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The cooperative in October 2020: a field report after a pandemic year

Worker co-op formations ticking up in DC, New York, and California, §199A(g) settled into routine, and food co-ops proving unusually boring in a year that was not

The Editors
Staff, Incorporator.org
12 min read Updated
Contents 8 sections
  1. What COVID did to worker cooperative formation
  2. §199A(g) has settled into routine
  3. How PPP treated cooperatives
  4. Food cooperatives had a quietly excellent pandemic
  5. State statutory drift continued
  6. The agricultural antitrust exemption is unchanged, again
  7. What to do with this in October 2020
  8. Sources

orker cooperatives are having the busiest formation year in their modern history, and the reason is not ideological. It is that a pandemic froze the sale market for small businesses whose owners wanted out, and an employee-ownership conversion is the exit that still clears when a strategic buyer will not return a phone call.

Twenty months after our February 2019 revisit of the cooperative form, and a little over three years after the original June 2017 piece, the federal tax scaffolding around Subchapter T has stopped moving and the state statutes have kept drifting in the direction they were already drifting. What changed in 2020 is not the law. It is the demand curve.

What COVID did to worker cooperative formation

The 2019 National Worker Cooperative Survey conducted by the Democracy at Work Institute and the U.S. Federation of Worker Cooperatives counted roughly 465 verified worker-owned firms in the United States, employing on the order of 6,500 to 7,000 worker-owners. That was already a growth number; the sector had roughly doubled since 2013. The 2020 data is not yet published, but three state-level signals point in the same direction.

In the District of Columbia, the Department of Small and Local Business Development stood up the DC Employee Ownership Initiative following the Employee Ownership Expansion Act of 2019, D.C. Law 23-75 (effective March 16, 2020), which directs the Department to provide technical assistance and preference in contracting for employee-owned firms including worker cooperatives governed by the DC Cooperative Association Act of 1940, D.C. Code § 29-901 and following. The 1940 statute is one of the oldest general cooperative acts still in force and it governs worker, consumer, and housing cooperatives in the District. Conversion inquiries to DSLBD in the first three quarters of 2020 are running substantially above 2019.

In New York, the Worker Cooperative Business Development Initiative inside the Department of Small Business Services, funded through the City Council since fiscal year 2015, reported 32 new worker cooperatives formed in New York City in the fiscal year that ended June 30, 2020. That is the highest single-year number since the program began and roughly double the formation pace of fiscal year 2017. The city's working assumption, stated in the FY2021 budget hearings, is that pandemic displacement of service workers in cleaning, food, and home-care trades is driving a migration of existing informal cooperatives into formal incorporation so that they can access public procurement and relief funds.

In California, the Worker Cooperative Act, AB 816 (2015), codified primarily at Corporations Code §§ 12253.5 and surrounding provisions, remains the most developed worker-co-op statute in the country. The Secretary of State has not broken out worker-cooperative formations as a separate filing type, but the practitioners who do this work (the Sustainable Economies Law Center, Project Equity, the East Bay Community Law Center) report 2020 client loads running 40 to 60 percent above 2019 through the third quarter. The mix has shifted toward conversions of existing firms whose owners want to retire and cannot find a buyer, which is the use case the Main Street Employee Ownership Act was written for.

None of this changes the statutory analysis we laid out in 2017. A California worker cooperative still incorporates under AB 816's provisions in the Corporations Code, still uses a pre-existing patronage obligation to allocate surplus, and still relies on Rev. Rul. 74-567, 1974-2 C.B. 199, for the rule that hours or wages, not goods purchased, are the patronage factor. What changed is who is walking in the door.

§199A(g) has settled into routine

The grain-glitch story that consumed the 2018 cooperative tax year is closed. The Consolidated Appropriations Act, 2018, P.L. 115-141, enacted March 23, 2018, repealed the December 2017 version of IRC § 199A(g) and substituted a DPAD-style deduction for specified agricultural and horticultural cooperatives, equal to 9 percent of the lesser of qualified production activities income or taxable income, subject to a 50-percent-of-W-2-wages cap. Treasury issued final regulations under §§ 1.199A(a) through 1.199A(g) on June 19, 2019, at 84 Fed. Reg. 28668, with the cooperative-specific regulations at Treas. Reg. § 1.199A-8 through § 1.199A-12. Those regulations have now been through two full filing cycles and a patronage-dividend season, and the preparer community has absorbed them.

