDERATIONS
2. Define Efficient Single Level Tax Allocation for
Growth/Income Model.
• A cooperative shall allocate all taxable income of the cooperative to
the cooperative or to the members of the cooperative, as
determined by the cooperative. Income allocated to the cooperative
taxed as provided for corporations under Subchapter C. Income
allocated to members as provided under Subchapter K.
• A cooperative is not subject to Publicly Traded Partnership Rules
except to the extent interests in the cooperative are publicly traded
on an exchange.
• A cooperative may convert, merge, or otherwise transition to
another legal entity as a tax-free reorganization, provided any
gain subject to taxation as a cooperative will be subject to taxation
when realized in the new entity.
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ALTERNATIVE FEDERAL
POLICY/LAW CONSIDERATIONS
3. Provide Securities Registration and Reporting Exemptions that
Facilitate Investment by Producers and Aligned Investors.
• Require cooperative to disclose information and risks in federal securities format.
• Require notice filing to SEC and states where offering is conducted.
• Offering is exempt from registration to:
– Existing or new patrons
– Aligned investors
• Agricultural producers
• Persons or businesses in the trade or business related to the cooperative’s
trade or business
• Qualified rural residents and businesses within the rural trade area of the
cooperatives (residing in cities of 70,000 persons that are not suburbs of
metropolitan areas) to the extent of 25% of annual income or 10% of net
worth with investment not to exceed $50,000 per individual or $100,000 per
business entity [state approved]
• Integrated existing federal securities exemptions, e.g. accredited investors
• Up to 35 persons or entities not meeting above requirements
• Exempt cooperatives from public financial reporting requirements provided:
1. Equity or debt of cooperative is not publicly traded; and
2. Cooperative reports annual and quarterly financial information to its members.
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ALTERNATIVE FEDERAL
POLICY/LAW CONSIDERATIONS
4. Provide For Equity Liquidity By Authorizing Transfer and
Exchange of Equity Interests.
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For traditional cooperatives nonpatron (former patron) patronage
equities are growing portion of cooperative equity.
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Patronage equities should be transferable to third parties at ordinary
gain or loss based on issuance allocation amount.
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Cooperatives should be allowed to redeem patronage equities that are
more than three years old without tax consequences to the cooperative.
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Federal law should authorize one or more exchanges for debt and
equity (including patronage equity) instruments of cooperatives and
producer controlled entities.
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NASDAQ and NYSE type exchanges are not a fit for cooperative
and producer controlled entities.
–
Internet technology and defined equity and debt instruments would
allow cooperators and agricultural producers to transfer equity and
debt instruments at modest costs.
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SUMMARY
•
Eighty years ago federal law/policy institutionalized cooperatives on a
producer member, commodity marketing, income based model with
little or modest capital needs. Current federal law/policy serves that
business model very well.
•
Capital needs of cooperatives and liquidity needs of cooperators as
well as the desire for blended income/growth business model has led
cooperators to seek alternatives to cooperatives because the federal
restrictions on cooperatives and their members do not justify the
limited benefits. From a tax perspective the LLC and PIC Coop
single level tax and capital gain on sale of assets is more desirable
than the limited, patronage source deduction and ordinary income
treatment of gain on sale of assets.
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Federal law/policy should focus on a cooperative income/growth
business model that will benefit rural communities. Meaningful
structural benefits will stimulate economic growth and broaden
participation of rural populations and business in cooperatives.
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