Credit Union and Cooperative Patronage Refunds - Filene ...
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<strong>Credit</strong> <strong>Union</strong> <strong>and</strong><br />
<strong>Cooperative</strong> <strong>Patronage</strong> <strong>Refunds</strong><br />
Joel Dahlgren, JD<br />
Black Dog Co-op Law<br />
Dan Kitzberger<br />
Kitzberger Consulting
<strong>Credit</strong> <strong>Union</strong> <strong>and</strong><br />
<strong>Cooperative</strong> <strong>Patronage</strong> <strong>Refunds</strong><br />
Joel Dahlgren, JD<br />
Black Dog Co-op Law<br />
Dan Kitzberger<br />
Kitzberger Consulting
Copyright © 2011 by <strong>Filene</strong> Research Institute. All rights reserved.<br />
Printed in U.S.A.
<strong>Filene</strong> Research Institute<br />
Deeply embedded in the credit union tradition is an ongoing<br />
search for better ways to underst<strong>and</strong> <strong>and</strong> serve credit union<br />
members. Open inquiry, the free flow of ideas, <strong>and</strong> debate are<br />
essential parts of the true democratic process.<br />
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research organization dedicated to scientific <strong>and</strong> thoughtful<br />
analysis about issues affecting the future of consumer finance.<br />
Through independent research <strong>and</strong> innovation programs the<br />
Institute examines issues vital to the future of credit unions.<br />
Ideas grow through thoughtful <strong>and</strong> scientific analysis of toppriority<br />
consumer, public policy, <strong>and</strong> credit union competitive<br />
issues. Researchers are given considerable latitude in their<br />
exploration <strong>and</strong> studies of these high-priority issues.<br />
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replacing of the best there<br />
is with something still better!<br />
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The Institute is governed by an Administrative Board made<br />
up of the credit union industry’s top leaders. Research topics<br />
<strong>and</strong> priorities are set by the Research Council, a select group<br />
of credit union CEOs, <strong>and</strong> the <strong>Filene</strong> Research Fellows, a blue<br />
ribbon panel of academic experts. Innovation programs are<br />
developed in part by <strong>Filene</strong> i 3 , an assembly of credit union<br />
executives screened for entrepreneurial competencies.<br />
The name of the Institute honors Edward A. <strong>Filene</strong>, the “father<br />
of the U.S. credit union movement.” <strong>Filene</strong> was an innovative<br />
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Since its founding in 1989, the Institute has worked with over<br />
one hundred academic institutions <strong>and</strong> published hundreds of<br />
research studies. The entire research library is available online<br />
at www.filene.org.<br />
iii
Acknowledgments<br />
We appreciate <strong>and</strong> are grateful for the time that Brian Prunty from<br />
CoVantage <strong>Credit</strong> <strong>Union</strong>, Dennis Hanson from Dow Chemical<br />
Employees’ <strong>Credit</strong> <strong>Union</strong>, <strong>and</strong> Tim Mislansky from Wright-Patt<br />
<strong>Credit</strong> <strong>Union</strong> spent with us to discuss each of their credit union’s use<br />
of patronage refunds. We would like to extend a special thank-you to<br />
Callahan & Associates, in particular Nick Connors. Nick is a senior<br />
industry analyst <strong>and</strong> provided critical data for this project.<br />
iv
Table of Contents<br />
List of Figures<br />
Executive Summary <strong>and</strong> Commentary<br />
About the Authors<br />
vi<br />
vii<br />
ix<br />
Introduction 2<br />
Chapter 1<br />
<strong>Patronage</strong> <strong>Refunds</strong> Are More Than Rebates<br />
(<strong>and</strong> Co-ops Are More Than IOFs) 6<br />
Chapter 2 Why Do Co-ops Need to Be Profitable? 17<br />
Chapter 3 A Primer on <strong>Patronage</strong> <strong>Refunds</strong> (in the Abstract) 21<br />
Chapter 4 Tax Differences between <strong>Cooperative</strong>s 24<br />
Chapter 5 Use of <strong>Patronage</strong> <strong>Refunds</strong> by Other <strong>Cooperative</strong>s 32<br />
Chapter 6 <strong>Credit</strong> <strong>Union</strong> Perspective 41<br />
Chapter 7 <strong>Credit</strong> <strong>Union</strong> Implications 49<br />
Appendix 60<br />
Endnotes 65<br />
v
List of Figures<br />
1. Average of 27 <strong>Credit</strong> <strong>Union</strong>s Compared with Average of<br />
81 ACAs<br />
2. Contrast Statutes Governing Co-ops<br />
3. Farm <strong>Credit</strong> Associations<br />
4. Present Value of <strong>Patronage</strong> Distributions<br />
5. A Comparison of ACA Ratios<br />
6. Potential Tax Effects of <strong>Patronage</strong> <strong>Refunds</strong><br />
vi
Executive Summary <strong>and</strong> Commentary<br />
By Ben Rogers,<br />
Research Director<br />
Last year, I overestimated my tax liability <strong>and</strong> thrilled myself (<strong>and</strong><br />
my wife) with a refund. When I use my credit union credit card,<br />
I get a monthly 1% cash-back reward. On a different card, I earn<br />
airline miles that I use to fly my family home for Christmas. With<br />
my REI (Recreational Equipment, Inc.) membership, I get back<br />
10% of every dollar I spend at the end of each year. Each of these<br />
cases demonstrates one part, <strong>and</strong> sometimes both parts, of a powerful<br />
two-pronged formula: an incentive based on my use of a product,<br />
<strong>and</strong> the psychic gratification of windfall money.<br />
<strong>Credit</strong> <strong>Union</strong> <strong>and</strong> <strong>Cooperative</strong> <strong>Patronage</strong> <strong>Refunds</strong> seeks to illuminate<br />
patronage refunds, a unique tool credit unions <strong>and</strong> other cooperatives<br />
can use to manage capital levels, return value to membershareholders,<br />
<strong>and</strong> tie members more closely to the company. The<br />
report examines the details of common refund practices outside<br />
the credit union system <strong>and</strong> weighs the pros <strong>and</strong> cons of increasing<br />
the practice among credit unions.<br />
What Did the Researchers Find?<br />
Use rather than ownership is the traditional driver of value at a<br />
cooperative. Using cooperative theory, the authors argue that credit<br />
unions should consider patronage dividends as a long-term commitment<br />
to users. The difference between a cooperative (like a credit<br />
union) <strong>and</strong> an investor- owned firm shines through in how well the<br />
cooperative rewards members who contribute to its ongoing success.<br />
The report profiles three refund- paying credit unions as well as<br />
several non–credit union cooperatives. Each treats its patronage<br />
dividend differently, but some similarities emerge: By issuing regular<br />
refunds, leaders go beyond rhetoric in considering members as the<br />
owners of the credit union’s capital; members appreciate the periodic<br />
windfall (one study indicates that agricultural co-op members prefer<br />
it to superior prices or interest rates); <strong>and</strong> credit unions that regularly<br />
pay refunds must be financially disciplined to support a regular<br />
payout.<br />
Finally, the researchers explore patronage refunds as a tax management<br />
strategy. By paying out refunds as cash <strong>and</strong> as allocated<br />
equity held at the cooperative in the name of members, certain<br />
cooperatives—including grocers, agricultural lenders, <strong>and</strong> rural electric<br />
companies—minimize their corporate tax burden.<br />
vii
What Are the <strong>Credit</strong> <strong>Union</strong><br />
Implications?<br />
<strong>Credit</strong> unions, of course, pay member dividends every month in<br />
the form of ordinary interest. Very few, however, offer a consistent<br />
extraordinary dividend. St<strong>and</strong>ard reasons for not paying one include<br />
the following: Earnings are already tight, so it’s unaffordable; paying<br />
an extraordinary dividend once could lead members to expect one<br />
every year <strong>and</strong> be frustrated without one; <strong>and</strong> any potential excess is<br />
already reflected in the credit union’s attractive savings <strong>and</strong> loan rates.<br />
These reasons are all valid, but they are the same reasons any publicly<br />
traded firm with excess capital might use. Nevertheless, the boards of<br />
those publicly traded companies constantly remind themselves that<br />
their shareholders expect real value <strong>and</strong> can easily take their money<br />
elsewhere. Nothing—not good feelings, not good intentions—says<br />
“please stay” like cash.<br />
<strong>Credit</strong> unions considering a patronage refund should take steps to:<br />
• Encourage an honest governance <strong>and</strong> management discussion<br />
over not just the marketing value of a patronage dividend but the<br />
cooperative imperative to return unused capital to members.<br />
• Balance the benefits of any refund between saving members <strong>and</strong><br />
borrowing members, both of whom are essential to the credit<br />
union’s health.<br />
• Help set realistic member expectations for future payments <strong>and</strong><br />
teach members how to earn a bigger refund in the future.<br />
Back to the REI example above. Like credit unions, this outdoor<br />
supplier cooperative operates a modern company selling familiar<br />
products in an intensely competitive retail industry. Surely its leadership<br />
knows that it could plow its yearly member dividend funds back<br />
into the business by lowering prices 10% across the board. Doing so<br />
might even goose short-term sales. But REI has made a calculated,<br />
long-term choice to compete daily with other retailers on price. Then<br />
the company writes its member- users a yearly reminder of its tangible<br />
cooperative value—in the form of a patronage check.<br />
viii
About the Authors<br />
Joel Dahlgren<br />
Joel Dahlgren has 30 years of experience with cooperatives. He<br />
founded Black Dog Co-op Law (a Minnesota 308B co-op) solo law<br />
practice in 2010 <strong>and</strong> has been providing legal representation <strong>and</strong><br />
business advice to consumer <strong>and</strong> agricultural cooperatives across the<br />
United States since 1992. Dahlgren is also employed as general counsel<br />
<strong>and</strong> chief risk officer at a Minnesota farm supply <strong>and</strong> grain cooperative<br />
since 2010. Prior to law school, Dahlgren was a loan officer at<br />
the St. Paul Bank for <strong>Cooperative</strong>s (a predecessor to CoBank, ACA),<br />
a federated cooperative owned by its member agricultural co-ops.<br />
Later he was a business service manager on the Member Services staff<br />
of the Cenex/L<strong>and</strong> O’ Lakes joint venture, providing business <strong>and</strong><br />
strategic planning <strong>and</strong> human resource advice <strong>and</strong> products for affiliated<br />
member co-ops of Cenex (now CHS Inc.) <strong>and</strong> L<strong>and</strong> O’ Lakes<br />
(both are federated agricultural co-ops). Dahlgren holds a bachelor of<br />
science degree from the University of Minnesota <strong>and</strong> a JD from the<br />
University of Wisconsin–Madison.<br />
Dan Kitzberger<br />
Dan Kitzberger has several years of experience working for nonprofit<br />
organizations. He worked for the Minnesota Council of Nonprofits,<br />
where he provided technical assistance to community <strong>and</strong> human<br />
service organizations to increase their capacity for civic engagement.<br />
He was a community organizer for Neighborhood Housing Services<br />
in Duluth, where he worked on a variety of projects in low- income<br />
neighborhoods. Since 2009, Kitzberger has worked in the Minnesota<br />
House of Representatives, where he began as an intern, worked as a<br />
legislative assistant during the 2010 legislative session, <strong>and</strong> currently<br />
works as a constituent services specialist <strong>and</strong> writer. He attended the<br />
University of Minnesota Duluth <strong>and</strong> received his bachelor’s in communication<br />
in 2006, followed by his master of advocacy <strong>and</strong> political<br />
leadership (MAPL), with concentrations in nonprofit advocacy <strong>and</strong><br />
public sector leadership, in 2009.<br />
Dan is an independent contractor who has an interest in socially<br />
conscious <strong>and</strong> sustainable business organizations, including cooperatives.<br />
Dan was engaged by Black Dog Co-op Law to assist with the<br />
preparation <strong>and</strong> research for this report.<br />
ix
Introduction<br />
There are many ways in which to improve the<br />
condition of mankind but the noblest of them<br />
all is through co-operation.<br />
—George J. Holyoake
<strong>Credit</strong> <strong>Union</strong> <strong>and</strong> <strong>Cooperative</strong> <strong>Patronage</strong> <strong>Refunds</strong> discusses the use of<br />
patronage refunds by credit unions. A patronage refund is an amount<br />
returned to a cooperative’s members at the end of an accounting<br />
period, usually a year. It is paid to members on the basis of how<br />
much they used the cooperative. More use means a bigger refund;<br />
less use means a smaller one.<br />
Twenty-seven credit unions identified in a recent Callahan &<br />
Associates patronage report each generated an annual net income<br />
of $3.5 million (M) 1 on average during the years 2008, 2009, <strong>and</strong><br />
2010. These 27 credit unions paid, on average, $822,500 (23%) of<br />
that income to members as a cash patronage refund. At the upper<br />
end, one credit union distributed a cash patronage refund equal to<br />
100% of its earnings. Its actual patronage refund was in excess of<br />
its net income, but by definition a patronage refund cannot exceed<br />
earnings.<br />
We report that these 27 credit unions generated average annual<br />
earnings of $3.5M for the years 2008, 2009, <strong>and</strong> 2010, whereas<br />
the financial performance reports from the National <strong>Credit</strong> <strong>Union</strong><br />
Administration (NCUA) website report that these same credit unions<br />
averaged $2.7M of earnings for that period. The difference between<br />
the two is the cash patronage refund of $822,500. <strong>Credit</strong> unions<br />
deduct patronage refunds to calculate net income, but the rest of the<br />
co-op world in the United States includes cash patronage refunds in<br />
cooperatives’ reported GAAP (generally accepted accounting principles)<br />
earnings. We’ve made this adjustment to allow apples-to- apples<br />
comparisons with other cooperatives.<br />
As rebates, patronage refunds may be a good or even a “best” business<br />
practice, but any business—even a bank—can pay a rebate 2 to<br />
its customers. Hence—<strong>and</strong> this is important—a philosophical difference<br />
exists between cooperatives <strong>and</strong> investor- owned firms (IOFs),<br />
between credit unions <strong>and</strong> banks. Co-ops benefit users who capitalize<br />
the co-op in proportion to use. IOFs benefit investors who capitalize<br />
the IOF in proportion to ownership <strong>and</strong> wealth. So patronage<br />
refunds are more than a rebate. <strong>Patronage</strong> refunds encapsulate what<br />
3
to us is a philosophical gulf between IOFs <strong>and</strong> co-ops. We assume<br />
that if you are affiliated with a credit union, this philosophical<br />
distinction drives your business model forward because credit unions<br />
are cooperatives too.<br />
To be clear, this report is not about the virtues of a collective society<br />
as opposed to a society organized around capitalism. <strong>Cooperative</strong>s—<br />
including credit unions—are the ultimate self-help business organization,<br />
3 <strong>and</strong> hence they are part of a capitalist system that allocates<br />
money <strong>and</strong> wealth across the economy through profits <strong>and</strong> losses.<br />
But cooperatives reward users rather than owners through patronage<br />
refunds distributed to the cooperative’s members on the basis of<br />
patronage (i.e., use). IOFs do not.<br />
Failing to pay a patronage refund is not an existential threat to a<br />
cooperative. As few as 27 credit unions out of more than 7,000 in<br />
the Callahan report regularly paid an annual patronage refund in<br />
each of the last five years. Later in this report we discuss the unresolved<br />
debate about whether to pay patronage refunds, a debate that<br />
is occurring within the board of directors <strong>and</strong> management of a farm<br />
credit association that is a member of the cooperatively owned Farm<br />
<strong>Credit</strong> System. Paying patronage refunds is far more accepted <strong>and</strong><br />
perhaps even expected for a farm credit association. Thus it will be<br />
obvious that the question of whether to pay a patronage refund is not<br />
an issue limited to credit unions.<br />
We note, however, that Callahan’s study of the 27 credit unions that<br />
paid patronage refunds documented that business growth, member<br />
involvement, <strong>and</strong> return on assets were all stronger for these 27 than<br />
for the other credit unions. It is very difficult to argue against the<br />
positive impact of paying a patronage refund. Our own experience<br />
with cooperatives paying a patronage refund is positive <strong>and</strong> entirely<br />
consistent with this conclusion.<br />
The balance of this report will discuss patronage refunds from several<br />
viewpoints. First, we drill down further to explore how patronage<br />
refunds are more than just a rebate, how they relate to capitalization,<br />
<strong>and</strong> how they are influenced by the principles of subordination of<br />
capital, service at cost, <strong>and</strong> co-op agency theory. These principles<br />
sum up the philosophical gulf that separates cooperatives <strong>and</strong> IOFs,<br />
<strong>and</strong> they drive the distribution of earnings to members <strong>and</strong> patrons<br />
rather than to investors.<br />
Second, we address the question of why cooperatives—<strong>and</strong> credit<br />
unions—need to be financially successful <strong>and</strong> generate earnings.<br />
Third, we discuss patronage refunds in the abstract, without the<br />
application of tax, <strong>and</strong> then we discuss four tax regimes as applied to<br />
alternative types of open membership cooperatives.<br />
4
Fourth, we examine how members of the Farm <strong>Credit</strong> System use<br />
patronage refunds.<br />
Fifth, we examine the payment of patronage refunds by three credit<br />
unions.<br />
Finally, we conclude by addressing potential future tax implications<br />
of patronage refunds for credit unions.<br />
As you read this report, it may help to remind yourself from time to<br />
time that we weave the disciplines of finance, accounting, <strong>and</strong> tax<br />
together with co-op theory. One of the consistent themes <strong>and</strong> tension<br />
is whether to allocate earnings other than what the co-op pays as<br />
a cash patronage refund.<br />
5
CHAPTER 1<br />
<strong>Patronage</strong> <strong>Refunds</strong><br />
Are More Than Rebates<br />
(<strong>and</strong> Co-ops Are More Than IOFs)<br />
<strong>Cooperative</strong> principles govern the use <strong>and</strong> allocation<br />
of capital. Members who own capital<br />
generally have that ownership acknowledged<br />
<strong>and</strong> recorded. <strong>Cooperative</strong>s have to balance the<br />
use, distribution, <strong>and</strong> accumulation of capital<br />
carefully to serve current <strong>and</strong> future members.
