When addressing cooperatives and corporations, the rules, regulations and manners of doing business that apply to one, may or may not apply to the other. It is best never to make assumptions. Cooperative law is a specialty field in and of its own, the same as corporate law.

While it is mentioned several times elsewhere in this chapter, it cannot be stressed enough: Any decisions regarding your business structure, business regulations and requirements and applicable tax matters must be discussed with your legal and business advisors. This manual attempts to give you working knowledge and vocabulary, but is not meant to advise you.

Cooperatives
In many ways, a cooperative is like any other business; but in several important ways it’s unique. A cooperative business belongs to the people who use it - people who have organized to provide themselves with the goods and services they need. A cooperative operates for the benefit of its members.

These member-owners share equally in the control of their cooperative - they meet at regular intervals, review detailed reports and elect directors from among themselves. The directors, in turn, hire management to manage the day-to-day affairs of the cooperative in a way that serves the members’ interests.

Members invest in shares in the business to provide capital. The net – left after bills are paid and money is set aside for operations and improvements – is returned to coop members. Although not completely defined by statute or by tax law, operating a cooperative generally means adhering to the following principles:

• democratic control – one member, one vote – or at least not basing voting upon capital investment,
• subordination of capital, generally meaning that profits of the cooperative are not paid back based on the amount of the investment, but rather on the amount of patronage of business done for or with the cooperative, and
• preferences in liquidation based on patronage rather than investment.

Traditional cooperatives commonly are called open cooperatives, as they are cooperatives which any producer can join simply by bringing a product to be processed, marketed or handled by the cooperative. There is generally no up-front investment other than a nominal membership fee. Typically, there is no further commitment to further patronize the cooperative.

Types of Cooperatives
Producer-owned cooperatives are owned by farmers, producers or small businesses. Agricultural producers or crafts people organize cooperatives to process and market their goods, and to provide themselves with credit, equipment and production supplies. Similarly, retail stores or small businesses organize cooperatives to provide supplies or common services.

Consumer-owned cooperatives enable consumers to secure a wide array of goods and services. For example, they may offer health care, utilities, insurance or housing. They may buy and sell food, heating fuel, hardware and other consumer goods. Or, they may operate credit unions, child care facilities and funeral and memorial societies. Almost all consumer needs can be met by a cooperative.

Worker-owned cooperatives are businesses owned and controlled by their employees. Worker cooperatives may be found in almost any industry. Examples include employeeowned food stores, processing companies, restaurants, taxi cab companies, sewing companies, timber processors and light and heavy industry.

Value Added Cooperatives
In the last 20 -30 years, the value added cooperative model has been developed. This model has basic differences from the traditional cooperative model. The equity structure of the value-added cooperative is capitalized by members making a cash investment in stock or other equity of the cooperative. A traditional cooperative is internally capitalized through retained earnings or profits at the end of the year, commonly called “retained patronage” or through retaining a portion of the price to be paid to the producer upon delivery of the commodity to the cooperative, commonly called “unit retains.” Retained patronage or unit retains also can be used to provide supplemental capitalization for a value-added cooperative; however, the primary capitalization is most often through a direct investment through the purchase of stock or other equities of the cooperative.

Value added cooperatives, in particular processing cooperatives, are typically financed based on maximizing the capacity of the processing facility. Accordingly, membership is generally restricted to the members who purchase stock and acquire the coinciding delivery rights. In other words, if a hog processing cooperative is organized to process 50,000 head, members would typically purchase stock and security coinciding with delivery rights for 50,000 head of hogs to be delivered to the cooperative.

If the cooperative is profitable and a nonmember producer wants to deliver his or her commodity to the cooperative, that nonmember producer would not be allowed to deliver to the cooperative unless he or she purchases equity and delivery rights from an existing member. There are two reasons for this structure: (1) the cooperative can assure it will have a fixed supply of the commodities that are the basis of the cooperative’s business, thus allowing it to operate at 100 percent capacity; and (2) members who desire to leave the cooperative will have the opportunity to sell their equity and delivery rights to other producers. This is in contrast to the traditional cooperative model, where there is no incentive to purchase a member’s equity in the cooperative, because, as a new member, you can typically participate in business with the cooperative without an equity investment.

