credit union and cooperative patronage refunds · pdf filecredit union and cooperative...

78
Credit Union and Cooperative Patronage Refunds Joel Dahlgren, JD Black Dog Co-op Law Dan Kitzberger Kitzberger Consulting

Upload: doandung

Post on 08-Mar-2018

229 views

Category:

Documents


4 download

TRANSCRIPT

Page 1: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

Credit Union and

Cooperative Patronage Refunds

Joel Dahlgren, JDBlack Dog Co-op Law

Dan KitzbergerKitzberger Consulting

ideas grow here

PO Box 2998

Madison, WI 53701-2998

Phone (608) 231-8550

www.filene.org PUBLICATION #242 (7/11)

Page 2: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

Credit Union and

Cooperative Patronage Refunds

Joel Dahlgren, JDBlack Dog Co-op Law

Dan KitzbergerKitzberger Consulting

Page 3: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

Copyright © 2011 by Filene Research Institute. All rights reserved.Printed in U.S.A.

Page 4: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

Deeply embedded in the credit union tradition is an ongoing

search for better ways to understand and serve credit union

members. Open inquiry, the free flow of ideas, and debate are

essential parts of the true democratic process.

The Filene Research Institute is a 501(c)(3) not-for-profit

research organization dedicated to scientific and thoughtful

analysis about issues affecting the future of consumer finance.

Through independent research and innovation programs the

Institute examines issues vital to the future of credit unions.

Ideas grow through thoughtful and scientific analysis of top-

priority consumer, public policy, and credit union competitive

issues. Researchers are given considerable latitude in their

exploration and studies of these high-priority issues.

The Institute is governed by an Administrative Board made

up of the credit union industry’s top leaders. Research topics

and priorities are set by the Research Council, a select group

of credit union CEOs, and the Filene Research Fellows, a blue

ribbon panel of academic experts. Innovation programs are

developed in part by Filene i3, an assembly of credit union

executives screened for entrepreneurial competencies.

The name of the Institute honors Edward A. Filene, the “father

of the U.S. credit union movement.” Filene was an innova-

tive leader who relied on insightful research and analysis when

encouraging credit union development.

Since its founding in 1989, the Institute has worked with over

one hundred academic institutions and published hundreds of

research studies. The entire research library is available online

at www.filene.org.

Progress is the constant replacing of the best there

is with something still better!

— Edward A. Filene

iii

Filene Research Institute

Page 5: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

iv

We appreciate and are grateful for the time that Brian Prunty from

CoVantage Credit Union, Dennis Hanson from Dow Chemical

Employees’ Credit Union, and Tim Mislansky from Wright-Patt

Credit Union spent with us to discuss each of their credit union’s use

of patronage refunds. We would like to extend a special thank-you to

Callahan & Associates, in particular Nick Connors. Nick is a senior

industry analyst and provided critical data for this project.

Acknowledgments

Page 6: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

v

List of Figures vi

Executive Summary and Commentary vii

About the Authors ix

Introduction 2

Chapter 1 Patronage Refunds Are More Than Rebates

(and Co-ops Are More Than IOFs) 6

Chapter 2 Why Do Co-ops Need to Be Profitable? 17

Chapter 3 A Primer on Patronage Refunds (in the Abstract) 21

Chapter 4 Tax Differences between Cooperatives 24

Chapter 5 Use of Patronage Refunds by Other Cooperatives 32

Chapter 6 Credit Union Perspective 41

Chapter 7 Credit Union Implications 49

Appendix 60

Endnotes 65

Table of Contents

Page 7: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

vi

1. Average of 27 Credit Unions Compared with Average of

81 ACAs

2. Contrast Statutes Governing Co-ops

3. Farm Credit Associations

4. Present Value of Patronage Distributions

5. A Comparison of ACA Ratios

6. Potential Tax Effects of Patronage Refunds

List of Figures

Page 8: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

vii

By Ben Rogers,

Research DirectorLast year, I overestimated my tax liability and thrilled myself (and

my wife) with a refund. When I use my credit union credit card,

I get a monthly 1% cash-back reward. On a different card, I earn

airline miles that I use to fly my family home for Christmas. With

my REI (Recreational Equipment, Inc.) membership, I get back

10% of every dollar I spend at the end of each year. Each of these

cases demonstrates one part, and sometimes both parts, of a power-

ful two-pronged formula: an incentive based on my use of a product,

and the psychic gratification of windfall money.

Credit Union and Cooperative Patronage Refunds seeks to illuminate

patronage refunds, a unique tool credit unions and other coopera-

tives can use to manage capital levels, return value to member-

shareholders, and tie members more closely to the company. The

report examines the details of common refund practices outside

the credit union system and weighs the pros and cons of increasing

the practice among credit unions.

What Did the Researchers Find?Use rather than ownership is the traditional driver of value at a

cooperative. Using cooperative theory, the authors argue that credit

unions should consider patronage dividends as a long-term commit-

ment to users. The difference between a cooperative (like a credit

union) and an investor- owned firm shines through in how well the

cooperative rewards members who contribute to its ongoing success.

The report profiles three refund- paying credit unions as well as

several non–credit union cooperatives. Each treats its patronage

dividend differently, but some similarities emerge: By issuing regular

refunds, leaders go beyond rhetoric in considering members as the

owners of the credit union’s capital; members appreciate the periodic

windfall (one study indicates that agricultural co-op members prefer

it to superior prices or interest rates); and credit unions that regu-

larly pay refunds must be financially disciplined to support a regular

payout.

Finally, the researchers explore patronage refunds as a tax man-

agement strategy. By paying out refunds as cash and as allocated

equity held at the cooperative in the name of members, certain

cooperatives—including grocers, agricultural lenders, and rural elec-

tric companies—minimize their corporate tax burden.

Executive Summary and Commentary

Page 9: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

viii

What Are the Credit Union Implications?Credit unions, of course, pay member dividends every month in

the form of ordinary interest. Very few, however, offer a consistent

extraordinary dividend. Standard reasons for not paying one include

the following: Earnings are already tight, so it’s unaffordable; paying

an extraordinary dividend once could lead members to expect one

every year and be frustrated without one; and any potential excess is

already reflected in the credit union’s attractive savings and loan rates.

These reasons are all valid, but they are the same reasons any publicly

traded firm with excess capital might use. Nevertheless, the boards of

those publicly traded companies constantly remind themselves that

their shareholders expect real value and can easily take their money

elsewhere. Nothing—not good feelings, not good intentions—says

“please stay” like cash.

Credit unions considering a patronage refund should take steps to:

• Encourage an honest governance and management discussion

over not just the marketing value of a patronage dividend but the

cooperative imperative to return unused capital to members.

• Balance the benefits of any refund between saving members and

borrowing members, both of whom are essential to the credit

union’s health.

• Help set realistic member expectations for future payments and

teach members how to earn a bigger refund in the future.

Back to the REI example above. Like credit unions, this outdoor

supplier cooperative operates a modern company selling familiar

products in an intensely competitive retail industry. Surely its leader-

ship knows that it could plow its yearly member dividend funds back

into the business by lowering prices 10% across the board. Doing so

might even goose short-term sales. But REI has made a calculated,

long-term choice to compete daily with other retailers on price. Then

the company writes its member- users a yearly reminder of its tan-

gible cooperative value—in the form of a patronage check.

Page 10: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

ix

Joel Dahlgren

Joel Dahlgren has 30 years of experience with cooperatives. He

founded Black Dog Co-op Law (a Minnesota 308B co-op) solo law

practice in 2010 and has been providing legal representation and

business advice to consumer and agricultural cooperatives across the

United States since 1992. Dahlgren is also employed as general coun-

sel and chief risk officer at a Minnesota farm supply and grain coop-

erative since 2010. Prior to law school, Dahlgren was a loan officer at

the St. Paul Bank for Cooperatives (a predecessor to CoBank, ACA),

a federated cooperative owned by its member agricultural co-ops.

Later he was a business service manager on the Member Services staff

of the Cenex/Land O’ Lakes joint venture, providing business and

strategic planning and human resource advice and products for affili-

ated member co-ops of Cenex (now CHS Inc.) and Land O’ Lakes

(both are federated agricultural co-ops). Dahlgren holds a bachelor of

science degree from the University of Minnesota and a JD from the

University of Wisconsin–Madison.

Dan Kitzberger

Dan Kitzberger has several years of experience working for nonprofit

organizations. He worked for the Minnesota Council of Nonprofits,

where he provided technical assistance to community and human

service organizations to increase their capacity for civic engagement.

He was a community organizer for Neighborhood Housing Services

in Duluth, where he worked on a variety of projects in low- income

neighborhoods. Since 2009, Kitzberger has worked in the Minnesota

House of Representatives, where he began as an intern, worked as a

legislative assistant during the 2010 legislative session, and currently

works as a constituent services specialist and writer. He attended the

University of Minnesota Duluth and received his bachelor’s in com-

munication in 2006, followed by his master of advocacy and political

leadership (MAPL), with concentrations in nonprofit advocacy and

public sector leadership, in 2009.

Dan is an independent contractor who has an interest in socially

conscious and sustainable business organizations, including coopera-

tives. Dan was engaged by Black Dog Co-op Law to assist with the

preparation and research for this report.

About the Authors

Page 11: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

Introduction

There are many ways in which to improve the condition of mankind but the noblest of them all is through co-operation.

—George J. Holyoake

Page 12: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

3

Credit Union and Cooperative Patronage Refunds discusses the use of

patronage refunds by credit unions. A patronage refund is an amount

returned to a cooperative’s members at the end of an accounting

period, usually a year. It is paid to members on the basis of how

much they used the cooperative. More use means a bigger refund;

less use means a smaller one.

Twenty-seven credit unions identified in a recent Callahan &

Associates patronage report each generated an annual net income

of $3.5 million (M)1 on average during the years 2008, 2009, and

2010. These 27 credit unions paid, on average, $822,500 (23%) of

that income to members as a cash patronage refund. At the upper

end, one credit union distributed a cash patronage refund equal to

100% of its earnings. Its actual patronage refund was in excess of

its net income, but by definition a patronage refund cannot exceed

earnings.

We report that these 27 credit unions generated average annual

earnings of $3.5M for the years 2008, 2009, and 2010, whereas

the financial performance reports from the National Credit Union

Administration (NCUA) website report that these same credit unions

averaged $2.7M of earnings for that period. The difference between

the two is the cash patronage refund of $822,500. Credit unions

deduct patronage refunds to calculate net income, but the rest of the

co-op world in the United States includes cash patronage refunds in

cooperatives’ reported GAAP (generally accepted accounting princi-

ples) earnings. We’ve made this adjustment to allow apples-to- apples

comparisons with other cooperatives.

As rebates, patronage refunds may be a good or even a “best” busi-

ness practice, but any business—even a bank—can pay a rebate2 to

its customers. Hence—and this is important—a philosophical differ-

ence exists between cooperatives and investor- owned firms (IOFs),

between credit unions and banks. Co-ops benefit users who capitalize

the co-op in proportion to use. IOFs benefit investors who capital-

ize the IOF in proportion to ownership and wealth. So patronage

refunds are more than a rebate. Patronage refunds encapsulate what

Page 13: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

4

to us is a philosophical gulf between IOFs and co-ops. We assume

that if you are affiliated with a credit union, this philosophical

distinction drives your business model forward because credit unions

are cooperatives too.

To be clear, this report is not about the virtues of a collective society

as opposed to a society organized around capitalism. Cooperatives—

including credit unions—are the ultimate self-help business organi-

zation,3 and hence they are part of a capitalist system that allocates

money and wealth across the economy through profits and losses.

But cooperatives reward users rather than owners through patron-

age refunds distributed to the cooperative’s members on the basis of

patronage (i.e., use). IOFs do not.

Failing to pay a patronage refund is not an existential threat to a

cooperative. As few as 27 credit unions out of more than 7,000 in

the Callahan report regularly paid an annual patronage refund in

each of the last five years. Later in this report we discuss the unre-

solved debate about whether to pay patronage refunds, a debate that

is occurring within the board of directors and management of a farm

credit association that is a member of the cooperatively owned Farm

Credit System. Paying patronage refunds is far more accepted and

perhaps even expected for a farm credit association. Thus it will be

obvious that the question of whether to pay a patronage refund is not

an issue limited to credit unions.

We note, however, that Callahan’s study of the 27 credit unions that

paid patronage refunds documented that business growth, member

involvement, and return on assets were all stronger for these 27 than

for the other credit unions. It is very difficult to argue against the

positive impact of paying a patronage refund. Our own experience

with cooperatives paying a patronage refund is positive and entirely

consistent with this conclusion.

The balance of this report will discuss patronage refunds from several

viewpoints. First, we drill down further to explore how patronage

refunds are more than just a rebate, how they relate to capitalization,

and how they are influenced by the principles of subordination of

capital, service at cost, and co-op agency theory. These principles

sum up the philosophical gulf that separates cooperatives and IOFs,

and they drive the distribution of earnings to members and patrons

rather than to investors.

Second, we address the question of why cooperatives—and credit

unions—need to be financially successful and generate earnings.

Third, we discuss patronage refunds in the abstract, without the

application of tax, and then we discuss four tax regimes as applied to

alternative types of open membership cooperatives.

Page 14: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

5

Fourth, we examine how members of the Farm Credit System use

patronage refunds.

Fifth, we examine the payment of patronage refunds by three credit

unions.

Finally, we conclude by addressing potential future tax implications

of patronage refunds for credit unions.

As you read this report, it may help to remind yourself from time to

time that we weave the disciplines of finance, accounting, and tax

together with co-op theory. One of the consistent themes and ten-

sion is whether to allocate earnings other than what the co-op pays as

a cash patronage refund.

Page 15: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

CHAPTER 1Patronage Refunds

Are More Than Rebates (and Co-ops Are More Than IOFs)

Cooperative principles govern the use and allo-cation of capital. Members who own capital generally have that ownership acknowledged and recorded. Cooperatives have to balance the use, distribution, and accumulation of capital carefully to serve current and future members.

Page 16: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

7

Patronage refunds are integral to the larger subject of capitalization.

The discussion in this chapter will be foreign to credit unions and

their members because credit unions’ earnings are not allocated to

individual members. In the abstract, patronage earnings that are not

distributed to members as cash are supposed to be distributed as

allocated equity, which forms the primary source of equity capital for

co-ops.

The theory is that a co-op’s earnings belong to members in propor-

tion to their use of the co-op. In other words, the earnings do not

belong to the co-op. It follows that if earnings belong to members,

then the earnings should be distributed either as a cash patronage

refund on the basis of use or as equity that is allocated on the co-op’s

books and identified with each member in proportion to the mem-

ber’s use of the co-op.

