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).