The value added cooperative is structured to be capitalized by investment from producers. Value added cooperatives are also structured to pay out earnings annually, rather than retain earnings for many years or to a particular age of the investor.

Laws that Affect Cooperatives
Cooperative law is a specialty in and of itself. The following addresses the very general intent of early and existing legislation. The State of Iowa, as virtually every state, has laws that are very specific to cooperatives doing business in Iowa. The information provided here is for general reference only and is in no way intended to be complete or all encompassing.

In the beginning, no legal restrictions existed on the formation or activities of agricultural cooperatives. The passage by Congress in 1890 of the Sherman Antitrust Act and the Clayton Antitrust Act in 1914 applied to cooperatives engaged in interstate commerce, just as they did to other businesses. During ensuing years, cooperatives were attacked under many state and federal laws as being unlawful price-fixing conspiracies under the antitrust laws. The Clayton Act partially excluded labor and agricultural organizations from antitrust suit, but did not use the word cooperative, promoting a suspicion among farmers that acting through a cooperative might be a violation of the antitrust laws. Thirty-two years later, farmer leaders opened the door to modern farmer cooperatives in the U.S.

In 1922, Congress passed the Capper-Volstead Act, removing any doubt that cooperatives could legally negotiate sales for farmers or associations of farmers. Federal and state antitrust laws prohibit agreement among competitors that unreasonably restrain free enterprise. Together with the Cooperative Marketing Act of 1926, which permits cooperatives and their members to exchange virtually any kind of information regarding production and marketing, the Capper-Volstead Act provided the legal foundation for formation and operation of agricultural cooperatives in the U.S.

Antitrust Requirements
To be eligible for antitrust protection, a marketing cooperative must meet several organizational and operational requirements, including:

• Membership must be limited to persons actually engaged in the production of agricultural products.
• The association must be operated for the mutual benefit of the members as agricultural producers.
• The association must make decisions on the basis of one member/one vote or limit dividends on stock and membership capital to no more than 8 percent each year. The association may do both.
• The association may market products for nonmembers, however, the value of products handled for members must exceed the value of products handled for nonmembers.

Ownership
The ownership of an organization focuses on two characteristics: Who can participate as an owner of the business? What is the nature of the ownership interest?

In general, C Corporations, cooperatives, partnerships and LLCs do not restrict the maximum number of shareholders, partners or members. All of the entities may have different classes of ownership and voting rights. Cooperatives, however, usually restrict the eligibility of members and generally restrict voting to one member/one vote basis, subject to certain exceptions provided by state law. All of the entities generally have a perpetual existence unless limited in the organizational documents. However, a general partnership is terminated by agreement of the partners, upon a partner’s death, bankruptcy, dissolution, etc.

Liability of Owners
The liability of owners who are part of an organization is a significant consideration in establishing a business. The general rule is that the shareholders or members of a C Corporation, S Corporation, cooperative or LLC are not liable for the debts and obligations of the entity merely on account of their status as shareholder or member. A shareholder or member is always liable to the entity for any amount of unpaid subscriptions for stock or interests in the entity. In addition, contractual obligations between the entity and the shareholder or member for delivery of crops or livestock may also incur liability to the member or shareholder. As a general matter, the shareholder’s or member’s risk is limited to investment in the shares or his or her interest plus any contractual liability.

Corporations
There are two basic types of corporations: C Corporations and S Corporations.

C Corporations
C Corporations are owned by shareholders, who may be individuals or other business entities such as corporations or partnerships. The shares of a corporation’s stock may be publicly traded on stock exchanges or over the counter, or may be closely held. For closely held corporations, shareholder agreements are often of critical importance in planning for management succession, control over the distribution of stock, handling fundamental disagreements between key stockholders, and in some cases, providing liquidity for shareholders. C Corporations are considered separate entities for most legal and tax purposes. Venture capital investors usually require C Corporation status for their portfolio companies for a variety of tax considerations. Thus, C Corporation status is usually recommended for entrepreneurs who seek to attract venture capital.

