Lower Your Taxes with Economic Democracy

Lower Your Taxes with Economic Democracy

Many business people know that S corporations and limited liability companies (LLCs) are tools to skip tax on a business’s income. But did you know that Subchapter T allows certain enterprises to benefit from the corporate form AND pass profits through to members tax-free?

Subchapter T of the Internal Revenue Code[1] allows qualifying corporations to subtract “patronage dividends” from the corporation’s taxable income. Patronage dividends are NOT dividends on stock, despite the confusing use of the same word. Patronage dividends work like this:

The enterprise does business with patrons: selling to them, buying from them, and/or employing them and making profit through their labor. Then the profit is shared among the patrons in proportion to the quantity or value of business each patron did with the enterprise.

This arrangement is appropriate for worker-owned business, and potentially any type of enterprise that shares its profits with its customers, users, or suppliers in a meaningful way. This arrangement will NOT work for any business that wants to return profits only to investors.

How to qualify:

First, the business must be “operating on a cooperative basis.”[2] This means:

  • Most transactions are with “patrons.” Patrons are people with whom there is a pre-existing, legally binding agreement to share profit. Patrons could be customers, suppliers, and/or workers.
  • Most profits are returned to the patrons. The profits of investors, if any, cannot take precedence. The business may have loans and outside investors, and it may pay its investors first, but benefiting patrons must be the primary goal.
  • The corporation must be democratically controlled by its members. This generally means one member, one vote. Members cannot give control away to investors. The business can be run by a board and managed by managers, but they are ultimately accountable to members.
  • Profits must be shared with patrons on the basis of patronage, which means in proportion to the quantity or value of business each patron does with the enterprise.

Next, the patronage dividend must meet all of the tax code’s requirements. Here’s a summary of how to do that:

  • Patronage dividends must come from “patronage net income,” which derives from business done with or for patrons. Patronage dividends cannot come from “profit” from business with non-patrons.
  • Patronage dividends must be allocated on the basis of relative patronage – again, in proportion to the quantity or value of business each patron transacted with the co-op.
  • The patronage dividend must be paid in cash, or a specific type of written notice of the patronage dividend must be given within 8 ½ months after the close of the fiscal year, and at least 20% of the dividend must be paid in cash no matter what.[3]

If all of these requirements are met, the business can subtract all of the patronage dividends from its own taxable income.

How this is the best of both worlds:

Corporations offer certain advantages. When members come and go from an LLC, the accounting can be complex and thus expensive. Corporations make it much simpler.

A member’s income from an LLC might be business income, and might be self-employment income. The member might need to do quarterly estimated tax payments, and complete Schedule C on their tax return. The member might need to file a tax return in another state, if the LLC operates in one state and the member lives in another. On the other hand, receiving a 1099-PATR from a corporation, and a W-2 in the case of a worker, are much easier to deal with on the member’s personal tax return.

The income of an LLC or an S corp “passes through” to members and becomes part of the members’ taxable income … even if the business needs to build a reserve. This is the “phantom income” problem; LLC and S corp owners must pay tax on money held in reserve, even if they do not receive the income in cash. Members must pay tax out of pocket, or the business must carefully pay out to each member just enough for the members to pay their taxes. In a corporation using Subchapter T, only the corporation pays tax on income that is kept in reserve.

A democratic corporation enjoys these conveniences, AND it is a pass-through entity to the extent that its income comes from transactions with “patrons” and it shares that income with the patrons on the basis of the relative value each patron contributed.

Please note that there are some reasons that a worker-owned business, particularly a startup, would not want to organize as a corporation right away; I would be happy to explain those reasons via email or over the phone.

If you read to the end, you may have noticed that this article is about the tax advantage for cooperatives. I love Subchapter T and can talk about it all day.

Cutting Edge also supports cooperatives by helping to design structures that meet their goals, providing legal documents, and consulting and legal documentation for raising capital. We also help retiring business owners sell businesses to their workers. If you have a legal or funding question about a cooperative, let us know about it by clicking here or emailing us at info@cuttingedgecapital.com.

 

[1] I.R.C. §§ 1381 – 1388.

[2] I.R.C. § 1381(a)(2).

[3] I.R.C. §§ 1382(b)(1) , I.R.C. § 1388(a)(3).

WEBINAR REPLAY: Capital Raising Strategies for Cooperatives

WEBINAR REPLAY: Capital Raising Strategies for Cooperatives

Cutting Edge Capital is partnering with Project Equity to provide a free webinar outlining the creative ways that cooperatives can raise capital. Kim Arnone & Sarah Kaplan will discuss how cooperatives can utilize Direct Public Offerings (DPOs), California Cooperative Corporation Law, and Title III JOBS Act crowdfunding to fund their cooperative venture.

 

Memberships as Securities

Memberships as Securities

In 1959, some enterprising developers bought land in Marin County to develop a country club.  To pay for some of the costs of building the club, they sold charter memberships in the club.  The members would not share in the profits or ownership of the club but would have the right to use club facilities.

Under the federal definition, these memberships would not be securities because the members joined the club to get the benefits of membership, not for a financial return.

But the California Supreme Court, in a landmark case called Silver Hills Country Club v. Sobieski (1961), found that these memberships are securities.

The court formulated a new test for whether something is a security, called the “risk capital test” which considers

(1) whether funds are being raised for a business venture or enterprise;

(2) whether the transaction is offered indiscriminately to the public at large;

(3) whether the investors are substantially powerless to effect the success of the enterprise; and

(4) whether the investor’s money is substantially at risk because it is inadequately secured.

This test is used by many states.

What does this mean for coop memberships?

Memberships in an existing coop that is adequately capitalized would not be a security under the risk capital test because the funds are not “being raised for a business venture.”  However, memberships in a start-up coop where memberships are needed to pay for start up-costs would likely be considered securities.

California has an exemption for the sale of coop memberships for less than $300.  It would be risky to offer memberships in a coop in California for more than $300 if the membership revenue us going to be used for the development of the business.

Worker coops in which the workers are actively involved in management should be able to avoid this problem because the members are not “substantially powerless to effect the success of the enterprise.”

In People v. Syde, the court said the California securities law “was not intended to afford supervision and regulation of instruments which constitute agreements with persons who expect to reap a profit from their own services or other active participation in a business venture.”