The new tax law was amended in March 2018 to change the patronage dividends rules but did allow them to be eligible for the 20% pass through business deduction. Co-ops where the recipients of patronage dividends are businesses, or are individuals not paying tax due to the personal use exemption, are not affected by this change. I will explore what some of the tax advantages are for worker co-ops now that the 20% pass through business deduction is available for entities taxed as corporations.
The IRS has yet to issue guidance on applying the new tax law so the advice here may change once that is issued.
Subchapter T Worker Co-ops
The IRS defines the tax treatment of co-ops in code sections of the Internal Revenue Code that are called Subchapter T. The IRS only recognizes incorporated co-ops and those taxed as corporations as subject to Subchapter T rules. The IRS does not explicitly define who qualifies as a co-op but some past court cases have referred to co-op principles when addressing this. This includes one member – one vote, limited return on equity, and allocation of profits based on business done with the cooperative. Co-ops taxed as partnerships or as S-corporations do not fall under Subchapter T.
Worker co-ops under subchapter T include incorporated co-ops and those that are LLCs (Limited Liability Corporations) or LCAs (Limited Cooperative Associations) that have elected to be taxed as corporations.
The primary advantage of being taxed as a co-op corporation is using patronage dividends to allocate the profits. Patronage dividends allow the flexibility of paying the tax in the co-op or allocating some or all of the profit to the patrons and having them pay the tax. The tax paid by recipients of patronage dividends is paid in the year cash or a qualified notice of allocation is received. This can result in deferring the tax paid on the patronage dividend for a year. The flexibility of who pays the tax and the deferral of tax are significant advantages of Subchapter T co-ops.
Strategies for the 20% Pass through Business Deduction
If the income and the profits of a co-op are significant, the 20% business pass through deduction may result in a significant tax savings to members.
Suppose that your co-op members are getting paid a total of $40,000 per year, with $30,000 for their W-2 wages and a patronage dividend allocation of $10,000. With the 20% pass through business deduction it would reduce a member’s federal taxable income by $2,000 ($10,000 x 20%). If the member is single and this is their only income they would be in the 12% federal tax bracket. So this results in a $240 tax savings ($2,000 x 12%).
If someone was paid three times as much, $120,000 per year, with $90,000 for their W-2 and a patronage dividend allocation of $30,000 the tax savings increase more than 3 times. The member’s taxable income is reduced by $6,000 ($30,000 x 20%). If the member is single and this is their only income they would be in the 24% tax bracket for most of the patronage dividend giving a tax savings of $1,440 ($6,000 x 24%).
Note that these savings of individual taxes have various factors that might reduce or eliminate the tax savings. So a review of individual tax situations is needed in helping to make this decision.
The primary limitations on the Form 1040 are when total income on the 1040 exceeds $157,500 for single filers or $315,000 for married joint filers. The first limitation is that profits earned in specified service businesses may be ineligible for the 20% deduction. These businesses include “health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its” employees or owners. The second limitation for high income taxpayers is that the 20% deduction is limited to the highest of 50% of the W-2 wages or the sum of 25% of W-2 wages plus 2.5% of the original cost of qualified depreciable property. If either the specified service business or the W-2 and/or property limits apply, the 20% deduction phases out above the taxable income limits mentioned above. When 1040 income is high, individual co-op members will need to review the limitations.
Payroll Tax Savings
One additional savings from patronage dividends is that they are generally not subject to payroll taxes. Although it is not settled, patronage dividends should be exempt from federal FICA and Medicare taxes. They should also be exempt from state unemployment, workers compensation, and other payroll taxes.
For the federal taxes the distinction that makes them not subject to FICA and Medicare taxes is that the patronage dividend is supposed to be an allocation of profits and not compensation for services as an employee or as a board member. This means that the pay someone receives for the work they perform on form W-2 should be fair compensation. The determination of fair compensation is subject to the facts and circumstances of each person. It is a good idea to document the compensation set for each member as W-2 wages so that it can be defended in the event of an IRS inquiry into the allocation of wages versus patronage dividends.
Worker co-ops have a significant tax break with the 20% pass through business deduction. This is a good time for worker co-ops to consider if they can pay out more in patronage dividends to take advantage of this new tax law. Paying more in patronage dividends will allow income tax savings to the members as well as payroll tax savings for both the members and the co-op.
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.