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Tax Advantages of Selling to a Worker Cooperative

Why Try a Worker Co-op

Business owners should think carefully and develop a strategic plan for exiting a business. You, the business owner looking to sell, can leave your business by selling it to family members or third parties, merging it into a larger organization, selling it to employees through an employee stock ownership plan (ESOP), or by simply closing up shop. However, one often overlooked method that business owners, especially small to medium-sized business owners, might consider is having the employees form a worker cooperative. You can then sell the business to the cooperative with some possible tax advantages.

The benefits from this type of exit strategy are numerous. For the employees, a purchase of the business would mean job stability, more control over their careers, higher morale, and usually better productivity. unlike an ESOP, where the employees are simply beneficiaries of a trust holding their stock, with little management authority, in a worker cooperative the employees can directly operate the business. Through year-end distributions of net margins, the employee-owners build up equity accounts that act as their retirement nest egg.

Also, unlike an ESOP, there are no added administrative costs in forming or maintaining a worker cooperative and the regulatory environment

is much less strict. A cooperative is a business model, not an ERISA regulated retirement plan, and therefore it is governed by state incorporation statutes and federal tax statutes.

Selling to a worker cooperative is a business exit strategy that ensures your business will continue, while also providing the seller with compensation for creating and growing the business. If the sale to employees is completed over a number of years, you could continue with management and training until the sale is finished. Note that not all the employees of a company have to become member/owners of the worker coop. But for those who choose to become owners, they can be trained in the responsibilities of ownership and management, giving you assurance that the company will continue as planned. The sale of the company to the employees can take place on a designated date or over a substantial period of time (such as five to ten years). This would allow the employees or the co-op to pay the entire purchase price over several years, often out of net profits. Rhere is the possible favorable tax treatment for you, the selling owner under internal revenue code §1042 (26 u.s.c. § 1042).

Section 1042 Tax Treatment

Code §1042 allows you to sell your stock to a worker cooperative with resulting favorable tax treatment. To qualify for the favorable treatment under §1042, the proceeds from the sale of your interest in the company must be reinvested in a “qualified security,” and the gain then is deferred indefinitely.  In other words, the capital gains that result from the difference between what you invested in the company and what you receive upon sale will not be taxed unless or until you sell the “qualified security” that you purchased from the proceeds of the sale.  And then the gain will be recognized as a long-term capital gain only to the extent that the amount realized on the sale exceeds the cost to the owner of the qualified replacement property (26 U.S.C. 1042(a)(3)).

For a very simple example, say you invested $100,000 in your company and over the years it has gained in value.  You sell the company to a worker cooperative for $1,000,000. You use those funds to purchase a qualified security (like Apple or Amazon stock). When those shares are sold in the future, the tax will only be on the difference in value relative to when you purchased the Apple stock and when you sold it.  If you don’t sell it and the Apple stock becomes part of your inheritance, there will be no capital gains tax liability to you or your heirs. If you have not used the §1042 advantages, then you will be required to pay capital gains tax on the $900,000

Specific requirements must be met before §1042 is available to you. To qualify for § 1042 treatment, there is a four-step process:

  1. The sale of the company’s stock must be to an eligible worker-owned cooperative or to an ESOP.
  2. The worker cooperative must own at least 30% of the total value of all outstanding stock, or of each class of outstanding stock, immediately after the sale.
  3. The taxpayer (either you or the cooperative) must file a written statement with the IRS consenting to the application of §§ 4978 and 4979A with respect to the owner or the cooperative.
  4. Your holding period with respect to the purchased qualified securities must be at least three 3 years (determined as of the time of the sale).

 

The first step is satisfied by the formation of a cooperative under Title 7, either Article 56 or Article 58, of the Colorado statutes.

The second step requires some financial planning on your part and the employees who will be purchasing the business. You have to look seriously at your employees and have lengthy discussions with them about potential ownership.  Not all employees may be capable or willing to become owners.  You may have to bring in a new person who will eventually replace you as the senior manager if you do not have personnel you believe can be trained to do what you do.  Then you must determine the value of the company, which may require the services of a business valuation professional. The employees will be required to find a way to purchase at least 30% of the business the first year of the sale. This may require the employees to obtain a loan or other funding sources for the initial payment. There are other financing options available, such as an owner carry-back, or the cooperative itself executes a loan for the 30% initial payment. The remaining 70% of the purchase price can be paid over a number of years, as determined up front by you and the new employee-owners.

