Riezman Berger P.C. Explains the Missouri Cooperative Associations Act

Missouri Cooperative Associations Act: Flexibility for the Modern Cooperative

On August 28, 2011, the Missouri Cooperative Associations Act (the “Missouri Act”) goes into effect. The Missouri Act was developed to create greater flexibility in the design and operation of cooperatives, so that those businesses which want to come together and operate in a cooperative format can do so in the most competitive manner. The concepts incorporated in the Missouri Act resolve many issues that have arisen in day-to-day cooperative operations, building on the strengths of the cooperative structure, while addressing the weaknesses in many state statutes that have limited the development of cooperatives. The timing of the Missouri Act is particularly relevant given the need and push in this country to develop new, competitive independent businesses. Cooperatives foster independent businesses while allowing such businesses to come together in a collaborative manner to take advantage of opportunities that would not otherwise be available to the typical independent business operating alone.

Riezman Berger, P.C., a law firm with over twenty five years of experience representing cooperatives, worked in close conjunction with one of the largest cooperative organizations in the United States, to identify the real world issues cooperatives face in today’s business environment, and the Missouri Act is the result thereof.

The Case for Cooperatives

A cooperative association is an alliance of persons and entities working together for their mutual benefit. One of the most prominent features of a cooperative is the fact that each member is in fact an owner and has say in the direction of the cooperative as a whole, while at the same time retaining control over the member’s own business. Unlike a franchise system, where a third party may dictate to a business its entire business operation, in a cooperative, the members themselves dictate the direction of the cooperative. In addition, cooperatives have certain statutory benefits (not a franchise for Federal franchise registration purposes, a cooperative is entitled to take a deduction for patronage dividends paid to its members, and is exempt from certain antitrust provisions) and cooperatives offer businesses with like interests an important vehicle for offering their members products and/or services which allow the members to better compete in the marketplace, all without requiring a member to give up its independence. Unfortunately, there remains a lack of understanding of the day-to-day workings of cooperatives, and much of the law on the operations of cooperatives is old and not reflective of modern business. Further, much of the law which has developed relates to the conditions under which a cooperative could receive the benefits of Subchapter T of the Internal Revenue Code. Compliance with the Internal Revenue Service’s requirements were necessary before the advent of “check the box” and limited liability companies but in the world today, much of what is achieved through Subchapter T can be accomplished through other structures. The Missouri Act was drafted so as not to lose the non-tax benefits of cooperatives while still developing a modern cooperative that can take advantage of the theories of modern business structure and law.

Fundamentals of Cooperatives

Cooperatives are founded on three main principles (1) subordination of capital; (2) democratic control; and (3) operation at cost. The Missouri Act maintains these fundamentals but also recognizes the needs of the modern cooperative.

Subordination of Capital. “Subordination of capital” requires that control of the cooperative and ownership of the pecuniary benefits arising from the cooperative’s business remain in the hands of the member/patrons of the cooperative rather than with non-patron equity investors in the cooperative;” and accordingly, “to be operating on a cooperative basis, a cooperative must limit the financial return with respect to its equity capital.” This has proven quite problematic for cooperatives seeking to raise capital. Taking into account that cooperatives are required to pass along almost all profits to the members pursuant to the “operation at cost” criteria, institutions are often reluctant to lend to cooperatives due to the cooperative’s inability to provide acceptable security. Further due to the IRS regulations, equity investment in cooperatives must be limited, thus leaving cooperatives with few options to raise capital.

The more modern cooperative acts have recognized that a cooperative may need to bring in outside investors. Likewise, the Missouri Act offers cooperative associations the option of accepting equity investors as non-patron members on the terms and conditions authorized by the Board of Directors or as otherwise set forth in the articles or bylaws. The Missouri Act does require that patron membership interests shall hold not less than 50% of the financial rights of the cooperative but permits the cooperative to provide otherwise in the bylaws or articles. The Missouri Act also allows the cooperative to divide the authorized membership interests into classes or series, which may have different distribution rights, preferences, and/or voting rights. This option gives cooperative associations the opportunity to tailor the membership classes, thus enabling the acceptance of a silent or semi-silent investor class, with a preferential right to distribution.