<strong>Patronage</strong> refunds are integral to the larger subject of capitalization.<br />
The discussion in this chapter will be foreign to credit unions <strong>and</strong><br />
their members because credit unions’ earnings are not allocated to<br />
individual members. In the abstract, patronage earnings that are not<br />
distributed to members as cash are supposed to be distributed as<br />
allocated equity, which forms the primary source of equity capital for<br />
co-ops.<br />
The theory is that a co-op’s earnings belong to members in proportion<br />
to their use of the co-op. In other words, the earnings do not<br />
belong to the co-op. It follows that if earnings belong to members,<br />
then the earnings should be distributed either as a cash patronage<br />
refund on the basis of use or as equity that is allocated on the co-op’s<br />
books <strong>and</strong> identified with each member in proportion to the member’s<br />
use of the co-op.<br />
For co-ops generally, then, a corollary to the benefits of paying<br />
patronage refunds to users is that users are expected to provide equity<br />
capital in proportion to their use of the cooperative. In the United<br />
States, most cooperatives obtain equity capital from members by<br />
retaining a portion of patronage refunds as allocated equity. A return<br />
is not usually paid for the use of the capital retained from patronage<br />
earnings, because capitalizing the cooperative is considered an obligation<br />
of membership. 4<br />
If capitalization is an obligation of membership, then one specific<br />
aim is to align capitalization of the co-op with use so that current<br />
members who use the co-op also capitalize the co-op. Obviously, to<br />
redeem allocated equity as members retire or die <strong>and</strong> no longer use<br />
the co-op, the co-op must know how much equity each member has<br />
provided. The co-op maintains patronage <strong>and</strong> equity records that<br />
show how much patronage earnings are allocated to <strong>and</strong> retained<br />
from each member.<br />
The retained earnings of credit unions are not allocated to members.<br />
These earnings form undivided equity (“unallocated” in general<br />
co-op–speak). In other words, we cannot relate members’ business<br />
7
activities with their credit union to the equity retained from each<br />
member’s activities or the income generated from each member’s<br />
activities. Pure co-op theory 5 takes issue with this approach, because<br />
if all earnings belong to members, then all earnings should be<br />
distributed either with cash or with allocated equity. Hence, all or<br />
substantially all of a co-op’s patronage earnings should be distributed<br />
to members on a patronage basis. There should be an observable link<br />
between each member’s use <strong>and</strong> the member’s capitalization of the<br />
co-op.<br />
This credit union deviation from co-op allocated equity principles<br />
of retaining earnings as undivided equity capital is more dramatic in<br />
a theoretic sense than it is in a practical sense. The following comparisons<br />
of credit unions with agricultural credit associations (ACAs)<br />
illustrate that even though credit unions do not distribute their<br />
earnings with allocated equity or undertake to eventually redeem that<br />
equity, credit unions are quite similar in this respect (<strong>and</strong> others) to<br />
ACAs, which have been functioning as co-op financial institutions<br />
since as early as 1916.<br />
The Farm <strong>Credit</strong> System includes 81 ACAs across the country that<br />
provide short- <strong>and</strong> long-term financing to agricultural producers<br />
(farmers). ACAs operate on a cooperative basis, as does the entire<br />
Farm <strong>Credit</strong> System. Whereas in a credit union the members hold<br />
the voting control <strong>and</strong> are eligible to serve on the board of directors,<br />
in an ACA, the farmers are the voting members <strong>and</strong> are elected to<br />
serve on the board of directors.<br />
The 27 credit unions in the Callahan study distributed on average<br />
23% of their earnings as a cash patronage refund, whereas the<br />
81 ACAs paid 21.5% of their earnings as a cash patronage refund.<br />
The ACAs retained $4.0M per year in allocated equity to capitalize<br />
the ACA, amounting to 18% of their earnings (<strong>and</strong> redeemed $2.4M<br />
per year on average during those years), while the credit unions did<br />
not distribute any patronage refunds with allocated equity.<br />
ACAs <strong>and</strong> credit unions each retain substantial portions of their<br />
earnings (60% <strong>and</strong> 75%, respectively) as permanent unallocated<br />
equity. Even for ACAs, this approach is not consistent with the co-op<br />
Figure 1: Average of 27 <strong>Credit</strong> <strong>Union</strong>s Compared with Average of 81 ACAs<br />
Average of 2008, 2009, <strong>and</strong> 2010 <strong>Credit</strong> unions % Total ACAs % Total<br />
Cash patronage refund 822,800 23.34 4,836,948 21.56<br />
<strong>Patronage</strong> refund in allocated equity — 0.00 4,028,708 17.96<br />
Undivided/Unallocated earnings 2,703,149 76.66 13,192,951 58.81<br />
Income tax on co-op’s earnings — 0.00 376,051 1.68<br />
Total earnings (average per co-op) $3,525,949 100.00 $22,434,658 100.00<br />
8
At the dissolution of a co-op, co-op theory calls for the remaining<br />
proceeds to be distributed on the basis of historical patronage<br />
to present <strong>and</strong> former members, theoretically back to the<br />
beginning of the cooperative.<br />
principle that earnings belong to members rather than the co-op. We<br />
believe, however, this information reveals that ACAs are balancing<br />
that co-op ideal (that earnings belong to members <strong>and</strong> should be distributed<br />
with allocated equity if they are not distributed with cash)<br />
against the financial reality that these cooperatives simply cannot<br />
generate enough earnings <strong>and</strong><br />
cash flow to redeem allocated<br />
equity while maintaining a<br />
viable business organization.<br />
Moreover, it does not follow<br />
that just because patronage<br />
earnings are not allocated as<br />
patronage refunds to members with allocated equity, the resulting<br />
undivided or unallocated equity is not owned by the members.<br />
In other words, the co-op’s earnings do not have to be allocated to<br />
members to demonstrate that the earnings belong to the members.<br />
The three credit unions that we discuss later in the report seem to<br />
have adopted that philosophy even though their earnings are not<br />
apportioned 6 or allocated to members in proportion to use. An even<br />
stronger position would be to educate <strong>and</strong> communicate with members<br />
about why the co-op does not allocate “their” earnings <strong>and</strong> how<br />
the co-op uses “their” unallocated equity.<br />
At the dissolution of a co-op, co-op theory calls for the remaining<br />
proceeds to be distributed on the basis of historical patronage to<br />
present <strong>and</strong> former members, theoretically back to the beginning of<br />
the cooperative. At the dissolution of a credit union, another deviation<br />
from co-op principles occurs when the remaining proceeds<br />
are distributed on the basis of share ownership to the last members<br />
st<strong>and</strong>ing.<br />
It is worthwhile to drill down further to explain how this dissolution<br />
issue relates to patronage refunds <strong>and</strong> why this deviation from co-op<br />
principles is more striking for credit unions than the issue of whether<br />
all or substantially all of the credit unions’ earnings are distributed<br />
with cash or allocated equity.<br />
Co-op Dissolutions: Service at Cost,<br />
Subordination of Capital, <strong>and</strong> Co-op<br />
Agency Theory<br />
The principles of service at cost, subordination of capital, <strong>and</strong> the<br />
co-op agency theory direct the co-op’s financial operations from its<br />
incorporation to its dissolution. These principles are ignored when<br />
any dissolving co-op distributes the remaining proceeds to the last<br />
9
members st<strong>and</strong>ing on the basis of ownership rather than to present<br />
<strong>and</strong> former members on the basis of historical patronage.<br />
The co-op agency theory holds that the co-op is an agent of its<br />
members <strong>and</strong>, therefore, that the co-op’s earnings really belong—<br />
have always belonged—to members <strong>and</strong> have never belonged to the<br />
co-op. This theory dovetails with the principle of service at cost,<br />
which holds that patronage earnings are rebates, discounts, or price<br />
enhancements when they are allocated <strong>and</strong> distributed as patronage<br />
refunds in cash or allocated equity to members on a patronage basis. 7<br />
The co-op agency theory <strong>and</strong> service-at- cost principles support the<br />
favorable income tax treatment of co-ops. If the earnings were never<br />
the co-op’s in the first place, there is no justification for taxing the<br />
earnings at the co-op level. If the earnings are taxed, they should be<br />
taxed at the member level.<br />
Service at cost requires that earnings be distributed on a patronage<br />
basis as patronage refunds to qualify as rebates, discounts, or price<br />
enhancements that reduce “costs” to the members. If the earnings<br />
are distributed on the basis of share ownership, that distribution is<br />
a return on equity rather than a zeroing out of the co-op’s earnings<br />
to the logical conclusion that the costs of products or services are<br />
reduced to breakeven. The service-at- cost principle is not followed if<br />
the co-op’s earnings are distributed on the basis of share ownership.<br />
And what applies to the co-op’s earnings while it is a going concern<br />
also applies to its equity at its dissolution. So in a dissolution, when<br />
credit unions distribute the remaining proceeds on the basis of share<br />
ownership to the last members st<strong>and</strong>ing rather than on the basis of<br />
historical patronage to present <strong>and</strong> former members, they are deviating<br />
from the co-op agency theory <strong>and</strong> service-at- cost principles.<br />
Distribution of the remaining proceeds at dissolution should be on<br />
the basis of historical patronage going back to the beginning of the<br />
co-op to adhere to these principles consistently. If all the earnings<br />
<strong>and</strong> remaining proceeds are distributed on the basis of historical<br />
patronage, we can logically conclude that the co-op always operated<br />
at cost from its beginning to its end.<br />
The co-op principle of subordination of capital is also not followed<br />
when credit unions distribute the remaining proceeds on the basis of<br />
share ownership to the last members st<strong>and</strong>ing. This principle limits<br />
the financial return paid on equity to investors to a “reasonable”<br />
return for its use. The last members st<strong>and</strong>ing at a credit union’s dissolution<br />
benefit disproportionately to all the former members. Not<br />
only is their proportionate equity capital returned as it would be if<br />
the agency <strong>and</strong> service-at- cost theories were followed using historical<br />
patronage, but the last members st<strong>and</strong>ing receive an extraordinarily<br />
large return on that capital when the balance of the dissolution<br />
10
proceeds—in excess of what they were entitled to receive on the basis<br />
of historical patronage—is also distributed to them on the basis of<br />
share ownership.<br />
Although we cannot reconcile this credit union inconsistency with<br />
the co-op principles that should govern at dissolution, it does not<br />
deter us from applying co-op patronage principles to credit unions<br />
while they are operating <strong>and</strong> going concerns before dissolution. 8<br />
We said earlier that patronage refunds encapsulate what is a philosophical<br />
gulf between cooperatives <strong>and</strong> IOFs. In the next section we<br />
drill down even further to explore the differences between IOFs <strong>and</strong><br />
co-ops <strong>and</strong> to identify why cooperatives are more sustainable <strong>and</strong><br />
operate with a more modest capital footprint than IOFs.<br />
Co-ops Are More Than IOFs<br />
The principles of subordination of capital, service at cost, <strong>and</strong> co-op<br />
agency theory draw a crucial distinction between IOFs <strong>and</strong> co-ops.<br />
IOFs are like VELCRO: They attract, use, <strong>and</strong> hoard capital for their<br />
own benefit. Co-ops are like GORE-TEX: As they generate surplus<br />
working capital, they shed <strong>and</strong> return capital to members on the<br />
basis of use, either as cash patronage refunds or eventually as redemptions<br />
of allocated equity.<br />
First, consider that an expenditure on an asset that tripled an IOF’s<br />
value is immediately reflected in the value of an IOF’s common<br />
stock. Each investor holding common stock is immediately wealthier.<br />
The IOF continues to look for investment opportunities in which to<br />
deploy capital, <strong>and</strong> to look for more capital to deploy in those investments.<br />
This process replicates itself over <strong>and</strong> over. The IOF’s selfinterest<br />
is in attracting more <strong>and</strong> more capital to feed this process.<br />
Now contrast the impact of that same expenditure on a cooperative<br />
<strong>and</strong> its members. The allocated equity of members does not appreciate<br />
in value. This equity is still<br />
A natural tension occurs among members in a co-op, where redeemable at no more than<br />
acquiring assets <strong>and</strong> growing the business necessarily mean its face value to members. No<br />
that cash for redemptions of allocated equity is reduced or member is wealthier as a result<br />
eliminated.<br />
of the expenditure. Neither<br />
the co-op nor its members are<br />
driven or motivated to invest<br />
more <strong>and</strong> more capital into the co-op. Members might hope that<br />
an expenditure tripling the co-op’s market value would improve the<br />
co-op’s earnings, <strong>and</strong> perhaps their allocated equity can be redeemed<br />
faster than it would have been, but who knows.<br />
If the expenditure spurs sales growth that increases working capital<br />
requirements, if the asset was financed with term debt requiring<br />
11
epayment, <strong>and</strong>/or if the asset is one of those expenditures that<br />
begets more expenditures on other assets to supplement the initial<br />
expenditure, there is no assurance that redemptions can be sped up.<br />
The opposite—that redemptions are slowed down—may, in fact,<br />
be true. But, as between an IOF <strong>and</strong> a co-op, the co-op’s incentives<br />
clearly lean in favor of distributing as much cash as soon as possible<br />
to redeem equity, while the IOF’s incentives clearly lean in favor of<br />
holding on to extra cash <strong>and</strong> reinvesting it in the IOF.<br />
In fact, an expenditure that triples the co-op’s market value does<br />
not hold the same fascination for a co-op that it does for an IOF. A<br />
natural tension occurs among<br />
members in a co-op, where<br />
The counterweight to members who want redemptions of acquiring assets <strong>and</strong> growing<br />
equity is usually that the board of directors has a fiduciary the business necessarily mean<br />
obligation to look out for the co-op’s interest in surviving <strong>and</strong> that cash for rede mptions of<br />
flourishing for future generations.<br />
allocated equity is reduced or<br />
eliminated. This member interplay<br />
pushes management <strong>and</strong><br />
the board of directors to carefully examine asset expenditures because<br />
the leadership knows it will be criticized by members who prefer cash<br />
redemptions of their allocated equity over asset expenditures. The<br />
incentives that an IOF operates under to continue investing in assets<br />
to grow the IOF’s value do not exist in a co-op.<br />
Because a co-op’s strongest <strong>and</strong> most respected members are typically<br />
older, more vocal, <strong>and</strong> experienced <strong>and</strong> hold more allocated equity in<br />
the cooperative, their views often carry more weight 9 than the views<br />
of younger members, who care less about redemption of equity <strong>and</strong><br />
more about the state of the co-op’s competitiveness, its asset bases,<br />
<strong>and</strong> the extent to which it is providing for the needs of members. So<br />
the counterweight to members who want redemptions of equity is<br />
usually that the board of directors has a fiduciary obligation to look<br />
out for the co-op’s interest in surviving <strong>and</strong> flourishing for future<br />
generations.<br />
The only time that a co-op member (or former member) benefits<br />
from the market value of the cooperative is at its dissolution. The<br />
members of the cooperative who purchased an asset tripling the<br />
co-op’s market value would enjoy that added value only if the cooperative<br />
is dissolved, but former members (even members who are<br />
deceased <strong>and</strong> no longer own allocated equity) would also enjoy that<br />
accretion in value because they are all entitled to a portion of the dissolution<br />
distribution after all allocated equity is first redeemed. The<br />
remaining proceeds are distributed to members <strong>and</strong> former members<br />
on the basis of historical patronage, theoretically to former members<br />
12
If the co-op’s earnings are not distributed to the member in<br />
cash, they are distributed with allocated equity, each dollar<br />
of equity being identified with a member on the basis of the<br />
member’s proportional use.<br />
going all the way back to the beginning of the cooperative. Again,<br />
this distribution leads to the logical conclusion that the service-atcost<br />
principle was followed through to the very end of the co-op’s<br />
existence.<br />
Second, consider who owns the earnings generated by an IOF <strong>and</strong><br />
a co-op. An IOF’s earnings belong first to the IOF. Most of the<br />
profits will be reinvested in the IOF to enhance the value of the firm.<br />
Some IOFs pay dividends 10 on common stock or repurchase shares<br />
if the IOF has excess working capital, but these are not common<br />
occurrences.<br />
Even when dividends or stock repurchases occur, one can argue the<br />
benefits of an IOF as much as any common stockholder because<br />
repurchased shares or dividends paid on stock usually enhance the<br />
long-term valuation of the IOF’s common stock <strong>and</strong> hence its attractiveness<br />
to investors. Most, if not all, of an IOF’s decisions are driven<br />
by its interest in maximizing its own book value <strong>and</strong> the value of its<br />
equity.<br />
In contrast, the co-op’s patronage earnings each year belong to members<br />
in proportion to their use of the cooperative in that year rather<br />
than to anyone else. This year’s earnings may belong to a different<br />
cast of members, in different proportions, than next year’s earnings if<br />
the makeup of the membership changes or each member’s use of the<br />
co-op changes from year to year.<br />
The co-op’s entire mission is not to make itself more valuable but<br />
to integrate <strong>and</strong> serve its members’ lives <strong>and</strong> businesses. Because<br />
the co-op is considered an agent of the members, it is an extension<br />
of their lives <strong>and</strong> of their businesses. And because it operates under<br />
the service-at- cost principle, its returns are added to the members’<br />
returns to judge whether the<br />
whole composite return—of<br />
the co-op plus the member—is<br />
successful.<br />
This is why it makes sense when<br />
we read that the <strong>Credit</strong> <strong>Union</strong><br />
National Association (CUNA)<br />
asserted that in 2009 the Wright-Patt <strong>Credit</strong> union “provided $1,268<br />
in savings throughout the year for households with ‘high use’ of the<br />
credit union.” CUNA said this credit union provided total benefits<br />
of $26.0M to its members in 2009. 11 As a cooperative, Wright-Patt is<br />
viewed as an adjunct to its members rather than as an IOF that is an<br />
isl<strong>and</strong> unto itself. This is a key distinction between co-ops <strong>and</strong> IOFs.<br />
13
If the co-op’s earnings are not distributed to the member in cash,<br />
they are distributed with allocated equity, each dollar of equity being<br />
identified with a member on the basis of the member’s proportional<br />
use. Each dollar of allocated equity that is eventually redeemed is<br />
redeemed at no more than its face value. But in the meantime, until<br />
the allocated equity is redeemed, it does not appreciate in value. In<br />
fact, the longer the co-op uses <strong>and</strong> holds the equity, the more the<br />
equity is depreciated from the effect of the time value of money.<br />
But as soon as the co-op has surplus working capital, allocated equity<br />
is redeemed <strong>and</strong> returned to members. The co-op is motivated to<br />
distribute surplus working capital rather than reinvest it in the co-op<br />
because aggr<strong>and</strong>izing itself over its members benefits no one <strong>and</strong> is<br />
counter to the philosophy under which the co-op is formed. The<br />
board of directors is motivated to distribute surplus working capital<br />
through equity redemptions because each director—like every other<br />
member—eventually wants that surplus capital if <strong>and</strong> when the<br />
co-op can afford to return it.<br />
This same dynamic does not exist in an IOF, because the principles<br />
of subordination of capital, service at cost, <strong>and</strong> co-op agency theory<br />
are not in play. Obviously some investors desire dividends, while<br />
others desire retention of earnings <strong>and</strong> appreciation in the value of<br />
their holdings. But the IOF decides what to do with its earnings by<br />
reference to their impact on the IOF’s value, not, as a co-op does,<br />
by reference to the extent that the co-op integrates <strong>and</strong> adds value to<br />
members’ lives or businesses. An IOF is a supplier to customers, not<br />
an agent of its members or an extension of their lives or businesses.<br />
Finally, consider that an IOF’s universe of investors is narrow, limited<br />
by the number of shares of common stock the IOF has issued.<br />
Hence, the number of claims on earnings is finite. A finite number<br />
of shares means that as the value of the business increases, the same<br />
number of shares is now more valuable than before the increase in<br />
the value of the business.<br />
By comparison, an open membership co-op’s universe of members<br />
is dynamic <strong>and</strong> exp<strong>and</strong>ing all the time. The number of claims on<br />
earnings in an open membership cooperative is infinite, limited<br />
only by the number of co-op members <strong>and</strong> their proportion of the<br />
business of all members combined. Because at the co-op’s dissolution<br />
the remaining proceeds are distributed on the basis of historical<br />
patronage to present <strong>and</strong> former members, the longer that an open<br />
membership is in business before dissolution, the more claims that<br />
are created from present <strong>and</strong> former members who are entitled to a<br />
portion of the remaining proceeds at the co-op’s dissolution.<br />
14
The principles of subordination of capital, service at cost, <strong>and</strong> the<br />
co-op agency theory work together to make co-ops more sustainable,<br />
more just, <strong>and</strong> more beneficial to society than IOFs. A co-op does<br />
not, in theory, hoard or hog capital, nor does it have an insatiable<br />
appetite for capital like an IOF.<br />
Balancing Co-op Principles against<br />
the Financial Realities of Equity<br />
Redemptions<br />
The tension between allocating earnings <strong>and</strong> building up expectations<br />
for redemptions of equity must be acknowledged <strong>and</strong> managed<br />
by the co-op’s board of directors. Is retaining 60%–75% of earnings<br />
as undivided or unallocated equity really a significant deviation from<br />
co-op principles?<br />
One way to manage this tension is to balance the co-op principles of<br />
subordination of capital, service at cost, <strong>and</strong> the co-op agency theory<br />
with the finance principle that no business organization—co-ops<br />
included—should voluntarily create obligations that detract from<br />
the organization’s mission or weaken it financially. In other words, a<br />
co-op is like any business organization in that it needs strong capital<br />
structures.<br />
Finance principles cause or should cause the co-op’s leadership to<br />
make informed judgments about how much of the co-op’s earnings<br />
are distributed with allocated equity. Each dollar of earnings<br />
distributed with allocated equity might create one dollar more of<br />
expectation that this equity will eventually be redeemed. The co-op’s<br />
leadership should want to soften or even eliminate the tension<br />
between making necessary expenditures <strong>and</strong> redeeming equity.<br />
Circling back to the beginning of this chapter, where we said that<br />
both ACAs <strong>and</strong> credit unions deviate from the co-op principle that<br />
earnings belong to members when they retain 60%–75% of earnings<br />
as undivided or unallocated equity, the most logical response to that<br />
criticism is that credit unions <strong>and</strong> ACAs are simply balancing co-op<br />
principles with finance principles. ACAs <strong>and</strong> credit unions are being<br />
logical when they distribute what they can as a cash patronage refund<br />
each year, <strong>and</strong> when they avoid allocating equity that cannot be<br />
redeemed in a reasonable time.<br />
ACAs <strong>and</strong> credit unions—like banks—are some of the most leveraged<br />
business organizations across the entire economy. These co-ops<br />
are likely to be the least able to redeem allocated equity if they follow<br />
only more traditional co-op principles <strong>and</strong> do not consider finance<br />
15
principles. When we discuss other co-ops’ use of patronage refunds,<br />
we will note the pressure that AgGeorgia puts on itself by allocating<br />
much of its income as patronage refunds that members expect will<br />
eventually be redeemed.<br />
If the cooperative is not profitable or has no earnings, we never get<br />
to the issues of subordination of capital, service at cost, or the co-op<br />
agency theory. We need earnings before we can apply these principles.<br />
So as important as these principles are, the more important<br />
immediate point is to address why co-ops must be profitable.<br />
16
CHAPTER 2<br />
Why Do Co-ops<br />
Need to Be Profitable?<br />
Is comparing banks <strong>and</strong> credit unions a fruitful<br />
endeavor? Yes, because they compete with each<br />
other, <strong>and</strong> both need to be profitable to remain<br />
relevant, to return value to shareholders, <strong>and</strong> to<br />
grow. But they should go about it in different<br />
ways.