The money you receive for the sale of the business must be invested in qualified replacement property for a minimum of three years. “Qualified replacement property” is defined in the Code, but the definition is a little cumbersome. Generally, it means any security issued by an active domestic corporation that is not issued by the company being sold and that does not have passive investment income in excess of 25% of the gross receipts of the corporation for the preceding tax year.

Codes §§ 4978 and 4979(a) concern tax on certain dispositions by cooperatives and generally provide that there will be a tax imposed if the cooperative sells the securities it purchased from the owner before the three-year holding period provided in step 4 above is concluded. Of course, a tax professional should be consulted concerning whether a §1042 election is appropriate or even warranted for your particular business.

Example

As a simplified example of how this might work, suppose that a company has ten employees and you wish to sell the company for an agreed-on value of $750,000. All of the employees wish to purchase the company from you (although it is possible to sell the company to fewer than all employees). The employees form a worker cooperative and purchase the entire company.

The employees purchase at least 30% ($225,000) in cash on the date of sale and the new cooperative signs promissory notes to you for the remaining 70%. You use the $225,000 to purchase qualified replacement property to be held for at least three years. You and the employees are now owners of the cooperative, each with one vote and each with the power to participate in the governance of the company. As part of the agreement between you and the new employee–owners, it could be provided that you retain certain management authority or a Board seat until more of the notes are paid.

Over a period of years (all as agreed), either the cooperative itself or the employees can pay for the remaining ownership interests. Payment can be made from net margins or by the employees making additional capital contributions, or by raising capital from non-member outside investors (e.g. through a private placement offering, a crowdfund offering, or a direct public offering).

Eventually, you are paid in full and can retire, knowing that your company will continue with owners that you have trained and who you believe will continue your legacy. The community has not lost a business and its tax base, the employees have job stability, and their families have the knowledge that a nest egg is growing in the company. When an employee leaves the company or retires, the cooperative can redeem his or her equity account over a period of time or all at once, as agreed by the employee–owners.

Conclusion

The worker cooperative is a flexible business model that can be used by any group that is interested in creating a democratic decision-making company that benefits the employee–owners with job security, a sense of pride, and possible retirement income. In today’s economy, many small business owners would like to retire or at least start planning their retirement. However, they may find that there are very few opportunities to sell their businesses to a third party, and family members may not want to continue the company. By using a worker cooperative model and selling your business to employees who have the knowledge and enthusiasm to continue to provide products or services, you can feel good about passing the business along to someone who cares.

Limited Cooperative Associations and Early Stage Financing

Cooperatives are the original social enterprise business model and Colorado is emerging as the “Delaware of cooperative law,” thanks in no small part to limited cooperative associations (LCAs), authorized by C.R.S. Title 7, Article 58. The limited cooperative association is a relatively new entity type, adopted in Colorado in 2010.  It offers a balance of flexibility, self-determination, cooperative identity and fundamental protection for the cooperative principles and economic structure. As of 2017, LCAs can also elect the protections and privileges of the Colorado Public Benefit Corporation Act.

LCA’s, like traditional cooperative corporations, are for-profit member-owned business structures that also subscribe and adhere to seven widely recognized cooperative principles.

Benefits

The cooperative and LCA model leverage certain unique theoretical and empirically proven advantages (see references one, two, and three), including:

  • Stickier relationship between user-customer-members and platforms
  • Greater user trust, based on data protection, user-member centricity
  • Higher success rate (lower failure rate) over long-term
  • Higher customer retention rate when ownership is shared
  • More resilient business models through economic cycles
  • Lower workforce attrition rates and higher employee morale
  • More stable governance
  • Alignment of interest between members and investors
  • Tax efficient as primarily pass-through entity for tax purposes
  • Leadership focused more on producing long-term value to co-op’s various stakeholders
  • Distributed capital and equity base creates motivated network of user-members
  • Stabilize and increase positive economic impact in communities
  • More transparent and democratic decision-making processes de-risks strategic maneuvers
  • Longer-term horizon and non-liquidity based options available for equity redemption and planning purposes

Investments and ROI

Like traditional corporations, public benefit corporations, or LLC’s, LCA’s can generate returns for investors.  LCA’s operate with pluralistic purpose, for the benefit of members, to generate a profit, and to tend to the interests of other stakeholders, including investors.  LCA’s distribute profit to their members on the basis of “patronage”; the value of goods or services contributed to or purchased from the LCA, and to investors based on the relative amount invested.  Subject to certain limitations, LCA’s can generate returns for investors based on profitability, distributions on profitable asset sales, refinancing, or through a liquidity event.  LCA’s, as member-owned and democratically-governed entities, seek to grow and operate sustainably for the benefit of their members, and thus do not set out with the objective of demutualizing or undergoing a liquidity event. Consequently, the primary mechanism for generating a return on investment is through sustainable operations and profitability.