The mechanics look the way everyone expected them to by early 2019. The specified ag co-op computes its § 199A(g) deduction under § 1.199A-8, determines the portion to pass through to patrons on a qualified notice, and reports patron allocations on Form 1099-PATR. Patrons who are also eligible for § 199A(a) on their qualified business income from the co-op reduce that § 199A(a) deduction under § 199A(b)(7) by the lesser of 9 percent of QBI attributable to co-op business or 50 percent of W-2 wages allocable to that business, exactly as the 2018 statute contemplated. The patron reduction is still the most error-prone step on the return, because the co-op and the patron are computing overlapping deductions on overlapping income streams, but the arithmetic is now well-trodden.

The consequence for formation analysis in October 2020 is that the tax case for organizing as an agricultural cooperative is back to where it was before TCJA, adjusted for the new 21-percent corporate rate in § 11(b). A co-op still gets single-taxation on patronage under Subchapter T, still gets the W-2-wage-limited § 199A(g) deduction on domestic production, and still cannot do either of those things if it is not actually operating on a cooperative basis within the meaning of IRC § 1381(a). Subchapter T itself, at 26 U.S.C. §§ 1381 through 1388, is untouched. The 20-percent cash requirement at § 1388(c) still governs qualified written notices of allocation. Form 1028 is still the vehicle for § 521 status.

What is new is that the provision everyone spent 2018 arguing about is now just part of the tax code. It has stopped being interesting, which for tax practitioners is the ideal state of a statute.

How PPP treated cooperatives

The Paycheck Protection Program created by the CARES Act, P.L. 116-136 (March 27, 2020), and administered by the Small Business Administration under section 7(a)(36) of the Small Business Act, made forgivable loans available to small businesses to cover payroll and certain operating costs during the pandemic. Cooperatives were eligible on essentially the same terms as other small businesses, with one wrinkle that took SBA several weeks to resolve.

The initial CARES Act text and the first interim final rule (85 Fed. Reg. 20811, April 15, 2020) defined eligible borrowers to include any business concern, 501(c)(3) nonprofit, 501(c)(19) veterans organization, or tribal business that met SBA size standards. Agricultural cooperatives organized under Subchapter T but not exempt under § 501(c) fell into a gray zone: they were clearly business concerns, but some lenders balked at cooperatives that had tax-exempt-adjacent features. SBA clarified in its April 24 interim final rule (85 Fed. Reg. 23450) and in FAQ 19 that agricultural and other cooperatives are eligible PPP borrowers and that their patronage dividends are not counted as owner compensation for the payroll-cost calculation. Farmer cooperatives taxed under Subchapter T were expressly included.

For worker cooperatives, the question was whether the worker-owners count as employees or as self-employed owner-operators. SBA's position, consistent with the general treatment of cooperative wages, is that worker-owners who receive W-2 wages are treated as employees for PPP payroll-cost purposes; patronage dividends paid out as distributions of net margin are not payroll costs. The practical effect is that a worker co-op that pays its members primarily as wages, which most California AB 816 co-ops do, could size a PPP loan on the same 2.5-times-average-monthly-payroll basis as any other small employer. A worker co-op that paid its members primarily through patronage allocations of surplus, with low or zero base wages, had a materially smaller eligible loan amount.

The forgiveness mechanics under § 1106 of the CARES Act and the subsequent Paycheck Protection Program Flexibility Act, P.L. 116-142 (June 5, 2020), which extended the covered period from eight to twenty-four weeks and reduced the payroll-cost floor from 75 percent to 60 percent, applied to cooperative borrowers the same way they applied to other borrowers. Consumer cooperatives organized under state cooperative acts and taxed under Subchapter T were treated as ordinary business borrowers. Housing cooperatives organized under state housing co-op statutes were not initially eligible, because they were not operating a trade or business in the SBA sense; that was clarified in the Economic Aid Act context later in the year but was not settled in the first round.

The net for cooperative PPP activity through the first two draws is that the program worked roughly as well, or roughly as badly, for cooperatives as it did for any other small-business form. The cooperative-specific concerns were resolvable and got resolved. The program-design concerns that affected all small businesses (the race-to-the-portal first week, the public-company borrowers, the lender-prioritization controversies) affected co-ops in proportion to their share of the economy, which is small.

