Originally published on Forbes.com.
You might say that Congress gave us a really sweet deal with the 20% business income deduction. But then they built a wall around it. Little people (taxable income below $157,500 twice that for married filing joint), who are part of the gig economy, can crawl under the wall. And many people can build ladders by paying W-2 wages or using depreciable assets. But people on the “you know” list:
business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees or owners – performance of services that consist of investing and investment management, trading, or dealing in securities (as defined in section 475(c)(2)), partnership interests, or commodities (as defined in section 475(e)(2))
don’t even get to build ladders.
There are a couple of pretty narrow gates that I have discussed – REIT dividends and income from publicly traded partnerships, but that is not going to help with the “you know” list. There is one other thing though. It is not a loophole – more of a gaping gap through which we can drive fleets of trucks. You will find it on Page 24 of the Joint Committee Report, but I will explain it.
The Hole In The Wall
The 20% deduction is defined in Section 199A. To make it easy let’s assume you have lots of taxable income so we can ignore limitations. The deduction then is the sum of two numbers. You combined “qualified business income amount” plus 20% of your “qualified cooperative dividends” . Most people will kind of skip over the second item and move to the part that tells you how to compute your “qualified business income amount”. And that is where you have all the complications with the wall and the ladders and the gates. Millions if not billions of words have been written about the “qualified business income amount”, since for most people that is where the action is.
So we’re going to look at “qualified cooperative dividends” which are not well known and even less understood. Here is the definition (199A(e)(4))-
(4) Qualified cooperative dividend.
The term “qualified cooperative dividend” means any patronage dividend (as defined in section 1388(a)), any per-unit retain allocation (as defined in section 1388(f)), and any qualified written notice of allocation (as defined in section 1388(c)), or any similar amount received from an organization described in subparagraph (B)(ii),
(Don’t worry about subparagraph (B)(ii)). OK. I know that is not a lot of help, but here is the thing. You might be able to transform your income into “qualified cooperative dividends”. And that would mean that you could be making millions of dollars without any W-2 wages or depreciable assets and qualify for the 20% deduction on all of it even if you are on the “you know” list.
Who Was This For?
The provision was stuck in for farmers. There was nothing about qualified cooperative dividends in either the House bill or the Senate bill. The process of creating the final bill included a phase in which any Republican senator who was willing to hold his breath until he turned blue before voting for the bill got some candy or a puppy or a case of beer, whatever, within reason in exchange for his or her vote. According to this story by Amy Bickel and Larry Drelling, Senators John Hoeven and John Thune had the patronage dividend provision as their puppy. They are both Republicans from the Dakotas – North and South respectively.
There is a concern that this provision will distort the agricultural economy because it gives farmers too much of an incentive to sell to cooperatives rather than independent processors and there may be a fix in the works. As this story in World-Grain.com indicates it might not be that easy.
The farmers are excited about this because producer cooperatives are the most well-known application of the cooperative concept. Some of them are brand names. Ocean Spray is probably the most famous. Being in New England and all where there are not a lot of amber waves of grain, Ocean Spray patronage dividends are the only ones I have ever seen go in a set of workpapers. The partner on the job told me that he would sometimes put on waders and go out into the bogs with his clients. That struck me as one of those things that would be fun for about five minutes.
Producer cooperatives are not the only kind though. There are consumer cooperatives. I had a grocery store that was a cooperative. That sort of thing is popular anywhere you get a good concentration of crunchy granola people. Those dividends can be not taxable at all since they essentially represent a refund of personal expenditures. But that’s not all. There are worker cooperatives and that is where the action will be if, as I would think is likely, the provision is not changed or it is just tweaked a little by technical corrections.
Here Is The Plan
As noted above among the people on the “you know” list are those engaged in the “field of law”. So let’s imagine a few attorneys who are running a kind of “eat what you kill” partnership (EWYK). It might be more of an expense sharing arrangement. How do they turn that into a cooperative? They convert to a professional corporation. From there it is all about the bylaws. Section 1381 applies to “any corporation operating on a cooperative basis”. The regulations don’t explain what it means to be operating on a cooperative basis.
Cooperatives are allowed to deduct “patronage dividends”. That is how they avoid having to pay corporate tax. The patronage dividends are ordinary income to the members. And as we have seen those patronage dividends will be subject to the 20% deduction. The net profits of EWYK PC will be distributed to its members based on the fees that they generated for the corporation. But can EWYK PC really be considered a cooperative?
