How patronage is really paid out to cooperative members: qualified and nonqualified written notice of allocations (2/2)

Patronage dividends represent a unique opportunity for cooperatives to avoid taxation on some of the cooperative’s earnings.[1] Early this month I highlighted the concept of patronage dividends.

Generally, when members receive taxable distributions of earnings from a cooperative, such as patronage dividends, they are included in the patrons’ gross income along with other income the member receives from their other activities. For example, in a worker cooperative, the member receives wages for their work, as well as a share of the net profits at the end of the year (on a 1099-PATR).  In addition to paying taxes on their wages, the members also recognize that patronage income in the tax year it is received from the cooperative. And by recognize I mean report on that member’s individual tax return and pay taxes.

Qualified Notice of Allocation

Patronage dividend distributions to members may be in the form of money, property, or noncash allocations of equity or debt in the cooperative, or a combination of these, through written notices of allocation.[2] The tax consequences to the member of written notices of allocation when received, and later when redeemed, depends primarily upon whether the notices are “qualified” or “nonqualified” distributions.[3]  The word qualified is used because it means the cooperative has acted in such a way that the distribution qualifies the cooperative to deduct the distribution from the cooperative’s taxable income, thereby reducing its obligations to pay taxes.  The allocation “qualifies” for a deduction for the cooperative.

A written notice of allocation is any written notice that discloses to the recipient the amount allocated to the patron-member and the portion of the allocation that is a cash dividend. It will say, here’s how much you generated and here’s how much we owe you in return as a patronage dividend, and we are paying you some of the allocation in cash but we are keeping some for now in an account we have in our books for you.  The amount kept on the books is often referred to as retained patronage or retained equity, and may be credited to that member’s internal capital account or by way of some other entry into the cooperative’s books and records.

When a cooperative allocates noncash patronage dividends to its members, it is actually increasing the member’s equity in the cooperative (by allocating to the member’s equity account the amount that may and will eventually be paid to the member in cash or property).

To qualify a written notice of allocation (deductible for the cooperative), the cooperative must pay at least 20% of the patronage dividend in money or by qualified check, AND the member must either:

  • Have the opportunity to obtain the total refund in cash within 90 days after the allocation is made, and must have received a written notice of his/her/their right of redemption at the same time as the written notice of allocation, or
  • Consent in one of the following ways to have the noncash portion treated as if it had been received in cash and reinvested by the member in the cooperative (which means agree to include the stated dollar value in its taxable income in the year the member received the notice):
    1. Signing and giving a written agreement to the cooperative.
    2. Getting or keeping membership in the cooperative after it adopted a bylaw providing that membership constitutes agreement to Subchapter T taxation.
    3. Endorsing and cashing a qualified check paid as part of the same patronage dividend. The member must cash the check by the 90th day after the close of the payment period for the cooperative’s tax year for which the patronage dividend was paid.

As long as the above requirements are met, patronage dividends received through qualified notices of allocation will be considered deductible from the cooperative’s taxable income for the year it is allocated. The member will then treat the notice as if it had been received in cash and reinvested by the member in the cooperative, and so the amount will be taxable on the member’s tax return that same year.

Nonqualified Notice of Allocation

A “nonqualified written notice of allocation” means a written notice of allocation which does not meet the above requirements or a qualified check which is not cashed on or before the 90th day after the close of the payment period for the taxable year in which the funds are earned. I know – why make it simple if we can complicate things, right?! It shouldn’t be surprising that nonqualified written notices of allocation are rarely used by cooperatives we work with.

A cooperative may elect not to meet all the requirements to qualify a written notice of allocation. If the cooperative does not pay at least 20% of a patronage refund in cash, the allocation is not considered qualified allocation. However, if the allocation is made before the end of the cooperative’s payment period and otherwise meets the definition of patronage refund, it is considered nonqualified written notice of allocation.

If a cooperative issues nonqualified notices of allocation, it must include the value of those allocations in its taxable income for the year the net profits are earned and pay tax on those allocations at the regular corporate tax rate.  The amount in the nonqualified notice will not be taxable income for the member when received. However, in the future, the member will be subject to tax when the notice is redeemed by the cooperative, at the tax rate for the year in which the notice is redeemed and cash is actually received, and at that time, the cooperative gets to deduct the tax paid at the onset.

I’ll illustrate with a co-op I’m excited to see opening its doors within the next few weeks in Dayton, Ohio, the Gem City Market (GCM). Assume *Cory* works for the GCM as a worker-owner in 2021. In February 2022, the GCM send Cory a notice:

“You’ve worked 2,000 hours in 2021, and as a result, we are allocating you $_ corresponding to your patronage dividends for 2021. We are sending you a check corresponding to 20% of the amount allocated, so you can pay any taxes that you might owe for the entire amount we allocated to you. The remainder will be put in an equity account in your name in the books of the cooperative.  Besides this notice, you will also receive a 1099-PATR for the full amount of patronage dividends you were allocated and this needs to be reported on your next year’s tax return.  You can redeem this notice with our co-op no later than 90 days after this allocation was made (meaning the end of the coop’s tax-year, possibly December 31st, 2021).”

