Originally published on Forbes.com where it was an Editor’s Pick. Subsequent legislation killed this clever idea. An instance of Reilly’s Third Law of Tax Planning.
The 20% “Qualified Business Income” deduction under Code Section 199A is a brand new pretty substantial tax break. The 20% deduction is hedged by a lot of restrictions, but I think I may have found the secret to unleashing its power. Out of the over one thousand pages in the committee report on the bill, I am obsessing about one sentence fragment on page 24: “20 percent of the aggregate amount of the qualified cooperative dividends of the taxpayer for the taxable year.”
No Restrictions
The way the act is written there are no restrictions on cooperative dividends – no requirement for W-2 wages or depreciable assets once taxpayer is over an income threshold and even more intriguing no restriction of the fields of endeavor that generate the cooperative dividends. Once taxpayers are above the income threshold, income from the fields of law and health and several others generally does not qualify for the deduction, but those restrictions do not affect qualified cooperative dividends.
It is likely that Congress was not thinking about worker-owned cooperatives when that sentence fragment was added to the final bill. (It does not appear in either the House or the Senate bill and there is nothing in the committee explanation that clarifies it). If that is the case they have created a major loophole for professionals in their zeal to take care of farmers.
You might argue that the purpose of cooperatives is to cut out the middleman. One of the best known forms of cooperative are producer cooperatives, which seems to have been the focus of concern when the bill was tweaked. Credit unions are another example of the cooperative principle as are food co-ops.
And then there are worker-owned coops. The middleman being cut out there is the employer. Alana Semuels had an article in The Atlantic titled Getting Rid of Bosses to discuss the phenomenon. And it is here that we have to do a little bit of a mental split. The worker-cooperative movement and the tax treatment of cooperatives are two different things.
Cooperatives In Spirit
The worker-owned cooperative movement is suffused with idealism. The United States Federation of Worker Cooperatives tells us:
The two central characteristics of worker cooperatives are: (1) worker-members invest in and own the business together, and it distributes surplus to them and (2) decision-making is democratic, adhering to the general principle of one member-one vote. The international worker cooperative federation CICOPA established basic standards for worker cooperatives in the World Declaration on Cooperative Worker Ownership (also known as the Oslo Declaration) at a meeting in Oslo, Norway in 2003. The US Federation of Worker Cooperatives has signed on to this document.
It is also, at least in the form recognized by USFWC, not a very large phenomenon in this country.
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.
It is worth noting that if you were to boil it down to the essentials of worker-ownership and democratic governance, independent of the idealism, there are a vast number of entities that are, in essence, worker-owned cooperatives including, for example, the little boutique accounting practice that is still my day job. And here is where things get a little more complicated.
Often when a few, just, for example, bicycle mechanics get together and decide that they want to embrace the worker cooperative principles, they end up with an LLC that is taxed as a partnership or an S corporation. They might view themselves as part of the worker cooperative movement and be on the USFWC list and promote themselves as worker-owned to their customers and potential team members (or whatever term they might use for the people doing the work and getting paid), but there is nothing exceptional or different about their tax situation. It’s a partnership or an S corporation and the accountants doing the returns have no way or need to distinguish it from similar businesses.
Cooperatives In The Tax Law
The other option is to organize the business to qualify for the treatment allowed by Subchapter T of the Internal Revenue Code. It needs to be a corporation and I haven’t figured out how it can be an S corporation, so let’s say it needs to be a C corporation. There are a few types of corporations that are excluded, but putting them aside, the only requirement is that it be a “corporation operating on a cooperative basis”. What does that mean?
There is not a lot of guidance on what “corporation operating on a cooperative basis” means. No definition in the Code. No regulation. The only guidance is in pretty sparse case law. The leading case which goes back to 1965 is the Tax Court decision in the case of Puget Sound Plywood. There are three principles that determine whether you have a “corporation operating on a cooperative basis”:
(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.
Oddly enough a pretty large proportion of professional practices operate under those principles or pretty close to them. And there are more that pretend to operate that way even though they are actually dictatorships of greater or lesser benevolence in the grip of sociopathic managing partners, who have no patience with democratic process.
So What’s The Tax Break For Cooperatives?
Unlike other corporations “corporations operating on a cooperative basis” can deduct some dividends. That would be patronage dividends. I’m not going to get into the fine points. A very oversimplified explanation is that dividends paid based on the participation of members in the enterprise of the profits attributable to member participation are deductible.
So a food cooperative might pay a dividend based on how much a patron spent at the coop. An agricultural cooperative will pay based on how much grain the farmer sold through the cooperative. And a worker cooperative will pay based on the work done by the member. Profits attributable to non-members cannot be the basis of deductible patronage dividends, but for the rest of the discussion, I will ignore that and other complications such as per-unit-retains.
How Are Patronage Dividends Taxed?
Patronage dividends, being deductible, do not come out of earnings and profits, so they are taxed as ordinary income. Dividends from producer cooperatives will, for an individual, be part of business income and subject to self-employment tax. Dividends from a food coop will generally not be taxable, since they are, in effect, a kind of rebate of personal expenditures. And dividends from worker-owned cooperatives? Well, that’s a little bit of a long story, so first I will introduce my experts.