Reilly Third Law of Tax Planning – Any clever idea that pops into your head probably has (or will have) a corresponding rule that makes it not work. To figure out why this crazy idea does not work I consulted with Erin Fraser and Christopher Karachale of HansonBridgett. As we discussed it we figured there might be a host of state law or professional standards that might make the plan impractical. There are also some business issues. But we could not come up with any federal tax principle that definitively killed it. Mr. Fraser pointed me to the case law to determine what “operating on a cooperative basis” means.
Operating On A Cooperative Basis
The leading case on what it means to be corporation “operating on a cooperative basis” is a 1965 Tax Court decision – Puget Sound Plywood Inc (44 TC 305). Here is the summary
The petitioner was and is a cooperative association of the type commonly known as a workers cooperative association, which was incorporated and operated in accordance with a statute of the State of Washington that pertains particularly to the creation and regulation of associations operating on a cooperative basis. Held, that said cooperative association is entitled to be classified and treated for Federal income tax purposes, as a “nonexempt cooperative association”; and that as such, it is entitled to exclude from the proceeds of the association’s operations, for Federal income tax purposes, the patronage dividends which were, pursuant to a preexisting legal obligation, allocated to the worker-members in proportion to the hours worked by them in producing and marketing the products of their cooperative endeavor.
The decision is really worth reading as it takes you a bit of a tour of nineteenth century reform thinking that is quite alien to people raised on a philosophy of shareholder value as the be all and end all of business operations.
One of the earliest examples of cooperative associations as they exist today was the Rochdale Cooperative, which was founded in England in 1844 by 28 textile weavers who associated themselves together for the purpose of operating a retail store. The objectives which the members of that association sought to attain were: (1) For themselves to own and manage the store, as distinguished from having it owned and managed by outside equity investors; and then (2) to have their association turn back to the members the excess of the receipts from the store sales over the cost of the goods sold and the expenses of operation. This general form of cooperative organization thereafter spread from England to other nations including the United States, where it has since been utilized not only by consumer cooperatives, but also by producing and marketing cooperatives. Thus in the United States for example, in years immediately preceding and following the War Between the States, various types of cooperative enterprises were organized, including those composed of farmers, dairymen, shoemakers, textile and clothing manufacturers, coopers, and ironworkers.
The essence of the cooperative principle as enshrined in case law since 1965 goes back to Rochdale.
(1) Subordination of capital, both as regards control over the cooperative undertaking, and as regards the ownership of the pecuniary benefits arising therefrom ; (2) democratic control by the worker-members themselves; and (3) the vesting in and the allocation among the worker-members of all fruits and increases arising from their cooperative endeavor (i.e., the excess of the operating revenues over the costs incurred in generating those revenues), in proportion to the worker-members’ active participation in the cooperative endeavor.
Doesn’t that “subordination of capital” sound almost heretical?
Worker Cooperatives – Not Big – But Ready To Get Bigger?
If you put aside my scheming to benefit highly paid professionals, it is worth noting that the provision in the bill may benefit current worker owner cooperatives. According to the United States Federation of Worker Cooperatives,
Though we lack comprehensive data on the nature and scope of worker cooperatives in the U.S., researchers and practitioners conservatively estimate that there are over 350 democratic workplaces in the United States, employing over 5,000 people and generating over $500 million in annual revenues.
I’m going to work to get a better handle on how much of the income of current worker cooperatives is disbursed in the form of patronage dividends. Something tells me that it may go up.
It will be supremely ironic, if the Tax Cuts and Jobs Act sparks a renaissance in cooperative enterprises. In the second half of the twentieth century many of the philanthropic businesses from an earlier era were turned over to the shareholder value types – mutual banks, mutual insurance companies, not-for-profit hospital. I sometimes call us the cash-out generation.
Now workers have a 20% deduction tax incentive to be working in a cooperative. Something tells me that they were not thinking about that when the bill was pushed through.
Other Coverage And Closing Thought
As noted there is a bit of coverage on the effect of the bill on agricultural cooperatives, but I have not found anybody thinking about the implications for worker owned cooperatives and the notion that this fairly obscure form might suddenly become popular.
I think that one of the reasons that the concept has not taken hold very well in the land of the free and the home of the brave is that the people with entrepreneurial personalities who can really make a business go do not have a lot of patience with democratic governance.
That was the story with Fraternal Communion Number One founded by Adin Ballou. The enterprise was pretty successful but the members with the largest capital ended up taking the enterprise over and turning it into the Town of Hopedale, Massachusetts, and Draper Industries. It is an interesting story, which I shared in this piece and this one.
The only people that might want to consider acting on this notion, before things become clearer, are the owners of professional corporations with multiple shareholders. They could just tweak their bylaws and arguably fall under the statute. And if by December it is clear the idea does not work, it would be no harm, no foul. I would not recommend revoking an S election or forming a corporation at this point.
I hope to have more on this in the next few weeks.