Unit III: Financing and taxation

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Unit IIIFinancing and taxation

• Bob Cropp
• Fall 2007

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Basic principles of financing cooperatives

• Capital should be subscribed in relation to
  patronage
• Member-patrons should invest in their co-op an
  amount sufficient to make them realize that they
  have a financial stake in the co-op.
• At least 50 of the capital should be provided by
  members (member-equity)
• Member-patrons should provide all of the
  operating capital, at least at its lowest point
  in the business volume.
• Ownership capital should be vested with active
  patrons.

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Two distinctions between cooperatives and
non-cooperatives

• Equity investments (non-debt) by members are made
  for the purpose of providing capital for the
  cooperative, the benefits of which are received
  through patronage. Unlike non-cooperatives
  members do not seek a return on investment
  through dividends based on ownership of stock or
  a return on investment from sale of appreciated
  equity.
• The level of investment. In non-cooperative the
  levels by investors are governed by an investors
  desire and ability to invest. In a cooperative
  investment is a burden on members.

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Logic that member investment should be in
proportion to business conducted with the co-op

• Financial contributions are a burden upon
  members.
• Members can only receive benefits from co-op in
  proportion to patronage.
• A greater financing burden should be borne by
  those who use the co-op more and thus realize
  more benefits from the service their investment
  supports.

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Two types of capital

• Equity capital
• Debt capital
• What is the difference?

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Three unique features of equity capital in a
cooperative

• Both members and non-members can hold equity
  capital
• Net income (profit, net margin, net savings)
  returned on basis of patronage and not
  investment.
• Equity redeemed at book and not face value.

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Direct investment

• Cash purchase of common stock, membership
  certificates (fees)
• May be a membership requirement
• Major source of new generation/value-added co-ops
• Advantages
• Only available option to start a co-op
• Provides a critical test of member interest and
  commitment
• Assures co-op has proper level of equity
• Allows greater cash returns
• Disadvantages
• Limited appeal because of difficulty in measuring
  return
• No capital appreciation/depreciation
• Thus, may be difficult to get members and
  non-members to invest

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Differences between co-op and non-co-op

• Holder of common stock in a non-co-op are called
  stockholders or shareholders. Holder of common
  stock in a co-op, while they are stockholders,
  are called members.
• While ownership of common stock gives rights to
  voting power, in a non-co-op its is one-vote per
  share of stock and in a co-op one vote per
  member.
• In non-co-op stockholders have a claim of the
  corporations income after the corporation
  satisfies its obligations to more senior
  investors such as debt-holders and holders of
  senior equitythat is a dividend. There is no
  limit on return. In a co-op, most dont pay
  dividends, if due most state laws limit it to 8
  percent

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Continued

• In non-co-op transfers of common stock is not
  restricted. In a co-op common stock maybe
  transferred only with the consent of the board of
  directors and then only to person eligible to
  hold it.
• In a co-op, common stock is redeemed upon
  termination of membership because it is evidence
  of membership.

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Retained patronage refunds

• New investments made by those who patronage the
  co-op
• Advantages
• Easy and systematic method of generating equity
  capital
• May encourage non-members to become members
• Members can earn their way into the co-op
• Well suited to supply and service co-ops where
  capital retains dont work well.
• Disadvantages
• Dependent on adequate net income generated
• Members may not associate that this is their
  investmentrather a debt co-op owes them
• Since no interest/dividend or definite repayment
  boards/management may make un-wise investment
  decisions

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Per unit capital retains

• Patron investment in a co-op based on volume of
  business of each member.
• Advantages
• Not affected by level of net income
• Easily administered
• Disadvantages
• May be viewed as a price decrease (marketing
  coops) or price increase (supply co-opshowever,
  doesnt work well for supply)
• Less pressure on board/management to generate net
  income???
• Cash otherwise available to members reduced.
• Often viewed by members as a co-op debt to
  members.

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More co-ops going to non-qualified allocation

• Pay out larger share on net income as cash in
  year earned.
• May or may not ever redeem the retained.
• Co-op pays income tax on retained partif and
  when paid out, co-op gets tax credit and member
  pays tax.

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Advantage of un-allocated equity

• Minimizes adverse impact on members of possible
  operating losses
• Creditors like itpermanent capital
• Disadvantage of un-allocated equity
• 1. Principle of operating at cost violated
• Ties between member and co-op eroded
• If too large, question as to who really owns the
  co-op
• Equity distribution in liquidation difficultmay
  be distributed according to past patronagebut,
  difficult to trace prior members.
• Reduces the members realized return on
  equitynever paid back unless liquidation

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Preferred stock and equity from non-members

• Preferred stock, unless declared non-dividend
  bearing, has a dividend rate that must be paid
  before other returnspatronage refunds
• Can get preferred stock from
• Retained earnings and converted
• Sold directly to public
• - CHS Inc. offered 50 million---8 annual
  dividend
• - CROPP Co-op---5 million

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Sources of debt capital

• CoBank
• National Cooperative Bank
• Commercial banks
• Sale of bonds
• Regional co-ops
• Member notes

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How do members measure the returns on their
investment in a co-op?