A recent post to the <strong>Filene</strong> Research Institute’s website posed the<br />
question: Why do credit unions compare themselves to banks or<br />
even worry about return on assets? One could argue that cooperatives<br />
should not compare themselves with IOFs or that cooperatives could<br />
operate economically on a shoestring, out of a shoe box, inside a steel<br />
shed—a most utilitarian approach. It is also argued that cooperatives<br />
do not have to worry about financial comparisons so long as money<br />
flowing into the cooperative is just one penny more than money<br />
flowing out.<br />
For cooperatives—including credit unions—there are always at least<br />
three criticisms of this philosophical position. First, it is impractical<br />
to operate or manage any business organization of any size that<br />
close to the edge. Second, most<br />
members expect that their<br />
<strong>Cooperative</strong>s must generate enough earnings to compete with shares (<strong>and</strong> entitlement to undivided<br />
earnings; more on that<br />
IOFs by maintaining <strong>and</strong> growing the cooperative’s base of<br />
capital assets <strong>and</strong> its business. So even if the cooperative does later) will be safeguarded by the<br />
not raise capital in private capital markets, it is likely to have its board of directors <strong>and</strong> management.<br />
Members underst<strong>and</strong>ably<br />
own business objectives that must be financed with the cooperative’s<br />
earnings <strong>and</strong> equity.<br />
expect that the cushion will be<br />
more than a penny. The board<br />
must pay attention to earnings<br />
because members have legal recourse to sue the board if they suffer<br />
losses from a breach of the board’s fiduciary obligations.<br />
Third, some cooperatives are regulated by government agencies<br />
(NCUA for credit unions; FCA [Farm <strong>Credit</strong> Administration] for<br />
farm credit associations) <strong>and</strong> required to maintain minimum st<strong>and</strong>ards<br />
of financial strength. In addition, some cooperatives join<br />
together to raise capital from private markets. These cooperatives<br />
must maintain strong financial st<strong>and</strong>ards so that the notes <strong>and</strong><br />
bonds sold by their agents are attractive to investors in those markets.<br />
For example, the National Rural Utilities <strong>Cooperative</strong> Finance<br />
18
While cooperatives cannot escape the imperative that confronts<br />
any business organization to generate profits, cooperatives are<br />
different <strong>and</strong>, in principle, more sustainable than IOFs because<br />
co-ops do not hoard capital.<br />
Corporation (CFC) <strong>and</strong> the Federal Farm Bank Funding Corporation<br />
(BFC) issue tens <strong>and</strong> hundreds of billions of dollars in securities<br />
annually to provide capital for rural electric cooperatives <strong>and</strong> farm<br />
credit associations, respectively.<br />
Those securities are secured by loans to rural electric cooperatives<br />
<strong>and</strong> farm credit associations, respectively. The latter, in turn, makes<br />
loans to farmers <strong>and</strong> agricultural cooperatives. If those rural electric<br />
cooperatives <strong>and</strong> farm credit associations do not attain <strong>and</strong> maintain<br />
st<strong>and</strong>ards of financial strength, their agents will pay more in private<br />
capital markets to raise capital,<br />
or worse, their agents won’t be<br />
able to raise any capital.<br />
In addition, cooperatives must<br />
generate enough earnings to<br />
compete with IOFs by maintaining<br />
<strong>and</strong> growing their base<br />
of capital assets <strong>and</strong> their business. So even if the cooperative does<br />
not raise capital in private capital markets, it is likely to have its<br />
own business objectives 12 that must be financed with the cooperative’s<br />
earnings <strong>and</strong> equity. Boards of directors <strong>and</strong> management are<br />
accountable to use the co-op’s equity efficiently <strong>and</strong> effectively.<br />
Yes, a cooperative can operate as close to breakeven as possible, without<br />
aiming to make any earnings or profits. But unless these cooperatives<br />
operate very conservatively with little or no risk, they are more<br />
prone to financial failure because it is impossible to make decisions<br />
that well—to be right that often—<strong>and</strong> hence, impossible to avoid<br />
the cumulative weakness created from wrong decisions. 13<br />
So while cooperatives cannot escape the imperative that confronts<br />
any business organization to generate profits, cooperatives are different<br />
<strong>and</strong>, in principle, more sustainable than IOFs because co-ops do<br />
not hoard capital.<br />
The incentives that drive IOFs <strong>and</strong> cooperat ives oppose each other.<br />
For either business organization, management <strong>and</strong> the board of<br />
directors are accountable to use equity capital from members or<br />
investors efficiently <strong>and</strong> to maximize the returns paid to members<br />
or investors according to their expectations, respectively. The IOF’s<br />
incentives drive it to retain <strong>and</strong> reinvest capital for the benefit of the<br />
IOF. The cooperative’s incentives drive it to pay cash to members <strong>and</strong><br />
patrons <strong>and</strong> to retain only what is needed to finance the cooperative’s<br />
growth objectives, which are all aimed to benefit members rather<br />
than the cooperative.<br />
19
Our response to the blog post question about co-op profitability<br />
would be the following:<br />
Thank you for your comments. <strong>Credit</strong> unions need profits to sustain<br />
themselves, so if a comparison with a bank is helpful for identifying<br />
areas of inefficiency, that comparison is not objectionable. We<br />
know you will appreciate hearing that credit unions are not capital<br />
hogs, <strong>and</strong> that their genetic makeup—being from the family of<br />
cooperatives—is to return unneeded earnings <strong>and</strong> capital to members<br />
in the form of patronage refunds. Cash is returned to members as<br />
soon as possible because there is no incentive for the co-op to hoard the<br />
cash for itself, or for members to leave their equity in the co-op hoping<br />
that it will appreciate in value. The same thing cannot be asserted<br />
about the expected behavior of an IOF bank. Consequently, the more<br />
successful a cooperative is, the more capital that it returns to its users<br />
on the basis of patronage.<br />
In this chapter we addressed the issue of why cooperatives need earnings<br />
<strong>and</strong> how the cooperative’s business objectives are geared toward<br />
the financial <strong>and</strong> economic benefit of members rather than the<br />
cooperative. In Chapter 3 we will address the mechanics of patronage<br />
refunds in the abstract. In Chapter 4, we will apply the requirements<br />
of four alternative co-op tax regimes to the payment of patronage<br />
refunds.<br />
20
CHAPTER 3<br />
A Primer on <strong>Patronage</strong> <strong>Refunds</strong><br />
(in the Abstract)<br />
<strong>Credit</strong> unions are open membership cooperatives<br />
that can grow membership <strong>and</strong> corresponding<br />
capital in relation to the number of<br />
potential members available. Capital distribution<br />
decisions stem from careful deliberation by<br />
the board.
The subject of this chapter is a theoretical open membership cooperative.<br />
The focus of this report, in fact, is directed at open membership<br />
cooperatives. Open membership means there are no limitations<br />
on the number of members who can join the cooperative or do<br />
business with it. The allocated equity that members earn from doing<br />
business with open membership cooperatives does not appreciate in<br />
value. When allocated equity is redeemed, the co-op pays no more<br />
than the face value of the allocated equity.<br />
In contrast, the common stock in a closed membership cooperative<br />
can appreciate in value if the cooperative is financially successful.<br />
Closed membership cooperatives limit membership because the<br />
co-op’s physical plant size is defined. An ethanol cooperative, for<br />
example, produces a finite number of gallons of ethanol, <strong>and</strong> it needs<br />
a finite number of bushels of corn to produce that ethanol. The<br />
cooperative does not sell more stock or approve new members after<br />
its membership is of sufficient size to produce <strong>and</strong> deliver enough<br />
corn to supply the cooperative’s ethanol production capabilities.<br />
We have already said that a cooperative’s earnings belong to members<br />
rather than the co-op. <strong>Patronage</strong> refunds are distributed from the<br />
co-op’s GAAP patronage- sourced income. Assuming that all earnings<br />
are, in fact, generated from transactions with or for members,<br />
then all of the co-op’s income is theoretically available to allocate to<br />
members on a patronage basis.<br />
Capitalization of the cooperative naturally occurs proportionate to<br />
each member’s use of the cooperative. Earnings are distributed in<br />
cash to the extent possible but are retained by the cooperative as allocated<br />
equity to finance its need for equity capital. The cooperative’s<br />
need for equity turns on its growth objectives, its plans to borrow<br />
debt capital, <strong>and</strong> its desire to redeem equities allocated from previous<br />
years’ earnings. The cooperative aims to generate enough earnings<br />
<strong>and</strong> surplus cash flow to align ownership with use by redeeming the<br />
allocated equity of former, retired, or deceased members.<br />
22
Equity redemption policies are adopted by the board of directors<br />
minimally to maintain an alignment between each member’s equity<br />
capitalization <strong>and</strong> his or her use of the cooperative. The board of<br />
directors is not required to redeem any allocated equity. Case law<br />
generally supports the board’s discretion to redeem allocated equity,<br />
but it also appears that courts are inclined to order redemptions if<br />
they conclude that the co-op had surplus working capital that it did<br />
not need. Redemption policies include the redemption of allocated<br />
equities when a member or former member dies. For more successful<br />
cooperatives, the redemption of allocated equities occurs when<br />
a member reaches a certain age (e.g., age 70) or by year of allocation<br />
(e.g., in 2011, the co-op redeems equities that were allocated in<br />
1990).<br />
Some boards of directors adopt base capital plans that tie the amount of allocated equity to the<br />
member’s use of the cooperative. When the member’s use increases, the member’s base capital<br />
requirement also increases, <strong>and</strong> more of that member’s patronage distribution is retained, or<br />
redemptions to that member are slowed to build up the member’s base capital.<br />
Some bo ards of directors adopt base capital plans that tie the amount<br />
of allocated equity to the member’s use of the cooperative. When<br />
the member’s use increases, the member’s base capital requirement<br />
also increases, <strong>and</strong> more of that member’s patronage distribution is<br />
retained, or redemptions to that member are slowed to build up the<br />
member’s base capital. When the member’s use of the cooperative<br />
decreases <strong>and</strong> thus less base capital is required, then retained earnings<br />
are reduced or redemptions of allocated equity are increased to<br />
reduce the member’s level of base capital.<br />
So far we have discussed patronage refunds in the abstract. Next we<br />
will drill down into the tax mechanics of patronage refunds.<br />
23
CHAPTER 4<br />
Tax Differences between<br />
<strong>Cooperative</strong>s<br />
Governed by different statutes, credit unions<br />
<strong>and</strong> other cooperatives operate under a mix of<br />
tax obligations. The distribution <strong>and</strong> accounting<br />
of patronage dividends is a key component<br />
affecting the corporate tax liability of<br />
cooperatives.
