For Services, Not for Sale: How Taxation Policies Affect Demutualization of Cooperatives

By Reynolds, Bruce J. | Rural Cooperatives, November-December 2015 | Go to article overview

For Services, Not for Sale: How Taxation Policies Affect Demutualization of Cooperatives


Reynolds, Bruce J., Rural Cooperatives


The services and benefits provided to the founders of cooperatives continue to benefit new generations of members. As of 2015,

173 farmer cooperatives have reached the century mark for longevity. Projections are that there will be a twofold increase of 100-year-old co-ops during the next five years (Eversull).

Farmer co-ops are now fewer in number than in earlier decades, many having merged with other co-ops while some went out of business. Another category of organizational change is the conversion of co-ops to investor-owned businesses, a process often called "a demutualization."

The buying and selling of businesses is a part of the dynamics of a market economy. This process is often applauded when inefficient firms are acquired and improved with new management and restructuring. Yet, such efficiency gains are questionable in many cases in regard to demutualization (Chaddad). In addition, recent evidence of buyouts among non-cooperative businesses shows that the targeted firms are often efficient and profitable. The gains for new owners stem from monetizing assets with debt and eliminating worker retirement and other benefits (Appelbaum). Efficient co-ops have also been targeted for acquisitions.

When members deal with outside investors to capture the capitalized value of a co-op through demutualization, they may, in some cases, be gaining from the endowments and contributions of founders and retired members. From then on, investor-owners may reduce availability of services. Furthermore, demutualization may foreclose the benefits of a co-op for future members.

Demutualization is, in some cases, the most effective way to sustain a business. Taxation and regulatory policies can be designed so that demutualization may occur for weak performing co-ops and not be otherwise incentivized to take place.

Taxation and other regulatory policies for cooperatives can unintentionally increase incentives to demutualize, or--to the contrary--can be designed to discourage such conversions (Chaddad). Since 2004, taxation rule changes offer some tax-advantaged ways to use non-member earnings to diminish incentives for demutualization.

Another method to preserve high-value co-ops is to regulate the distribution of unallocated reserves.

This latter control is widely used by co-ops in Western Europe and in Quebec, but aspects of this method actually existed in some limited instances for U.S. farmer co-ops prior to 1951 tax reforms.

This article reviews two approaches for how co-ops can exercise some control over demutualization. First, tax rules from 2004 are examined as to how they can be applied for supporting longevity. The second approach explains historical and current uses of indivisible reserves (IR) as a means to prevent the loss of successful co-ops.

Paying dividends on stock

Member patronage equity is a major source of internal financing that a co-op can deduct from its taxable earnings.

Yet, this equity is redeemed to members at face value, which leads to questions about receiving a return for the period of time such stock is held by a cooperative. When members don't receive a return via a stock dividend, they may pressure their cooperatives to redeem equity sooner.

In response, co-ops may try to limit their exposure to equity redemption by increasing their unallocated reserves with earnings from non-patronage business. When an unallocated reserve becomes substantial and the earnings of a co-op are relatively high, outside investors have incentive to offer a demutualization.

Unallocated reserves are a form of permanent capital that may strengthen the financial balance sheet of cooperatives. The allocation of earnings as member equity, based on their patronage, lacks permanence in the sense that it is revolved back to members over varying periods of time and cannot be converted to marketable securities. …

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