• The decision to do business with a co-op differs
  from doing business with an IOF
• If I do business with a co-op, I also have to
  invest in the co-op
• If I do business with an IOF, I dont have to
  invest or I can invest and not do business.
• This make managing a co-op harderneed to have
  competitive prices/services plus adequate returns
  on capital

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Creating returns Investment decisions in a
co-op

• The need for effective decision making
• - Assets are the key to creating strong
  recurring stream of returns to members.
• - The asset portfolio should exhibit the
  following characteristics
• Producer competitive products and services
• Result in value-added activities
• Attract member and lender interest (assets
  have predictable returns)
• Investment decision making methods
• - Evert asset invested by a co-op should result
  in a stream of positive cash flow returns
• Continued

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- Need to calculate a cash return on
investment - Need to calculate a payback
period

• - One simple measure of return on invested
  assets is Net Present Value (NPV)
• - NPV considers the time value of money---a
  dollar today is worth more than a dollar 5 years
  from now.
• - NPV expresses future cash flows in terms of
  current dollars
• - Example
• The co-op is deciding whether to invest in a
  new grain dryer. It costs 1,000 and is projected
  to yield a cash flow of 600 a year for three
  years.
• Discounting at 12 cost of capital
• Time 0 Yr. 1 Yr.
  2 Yr. 3
• (1,000/1) 600/1.12
  600/(1.12) 600/(1.12)
• Results (1,000) 536
  478 427
• Sum (NPV) 441
• If the cash flow was 333, the NPV sum (201)

3333
2
3
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Does the investment create value to members?

• If NPV is positive, cash inflows (benefits) in
  current dollars exceed cash flow (spending) in
  current dollarsvalue is created.
• If NPV is negative, cash outflows in current
  dollars exceed cash inflows in current
  dollarsvalue is destroyed

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Other measures of investment decisions

• Internal rate of return (IRR)
• - Calculates the discount rate that makes NPV
  0
• - With NPV we know the discount rate
• - If IRR 18, that is an interest cost of 18
  required to get NPV to 0, and the cost of money
  is 9, clearly a good investment if IRR is 5,
  not
• Returns on equity Net income divided by total
  member equity

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However, a difference between a co-op and an IOF.

• An IOF will make an asset investment decision
  based on a positive NPV
• A co-op may still invest if NPV is 0, if member
  level returns are positive
• Thus, a co-op unlike an IOF has a two-step asset
  investment decision
• Is NPV zero or positive at the co-op level
• Is the NPV positive at the member level
• However, a co-op cant afford too many 0 NPV
  investments and expect to generate adequate net
  margins to maintain and grow the co-op.

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Guidelines for co-ops to follow to demonstrate to
members good returns on member equity

• Co-ops should attempt to create a significant
  amount of returns at the co-op levelallows the
  co-op to pay out higher percentage as cash
  patronage and/or dividends
• Co-ops should generate more of their returns from
  activities not subject to free-rider problembut,
  this is difficult
• Co-ops need to benchmark their performance
  against the best competitors
• Co-ops should scrutinize closely any investments
  made solely on the basis of service
  differentials, the value of existence, or the
  value of risk reductionthese are hard to measure
  as member benefitsso in addition, need strong
  bottom line
• Continued

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But, almost contradictory, co-ops financial
performance cant be measured solely on the
basis of financial statements. If co-op acts
only on the basis of co-op level of returns, they
will make the exact same decisions as
IOFspossible good returns, but not meeting
member needs.

• Co-ops need to deal fairly with members as
  investors and as patrons

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A typical problem of co-ops
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Decisions by the board

• Patronage refunds, dividends, or un-allocated
• - Patronage refunds can be based on dollar
  volume or physical units
• - Patronage refunds on one pool (netting) or
  multiple pools
• - Dividends limited to 8
• - Can use dividends to return to members income
  earned from non-member business
• - pay dividends to over-invested/retired members
• - Un-allocated incomegood use of non-member
  business
• - General rule Board should maximize patronage
  refundsfulfills service at cost principle

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2. Qualified or non-qualified

• - Non-qualified, co-op pays income tax
  qualified member pays income tax (20 must be
  paid in cash in year earned)
• Cash versus retained
• - Decision 2 is part of this
• - Higher cash encourages patronage, but might
  compromise
• co-ops financial strength lengthen redemption
  period

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Summary of Impact of these 3 decisions
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Continues
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Equity Redemption

• Equity redemption is returning cash to
  member-patrons who have previously invested.
• Failure to redeem systematically the equity of
  inactive or over-invested members means that
  these past members bear the burden of financing a
  co-op for services they do not usea violation of
  cooperative principles.
• Failure to redeem equity reduces the realized ROE
  of members
• Board are torn between requests for redemption by
  past/inactive members and the need for equity to
  support and grow the co-op and to pay out good
  cash patronage refund.

