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Individual tax strategies
Nonqualified Patronage Distributions Provide Alternative for Coops
Cooperatives distribute member-based income to patrons in the form of patronage dividends. Historically, these took the form of qualified patronage dividends with a portion paid in cash and the rest paid in qualified equity credits. Subchapter T of the Internal Revenue Code has specific requirements for a distribution to be considered “qualified.” Once these requirements are met, the cooperative is allowed a tax deduction for the entire patronage distribution, and the patron typically includes the full distribution in taxable income.
Another distribution method may provide cooperatives an attractive alternative.
Nonqualified patronage distributions
Non-qualified patronage distributions do not meet the Internal Revenue Code requirements to be considered a qualified patronage distribution, typically because less than 20 percent of the total distribution is paid in cash. Instead, the full amount is allocated in equity credits to the patron. The cooperative does not include the patronage distribution as a tax deduction, and the patron does not include this amount in taxable income in the year of distribution. When the nonqualified equity is paid out in the future, the cooperative takes a tax deduction and the patrons include the amount paid in their taxable incomes.
The biggest difference between qualified and nonqualified patronage distributions is timing of cash flows and tax deductions. However, both maintain a single layer of taxation at the patron’s tax rate.
Potential advantages of nonqualified distributions
Depending on the percentage of the distribution that was paid in cash and the patron’s tax rate, patrons may see qualified distributions as a negative.
For example, consider the following situation:
- A patron is allocated a total qualified patronage dividend of $1,000.
- Subchapter T requires that a minimum of 20 percent is paid in cash, and the remaining $800 is paid in equity certificates, but the patron must pay tax on the full $1000 dividend.
If the patron pays tax at the highest individual rate of 39.6 percent, the patron would owe tax of $396, but only receive cash of $200 in the year of distribution.
Patrons are more likely to perceive nonqualified distributions positively because the cash received when nonqualified equity is paid out matches the amount taxed.
Evaluate tax rates for the cooperative and the patron
Depending on the situation, paying tax at the cooperative level may be more beneficial for the patron than paying top individual ordinary tax rates of 39.6 percent, self-employment tax rates of 15.3 percent, and a potential surtax of 3.8 percent on net investment income. Paying the typical corporate tax rate of 34 percent can be accomplished by issuing non-qualified distributions.
Other tax benefits to consider include accelerated depreciation methods and section 199 Domestic Production Activities Deduction (DPAD). In order for the cooperative to fully take advantage of these deductions and lower corporate tax rates, taxable income may need to be created at the cooperative level, which again can be accomplished through the issuance of nonqualified distributions. This then allows for some potential tax planning in future years should the need arise.
Potential problems with nonqualified distributions
The largest potential issue with nonqualified distributions is in the year of transition. The cooperative’s cash flow may be reduced because issuing nonqualified patronage provides no tax benefit, while at the same time, prior years’ qualified equity may continue to be redeemed again with no tax benefit. However, this can be remedied by utilizing DPAD and accelerated depreciation methods to offset the cooperative’s income tax or if the cooperative’s board limits the amount of prior years’ qualified patronage that may be redeemed in cash in the year of transition.
Educate board and patrons
Educating patrons is essential if cooperative leadership makes a change to nonqualified patronage distributions. The good news is often nonqualified distributions are easy to explain because the timing of cash receipts matches the timing of inclusion in taxable income for the patron. However, it is essential that the patron’s tax preparers and accountants understand the difference between qualified and nonqualified patronage distributions.
Nonqualified distributions are one more tool for cooperatives to use that may benefit for both the cooperative and the patrons. However, each cooperative has unique circumstances, and so do its patrons. Very often the conversation about nonqualified distributions begins with a discussion with professional advisors during the development of an equity management plan. Many times qualified and nonqualified distributions are used together to properly manage equity, cash flow, and income taxes. It is important that the cooperative board and management understand these aspects of the IRS Code to be able to fully utilize all the tools available to maximize benefits for the patrons and cooperative.