In this chapter, we will review four tax regimes that are applied to<br />
cooperatives. The first is Subchapter T, which applies to the widest<br />
variety of cooperatives. The second is 26 U.S.C. 501(c)(12),<br />
which applies to rural electric cooperatives. The third is 26 U.S.C.<br />
501(c)(1) as applied to Federal L<strong>and</strong> Bank Associations under<br />
12 U.S.C. 2098. 14 The fourth is 26 U.S.C. 501(c)(14), which applies<br />
to state- chartered credit unions.<br />
The key points of distinction among these tax regimes include<br />
(1) whether the co-op is treated as tax exempt or nonexempt,<br />
(2) whether earnings (<strong>and</strong> which ones—patronage earnings only or<br />
nonpatronage earnings too) are apportioned to individual patrons,<br />
(3) when the co-op pays cash to members, (4) when members pay<br />
income tax on income allocated to them from their co-op, <strong>and</strong><br />
(5) whether the co-op is required to give notice of patronage allocations<br />
to members.<br />
The tax exemption under which state-chartered credit unions operate does not require credit<br />
unions to allocate or apportion their earnings to individual members. <strong>Credit</strong> unions’ equity is<br />
undivided. Members have no idea how much of their own transactional activity with the credit<br />
union contributes to the credit unions’ equity.<br />
On a continuum moving from left to right in Figure 2, Sub-T<br />
co-ops are most regulated, <strong>and</strong> state- chartered credit unions are least<br />
regulated by their tax statutes, in how closely they must follow co-op<br />
principles. The tax exemption under which state- chartered credit<br />
unions operate does not require credit unions to allocate or apportion<br />
their earnings to individual members. <strong>Credit</strong> unions’ equity is<br />
undivided. Members have no idea how much of their transactional<br />
activity with the credit union contributes to the credit unions’ equity.<br />
<strong>Credit</strong> union members do not expect any equity to be redeemed,<br />
ever.<br />
The relevance of including a discussion of rural electric cooperatives<br />
under 501(c)(12) may not become apparent until much later in the<br />
25
Figure 2: Contrast Statutes Governing Co-ops<br />
Federal L<strong>and</strong> Bank<br />
Sub-T co-op Rural electric co-op<br />
(<strong>and</strong> federal<br />
credit unions)<br />
State-chartered<br />
credit union<br />
Statute 26 U.S.C. 1382 26 U.S.C. 501(c)(12) 501(c)(1) 26 U.S.C. 501(c)(14)<br />
Exempt or nonexempt Nonexempt Exempt Exempt Exempt<br />
Are patronage earnings<br />
allocated or apportioned<br />
to individual members?<br />
Notification of allocation<br />
to member required?<br />
When does member pay<br />
income tax, if ever?<br />
Is patronage earnings<br />
part of capitalization of<br />
co-op?<br />
How are proceeds<br />
distributed at dissolution<br />
of co-op or credit union?<br />
When are income taxes<br />
paid by the co-op or<br />
credit union?<br />
Yes. Must be allocated<br />
to qualify for tax<br />
deduction allowed for<br />
patronage-sourced<br />
earnings. “Allocation”<br />
is apportionment plus<br />
“notice.”<br />
Yes. Co-op is required<br />
to give specific written<br />
notice of member’s prorata<br />
allocated patronage<br />
earnings.<br />
In the year that member<br />
received qualified written<br />
notice. Members pay tax<br />
on entire distribution even<br />
though no more than 20%<br />
is paid in cash (if business<br />
with co-op was taxable as<br />
income or deductible as<br />
expense).<br />
Yes. Allocated equity is<br />
usually major portion of all<br />
equity capitalization. This<br />
equity is redeemed as <strong>and</strong><br />
when co-op has excess<br />
working capital.<br />
On basis of historical<br />
patronage. Articles <strong>and</strong>/or<br />
bylaws may limit length of<br />
look back.<br />
On all nonpatronagesourced<br />
income <strong>and</strong><br />
patronage income that is<br />
not allocated.<br />
Not required. Minimum<br />
requirement is to maintain<br />
records showing each<br />
member’s interest in<br />
co-op’s earnings <strong>and</strong> equity.<br />
Some notify members of<br />
apportionment of each<br />
member’s pro-rata portion<br />
of patronage earnings.<br />
No. But recommended<br />
practice is to specifically<br />
notify members of pro-rata<br />
portion of apportioned<br />
earnings. Notification is<br />
seen as opportunity to<br />
communicate about co-op<br />
values.<br />
Upon redemption of<br />
allocated equity in cash<br />
paid to the member by<br />
co-op (if purchase was for<br />
tax-deductible business<br />
purpose).<br />
Yes. Apportioned <strong>and</strong><br />
allocated equity is usually<br />
major portion of all equity<br />
capitalization. This equity<br />
is redeemed as <strong>and</strong> when<br />
co-op has excess working<br />
capital.<br />
On basis of historical<br />
patronage. Articles <strong>and</strong>/or<br />
bylaws may limit length of<br />
look back.<br />
If more than 15% of<br />
income arises from<br />
unrelated nonmember<br />
business.<br />
Not required. If the<br />
earnings are not<br />
apportioned, the earnings<br />
are accounted for in an<br />
unallocated surplus.<br />
No. Practice is mixed.<br />
Some do notify but others<br />
do not notify. Notification<br />
seen as an opportunity<br />
to communicate with<br />
members about co-op<br />
values.<br />
Upon redemption of<br />
allocated equity in cash<br />
paid to the member by<br />
co-op (if loans or services<br />
were for tax-deductible<br />
purpose).<br />
Mixed. Some promote<br />
member ownership of<br />
allocated equity capital,<br />
but others are silent about<br />
that feature of co-op’s<br />
capitalization.<br />
L<strong>and</strong> Banks—usually<br />
historical patronage, <strong>and</strong><br />
governed by articles of<br />
incorporation or bylaws.<br />
(<strong>Credit</strong> unions—to<br />
members on basis of share<br />
ownership).<br />
Never.<br />
No. Earnings are<br />
unallocated. Most earnings<br />
are accounted for as<br />
“undivided earnings.”<br />
No. But notice of cash<br />
patronage refunds is<br />
seen as an opportunity<br />
to communicate with<br />
members about co-op<br />
values.<br />
Upon receipt of cash<br />
refund paid to member<br />
by credit union (if loans<br />
or services were for taxdeductible<br />
purpose).<br />
No. Equity is all<br />
unallocated. On the other<br />
h<strong>and</strong>, we know that<br />
members’ businesses<br />
generated earnings that<br />
make up the undivided<br />
equity.<br />
Governed by state law<br />
where incorporated rather<br />
than federal law.<br />
If more than 15% of<br />
income arises from<br />
unrelated nonmember<br />
business.<br />
report, when we discuss tax implications for credit unions. Rural<br />
electric co-ops will be particularly relevant then because their tax<br />
exemption has been criticized even more harshly than that of credit<br />
unions. Moreover, in cases where members are litigating the redemption<br />
of their allocated equity, rural electric cooperatives are of interest<br />
26
ecause they are being challenged more than any other type of cooperative<br />
to live up to the ideal that cooperatives are not capital hogs.<br />
Under any of these four tax regimes, members pay income tax on<br />
patronage distributions only if the transaction that gave rise to the<br />
patronage distribution is taxable<br />
income (like the sale of corn<br />
Under any of these four tax regimes, members pay income tax to a co-op where the proceeds<br />
on patronage distributions only if the transaction that gave from the sale are taxed) or a<br />
rise to the patronage distribution is taxable income or a tax- tax- deductible expense (like the<br />
deductible expense.<br />
payment of interest on a loan<br />
that is used to finance a business).<br />
In either case, the patronage<br />
refund is also taxed. Only members of Sub-T co-ops, however,<br />
pay income tax on the entire patronage distribution before they have<br />
received all the cash.<br />
Subchapter T <strong>Cooperative</strong>s<br />
(26 U.S.C. 1382 et al.)<br />
The broadest cross section of cooperatives is taxed under Subchapter<br />
T <strong>and</strong> described as nonexempt (“Sub-T” or “nonexempt”). This<br />
group includes but is not limited to natural food cooperatives, bargaining<br />
cooperatives, cable television cooperatives, most agricultural<br />
cooperatives, a minority of rural electric distribution cooperatives,<br />
<strong>and</strong> some electric generation <strong>and</strong> transmission cooperatives.<br />
Sub-T cooperatives are faced with the choice of either paying income<br />
tax or paying a cash patronage refund of at least 20% of allocated<br />
patronage earnings to members. Sub-T cooperatives are treated like<br />
corporations in that they pay income tax on nonpatronage- sourced<br />
income 15 <strong>and</strong> on patronage earnings that are not allocated to patrons.<br />
The cooperative is allowed a tax deduction for patronage earnings<br />
that it allocates to patrons on the basis of their proportional patronage<br />
of the cooperative.<br />
Three conditions are necessary in order to receive a patronage tax<br />
deduction under Subchapter T for income allocated to patrons.<br />
First, an obligation to allocate income to members must have existed<br />
at the time of the members’ transaction with the cooperative. This<br />
obligation is usually found in the bylaws, but it can be in an agreement<br />
as well. Second, the allocation must be from profits or income<br />
realized from transactions with the members for whom the allocation<br />
is made. Third, the allocation must be made ratably to the members<br />
whose patronage created the income from which the allocation is<br />
made. 16<br />
27
<strong>Patronage</strong> earnings that are allocated <strong>and</strong> distributed to patrons must<br />
be “paid” within eight <strong>and</strong> one-half months of the cooperative’s fiscal<br />
year end, the outside limit of the statutory time allotted to file the<br />
cooperative tax return. At least 20% of this distribution must be paid<br />
with cash or by qualified check.<br />
The balance (up to 80%) of the allocation is distributed <strong>and</strong> “paid”<br />
to patrons with qualified written notices of allocation (QNAs). 17<br />
The written notice advises the<br />
patron that a finite amount of<br />
In Subchapter T cooperatives, a tax deduction is allowed to the patronage earnings (up to 80%<br />
cooperative for patronage earnings that it allocates to patrons of allocated patronage earnings)<br />
on the basis of their proportional patronage of the cooperative. was allocated on the cooperative’s<br />
books to the patron on<br />
the basis of the patron’s proportional<br />
patronage of the cooperative. Patrons are required to consent<br />
18 (most often contained in the bylaws, but consent can also be<br />
obtained by endorsement of a qualified check or separate agreement)<br />
to report these earnings on their tax returns.<br />
Sub-T co-ops report payments to patrons who receive a distribution<br />
of patronage earnings in cash <strong>and</strong> QNAs of $10 or more on form<br />
1099-PATR. Consumers do not pay income tax if the transactions<br />
from which the patronage income arose were for personal, living,<br />
or family expenditures that were not tax deductible. In fact, some<br />
consumer cooperatives may apply for <strong>and</strong> receive an exemption from<br />
filing 1099-PATRs. 19 If, however, the member’s transaction with the<br />
cooperative produces taxable income or a tax deduction, the income<br />
reported on a 1099-PATR must be reported on the member or<br />
patron’s tax return as well.<br />
Sub-T cooperatives are not required to redeem allocated equities.<br />
Case law from across the United States upholds the authority of a<br />
board of directors to determine for itself, at its sole discretion, when<br />
to redeem allocated equities. Some of these cases, however, also<br />
intimate that the board cannot just retain surplus working capital<br />
without redeeming allocated equity. This is consistent with the view<br />
that cooperatives do not exist to hoard capital.<br />
Sub-T cooperatives are required to maintain patronage records so<br />
that in the event of dissolution of the cooperative, the remaining<br />
proceeds can be distributed on the basis of historical patronage.<br />
28
Rural Electric <strong>Cooperative</strong>s<br />
(26 U.S.C. 501(c)(12))<br />
Like credit unions, most rural electric cooperatives are exempt from<br />
income tax rather than nonexempt like a Sub-T co-op. At least 85%<br />
of rural electric cooperatives’ income must be from member business,<br />
or the unrelated business income tax is imposed if more than 15%<br />
of their income is derived from nonmember sources. Exempt rural<br />
electric cooperatives—again, like credit unions—are not required<br />
to allocate or distribute income to members in the year the income<br />
is generated by the rural electric. Further, rural electrics can allocate<br />
patronage <strong>and</strong> nonpatronage or unrelated income to members.<br />
But unlike credit unions, rural electrics must at least maintain books<br />
<strong>and</strong> records showing to whom each year’s earnings would be allocated<br />
on the basis of patronage, <strong>and</strong> the interest of each member in<br />
the cooperative’s equity. The<br />
National Rural Electric <strong>Cooperative</strong><br />
Association (NRECA)<br />
At least six lawsuits have been initiated against rural electric<br />
cooperatives to redeem equity to members. The lawsuits are not goes further, recommending<br />
evidence that rural electric cooperatives are hoarding capital, that rural electric cooperatives<br />
but that is what is at issue in this litigation.<br />
administer <strong>and</strong> account for their<br />
earnings from members like a<br />
Sub-T co-op. 20 Hence, rural<br />
electric cooperatives are encouraged to annually notify their members<br />
of the amount of earnings apportioned to the member on the rural<br />
electric cooperative’s books.<br />
The NRECA makes this recommendation to rural electric cooperatives<br />
to (1) protect rural electric cooperatives’ tax exemption under<br />
501(c)(12), because notification solidifies the record- keeping aspect<br />
of the tax exemption, (2) position rural electric cooperatives to argue<br />
for a Sub-T tax deduction if their 501(c)(12) exemption is denied<br />
by the IRS, <strong>and</strong> (3) create an opportunity for communication with<br />
members about cooperative values. 21<br />
Rural electric cooperatives are not required to file Form 1099<br />
information returns to report payments of patronage dividends, 22<br />
although these cooperatives may use 1099-MISC to report payments<br />
of $600 or more. Unlike in the case of Sub-T cooperatives,<br />
where patrons consent to report their allocated portion of patronage<br />
refunds in the year the earnings were generated even though up to<br />
80% of the patronage income is noncash, members of rural electric<br />
cooperatives do not pay income tax until they receive a cash redemption<br />
of their allocated equity from the rural electric cooperative, <strong>and</strong><br />
then only if the expenditure for electricity was tax deductible.<br />
29
When rural electric cooperatives are dissolved, <strong>and</strong> after payment of<br />
all creditors <strong>and</strong> equity credits, the remaining proceeds are distributed<br />
on the basis of historical patronage in keeping with the co-op<br />
principles of subordination of capital, service at cost, <strong>and</strong> the co-op<br />
agency theory of earnings.<br />
The NRECA is <strong>and</strong> has been proactive in encouraging rural electric<br />
cooperatives to ratchet up the priority of redeeming capital credits.<br />
In 2005, the NRECA reassembled a task force <strong>and</strong> updated its guide,<br />
“Capital <strong>Credit</strong>s Task Force Report, a Distribution <strong>Cooperative</strong>’s<br />
Guide to Making Capital <strong>Credit</strong>s Decisions.” This guide supports<br />
the idea that rural electric cooperatives must manage their equity<br />
capital more proactively <strong>and</strong> redeem equity credits on a systematic<br />
basis.<br />
Rural electric cooperatives are being challenged in lawsuits 23 to live<br />
up to the idea that they are not capital hogs. At least six lawsuits have<br />
been initiated against rural electric cooperatives to redeem equity to<br />
members. The lawsuits are not evidence that rural electric cooperatives<br />
are hoarding capital, but that is what is at issue in this litigation.<br />
In each case, the board of directors is alleged to have failed to redeem<br />
equity credits according to its fiduciary obligations. These boards of<br />
directors may be ordered to redeem equity credits if the plaintiffs can<br />
prove these rural electric cooperatives have surplus working capital<br />
that is not required for present or future capital requirements. The<br />
oddity is that most boards of directors of cooperatives—including<br />
rural electric cooperatives—are driven by a strong moral compulsion<br />
to redeem allocated equity sooner rather than later. As we said<br />
earlier, co-ops are not driven to hoard capital. Hence, we would not<br />
be surprised that these rural electric cooperatives simply do not have<br />
sufficient surplus working capital to redeem lots of allocated equity.<br />
In addition, these plaintiffs may also need to overcome the presumption<br />
that equity credits do not vest or confer ownership in members<br />
until the board of directors affirmatively resolves to redeem the<br />
equities. This, parenthetically, is a point of contrast with Sub-T<br />
cooperatives, where, under the consent provisions discussed above,<br />
ownership of the equities vests immediately in members upon allocation<br />
of patronage income to members.<br />
Federal L<strong>and</strong> Bank Associations<br />
(501(c)(1) <strong>and</strong> 12 U.S.C. 2098)<br />
Federal L<strong>and</strong> Bank Associations (“L<strong>and</strong> Banks”) are tax exempt (as<br />
are federal credit unions under 501(c)(1)) because they exist under<br />
an act of Congress. L<strong>and</strong> Banks may, but are not required to, allocate<br />
or apportion income (patronage or nonpatronage <strong>and</strong> unrelated<br />
30
income) on a patronage basis to members, maintain patronage<br />
records, or pay a cash refund. 24 Members pay income tax only upon<br />
the receipt of cash the L<strong>and</strong> Bank pays as cash refunds or to redeem<br />
allocated equity. Further, these co-ops are not subject to the unrelated<br />
business tax.<br />
L<strong>and</strong> Banks are closely regulated by the FCA. Regulations include<br />
direction about how farm credit associations distribute income <strong>and</strong><br />
manage their capital. For example, the FCA regulates the capitalization<br />
provisions contained in L<strong>and</strong> Banks’ bylaws (12 CFR<br />
615.5220), the distribution of earnings (12 CFR 615.5215), <strong>and</strong><br />
the implementation of co-op principles by farm credit associations<br />
(12 CFR 615.5230).<br />
<strong>Credit</strong> <strong>Union</strong>s (26 U.S.C. 501(c)(14))<br />
State credit unions are exempt from income taxation under 501(c)<br />
(14), while federal credit unions are exempt from income tax under<br />
501(c)(1). Even though credit unions operate on co-op principles<br />
of democratic control <strong>and</strong> subordination of capital, they are not<br />
required to maintain records or apportion earnings individually from<br />
member business.<br />
At dissolution, federal credit unions distribute remaining funds on<br />
the basis of share ownership at the time of the dissolution. 25 The<br />
dissolution provisions of the<br />
statutes <strong>and</strong> law of the state in<br />
<strong>Credit</strong> union dissolutions are unlike dissolutions of other cooperatives<br />
in that the last credit union member st<strong>and</strong>ing benefits is chartered will govern its dis-<br />
which a 501(c)(14) credit union<br />
disproportionately to former members who have died or who solution <strong>and</strong> the distribution<br />
no longer have a share account.<br />
of remaining proceeds after all<br />
creditors <strong>and</strong> superior claims<br />
are paid. We have not reviewed<br />
the statutes of all 50 states, but it appears that based on a sampling<br />
of statutes from Iowa, Kentucky, North Dakota, <strong>and</strong> Wisconsin,<br />
state statutory requirements are likely to follow the federal scheme<br />
in 12 CFR 701.6. 26 <strong>Credit</strong> union dissolutions are unlike dissolutions<br />
of other cooperatives in that the last credit union member st<strong>and</strong>ing<br />
benefits disproportionately to former members who have died or<br />
who no longer have a share account.<br />
<strong>Credit</strong> unions report payments of dividends to holders of share<br />
accounts for payments in excess of $10 on form 1099-INT. <strong>Credit</strong><br />
unions also report mortgage interest refunded with form 1098.<br />
31
CHAPTER 5<br />
Use of <strong>Patronage</strong> <strong>Refunds</strong><br />
by Other <strong>Cooperative</strong>s<br />
In this chapter we compare <strong>and</strong> contrast<br />
Georgia- based AgGeorgia Farm <strong>Credit</strong> ACA<br />
<strong>and</strong> Wisconsin- based Badgerl<strong>and</strong> Financial<br />
ACA. These associations illustrate widely differing<br />
views of patronage refund philosophies.<br />
Some argue that cooperatives pay out their<br />
dividends in better everyday rates. Others argue<br />
that the co-op should reward member- owners in<br />
a more measured, visible way.