For co-ops generally, then, a corollary to the benefits of paying

patronage refunds to users is that users are expected to provide equity

capital in proportion to their use of the cooperative. In the United

States, most cooperatives obtain equity capital from members by

retaining a portion of patronage refunds as allocated equity. A return

is not usually paid for the use of the capital retained from patronage

earnings, because capitalizing the cooperative is considered an obliga-

tion of membership.4

If capitalization is an obligation of membership, then one specific

aim is to align capitalization of the co-op with use so that current

members who use the co-op also capitalize the co-op. Obviously, to

redeem allocated equity as members retire or die and no longer use

the co-op, the co-op must know how much equity each member has

provided. The co-op maintains patronage and equity records that

show how much patronage earnings are allocated to and retained

from each member.

The retained earnings of credit unions are not allocated to members.

These earnings form undivided equity (“unallocated” in general

co-op–speak). In other words, we cannot relate members’ business

Page 17: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

8

activities with their credit union to the equity retained from each

member’s activities or the income generated from each member’s

activities. Pure co-op theory5 takes issue with this approach, because

if all earnings belong to members, then all earnings should be

distributed either with cash or with allocated equity. Hence, all or

substantially all of a co-op’s patronage earnings should be distributed

to members on a patronage basis. There should be an observable link

between each member’s use and the member’s capitalization of the

co-op.

This credit union deviation from co-op allocated equity principles

of retaining earnings as undivided equity capital is more dramatic in

a theoretic sense than it is in a practical sense. The following com-

parisons of credit unions with agricultural credit associations (ACAs)

illustrate that even though credit unions do not distribute their

earnings with allocated equity or undertake to eventually redeem that

equity, credit unions are quite similar in this respect (and others) to

ACAs, which have been functioning as co-op financial institutions

since as early as 1916.

The Farm Credit System includes 81 ACAs across the country that

provide short- and long-term financing to agricultural producers

(farmers). ACAs operate on a cooperative basis, as does the entire

Farm Credit System. Whereas in a credit union the members hold

the voting control and are eligible to serve on the board of directors,

in an ACA, the farmers are the voting members and are elected to

serve on the board of directors.

The 27 credit unions in the Callahan study distributed on aver-

age 23% of their earnings as a cash patronage refund, whereas the

81 ACAs paid 21.5% of their earnings as a cash patronage refund.

The ACAs retained $4.0M per year in allocated equity to capitalize

the ACA, amounting to 18% of their earnings (and redeemed $2.4M

per year on average during those years), while the credit unions did

not distribute any patronage refunds with allocated equity.

ACAs and credit unions each retain substantial portions of their

earnings (60% and 75%, respectively) as permanent unallocated

equity. Even for ACAs, this approach is not consistent with the co-op

Figure 1: Average of 27 Credit Unions Compared with Average of 81 ACAs

Average of 2008, 2009, and 2010 Credit unions % Total ACAs % Total

Cash patronage refund 822,800 23.34 4,836,948 21.56

Patronage refund in allocated equity — 0.00 4,028,708 17.96

Undivided/Unallocated earnings 2,703,149 76.66 13,192,951 58.81

Income tax on co-op’s earnings — 0.00 376,051 1.68

Total earnings (average per co-op) $3,525,949 100.00 $22,434,658 100.00

Page 18: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

9

principle that earnings belong to members rather than the co-op. We

believe, however, this information reveals that ACAs are balancing

that co-op ideal (that earnings belong to members and should be dis-

tributed with allocated equity if they are not distributed with cash)

against the financial reality that these cooperatives simply cannot

generate enough earnings and

cash flow to redeem allocated

equity while maintaining a

viable business organization.

Moreover, it does not follow

that just because patronage

earnings are not allocated as

patronage refunds to members with allocated equity, the result-

ing undivided or unallocated equity is not owned by the members.

In other words, the co-op’s earnings do not have to be allocated to

members to demonstrate that the earnings belong to the members.

The three credit unions that we discuss later in the report seem to

have adopted that philosophy even though their earnings are not

apportioned6 or allocated to members in proportion to use. An even

stronger position would be to educate and communicate with mem-

bers about why the co-op does not allocate “their” earnings and how

the co-op uses “their” unallocated equity.

At the dissolution of a co-op, co-op theory calls for the remaining

proceeds to be distributed on the basis of historical patronage to

present and former members, theoretically back to the beginning of

the cooperative. At the dissolution of a credit union, another devia-

tion from co-op principles occurs when the remaining proceeds

are distributed on the basis of share ownership to the last members

standing.

It is worthwhile to drill down further to explain how this dissolution

issue relates to patronage refunds and why this deviation from co-op

principles is more striking for credit unions than the issue of whether

all or substantially all of the credit unions’ earnings are distributed

with cash or allocated equity.

Co-op Dissolutions: Service at Cost, Subordination of Capital, and Co-op Agency TheoryThe principles of service at cost, subordination of capital, and the

co-op agency theory direct the co-op’s financial operations from its

incorporation to its dissolution. These principles are ignored when

any dissolving co-op distributes the remaining proceeds to the last

At the dissolution of a co-op, co-op theory calls for the remain-

ing proceeds to be distributed on the basis of historical patron-

age to present and former members, theoretically back to the

beginning of the cooperative.

Page 19: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

10

members standing on the basis of ownership rather than to present

and former members on the basis of historical patronage.

The co-op agency theory holds that the co-op is an agent of its

members and, therefore, that the co-op’s earnings really belong—

have always belonged—to members and have never belonged to the

co-op. This theory dovetails with the principle of service at cost,

which holds that patronage earnings are rebates, discounts, or price

enhancements when they are allocated and distributed as patronage

refunds in cash or allocated equity to members on a patronage basis.7

The co-op agency theory and service-at- cost principles support the

favorable income tax treatment of co-ops. If the earnings were never

the co-op’s in the first place, there is no justification for taxing the

earnings at the co-op level. If the earnings are taxed, they should be

taxed at the member level.

Service at cost requires that earnings be distributed on a patronage

basis as patronage refunds to qualify as rebates, discounts, or price

enhancements that reduce “costs” to the members. If the earnings

are distributed on the basis of share ownership, that distribution is

a return on equity rather than a zeroing out of the co-op’s earnings

to the logical conclusion that the costs of products or services are

reduced to breakeven. The service-at- cost principle is not followed if

the co-op’s earnings are distributed on the basis of share ownership.

And what applies to the co-op’s earnings while it is a going concern

also applies to its equity at its dissolution. So in a dissolution, when

credit unions distribute the remaining proceeds on the basis of share

ownership to the last members standing rather than on the basis of

historical patronage to present and former members, they are deviat-

ing from the co-op agency theory and service-at- cost principles.

Distribution of the remaining proceeds at dissolution should be on

the basis of historical patronage going back to the beginning of the

co-op to adhere to these principles consistently. If all the earnings

and remaining proceeds are distributed on the basis of historical

patronage, we can logically conclude that the co-op always operated

at cost from its beginning to its end.

The co-op principle of subordination of capital is also not followed

when credit unions distribute the remaining proceeds on the basis of

share ownership to the last members standing. This principle limits

the financial return paid on equity to investors to a “reasonable”

return for its use. The last members standing at a credit union’s dis-

solution benefit disproportionately to all the former members. Not

only is their proportionate equity capital returned as it would be if

the agency and service-at- cost theories were followed using historical

patronage, but the last members standing receive an extraordinarily

large return on that capital when the balance of the dissolution

Page 20: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

11

proceeds—in excess of what they were entitled to receive on the basis

of historical patronage—is also distributed to them on the basis of

share ownership.

Although we cannot reconcile this credit union inconsistency with

the co-op principles that should govern at dissolution, it does not

deter us from applying co-op patronage principles to credit unions

while they are operating and going concerns before dissolution.8

We said earlier that patronage refunds encapsulate what is a philo-

sophical gulf between cooperatives and IOFs. In the next section we

drill down even further to explore the differences between IOFs and

co-ops and to identify why cooperatives are more sustainable and

operate with a more modest capital footprint than IOFs.

Co-ops Are More Than IOFsThe principles of subordination of capital, service at cost, and co-op

agency theory draw a crucial distinction between IOFs and co-ops.

IOFs are like VELCRO: They attract, use, and hoard capital for their

own benefit. Co-ops are like GORE-TEX: As they generate surplus

working capital, they shed and return capital to members on the

basis of use, either as cash patronage refunds or eventually as redemp-

tions of allocated equity.

First, consider that an expenditure on an asset that tripled an IOF’s

value is immediately reflected in the value of an IOF’s common

stock. Each investor holding common stock is immediately wealthier.

The IOF continues to look for investment opportunities in which to

deploy capital, and to look for more capital to deploy in those invest-

ments. This process replicates itself over and over. The IOF’s self-

interest is in attracting more and more capital to feed this process.

Now contrast the impact of that same expenditure on a cooperative

and its members. The allocated equity of members does not appreci-

ate in value. This equity is still

redeemable at no more than

its face value to members. No

member is wealthier as a result

of the expenditure. Neither

the co-op nor its members are

driven or motivated to invest

more and more capital into the co-op. Members might hope that

an expenditure tripling the co-op’s market value would improve the

co-op’s earnings, and perhaps their allocated equity can be redeemed

faster than it would have been, but who knows.

If the expenditure spurs sales growth that increases working capital

requirements, if the asset was financed with term debt requiring

A natural tension occurs among members in a co-op, where

acquiring assets and growing the business necessarily mean

that cash for redemptions of allocated equity is reduced or

eliminated.

Page 21: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

12

repayment, and/or if the asset is one of those expenditures that

begets more expenditures on other assets to supplement the initial

expenditure, there is no assurance that redemptions can be sped up.

The opposite—that redemptions are slowed down—may, in fact,

be true. But, as between an IOF and a co-op, the co-op’s incentives

clearly lean in favor of distributing as much cash as soon as possible

to redeem equity, while the IOF’s incentives clearly lean in favor of

holding on to extra cash and reinvesting it in the IOF.

In fact, an expenditure that triples the co-op’s market value does

not hold the same fascination for a co-op that it does for an IOF. A

natural tension occurs among

members in a co-op, where

acquiring assets and growing

the business necessarily mean

that cash for rede mptions of

allocated equity is reduced or

eliminated. This member inter-

play pushes management and

the board of directors to carefully examine asset expenditures because

the leadership knows it will be criticized by members who prefer cash

redemptions of their allocated equity over asset expenditures. The

incentives that an IOF operates under to continue investing in assets

to grow the IOF’s value do not exist in a co-op.

Because a co-op’s strongest and most respected members are typically

older, more vocal, and experienced and hold more allocated equity in

the cooperative, their views often carry more weight9 than the views

of younger members, who care less about redemption of equity and

more about the state of the co-op’s competitiveness, its asset bases,

and the extent to which it is providing for the needs of members. So

the counterweight to members who want redemptions of equity is

usually that the board of directors has a fiduciary obligation to look

out for the co-op’s interest in surviving and flourishing for future

generations.

The only time that a co-op member (or former member) benefits

from the market value of the cooperative is at its dissolution. The

members of the cooperative who purchased an asset tripling the

co-op’s market value would enjoy that added value only if the coop-

erative is dissolved, but former members (even members who are

deceased and no longer own allocated equity) would also enjoy that

accretion in value because they are all entitled to a portion of the dis-

solution distribution after all allocated equity is first redeemed. The

remaining proceeds are distributed to members and former members

on the basis of historical patronage, theoretically to former members

The counterweight to members who want redemptions of

equity is usually that the board of directors has a fiduciary

obligation to look out for the co-op’s interest in surviving and

flourishing for future generations.

Page 22: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

13

going all the way back to the beginning of the cooperative. Again,

this distribution leads to the logical conclusion that the service-at-

cost principle was followed through to the very end of the co-op’s

existence.

Second, consider who owns the earnings generated by an IOF and

a co-op. An IOF’s earnings belong first to the IOF. Most of the

profits will be reinvested in the IOF to enhance the value of the firm.

Some IOFs pay dividends10 on common stock or repurchase shares

if the IOF has excess working capital, but these are not common

occurrences.

Even when dividends or stock repurchases occur, one can argue the

benefits of an IOF as much as any common stockholder because

repurchased shares or dividends paid on stock usually enhance the

long-term valuation of the IOF’s common stock and hence its attrac-

tiveness to investors. Most, if not all, of an IOF’s decisions are driven

by its interest in maximizing its own book value and the value of its

equity.

In contrast, the co-op’s patronage earnings each year belong to mem-

bers in proportion to their use of the cooperative in that year rather

than to anyone else. This year’s earnings may belong to a different

cast of members, in different proportions, than next year’s earnings if

the makeup of the membership changes or each member’s use of the

co-op changes from year to year.

The co-op’s entire mission is not to make itself more valuable but

to integrate and serve its members’ lives and businesses. Because

the co-op is considered an agent of the members, it is an extension

of their lives and of their businesses. And because it operates under

the service-at- cost principle, its returns are added to the members’

returns to judge whether the

whole composite return—of

the co-op plus the member—is

successful.

This is why it makes sense when

we read that the Credit Union

National Association (CUNA)

asserted that in 2009 the Wright-Patt Credit union “provided $1,268

in savings throughout the year for households with ‘high use’ of the

credit union.” CUNA said this credit union provided total benefits

of $26.0M to its members in 2009.11 As a cooperative, Wright-Patt is

viewed as an adjunct to its members rather than as an IOF that is an

island unto itself. This is a key distinction between co-ops and IOFs.

If the co-op’s earnings are not distributed to the member in

cash, they are distributed with allocated equity, each dollar

of equity being identified with a member on the basis of the

member’s proportional use.

Page 23: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

14

If the co-op’s earnings are not distributed to the member in cash,

they are distributed with allocated equity, each dollar of equity being

identified with a member on the basis of the member’s proportional

use. Each dollar of allocated equity that is eventually redeemed is

redeemed at no more than its face value. But in the meantime, until

the allocated equity is redeemed, it does not appreciate in value. In

fact, the longer the co-op uses and holds the equity, the more the

equity is depreciated from the effect of the time value of money.

But as soon as the co-op has surplus working capital, allocated equity

is redeemed and returned to members. The co-op is motivated to

distribute surplus working capital rather than reinvest it in the co-op

because aggrandizing itself over its members benefits no one and is

counter to the philosophy under which the co-op is formed. The

board of directors is motivated to distribute surplus working capital

through equity redemptions because each director—like every other

member—eventually wants that surplus capital if and when the

co-op can afford to return it.