S Corporations
S Corporations are similar to C Corporations except that they are generally taxed as partnerships. This can present a considerable advantage if the corporation is expected to generate tax losses in its early years, or if the company ends up selling substantially all of its assets to an acquirer. In the former case, the shareholders may deduct their proportionate share of the corporation’s losses on their personal income tax returns (subject to certain limitations). In the latter case, there will be one, rather than two, levels of taxation on the gain from the sale.

Limited Liability Companies
Limited Liability Companies (LLCs) are a hybrid that combines some characteristics of a corporation with other characteristics of a partnership. On the corporate side, the LLC offers limited liability for all of its members and the option of centralized management (which the LLC may choose not to adopt). On the partnership side, the LLC offers partnership tax status (similar to that offered by an S Corporation) with a great deal of flexibility in handling unequal contributions of capital, different classes of capital and customized operating agreements that the S Corporation cannot match. The price to be paid for this flexibility is that a customized operating agreement must be drafted to spell out the unique arrangements of the LLC, whereas corporations may often be formed with standardized documents.

Partnerships
There are three types of partnerships: Limited Partnerships, Limited Liability Partnerships and General Partnerships. Their key common element is there is no entity-level federal taxation of partnerships. These entities, like S Corporations, file a federal tax return that allocates the entity’s income, deductions, gain and loss to its partners, who then must report such items on their personal tax returns. This generally results in tax savings, but may present hardships in years when the entity has taxable income but lacks cash to distribute to the partners to help them pay the tax on income. This problem, called “phantom income,” may occur, for example, if a real estate asset is sold at foreclosure under circumstances where the lender writes off a portion of a loan made to the partnership, resulting in debt forgiveness income.

Limited Partnerships
Limited Partnerships have many of the same characteristics of Limited Liability Companies, but must include one partner (the general partner) having unlimited liability for the debts of the partnership. Special IRS rules govern whether a corporate general partner is sufficiently at risk to qualify the entity as a partnership rather than a corporation for tax purposes.

Limited Liability Partnerships
Limited Liability Partnerships (LLPs) are general partnerships that have elected LLP status under state law. Partners of an LLP have unlimited liability for their own actions taken in furtherance of the business of the LLP, but they do not have joint and several liability for the actions of their partners. LLP status is appropriate for businesses that traditionally have been conducted as general partnerships if the partners wish to limit their potential liability for each other’s actions. Special rules govern the LLP election by partnership of licensed professionals.

General Partnerships
General Partnerships may be based upon the simplest of arrangements. No registration of general partnerships is necessary in most states, and the partnership agreement may be oral. If the partners do not have a detailed agreement, the Uniform Partnership Act, which is in effect in some form in most states, will supply numerous default rules that will govern the relationship of the partners. A more detailed partnership agreement may override these default rules.

Shareholder Agreements
It is usually prudent for the founders of a business to have an agreement in place that deals with such questions as: What if someone wants to sell his or her interest in the business to someone else? What if a founder dies, retires, declares bankruptcy or leaves the company to compete with it? What if the founders become deadlocked in matters basic to the conduct of the business?

The appropriate answers to these and other questions will vary depending upon the nature of the business, the interests of investors, the relative positions of the various founders, their respective personal circumstances and a number of other factors.

Counsel to the company can be helpful in identifying the questions that need answering and in suggesting possible answers. Sorting through these questions is unpleasant when the founders are focused on building a new enterprise; but it can be catastrophic if attention is deferred until the questions are no longer hypothetical.

For these reasons, it is good business for owners to develop and keep current a shareholders agreement that is appropriate to their circumstances. Although shareholder agreements technically apply to corporations only, the issues addressed in a shareholders agreement are just as pertinent to non-corporate organizations, such as limited liability companies and partnerships. These issues are frequently dealt with in the operating agreement (in the case of an LLC) or the partnership agreement (especially if the entity is a limited partnership). In those cases, care must be taken to avoid using “off the shelf” language that is inappropriate to the circumstances of the parties.