Outside investment can be instrumental for start-up cooperatives, as well as cooperatives seeking to expand their operations. Accepting outside investors also allows a cooperative to distribute a greater amount to its members, due to its resulting ability to retain fewer dividends for operational reserves.

Democratic Control. “Democratic control” is “typically achieved by voting on a one-member, one-vote basis.” While even the IRS has recognized that some deviations from the one-member, one vote basis may be permitted without changing a business’ characterization as a cooperative, traditionally the IRS has ruled that “Each member must have a single vote regardless of size of its investment or the amount of business it does with the corporation.” That one member, one vote concept, while fundamentally sound, does not create the flexibility that the marketplace has been pushing for; that is the ability to have members vote based upon the business which each member does with the cooperative. This is no different than a partnership where the partners vote based upon their ownership interest in the partnership, which often is based upon the amount of money invested in the partnership. Certainly, the one member, one vote dictate has often made it more difficult to get larger members to join cooperatives as such a large company has exactly the same vote as a member doing little business with the cooperative.

The Missouri Act allows cooperatives to choose which method of voting better furthers the cooperative’s goals and operations. Specifically, the Missouri Act allows for cooperatives to choose the method of voting by members, being either (i) the “one member, one vote” concept, or (ii) on the basis of a member’s patronage done with or for the cooperative. While straying from the one-member, one vote method of voting may adversely affect a cooperative’s ability to qualify for Subchapter T treatment, the Missouri Act allows a cooperative to choose to be taxed as a partnership, thus offering a comparable substitute to Subchapter T treatment without many of the restrictions imposed by the IRS on a cooperative in order to qualify thereunder.

Operation At Cost. The theory of “Operation at Cost” is related to “the proportionate vesting in and allocation among the worker-members of all fruits and increases from their cooperative endeavor…” and means that a cooperative’s net earnings or savings must be distributed to the members based on patronage. The Missouri Act provides for the allocation of the cooperative’s profits and losses, which will be distributed on the basis of patronage, unless the Board states differently, and the distribution of the cooperative’s cash and other assets, which will be based on the number of membership interests owned by each member in relation to the total number owned by all members, which may be determined differently in the articles or bylaws. In either case, patron members must receive no less than 15% of the total allocation or distribution in any year.

Operating at cost, however, often allows cooperatives little room to establish reserves for costs other than those related to operating expenses. The Missouri Act expands a cooperative’s right to retain dividends for the creation and/or maintenance of a capital reserve by setting aside amounts for promoting and encouraging the cooperative, as well as a cooperative’s right to retain that portion of the annual net income to meet the upcoming and ongoing capital needs of the cooperative. Also, cooperatives are authorized to establish and accumulate reserves for the advancement of the cooperative’s business purposes, which may be any lawful purpose that aids, assists or is beneficial to the cooperative. Unlike many other state cooperative statutes, this provision affords the cooperative an opportunity to expand into new lines of business in order to further the enterprise of the members, without necessarily seeking outside investors.

Specific Concepts Incorporated in the Missouri Act

Tax Treatment. Pursuant to the Missouri Act, a cooperative has the option to choose between being taxed as a corporation or as a partnership. While this is actually not a state law issue, the Missouri Act specifically acknowledges that electing to be taxed as a partnership does not prevent the business from being a cooperative. Under the Missouri Act, cooperatives have the flexibility to be taxed: (i) as a corporation enjoying the benefits of Subchapter T of the Internal Revenue Code, (b) as a partnership, taxed under Subchapter K, or (c) as a corporation taxed under Subchapter C. Cooperatives electing to be taxed as a partnership under Subchapter K of the Internal Revenue Code will potentially be able to pass through income, both patronage and non-patronage, to their members, and bypass the requirements of Subchapter T. Given the popularity of pass-through entities, many new cooperatives will likely avail themselves of the opportunity to be taxed as a partnership.