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Co-ops need to have an equity redemption plan
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Continued

• Will the co-op have the cash flow and financial
  stability to sustain the plan?
• Can the plan be sustained given the redemption
  practices of the federated co-op?
• Does the plan meet requirements of the lender?
  Retirements reduce the cash available for loan
  repayment.
• Bottom line No plan can be sustained unless the
  co-op generates adequate net profits.

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Base capital plan continued

• In a pure base capital plan the co-op determines
  equity obligations annually based on the co-ops
  need for capital and on the members use of the
  co-op
• For example, if a member does 5 of the co-ops
  business, the member is obligated for 5 of the
  equity capital needs.
• A modified base capital plan (targeted base
  capital plan)
• - Option of investing upfront and thereafter
  receive 100 of patronage in cash, or
• - Have the co-op pay 20 of patronage refund in
  cash and retain the 80 until target is reached.
• - Fully or over-invested members may sell at a
  discount their equity to an under invested member

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Advantages

• Fulfills the co-op principle of investment
  proportioned to usethus, equitable
• Enable the co-op to alter equity requirements to
  meet changing needs.
• Disadvantages
• Burden on new members to come up with their share
  of equityreason many co-ops use targeted base
  capital plan.
• Board of directors may be reluctant to increase
  equity requirementeasier to lengthen retirement
  period
• Doesnt work well with high member turnover

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Allocation of equity to accounts receivable
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2006 survey of IA, MN and WI co-ops
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Percentage of equity held by active and past
members and outside investors
2006 survey of IA, MN and WI co-ops
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Years of revolvement ability to consistently
maintain that period
2006 survey of IA, MN and WI co-ops
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What some co-ops are doing with equity

• Discounting Knowing that they will have
  difficulty in redeeming equity on time, they are
  asking members/past members to receive an equity
  pay-out at a discount.
• Going to more un-allocated equity or issuing
  non-qualified allocations.
• Are these appropriate moves for a co-op?

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Member Equity Allocation
2006 Survey of IA, MN, WI Co-ops
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Parking equity

• A past member with equity in the cooperative.
• Member has moved and left no forwarding address.
• Park the members equity.
• Since not redeemed, cooperative can keep the
  equity

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Another option for over-invested members

• Convert allocated equity to preferred stock and
  pay a dividend.

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The traditional revolving fund plan creates
problems for the cooperative

• Free Rider problem
• Horizon Problem
• Portfolio Problem

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Free Rider Problem

• This is the insider free rider problem
• New members obtain the same patronage and
  residual rights as existing members and are
  entitled to the same payment per unit of
  patronage.

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Horizon Problem

• Members right to receive a return on their
  investment in the co-op is shorter than the time
  they have investments in the co-opthat is, no
  longer doing business with the co-op, but yet
  have investment in the co-op that pays no return.
• Problem is caused by the lack of ability to
  transfer investment in the co-op.
• Puts pressure on the board to speed up equity
  redemption at the expense of retained earnings

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Portfolio Problem

• Caused by lack of transferability, liquidity and
  appreciation of equity.
• Members cant adjust their cooperative assets
  (investments) to match their personal risk
  preferences.
• Members investment decision is tied to the
  patronage decision.

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New Generation Cooperatives Minimize These Equity
Issues

• Up-front capital
• Members purchase marketing rights (shares)
• Members obligated to do business with the co-op
• Appreciable equity
• Transferable equity

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Summary What makes for a good equity program?

• Raises adequate equity
• Minimizes redemption
• Treats members fairly as to
• - Investment proportion to patronage
• Delivers sufficient cash to allow members to pay
  taxes (coop used for business purposes)
• Demonstrates a good return on equity
• Encourages a willingness of members to invest
  equity

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How can cooperatives treat losses?

• Charge losses to unallocated reserve
• Reduce a prior years patronage refund.
• - This reduces allocated equity
• 3. Charge losses to current members
• - Deduct amount from marketing proceeds
• - Charge individual member accounts or bill them
• 4. Carry losses forward as unallocated

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Taxation

• The net income of cooperatives is generally taxed
  according to the single tax principle.
  Established by Revenue Act of 1962.
• Subchapter T of the Internal Revenue Code applies
  to any corporate entity operating on a
  cooperative basis except mutual savings banks,
  mutual insurance companies, and electric and
  telephone cooperatives or Section 521
  cooperatives (exempt co-ops).