Tax Considerations
(The following does not constitute legal advice. Consultation with an attorney or another tax professional is strongly recommended.)
Tax considerations are often of critical importance in deciding upon a business structure and exit strategy. The basic tax considerations associated with various organizations focus on the tax treatment of income and losses, distributions of the owners, consequence of liquidating the business and the tax consequences of selling ownership interests.

General Partnership
A partnership itself pays no federal income tax. Partnership income is taxable, however, to the partners regardless of whether it is actually distributed or retained by the business. The partner’s share of the partnership income is taxed at the individual income tax rate applicable to the partner’s tax bracket. Losses from the business, as they are allocated to the partners, may be offset against other personal income.

Limited Liability Partnerships
Despite the limited liability provided to partners, LLPs are treated like general partnerships for tax purposes.

Limited Partnership
Limited partnerships are treated like general partnerships for tax purposes.

Corporations
In general, a corporation is subject to separate tax procedures and rates imposed by federal and state tax laws. Unlike a partnership, where income passes through to the individual partners, a corporation is separately taxed on its own income. Corporate taxation may result in “double taxation” since income received by the corporation is taxed at the corporate level, and any profits remaining after taxes are then available to be distributed as dividends, which are taxed again as personal income. This double taxation can be a distinct disadvantage of the corporate form of businesses. Larger corporations with many shareholders simply accept the disadvantages, but in smaller, closely held corporations, double taxation can be minimized. There are several planning possibilities, which can minimize such double taxation. They should be investigated.

Salaries
Whenever shareholders are officers or employees of the corporation, they may be paid salaries that are deductible as a corporate expense, and thereby compensated other than with divided distributions. Salaries are deductible to the extent that they are reasonable and necessary.

Loans
A small corporation may be structured so that a significant portion of its capital comes from loans to the business rather than investments made by shareholders. Having established sufficient equity capital, the remaining funds needed for the business may be raised through interest-bearing loans and such interest is deductible to the corporation as an expense. The interest paid to the creditor is individual income to him or her and is not subject to double taxation.

S Election
A small business corporation may decide to not be taxed at the corporate level, but to have its income (whether distributed or not) passed through and taxed pro rata to its shareholders. An S Election can also permit shareholders to take advantage of losses in the early stages of the business. In general, the following requirements must be met for a corporation to qualify: (i) there may be no more than 75 shareholders, (ii) shareholders must be natural persons, and cannot be another corporation or partnership, (iii) the corporation may have only one class of stock, (iv) the corporation cannot have a nonresident as a shareholder and (v) the corporation’s foreign income and passive investment income may not exceed certain limitations. All shareholders must consent to the S Election by signing a statement of consent to be submitted to the Internal Revenue Service.

Limited Liability Company
A properly structured LLC may be reasonably certain it will be taxed as a partnership for federal income tax purposes. If an LLC is treated like a partnership, the members are required to declare their share of the LLCs income or loss on their individual income tax returns. Profits earned by an LLC are included in the individual incomes of the members whether such profits have been distributed or not, and the losses from the business, as they are allocated to the members, may offset a member’s other personal income.

Cooperatives
Both exempt and nonexempt cooperatives may reduce or eliminate federal income tax on patronage source earnings at the entity level by distributing income to patrons on the basis of patronage (rather than investment). In this way, cooperatives may achieve a single level taxation (at the patronage level) similar to partnerships. Exempt cooperatives may also reduce federal taxable income by distributing nonpatronage sourced income to patrons. Distributions may be in cash or noncash form, but must be at least 20 percent cash in order to reduce the taxable income of the cooperative.

Additional Information
The following Web sites were frequently used as direct sources for materials included in this article and may provide further information for readers:
www.cooperative.org/primer.cfm
www.cooperative.org/success.cfm
www.bromsun.com/practice/buatxt.htm#ccorp
www.bromsun.com/practice/bubtxt.htm