Advisers To Cooperatives
Sarah Kaplan felt called to help cooperatives. When she was thirteen, she decided, on moral grounds, to become a vegetarian. While attending Princeton, she got her vegetarian food from the 2d Co-0p. She was fascinated by the governance, which influenced her to make cooperatives part of her law practice. She spent some time as a bicycle mechanic after Princeton and before starting law school. She helped me a bit with background on the movement. Ms. Kaplan is affiliated with Cutting Edge Counsel – Legal Strategies For a New Economy
Gregory Wilson seems to have more or less fallen into the cooperative field. He is a pretty conventional tax attorney. He represented some people who were being audited on the issue of whether worker patronage dividends are subject to self-employment tax. That led to an audit of the substantial co-op (100 or so members) that they belonged to asserting that co-op dividends are wages subject to payroll taxes. He has written on the subject. Mr. Wilson may well be the leading expert in the field of taxation of worker cooperative patronage dividends.
David Hammer is the executive director of The ICA Group, a not for profit with a mission to:
expand economic opportunity and self-determination by supporting initiatives that empower workers, build community assets, and root capital locally through employee ownership
Tax Advantages Of Running As A Worker Cooperative
Up till now, there have been two major tax advantages of running as a worker cooperative. One, which is probably not that meaningful to cooperatives with workers living paycheck to paycheck, is deferral. The deductible patronage dividends can be paid up to eight and a half months after the end of the corporate year. Back in the day, when money earned interest, we used to get real excited about kicking the can down the road for a year. Not so much anymore, but still it is something.
The other advantage, which is more contested, is not having to pay payroll taxes or self-employment tax on patronage dividends from worker-owned cooperatives, which brings us to the secret law of worker cooperative dividends.
The Secret Law Of Worker Cooperative Dividends
Mr. Wilson told me that he has represented numerous taxpayers in audits where the IRS has asserted self-employment tax on worker cooperative patronage dividends. The IRS always backs down. Sometimes he has to go as far as filing a Tax Court petition. The case is always kicked back to appellate where it is settled favorably to the taxpayer. Mr. Wilson has a substantial co-op as a client which has paid as much as 30% of compensation out as patronage dividends. They requested that IRS issue a TAM. So they were audited on the notion that the dividends are actually payroll. IRS also backed off on that.
What makes the law secret is lack of Tax Court transparency. There are stipulated decisions, but no way for people to figure out what they are about without significant expense. The only public IRS document on the issue is a Field Service Advice (FSA 2838) from 1994 that stakes out the position that the dividends are subject to SE tax, but according to Mr. Wilson’s experience appellate will not stand behind the position. So the current state of the law is that you have to pay if you are audited unless you complain about it.
Mr. Hammer sent me a copy of a letter that IRS Commissioner John Koskinen sent to Congressman Jared Polis in September. He told the congressman that it was a “facts and circumstances” matter and it would have to be considered whether the taxpayer’s membership rose to the level of a trade or business. Neither I nor Mr. Wilson found the letter all that enlightening.
And Now A Third Benefit
And now there is a 20% deduction for qualified patronage dividends. And that deduction is not hedged with restrictions. So here is my idea of what can be done. I’m going to assume a professional corporation with five shareholders who average $700,000 per year. They are in one of the fields that are excluded from the general 20% deduction – health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services.
The shareholders rewrite the corporate bylaws and revise their employment contracts. They now have salaries of $150,000 per year and the corporation operating in a cooperative manner is required to pay out its profits in patronage dividends. That gives them each a deduction of $110,000 which is worth about $40,000. That’s $200,000 in federal tax savings for just fiddling a little with the paperwork and having a somewhat more complicated return.
Mr. Wilson noticed the same thing I did as he was going through the bill and agrees that it works (Maybe the salary is on the low side. His guide to best practices calls for a market salary). His thinking was that the IRS would plug the hole with regulations or that there will be technical corrections. I don’t think that there is a regulatory fix given the way the statute is written and I am skeptical that there will be a technical corrections bill.
Concerns about technical corrections and also the fact that there is a time limit on the deduction are why I would only recommend this plan to an entity that is already a C corporation. I would really be hesitant about revoking an S election or turning a partnership into a corporation to take advantage of this quirk, although I would not totally rule out the latter.
Don’t Try This At Home
Cooperative taxation is very complicated so a great deal of care should be taken if you are going to try this.
Feeling Kind Of Bad
The idealism around the worker-owner movement is pretty inspiring and has a deep history. It makes me almost feel like the loophole is like the Ring of Power hidden in the Shire and that I am kind of like Saruman unleashing a band of bad guys into a kindly sector of the world. I actually would feel pretty good, if there was a technical correction that fixed this, but always remember Reilly’s First Law of Tax Planning – It is what it is. Deal with it. I would hope the deduction stays intact for the bicycle mechanics, house cleaners and artisan bakers among others, who might only be getting a few hundred bucks out of it. I’m afraid that a lot of them will miss it, because it is kind of obscure. I’ll try to remember to post a reminder.
Correction
In an earlier version I wrote that the patronage dividends could be paid as late as nine and a half months after the end of the year they are attributed to. Actually it is the fifteenth day of the ninth month after, which is more like eight and a half months. – Reilly’s Sixth Law of Tax Planning– Don’t do the math in your head.