Blogging Beyond the Numbers

Patronage Dividends under the New Tax Law
Posted by: Bruce Mayer 3 months ago

A key feature of the tax changes is that patronage dividends are eligible for the new 20% pass through business income deduction.  This is the new tax rule that is supposed to equalize taxes on pass through businesses (sole proprietorships, S corporations and partnerships) with the corporate tax rate reduction from 35% to 21% (applicable only to C corporations).  The math is convoluted but it actually does this for those pass through businesses that qualify. Co-ops do qualify and without the income limitations that other businesses must meet.

The one limitation that does apply is that if the recipient of a patronage dividend is a C corporation the reduction will not apply since the tax rate for C corporations was already reduced.  Note that incorporated cooperatives are C corporations for this purpose.  So when a co-op pays a patronage dividend to another co-op, the recipient cannot use the 20% pass through deduction.

An exception to the taxability rules applies to consumer co-ops where members purchase items for personal use, such as groceries.  The exemption from tax on such patronage dividends was not changed in the new tax law.

20% Business Income Deduction Applied to Patronage Dividends

To help out farmers this rule was extended to cover the business that farmers do with co-ops by allowing the farmer to deduct 20% of their patronage dividends. The effect will be that the patronage dividend is income and then 20% will be deducted.  The rules are not restricted to farm co-ops, so this means any recipient of a patronage dividend can take a deduction equal to 20% of that income as long as they are not a C corporation.

A patronage dividend that is paid on 2017 income will be 2018 income to the recipient so the new tax law applies now.

If your co-op issues a qualified patronage dividend for $1,000 that the co-op deducts on its 2017 return, the pass through recipient will pay tax on only $800 on their 2018 return.  One thing to remember about this is that the patronage dividend is ordinary income and not eligible for the qualified dividend tax rates.

Purchasing Co-ops

For purchasing co-ops that use patronage rebates the value of rebates just increased if your members are individuals or pass through businesses.

Worker Co-ops

For worker co-ops there are additional considerations.  The amount paid to an individual member as a salary or wage must be fair compensation for the work they do.  The patronage dividend should be the profits of the business above that fair compensation amount.  This is not an area where co-ops have been examined closely by the IRS in the past.  There is, however, a long history on this issue in the S-corporation area.  There are many court cases and IRS guidance on what is fair compensation in an S-corporation.  One very rough measure is that a wage or salary should be at least 75% of total compensation with the patronage dividend making up the other 25% or less of compensation.

For worker co-ops the other factor is that patronage dividends may or may not be subject self-employment (SE) tax.  This is not a settled area of tax law with the IRS often asserting that the patronage dividend is compensation for governance duties and so is subject to SE tax.  Workers receiving patronage dividends generally assert that the patronage dividend is an allocation of profit and not payment for services so it should not be subject to the SE tax.  This area may be more interesting to the IRS with the new 20% pass through business deduction. Every worker co-op member will need to decide for themselves how to report this.  There are efforts to fix this through legislation to define it as non-SE income but the chances of passage are not easily estimated.

What Is All Of This Talk About Co-ops Being a Loophole?

One of the limitations that generally applies to the 20% business deduction is that it cannot be used by businesses providing consulting, law, accounting and a list of similar knowledge businesses when the recipient’s income is over certain limits. The income limit is that on a person’s 1040 they phase out of taking the 20% reduction if their Adjusted Gross Income (AGI) is over $315,000 for married filing joint or $157,500 for single and other filers.  This knowledge profession income limitation does not apply to patronage dividends.  So a Washington attorney/lobbyist who made $2 million last year could put their business inside a co-op and use the 20% reduction to shield hundreds of thousands of income from income tax and possibly SE tax as well.  That could be a big deal but is also ripe for a technical correction to extend the knowledge profession and income limitations to individuals and pass through businesses receiving patronage dividends.

And What about a Tax Break for Farmers Supplying Food Co-ops

One of the big topics we have not covered is the break for famers selling to farm co-ops.  The details are beyond our scope here but the summary is that a farmer could qualify for the 20% reduction on the entire sales price of grain, dairy, and produce they sell to a co-op.  That is a big tax break and the subject of lots of talk since it puts non-cooperative businesses at a disadvantage.

This rule works because the purchasing agricultural co-op can use a form of patronage dividends called per-unit retains when purchasing from a farmer.  This only works when the farmer is an owner of the co-op and when the co-op is legitimately an agricultural co-op.  So retail food co-ops cannot use this rule since they are not owned by the farmers and since the food co-op is not an agricultural co-op.  If a food hub was owned by farmers it might qualify under this rule.  It would need to implement a per-unit retain system and make sure it qualified under the agricultural co-op rules.

Likely IRS or Congressional Guidance

All co-ops should remember that the IRS has yet to issue any guidance on this new rule.  There is also talk that there may be a technical corrections bill by Congress to narrow the scope of the patronage dividend rule. Before making a change to your co-op you should consider this carefully.


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Bruce Mayer

About the Author

Bruce Mayer, MBA, CPA currently serves as a Partner in the Assurance Department, working primarily on audits and tax returns of cooperatives, nonprofits, employee benefit plans and commercial businesses.  Bruce performs audits of all kinds and provides consulting services on taxation of nonprofits and cooperatives.  Bruce enjoys helping clients solve problems and providing clients advice on accounting and tax strategies that meet their needs.



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