The annual reports of AgGeorgia Farm <strong>Credit</strong> ACA <strong>and</strong> Badgerl<strong>and</strong><br />
Financial ACA (individually an “association” or collectively “associations”)<br />
can be found on their websites. 27 Each of these associations is<br />
a member of the Farm <strong>Credit</strong> System. Selected financial information<br />
is contained in Figure 3. Figure 4 evaluates the value of patronage<br />
refunds received by the members of AgGeorgia <strong>and</strong> Badgerl<strong>and</strong>.<br />
The Farm <strong>Credit</strong> System is cooperatively owned <strong>and</strong> operated by<br />
agricultural producers. System institutions provide financing for<br />
members who are engaged in production agriculture. Federal L<strong>and</strong><br />
Bank Associations were the first system institutions chartered by<br />
Congress in 1916. These associations provide their members—<br />
agricultural producers—with long-term credit for purchases of l<strong>and</strong><br />
<strong>and</strong> long-lived assets. By 1947, L<strong>and</strong> Banks had repaid all government<br />
capital.<br />
The Federal Intermediate <strong>Credit</strong> Bank <strong>and</strong> related Production <strong>Credit</strong><br />
Associations were chartered by Congress in 1933. These associations<br />
Figure 3: Farm <strong>Credit</strong> Associations<br />
Average of 2007, 2008, <strong>and</strong> 2009 AgGeorgia Badgerl<strong>and</strong><br />
Income statement (thous<strong>and</strong>s)<br />
1. Not allocated $7,555 $32,876<br />
2. Total patronage refund distributed with QNAs $15,189 $5,476<br />
2a. Refund portion paid in cash $5,069 (33%) $5,476 (100%)<br />
2b. Refund portion paid with allocated QNAs $10,120 (67%) $0<br />
2c. Refund portion paid with allocated NQNAs $1,707.0 $0<br />
3. Net income $24,451 $38,352<br />
4. Gross interest income $74,346 $118,634<br />
Balance sheet (000’s omitted)<br />
5. Common stock $4.0 $7.0<br />
6. Allocated equity $82.5 $0<br />
7. Unallocated equity $90.7 $405.2<br />
8. Total equity (fiscal year end 2009) $177.1 $412.2<br />
9. Redemption of allocated equity $13.3 $0<br />
33
Figure 4: Present Value of <strong>Patronage</strong> Distributions<br />
Badgerl<strong>and</strong> AgGeorgia<br />
1. <strong>Patronage</strong> distribution allocated to members $1.00 $5.00<br />
2. Allocated equity $0.00 $3.35<br />
3. Cash portion paid by co-op $1.00 $1.65<br />
4. Member taxes paid $(0.35) $(1.75)<br />
5. Member net cash position year 1 $0.65 $(0.10)<br />
6. Present value of redeemed equity at 5% cost of capital $0.00 $2.26<br />
over 8 years<br />
7. Member net cash position after redemption of equity<br />
year 8<br />
$0.65 $2.16<br />
provide their members—again,<br />
agricultural producers—with<br />
short-term credit for crop <strong>and</strong><br />
livestock enterprises <strong>and</strong> for<br />
purchases of farm machinery.<br />
By 1968, all government capital<br />
was repaid.<br />
Originally, the system’s associations<br />
were operated separately<br />
from one another, but in the<br />
late 1980s they were consolidated<br />
under the same management<br />
structures into ACAs. Each ACA has at least two subsidiary<br />
lending institutions: a Federal L<strong>and</strong> <strong>Credit</strong> Association (L<strong>and</strong> Bank)<br />
<strong>and</strong> a Production <strong>Credit</strong> Association (<strong>Credit</strong> Association).<br />
Federal L<strong>and</strong> Banks were—<strong>and</strong> inside of an ACA, still are—exempt<br />
from income tax under 501(c)(1) because they are federally chartered<br />
organizations. Production <strong>Credit</strong> Associations are nonexempt<br />
cooperatives under Subchapter T. From the provision for income tax<br />
in the audits of AgGeorgia <strong>and</strong> Badgerl<strong>and</strong>, respectively, approximately<br />
60% of these ACAs’ income is generated by their L<strong>and</strong> Banks<br />
(tax exempt) <strong>and</strong> 40% of their income is generated by their <strong>Credit</strong><br />
Associations (nonexempt under Subchapter T).<br />
Later in this chapter, we also discuss a third ACA. However, the<br />
officers of this ACA requested that we not disclose their names or<br />
the identity of the ACA, because the board of directors <strong>and</strong> senior<br />
management are engaged in an ongoing discussion about whether<br />
the ACA will pay patronage refunds. The chief financial officer we<br />
spoke with is concerned that identifying the ACA might diminish<br />
the openness of the deliberations currently under way <strong>and</strong>/or suggest<br />
that senior management is biased either for or against the payment of<br />
patronage refunds.<br />
FCA—Regulatory Agency of ACAs<br />
The FCA regulates AgGeorgia, Badgerl<strong>and</strong>, <strong>and</strong> the other 79 ACAs,<br />
<strong>and</strong> it establishes capital adequacy ratios for these associations.<br />
Figure 5 contains the 2009 ratios for AgGeorgia <strong>and</strong> Badgerl<strong>and</strong>,<br />
the FCA minimum ratio, <strong>and</strong> the ratios for the combined 81 ACAs<br />
as of December 31, 2010. Capital ratios are also provided for the<br />
unnamed ACA that we will discuss later in this chapter.<br />
FCA regulations prohibit the inclusion of more than two percentage<br />
points of allocated equities in the calculation of the core surplus<br />
ratio. 28 Further, the regulations also prohibit in the calculation of<br />
34
Figure 5: A Comparison of ACA Ratios<br />
FCA ratio* FCA minimum 81 ACAs Badgerl<strong>and</strong> AgGeorgia Unnamed<br />
Permanent capital 7.00% 13.46% 12.70% 13.75% 16.20%<br />
Total surplus 7.00% 12.93% 12.40% 13.50% 16.00%<br />
Core surplus 3.50% 12.18% 12.40% 10.47% 16.00%<br />
*St<strong>and</strong>ards imposed by the Farm <strong>Credit</strong> Administration, the regulatory arm that provides oversight to the Farm <strong>Credit</strong> System <strong>and</strong> individual<br />
institutions like Badgerl<strong>and</strong> <strong>and</strong> AgGeorgia.<br />
the core surplus ratio the inclusion of any allocated equities that are<br />
scheduled or intended to be retired during the next three years. 29<br />
Consequently, these regulations are a disincentive for associations to<br />
distribute earnings with allocated equity to their members.<br />
AgGeorgia <strong>Patronage</strong> <strong>Refunds</strong><br />
AgGeorgia’s average annual net income was $24.5M over the past<br />
three years, <strong>and</strong> it has allocated <strong>and</strong> distributed 70% of that income<br />
($15.1M with cash <strong>and</strong> QNAs) to members on the basis of patronage.<br />
AgGeorgia has distributed 33% of that distribution in cash, <strong>and</strong><br />
the balance of earnings is retained as allocated equity.<br />
Because these earnings were distributed with QNAs, <strong>and</strong> because<br />
we assume the interest paid to AgGeorgia was deductible on the tax<br />
returns of its members, AgGeorgia’s members also report this patronage<br />
income on their tax returns. Only the cash patronage distribution<br />
from the L<strong>and</strong> Bank subsidiary is reported on the members’ tax<br />
returns, whereas the cash <strong>and</strong> noncash allocated equity distributions<br />
from the Production <strong>Credit</strong> Association subsidiary are reported on<br />
members’ tax returns.<br />
We assume that AgGeorgia’s board of directors <strong>and</strong> management has<br />
made a calculated decision that paying 33% of the distribution in<br />
cash is sufficient to at least pay the income taxes that most members<br />
will owe to federal <strong>and</strong> state governments on these patronage distributions.<br />
Recall that the interest payments that members make to<br />
AgGeorgia are likely to be tax deductible to the member as a business<br />
expense, so patronage income must be reported as taxable income as<br />
well.<br />
Because AgGeorgia distributes patronage refunds with QNAs that<br />
its members pay income tax on, AgGeorgia’s members undoubtedly<br />
have high expectations that AgGeorgia will redeem that equity<br />
sooner rather than later. Just under half of all of AgGeorgia’s total<br />
earned equity ($82.5M; see Figure 3, row 6) is allocated to members.<br />
AgGeorgia’s average annual redemption expenditure over the past<br />
three years was $13.3M. Hence, AgGeorgia could redeem all of its<br />
allocated equity in as little as seven years (see Figure 3, row 6 divided<br />
35
y row 9). All in all, this is a very aggressive posture for a financial<br />
co-op.<br />
Significantly, AgGeorgia’s patronage refund philosophy is pressuring<br />
its capital position. As a percentage of its total loans, the cash that<br />
AgGeorgia pays to redeem allocated equity <strong>and</strong> its cash patronage<br />
refund (at 1.9%) is three to four times the average paid by other farm<br />
credit associations (.49%) or the 27 credit unions in Callahan’s study<br />
(.5%).<br />
Badgerl<strong>and</strong> <strong>Patronage</strong> <strong>Refunds</strong><br />
Badgerl<strong>and</strong>’s average annual net income was $38.4M over the past<br />
three years (see Figure 3, row 3). Badgerl<strong>and</strong> allocates <strong>and</strong> distributes<br />
only 14% of its income on a patronage basis, but its entire distribution<br />
is 100% cash; its average annual patronage refund is $5.5M.<br />
The balance of Badgerl<strong>and</strong>’s earnings is not allocated, <strong>and</strong> hence it<br />
is used to build Badgerl<strong>and</strong>’s unallocated equity. Because Badgerl<strong>and</strong><br />
does not distribute any earnings with allocated equity, all of its<br />
equity is unallocated (undivided) <strong>and</strong> its members do not expect that<br />
Badgerl<strong>and</strong> will redeem equity to them (see Figure 3, rows 6 <strong>and</strong> 7).<br />
Approximately 40% of earnings is related to Badgerl<strong>and</strong>’s nonexempt<br />
Production <strong>Credit</strong> Association <strong>and</strong>, therefore, exposed to corporate<br />
income tax.<br />
Badgerl<strong>and</strong>’s members are in a stronger cash position than AgGeorgia’s<br />
members in the year they receive the cash patronage distribution<br />
from each association (see Figure 4, row 5) because whatever<br />
AgGeorgia’s members receive is paid to federal <strong>and</strong> state governments<br />
when AgGeorgia’s members pay their income taxes.<br />
In contrast, Badgerl<strong>and</strong> members probably keep 67 cents of every<br />
dollar of patronage refund after they pay their income tax obligations<br />
from the 100% cash patronage refund they receive from Badgerl<strong>and</strong>.<br />
However, AgGeorgia’s members fare better in the long run after the<br />
earnings distributed with QNAs are redeemed. The present value of<br />
AgGeorgia’s patronage distribution is stronger than Badgerl<strong>and</strong>’s (see<br />
Figure 4, row 7) by a factor of more than three to one.<br />
Impact on Adequacy of Capital<br />
Position<br />
The patronage refund philosophies of AgGeorgia <strong>and</strong> Badgerl<strong>and</strong><br />
affect their compliance with FCA capital management guidelines.<br />
Because all of Badgerl<strong>and</strong>’s equity is unallocated (except for the<br />
capital stock that members purchase when they borrow money; see<br />
Figure 3, row 5), the calculation of its core surplus ratio, which was<br />
36
12.40% at its 2009 fiscal year end, is not diluted by allocated equity<br />
(see Figure 3, row 6).<br />
On the other h<strong>and</strong>, at 10.47%, AgGeorgia’s core surplus ratio is considerably<br />
softer than Badgerl<strong>and</strong>’s ratio. Not only do the FCA regulations<br />
prohibit the inclusion of more than two percentage points of<br />
allocated equity in the calculation of the core surplus ratio, but the<br />
FCA could argue that AgGeorgia intends to redeem $40M over the<br />
next three years based on its average redemption of $13.3M the past<br />
three years.<br />
Juxtaposing the philosophies of Badgerl<strong>and</strong> <strong>and</strong> AgGeorgia illustrates<br />
the choices that each co-op makes about patronage refunds, capital<br />
structure, <strong>and</strong> the payment of corporate income tax. AgGeorgia pays<br />
far less income tax than Badgerl<strong>and</strong>. Each dollar that AgGeorgia<br />
distributes as a patronage refund (with QNAs, both the cash portion<br />
<strong>and</strong> the allocated equity portion) reduces its taxable income by a<br />
dollar for its nonexempt Subchapter T subsidiary. At the same time,<br />
every dollar that AgGeorgia allocates with QNAs builds up member<br />
expectations that this equity will eventually be redeemed, sooner<br />
rather than later. In contrast, Badgerl<strong>and</strong> has not created an expectation<br />
among its patrons that it will redeem equity every year, or at any<br />
time, <strong>and</strong> accordingly, Badgerl<strong>and</strong>’s capital position is stronger than<br />
AgGeorgia’s position.<br />
This observation brings us back to a point we made in Chapter 1<br />
in regard to building strong capital structures by not allocating<br />
patronage refunds <strong>and</strong> how allocating earnings puts pressure on the<br />
cooperative to redeem equity capital. AgGeorgia’s board of directors<br />
<strong>and</strong> management must have concluded that they are not pressuring<br />
AgGeorgia’s capital position too much by allocating so much income<br />
<strong>and</strong> then redeeming that equity within seven or eight years. It is difficult<br />
for us to conclude that this approach will accrue to AgGeorgia’s<br />
benefit over the long run because its patronage philosophy is depleting<br />
capital that may be needed for growth.<br />
Like any business organization, co-ops might pursue short-term<br />
objectives that are not aligned with their long-term interests. It could<br />
be that AgGeorgia is one of those organizations.<br />
A Farm <strong>Credit</strong> Association’s <strong>Patronage</strong><br />
Refund Debate<br />
In the course of our research, we encountered a farm credit association<br />
(virtually identical to Badgerl<strong>and</strong> or AgGeorgia but operating in<br />
a trade territory far from either of those associations) where an ongoing<br />
debate is the issue of whether to pay a patronage refund. This<br />
association’s 2010 year-end loan volume was over $3 billion (B). Like<br />
37
Badgerl<strong>and</strong>, all of this association’s equity is unallocated except for<br />
approximately $8.0M of common stock. Its net income has nearly<br />
doubled in the last five years.<br />
This association is stronger than either Badgerl<strong>and</strong> or AgGeorgia. At<br />
its 2009 fiscal year end, its core surplus ratio was under 14%, <strong>and</strong> it<br />
grew stronger in 2010 when the ratio reached 16%. Obviously this<br />
association—which we agreed to leave unnamed—is in a position<br />
to pay a patronage refund if the board approves it. The association’s<br />
chief financial officer summarized the debate as follows.<br />
Those Arguing “No <strong>Patronage</strong> Refund”<br />
A portion of this association’s board of directors takes the position<br />
that it operates on a cooperative basis every day even though the<br />
association does not pay a patronage refund. These directors say that<br />
the very existence of the association acts as a competitive force to<br />
keep other lending institutions’ rates comparable to the association’s<br />
rates <strong>and</strong> cost of services. That being true, these directors are not<br />
in favor of paying a patronage refund. Members, they would argue,<br />
already receive a patronage refund.<br />
These directors also contend that it is unnecessary to charge higher<br />
interest rates or prices for services only to return some of those earnings<br />
in cash as a patronage refund. Obviously the association’s growth<br />
is strong <strong>and</strong> it appears unnecessary to prime it further. In fact, no<br />
one on the board of directors takes the view that a patronage refund<br />
would improve the association’s rate of growth.<br />
Those Arguing “Pay a <strong>Patronage</strong> Refund”<br />
On the other side is a portion of directors who are in favor of paying<br />
a patronage refund. These directors’ position is that co-ops are<br />
supposed to pay a patronage refund. These directors also believe<br />
that paying a patronage refund ties members more closely with, <strong>and</strong><br />
deepens their loyalty to, the association.<br />
If Paid, Pay <strong>Patronage</strong> Refund in Cash; No Allocated<br />
Equity<br />
If there is a consensus within the board of directors, it is that a<br />
patronage refund, if paid, should be entirely cash. All of the directors<br />
are farmers <strong>and</strong> hence very familiar with agricultural cooperatives.<br />
These directors do not like the idea of receiving an allocation of<br />
patronage refunds but not receiving a large enough cash patronage<br />
refund to pay the income taxes those members will owe state <strong>and</strong><br />
federal governments on that patronage income. 30<br />
38
The CFO’s View; Similarity to <strong>Credit</strong> <strong>Union</strong>s<br />
If the CFO voted today, he would probably vote in favor of paying a<br />
patronage refund. The beneficial effect of paying a patronage refund<br />
is that it provides the association with one more mechanism to manage<br />
the level of its capital.<br />
• • •<br />
This debate raises issues similar to those of a credit union board<br />
considering a patronage refund. The answer hinges on directors’ philosophies<br />
about the need for capital- intensive growth <strong>and</strong> whether it<br />
is better to reward members for their business every day or to declare<br />
extraordinary dividends annually.<br />
Business challenges remain in paying out a regular refund, but<br />
initiating one is likely to build member loyalty <strong>and</strong> provide<br />
opportunities to communicate with members about co-op<br />
values.<br />
Are AgGeorgia, Badgerl<strong>and</strong>, <strong>and</strong> the<br />
Unnamed Association Capital Hogs?<br />
Badgerl<strong>and</strong> is arguably overcapitalized because its core surplus is<br />
much stronger than AgGeorgia’s or the FCA guide of 3.5%. Badgerl<strong>and</strong><br />
could, however, quickly counter that surplus by ratcheting<br />
up its 100% cash refund allocation from 14% (see Figure 3, row 2a<br />
divided by row 4) of its income to 15%, 16%, or even higher.<br />
In other words, the strength of Badgerl<strong>and</strong>’s approach to patronage<br />
refunds <strong>and</strong> capital management over AgGeorgia’s is that Badgerl<strong>and</strong><br />
can change directions quickly. If Badgerl<strong>and</strong> encounters prosperity, it<br />
can increase the 100% cash patronage refund above 14% of income.<br />
Alternatively, if Badgerl<strong>and</strong> encounters financial stress, it can quickly<br />
retreat back to distributing 14%<br />
of income, or lower, with its<br />
100% cash patronage refund.<br />
In contrast, we could argue that<br />
AgGeorgia not only is overcapitalized<br />
but is diminishing<br />
its capital by operating more<br />
closely to pure co-op patronage principles. Between redemptions <strong>and</strong><br />
cash patronage refunds, AgGeorgia is paying out approximately three<br />
times the amount of cash as a percentage of total loans as the average<br />
of the 81 ACAs in the Farm <strong>Credit</strong> System, <strong>and</strong> seven times the<br />
amount of cash paid by Badgerl<strong>and</strong>.<br />
The issue with AgGeorgia is that its patronage refund approach is<br />
difficult to change quickly without affecting member expectations.<br />
AgGeorgia’s earnings had been in decline for two years at the end<br />
of 2009, so the pressure to conserve capital could be building. But<br />
39
AgGeorgia’s members probably expect AgGeorgia will adhere to its<br />
present redemption cycle of approximately seven years. The longer<br />
AgGeorgia redeems on a seven- year cycle, the higher <strong>and</strong> more firm<br />
members’ expectations will be.<br />
Compared to Badgerl<strong>and</strong> or AgGeorgia, the unnamed association<br />
is strikingly overcapitalized. Its core surplus ratio grew from 14%<br />
to 16% while it was growing its loan volume by 10% in 2010.<br />
The implementation of a cash patronage refund program could be<br />
expected to strengthen the association’s effectiveness in managing its<br />
capital position. Initiating a patronage refund program is also likely<br />
to build member loyalty <strong>and</strong> provide opportunities to communicate<br />
with members about co-op values.<br />
40
CHAPTER 6<br />
<strong>Credit</strong> <strong>Union</strong> Perspective<br />
From cooperative principles <strong>and</strong> outside examples<br />
to actual credit union practices, this chapter<br />
describes patronage refunds at three credit<br />
unions. Each is slightly different, but all three<br />
emphasize members’ inherent right to the excess<br />
capital <strong>and</strong> membership benefits of giving tangible<br />
reminders of members’ ownership.