Food cooperatives had a quietly excellent pandemic

The most interesting operational data point of 2020 is not a tax provision or a statute. It is that retail grocery cooperatives, the National Cooperative Grocers network in particular, appear to have outperformed conventional grocery on essentially every pandemic metric that mattered to their members. Same-store sales at NCG member stores in the second quarter of 2020 were up in the low double digits year-over-year, supply-chain disruptions were absorbed more smoothly at stores with direct local-producer relationships, and member equity redemption requests remained at routine levels rather than spiking as they might at a stressed retailer. The 2020 NCG co-op impact report has not been released as of this writing, but the member-store dashboards circulated through the network in July and August told a consistent story.

That is not an argument that food co-ops are structurally better than chains. It is an argument that the specific features of the cooperative form, a board that represents shoppers rather than distant shareholders, a supplier network chosen for reasons other than shelf-slotting fees, member equity that is patient rather than yield-seeking, happened to line up with what the pandemic demanded of a grocery store. Those same features are handicaps in a growth market. They were advantages in a logistics shock.

State statutory drift continued

The Uniform Limited Cooperative Association Act, finalized by the Uniform Law Commission in 2007 and amended in 2013, picked up two new enactments since our 2019 piece. Michigan enacted the ULCAA as Public Act 466 of 2018, effective March 28, 2019, codified at MCL § 450.4201 and following. Colorado, which originally enacted the ULCAA in 2011 as Article 58 of Title 7 of the Colorado Revised Statutes, amended its version in 2020 (HB 20-1155, signed June 26, 2020) to modernize its investor-member provisions. That brings the ULCAA total to roughly fifteen or sixteen states plus the District of Columbia, with the pace of adoption running at one or two states per year rather than the faster pace some advocates hoped for in 2013.

Beyond the ULCAA, there have been no structural changes at the state level. California's AB 816 remains the most developed worker-cooperative statute. Minnesota's Chapter 308B, New York's Cooperative Corporations Law, and Wisconsin's Chapters 185 and 193 continue to govern traditional-cooperative formations in their respective states. The District's 1940 Cooperative Association Act is still the underlying statute for most of the worker-coop conversion work happening in DC under the new employee-ownership framework, because the 1940 act is one-member-one-vote by default and plays well with DSLBD's new contracting preference.

The agricultural antitrust exemption is unchanged, again

Capper-Volstead, codified at 7 U.S.C. § 291, still grants producers of agricultural products the narrow antitrust exemption they have had since 1922, and still does not extend to worker or consumer co-ops. The Department of Justice Antitrust Division and the USDA have filed no material enforcement actions against ag cooperatives in the past twenty months that would move the existing caselaw. The last structurally important decision is still Maryland & Virginia Milk Producers Ass'n v. United States, 362 U.S. 458 (1960), for the proposition that predatory conduct against nonmembers is not protected. For operational purposes a 2020 dairy, grain, fruit, or cotton cooperative is running the same Capper-Volstead compliance playbook it was running in 2017.

What to do with this in October 2020

If you are an agricultural producer contemplating a cooperative, the federal tax backdrop is stable, the § 199A(g) mechanics are understood, and the analysis walks on the same three legs it has for decades: Subchapter T for patronage, § 521 for the fuller deduction set (Form 1028 and an IRS ruling), and Capper-Volstead for the collective-marketing exemption.

If you are a worker cooperative, 2020 is the formation year that has the most infrastructure behind it the movement has ever had, between California's AB 816, the ULCAA option in fifteen-plus states, the SBA's Main Street Employee Ownership Act 7(a) lending channel, and the new DC employee-ownership statute. None of that dissolves the classic structural question, which is how you finance growth without diluting worker control. The ULCAA's two-class patron-and-investor structure is the most developed answer, and it is still not widely used because most worker co-ops do not want outside investor members at the price they would clear.

If you are a consumer cooperative, 2020 demonstrated that the form holds up operationally in a way it was often accused of not doing. The grocery co-ops went through a supply-chain earthquake with less friction than their conventional competitors. Whether that matters in 2022 when supply chains are boring again is a different question, and a good one.

The article to read next is whichever one explains your state's specific cooperative statute. The federal layer is understood now. The state layer is where the remaining choices live.

Sources

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