 

Financing Examples

Traditional and mature cooperatives have tended to finance operations and growth using a preferred share that earns a target, non-cumulative, non-guaranteed dividend over a minimum holding period of between five to ten years.

More recently, multi-stakeholder start-up LCA’s have been using revenue-based financing mechanisms to raise capital, offering investors a return of up to a multiple of 1-5x the original investment, or a fixed percentage of profit for a fixed duration of time.  Once the cap is reached, the shares are treated as automatically repurchased. These instruments are sometimes called demand dividends.  Even Silicon Valley and New York VC’s are catching on to revenue-based financing and alternative business models as a way of helping to build a more sustainable and healthy business.

Non-exhaustive list of examples of seed-stage investment terms based on recent offerings.

Equity equivalent investment type:“Capped Return, Self-Redeeming”“Profit Share, Self-Redeeming”“Hybrid Profit Share – Capped Return”“Target Dividend”
Original investment (e.g.)$500,000$500,000$500,000$500,000
Return3x cap, no pre-set profit allocationX% of profit for 5-years.Greater of Cap or X% of profits for 5-years, with true-up within 90-days of 5-year anniversaryTarget 5-8% annual dividend (non-cumulative)
LiquidityPriority distribution of Cap, less prior distributions before any distributions to membersX% of positive proceeds after debt.Greater or Lesser of Cap or X% of positive proceeds after debt.Priority distribution of original purchase price plus declared but undistributed dividends.
RedemptionAutomatically redeemed at CapAutomatically redeemed as of 5-year anniversary, subject to true-upPut option at 5-year anniversary. Call option by Cooperative at any time.
Transferability/

Resale

NoNoNoNo
“Bandwidth” for realized ROIDiscretionary cash flowX% of profitGreater of discretionary cash flow or X% of profitAfter-tax net income

 

Creating the Workplace We Want

Management and operation of a law firm has taken many forms over the years and we are exploring new, innovative ways to run our firm. We are experimenting with the use of democratic principles, Teal, and self-management to develop a style that works for us and our clients. Earlier this week, Jason sent an article around to the team that highlighted The Wellington Community Law Centre (WCLC), a New Zealand law firm that went from a traditional hierarchical management system to fully self-managed in six months. Our firm has been discussing and implementing self-management techniques and it was inspiring and encouraging to read about WCLC’s journey. While reading the article I was tripped up by the reference to “advice process.” I had never heard the term before and we haven’t formally chosen a decision-making process to adhere to, so I did a little research. In a nutshell, advice process is an alternative to top-down and consensus decision making. Instead of executives or leaders making decisions, the employee who notices the problem or opportunity is empowered to act on that knowledge and becomes the decision-maker. The decision maker must seek input and advice from the relevant team members, leaders, and stake holders, but is ultimately responsible for creating a proposal and deciding what action to take. The process resonates with me because even as the least experienced member of our firm, I feel empowered to make decisions and suggestion for improving processes or creating new ones. I’m comfortable approaching the more senior attorneys to discuss my ideas and get their feedback and I’m able to pursue projects that interest me and be an active participant in my career development.

My favorite quote from Geoffrey Roberts, the general manager of WCLC, was, “When you treat people with high levels of trust, then they will live up to that. They will give you much more than you can imagine. Anecdotally, I argue that high levels of trust result in high levels of engagement and flexibility.” Perhaps more than anything else discussed, I feel that building trust is critical. For me, feeling trusted makes me feel like I can make mistakes and that I will get productive feedback that will help me grow as a lawyer. Having trust also means that I’m not afraid to come forward when I have made a mistake or to be held accountable for a decision I made. One way our firm fosters a trusting environment is through quarterly retrospectives. Retrospectives give us the chance to reflect on what is and isn’t working – they also help remove the negative connotations from accountability. Instead of accountability being scary, it simply becomes an opportunity to celebrate a win or learn from a decision that didn’t work out.