All three credit unions use their patronage programs as differentiators<br />
from local competitors. <strong>Credit</strong> union executives <strong>and</strong><br />
their staffs use the payment of patronage refunds as occasions<br />
for their credit unions to communicate with members about<br />
co-op values.<br />
In this chapter we will discuss the use of patronage refunds by<br />
CoVantage <strong>Credit</strong> <strong>Union</strong>, Dow Chemical Employees’ <strong>Credit</strong> <strong>Union</strong>,<br />
<strong>and</strong> Wright-Patt <strong>Credit</strong> <strong>Union</strong>, Inc. Each of these credit unions pays<br />
a patronage refund to its members.<br />
Executives at each credit union stressed that patronage refunds are<br />
only paid to members in good st<strong>and</strong>ing, a crucial point we need to<br />
emphasize. In each case, we were told that limiting the payment of<br />
patronage refunds to members in good st<strong>and</strong>ing is an important<br />
practice because members respond to the payment as an incentive to<br />
manage their business relationship with the credit union in a way so<br />
that the member avoids disqualifying<br />
himself or herself from<br />
receiving the patronage refund<br />
when it is declared.<br />
One of the recurring themes in<br />
this chapter is that the leadership<br />
of each credit union views<br />
the credit union’s earnings as<br />
belonging to the members (<strong>and</strong> in one case to employees as a specific<br />
stakeholder group), <strong>and</strong> hence that the leadership is accountable<br />
to members as stakeholders. The leadership of these credit unions<br />
feels that the credit unions’ earnings belong to members (<strong>and</strong> other<br />
stakeholder groups) regardless of whether the earnings are allocated<br />
to members on the credit union’s books.<br />
All three credit union executives said their credit union’s patronage<br />
program is a differentiator that set their credit union apart from<br />
competitors. Earlier in this report we discussed how other cooperatives<br />
use the payment of a patronage refund as an opportunity to<br />
communicate with their members about the value of the cooperative<br />
form of business organization. All three executives <strong>and</strong> their staffs use<br />
the payment of patronage refunds as occasions for their credit unions<br />
to communicate with members about co-op values. A sampling of<br />
their newsletters <strong>and</strong> websites is shown in the appendix.<br />
42
CoVantage <strong>Credit</strong> <strong>Union</strong><br />
CoVantage <strong>Credit</strong> <strong>Union</strong> is based in Antigo, Wisconsin, <strong>and</strong> operates<br />
nine branch offices in 17 counties (15 in Wisconsin, 2 in Michigan),<br />
most of which are rural <strong>and</strong> considered to be populated by a<br />
largely blue- collar workforce. CoVantage recently opened its third<br />
branch in the greater Wausau area, the largest community in which<br />
it does business. CoVantage also operates about a half dozen Kids<br />
<strong>Credit</strong> <strong>Union</strong>s in Middle Schools across its trade territory. But of the<br />
$850M in assets, less than $125M is from the Wausau membership.<br />
As of December 31, 2010, CoVantage had just over 62,000 members<br />
(6% of potential members), 215 full-time employees, <strong>and</strong> total loan<br />
volume of $651.0M. Membership grew by 5.98% in 2010. Brian<br />
Prunty is CoVantage’s chief executive officer.<br />
CoVantage is one of the 27 credit unions in Callahan’s database that<br />
paid a patronage refund in each of the last five years, <strong>and</strong> is in the<br />
top 10 of those 27 credit unions on a number of measures. CoVantage<br />
is 3rd in five-year loan growth, five-year member growth, <strong>and</strong><br />
five-year share growth; 5th in one-year loan growth; 7th for its 2004<br />
<strong>and</strong> 2009 return on assets (ROA); <strong>and</strong> 10th for its dividend payment<br />
as a percent of total shares (in dollars).<br />
CoVantage’s average cash patronage refund over the last three years<br />
totals $1,341,936, <strong>and</strong> its earnings (including the refund) averaged<br />
$6,939,880 during that time. So over the past three years,<br />
CoVantage has paid an average of 19.34% of its earnings in cash on<br />
a patronage basis to members, ranking it 19th out of the Callahan 27<br />
for its interest refund as a percentage of earnings.<br />
CoVantage has paid a cash<br />
The leadership of credit unions must evaluate what they are patronage refund since 1981. Its<br />
doing <strong>and</strong> how well the credit union is performing before they 19th-place ranking for the size<br />
determine whether the credit union can justify paying bonuses of patronage refund as a percentage<br />
of earnings suggests that<br />
or rebates on top of what it is paying for share deposits or<br />
charging for products <strong>and</strong> services.<br />
paying a patronage refund is not<br />
everything or the only thing.<br />
Many factors determine the<br />
success of any person or business. More important than the size of<br />
the patronage refund is what it says about the business organization.<br />
CoVantage’s patronage refund is consistent with its overall philosophy<br />
that it is a financial co-op that belongs to its members.<br />
Employees view members as the real owners. CoVantage exists<br />
to help its members. Like any credit union, CoVantage does not<br />
allocate its earnings—<strong>and</strong> equity—to members on the basis of share<br />
ownership or loan volume, but it acts like it does. Hence, CoVantage’s<br />
earnings “belong” to its members, which makes it less difficult<br />
to pay a cash patronage refund to members.<br />
43
The capital accumulated through earnings is considered commonwealth,<br />
<strong>and</strong> since it’s a financial cooperative, there has to be some<br />
benefit to ownership. Prunty acknowledges that a 10% capital target<br />
dem<strong>and</strong>s significant fiscal discipline to be able to meet all the credit<br />
union’s obligations. He is fortunate to have a board of directors<br />
that finds CoVantage’s patronage refund program indispensable.<br />
According to Prunty, the board is the driver of CoVantage’s patronage<br />
refund payments. And since the board represents the members,<br />
one cannot help but conclude that members are the wellspring from<br />
which this patronage refund co-op philosophy emanates.<br />
CoVantage tailors its patronage refund program to recognize the<br />
contributions of members at all stages of their financial lives. It<br />
acknowledges that in a member’s younger years, he or she is more<br />
frequently a borrower, <strong>and</strong> thus it pays a 4% rebate on interest paid.<br />
As members age, they can receive a savings bonus of up to 4% on<br />
interest earned. Both of these expenditures are expenses on CoVantage’s<br />
income statement <strong>and</strong> hence reduce CoVantage’s ROA.<br />
CoVantage is an aggressive marketer, but its use of, for example,<br />
bonus payments on debit cards or other profitable services does<br />
not go as far as the programs of Dow Chemical or Wright-Patt.<br />
Prunty noted that the rates the credit union pays on share deposits<br />
are already the highest or second highest in the market. Prunty’s<br />
comments highlight the fact that the leadership of credit unions<br />
must evaluate what they are doing <strong>and</strong> how well the credit union<br />
is performing before they determine whether the credit union can<br />
justify paying bonuses or rebates on top of what it is paying for share<br />
deposits or charging for products <strong>and</strong> services.<br />
This notion echoes the earlier debate of the unnamed farm credit<br />
association. The argument of some of the directors is that the association<br />
is already providing a patronage refund in charging relatively<br />
modest fees <strong>and</strong> rates <strong>and</strong>, therefore, is a competitive force that<br />
provides economic <strong>and</strong> financial benefits without paying a patronage<br />
refund.<br />
Prunty says that when CoVantage’s portfolio is compared with<br />
credit unions that don’t offer patronage refunds to their members,<br />
CoVantage’s loan portfolio is of higher quality. In addition,<br />
CoVantage members who went through bankruptcy reaffirmed their<br />
debt 60% of the time in 2010 <strong>and</strong> 50% in 2009. He believes this is<br />
due in part to the patronage refund program.<br />
44
Dow Chemical Employees’ <strong>Credit</strong><br />
<strong>Union</strong><br />
Dow Chemical Employees’ <strong>Credit</strong> <strong>Union</strong> is located in Midl<strong>and</strong>,<br />
Michigan. As of December 31, 2010, Dow Chemical had just over<br />
55,000 members (95% of potential members), 124 full-time employees,<br />
total assets of $1.35B, <strong>and</strong> total loan volume of $482.0M. Membership<br />
grew by 1.03% in 2010. Dennis Hanson is Dow Chemical’s<br />
chief executive officer.<br />
Dow Chemical is one of the 27 credit unions in Callahan’s database<br />
that paid a patronage refund in each of the last five years. Dow<br />
Chemical is in the top 10 of those 27 credit unions on a number<br />
of measures: second in total assets, fifth in total loans, ninth for its<br />
2009 ROA, fifth in member relationships, <strong>and</strong> seventh for 2009 real<br />
estate loan penetration.<br />
Dow Chemical has missed paying a cash patronage refund only once<br />
in the last 50 years. Its average annual cash patronage refund over<br />
the last three years was $3,807,972, <strong>and</strong> its earnings (including the<br />
refund) averaged $11,559,969 during that time. So over the past<br />
three years, Dow Chemical has paid an average of 32.94% of its<br />
earnings in cash on a patronage basis to members, ranking it 11th<br />
out of the 27 credit unions for size of refund in relationship to Dow<br />
Chemical’s earnings.<br />
Dow Chemical’s patronage refund (loan interest refund) amounts<br />
to 15% of interest paid on loans. The patronage refund is not set at<br />
15%, but it consistently works out to approximately 15% of interest<br />
paid.<br />
In addition to the patronage refund, Dow Chemical also pays<br />
bonuses on its share deposits <strong>and</strong> debit cards. These bonuses have<br />
averaged $3.5M annually. Dow Chemical has paid a bonus on share<br />
deposits for 7 consecutive years <strong>and</strong> 10 of the last 15 years. This<br />
bonus averages 15% of share deposits as well. Including share deposit<br />
<strong>and</strong> debit card bonuses, Dow Chemical distributes 63% of its earnings<br />
with cash each year.<br />
Like CoVantage, Dow Chemical’s patronage refund is consistent<br />
with its overall philosophy that it is a financial co-op whose earnings<br />
belong to its members. Dennis Hanson is the fourth CEO of Dow<br />
Chemical. Dennis told us that if the authors replaced him tomorrow,<br />
his board of directors would absolutely require <strong>and</strong> expect us, as new<br />
management, to toe the line on patronage refunds. After 50 years,<br />
the payment of a patronage refund is a cultural imperative that is<br />
nearly impossible to change.<br />
45
As we visited with Hanson, it was difficult to ignore the institutional<br />
tone that is created from paying a patronage refund to members.<br />
<strong>Patronage</strong> refunds championed by the board <strong>and</strong> management make<br />
member ownership feel more real for members. Hanson emphasized<br />
that, aside from the issue of being accountable to members, the<br />
important thing to note is that patronage refunds are a differentiator<br />
<strong>and</strong> distinguish the credit union from IOF firms.<br />
Wright-Patt <strong>Credit</strong> <strong>Union</strong>, Inc.<br />
Our conversation with Tim Mislansky, senior vice president <strong>and</strong><br />
chief lending officer, may have been the most exciting because the<br />
payment of patronage refunds is a relatively new practice at Wright-<br />
Patt <strong>Credit</strong> <strong>Union</strong>, Inc. Mislansky told us that patronage refunds<br />
were not necessarily top of mind at Wright-Patt until its management<br />
determined that they were a mechanism for managing the<br />
credit union’s capital growth.<br />
Management had been trying to control the credit union’s growth in<br />
capital by lowering service fees <strong>and</strong> other rates. But as fees <strong>and</strong> rates<br />
were lowered, the credit union’s capital <strong>and</strong> its success continued to<br />
grow, which prompted some directors to tease whether management<br />
had solved Wright-Patt’s issue of excess capital.<br />
Wright-Patt management requested that Callahan consultants<br />
provide information about patronage refunds for management’s<br />
consideration. Management had already developed a sophisticated<br />
stakeholder model including (1) members, (2) employees, <strong>and</strong><br />
(3) the <strong>Credit</strong> <strong>Union</strong>. Management proposed that Wright-Patt dovetail<br />
patronage refunds into its stakeholder model, <strong>and</strong> the Board of<br />
Directors reviewed <strong>and</strong> adopted management’s recommendation.<br />
Wright-Patt is not identified in the Callahan 27 credit unions,<br />
<strong>and</strong> Mislansky brought to our attention that not all credit unions<br />
separately account for patronage refunds from dividends in the call<br />
reports that are submitted to the NCUA. Wright-Patt reports its<br />
patronage refund with the dividends it pays on shares.<br />
Wright-Patt is located in Fairborn, Ohio, <strong>and</strong> operates 24 branch<br />
offices. As of December 31, 2010, Wright-Patt had over 202,320<br />
members (15% of potential members), 428 full-time employees,<br />
total assets of nearly $2.0B, <strong>and</strong> total loan volume of $1.12B. Membership<br />
grew by 8.59% in 2010. Douglas Fecher is Wright-Patt’s<br />
chief executive officer.<br />
Wright-Patt’s average annual cash patronage refund over the last<br />
three years was $3,751,478, <strong>and</strong> its earnings (including the refund)<br />
averaged $19,867,464 during that time. So over the past three years,<br />
Wright-Patt has paid an average of 18.88% of its earnings in cash on<br />
46
a patronage basis to members, ranking it 20th out of the 27 credit<br />
unions for size of refund in relationship to Wright-Patt’s earnings.<br />
Parenthetically, we may be overstating Wright-Patt’s ranking, because<br />
its patronage refund includes dividends paid on share deposit<br />
accounts <strong>and</strong> flat fee payments on specific products <strong>and</strong> services,<br />
whereas the other credit unions paid patronage refunds in the more<br />
narrow sense that the payments were tied to proportional use of the<br />
credit union. This issue will be amplified later in this section.<br />
Wright-Patt’s management begins to model its December 31 capital<br />
position in October each year <strong>and</strong> by November the board of<br />
directors <strong>and</strong> management begin to settle on a number for patronage<br />
refunds. By late November or early December, the Wright-Patt<br />
leadership has settled on a patronage number.<br />
Management is as concerned about the size of the patronage refund<br />
as compared to prior years as it is about the size of the patronage<br />
refund compared to interest earned. For purposes of this discussion,<br />
we’ll assume that management recommended <strong>and</strong> the board<br />
approved a patronage dividend of $4.0M.<br />
The first consideration is to reward profitable products <strong>and</strong> services<br />
like debit cards, online electronic banking, receipt of statements<br />
electronically, <strong>and</strong> use of Wright-Patt’s financial planning <strong>and</strong> broker<br />
services. Between one-fourth <strong>and</strong> one-third of the total patronage<br />
dividend is paid to members who used these products <strong>and</strong> services.<br />
Mortgage lending is included in flat charges because some mortgages<br />
are sold off while others are held by the credit union. Wright-Patt’s<br />
management does not want to prejudice those members whose mortgages<br />
are sold, because the member has no control over that decision.<br />
These patronage refunds are flat payments to each member who used<br />
these products <strong>and</strong> services. We’ll assume that $1.0M was allocated<br />
for these patronage refunds.<br />
The second consideration is to distribute the remaining patronage<br />
dividend of $3.0M to members on the basis of shares <strong>and</strong> to members<br />
on the basis of their loans from Wright-Patt. If we assume that<br />
Wright-Patt has $1.0B in loans <strong>and</strong> $1.5B in share deposits, each<br />
qualifying member receives $.0012 cents per dollar of share deposit<br />
<strong>and</strong> per dollar of loan balance. Mislansky indicated that this portion<br />
of Wright-Patt’s patronage refund has been 7–10 basis points on<br />
deposits <strong>and</strong> loans.<br />
If its program was graded for adherence to co-op principles, all of<br />
Wright-Patt’s patronage refund program would not qualify as a true<br />
patronage refund, because a portion of it is paid as a flat fee that is<br />
not related to the amount of business each member did with Wright-<br />
Patt. Moreover, as with all credit unions, the payment of a dividend<br />
47
on share deposits is not a patronage refund, because it is paid on the<br />
basis of investment in Wright-Patt in contrast to use based on borrowings<br />
from the credit union.<br />
This is not to criticize Wright-Patt’s program but only to highlight<br />
that in a report about patronage refunds, we must pay attention to<br />
whether the payment was made on a patronage basis or the member’s<br />
use of the credit union. In fact, Wright-Patt’s program highlights<br />
the advantage of paying patronage refunds under 501(c)(14) rather<br />
than, for example, Subchapter T. Under 501(c)(14), Wright-Patt is<br />
allowed to be more creative in how it distributes its patronage payments<br />
to members. Subchapter T would force a far narrower concept<br />
of patronage on Wright-Patt because a patronage tax deduction is<br />
allowed only for payments made on the basis of each member’s proportional<br />
use of Wright-Patt.<br />
Mislansky says that patronage refunds are a differentiator that distinguishes<br />
Wright-Patt from IOF banks that compete in the credit<br />
union’s market. Mislansky says that Wright-Patt’s membership grows<br />
substantially each year after its patronage refunds are announced <strong>and</strong><br />
paid. The idea that patronage refunds are a differentiator resonates<br />
with us, but on more levels than just whether patronage refunds are<br />
good ideas as rebates. As we said earlier, we believe that patronage<br />
refunds highlight the philosophical gulf that separates co-ops from<br />
IOFs.<br />
48
CHAPTER 7<br />
<strong>Credit</strong> <strong>Union</strong> Implications<br />
<strong>Cooperative</strong>s, including lending cooperatives,<br />
are quite used to the practice of paying regular<br />
patronage refunds. Most credit unions are not.<br />
This chapter synthesizes the findings from earlier<br />
in this report <strong>and</strong> offers suggestions to credit<br />
unions considering a refund program.
