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Blogging Beyond the Numbers

Worker Co-ops Operating Under Subchapter T and the New Tax Law
Posted by: Bruce Mayer 1 week ago

The new tax law was amended in March 2018 to remove patronage dividends from the 20% pass through business deduction.  This is a tax disadvantage for worker co-ops taxed under Subchapter T. 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 and disadvantages for worker co-ops are now that the 20% pass through business deduction is available for entities taxed as partnerships and S-corporations, and for sole proprietors.

The IRS has yet to issue guidance on applying the new tax law so the advice here will likely change once that is issued.  For this reason a change of the form of your co-op should probably wait until this guidance is issued.  But it is useful to be aware of the possibilities so that you can make a decision and implement changes by the end of 2018 so that the changes will be applicable to 2019 taxes.   The taxation of co-ops taxed as partnerships or S-corporations under the new tax law is addressed in another blog post.

All entities qualifying as cooperatives need to meet the co-op principles. The key ones from a tax point of view are:

  • One member – One vote
  • Limited return on equity
  • Allocation of profits based on business done with the co-op

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.  Co-ops taxed as partnerships or as S-corporations do not fall under Subchapter T.

Subchapter T Worker Co-ops

These 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 is using patronage dividends to allocate the profits.  The major advantage of patronage dividends is that they 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 to Convert Income to Qualify for the 20% Pass Through Business Deductions

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.  There are several strategies that may convert the income from a worker co-op to be eligible for the 20% business pass through deduction.  

Should You Bother Changing Form to Qualify for the 20% Pass Through Business Deduction?

For a co-op that is not generating large income or profits the cost and effort of conversion plus possibly increased ongoing costs of the new structure may not make sense.  Suppose that your co-op members are getting paid $30,000 per year for their W-2 wages with a patronage dividend allocation of $10,000.  If you could convert that $10,000 into eligibility for the 20% 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%).  The question to ask is if this is enough to justify investigating and changing the form of the co-op or adding an entity between the co-op and the member to allow for the 20% pass through business deduction.

If someone was paid three times as much, $90,000 for their W-2 and a patronage dividend 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%).  This would make it more likely that pursuing changes is worth the effort.

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.

Converting the Co-op to Qualify

A Subchapter T co-op has two options for switching to an entity that allows for members to potentially receive the 20% business pass through deduction.  The treatment of these two entities under the new tax rules is covered in a separate blog post.

S-Corporation

The simplest option is to elect to be taxed as an S-corporation.  This can be done by modifying the bylaws to meet the requirements of an S-corporation and by filing an election with the IRS.  This election needs to be filed no later than 75 days after the first year it will apply.  To elect S-corporation status for 2019 the form needs to be filed with the IRS by March 15, 2019.  S-corporations are a challenging form to use for a co-op.  It is best suited to small co-ops that do not use non-member labor and where the members work similar amounts or are paid similar total amounts.  If these are not the case a profit sharing system can be used to meet the co-op requirement of allocating profits in accordance with the business done with the co-op.

The short summary of S-corporation requirements is that owners must consist of no more than 100 individuals.  Other entities like corporations and partnerships cannot be owners.  The owners working in the S-corporation receive a W-2 and profits must be allocated on the percentage of ownership.  There are other requirements but those are the key ones.  Any violation of those requirements results in automatically losing S status.

A good thing with S status is that the profit allocation is not subject to self-employment tax.  This is in contrast to patronage dividends where the application of self-employment tax is not a settled issue. A disadvantage of S status is that the profit allocation is taxed to the owner in the year it is earned.  This is also in contrast to patronage dividends where the amount is taxed in the year received so there may be a deferral of tax if it is paid or allocated in the next year.

An S-corporation must allocate all profits to owners so there is no option to have the co-op pay income tax on the profits.  This results in S-corporations not having any retained earnings or equity that belongs to the co-op.  This is in contrast to Subchapter T co-ops which can have profits taxed to the co-op and can have retained earnings and equity belonging to the co-op.

Partnership

The other option to convert the co-op is to move to an LLC or LCA form.  This requires dissolving the current entity and contributing the assets to a newly formed LLC or LCA.  This is true even for current LLCs and LCAs that elected taxation as a corporation.  There is no going back directly from corporate taxation to partnership taxation.  The costs of doing this would be to have an attorney draw up an operating agreement for the new LLC or LCA, registering it with a state, and drafting a contract for the transfer of assets to the new entity.  There may be tax on the assets in the current co-op as they come out of the co-op being taxed as a corporation and are contributed to the new LLC or LCA.  These assets would include appreciated equipment or real estate, and any assets in excess of the member equity.  These rules are very complicated so each co-op will need to evaluate its tax situation in any dissolution.  Many worker co-ops have little in the way of assets so taxes on dissolution will often not be a significant issue. The entity that is being dissolved will need to file a final tax return and dissolve by filing notice with the state where it is registered.  The new LLC or LCA will have a new Employer Identification Number (EIN) so any registrations will need to be re-assigned to the new entity.

In an entity taxed as a partnership the members will not receive a W-2 and any profits will be allocated based on the formula in the operating agreement.  In a co-op this should be based on the business done by workers with the co-op.  As with an S-corporation, the profits must be allocated to the owners and taxed in the year earned so there are no retained earnings or equity belonging to the co-op.  Also all allocations for work done and allocations of profits are subject to self-employment tax.  This will reduce the tax advantage of the partnership profit allocation compared to patronage dividends.

Converting Patrons to Qualify for the 20% Pass Through Business Deduction

An alternative to changing the co-op’s form is to have each interested member consider if they can qualify as an independent contractor or if they can form a personal S-corporation.  In some existing co-ops some or all of the members may already be doing this.  In those cases the profits they earn through their sole proprietorship or S-corporation will qualify for the 20% deduction.

Independent Contractor

In some co-ops, some or all of the owners may qualify as independent contractors.  The rules on this are strictly enforced by the IRS and by state workforce agencies.  Each co-op must look at the tests for determining if a person providing services meets the qualifications to be classified as an employee or as an independent contractor.  The very short version is that a contractor controls their work environment, provides their own tools or equipment and has liability for not delivering the specified work product.  An employee can be asked to work at a specific time and place, is usually provided equipment needed to perform their job and does not have personal liability for failure to deliver work.

If a person does qualify as an independent contractor the payments for their work would be to their sole proprietorship or one person LLC.  All income and profits will be reported on their personal federal Form 1040 and is eligible for the 20% pass through business deduction.

Personal S-Corporation       

A member can also set up their own S-corporation and have the S-corporation contract with the co-op to provide services.  The member will need to incorporate the S-corporation and it will need to file its own 1120-S federal tax return and the state equivalent.  The member will need to receive W-2 income from the S-corporation.  But they can allocate some of the income as a profit allocation from the S-corporation and this will be eligible for the 20% pass through business deduction.

Conclusion

A Subchapter T co-op has various options to consider in relation to the new tax law’s 20% pass through business deduction.  For many the advantages of the co-op form and patronage dividends are not offset by the costs of changing plus the ongoing costs of the new structure.  For others the tax savings may be significant and the cost of the change is more than offset.  If you think you want to consider a change check in with your accountant or attorney to discuss if a detailed analysis is appropriate.

 

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About the Author

Bruce Mayer

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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