This same dynamic does not exist in an IOF, because the principles

of subordination of capital, service at cost, and co-op agency theory

are not in play. Obviously some investors desire dividends, while

others desire retention of earnings and appreciation in the value of

their holdings. But the IOF decides what to do with its earnings by

reference to their impact on the IOF’s value, not, as a co-op does,

by reference to the extent that the co-op integrates and adds value to

members’ lives or businesses. An IOF is a supplier to customers, not

an agent of its members or an extension of their lives or businesses.

Finally, consider that an IOF’s universe of investors is narrow, lim-

ited by the number of shares of common stock the IOF has issued.

Hence, the number of claims on earnings is finite. A finite number

of shares means that as the value of the business increases, the same

number of shares is now more valuable than before the increase in

the value of the business.

By comparison, an open membership co-op’s universe of members

is dynamic and expanding all the time. The number of claims on

earnings in an open membership cooperative is infinite, limited

only by the number of co-op members and their proportion of the

business of all members combined. Because at the co-op’s dissolu-

tion the remaining proceeds are distributed on the basis of historical

patronage to present and former members, the longer that an open

membership is in business before dissolution, the more claims that

are created from present and former members who are entitled to a

portion of the remaining proceeds at the co-op’s dissolution.

Page 24: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

15

The principles of subordination of capital, service at cost, and the

co-op agency theory work together to make co-ops more sustainable,

more just, and more beneficial to society than IOFs. A co-op does

not, in theory, hoard or hog capital, nor does it have an insatiable

appetite for capital like an IOF.

Balancing Co-op Principles against the Financial Realities of Equity RedemptionsThe tension between allocating earnings and building up expecta-

tions for redemptions of equity must be acknowledged and managed

by the co-op’s board of directors. Is retaining 60%–75% of earnings

as undivided or unallocated equity really a significant deviation from

co-op principles?

One way to manage this tension is to balance the co-op principles of

subordination of capital, service at cost, and the co-op agency theory

with the finance principle that no business organization—co-ops

included—should voluntarily create obligations that detract from

the organization’s mission or weaken it financially. In other words, a

co-op is like any business organization in that it needs strong capital

structures.

Finance principles cause or should cause the co-op’s leadership to

make informed judgments about how much of the co-op’s earn-

ings are distributed with allocated equity. Each dollar of earnings

distributed with allocated equity might create one dollar more of

expectation that this equity will eventually be redeemed. The co-op’s

leadership should want to soften or even eliminate the tension

between making necessary expenditures and redeeming equity.

Circling back to the beginning of this chapter, where we said that

both ACAs and credit unions deviate from the co-op principle that

earnings belong to members when they retain 60%–75% of earnings

as undivided or unallocated equity, the most logical response to that

criticism is that credit unions and ACAs are simply balancing co-op

principles with finance principles. ACAs and credit unions are being

logical when they distribute what they can as a cash patronage refund

each year, and when they avoid allocating equity that cannot be

redeemed in a reasonable time.

ACAs and credit unions—like banks—are some of the most lever-

aged business organizations across the entire economy. These co-ops

are likely to be the least able to redeem allocated equity if they follow

only more traditional co-op principles and do not consider finance

Page 25: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

16

principles. When we discuss other co-ops’ use of patronage refunds,

we will note the pressure that AgGeorgia puts on itself by allocating

much of its income as patronage refunds that members expect will

eventually be redeemed.

If the cooperative is not profitable or has no earnings, we never get

to the issues of subordination of capital, service at cost, or the co-op

agency theory. We need earnings before we can apply these prin-

ciples. So as important as these principles are, the more important

immediate point is to address why co-ops must be profitable.

Page 26: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

Is comparing banks and credit unions a fruitful endeavor? Yes, because they compete with each other, and both need to be profitable to remain relevant, to return value to shareholders, and to grow. But they should go about it in different ways.

CHAPTER 2Why Do Co-ops

Need to Be Profitable?

Page 27: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

18

A recent post to the Filene Research Institute’s website posed the

question: Why do credit unions compare themselves to banks or

even worry about return on assets? One could argue that cooperatives

should not compare themselves with IOFs or that cooperatives could

operate economically on a shoestring, out of a shoe box, inside a steel

shed—a most utilitarian approach. It is also argued that cooperatives

do not have to worry about financial comparisons so long as money

flowing into the cooperative is just one penny more than money

flowing out.

For cooperatives—including credit unions—there are always at least

three criticisms of this philosophical position. First, it is impracti-

cal to operate or manage any business organization of any size that

close to the edge. Second, most

members expect that their

shares (and entitlement to undi-

vided earnings; more on that

later) will be safeguarded by the

board of directors and manage-

ment. Members understandably

expect that the cushion will be

more than a penny. The board

must pay attention to earnings

because members have legal recourse to sue the board if they suffer

losses from a breach of the board’s fiduciary obligations.

Third, some cooperatives are regulated by government agencies

(NCUA for credit unions; FCA [Farm Credit Administration] for

farm credit associations) and required to maintain minimum stan-

dards of financial strength. In addition, some cooperatives join

together to raise capital from private markets. These cooperatives

must maintain strong financial standards so that the notes and

bonds sold by their agents are attractive to investors in those mar-

kets. For example, the National Rural Utilities Cooperative Finance

Cooperatives must generate enough earnings to compete with

IOFs by maintaining and growing the cooperative’s base of

capital assets and its business. So even if the cooperative does

not raise capital in private capital markets, it is likely to have its

own business objectives that must be financed with the coop-

erative’s earnings and equity.

Page 28: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

19

Corporation (CFC) and the Federal Farm Bank Funding Corpora-

tion (BFC) issue tens and hundreds of billions of dollars in securities

annually to provide capital for rural electric cooperatives and farm

credit associations, respectively.

Those securities are secured by loans to rural electric cooperatives

and farm credit associations, respectively. The latter, in turn, makes

loans to farmers and agricultural cooperatives. If those rural electric

cooperatives and farm credit associations do not attain and maintain

standards of financial strength, their agents will pay more in private

capital markets to raise capital,

or worse, their agents won’t be

able to raise any capital.

In addition, cooperatives must

generate enough earnings to

compete with IOFs by main-

taining and growing their base

of capital assets and their business. So even if the cooperative does

not raise capital in private capital markets, it is likely to have its

own business objectives12 that must be financed with the coopera-

tive’s earnings and equity. Boards of directors and management are

accountable to use the co-op’s equity efficiently and effectively.

Yes, a cooperative can operate as close to breakeven as possible, with-

out aiming to make any earnings or profits. But unless these coopera-

tives operate very conservatively with little or no risk, they are more

prone to financial failure because it is impossible to make decisions

that well—to be right that often—and hence, impossible to avoid

the cumulative weakness created from wrong decisions.13

So while cooperatives cannot escape the imperative that confronts

any business organization to generate profits, cooperatives are differ-

ent and, in principle, more sustainable than IOFs because co-ops do

not hoard capital.

The incentives that drive IOFs and cooperat ives oppose each other.

For either business organization, management and the board of

directors are accountable to use equity capital from members or

investors efficiently and to maximize the returns paid to members

or investors according to their expectations, respectively. The IOF’s

incentives drive it to retain and reinvest capital for the benefit of the

IOF. The cooperative’s incentives drive it to pay cash to members and

patrons and to retain only what is needed to finance the cooperative’s

growth objectives, which are all aimed to benefit members rather

than the cooperative.

While cooperatives cannot escape the imperative that confronts

any business organization to generate profits, cooperatives are

different and, in principle, more sustainable than IOFs because

co-ops do not hoard capital.

Page 29: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

20

Our response to the blog post question about co-op profitability

would be the following:

Thank you for your comments. Credit unions need profits to sustain

themselves, so if a comparison with a bank is helpful for identify-

ing areas of inefficiency, that comparison is not objectionable. We

know you will appreciate hearing that credit unions are not capital

hogs, and that their genetic makeup—being from the family of

cooperatives—is to return unneeded earnings and capital to members

in the form of patronage refunds. Cash is returned to members as

soon as possible because there is no incentive for the co-op to hoard the

cash for itself, or for members to leave their equity in the co-op hoping

that it will appreciate in value. The same thing cannot be asserted

about the expected behavior of an IOF bank. Consequently, the more

successful a cooperative is, the more capital that it returns to its users

on the basis of patronage.

In this chapter we addressed the issue of why cooperatives need earn-

ings and how the cooperative’s business objectives are geared toward

the financial and economic benefit of members rather than the

cooperative. In Chapter 3 we will address the mechanics of patronage

refunds in the abstract. In Chapter 4, we will apply the requirements

of four alternative co-op tax regimes to the payment of patronage

refunds.

Page 30: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

Credit unions are open membership coopera-tives that can grow membership and corre-sponding capital in relation to the number of potential members available. Capital distribu-tion decisions stem from careful deliberation by the board.

CHAPTER 3A Primer on Patronage Refunds

(in the Abstract)

Page 31: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

22

The subject of this chapter is a theoretical open membership coop-

erative. The focus of this report, in fact, is directed at open member-

ship cooperatives. Open membership means there are no limitations

on the number of members who can join the cooperative or do

business with it. The allocated equity that members earn from doing

business with open membership cooperatives does not appreciate in

value. When allocated equity is redeemed, the co-op pays no more

than the face value of the allocated equity.

In contrast, the common stock in a closed membership cooperative

can appreciate in value if the cooperative is financially successful.

Closed membership cooperatives limit membership because the

co-op’s physical plant size is defined. An ethanol cooperative, for

example, produces a finite number of gallons of ethanol, and it needs

a finite number of bushels of corn to produce that ethanol. The

cooperative does not sell more stock or approve new members after

its membership is of sufficient size to produce and deliver enough

corn to supply the cooperative’s ethanol production capabilities.

We have already said that a cooperative’s earnings belong to members

rather than the co-op. Patronage refunds are distributed from the

co-op’s GAAP patronage- sourced income. Assuming that all earn-

ings are, in fact, generated from transactions with or for members,

then all of the co-op’s income is theoretically available to allocate to

members on a patronage basis.

Capitalization of the cooperative naturally occurs proportionate to

each member’s use of the cooperative. Earnings are distributed in

cash to the extent possible but are retained by the cooperative as allo-

cated equity to finance its need for equity capital. The cooperative’s

need for equity turns on its growth objectives, its plans to borrow

debt capital, and its desire to redeem equities allocated from previous

years’ earnings. The cooperative aims to generate enough earnings

and surplus cash flow to align ownership with use by redeeming the

allocated equity of former, retired, or deceased members.

Page 32: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

23

Equity redemption policies are adopted by the board of directors

minimally to maintain an alignment between each member’s equity

capitalization and his or her use of the cooperative. The board of

directors is not required to redeem any allocated equity. Case law

generally supports the board’s discretion to redeem allocated equity,

but it also appears that courts are inclined to order redemptions if

they conclude that the co-op had surplus working capital that it did

not need. Redemption policies include the redemption of allocated

equities when a member or former member dies. For more success-

ful cooperatives, the redemption of allocated equities occurs when

a member reaches a certain age (e.g., age 70) or by year of alloca-

tion (e.g., in 2011, the co-op redeems equities that were allocated in

1990).

Some bo ards of directors adopt base capital plans that tie the amount

of allocated equity to the member’s use of the cooperative. When

the member’s use increases, the member’s base capital requirement

also increases, and more of that member’s patronage distribution is

retained, or redemptions to that member are slowed to build up the

member’s base capital. When the member’s use of the cooperative

decreases and thus less base capital is required, then retained earn-

ings are reduced or redemptions of allocated equity are increased to

reduce the member’s level of base capital.

So far we have discussed patronage refunds in the abstract. Next we

will drill down into the tax mechanics of patronage refunds.

Some boards of directors adopt base capital plans that tie the amount of allocated equity to the

member’s use of the cooperative. When the member’s use increases, the member’s base capital

requirement also increases, and more of that member’s patronage distribution is retained, or

redemptions to that member are slowed to build up the member’s base capital.

Page 33: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

CHAPTER 4Tax Differences between

Cooperatives

Governed by different statutes, credit unions and other cooperatives operate under a mix of tax obligations. The distribution and account-ing of patronage dividends is a key compo-nent affecting the corporate tax liability of cooperatives.

Page 34: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

25

In this chapter, we will review four tax regimes that are applied to

cooperatives. The first is Subchapter T, which applies to the wid-

est variety of cooperatives. The second is 26 U.S.C. 501(c)(12),

which applies to rural electric cooperatives. The third is 26 U.S.C.

501(c)(1) as applied to Federal Land Bank Associations under

12 U.S.C. 2098.14 The fourth is 26 U.S.C. 501(c)(14), which applies

to state- chartered credit unions.

The key points of distinction among these tax regimes include

(1) whether the co-op is treated as tax exempt or nonexempt,

(2) whether earnings (and which ones—patronage earnings only or

nonpatronage earnings too) are apportioned to individual patrons,

(3) when the co-op pays cash to members, (4) when members pay

income tax on income allocated to them from their co-op, and

(5) whether the co-op is required to give notice of patronage alloca-

tions to members.

On a continuum moving from left to right in Figure 2, Sub-T

co-ops are most regulated, and state- chartered credit unions are least

regulated by their tax statutes, in how closely they must follow co-op

principles. The tax exemption under which state- chartered credit

unions operate does not require credit unions to allocate or appor-

tion their earnings to individual members. Credit unions’ equity is

undivided. Members have no idea how much of their transactional

activity with the credit union contributes to the credit unions’ equity.

Credit union members do not expect any equity to be redeemed,

ever.

The relevance of including a discussion of rural electric cooperatives

under 501(c)(12) may not become apparent until much later in the

The tax exemption under which state-chartered credit unions operate does not require credit

unions to allocate or apportion their earnings to individual members. Credit unions’ equity is

undivided. Members have no idea how much of their own transactional activity with the credit

union contributes to the credit unions’ equity.

Page 35: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

26

report, when we discuss tax implications for credit unions. Rural

electric co-ops will be particularly relevant then because their tax

exemption has been criticized even more harshly than that of credit

unions. Moreover, in cases where members are litigating the redemp-

tion of their allocated equity, rural electric cooperatives are of interest

Figure 2: Contrast Statutes Governing Co-ops

Sub-T co-op Rural electric co-op

Federal Land Bank

(and federal

credit unions)

State-chartered

credit union

Statute 26 U.S.C. 1382 26 U.S.C. 501(c)(12) 501(c)(1) 26 U.S.C. 501(c)(14)

Exempt or nonexempt Nonexempt Exempt Exempt Exempt

Are patronage earnings

allocated or apportioned

to individual members?

Yes. Must be allocated

to qualify for tax

deduction allowed for

patronage-sourced

earnings. “Allocation”

is apportionment plus

“notice.”

Not required. Minimum

requirement is to maintain

records showing each

member’s interest in

co-op’s earnings and equity.