Authority. Cooperatives are authorized under the Missouri Act to perform all acts necessary or proper to the conduct of the cooperative’s business as an agent of the members, including the negotiation for and procurement of all goods, services and programs provided to the members, however the cooperative will not be liable for the failure of the members to perform or pay under any contracts, without an affirmative acceptance of such responsibility. This allows cooperatives the freedom to act in the members’ best interest with respect to the negotiation for and procurement of goods and services, without requiring involvement by the individual members.

Governance. It has long been recognized that “democratic control” is satisfied with the election by the members of a board of directors which is responsible for the decision making of the cooperative. The Missouri Act codifies that and makes it clear that the board of directors of a cooperative has the legal power and right to govern. The Missouri Act permits a cooperative’s directors to be elected in classes (but it is not required). Directors do not need to be members, but a majority of the directors shall be elected by patron members, unless otherwise set forth in the articles or bylaws. For cooperatives not taxed as a partnership, each director is allowed one vote on each matter, and voting may be allocated according to allocation units and/or equity classifications. Additionally, unless otherwise set forth in the articles or bylaws of the cooperative, at least 50% of the voting power on the cooperative’s general matters must be allocated to directors which were elected by patron members.

Outside Management. Many cooperatives are actually run under a management contract with a company that has experience running cooperatives. The Missouri Act specifically codifies that reality and allows a cooperative association the option to choose whether to permit a manager to provide management services to the cooperative.

Unclaimed Distributions. Cooperatives are often faced with the dilemma of what to do with patronage dividends owed to members that have left the system and have gone out of business. This is particularly an issue upon the liquidation of the cooperative, where “retained earnings” are to be distributed to the members who have had patronage (whether in the current year or in past years). Under the Missouri Act, a cooperative which holds unclaimed patronage dividends may distribute the dividends to a tax-exempt organization, or retain the dividends for operational reserves, but only once a reasonable effort has been made to distribute the dividends to the member and the cooperative has received no response for a period of two years. This is in lieu of filing a report of unclaimed property with the Missouri Secretary of State.

Cooperative Exclusion. It is widely known that retailer-owned cooperative associations and cooperatives authorized by the Capper Volstead Act are specifically excluded from 16 C.F.R. 436, the Federal Trade Commission’s Rule on Franchise Disclosure. In furtherance of this, and to avoid any confusion, the Missouri Act specifically excludes cooperative associations formed thereunder from being deemed or construed as a franchise under Missouri law.

Cautions

The Missouri Cooperative Associations Act was not drafted to be automatically compliant with Subchapter T of the IRC, but was instead intended to act as a framework for cooperatives, outlining the possibilities for operation. To that end, many provisions are optional or amendable allowing a cooperative to form and operate in the manner best suited to it, as well as change operations as needed for the best interests of such cooperative. Cooperatives should be aware, however, of the possible ramifications of deviating from the requirements of Subchapter T, including but not limited to possible violation of the Capper Volstead Act, the Robinson Patman Act, and possibly the FTC’s Franchise Rule. Further, the equity (and perhaps debt) interests issued by a cooperative may be deemed to be a “security.” and advisors to cooperatives need to be sensitive to federal and state securities laws.

The Missouri Act is a modern statute giving cooperatives great flexibility in their structure, operation, and tax treatment. Those forming cooperatives under the new Missouri Act should fully explore their choices with capable counsel, and structure their entities to meet the needs of the cooperative business now and well into future.

Endnotes:

(1) PLR200224017
(2) Ibid. 
(3) “Wyoming Processing Cooperative Law”, Wyo. Stat. Ann. §17-10-201, et.seq.; “Minnesota Cooperative Associations Act” Minn. Stat. Ann. §308B.001, et.seq.; “Tennessee Processing Cooperative Law” Tenn. Code Ann. §43-38-101-1109, et.seq; “Iowa Cooperative Associations Act” Iowa Code Ann. §§ 501A.101–.1216; “Wisconsin Cooperative Associations Act” Wisc. Stat. Ann. §193.001, et.seq.
(4) PLR20062901
(5) Ibid.
(6) Puget Sound Plywood, Inc. v. Commissioner, 44 T.C. 305 (1965) at 308 
(7) Whether these new lines of business are patronage-sourced or non-patronage sourced has tax consequences that professionals providing guidance to cooperatives must take into account.