How Cooperatives Measure Earnings Affects Patronage Refunds
Patronage refunds are one of main differentiating factors between a cooperative business and a regular corporation or other business entity. One of the major parts of the statutory definition of a patronage refund is that it is determined by the net earnings of the cooperative. The statutory definition, does not, however, state whether those net earnings are determined by federal income tax or financial accounting rules.
Based on my experience, the method used to determine net earnings has been based on the region of the country that the cooperative is located in and size of the cooperative. In recent years, cooperatives have begun to review their method for determining net earnings in the hopes of taking full advantage of tax breaks and still providing a fair and equitable return to their members.
Two approaches to measuring earnings
Financial accounting and tax accounting have different goals; consequently they measure earnings differently. Financial accounting is oriented towards the long-term and attempts to present a basically accurate historical picture of a coop’s economic position. A tax approach can take advantage of some of the federal tax code’s incentives, but may somewhat distort a coop’s financial picture. In the short term, it can also affect patronage dividends.
Over recent years, accelerated depreciation and the Domestic Production Activities Deduction (DPAD) have provided opportunities to reduce taxable income without reducing financial income. Other items, such as non-qualified deferred compensation, bad debts, life insurance, and meals also create differences between taxable earnings (tax approach) and financial net earnings (accounting approach). When there are large differences between tax and financial net earnings, the net earnings allocated to members will also vary.
Accounting approach affects current and future members differently
The following example will help demonstrate how the accounting approach can affect coop members.
The Coug Cooperative is a tax basis patronage cooperative. It purchases a piece of equipment that qualifies for bonus depreciation for $5 million in 2016. In this year, using 50 percent bonus depreciation, its taxable net earnings will be $1 million and financial net earnings will be $3.5 million. Assuming 75 percent of net earnings are used as patronage refunds, the total amount available as a patronage refund for The Coug Cooperative as a tax basis patronage cooperative is $750,000, versus $2,625,000 if the cooperative paid patronage on a financial basis.
The financial and tax depreciation difference will equalize over time; however, imagine if you are a patron who retires in 2016. Essentially, your patronage refund was significantly reduced in 2016, and you will not see the benefit that asset brings in future years. Arguably, the wrong patrons can bear the full cost of items.
This is an example of a temporary difference that will impact current year members one way and future members another. On the other hand, DPAD is a permanent difference, which means it will only impact members that did business with the cooperative in the year the deduction is taken.
How we can help
There are many factors to consider when assessing whether net earnings for patronage refunds should be calculated using financial or tax rules. There are pros and cons to both the tax and financial patronage bases, so the decision making process can be quite complex. Above all, the cooperative should always do what is in the best interest of the patrons. And to accomplish that goal, it’s also wise to consult with a knowledgeable advisor to help you understand all benefits and consequences of the different methods.