Some notify members of

apportionment of each

member’s pro-rata portion

of patronage earnings.

Not required. If the

earnings are not

apportioned, the earnings

are accounted for in an

unallocated surplus.

No. Earnings are

unallocated. Most earnings

are accounted for as

“undivided earnings.”

Notification of allocation

to member required?

Yes. Co-op is required

to give specific written

notice of member’s pro-

rata allocated patronage

earnings.

No. But recommended

practice is to specifically

notify members of pro-rata

portion of apportioned

earnings. Notification is

seen as opportunity to

communicate about co-op

values.

No. Practice is mixed.

Some do notify but others

do not notify. Notification

seen as an opportunity

to communicate with

members about co-op

values.

No. But notice of cash

patronage refunds is

seen as an opportunity

to communicate with

members about co-op

values.

When does member pay

income tax, if ever?

In the year that member

received qualified written

notice. Members pay tax

on entire distribution even

though no more than 20%

is paid in cash (if business

with co-op was taxable as

income or deductible as

expense).

Upon redemption of

allocated equity in cash

paid to the member by

co-op (if purchase was for

tax-deductible business

purpose).

Upon redemption of

allocated equity in cash

paid to the member by

co-op (if loans or services

were for tax-deductible

purpose).

Upon receipt of cash

refund paid to member

by credit union (if loans

or services were for tax-

deductible purpose).

Is patronage earnings

part of capitalization of

co-op?

Yes. Allocated equity is

usually major portion of all

equity capitalization. This

equity is redeemed as and

when co-op has excess

working capital.

Yes. Apportioned and

allocated equity is usually

major portion of all equity

capitalization. This equity

is redeemed as and when

co-op has excess working

capital.

Mixed. Some promote

member ownership of

allocated equity capital,

but others are silent about

that feature of co-op’s

capitalization.

No. Equity is all

unallocated. On the other

hand, we know that

members’ businesses

generated earnings that

make up the undivided

equity.

How are proceeds

distributed at dissolution

of co-op or credit union?

On basis of historical

patronage. Articles and/or

bylaws may limit length of

look back.

On basis of historical

patronage. Articles and/or

bylaws may limit length of

look back.

Land Banks—usually

historical patronage, and

governed by articles of

incorporation or bylaws.

(Credit unions—to

members on basis of share

ownership).

Governed by state law

where incorporated rather

than federal law.

When are income taxes

paid by the co-op or

credit union?

On all nonpatronage-

sourced income and

patronage income that is

not allocated.

If more than 15% of

income arises from

unrelated nonmember

business.

Never. If more than 15% of

income arises from

unrelated nonmember

business.

Page 36: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

27

because they are being challenged more than any other type of coop-

erative to live up to the ideal that cooperatives are not capital hogs.

Under any of these four tax regimes, members pay income tax on

patronage distributions only if the transaction that gave rise to the

patronage distribution is taxable

income (like the sale of corn

to a co-op where the proceeds

from the sale are taxed) or a

tax- deductible expense (like the

payment of interest on a loan

that is used to finance a busi-

ness). In either case, the patron-

age refund is also taxed. Only members of Sub-T co-ops, however,

pay income tax on the entire patronage distribution before they have

received all the cash.

Subchapter T Cooperatives (26 U.S.C. 1382 et al.)The broadest cross section of cooperatives is taxed under Subchap-

ter T and described as nonexempt (“Sub-T” or “nonexempt”). This

group includes but is not limited to natural food cooperatives, bar-

gaining cooperatives, cable television cooperatives, most agricultural

cooperatives, a minority of rural electric distribution cooperatives,

and some electric generation and transmission cooperatives.

Sub-T cooperatives are faced with the choice of either paying income

tax or paying a cash patronage refund of at least 20% of allocated

patronage earnings to members. Sub-T cooperatives are treated like

corporations in that they pay income tax on nonpatronage- sourced

income15 and on patronage earnings that are not allocated to patrons.

The cooperative is allowed a tax deduction for patronage earnings

that it allocates to patrons on the basis of their proportional patron-

age of the cooperative.

Three conditions are necessary in order to receive a patronage tax

deduction under Subchapter T for income allocated to patrons.

First, an obligation to allocate income to members must have existed

at the time of the members’ transaction with the cooperative. This

obligation is usually found in the bylaws, but it can be in an agree-

ment as well. Second, the allocation must be from profits or income

realized from transactions with the members for whom the allocation

is made. Third, the allocation must be made ratably to the members

whose patronage created the income from which the allocation is

made.16

Under any of these four tax regimes, members pay income tax

on patronage distributions only if the transaction that gave

rise to the patronage distribution is taxable income or a tax-

deductible expense.

Page 37: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

28

Patronage earnings that are allocated and distributed to patrons must

be “paid” within eight and one-half months of the cooperative’s fiscal

year end, the outside limit of the statutory time allotted to file the

cooperative tax return. At least 20% of this distribution must be paid

with cash or by qualified check.

The balance (up to 80%) of the allocation is distributed and “paid”

to patrons with qualified written notices of allocation (QNAs).17

The written notice advises the

patron that a finite amount of

patronage earnings (up to 80%

of allocated patronage earnings)

was allocated on the coopera-

tive’s books to the patron on

the basis of the patron’s propor-

tional patronage of the cooperative. Patrons are required to con-

sent18 (most often contained in the bylaws, but consent can also be

obtained by endorsement of a qualified check or separate agreement)

to report these earnings on their tax returns.

Sub-T co-ops report payments to patrons who receive a distribution

of patronage earnings in cash and QNAs of $10 or more on form

1099-PATR. Consumers do not pay income tax if the transactions

from which the patronage income arose were for personal, living,

or family expenditures that were not tax deductible. In fact, some

consumer cooperatives may apply for and receive an exemption from

filing 1099-PATRs.19 If, however, the member’s transaction with the

cooperative produces taxable income or a tax deduction, the income

reported on a 1099-PATR must be reported on the member or

patron’s tax return as well.

Sub-T cooperatives are not required to redeem allocated equities.

Case law from across the United States upholds the authority of a

board of directors to determine for itself, at its sole discretion, when

to redeem allocated equities. Some of these cases, however, also

intimate that the board cannot just retain surplus working capital

without redeeming allocated equity. This is consistent with the view

that cooperatives do not exist to hoard capital.

Sub-T cooperatives are required to maintain patronage records so

that in the event of dissolution of the cooperative, the remaining

proceeds can be distributed on the basis of historical patronage.

In Subchapter T cooperatives, a tax deduction is allowed to the

cooperative for patronage earnings that it allocates to patrons

on the basis of their proportional patronage of the cooperative.

Page 38: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

29

Rural Electric Cooperatives (26 U.S.C. 501(c)(12))Like credit unions, most rural electric cooperatives are exempt from

income tax rather than nonexempt like a Sub-T co-op. At least 85%

of rural electric cooperatives’ income must be from member business,

or the unrelated business income tax is imposed if more than 15%

of their income is derived from nonmember sources. Exempt rural

electric cooperatives—again, like credit unions—are not required

to allocate or distribute income to members in the year the income

is generated by the rural electric. Further, rural electrics can allocate

patronage and nonpatronage or unrelated income to members.

But unlike credit unions, rural electrics must at least maintain books

and records showing to whom each year’s earnings would be allo-

cated on the basis of patronage, and the interest of each member in

the cooperative’s equity. The

National Rural Electric Coop-

erative Association (NRECA)

goes further, recommending

that rural electric cooperatives

administer and account for their

earnings from members like a

Sub-T co-op.20 Hence, rural

electric cooperatives are encouraged to annually notify their members

of the amount of earnings apportioned to the member on the rural

electric cooperative’s books.

The NRECA makes this recommendation to rural electric coopera-

tives to (1) protect rural electric cooperatives’ tax exemption under

501(c)(12), because notification solidifies the record- keeping aspect

of the tax exemption, (2) position rural electric cooperatives to argue

for a Sub-T tax deduction if their 501(c)(12) exemption is denied

by the IRS, and (3) create an opportunity for communication with

members about cooperative values.21

Rural electric cooperatives are not required to file Form 1099

information returns to report payments of patronage dividends,22

although these cooperatives may use 1099-MISC to report pay-

ments of $600 or more. Unlike in the case of Sub-T cooperatives,

where patrons consent to report their allocated portion of patronage

refunds in the year the earnings were generated even though up to

80% of the patronage income is noncash, members of rural electric

cooperatives do not pay income tax until they receive a cash redemp-

tion of their allocated equity from the rural electric cooperative, and

then only if the expenditure for electricity was tax deductible.

At least six lawsuits have been initiated against rural electric

cooperatives to redeem equity to members. The lawsuits are not

evidence that rural electric cooperatives are hoarding capital,

but that is what is at issue in this litigation.

Page 39: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

30

When rural electric cooperatives are dissolved, and after payment of

all creditors and equity credits, the remaining proceeds are distrib-

uted on the basis of historical patronage in keeping with the co-op

principles of subordination of capital, service at cost, and the co-op

agency theory of earnings.

The NRECA is and has been proactive in encouraging rural electric

cooperatives to ratchet up the priority of redeeming capital credits.

In 2005, the NRECA reassembled a task force and updated its guide,

“Capital Credits Task Force Report, a Distribution Cooperative’s

Guide to Making Capital Credits Decisions.” This guide supports

the idea that rural electric cooperatives must manage their equity

capital more proactively and redeem equity credits on a systematic

basis.

Rural electric cooperatives are being challenged in lawsuits23 to live

up to the idea that they are not capital hogs. At least six lawsuits have

been initiated against rural electric cooperatives to redeem equity to

members. The lawsuits are not evidence that rural electric coopera-

tives are hoarding capital, but that is what is at issue in this litigation.

In each case, the board of directors is alleged to have failed to redeem

equity credits according to its fiduciary obligations. These boards of

directors may be ordered to redeem equity credits if the plaintiffs can

prove these rural electric cooperatives have surplus working capital

that is not required for present or future capital requirements. The

oddity is that most boards of directors of cooperatives—including

rural electric cooperatives—are driven by a strong moral compul-

sion to redeem allocated equity sooner rather than later. As we said

earlier, co-ops are not driven to hoard capital. Hence, we would not

be surprised that these rural electric cooperatives simply do not have

sufficient surplus working capital to redeem lots of allocated equity.

In addition, these plaintiffs may also need to overcome the presump-

tion that equity credits do not vest or confer ownership in members

until the board of directors affirmatively resolves to redeem the

equities. This, parenthetically, is a point of contrast with Sub-T

cooperatives, where, under the consent provisions discussed above,

ownership of the equities vests immediately in members upon alloca-

tion of patronage income to members.

Federal Land Bank Associations (501(c)(1) and 12 U.S.C. 2098)Federal Land Bank Associations (“Land Banks”) are tax exempt (as

are federal credit unions under 501(c)(1)) because they exist under

an act of Congress. Land Banks may, but are not required to, allocate

or apportion income (patronage or nonpatronage and unrelated

Page 40: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

31

income) on a patronage basis to members, maintain patronage

records, or pay a cash refund.24 Members pay income tax only upon

the receipt of cash the Land Bank pays as cash refunds or to redeem

allocated equity. Further, these co-ops are not subject to the unre-

lated business tax.

Land Banks are closely regulated by the FCA. Regulations include

direction about how farm credit associations distribute income and

manage their capital. For example, the FCA regulates the capi-

talization provisions contained in Land Banks’ bylaws (12 CFR

615.5220), the distribution of earnings (12 CFR 615.5215), and

the implementation of co-op principles by farm credit associations

(12 CFR 615.5230).

Credit Unions (26 U.S.C. 501(c)(14))State credit unions are exempt from income taxation under 501(c)

(14), while federal credit unions are exempt from income tax under

501(c)(1). Even though credit unions operate on co-op principles

of democratic control and subordination of capital, they are not

required to maintain records or apportion earnings individually from

member business.

At dissolution, federal credit unions distribute remaining funds on

the basis of share ownership at the time of the dissolution.25 The

dissolution provisions of the

statutes and law of the state in

which a 501(c)(14) credit union

is chartered will govern its dis-

solution and the distribution

of remaining proceeds after all

creditors and superior claims

are paid. We have not reviewed

the statutes of all 50 states, but it appears that based on a sampling

of statutes from Iowa, Kentucky, North Dakota, and Wisconsin,

state statutory requirements are likely to follow the federal scheme

in 12 CFR 701.6.26 Credit union dissolutions are unlike dissolutions

of other cooperatives in that the last credit union member standing

benefits disproportionately to former members who have died or

who no longer have a share account.

Credit unions report payments of dividends to holders of share

accounts for payments in excess of $10 on form 1099-INT. Credit

unions also report mortgage interest refunded with form 1098.

Credit union dissolutions are unlike dissolutions of other coop-

eratives in that the last credit union member standing benefits

disproportionately to former members who have died or who

no longer have a share account.

Page 41: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

CHAPTER 5Use of Patronage Refunds

by Other Cooperatives

In this chapter we compare and contrast Georgia- based AgGeorgia Farm Credit ACA and Wisconsin- based Badgerland Financial ACA. These associations illustrate widely dif-fering views of patronage refund philosophies. Some argue that cooperatives pay out their dividends in better everyday rates. Others argue that the co-op should reward member- owners in a more measured, visible way.

Page 42: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

33

The annual reports of AgGeorgia Farm Credit ACA and Badgerland

Financial ACA (individually an “association” or collectively “associa-

tions”) can be found on their websites.27 Each of these associations is

a member of the Farm Credit System. Selected financial information

is contained in Figure 3. Figure 4 evaluates the value of patronage

refunds received by the members of AgGeorgia and Badgerland.

The Farm Credit System is cooperatively owned and operated by

agricultural producers. System institutions provide financing for

members who are engaged in production agriculture. Federal Land

Bank Associations were the first system institutions chartered by

Congress in 1916. These associations provide their members—

agricultural producers—with long-term credit for purchases of land

and long-lived assets. By 1947, Land Banks had repaid all govern-

ment capital.

The Federal Intermediate Credit Bank and related Production Credit

Associations were chartered by Congress in 1933. These associations

Figure 3: Farm Credit Associations

Average of 2007, 2008, and 2009 AgGeorgia Badgerland

Income statement (thousands)

1. Not allocated $7,555 $32,876

2. Total patronage refund distributed with QNAs $15,189 $5,476

2a. Refund portion paid in cash $5,069 (33%) $5,476 (100%)

2b. Refund portion paid with allocated QNAs $10,120 (67%) $0

2c. Refund portion paid with allocated NQNAs $1,707.0 $0

3. Net income $24,451 $38,352

4. Gross interest income $74,346 $118,634

Balance sheet (000’s omitted)

5. Common stock $4.0 $7.0

6. Allocated equity $82.5 $0

7. Unallocated equity $90.7 $405.2

8. Total equity (fiscal year end 2009) $177.1 $412.2

9. Redemption of allocated equity $13.3 $0

Page 43: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

34

provide their members—again,

agricultural producers—with

short-term credit for crop and

livestock enterprises and for

purchases of farm machinery.