This is GCM’s qualified notice of allocation. The grocery paid Cory, in cash, 20% of her patronage allocation, give her a notice indicating her right to redeem the notice and let her know when that needs to be done.

This same notice would be nonqualified if the co-op missed any element, didn’t send the check or cash for 20$, didn’t let her know she could redeem it within 90 days. This notice would also be considered nonqualified if Cory actually forgot to cash her check within 90 days from the end of the co-op’s tax year! Note that this is not true if the cooperative bylaws include a provision whereby the member agrees to include the stated dollar or face amount of the total refund as ordinate income earned during the year in which it was received. If the member includes the amounts in her tax return, then it is still a qualified allocation.

Now to another layer: While a nonqualified notice of allocation might imply the lack of payment of 20% of the notice in cash (in cases in which this requirement was not fulfilled), if an allocation that is otherwise considered nonqualified patronage refund includes both cash and a nonqualified notice, the cash portion is included in the member’s taxable income and is deductible from the cooperative’s income that same year[4] (and the remaining taxable at the member level the year the notice is redeemed).

Patronage dividends received through nonqualified notices of allocation will (i) prevent the cooperative from taking a deduction, (ii) require the cooperative to pay income tax on the amounts allocated, and (iii) will not become part of the member’s taxable gross income. The year the nonqualified notice is redeemed by the cooperative, the amount will become part of the member’s gross income, and the cooperative may then exclude the redemption amounts from its own taxable income, and the member who received a redemption includes the amount of the payment received in their taxable income.

Why use one or another?

There are a variety of reasons why a cooperative would use nonqualified notices of allocation: the cooperative can use them to manage its cash flow, handle losses, and manage taxes; it can also help avoid negative cash flows to the patrons resulting from tax on qualified notices.

According to the USDA, “a comparative analysis of patron cash flow suggests that neither the qualified nor the nonqualified method of distributing patronage refunds is clearly superior to the other.”[5]

Nonqualified notices may be a good tool when the member’s tax rate is high and the cooperative’s tax rate is low, since the cooperative may be able to anticipate the taxes due over the allocated but unpaid patronage dividends, whereas the member might have had a cash flow issue. With the nonqualified notice, the member would be able to avoid taxes on the allocation until a later date, even after retirement, when the member’s tax rate might be lower. With the current corporate tax rates (21%), a cooperative of accountants or similar professional entities formed as a cooperative would make good use of nonqualified notices, by allowing those professionals from deferring taxation on patronage.

“Qualified” or “non-qualified” written notices are a matter of tax law. Subchapter T not only defines patronage dividends, but it also establishes a single tax principle. This principle places the tax burden of patronage dividends on the final recipient and not the cooperative.

But this applies only if payments are distributed according to Subchapter T rules, i.e. business income sources and distribution methods are “cooperative” in nature; earnings from sources other than patronage and margins not distributed according to the three-criteria defining patronage dividends (see previous post) are generally not eligible for the single tax treatment, resulting in taxation at the cooperative level, and since nonpatronage income is subject to regular corporate double tax treatment,[6] the recipient will also be taxed.

The choice to issue notices of allocation is not a once-and-for-all decision. A cooperative can include in its bylaws authorization to issue both qualified and nonqualified notices with the idea each may be useful under certain conditions (remember: the member need to have agreed to the form of the allocation for it to be a properly qualified notice, so the co-op wants to ensure that the member knows and agree upfront to receive either notice from the co-op). Then it can make the choice whether to issue nonqualified notices on a yearly basis according to the situation it and its members face each year. For example, if conditions in a given year are such that patrons have high tax rates relative to the cooperative, it may choose to issue nonqualified notices that year. A cooperative also can choose to issue both qualified and nonqualified notices in that same year – and a mix-and-match for each member, if necessary and practical.[7]

I hope this post helped shed some light on this topic. As co-ops grow, the need or opportunity to pay patronage dividends should help clarify the practical aspects of these complicated concepts. Know that we are here to help you walk through this phase!

[1] This post only covers amounts received by a member from the cooperative based on the cooperative-patron relationship. Other kinds of income, such as interests and distribution of income from non-patron-based sources are not contemplated by this post and are covered by rules not specific to cooperatives. The use of the term “member” here implies a member who patronizes the cooperative.

[2] Or per-unit retain certificates, for certain cooperatives.

[3] USDA, Frederick, Donald A., Income Tax Treatment of Cooperatives: Distributions, Retains, Redemptions, and Patrons’ Taxation, Cooperative Information Report 44, part 3, 2005, p. 123.

[4] USDA, Nonqualified Notices, An Alternative of Distribution Cooperative Earnings, ACS Research Report Number 80, 1989, p.4,

[5] Id., p. v.

[6] USDA, Frederick, Donald A., Income Tax Treatment of Cooperatives: Patronage Refunds and other Income Issues, Cooperative Information Report 44, part 2, p. 12 (2005), p. 28.

[7] USDA, Nonqualified Notices, An Alternative of Distribution Cooperative Earnings, note 13 above, p. 39. A cooperative may also time the redemption of nonqualified notices according to income and tax considerations.

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