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Patronage refunds

• Patronage refunds are amounts paid patrons from
  the net income of a cooperative on the basis of
  quantity OR value of business done with or
  for the patrons under a preexisting legal
  obligation.
• The IRS incorrectly uses the term patronage
  refunds.

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Patronage refunds not considered by IRS as net
income of the co-op to be taxed is because

• In reality, the patronage refund is price
  adjustment to prices cooperatives paid patrons
  for products delivered to the cooperative for
  marketing or prices received for supplies
  provided to patrons.
• The retained patronage by the co-op are
  investments by the membership. This is similar to
  non-co-opswhen they investors purchase stock
  this is not considered earned income and is not
  taxed.

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Written notice of allocation

• A written notice to the patron the amount of
  allocation.
• Qualified allocation A written notice that
  qualifies for deduction from a co-ops taxable
  income

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Patronage refunds must be paid during payment
period for the tax year to make it eligible for
deduction.

• Payment period begins the first day of the tax
  year and ends on the 15th day of the 9th month
  after the close of the tax year (20 ½ months).
• Allocations after 20 ½ months do not qualify and
  must be reported in co-ops taxable income
• However, any CASH paid out after 20 ½ months must
  be included in the patrons taxable income.

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Later, if non-qualified patronage refunds
are redeemed, the co-op gets a tax credit and
the patron pays individual income tax.

• Here the co-ops tax in year the allocation is
  redeemed is the lesser of either (1) the tax for
  the current year after deducting the redemption
  from current income or (2) the tax for the
  current year without the deduction less the
  reduction in tax that would have occurred in
  prior years if the allocation originally had been
  issued qualified.

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Taxation at Member Level

• Patron does the following business with
  Progressive Co-op in 2005
• 5,000 fertilizer
  43.6 of business
• 2,000 Ag chemicals 17.4 of
  business
• 3,000 Feed 26.1
  of business
• 1,500 Home heating oil 13.0 of
  business
• 11,500 total business 100.0
• Co-op has net income of 4, pays 20 in cash and
  allocates as qualified 80
• Patrons share of net income is 4 X 11,500
  460
• Patron receives 20 in cash (92) and 80
  allocated (368)
• Patron includes for taxable income 87 (100 -
  13) X 460 400.20

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Taxing Per unit capital retains

• IRS views per unit capital retains differently
  than patronage refunds.
• The co-op can allocate per unit capital retains
  to patrons, if patron consents, and deduct 100
  from taxable income in year allocatedbut the
  co-op Is not obligated to pay 20 in cash.

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Subchapter T, section 521 Co-ops

• Also called exempt co-ops
• 521 co-ops can exclude from income non-patronage
  taxable income non-patronage income distributed
  to patrons on a patronage basis.
• - Includes non-patronage income and dividends
  paid on capital stock.
• Only applies to agricultural marketing or farm
  supply
• co-ops.

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To qualify as 521 status the co-op must

• 85 of co-ops voting stock must be owned by
  agricultural producers.
• Dividends on capital stock limited to 8 or state
  rate.
• Financial reserves (un-allocated equity) do not
  exceed a reasonable level.
• Co-op must conduct no more than 50 of its
  marketing business and no more than 50 of its
  purchasing (supply) business with
  non-membersbut, supply co-ops must not do more
  than 15 of its business with patrons who are
  neither members nor producers.
• Non-members must be treated the same as members

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Co-ops that are non-521 cannot deduct dividends
paid on capital stock from taxable income.

• Further, until tax law changes in 2003, IRS
  required that the amount of dividend paid be
  allocated between co-ops patronage and
  non-patronage business in proportion to the
  relative amount of patronage and non-patronage
  business done with the c-ops and the dollar value
  of dividends paid on the patronage portion be
  deducted from the co-ops net income available
  for patronage refunds.
• The 2003 IRS change now does not require the
  reduction of net income available for patronage
  refund by dividends paid.

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Taxation of Federated Co-ops

• A federated co-op can distribute net income in
  cash and qualified patronage refunds to its
  member local co-ops to avoid federal income tax.
• In turn, the local co-op can distribute this
  patronage refund to its member-producers
• Thus, all net income for member patronage can be
  passed through from federated to local to local
  member-patrons on the basis of cash or qualified
  patronage refund.
• If both the federated co-op AND its local member
  co-ops are 521, dividends paid are also deducted
  from taxable income

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Other Taxes

• Most co-ops pay some tax because of
• Non-member or non-patronage business
• Sales taxes
• Payroll taxes
• Real estate taxes

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Taxation of other cooperatives

• Subchapter T, Section 501 exempts from federal
  income tax net income from patronage of credit
  unions, mutual insurance associations, rural
  telephone and rural electrics.
• Consumer co-ops are taxed similar to agricultural
  coops except they are not eligible for Section
  521, but they can deduct patronage refunds and
  consumer-patrons do not include either cash or
  patronage refunds ad taxable income.