By 1968, all government capi-

tal was repaid.

Originally, the system’s associa-

tions were operated separately

from one another, but in the

late 1980s they were consoli-

dated under the same manage-

ment structures into ACAs. Each ACA has at least two subsidiary

lending institutions: a Federal Land Credit Association (Land Bank)

and a Production Credit Association (Credit Association).

Federal Land Banks were—and inside of an ACA, still are—exempt

from income tax under 501(c)(1) because they are federally char-

tered organizations. Production Credit Associations are nonexempt

cooperatives under Subchapter T. From the provision for income tax

in the audits of AgGeorgia and Badgerland, respectively, approxi-

mately 60% of these ACAs’ income is generated by their Land Banks

(tax exempt) and 40% of their income is generated by their Credit

Associations (nonexempt under Subchapter T).

Later in this chapter, we also discuss a third ACA. However, the

officers of this ACA requested that we not disclose their names or

the identity of the ACA, because the board of directors and senior

management are engaged in an ongoing discussion about whether

the ACA will pay patronage refunds. The chief financial officer we

spoke with is concerned that identifying the ACA might diminish

the openness of the deliberations currently under way and/or suggest

that senior management is biased either for or against the payment of

patronage refunds.

FCA—Regulatory Agency of ACAsThe FCA regulates AgGeorgia, Badgerland, and the other 79 ACAs,

and it establishes capital adequacy ratios for these associations.

Figure 5 contains the 2009 ratios for AgGeorgia and Badgerland,

the FCA minimum ratio, and the ratios for the combined 81 ACAs

as of December 31, 2010. Capital ratios are also provided for the

unnamed ACA that we will discuss later in this chapter.

FCA regulations prohibit the inclusion of more than two percent-

age points of allocated equities in the calculation of the core surplus

ratio.28 Further, the regulations also prohibit in the calculation of

Figure 4: Present Value of Patronage Distributions

Badgerland AgGeorgia

1. Patronage distribution allocated to members $1.00 $5.00

2. Allocated equity $0.00 $3.35

3. Cash portion paid by co-op $1.00 $1.65

4. Member taxes paid $(0.35) $(1.75)

5. Member net cash position year 1 $0.65 $(0.10)

6. Present value of redeemed equity at 5% cost of capital

over 8 years

$0.00 $2.26

7. Member net cash position after redemption of equity

year 8

$0.65 $2.16

Page 44: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

35

the core surplus ratio the inclusion of any allocated equities that are

scheduled or intended to be retired during the next three years.29

Consequently, these regulations are a disincentive for associations to

distribute earnings with allocated equity to their members.

AgGeorgia Patronage RefundsAgGeorgia’s average annual net income was $24.5M over the past

three years, and it has allocated and distributed 70% of that income

($15.1M with cash and QNAs) to members on the basis of patron-

age. AgGeorgia has distributed 33% of that distribution in cash, and

the balance of earnings is retained as allocated equity.

Because these earnings were distributed with QNAs, and because

we assume the interest paid to AgGeorgia was deductible on the tax

returns of its members, AgGeorgia’s members also report this patron-

age income on their tax returns. Only the cash patronage distribu-

tion from the Land Bank subsidiary is reported on the members’ tax

returns, whereas the cash and noncash allocated equity distributions

from the Production Credit Association subsidiary are reported on

members’ tax returns.

We assume that AgGeorgia’s board of directors and management has

made a calculated decision that paying 33% of the distribution in

cash is sufficient to at least pay the income taxes that most members

will owe to federal and state governments on these patronage dis-

tributions. Recall that the interest payments that members make to

AgGeorgia are likely to be tax deductible to the member as a business

expense, so patronage income must be reported as taxable income as

well.

Because AgGeorgia distributes patronage refunds with QNAs that

its members pay income tax on, AgGeorgia’s members undoubt-

edly have high expectations that AgGeorgia will redeem that equity

sooner rather than later. Just under half of all of AgGeorgia’s total

earned equity ($82.5M; see Figure 3, row 6) is allocated to members.

AgGeorgia’s average annual redemption expenditure over the past

three years was $13.3M. Hence, AgGeorgia could redeem all of its

allocated equity in as little as seven years (see Figure 3, row 6 divided

Figure 5: A Comparison of ACA Ratios

FCA ratio* FCA minimum 81 ACAs Badgerland AgGeorgia Unnamed

Permanent capital 7.00% 13.46% 12.70% 13.75% 16.20%

Total surplus 7.00% 12.93% 12.40% 13.50% 16.00%

Core surplus 3.50% 12.18% 12.40% 10.47% 16.00%

*Standards imposed by the Farm Credit Administration, the regulatory arm that provides oversight to the Farm Credit System and individual

institutions like Badgerland and AgGeorgia.

Page 45: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

36

by row 9). All in all, this is a very aggressive posture for a financial

co-op.

Significantly, AgGeorgia’s patronage refund philosophy is pressuring

its capital position. As a percentage of its total loans, the cash that

AgGeorgia pays to redeem allocated equity and its cash patronage

refund (at 1.9%) is three to four times the average paid by other farm

credit associations (.49%) or the 27 credit unions in Callahan’s study

(.5%).

Badgerland Patronage RefundsBadgerland’s average annual net income was $38.4M over the past

three years (see Figure 3, row 3). Badgerland allocates and distributes

only 14% of its income on a patronage basis, but its entire distribu-

tion is 100% cash; its average annual patronage refund is $5.5M.

The balance of Badgerland’s earnings is not allocated, and hence it

is used to build Badgerland’s unallocated equity. Because Badger-

land does not distribute any earnings with allocated equity, all of its

equity is unallocated (undivided) and its members do not expect that

Badgerland will redeem equity to them (see Figure 3, rows 6 and 7).

Approximately 40% of earnings is related to Badgerland’s nonexempt

Production Credit Association and, therefore, exposed to corporate

income tax.

Badgerland’s members are in a stronger cash position than AgGeor-

gia’s members in the year they receive the cash patronage distribu-

tion from each association (see Figure 4, row 5) because whatever

AgGeorgia’s members receive is paid to federal and state governments

when AgGeorgia’s members pay their income taxes.

In contrast, Badgerland members probably keep 67 cents of every

dollar of patronage refund after they pay their income tax obligations

from the 100% cash patronage refund they receive from Badgerland.

However, AgGeorgia’s members fare better in the long run after the

earnings distributed with QNAs are redeemed. The present value of

AgGeorgia’s patronage distribution is stronger than Badgerland’s (see

Figure 4, row 7) by a factor of more than three to one.

Impact on Adequacy of Capital PositionThe patronage refund philosophies of AgGeorgia and Badgerland

affect their compliance with FCA capital management guidelines.

Because all of Badgerland’s equity is unallocated (except for the

capital stock that members purchase when they borrow money; see

Figure 3, row 5), the calculation of its core surplus ratio, which was

Page 46: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

37

12.40% at its 2009 fiscal year end, is not diluted by allocated equity

(see Figure 3, row 6).

On the other hand, at 10.47%, AgGeorgia’s core surplus ratio is con-

siderably softer than Badgerland’s ratio. Not only do the FCA regula-

tions prohibit the inclusion of more than two percentage points of

allocated equity in the calculation of the core surplus ratio, but the

FCA could argue that AgGeorgia intends to redeem $40M over the

next three years based on its average redemption of $13.3M the past

three years.

Juxtaposing the philosophies of Badgerland and AgGeorgia illustrates

the choices that each co-op makes about patronage refunds, capital

structure, and the payment of corporate income tax. AgGeorgia pays

far less income tax than Badgerland. Each dollar that AgGeorgia

distributes as a patronage refund (with QNAs, both the cash portion

and the allocated equity portion) reduces its taxable income by a

dollar for its nonexempt Subchapter T subsidiary. At the same time,

every dollar that AgGeorgia allocates with QNAs builds up member

expectations that this equity will eventually be redeemed, sooner

rather than later. In contrast, Badgerland has not created an expecta-

tion among its patrons that it will redeem equity every year, or at any

time, and accordingly, Badgerland’s capital position is stronger than

AgGeorgia’s position.

This observation brings us back to a point we made in Chapter 1

in regard to building strong capital structures by not allocating

patronage refunds and how allocating earnings puts pressure on the

cooperative to redeem equity capital. AgGeorgia’s board of directors

and management must have concluded that they are not pressuring

AgGeorgia’s capital position too much by allocating so much income

and then redeeming that equity within seven or eight years. It is dif-

ficult for us to conclude that this approach will accrue to AgGeorgia’s

benefit over the long run because its patronage philosophy is deplet-

ing capital that may be needed for growth.

Like any business organization, co-ops might pursue short-term

objectives that are not aligned with their long-term interests. It could

be that AgGeorgia is one of those organizations.

A Farm Credit Association’s Patronage Refund DebateIn the course of our research, we encountered a farm credit associa-

tion (virtually identical to Badgerland or AgGeorgia but operating in

a trade territory far from either of those associations) where an ongo-

ing debate is the issue of whether to pay a patronage refund. This

association’s 2010 year-end loan volume was over $3 billion (B). Like

Page 47: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

38

Badgerland, all of this association’s equity is unallocated except for

approximately $8.0M of common stock. Its net income has nearly

doubled in the last five years.

This association is stronger than either Badgerland or AgGeorgia. At

its 2009 fiscal year end, its core surplus ratio was under 14%, and it

grew stronger in 2010 when the ratio reached 16%. Obviously this

association—which we agreed to leave unnamed—is in a position

to pay a patronage refund if the board approves it. The association’s

chief financial officer summarized the debate as follows.

Those Arguing “No Patronage Refund”A portion of this association’s board of directors takes the position

that it operates on a cooperative basis every day even though the

association does not pay a patronage refund. These directors say that

the very existence of the association acts as a competitive force to

keep other lending institutions’ rates comparable to the association’s

rates and cost of services. That being true, these directors are not

in favor of paying a patronage refund. Members, they would argue,

already receive a patronage refund.

These directors also contend that it is unnecessary to charge higher

interest rates or prices for services only to return some of those earn-

ings in cash as a patronage refund. Obviously the association’s growth

is strong and it appears unnecessary to prime it further. In fact, no

one on the board of directors takes the view that a patronage refund

would improve the association’s rate of growth.

Those Arguing “Pay a Patronage Refund”On the other side is a portion of directors who are in favor of pay-

ing a patronage refund. These directors’ position is that co-ops are

supposed to pay a patronage refund. These directors also believe

that paying a patronage refund ties members more closely with, and

deepens their loyalty to, the association.

If Paid, Pay Patronage Refund in Cash; No Allocated EquityIf there is a consensus within the board of directors, it is that a

patronage refund, if paid, should be entirely cash. All of the directors

are farmers and hence very familiar with agricultural cooperatives.

These directors do not like the idea of receiving an allocation of

patronage refunds but not receiving a large enough cash patronage

refund to pay the income taxes those members will owe state and

federal governments on that patronage income.30

Page 48: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

39

The CFO’s View; Similarity to Credit UnionsIf the CFO voted today, he would probably vote in favor of paying a

patronage refund. The beneficial effect of paying a patronage refund

is that it provides the association with one more mechanism to man-

age the level of its capital.

• • •

This debate raises issues similar to those of a credit union board

considering a patronage refund. The answer hinges on directors’ phi-

losophies about the need for capital- intensive growth and whether it

is better to reward members for their business every day or to declare

extraordinary dividends annually.

Are AgGeorgia, Badgerland, and the Unnamed Association Capital Hogs?Badgerland is arguably overcapitalized because its core surplus is

much stronger than AgGeorgia’s or the FCA guide of 3.5%. Bad-

gerland could, however, quickly counter that surplus by ratcheting

up its 100% cash refund allocation from 14% (see Figure 3, row 2a

divided by row 4) of its income to 15%, 16%, or even higher.

In other words, the strength of Badgerland’s approach to patronage

refunds and capital management over AgGeorgia’s is that Badgerland

can change directions quickly. If Badgerland encounters prosperity, it

can increase the 100% cash patronage refund above 14% of income.

Alternatively, if Badgerland encounters financial stress, it can quickly

retreat back to distributing 14%

of income, or lower, with its

100% cash patronage refund.

In contrast, we could argue that

AgGeorgia not only is over-

capitalized but is diminishing

its capital by operating more

closely to pure co-op patronage principles. Between redemptions and

cash patronage refunds, AgGeorgia is paying out approximately three

times the amount of cash as a percentage of total loans as the aver-

age of the 81 ACAs in the Farm Credit System, and seven times the

amount of cash paid by Badgerland.

The issue with AgGeorgia is that its patronage refund approach is

difficult to change quickly without affecting member expectations.

AgGeorgia’s earnings had been in decline for two years at the end

of 2009, so the pressure to conserve capital could be building. But

Business challenges remain in paying out a regular refund, but

initiating one is likely to build member loyalty and provide

opportunities to communicate with members about co-op

values.

Page 49: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

40

AgGeorgia’s members probably expect AgGeorgia will adhere to its

present redemption cycle of approximately seven years. The longer

AgGeorgia redeems on a seven- year cycle, the higher and more firm

members’ expectations will be.

Compared to Badgerland or AgGeorgia, the unnamed association

is strikingly overcapitalized. Its core surplus ratio grew from 14%

to 16% while it was growing its loan volume by 10% in 2010.

The implementation of a cash patronage refund program could be

expected to strengthen the association’s effectiveness in managing its

capital position. Initiating a patronage refund program is also likely

to build member loyalty and provide opportunities to communicate

with members about co-op values.

Page 50: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

From cooperative principles and outside exam-ples to actual credit union practices, this chap-ter describes patronage refunds at three credit unions. Each is slightly different, but all three emphasize members’ inherent right to the excess capital and membership benefits of giving tan-gible reminders of members’ ownership.

CHAPTER 6Credit Union Perspective

Page 51: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

42

In this chapter we will discuss the use of patronage refunds by

CoVantage Credit Union, Dow Chemical Employees’ Credit Union,

and Wright-Patt Credit Union, Inc. Each of these credit unions pays

a patronage refund to its members.

Executives at each credit union stressed that patronage refunds are

only paid to members in good standing, a crucial point we need to

emphasize. In each case, we were told that limiting the payment of

patronage refunds to members in good standing is an important

practice because members respond to the payment as an incentive to

manage their business relationship with the credit union in a way so

that the member avoids disqual-

ifying himself or herself from

receiving the patronage refund

when it is declared.