As a member of a law firm that is treading an unconventional path, I love seeing what WCLC has been able to accomplish. It gives me hope for the future of the profession and it’s nice to know our firm is in good company.

Choosing the Right Entity for Your Business

Last week our team held its first legal café at Green Spaces in Denver. We welcomed a group of approximately thirty entrepreneurs and discussed the nuances of entity choice. Our team was excited for the launch of what we hope will become a mainstay for the firm and a valuable resource for our community. We selected entity choice as our first topic because this early decision can often have far-reaching consequences for businesses. The right entity is critical for many aspects of the business, from protecting the social mission to attracting outside capital. Our hope is that we can help early stage entrepreneurs avoid the pitfalls of choosing an entity not well suited to their long term vision. To that end we created this presentation with an overview of entity types and strategies for choosing the right entity. Those who attended the legal cafe also had the opportunity to participate in an hour of small group Q&A with our team.

The event exceeded our expectations and our team is looking forward to hosting future legal cafes that provide useful information to entrepreneurs at all stages of developing their business.

Electing Public Benefit Corporation Status as a Limited Cooperative Association: Limiting Director Liability

All certified Colorado B-Corps, organized as Colorado Corporations or Cooperatives, are required to become Public Benefit Corporations (PBCs) by April 1, 2018. Since a number of our clients are B-Corps, we’ve been immersing ourselves in the finer points of the Colorado Public Benefit Corporation Act (PBCA), particularly as applied to Limited Cooperative Associations (LCAs). As originally enacted, the PBCA did not allow LCAs to elect PBC status despite Article 55 and Article 56 cooperatives being able to do so. It appears that the omission was simply an oversight by the drafters that was recently corrected in an amendment that allows LCAs to elect PBC status. While this was a needed amendment to the PBCA, the PBCA is not as cleanly applied to LCAs as to Article 55 and Article 56 cooperatives.  Unlike Article 55 and 56 cooperatives, the Colorado Business Corporation Act (CBCA) is not used as a gap filler for the Uniform Limited Cooperative Association Act (ULCAA), which governs LCAs. This presents a challenge to limiting director liability for LCAs under the PBCA. The PBCA is written with the corporate form in mind and references the CBCA with regards to director liability, but is silent as to how use of the PBC form will affect director liability when the entity is an LCA.

Section 7-101-506 of the PBCA lays out the duties of the directors of a PBC:

(1) The board of directors shall manage or direct the business and affairs of a public benefit corporation in a manner that balances the pecuniary interests of the shareholders, the best interests of those materially affected by the corporation’s conduct, and the specific public benefit identified in its articles of incorporation.

(2) A director of a public benefit corporation:

     (a) Does not, by virtue of the public benefit provisions of section 7-101-503 (1), have a duty to any person on account of an interest of the person in the public benefit identified in the articles of incorporation or on account of an interest materially affected by the corporation’s conduct; and

Additionally, it permits a PBC to expressly state in its articles of incorporation that a “disinterested director’s failure to satisfy this section does not, for the purposes of section 7-108-401 or 7-108-402 or article 109 of this title 7, constitute an act or omission not in good faith or breach of the duty of loyalty.” The problem for LCAs is that this provision only contemplates a corporation using the PBC form as evidenced by its reference to “articles of incorporation” and the statutory references to the CBCA. The concern for an LCA organized using the PBC form is that its directors may not be protected by the limiting language as it is currently written in the statute. Further, simply altering the express language provided in the PBCA to reference the analogous sections in the ULCAA could render the language unenforceable because it does not track the statutory language of the PBCA. This is not a concern for cooperatives organized under Article 55 or Article 56 because both Articles use the CBCA as a gap filler. ULCAA, on the other hand, was enacted as a stand-alone statute and there was no intent to use the CBCA as a gap filler.

The ideal solution is an amendment to the PBCA that makes the limiting language inclusive of LCAs. In the interim, it is prudent for LCAs using the PBC form to include the limiting language as it is written in the PBCA and include another provision that clearly expresses the intent of the LCA to apply the ULCAA provisions that are analogous to those CBCA provisions regarding limiting director liability. This statement of intent should be drafted to give parties, a court and other interpreters clear guidance to resolve conflicts of interpretation between the PBCA, ULCAA and the Articles of Organization. As a firm, and a PBC, we are invested in the implementation of this statute and look forward to following and participating in its evolution to meet the needs of the businesses that are utilizing the PBC form.