<strong>Patronage</strong> <strong>Refunds</strong>: A Differentiator?<br />
In 2009, Brian Briggeman of the Federal Reserve Bank of Kansas<br />
City <strong>and</strong> Quatie Jorgensen of the University of Arizona wrote<br />
an article entitled “Farm <strong>Credit</strong> Member- Borrowers’ Preferences<br />
for <strong>Patronage</strong> Payments,” which appeared in Agricultural Finance<br />
Review. This article reviewed studies that analyzed the preferences of<br />
member- borrowers from Farm <strong>Credit</strong> Services of East Central Oklahoma.<br />
The conclusion was that members strongly preferred patronage<br />
refunds compared to lower fixed- interest rates, particularly when<br />
given the option of one or the other. In fact, on average, memberborrowers<br />
were even willing to pay higher interest rates in order to<br />
receive a patronage refund.<br />
The 2010 Callahan & Associates study also spoke to the influence of<br />
patronage refunds on membership growth. <strong>Credit</strong> unions that offer<br />
patronage refunds, through interest refunds, report much higher<br />
annual member growth rates—both for a single point in time (over<br />
the course of 2009) <strong>and</strong> over a five-year period. In addition, longterm<br />
loan growth appears to be an additional strength for credit<br />
unions offering interest refunds. While the 12-month loan growth<br />
for both groups would be lower due to the economic conditions in<br />
2008 <strong>and</strong> 2009, the five-year average annual growth of 8.4% for the<br />
patronage refunds group is 30% higher than the other group’s rate of<br />
5.8%.<br />
Capital Management Tool<br />
To us, there seems little doubt that credit unions will need to focus<br />
on capital accumulation in the years ahead. Earnings are needed to<br />
build balance sheet strength, ward off adversity, <strong>and</strong> attract the kinds<br />
of secondary capital (preferred stock, debentures, etc., from members)<br />
that credit unions have lobbied for. <strong>Patronage</strong> refunds are the<br />
necessary tool that demonstrates to members that the cooperative is<br />
socially <strong>and</strong> fiscally responsible with the member’s money. When the<br />
cooperative has too much capital, it will be returned as patronage<br />
refunds or equity retirements.<br />
50
We encourage you to have your credit union’s articles of incorporation<br />
<strong>and</strong> bylaws reviewed by legal counsel for the specific purpose of<br />
learning whether your credit union might be prohibited from paying<br />
a patronage refund. Our concern arises from the fact that at dissolution,<br />
credit union statutes appear to favor share ownership over<br />
historical patronage.<br />
If the owners of shares in the credit union are the beneficiaries of the<br />
remaining proceeds in dissolution, the question arises whether they<br />
could object to any payment that is not paid on the basis of ownership<br />
while the credit union is operating. We recommend that you<br />
discuss with your legal counsel whether your credit union should<br />
amend its articles <strong>and</strong> bylaws to specifically allow payments of<br />
patronage refunds on a patronage basis any time prior to a dissolution<br />
vote.<br />
Future Tax Considerations<br />
Nothing on the horizon points to any modification of the federal tax<br />
exemptions that apply to federal or state- chartered credit unions. In<br />
this section, we consider two alternatives: (1) that credit unions are<br />
taxed under Subchapter T <strong>and</strong> (2) an argument for why 501(c)(14)<br />
<strong>and</strong> 501(c)(1) tax statutes will not be touched.<br />
The Case for Subchapter T<br />
From time to time, the General Accounting Office (GAO) prepares<br />
reports on tax- exempt business entities. In 2005, the GAO prepared<br />
a report on credit unions that, aside from reciting the arguments for<br />
<strong>and</strong> against the tax exemption, contained no recommendations for or<br />
against the tax exemption.<br />
In 1983, the GAO issued a report recommending that Congress<br />
consider taxing rural electric cooperatives under Subchapter T. The<br />
recommendation was not adopted by Congress, but in this section<br />
we consider what would happen if the GAO made the same recommendation<br />
for taxation of credit unions. Assuming that Congress<br />
acted on the GAO recommendation this time, we apply Subchapter<br />
T to the 27 credit unions in the Callahan study.<br />
Figure 6, a modification of Figure 1, shows these 27 credit unions<br />
under 501(c)(14) <strong>and</strong> then compares this with two scenarios under<br />
Subchapter T. One scenario shows these credit unions allocating<br />
40% of patronage- sourced income (<strong>and</strong> paying a cash patronage<br />
refund of 20% of the total allocated) <strong>and</strong> paying taxes (federal <strong>and</strong><br />
state) on the other 60%. The other scenario shows these credit<br />
unions allocating 100% of patronage- sourced income <strong>and</strong> paying no<br />
income tax.<br />
51
Figure 6: Potential Tax Effects of <strong>Patronage</strong> <strong>Refunds</strong><br />
27 <strong>Credit</strong> <strong>Union</strong>s as Exempt, Allocated 40% under Sub-T, <strong>and</strong> Allocated 100% Under Sub-T<br />
Average of 2008, 2009, <strong>and</strong> 2010 501(c)(14) % Total Sub-T: 40% % Total Sub-T: 100% % Total<br />
Cash patronage refund 822,800 23.34 282,076 8.0 822,800 23.34<br />
<strong>Patronage</strong> refund in allocated equity — 0.00 1,128,304 32.0 2,703,149 76.66<br />
Undivided/Unallocated earnings 2,703,149 76.66 1,184,719 33.6 — 0.00<br />
Income tax on co-op’s earnings — 0.00 930,850 26.4 — 0.00<br />
Total earnings (average per co-op) $3,525,949 100.00 $3,525,949 100.00 $3,525,949 100.00<br />
Allocate <strong>and</strong> Distribute 100% of <strong>Patronage</strong> <strong>Refunds</strong><br />
Income tax is not owed under this Subchapter T scenario, because<br />
we assume that all income is patronage sourced (generated from<br />
transactions with members) <strong>and</strong> that all patronage income is allocated<br />
to members on the basis of patronage. 31<br />
The 27 credit unions in the Callahan study are already distributing<br />
enough cash to qualify for tax treatment under Subchapter T. A minimum<br />
of 20% cash refund is required by Subchapter T. These credit<br />
unions paid 23.34%. <strong>Credit</strong> unions would prepare 1099-PATR<br />
information returns, but we expect that many credit unions could<br />
apply for <strong>and</strong> receive an exemption from reporting 1099-PATRs. 32<br />
The bigger issue for these credit unions is whether they would be<br />
able to redeem allocated equity, <strong>and</strong> whether there would be pressure<br />
to redeem this equity. At the end of their first year operating under<br />
Subchapter T, these credit unions would have allocated equity totaling<br />
$2.7M dollars. If year two were identical, allocated equity would<br />
total $5.4M at the end of that year. You can see how allocated equity<br />
would quickly build up <strong>and</strong> grow from year to year. If these 27 credit<br />
unions had been allocating earnings all along, each credit union<br />
would, on average, have $54.0M of allocated equity as of December<br />
31, 2011.<br />
A 50-year equity redemption cycle, for example, applied to $54.0M<br />
of allocated equity implies an annual equity redemption obligation<br />
of $1.08M per credit union among the Callahan study credit unions.<br />
Hence, these 27 credit unions would be expected to redeem more<br />
than $1.20 of allocated equity for every $1.00 of patronage refunds<br />
paid in cash, an objective that most likely is all but impossible for<br />
these credit unions. So what would these credit unions do if they<br />
operated under Subchapter T <strong>and</strong> were faced with that allocated<br />
equity but could not redeem it?<br />
These 27 credit unions would not redeem allocated equity unless<br />
<strong>and</strong> until they had surplus working capital to allow redemptions of<br />
equity. In fact, if the board of directors determined that the credit<br />
52
union was unlikely to ever consistently redeem enough allocated<br />
equity to, at a minimum, redeem the equity of deceased members,<br />
the credit union should develop a communication plan that explains<br />
why no redemptions of equity could be made by the credit union.<br />
We expect that a significant part of that communication plan would<br />
be centered around the notion that the credit union provided significant<br />
benefits as a competitor in<br />
the market <strong>and</strong> that this alone<br />
The wisest approach would be to proactively manage expectations<br />
by educating members about what, exactly, they could union’s inability to redeem<br />
is enough to justify the credit<br />
expect from the credit union.<br />
equity on a regular basis. An<br />
aid to this plan is that most<br />
of the credit unions’ members<br />
would not pay income tax on these patronage distributions, because<br />
in most cases, the loans are for personal or family financing <strong>and</strong> not<br />
tax deductible to the member. Hence, the patronage income is not<br />
included in the member’s income, either.<br />
If equity redemptions occurred, we expect that the equity of the<br />
credit unions’ oldest members would be redeemed first. We also<br />
expect that the estates of deceased members would request redemption<br />
of equity. These credit unions are not obligated to redeem the<br />
equity. However, the wisdom of an education <strong>and</strong> communication<br />
plan to explain why the equity is not redeemed can easily be seen.<br />
If the equity is not redeemed, it would be assigned to the deceased<br />
member’s heirs, or the member’s estate could make a tax- deductible<br />
gift of the equity to a charity, perhaps to a 501(c)(3) owned by the<br />
credit union.<br />
Those members who obtain business loans from the credit union<br />
or who obtain real estate mortgages with tax- deductible interest are<br />
likely to pay tax on patronage distributions from the credit union.<br />
These members may be the most highly motivated to push the board<br />
of directors <strong>and</strong> management of the credit union to redeem their<br />
allocated equity. The argument of these members would be that a<br />
23% cash patronage refund is not large enough to pay the income<br />
taxes that they owe to federal <strong>and</strong> state governments. At present,<br />
under 501(c)(14), these members do not have that criticism, because<br />
under this exemption, the cash refund is the entirety of the income<br />
taxed by federal <strong>and</strong> state governments. Under Subchapter T, however,<br />
the credit unions’ business members would pay tax on both the<br />
cash patronage refund <strong>and</strong> the allocated equity used to distribute<br />
earnings to these members.<br />
These credit unions must be careful to manage members’ expectations<br />
about equity redemptions. If the income is allocated to members,<br />
members often expect that the equity will be redeemed sooner<br />
53
ather than later, particularly if the member is a business entity that<br />
would pay income tax on the patronage distributions of income<br />
(cash <strong>and</strong> noncash) to members. The wisest approach would be to<br />
proactively manage expectations by educating members about what,<br />
exactly, they could expect from the credit union. We would have the<br />
same concerns about this scenario as we expressed for AgGeorgia<br />
earlier in this report. Each of the 27 credit unions in the Callahan<br />
study would have followed the co-op principles to the letter. Each<br />
dollar of patronage earnings would have been allocated to members<br />
just as those principles call for. On the other h<strong>and</strong>, by allocating<br />
every dollar of patronage earnings, these credit unions would<br />
also have overcommitted their capital, creating more obligations to<br />
redeem allocated equity than we could reasonably expect from any<br />
of the 27 credit unions, while also expecting each to retain capital to<br />
finance its normal growth <strong>and</strong> expansion.<br />
Allocate <strong>and</strong> Distribute 40% of <strong>Patronage</strong> Income<br />
Another strategy these 27 credit unions could adopt under Subchapter<br />
T is to allocate <strong>and</strong> distribute less than 100% of patronage<br />
earnings to members. For this section, we assume these credit unions<br />
each allocated 40% of their patronage earnings rather 100%. Comparing<br />
the Sub T: 100% with the Sub T: 40%, each $1.00 of income<br />
tax a credit union paid to federal <strong>and</strong> state governments, it would<br />
reduce its allocated equity redemption obligation by $1.70.<br />
While a strategy of allocating less patronage earnings <strong>and</strong> paying<br />
more income tax might be useful for Badgerl<strong>and</strong> to conserve its capital,<br />
or helpful for AgGeorgia to begin conserving more of its capital,<br />
it may not be as useful or helpful for any co-op taxed under Subchapter<br />
T whose members are only or primarily consumers, including<br />
credit unions. The taxation of the income of consumers who<br />
are unlikely to deduct the interest they pay to credit unions—other<br />
than interest they pay on mortgages—creates a dynamic that is quite<br />
distinguishable from the taxation of the income of businesses who<br />
deduct the interest they pay as a business expense.<br />
Recall that under Subchapter T patrons pay income tax on the entire<br />
distribution, both the cash <strong>and</strong> the allocated equity. All income—<br />
both cash <strong>and</strong> allocated equity—are reported on the 1099-PATR<br />
information return as income. Under either Sub-T scenario in<br />
Figure 6 above, however, for every dollar of patronage earnings<br />
allocated to a consumer, the consumer does not owe any income<br />
tax on April 15. The consumers’ expenditures at the credit union<br />
(other than mortgage interest) are not deductible. Consequently, the<br />
patronage earnings that are allocated are not income for the consumer<br />
even though a 1099-PATR was reported to the IRS. Even so<br />
the consumer receives a minimum of a 20% cash patronage refund,<br />
54
<strong>and</strong> the consumer is money ahead over an IOF even if none of the<br />
balance of up to 80% of the allocation is ever redeemed to the consumer<br />
member.<br />
The business member of a co-op that is taxed under Subchapter T<br />
pays income tax on the entire distribution of cash plus allocated<br />
equity. Assume that each business member pays tax at a marginal<br />
rate of 35%. For every dollar of income that is reported to on<br />
1099-PATR to the IRS, the business pays income tax of 35 cents.<br />
If the co-op pays only a 20% cash refund, the business member is<br />
in a deficit position of 15 cents for each dollar of patronage income<br />
that is allocated to the member. Hence, business members are most<br />
likely to complain to the board of directors <strong>and</strong> management that the<br />
co-op is not paying enough cash <strong>and</strong>/or redeeming equity quickly<br />
enough to justify a co-op membership.<br />
Allocating less than all of the patronage income <strong>and</strong> paying income<br />
tax on the balance is not the only strategy that a co-op might adopt<br />
to help the co-op manage the amount of capital that is available to it.<br />
A Subchapter T co-op may also consider paying business members a<br />
higher cash patronage refund than consumer members to differentiate<br />
between consumers <strong>and</strong> businesses. In addition, a Subchapter T<br />
co-op could also distinguish between consumers <strong>and</strong> businesses by<br />
redeeming the allocated equity of businesses more quickly than it<br />
redeems the allocated equity of consumers.<br />
At the end of the day, any Subchapter T co-op’s board of directors<br />
<strong>and</strong> management must evaluate <strong>and</strong> determine how much capital<br />
its co-op can devote to redemptions of allocated equity. That determination<br />
will depend on the co-op’s need for capital. Its growth. Its<br />
potential. Its risk of sustaining losses. Its ability to attract outside<br />
capital. Its ability to generate earnings.<br />
The important thing for a Subchapter T co-op is to arrive at a<br />
redemption program that makes sense to the co-op <strong>and</strong> its members.<br />
A redemption program should be consistent with the varying<br />
tax positions of its members. The program should be sustainable<br />
but also challenge the co-op <strong>and</strong> its members. The program should<br />
reward patronage more than it rewards ownership. And finally, the<br />
program should be capable of being communicated to members in a<br />
way that makes sense to members.<br />
Examining the Tax Exemption<br />
In 1983, the GAO suggested that Congress consider an evolution<br />
of rural electric cooperatives from 501(c)(12) to Subchapter T, but<br />
Congress did not act on the GAO’s suggestion.<br />
In its 1983 report, the GAO contended that the tax exemption was<br />
difficult to administer <strong>and</strong> that industrial <strong>and</strong> commercial members<br />
55
of the cooperative were deducting the expense of purchasing electricity<br />
but escaped the payment of tax on equity credits if <strong>and</strong> when the<br />
credits were redeemed.<br />
The GAO also contended that cooperatives were not redeeming<br />
equity credits quickly enough. In fact, the GAO stated that some<br />
rural electric cooperatives had no intention of ever redeeming any<br />
credits.<br />
The experience of rural electric cooperatives does not translate easily<br />
to credit unions. The primary criticism of rural electric cooperatives<br />
was that they had no intention of redeeming allocated equity<br />
to members. That criticism does not exist for credit unions, because<br />
they do not distribute earnings with allocated equity.<br />
However, the GAO’s 2005 report on credit unions—like the 1983<br />
report on rural electric cooperatives—suggests that tax exemptions<br />
can never be conclusively presumed safe from attack. The following<br />
conclusions can be drawn about credit unions:<br />
• The 27 credit unions in the Callahan study are doing more to<br />
protect the tax exemption from attack than are credit unions that<br />
do not pay cash patronage refunds.<br />
• 501(c)(14) offers far more flexibility in paying patronage refunds<br />
than does Subchapter T, for example. Wright-Patt’s creativity in<br />
how it uses “patronage” refunds is noteworthy. Flat payments for<br />
profitable products <strong>and</strong> services, <strong>and</strong> variable payments for interest<br />
paid on loans <strong>and</strong> for dividends received on share deposits are<br />
permitted by 501(c)(14) but would not be permitted by Sub-T.<br />
Better to take advantage of the current flexibility <strong>and</strong> strengthen<br />
the tax exemption by using it creatively.<br />
• <strong>Credit</strong> unions are cooperatives. It is always worthwhile to ratchet<br />
up the co-op’s efforts to encourage member participation <strong>and</strong><br />
involvement in the cooperative.<br />
• <strong>Credit</strong> unions can prepare for battles over their tax- exempt status<br />
by communicating with members about the benefits of cooperatives<br />
<strong>and</strong> by educating members about the principles of cooperation.<br />
When the bullets start flying, it’s better to have the army<br />
already motivated for battle rather than just beginning to motivate<br />
the troops.<br />
• <strong>Patronage</strong> refunds (<strong>and</strong> eventually redemption of equity credits<br />
for those cooperatives that allocate earnings but redeem them<br />
later) bring the co-op membership experience—<strong>and</strong> the reason<br />
for the co-op’s existence—full circle. We expect that, like the<br />
farmers <strong>and</strong> agricultural producers that prefer patronage refunds<br />
56
to low interest rates, credit union members would hold similar<br />
preferences for the payment of annual patronage refunds.<br />
• There is something about consistent patronage refunds that<br />
matures the cooperative in the eyes of its members. It’s like the<br />
co-op has confidence in its membership <strong>and</strong> in its viability. The<br />
co-op is serious about financial success <strong>and</strong> wants to provide<br />
the goods <strong>and</strong> services that will make it profitable.<br />
• We think that co-ops that make money <strong>and</strong> pay patronage<br />
refunds are more likely to survive <strong>and</strong> flourish as businesses than<br />
co-ops that do not have the same emphasis on profitability or<br />
accountability to members.<br />
• Co-ops have a story to tell, particularly when they pay patronage<br />
refunds. The members of the American Bankers Association<br />
(ABA) would never willingly operate with the deep member<br />
involvement that is encouraged under co-op principles. The<br />
relevant audience of an IOF bank is limited to its common<br />
stockholders, whereas the relevant audience of a co-op is all of its<br />
customers or members. IOF banks do not subject their capital<br />
plans to customer scrutiny or think it necessary to explain to<br />
customers why the bank was investing in growth rather than in<br />
equity redemptions, why the firm did not pay a patronage refund,<br />
why the patronage refund decreased in size, or why that product<br />
or this service could not be provided at a lower overall price.<br />
• IOF banks would never accept as one of their primary objectives<br />
the return of surplus capital to customers. The inclination of IOF<br />
banks is to hoard <strong>and</strong> use capital rather than return it. Co-ops are<br />
not as glitzy as IOF banks. The discipline that management must<br />
execute <strong>and</strong> the leadership required of a co-op is more onerous<br />
than that needed for an IOF. But the rewards—the intangibles—<br />
of affiliating oneself with an organization that is operated for the<br />
benefit of its members rather than the organization’s own pocketbook<br />
are immensely rewarding. We heard as much from Prunty,<br />
Hanson, <strong>and</strong> Mislansky in our interviews for this report.<br />
• Timing is everything. With the Basel capital requirements <strong>and</strong><br />
the state of the economy, boards of directors <strong>and</strong> management<br />
must make educated, wise decisions about when to implement a<br />
patronage refund program.<br />
Similar to the experience of rural electric cooperatives, the more that<br />
regulators <strong>and</strong> investor- owned competitors see that the cooperative’s<br />
membership is vibrant, informed, <strong>and</strong> supportive of the credit union,<br />
the more difficult it is for the tax exemption to be attacked.<br />