One of the recurring themes in

this chapter is that the leader-

ship of each credit union views

the credit union’s earnings as

belonging to the members (and in one case to employees as a specific

stakeholder group), and hence that the leadership is accountable

to members as stakeholders. The leadership of these credit unions

feels that the credit unions’ earnings belong to members (and other

stakeholder groups) regardless of whether the earnings are allocated

to members on the credit union’s books.

All three credit union executives said their credit union’s patron-

age program is a differentiator that set their credit union apart from

competitors. Earlier in this report we discussed how other coopera-

tives use the payment of a patronage refund as an opportunity to

communicate with their members about the value of the cooperative

form of business organization. All three executives and their staffs use

the payment of patronage refunds as occasions for their credit unions

to communicate with members about co-op values. A sampling of

their newsletters and websites is shown in the appendix.

All three credit unions use their patronage programs as differ-

entiators from local competitors. Credit union executives and

their staffs use the payment of patronage refunds as occasions

for their credit unions to communicate with members about

co-op values.

Page 52: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

43

CoVantage Credit UnionCoVantage Credit Union is based in Antigo, Wisconsin, and operates

nine branch offices in 17 counties (15 in Wisconsin, 2 in Michi-

gan), most of which are rural and considered to be populated by a

largely blue- collar workforce. CoVantage recently opened its third

branch in the greater Wausau area, the largest community in which

it does business. CoVantage also operates about a half dozen Kids

Credit Unions in Middle Schools across its trade territory. But of the

$850M in assets, less than $125M is from the Wausau membership.

As of December 31, 2010, CoVantage had just over 62,000 members

(6% of potential members), 215 full-time employees, and total loan

volume of $651.0M. Membership grew by 5.98% in 2010. Brian

Prunty is CoVantage’s chief executive officer.

CoVantage is one of the 27 credit unions in Callahan’s database that

paid a patronage refund in each of the last five years, and is in the

top 10 of those 27 credit unions on a number of measures. CoVan-

tage is 3rd in five-year loan growth, five-year member growth, and

five-year share growth; 5th in one-year loan growth; 7th for its 2004

and 2009 return on assets (ROA); and 10th for its dividend payment

as a percent of total shares (in dollars).

CoVantage’s average cash patronage refund over the last three years

totals $1,341,936, and its earnings (including the refund) aver-

aged $6,939,880 during that time. So over the past three years,

CoVantage has paid an average of 19.34% of its earnings in cash on

a patronage basis to members, ranking it 19th out of the Callahan 27

for its interest refund as a percentage of earnings.

CoVantage has paid a cash

patronage refund since 1981. Its

19th-place ranking for the size

of patronage refund as a per-

centage of earnings suggests that

paying a patronage refund is not

everything or the only thing.

Many factors determine the

success of any person or business. More important than the size of

the patronage refund is what it says about the business organization.

CoVantage’s patronage refund is consistent with its overall philoso-

phy that it is a financial co-op that belongs to its members.

Employees view members as the real owners. CoVantage exists

to help its members. Like any credit union, CoVantage does not

allocate its earnings—and equity—to members on the basis of share

ownership or loan volume, but it acts like it does. Hence, CoVan-

tage’s earnings “belong” to its members, which makes it less difficult

to pay a cash patronage refund to members.

The leadership of credit unions must evaluate what they are

doing and how well the credit union is performing before they

determine whether the credit union can justify paying bonuses

or rebates on top of what it is paying for share deposits or

charging for products and services.

Page 53: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

44

The capital accumulated through earnings is considered common-

wealth, and since it’s a financial cooperative, there has to be some

benefit to ownership. Prunty acknowledges that a 10% capital target

demands significant fiscal discipline to be able to meet all the credit

union’s obligations. He is fortunate to have a board of directors

that finds CoVantage’s patronage refund program indispensable.

According to Prunty, the board is the driver of CoVantage’s patron-

age refund payments. And since the board represents the members,

one cannot help but conclude that members are the wellspring from

which this patronage refund co-op philosophy emanates.

CoVantage tailors its patronage refund program to recognize the

contributions of members at all stages of their financial lives. It

acknowledges that in a member’s younger years, he or she is more

frequently a borrower, and thus it pays a 4% rebate on interest paid.

As members age, they can receive a savings bonus of up to 4% on

interest earned. Both of these expenditures are expenses on CoVan-

tage’s income statement and hence reduce CoVantage’s ROA.

CoVantage is an aggressive marketer, but its use of, for example,

bonus payments on debit cards or other profitable services does

not go as far as the programs of Dow Chemical or Wright-Patt.

Prunty noted that the rates the credit union pays on share deposits

are already the highest or second highest in the market. Prunty’s

comments highlight the fact that the leadership of credit unions

must evaluate what they are doing and how well the credit union

is performing before they determine whether the credit union can

justify paying bonuses or rebates on top of what it is paying for share

deposits or charging for products and services.

This notion echoes the earlier debate of the unnamed farm credit

association. The argument of some of the directors is that the asso-

ciation is already providing a patronage refund in charging relatively

modest fees and rates and, therefore, is a competitive force that

provides economic and financial benefits without paying a patronage

refund.

Prunty says that when CoVantage’s portfolio is compared with

credit unions that don’t offer patronage refunds to their mem-

bers, CoVantage’s loan portfolio is of higher quality. In addition,

CoVantage members who went through bankruptcy reaffirmed their

debt 60% of the time in 2010 and 50% in 2009. He believes this is

due in part to the patronage refund program.

Page 54: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

45

Dow Chemical Employees’ Credit UnionDow Chemical Employees’ Credit Union is located in Midland,

Michigan. As of December 31, 2010, Dow Chemical had just over

55,000 members (95% of potential members), 124 full-time employ-

ees, total assets of $1.35B, and total loan volume of $482.0M. Mem-

bership grew by 1.03% in 2010. Dennis Hanson is Dow Chemical’s

chief executive officer.

Dow Chemical is one of the 27 credit unions in Callahan’s data-

base that paid a patronage refund in each of the last five years. Dow

Chemical is in the top 10 of those 27 credit unions on a number

of measures: second in total assets, fifth in total loans, ninth for its

2009 ROA, fifth in member relationships, and seventh for 2009 real

estate loan penetration.

Dow Chemical has missed paying a cash patronage refund only once

in the last 50 years. Its average annual cash patronage refund over

the last three years was $3,807,972, and its earnings (including the

refund) averaged $11,559,969 during that time. So over the past

three years, Dow Chemical has paid an average of 32.94% of its

earnings in cash on a patronage basis to members, ranking it 11th

out of the 27 credit unions for size of refund in relationship to Dow

Chemical’s earnings.

Dow Chemical’s patronage refund (loan interest refund) amounts

to 15% of interest paid on loans. The patronage refund is not set at

15%, but it consistently works out to approximately 15% of interest

paid.

In addition to the patronage refund, Dow Chemical also pays

bonuses on its share deposits and debit cards. These bonuses have

averaged $3.5M annually. Dow Chemical has paid a bonus on share

deposits for 7 consecutive years and 10 of the last 15 years. This

bonus averages 15% of share deposits as well. Including share deposit

and debit card bonuses, Dow Chemical distributes 63% of its earn-

ings with cash each year.

Like CoVantage, Dow Chemical’s patronage refund is consistent

with its overall philosophy that it is a financial co-op whose earnings

belong to its members. Dennis Hanson is the fourth CEO of Dow

Chemical. Dennis told us that if the authors replaced him tomorrow,

his board of directors would absolutely require and expect us, as new

management, to toe the line on patronage refunds. After 50 years,

the payment of a patronage refund is a cultural imperative that is

nearly impossible to change.

Page 55: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

46

As we visited with Hanson, it was difficult to ignore the institutional

tone that is created from paying a patronage refund to members.

Patronage refunds championed by the board and management make

member ownership feel more real for members. Hanson emphasized

that, aside from the issue of being accountable to members, the

important thing to note is that patronage refunds are a differentiator

and distinguish the credit union from IOF firms.

Wright-Patt Credit Union, Inc.Our conversation with Tim Mislansky, senior vice president and

chief lending officer, may have been the most exciting because the

payment of patronage refunds is a relatively new practice at Wright-

Patt Credit Union, Inc. Mislansky told us that patronage refunds

were not necessarily top of mind at Wright-Patt until its manage-

ment determined that they were a mechanism for managing the

credit union’s capital growth.

Management had been trying to control the credit union’s growth in

capital by lowering service fees and other rates. But as fees and rates

were lowered, the credit union’s capital and its success continued to

grow, which prompted some directors to tease whether management

had solved Wright-Patt’s issue of excess capital.

Wright-Patt management requested that Callahan consultants

provide information about patronage refunds for management’s

consideration. Management had already developed a sophisticated

stakeholder model including (1) members, (2) employees, and

(3) the Credit Union. Management proposed that Wright-Patt dove-

tail patronage refunds into its stakeholder model, and the Board of

Directors reviewed and adopted management’s recommendation.

Wright-Patt is not identified in the Callahan 27 credit unions,

and Mislansky brought to our attention that not all credit unions

separately account for patronage refunds from dividends in the call

reports that are submitted to the NCUA. Wright-Patt reports its

patronage refund with the dividends it pays on shares.

Wright-Patt is located in Fairborn, Ohio, and operates 24 branch

offices. As of December 31, 2010, Wright-Patt had over 202,320

members (15% of potential members), 428 full-time employees,

total assets of nearly $2.0B, and total loan volume of $1.12B. Mem-

bership grew by 8.59% in 2010. Douglas Fecher is Wright-Patt’s

chief executive officer.

Wright-Patt’s average annual cash patronage refund over the last

three years was $3,751,478, and its earnings (including the refund)

averaged $19,867,464 during that time. So over the past three years,

Wright-Patt has paid an average of 18.88% of its earnings in cash on

Page 56: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

47

a patronage basis to members, ranking it 20th out of the 27 credit

unions for size of refund in relationship to Wright-Patt’s earnings.

Parenthetically, we may be overstating Wright-Patt’s ranking, because

its patronage refund includes dividends paid on share deposit

accounts and flat fee payments on specific products and services,

whereas the other credit unions paid patronage refunds in the more

narrow sense that the payments were tied to proportional use of the

credit union. This issue will be amplified later in this section.

Wright-Patt’s management begins to model its December 31 capi-

tal position in October each year and by November the board of

directors and management begin to settle on a number for patron-

age refunds. By late November or early December, the Wright-Patt

leadership has settled on a patronage number.

Management is as concerned about the size of the patronage refund

as compared to prior years as it is about the size of the patronage

refund compared to interest earned. For purposes of this discus-

sion, we’ll assume that management recommended and the board

approved a patronage dividend of $4.0M.

The first consideration is to reward profitable products and services

like debit cards, online electronic banking, receipt of statements

electronically, and use of Wright-Patt’s financial planning and broker

services. Between one-fourth and one-third of the total patronage

dividend is paid to members who used these products and services.

Mortgage lending is included in flat charges because some mortgages

are sold off while others are held by the credit union. Wright-Patt’s

management does not want to prejudice those members whose mort-

gages are sold, because the member has no control over that decision.

These patronage refunds are flat payments to each member who used

these products and services. We’ll assume that $1.0M was allocated

for these patronage refunds.

The second consideration is to distribute the remaining patronage

dividend of $3.0M to members on the basis of shares and to mem-

bers on the basis of their loans from Wright-Patt. If we assume that

Wright-Patt has $1.0B in loans and $1.5B in share deposits, each

qualifying member receives $.0012 cents per dollar of share deposit

and per dollar of loan balance. Mislansky indicated that this por-

tion of Wright-Patt’s patronage refund has been 7–10 basis points on

deposits and loans.

If its program was graded for adherence to co-op principles, all of

Wright-Patt’s patronage refund program would not qualify as a true

patronage refund, because a portion of it is paid as a flat fee that is

not related to the amount of business each member did with Wright-

Patt. Moreover, as with all credit unions, the payment of a dividend

Page 57: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

48

on share deposits is not a patronage refund, because it is paid on the

basis of investment in Wright-Patt in contrast to use based on bor-

rowings from the credit union.

This is not to criticize Wright-Patt’s program but only to highlight

that in a report about patronage refunds, we must pay attention to

whether the payment was made on a patronage basis or the member’s

use of the credit union. In fact, Wright-Patt’s program highlights

the advantage of paying patronage refunds under 501(c)(14) rather

than, for example, Subchapter T. Under 501(c)(14), Wright-Patt is

allowed to be more creative in how it distributes its patronage pay-

ments to members. Subchapter T would force a far narrower concept

of patronage on Wright-Patt because a patronage tax deduction is

allowed only for payments made on the basis of each member’s pro-

portional use of Wright-Patt.

Mislansky says that patronage refunds are a differentiator that dis-

tinguishes Wright-Patt from IOF banks that compete in the credit

union’s market. Mislansky says that Wright-Patt’s membership grows

substantially each year after its patronage refunds are announced and

paid. The idea that patronage refunds are a differentiator resonates

with us, but on more levels than just whether patronage refunds are

good ideas as rebates. As we said earlier, we believe that patronage

refunds highlight the philosophical gulf that separates co-ops from

IOFs.

Page 58: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

Cooperatives, including lending cooperatives, are quite used to the practice of paying regular patronage refunds. Most credit unions are not. This chapter synthesizes the findings from ear-lier in this report and offers suggestions to credit unions considering a refund program.

CHAPTER 7Credit Union Implications

Page 59: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

50

Patronage Refunds: A Differentiator?In 2009, Brian Briggeman of the Federal Reserve Bank of Kan-

sas City and Quatie Jorgensen of the University of Arizona wrote

an article entitled “Farm Credit Member- Borrowers’ Preferences

for Patronage Payments,” which appeared in Agricultural Finance

Review. This article reviewed studies that analyzed the preferences of

member- borrowers from Farm Credit Services of East Central Okla-

homa. The conclusion was that members strongly preferred patron-

age refunds compared to lower fixed- interest rates, particularly when

given the option of one or the other. In fact, on average, member-

borrowers were even willing to pay higher interest rates in order to

receive a patronage refund.

The 2010 Callahan & Associates study also spoke to the influence of

patronage refunds on membership growth. Credit unions that offer

patronage refunds, through interest refunds, report much higher

annual member growth rates—both for a single point in time (over

the course of 2009) and over a five-year period. In addition, long-

term loan growth appears to be an additional strength for credit

unions offering interest refunds. While the 12-month loan growth

for both groups would be lower due to the economic conditions in

2008 and 2009, the five-year average annual growth of 8.4% for the

patronage refunds group is 30% higher than the other group’s rate of

5.8%.

