Entity Formation Basics: The Cooperative
Strategic business planning should involve thoughtful consideration of what form of business entity to use – whether a C corporation, S corporation, limited liability company (LLC), partnership, non-profit, or some other type of business entity.
This post is about one useful form of business entity that is frequently overlooked by business advisors and attorneys – the cooperative!
A cooperative or “co-op” is a type of legal entity that is distinguishable from standard, for-profit corporations, LLCs, and partnerships. Co-ops offer a flexible business model that can be used by any group of people who are interested in creating a democratic decision-making company that benefits all members. In other words, co-ops strive to be patron- or member-oriented, rather than investor-oriented like traditional corporations or LLCs.
At their core, co-ops are formed by a group of people who either work or shop there (a brewery co-op or a food co-op), use its services (a credit union or health insurance co-op), or product goods and items for it (a food producers co-op). Co-op members are not to be held liable for any debt, obligation or liability of the co-op.
The International Cooperative Alliance, a global membership association of co-ops and co-op support organizations, has established Seven Cooperative Principles including Democratic Member Control and Concern for Community, among others.
The “common purpose” of individuals wishing to form a co-op can include a number of things, including employee-ownership, group marketing, or group purchasing. Some of the most nationally well-known co-ops include Ace Hardware and REI, as well as dozens of successful agricultural co-ops such as Land-O-Lakes, Sunkist, and Ocean Spray.
Today, artist and freelancer co-ops are becoming more common due to the rise of the “sharing economy” and the realization of individual artists, photographers, software developers and other freelancers there can be great benefits to pooling resources, infrastructure or ideas.
Colorado cooperative law has developed cumulatively over more than five decades.
Today, a standard co-op should be formed under Article 56 of Title 7 of the Colorado Revised Statutes. Article 58 contains the “Colorado Uniform Limited Cooperative Association Act”, recently enacted in 2011. Also, Article 33.5 of Title 38 is a special Colorado code section for housing co-ops.
Interestingly, Colorado law explicitly prohibits the ability to use the word “cooperative” or any abbreviation or derivation of as part of your business name, trade name, trademark or brand unless you are actually formed as a co-op under these statutes, so be careful if you are loosely using the term “co-op” or “cooperative” in your business!
Under Colorado law, co-op members and those on a co-op’s Board of Directors are protected from personal liability from the activities of the company, similar to corporations and LLCs. Co-ops are also allowed to limit membership only to persons engaged in a particular business, persons who will use the goods or services of the co-op, and other membership conditions stated in the co-op’s Articles of Incorporation or Bylaws. Because they are so member-oriented, Colorado law requires a co-op to keep detailed membership lists with contact info.
Under the newer Limited Cooperative Association Act, a co-op can have investor members who do not participate as much in the common purposes of the company. This kind of co-op would have “patron members” who fully own and participate in the co-op and “investor members” who participate in the co-op on a more limited, financial basis.
Because the Article 58 was designed with maximum flexibility in mind, a co-op’s Bylaws and Membership Agreements can set forth all kinds of rules and arrangements for the patron members and investor members as far as how the company is run, how patron member votes versus investor member votes are counted towards certain decisions, and how allocation and distributions are made to these different kinds of members.
Cooperatives and Securities Laws
Both Articles 56 and 58 state that any unit or evidence of a membership interest in a co-op is exempt from the Colorado Securities Act or our state’s “Blue Sky” laws. This means a co-op can offer and sell its membership interests without needing to registered as a broker-dealer, unlike the ownership in a corporation or an LLC. This takes a lot of legal headache and expense away from co-ops who are looking to have dozens or even hundreds of members.
Nevertheless, if your co-op needs to raise a lot of capital and wants to do so by securing many membership fees or contributions, we strongly recommend this is done through a Regulation D private placement offering under the federal Securities and Exchange Commission’s (SEC) rules.
Worker co-ops (i.e., employee-owned companies) are gaining traction like never before as the socially-conscious business movement and sharing economy continue to gather momentum.
The common purpose of the worker co-op is each member’s livelihood – their job and income – as it relates to the success and sustainability of the company as a whole. In a worker co-op, the employees democratically control the management and operations of the company, with each employee-owner having an equal vote.
Generally, this means that all employees, no matter their salary, job title, or years of employment, are entitled to one vote per person on all matters brought before the membership of the company. However, this does not mean all employees have to be involved in every company decision. A worker co-op should still have a Board of Directors, and can also have other officers (for example, a President or a CEO) to set policies, manage day-to-day operations of the company, and determine when important decisions should be put to the members. Of course, the members vote for who is on the Board and can also vote for who the President or CEO is to be.
Taxation of Cooperatives
Co-ops have unique income tax structures governed by Subchapter T of the Internal Revenue Code. This tax structure is similar to partnership taxation, but with some different terminology. Profits of a co-op are called “net margins”. The members of a co-op are deemed “patrons”.
Under Subchapter T, net margins are not taxed a the co-op level, but are instead allocated to the patrons on an annual basis similar to a partnership distribution. Unlike a partnership distribution however, co-op allocations are based on a patrons use of the co-op rather than their investment. For example, in an agricultural co-op, if Farmer A uses 3,000 acres of the co-op’s land and Farmer B uses 10,000 acres, Farmer B had more “patronage” of the co-op and should expect a larger allocation.
Subchapter T states at least 20% of the allocation to a co-op’s patrons must be in cash. The remaining 80% can also be distributed in cash, or in can be retained on the books of the co-op as “patronage equity”, to be redeemed sometime in the future. Consequently, patronage equity allows a member of a worker co-op to build personal assets and net worth by having an equity account that can be redeemed when he or she retires or leaves the company.
Each patron should receive a Form 1099-PATR from the co-op every year reporting the allocation (both cash and non-cash). Then, each patron is responsible for paying his or her own income taxes based on the reported allocation.
If you would like to form a co-op or have a question related to an existing co-op, contact our offices today!