57
<strong>Patronage</strong> <strong>Refunds</strong> <strong>and</strong> Capital<br />
M anagement<br />
In a conversation about patronage refunds, capital management,<br />
<strong>and</strong> the 501(c)(14) tax exemption, it is worthwhile to consider<br />
OmniAmerican <strong>Credit</strong> <strong>Union</strong>. OmniAmerican completed a conversion<br />
from a credit union to an IOF bank on January 1, 2009. Half of<br />
its stock is now owned by 60 institutional investors. To us, conversions<br />
of cooperatives, <strong>and</strong> their accompanying loss of member- owned<br />
capital, are a significantly larger issue on the horizon than the modification<br />
or loss of the 501(c)(14) tax exemption. <strong>Patronage</strong> refunds<br />
could be the difference that thwarts conversions. 33<br />
Arguably the two most important changes in OmniAmerican’s financial<br />
metrics between its status as a credit union <strong>and</strong> its status now as<br />
an IOF bank are that (1) its equity capital almost doubled through<br />
the conversion <strong>and</strong> public sale of its common stock, <strong>and</strong> (2) its<br />
income is now an eighth of what it was when OmniAmerican was a<br />
credit union.<br />
OmniAmerican <strong>Credit</strong> <strong>Union</strong> generated $10.0M of net income in<br />
its last full year as a credit union (2004), but OmniAmerican Bancorp<br />
generated only $1.6M of net income in 2010. OmniAmerican’s<br />
average net income as a credit union was $9.2M for the years 2002,<br />
2003, <strong>and</strong> 2004, <strong>and</strong> it was on the rise; OmniAmerican generated<br />
$8.4M in 2002.<br />
If OmniAmerican had remained a credit union <strong>and</strong> had begun distributing<br />
a patronage refund equal to 20% of its earnings (approximately<br />
equal to the 27 credit unions in the Callahan study) starting<br />
with its 2004 year end, it would have distributed $14.0M in patronage<br />
refunds to its members by December 31, 2010. OmniAmerican<br />
would already have distributed a fifth of the wealth that was created<br />
in its conversion to an IOF. And that wealth would have been distributed<br />
to 250,000 members.<br />
Do you prefer $2.0M per year being distributed as a patronage<br />
refund to 250,000 OmniAmerican <strong>Credit</strong> <strong>Union</strong> members, or would<br />
you rather have 60 institutional investors benefiting from half of the<br />
$50M–$70M of new capital that was raised through the conversion<br />
<strong>and</strong> sale of stock? Do you prefer that those 250,000 members hold<br />
an unredeemed lottery ticket worth $50M–$70M pre- conversion,<br />
or would you rather those 60 institutional investors chase down <strong>and</strong><br />
corral $25.0M–$35.0M of capital for their own benefit?<br />
58
The ABA is eager to gripe about the credit unions’ tax exemption,<br />
but nowhere on its website does the ABA wrestle with these ethical<br />
charter conversion issues or the laudatory social <strong>and</strong> economic<br />
benefits that accrue to members of credit unions over IOF banks.<br />
The ABA either does not see or ignores the fact that credit unions are<br />
more sustainable than IOFs, that credit unions do not hoard capital<br />
for their own use, <strong>and</strong> that credit unions return unneeded capital to<br />
members.<br />
59
Appendix<br />
Exhibit A: 2007 Newsletter Article<br />
Announcing the <strong>Patronage</strong> Dividend<br />
at CoVantage <strong>Credit</strong> <strong>Union</strong> ($861M,<br />
Antigo, Wisconsin)<br />
$1.4 Million Rebated to Members<br />
Over 14,000 CoVantage members will “step into cash” when their<br />
loan interest rebate checks arrive in next week’s mail. This year’s 5%<br />
rebate will provide the largest payback ever, <strong>and</strong> will put a record<br />
$1.4 million back into the h<strong>and</strong>s of credit union member-owners.<br />
If you’re new to CoVantage, getting a rebate from the place you have<br />
your loan may be unheard of. But, members with a history of borrowing<br />
here see it as a valued reward for their patronage. And, this<br />
year’s rebate marks the 26th year that directors have determined there<br />
is sufficient net income to provide this benefit.<br />
Here’s how the rebate works. If you had a loan with CoVantage during<br />
2007, <strong>and</strong> all of your payments are current, you’ll automatically<br />
receive a check returning 5% of the interest you’ve paid. No application<br />
required! So, if you paid $5,000 in interest on your CoVantage<br />
home loan during 2007, you’ll receive a rebate for $250! This year<br />
we have enhanced our program to combine the interest paid on all<br />
loans under one account number. Because we send checks only when<br />
the rebate totals at least $5.00, this improvement will allow even<br />
more members to get their rebate. (Student loans are not eligible for<br />
the rebate.)<br />
The loan interest rebate is just one way members receive exceptional<br />
value from their credit union. Throughout the year we work to keep<br />
loan rates low, charge fewer fees than others, <strong>and</strong> pay market- leading<br />
rates on deposits. To ensure our rates <strong>and</strong> fees are competitive, we<br />
monitor what others are offering. And while some may have special<br />
rates <strong>and</strong> gimmicks, we are confident that CoVantage is one of the<br />
best when it comes to overall member value.<br />
To give you an outsider’s viewpoint, we would like to share that out<br />
of [thous<strong>and</strong>s of U.S. credit unions] we were ranked in the top 1%<br />
for “Return to Savers.” This ranking was provided by an independent<br />
consulting group, <strong>and</strong> is a measure of the deposit services a credit<br />
union provides.<br />
As a member- owner of CoVantage <strong>Credit</strong> <strong>Union</strong>, you deserve the<br />
best from your credit union. Staff, management, <strong>and</strong> directors are<br />
committed to ensure that each <strong>and</strong> every member receives outst<strong>and</strong>ing<br />
value.<br />
60
Exhibit B: 2011 Newsletter Article<br />
Announcing <strong>Patronage</strong> “Rebates<br />
<strong>and</strong> Rewards” to Members of Dow<br />
Chemical Employees’ <strong>Credit</strong> <strong>Union</strong><br />
($1.4B, Midl<strong>and</strong>, Michigan)<br />
Report from the President/CEO:<br />
Exceeding Expectations in Troubled Times<br />
$5.7 million returned in rebates <strong>and</strong> rewards<br />
Although the lingering effects remain from one of the worst financial<br />
events in modern memory, Dow Chemical Employees’ <strong>Credit</strong> <strong>Union</strong><br />
(DCECU) posted another banner year in 2010. In this unfortunate<br />
climate where bank <strong>and</strong> credit union failures exceeded the prior<br />
year’s results, DCECU continued to thrive.<br />
How is it that DCECU was able to take lemons <strong>and</strong> turn them into<br />
lemonade? What was this recipe for success? It’s really quite simple—<br />
don’t stray from the Core Values you’ve established, <strong>and</strong> stick to<br />
your Mission. Through conservative, principles- based decisionmaking,<br />
your credit union returned another $5.7 million back in<br />
the form of Loan Interest Rebates, Member Saver Rewards <strong>and</strong><br />
other rebates to DCECU member- owners on top of very competitive<br />
loan <strong>and</strong> deposit rates! (emphasis in original)<br />
DCECU’s leadership has worked tirelessly during these difficult<br />
economic times. Numerous financial forecasts have been reviewed,<br />
contingency plans have been created based on varying interest rate<br />
<strong>and</strong> economic scenarios, expenses have been carefully controlled, <strong>and</strong><br />
investments <strong>and</strong> capital expenditures have been scrutinized.<br />
Based on the above, one might conclude DCECU has been unaffected<br />
by the recent negative events. While not entirely true,<br />
DCECU is very proud of its foresight in the slight modification of<br />
its loan underwriting criteria when negative signals began to appear.<br />
The results—DCECU has performed superbly versus other similar<br />
financial institutions. And, while loan delinquencies were up slightly<br />
from one year ago, losses have been well- contained <strong>and</strong> have even<br />
fallen slightly year-over-year.<br />
61
Due to careful planning <strong>and</strong> prudent financial stewardship,<br />
DCECU’s Board of Directors declared the following for 2010:<br />
• 15.00% Loan Interest Rebate that entitles borrowers in good<br />
st<strong>and</strong>ing* to receive a portion of the total interest paid on all<br />
eligible** DCECU loans<br />
• 15.00% Member Saver Reward that entitles depositors in good<br />
st<strong>and</strong>ing* to receive a portion of the dividends/interest earned on<br />
all DCECU shares/deposits<br />
• A VISA®<br />
Check Card rebate*** for users in good st<strong>and</strong>ing*<br />
These rebates <strong>and</strong> rewards were paid on January 1, 2011 (excluding<br />
VISA®<br />
<strong>Credit</strong> Card rebates, which will be deposited to Share/Savings<br />
accounts in January) to members in good st<strong>and</strong>ing* via deposit to<br />
their Prime Share accounts.<br />
I would like to thank you personally for your continued support of<br />
Dow Chemical Employees’ <strong>Credit</strong> <strong>Union</strong> <strong>and</strong> for utilizing the many<br />
services we offer. Because we are a not-for- profit financial cooperative,<br />
the more members use these services, the more all members<br />
benefit. We look forward to serving you in 2011 <strong>and</strong> will share more<br />
of the positive news that’s happening at DCECU throughout the<br />
year.<br />
As always, please do not hesitate to contact me or any of the<br />
DCECU staff in person, by phone . . . or via e-mail through our<br />
website at www.dcecu.org. Remember, DCECU is your credit union.<br />
Sincerely,<br />
Dennis M. Hanson<br />
President/CEO<br />
*Defined as those members who had at least $5 in their Share Account on December 31, 2010, have no delinquent accounts, have not had<br />
adverse collection activities on their accounts <strong>and</strong> have not had accounts charged off.<br />
**Ineligible loans include certain DCECU auto loans <strong>and</strong> mortgages, as well as VISA ® accounts with TravelFree Rewards, CashBack Rewards or<br />
Transaction Rebates.<br />
***For members who utilized the DCECU VISA ® Check Card during 2010, the rebate is 0.125% (.00125) for signature-based transactions, calculated<br />
on net sales, <strong>and</strong> $0.01 for PIN-based transactions for each time the card was used during the year. Using your VISA ® Check Card helped<br />
DCECU reduce operating expenses <strong>and</strong> operate more efficiently.<br />
62
Exhibit C: 2011 Website<br />
Announcement of Membership<br />
Dividend at Wright-Patt <strong>Credit</strong> <strong>Union</strong>,<br />
Inc. ($2.1B, Fairborn, Ohio) 34<br />
Dividend Calculation<br />
Why It Pays to USE Your <strong>Credit</strong> <strong>Union</strong>!<br />
Giving over $4 million back in the form of a Special <strong>Patronage</strong> Dividend<br />
to our member- owners puts people before profits <strong>and</strong> showcases<br />
the success of our credit union cooperative. We’re not here to<br />
profit from our members—we don’t charge big fees to make a quick<br />
buck like big corporations often do.<br />
When we have a successful year, we pay for our operations, invest in<br />
products <strong>and</strong> services to better serve you, <strong>and</strong> put some away for a<br />
rainy day fund. Then we return any excess earnings to you.<br />
How Can I Find Out My Share of the Dividend?<br />
This year’s $4 million Special <strong>Patronage</strong> Dividend was automatically<br />
deposited to eligible members’ TrueSaver accounts on January 4th,<br />
2011. You can find your share by checking your TrueSaver account<br />
(see history tab) through WPCU’s Home Banking or Mobile Banking.<br />
If you’re not already enrolled in online Home Banking, sign up<br />
now by calling our Member Help Center.<br />
2010 Special <strong>Patronage</strong> Dividend Calculation<br />
The Special <strong>Patronage</strong> Dividend calculation was based upon the<br />
accounts <strong>and</strong> services you used with Wright-Patt <strong>Credit</strong> <strong>Union</strong> in<br />
2010. By using services like mobile banking, financial planning,<br />
WPCU loans <strong>and</strong> mortgages, you contribute to the credit union<br />
cooperative <strong>and</strong> your payment will reflect that usage. The idea—the<br />
more you use your credit union, the more you benefit!<br />
Last year, the average member earned $22.94.<br />
63
Think of how much more you, <strong>and</strong> other members, could be earning<br />
<strong>and</strong> saving by moving all of the accounts <strong>and</strong> services you have<br />
somewhere else over to Wright-Patt <strong>Credit</strong> <strong>Union</strong>.<br />
By trusting WPCU with more of your accounts <strong>and</strong> telling your<br />
friends <strong>and</strong> family members all the ways WPCU is crazy about our<br />
members, you’ll help the credit union grow—<strong>and</strong> help us on the way<br />
to paying another <strong>Patronage</strong> Dividend next year.<br />
Qualifying members received:<br />
• 0.09% (0.0009) of your average daily balance of your deposits<br />
(includes business share balances)<br />
• 0.09% (0.0009) of your average daily balance of your loans<br />
(excludes business loan balances)<br />
• Earn $100 for a business loan relationship<br />
• $45 for each first mortgage loan<br />
• $5 for each financial planning relationship<br />
• $5 for an active debit card<br />
• $5 for being enrolled in eStatements<br />
• $5 for active Call-24, Home Banking, or Mobile Banking<br />
64
Endnotes<br />
1. Based on call reports from the NCUA website for the years<br />
2008, 2009, <strong>and</strong> 2010.<br />
2. Nonrecurring tax- deductible rebates are allowed only in the tax<br />
year that the rebate is paid. Recurring rebates are deductible in<br />
the year that the liability is fixed <strong>and</strong> determinable. Regs. Secs.<br />
1.461-5(b)(1)(ii), (b)(1)(iii), <strong>and</strong> (b)(3).<br />
3. A point that should please capitalists <strong>and</strong> socialists alike but not<br />
communists.<br />
4. Obviously, to attract capital, the cooperative must pay a reasonable<br />
rate of return to third parties for the use of equity as in<br />
preferred stock or debt as in subordinated debentures.<br />
5. This is a point of disagreement with several academics in the<br />
co-op community with whom we are familiar. It’s not clear to<br />
us exactly why these academics resist the idea that a co-op’s<br />
financial metrics may not reasonably allow it to allocate all<br />
patronage earnings <strong>and</strong> redeem all the allocated equity while<br />
it is simultaneously maintaining, building, <strong>and</strong> capitalizing its<br />
business. Our sense is that it conflicts so violently with their<br />
progressive point of view. One cannot help conclude that these<br />
academics would argue that if a co-op allocates the income,<br />
then surely it can redeem the equity. We know of nothing in a<br />
co-op’s DNA that allows that indulgence.<br />
6. In co-op tax-speak, apportionment is different from allocation.<br />
Apportionment is to assign earnings <strong>and</strong> equity to members on<br />
the co-op’s books without notification to the member. Allocation<br />
is apportionment plus notification to the member, <strong>and</strong><br />
under Subchapter T, allocation also carries with it the vesting<br />
of the equity in each member to whom patronage earnings are<br />
distributed with allocated equity.<br />
7. Revenue Revisions, 1947–1948: Hearings Before the Comm. on<br />
Ways <strong>and</strong> Means, 80th Cong., pt. 4, at 3136 (1948).<br />
8. Some bylaws call for the distribution of all or part of the<br />
remaining proceeds to nonprofit or tax- exempt organizations<br />
as a way of honoring a commitment to the cooperative form of<br />
business organization.<br />
9. Co-ops are democratically controlled on a one member–one<br />
vote basis. Older members have bigger voices because they are<br />
respected, <strong>and</strong> they are respected if they have lots of allocated<br />
equity because they have loyally supported the co-op over the<br />
years.<br />
10. Financial firms in the S&P 500 paid an annual dividend of<br />
1.1% of capital in 2010 <strong>and</strong> 1.4% through March 31, 2011. In<br />
65
contrast, the 27 credit unions paid a cash patronage refund that<br />
was 1.62% of their average equity over the years 2008, 2009,<br />
<strong>and</strong> 2010. An IOF dividend is taxable income to the recipient,<br />
whereas a co-op’s cash patronage refund is not taxable income<br />
to the recipient if the refund is paid from transactions that were<br />
not themselves deductible from or includable in income. But<br />
recall too that the credit union’s earnings belong to the members,<br />
not the credit union, <strong>and</strong> it would be unnatural for the<br />
earnings to be exposed to income tax at a level other than at the<br />
member level.<br />
11. Wright-Patt <strong>Credit</strong> <strong>Union</strong>, Inc., “Wright-Patt <strong>Credit</strong> <strong>Union</strong><br />
Saved Members $26 Million in 2009 Says <strong>Credit</strong> <strong>Union</strong><br />
National Association,” wright4youmortgage.com/news/<br />
10-04-21/Wright-Patt_<strong>Credit</strong>_<strong>Union</strong>_Saved_Members_<br />
26_Million_in_2009_Says_<strong>Credit</strong>_<strong>Union</strong>_National_<br />
Association.aspx.<br />
12. <strong>Cooperative</strong>s are considered to be the ultimate self-help organization<br />
in the United States <strong>and</strong> around the world. In fact,<br />
since 1995, the United Nations General Assembly has annually<br />
recognized “International Day of <strong>Cooperative</strong>s,” a day that<br />
reaffirms <strong>and</strong> celebrates the role of cooperatives in economic,<br />
social, <strong>and</strong> cultural development. Each annual celebration has<br />
a theme; in 2010 it was “<strong>Cooperative</strong> Enterprise Empowers<br />
Women.”<br />
13. We do not distinguish among members, the board of directors,<br />
<strong>and</strong> management. Each stakeholder group is as prone to wrong<br />
decisions as the others.<br />
14. Federal credit unions are tax exempt under 501(c)(1) as well.<br />
Both L<strong>and</strong> Banks <strong>and</strong> federal credit unions are chartered by the<br />
federal government.<br />
15. Nonpatronage earnings do not arise from business done with<br />
or for patrons. For the balance of this section on Subchapter T,<br />
we will discuss these tax features as though the cooperative<br />
generated only patronage- sourced income.<br />
16. <strong>Union</strong> <strong>Cooperative</strong> Exchange v. Commissioner of Internal<br />
Revenue, 58 T.C. 427 (U.S. Tax Court 1969).<br />
17. Nonqualified written notices of allocation (NQNAs) are also<br />
used to distribute <strong>and</strong> “pay” the patronage earnings to patrons.<br />
The cooperative pays income tax on the NQNAs initially. If<br />
<strong>and</strong> when NQNAs are redeemed (no later than at dissolution,<br />
if not sooner), the patron pays income tax <strong>and</strong> the cooperative<br />
receives a tax benefit equal to the tax it paid earlier. In this way,<br />
single taxation is preserved.<br />
18. <strong>Patronage</strong> earnings from transactions relating to personal,<br />
living, or family purposes are not taxable. More later in this<br />
66
section on the exemption from filing 1099-PATRs for “consumer”<br />
cooperatives.<br />
19. 26 CFR 1.6044-4: “If 85 percent of its gross receipts for the<br />
preceding taxable year, or 85 percent of its aggregate gross<br />
receipts for the preceding three taxable years, are derived from<br />
the sale at retail of goods or services of a type which is generally<br />
for personal, living, or family use.”<br />
20. Only the allocation of member- related patronage earnings is<br />
deductible under Sub-T.<br />
21. National Rural Electric <strong>Cooperative</strong> Association <strong>and</strong> National<br />
Rural Utilities <strong>Cooperative</strong> Finance Corporation, Capital <strong>Credit</strong>s<br />
Task Force Report, January 2005.<br />
22. Treas. Reg. § 301.6044–2(b)(2)(iii).<br />
23. Coop Litigation News Publishing, “Coop Litigation News.”<br />
coop-litigation.com.<br />
24. Because each ACA operates a <strong>Credit</strong> Association subsidiary<br />
that is taxed under Subchapter T, <strong>and</strong> because Sub-T co-ops<br />
must allocate patronage- sourced income or maintain patronage<br />
records, each ACA can be expected to follow a similar recordkeeping<br />
process for its L<strong>and</strong> Bank subsidiary.<br />
25. 12 CFR 701.6.<br />
26. Examples include Iowa Code § 533.404, Kentucky Statutes<br />
286.6-705, Wisconsin Code 186.18, <strong>and</strong> North Dakota<br />
6-06.1-08.<br />
27. www.aggeorgia.com; www.badgerl<strong>and</strong>financial.com. The financial<br />
information discussed in this report is taken from each<br />
association’s 2007, 2008, <strong>and</strong> 2009 fiscal year-end audits.<br />
28. 12 CFR 615.5330.<br />
29. 12 CFR 615.5301(b)(2)(ii).<br />
30. See our earlier discussion at note 6.<br />
31. See discussion above on Subchapter T. Key qualifications<br />
include (1) preexisting obligation in the bylaws, (2) board of<br />
directors declares patronage refund, (3) within 8½ months<br />
following fiscal year end, prepare <strong>and</strong> send qualified written<br />
notices of allocation <strong>and</strong> qualified payment constituting at least<br />
20% of the allocation in cash, <strong>and</strong> (4) build out accounting<br />
program to allow tracking of each member’s allocated equity.<br />
32. See note 18 about cooperatives that primarily provide goods or<br />
services for family, personal, or living needs.<br />
33. It is not that all conversions of co-ops are ill conceived. Conversions<br />
or demutualizations of co-ops with large equity<br />
redemption obligations improve their financial metrics because<br />
they are no longer required to devote huge capital resources<br />
67
to redemptions. Think Diamond Walnut Growers in California.<br />
On the other h<strong>and</strong>, one wonders who benefited from<br />
the OmniAmerican conversion other than management <strong>and</strong><br />
institutional investors.<br />
34. Wright-Patt <strong>Credit</strong> <strong>Union</strong>, Inc., “Dividend Calculation,”<br />
www.wpcu.coop/patronagedividend/ DividendCalculation.aspx<br />
(retrieved 4/27/2011).<br />
68
ideas grow here<br />
PO Box 2998<br />
Madison, WI 53701-2998<br />
Phone (608) 231-8550<br />
www.filene.org PUBLICATION #242 (7/11)