Capital Management ToolTo us, there seems little doubt that credit unions will need to focus

on capital accumulation in the years ahead. Earnings are needed to

build balance sheet strength, ward off adversity, and attract the kinds

of secondary capital (preferred stock, debentures, etc., from mem-

bers) that credit unions have lobbied for. Patronage refunds are the

necessary tool that demonstrates to members that the cooperative is

socially and fiscally responsible with the member’s money. When the

cooperative has too much capital, it will be returned as patronage

refunds or equity retirements.

Page 60: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

51

We encourage you to have your credit union’s articles of incorpora-

tion and bylaws reviewed by legal counsel for the specific purpose of

learning whether your credit union might be prohibited from paying

a patronage refund. Our concern arises from the fact that at dis-

solution, credit union statutes appear to favor share ownership over

historical patronage.

If the owners of shares in the credit union are the beneficiaries of the

remaining proceeds in dissolution, the question arises whether they

could object to any payment that is not paid on the basis of owner-

ship while the credit union is operating. We recommend that you

discuss with your legal counsel whether your credit union should

amend its articles and bylaws to specifically allow payments of

patronage refunds on a patronage basis any time prior to a dissolu-

tion vote.

Future Tax ConsiderationsNothing on the horizon points to any modification of the federal tax

exemptions that apply to federal or state- chartered credit unions. In

this section, we consider two alternatives: (1) that credit unions are

taxed under Subchapter T and (2) an argument for why 501(c)(14)

and 501(c)(1) tax statutes will not be touched.

The Case for Subchapter TFrom time to time, the General Accounting Office (GAO) prepares

reports on tax- exempt business entities. In 2005, the GAO prepared

a report on credit unions that, aside from reciting the arguments for

and against the tax exemption, contained no recommendations for or

against the tax exemption.

In 1983, the GAO issued a report recommending that Congress

consider taxing rural electric cooperatives under Subchapter T. The

recommendation was not adopted by Congress, but in this section

we consider what would happen if the GAO made the same recom-

mendation for taxation of credit unions. Assuming that Congress

acted on the GAO recommendation this time, we apply Subchap-

ter T to the 27 credit unions in the Callahan study.

Figure 6, a modification of Figure 1, shows these 27 credit unions

under 501(c)(14) and then compares this with two scenarios under

Subchapter T. One scenario shows these credit unions allocating

40% of patronage- sourced income (and paying a cash patronage

refund of 20% of the total allocated) and paying taxes (federal and

state) on the other 60%. The other scenario shows these credit

unions allocating 100% of patronage- sourced income and paying no

income tax.

Page 61: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

52

Allocate and Distribute 100% of Patronage RefundsIncome tax is not owed under this Subchapter T scenario, because

we assume that all income is patronage sourced (generated from

transactions with members) and that all patronage income is allo-

cated to members on the basis of patronage.31

The 27 credit unions in the Callahan study are already distributing

enough cash to qualify for tax treatment under Subchapter T. A min-

imum of 20% cash refund is required by Subchapter T. These credit

unions paid 23.34%. Credit unions would prepare 1099-PATR

information returns, but we expect that many credit unions could

apply for and receive an exemption from reporting 1099-PATRs.32

The bigger issue for these credit unions is whether they would be

able to redeem allocated equity, and whether there would be pressure

to redeem this equity. At the end of their first year operating under

Subchapter T, these credit unions would have allocated equity total-

ing $2.7M dollars. If year two were identical, allocated equity would

total $5.4M at the end of that year. You can see how allocated equity

would quickly build up and grow from year to year. If these 27 credit

unions had been allocating earnings all along, each credit union

would, on average, have $54.0M of allocated equity as of Decem-

ber 31, 2011.

A 50-year equity redemption cycle, for example, applied to $54.0M

of allocated equity implies an annual equity redemption obligation

of $1.08M per credit union among the Callahan study credit unions.

Hence, these 27 credit unions would be expected to redeem more

than $1.20 of allocated equity for every $1.00 of patronage refunds

paid in cash, an objective that most likely is all but impossible for

these credit unions. So what would these credit unions do if they

operated under Subchapter T and were faced with that allocated

equity but could not redeem it?

These 27 credit unions would not redeem allocated equity unless

and until they had surplus working capital to allow redemptions of

equity. In fact, if the board of directors determined that the credit

Figure 6: Potential Tax Effects of Patronage Refunds

27 Credit Unions as Exempt, Allocated 40% under Sub-T, and Allocated 100% Under Sub-T

Average of 2008, 2009, and 2010 501(c)(14) % Total Sub-T: 40% % Total Sub-T: 100% % Total

Cash patronage refund 822,800 23.34 282,076 8.0 822,800 23.34

Patronage refund in allocated equity — 0.00 1,128,304 32.0 2,703,149 76.66

Undivided/Unallocated earnings 2,703,149 76.66 1,184,719 33.6 — 0.00

Income tax on co-op’s earnings — 0.00 930,850 26.4 — 0.00

Total earnings (average per co-op) $3,525,949 100.00 $3,525,949 100.00 $3,525,949 100.00

Page 62: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

53

union was unlikely to ever consistently redeem enough allocated

equity to, at a minimum, redeem the equity of deceased members,

the credit union should develop a communication plan that explains

why no redemptions of equity could be made by the credit union.

We expect that a significant part of that communication plan would

be centered around the notion that the credit union provided signifi-

cant benefits as a competitor in

the market and that this alone

is enough to justify the credit

union’s inability to redeem

equity on a regular basis. An

aid to this plan is that most

of the credit unions’ members

would not pay income tax on these patronage distributions, because

in most cases, the loans are for personal or family financing and not

tax deductible to the member. Hence, the patronage income is not

included in the member’s income, either.

If equity redemptions occurred, we expect that the equity of the

credit unions’ oldest members would be redeemed first. We also

expect that the estates of deceased members would request redemp-

tion of equity. These credit unions are not obligated to redeem the

equity. However, the wisdom of an education and communication

plan to explain why the equity is not redeemed can easily be seen.

If the equity is not redeemed, it would be assigned to the deceased

member’s heirs, or the member’s estate could make a tax- deductible

gift of the equity to a charity, perhaps to a 501(c)(3) owned by the

credit union.

Those members who obtain business loans from the credit union

or who obtain real estate mortgages with tax- deductible interest are

likely to pay tax on patronage distributions from the credit union.

These members may be the most highly motivated to push the board

of directors and management of the credit union to redeem their

allocated equity. The argument of these members would be that a

23% cash patronage refund is not large enough to pay the income

taxes that they owe to federal and state governments. At present,

under 501(c)(14), these members do not have that criticism, because

under this exemption, the cash refund is the entirety of the income

taxed by federal and state governments. Under Subchapter T, how-

ever, the credit unions’ business members would pay tax on both the

cash patronage refund and the allocated equity used to distribute

earnings to these members.

These credit unions must be careful to manage members’ expecta-

tions about equity redemptions. If the income is allocated to mem-

bers, members often expect that the equity will be redeemed sooner

The wisest approach would be to proactively manage expecta-

tions by educating members about what, exactly, they could

expect from the credit union.

Page 63: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

54

rather than later, particularly if the member is a business entity that

would pay income tax on the patronage distributions of income

(cash and noncash) to members. The wisest approach would be to

proactively manage expectations by educating members about what,

exactly, they could expect from the credit union. We would have the

same concerns about this scenario as we expressed for AgGeorgia

earlier in this report. Each of the 27 credit unions in the Callahan

study would have followed the co-op principles to the letter. Each

dollar of patronage earnings would have been allocated to mem-

bers just as those principles call for. On the other hand, by allocat-

ing every dollar of patronage earnings, these credit unions would

also have overcommitted their capital, creating more obligations to

redeem allocated equity than we could reasonably expect from any

of the 27 credit unions, while also expecting each to retain capital to

finance its normal growth and expansion.

Allocate and Distribute 40% of Patronage IncomeAnother strategy these 27 credit unions could adopt under Sub-

chapter T is to allocate and distribute less than 100% of patronage

earnings to members. For this section, we assume these credit unions

each allocated 40% of their patronage earnings rather 100%. Com-

paring the Sub T: 100% with the Sub T: 40%, each $1.00 of income

tax a credit union paid to federal and state governments, it would

reduce its allocated equity redemption obligation by $1.70.

While a strategy of allocating less patronage earnings and paying

more income tax might be useful for Badgerland to conserve its capi-

tal, or helpful for AgGeorgia to begin conserving more of its capital,

it may not be as useful or helpful for any co-op taxed under Sub-

chapter T whose members are only or primarily consumers, includ-

ing credit unions. The taxation of the income of consumers who

are unlikely to deduct the interest they pay to credit unions—other

than interest they pay on mortgages—creates a dynamic that is quite

distinguishable from the taxation of the income of businesses who

deduct the interest they pay as a business expense.

Recall that under Subchapter T patrons pay income tax on the entire

distribution, both the cash and the allocated equity. All income—

both cash and allocated equity—are reported on the 1099-PATR

information return as income. Under either Sub-T scenario in

Figure 6 above, however, for every dollar of patronage earnings

allocated to a consumer, the consumer does not owe any income

tax on April 15. The consumers’ expenditures at the credit union

(other than mortgage interest) are not deductible. Consequently, the

patronage earnings that are allocated are not income for the con-

sumer even though a 1099-PATR was reported to the IRS. Even so

the consumer receives a minimum of a 20% cash patronage refund,

Page 64: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

55

and the consumer is money ahead over an IOF even if none of the

balance of up to 80% of the allocation is ever redeemed to the con-

sumer member.

The business member of a co-op that is taxed under Subchapter T

pays income tax on the entire distribution of cash plus allocated

equity. Assume that each business member pays tax at a marginal

rate of 35%. For every dollar of income that is reported to on

1099-PATR to the IRS, the business pays income tax of 35 cents.

If the co-op pays only a 20% cash refund, the business member is

in a deficit position of 15 cents for each dollar of patronage income

that is allocated to the member. Hence, business members are most

likely to complain to the board of directors and management that the

co-op is not paying enough cash and/or redeeming equity quickly

enough to justify a co-op membership.

Allocating less than all of the patronage income and paying income

tax on the balance is not the only strategy that a co-op might adopt

to help the co-op manage the amount of capital that is available to it.

A Subchapter T co-op may also consider paying business members a

higher cash patronage refund than consumer members to differenti-

ate between consumers and businesses. In addition, a Subchapter T

co-op could also distinguish between consumers and businesses by

redeeming the allocated equity of businesses more quickly than it

redeems the allocated equity of consumers.

At the end of the day, any Subchapter T co-op’s board of directors

and management must evaluate and determine how much capital

its co-op can devote to redemptions of allocated equity. That deter-

mination will depend on the co-op’s need for capital. Its growth. Its

potential. Its risk of sustaining losses. Its ability to attract outside

capital. Its ability to generate earnings.

The important thing for a Subchapter T co-op is to arrive at a

redemption program that makes sense to the co-op and its mem-

bers. A redemption program should be consistent with the varying

tax positions of its members. The program should be sustainable

but also challenge the co-op and its members. The program should

reward patronage more than it rewards ownership. And finally, the

program should be capable of being communicated to members in a

way that makes sense to members.

Examining the Tax ExemptionIn 1983, the GAO suggested that Congress consider an evolution

of rural electric cooperatives from 501(c)(12) to Subchapter T, but

Congress did not act on the GAO’s suggestion.

In its 1983 report, the GAO contended that the tax exemption was

difficult to administer and that industrial and commercial members

Page 65: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

56

of the cooperative were deducting the expense of purchasing electric-

ity but escaped the payment of tax on equity credits if and when the

credits were redeemed.

The GAO also contended that cooperatives were not redeeming

equity credits quickly enough. In fact, the GAO stated that some

rural electric cooperatives had no intention of ever redeeming any

credits.

The experience of rural electric cooperatives does not translate easily

to credit unions. The primary criticism of rural electric coopera-

tives was that they had no intention of redeeming allocated equity

to members. That criticism does not exist for credit unions, because

they do not distribute earnings with allocated equity.

However, the GAO’s 2005 report on credit unions—like the 1983

report on rural electric cooperatives—suggests that tax exemptions

can never be conclusively presumed safe from attack. The following

conclusions can be drawn about credit unions:

• The 27 credit unions in the Callahan study are doing more to

protect the tax exemption from attack than are credit unions that

do not pay cash patronage refunds.

• 501(c)(14) offers far more flexibility in paying patronage refunds

than does Subchapter T, for example. Wright-Patt’s creativity in

how it uses “patronage” refunds is noteworthy. Flat payments for

profitable products and services, and variable payments for inter-

est paid on loans and for dividends received on share deposits are

permitted by 501(c)(14) but would not be permitted by Sub-T.

Better to take advantage of the current flexibility and strengthen

the tax exemption by using it creatively.

• Credit unions are cooperatives. It is always worthwhile to ratchet

up the co-op’s efforts to encourage member participation and

involvement in the cooperative.

• Credit unions can prepare for battles over their tax- exempt status

by communicating with members about the benefits of coopera-

tives and by educating members about the principles of coopera-

tion. When the bullets start flying, it’s better to have the army

already motivated for battle rather than just beginning to moti-

vate the troops.

• Patronage refunds (and eventually redemption of equity credits

for those cooperatives that allocate earnings but redeem them

later) bring the co-op membership experience—and the reason

for the co-op’s existence—full circle. We expect that, like the

farmers and agricultural producers that prefer patronage refunds

Page 66: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

57

to low interest rates, credit union members would hold similar

preferences for the payment of annual patronage refunds.

• There is something about consistent patronage refunds that

matures the cooperative in the eyes of its members. It’s like the

co-op has confidence in its membership and in its viability. The

co-op is serious about financial success and wants to provide

the goods and services that will make it profitable.

• We think that co-ops that make money and pay patronage

refunds are more likely to survive and flourish as businesses than

co-ops that do not have the same emphasis on profitability or

accountability to members.

• Co-ops have a story to tell, particularly when they pay patron-

age refunds. The members of the American Bankers Association

(ABA) would never willingly operate with the deep member

involvement that is encouraged under co-op principles. The

relevant audience of an IOF bank is limited to its common

stockholders, whereas the relevant audience of a co-op is all of its

customers or members. IOF banks do not subject their capital

plans to customer scrutiny or think it necessary to explain to

customers why the bank was investing in growth rather than in

equity redemptions, why the firm did not pay a patronage refund,

why the patronage refund decreased in size, or why that product

or this service could not be provided at a lower overall price.

