In my previous posts, I discuss how traditional businesses and cooperatives diverge from a capital (and return on capital) point-of-view.

Another common misconception is that cooperatives function like nonprofits, typically from the perspective of governance structure. They don’t. Cooperatives are businesses, and, as such, business principles and governance, and business governing structure apply to them. This distinction is important because the adoption of cooperative principles seem more natural to people with backgrounds in nonprofit, and sometimes things can feel mixed-up.

From a legal entity perspective, “nonprofits” are those organizations formed under the state’s nonprofit corporation statute, those that qualify as an unincorporated association, or are formed under the state’s limited liability company (LLC) in a state that recognizes nonprofit LLC’s (like Ohio). When we hear “nonprofit organization,” the speaker often means a 501c3 tax-exempt nonprofit corporation, which is a not-for-profit entity formed for religious, educational, scientific, or charitable purposes that received a tax-exempt status by the IRS, under Section 501(c) of the Internal Revenue Code.

According to the IRS, “[t]he term charitable is used in its generally accepted legal sense and includes relief of the poor, the distressed, or the underprivileged; advancement of religion; advancement of education or science; erection or maintenance of public buildings, monuments, or works; lessening the burdens of government; lessening neighborhood tensions; eliminating prejudice and discrimination; defending human and civil rights secured by law; and combating community deterioration and juvenile delinquency.” This definition has not substantially changed in more than a century, although it’s been evolving.^[1]

In addition to the definition itself, there are tests to ensure that a purpose is “charitable enough” for the IRS and that is because, if compliant, the organization receives federal (and often state) tax exemption over revenue received through or for the benefit of its charitable activities and also those donating cash or property to those organizations benefit from deduction of the contribution from their personal taxable income.

These not-for-profit entities have a typical governing structure: a board of directors (each a Director), an active board executive committee, and an executive director.

The board of directors (typically volunteers, not to be confused with executive director or other executive roles) develops the organization’s mission and vision, the strategic plan, and organizational policies (including HR). The executive committee (typically composed of the board’s president, treasurer, secretary) guides the executive director in managing and fulfilling the mission of the organization. The board president (or chair) does not have an executive position outside of their role in the executive committee. The board hires the executive director (ED), who is not considered a board member but may be a volunteer in small community-based nonprofits.

The ED hires the staff, runs the day-to-day of the organization, and reports back to the board. The board is in fact the ED’s boss. The executive director is assisted either by employees, volunteers, or both, in many or most of the organization’s roles.[2]

An important distinction between the Directors and the ED is that the Directors carry a high standard of fiduciary duties that the executive director is not bound by (although the executive director may have certain similar duties). – I’ll discuss fiduciary duties in my next post.

Why are cooperatives sometimes considered “nonprofit”?

Some states have adopted statutes that recognized cooperatives as “nonprofit” legal entities. So are cooperatives “nonprofits” or not? The short answer is NO, but it is more complicated than that.

The term cooperative has many meanings: it can be a legal entity form (a business formed under a cooperative corporation statute or limited cooperative association statute), it can be a way of doing business (on a cooperative basis, under any form of legal entity), and a way a business is run and governed (with some level of democratic participation/management, on the basis of one-share one-vote). In practice, at least two of these elements will join to form a cooperative.

Except for agriculture cooperatives, which benefit from specific regulation (IRC Section 521), and utility cooperatives which often utilize 501(c)12 tax exempt status, cooperatives have not been given the tax-exempt status of nonprofit entities, not at the federal and generally not at the state level either.

As we talked before, cooperatives are formed for the benefit of their members, not with the goal of producing profits for the cooperative itself. In that sense, they are not formed for profit, and as such, they do receive a beneficial tax treatment under Subchapter T of the Internal Revenue Code. You can see this post, and this one, and this series for more on that.

What does that mean for the cooperative governing structure?

Being de facto “for profit” business entities, cooperatives have adopted the governance structure found in for-profit businesses. And what is that? For-profits, and cooperatives are generally run by a chief executive officer (CEO) – or someone with a similar title. There is not an “Executive Director” like in nonprofits.

For-profit board members are not volunteers – they are typically paid professionals. The board chair and CEO are usually the same person. These boards do not have a fundraising responsibility, although they might be representative of the investors or members who brought capital funds to the business. They typically have fiduciary duties, although those limited and almost completely waived by the entity, unlike in nonprofits. While the CEO is an executive officer (akin to the executive director), they are also typically an owner/shareholder of the business.

In cooperatives, the members of the board of directors are typically representative of the membership classes. In multi-stakeholder coops, the directors will be elected by each class. Worker cooperatives will likely require that the majority of the board be representative of the worker members. It is uncommon for investors to have a board seat as a result of their investment, however some multi-stakeholder cooperatives do allow investor-members to elect certain directors. A cooperative will have a CEO (or a different title for its principal executive), an executive team or collective, or a manager, or any combination between horizontal and vertical management structure – and like in any business, those are not volunteers. Treating them as such is an easy way to get in trouble with the Department of Labor.

Did you notice my frequent use of the word “typically”? While nonprofits are more a matter of public interest, businesses are considered a matter of private interest (but don’t get me started…). From a legal approach, this means that there is a lot of flexibility to come up with a governance model that makes sense to a cooperative’s specific needs.

While I do recommend that cooperatives stay away from adopting a governance structure akin to nonprofits, the rest (governance and management) is fair game and I am always happy to work with clients to create a structure that makes sense for their cooperative model and their industry.

[1] See IRS EO 80 CPE for some history. https://www.irs.gov/pub/irs-tege/eotopicb80.pdf

[2] Remember though that not everyone can be considered a volunteer. Some consideration is required to ensure compliance with guidance of the Department of Labor, and the Fair Labor Standards Act. See https://www.dol.gov/sites/dolgov/files/WHD/legacy/files/whdfs14a.pdf and https://webapps.dol.gov/elaws/whd/flsa/docs/volunteers.asp.