• IOF banks would never accept as one of their primary objectives

the return of surplus capital to customers. The inclination of IOF

banks is to hoard and use capital rather than return it. Co-ops are

not as glitzy as IOF banks. The discipline that management must

execute and the leadership required of a co-op is more onerous

than that needed for an IOF. But the rewards—the intangibles—

of affiliating oneself with an organization that is operated for the

benefit of its members rather than the organization’s own pocket-

book are immensely rewarding. We heard as much from Prunty,

Hanson, and Mislansky in our interviews for this report.

• Timing is everything. With the Basel capital requirements and

the state of the economy, boards of directors and management

must make educated, wise decisions about when to implement a

patronage refund program.

Similar to the experience of rural electric cooperatives, the more that

regulators and investor- owned competitors see that the cooperative’s

membership is vibrant, informed, and supportive of the credit union,

the more difficult it is for the tax exemption to be attacked.

Page 67: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

58

Patronage Refunds and Capital M anagementIn a conversation about patronage refunds, capital management,

and the 501(c)(14) tax exemption, it is worthwhile to consider

OmniAmerican Credit Union. OmniAmerican completed a conver-

sion from a credit union to an IOF bank on January 1, 2009. Half of

its stock is now owned by 60 institutional investors. To us, conver-

sions of cooperatives, and their accompanying loss of member- owned

capital, are a significantly larger issue on the horizon than the modi-

fication or loss of the 501(c)(14) tax exemption. Patronage refunds

could be the difference that thwarts conversions.33

Arguably the two most important changes in OmniAmerican’s finan-

cial metrics between its status as a credit union and its status now as

an IOF bank are that (1) its equity capital almost doubled through

the conversion and public sale of its common stock, and (2) its

income is now an eighth of what it was when OmniAmerican was a

credit union.

OmniAmerican Credit Union generated $10.0M of net income in

its last full year as a credit union (2004), but OmniAmerican Ban-

corp generated only $1.6M of net income in 2010. OmniAmerican’s

average net income as a credit union was $9.2M for the years 2002,

2003, and 2004, and it was on the rise; OmniAmerican generated

$8.4M in 2002.

If OmniAmerican had remained a credit union and had begun dis-

tributing a patronage refund equal to 20% of its earnings (approxi-

mately equal to the 27 credit unions in the Callahan study) starting

with its 2004 year end, it would have distributed $14.0M in patron-

age refunds to its members by December 31, 2010. OmniAmerican

would already have distributed a fifth of the wealth that was created

in its conversion to an IOF. And that wealth would have been dis-

tributed to 250,000 members.

Do you prefer $2.0M per year being distributed as a patronage

refund to 250,000 OmniAmerican Credit Union members, or would

you rather have 60 institutional investors benefiting from half of the

$50M–$70M of new capital that was raised through the conversion

and sale of stock? Do you prefer that those 250,000 members hold

an unredeemed lottery ticket worth $50M–$70M pre- conversion,

or would you rather those 60 institutional investors chase down and

corral $25.0M–$35.0M of capital for their own benefit?

Page 68: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

59

The ABA is eager to gripe about the credit unions’ tax exemption,

but nowhere on its website does the ABA wrestle with these ethi-

cal charter conversion issues or the laudatory social and economic

benefits that accrue to members of credit unions over IOF banks.

The ABA either does not see or ignores the fact that credit unions are

more sustainable than IOFs, that credit unions do not hoard capital

for their own use, and that credit unions return unneeded capital to

members.

Page 69: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

60

Exhibit A: 2007 Newsletter Article Announcing the Patronage Dividend at CoVantage Credit Union ($861M, Antigo, Wisconsin)

$1.4 Million Rebated to MembersOver 14,000 CoVantage members will “step into cash” when their

loan interest rebate checks arrive in next week’s mail. This year’s 5%

rebate will provide the largest payback ever, and will put a record

$1.4 million back into the hands of credit union member-owners.

If you’re new to CoVantage, getting a rebate from the place you have

your loan may be unheard of. But, members with a history of bor-

rowing here see it as a valued reward for their patronage. And, this

year’s rebate marks the 26th year that directors have determined there

is sufficient net income to provide this benefit.

Here’s how the rebate works. If you had a loan with CoVantage dur-

ing 2007, and all of your payments are current, you’ll automatically

receive a check returning 5% of the interest you’ve paid. No applica-

tion required! So, if you paid $5,000 in interest on your CoVantage

home loan during 2007, you’ll receive a rebate for $250! This year

we have enhanced our program to combine the interest paid on all

loans under one account number. Because we send checks only when

the rebate totals at least $5.00, this improvement will allow even

more members to get their rebate. (Student loans are not eligible for

the rebate.)

The loan interest rebate is just one way members receive exceptional

value from their credit union. Throughout the year we work to keep

loan rates low, charge fewer fees than others, and pay market- leading

rates on deposits. To ensure our rates and fees are competitive, we

monitor what others are offering. And while some may have special

rates and gimmicks, we are confident that CoVantage is one of the

best when it comes to overall member value.

To give you an outsider’s viewpoint, we would like to share that out

of [thousands of U.S. credit unions] we were ranked in the top 1%

for “Return to Savers.” This ranking was provided by an independent

consulting group, and is a measure of the deposit services a credit

union provides.

As a member- owner of CoVantage Credit Union, you deserve the

best from your credit union. Staff, management, and directors are

committed to ensure that each and every member receives outstand-

ing value.

Appendix

Page 70: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

61

Exhibit B: 2011 Newsletter Article Announcing Patronage “Rebates and Rewards” to Members of Dow Chemical Employees’ Credit Union ($1.4B, Midland, Michigan)

Report from the President/CEO: Exceeding Expectations in Troubled Times$5.7 million returned in rebates and rewards

Although the lingering effects remain from one of the worst financial

events in modern memory, Dow Chemical Employees’ Credit Union

(DCECU) posted another banner year in 2010. In this unfortunate

climate where bank and credit union failures exceeded the prior

year’s results, DCECU continued to thrive.

How is it that DCECU was able to take lemons and turn them into

lemonade? What was this recipe for success? It’s really quite simple—

don’t stray from the Core Values you’ve established, and stick to

your Mission. Through conservative, principles- based decision-

making, your credit union returned another $5.7 million back in

the form of Loan Interest Rebates, Member Saver Rewards and

other rebates to DCECU member- owners on top of very competi-

tive loan and deposit rates! (emphasis in original)

DCECU’s leadership has worked tirelessly during these difficult

economic times. Numerous financial forecasts have been reviewed,

contingency plans have been created based on varying interest rate

and economic scenarios, expenses have been carefully controlled, and

investments and capital expenditures have been scrutinized.

Based on the above, one might conclude DCECU has been unaf-

fected by the recent negative events. While not entirely true,

DCECU is very proud of its foresight in the slight modification of

its loan underwriting criteria when negative signals began to appear.

The results—DCECU has performed superbly versus other similar

financial institutions. And, while loan delinquencies were up slightly

from one year ago, losses have been well- contained and have even

fallen slightly year-over-year.

Page 71: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

62

Due to careful planning and prudent financial stewardship,

DCECU’s Board of Directors declared the following for 2010:

• 15.00% Loan Interest Rebate that entitles borrowers in good

standing* to receive a portion of the total interest paid on all

eligible** DCECU loans

• 15.00% Member Saver Reward that entitles depositors in good

standing* to receive a portion of the dividends/interest earned on

all DCECU shares/deposits

• A VISA® Check Card rebate*** for users in good standing*

These rebates and rewards were paid on January 1, 2011 (excluding

VISA® Credit Card rebates, which will be deposited to Share/Savings

accounts in January) to members in good standing* via deposit to

their Prime Share accounts.

I would like to thank you personally for your continued support of

Dow Chemical Employees’ Credit Union and for utilizing the many

services we offer. Because we are a not-for- profit financial coopera-

tive, the more members use these services, the more all members

benefit. We look forward to serving you in 2011 and will share more

of the positive news that’s happening at DCECU throughout the

year.

As always, please do not hesitate to contact me or any of the

DCECU staff in person, by phone . . . or via e-mail through our

website at www.dcecu.org. Remember, DCECU is your credit union.

Sincerely,

Dennis M. Hanson

President/CEO

*Defined as those members who had at least $5 in their Share Account on December 31, 2010, have no delinquent accounts, have not had

adverse collection activities on their accounts and have not had accounts charged off.

**Ineligible loans include certain DCECU auto loans and mortgages, as well as VISA® accounts with TravelFree Rewards, CashBack Rewards or

Transaction Rebates.

***For members who utilized the DCECU VISA® Check Card during 2010, the rebate is 0.125% (.00125) for signature-based transactions, calcu-

lated on net sales, and $0.01 for PIN-based transactions for each time the card was used during the year. Using your VISA® Check Card helped

DCECU reduce operating expenses and operate more efficiently.

Page 72: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

63

Exhibit C: 2011 Website Announcement of Membership Dividend at Wright-Patt Credit Union, Inc. ($2.1B, Fairborn, Ohio)34

Dividend CalculationWhy It Pays to USE Your Credit Union!Giving over $4 million back in the form of a Special Patronage Divi-

dend to our member- owners puts people before profits and show-

cases the success of our credit union cooperative. We’re not here to

profit from our members—we don’t charge big fees to make a quick

buck like big corporations often do.

When we have a successful year, we pay for our operations, invest in

products and services to better serve you, and put some away for a

rainy day fund. Then we return any excess earnings to you.

How Can I Find Out My Share of the Dividend?

This year’s $4 million Special Patronage Dividend was automatically

deposited to eligible members’ TrueSaver accounts on January 4th,

2011. You can find your share by checking your TrueSaver account

(see history tab) through WPCU’s Home Banking or Mobile Bank-

ing. If you’re not already enrolled in online Home Banking, sign up

now by calling our Member Help Center.

2010 Special Patronage Dividend Calculation

The Special Patronage Dividend calculation was based upon the

accounts and services you used with Wright-Patt Credit Union in

2010. By using services like mobile banking, financial planning,

WPCU loans and mortgages, you contribute to the credit union

cooperative and your payment will reflect that usage. The idea—the

more you use your credit union, the more you benefit!

Last year, the average member earned $22.94.

Page 73: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

64

Think of how much more you, and other members, could be earn-

ing and saving by moving all of the accounts and services you have

somewhere else over to Wright-Patt Credit Union.

By trusting WPCU with more of your accounts and telling your

friends and family members all the ways WPCU is crazy about our

members, you’ll help the credit union grow—and help us on the way

to paying another Patronage Dividend next year.

Qualifying members received:

• 0.09% (0.0009) of your average daily balance of your deposits

(includes business share balances)

• 0.09% (0.0009) of your average daily balance of your loans

(excludes business loan balances)

• Earn $100 for a business loan relationship

• $45 for each first mortgage loan

• $5 for each financial planning relationship

• $5 for an active debit card

• $5 for being enrolled in eStatements

• $5 for active Call-24™, Home Banking, or Mobile Banking

Page 74: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

65

1. Based on call reports from the NCUA website for the years

2008, 2009, and 2010.

2. Nonrecurring tax- deductible rebates are allowed only in the tax

year that the rebate is paid. Recurring rebates are deductible in

the year that the liability is fixed and determinable. Regs. Secs.

1.461-5(b)(1)(ii), (b)(1)(iii), and (b)(3).

3. A point that should please capitalists and socialists alike but not

communists.

4. Obviously, to attract capital, the cooperative must pay a reason-

able rate of return to third parties for the use of equity as in

preferred stock or debt as in subordinated debentures.

5. This is a point of disagreement with several academics in the

co-op community with whom we are familiar. It’s not clear to

us exactly why these academics resist the idea that a co-op’s

financial metrics may not reasonably allow it to allocate all

patronage earnings and redeem all the allocated equity while

it is simultaneously maintaining, building, and capitalizing its

business. Our sense is that it conflicts so violently with their

progressive point of view. One cannot help conclude that these

academics would argue that if a co-op allocates the income,

then surely it can redeem the equity. We know of nothing in a

co-op’s DNA that allows that indulgence.

6. In co-op tax-speak, apportionment is different from allocation.

Apportionment is to assign earnings and equity to members on

the co-op’s books without notification to the member. Alloca-

tion is apportionment plus notification to the member, and

under Subchapter T, allocation also carries with it the vesting

of the equity in each member to whom patronage earnings are

distributed with allocated equity.

7. Revenue Revisions, 1947–1948: Hearings Before the Comm. on

Ways and Means, 80th Cong., pt. 4, at 3136 (1948).

8. Some bylaws call for the distribution of all or part of the

remaining proceeds to nonprofit or tax- exempt organizations

as a way of honoring a commitment to the cooperative form of

business organization.

9. Co-ops are democratically controlled on a one member–one

vote basis. Older members have bigger voices because they are

respected, and they are respected if they have lots of allocated

equity because they have loyally supported the co-op over the

years.

10. Financial firms in the S&P 500 paid an annual dividend of

1.1% of capital in 2010 and 1.4% through March 31, 2011. In

Endnotes

Page 75: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

66

contrast, the 27 credit unions paid a cash patronage refund that

was 1.62% of their average equity over the years 2008, 2009,

and 2010. An IOF dividend is taxable income to the recipient,

whereas a co-op’s cash patronage refund is not taxable income

to the recipient if the refund is paid from transactions that were

not themselves deductible from or includable in income. But

recall too that the credit union’s earnings belong to the mem-

bers, not the credit union, and it would be unnatural for the

earnings to be exposed to income tax at a level other than at the

member level.

11. Wright-Patt Credit Union, Inc., “Wright-Patt Credit Union

Saved Members $26 Million in 2009 Says Credit Union

National Association,” wright4youmortgage.com/news/

10-04-21/Wright-Patt_Credit_Union_Saved_Members_

26_Million_in_2009_Says_Credit_Union_National_

Association.aspx.

12. Cooperatives are considered to be the ultimate self-help orga-

nization in the United States and around the world. In fact,

since 1995, the United Nations General Assembly has annu-

ally recognized “International Day of Cooperatives,” a day that

reaffirms and celebrates the role of cooperatives in economic,

social, and cultural development. Each annual celebration has

a theme; in 2010 it was “Cooperative Enterprise Empowers

Women.”

13. We do not distinguish among members, the board of directors,

and management. Each stakeholder group is as prone to wrong

decisions as the others.

14. Federal credit unions are tax exempt under 501(c)(1) as well.

Both Land Banks and federal credit unions are chartered by the

federal government.

15. Nonpatronage earnings do not arise from business done with

or for patrons. For the balance of this section on Subchapter T,

we will discuss these tax features as though the cooperative

generated only patronage- sourced income.

16. Union Cooperative Exchange v. Commissioner of Internal

Revenue, 58 T.C. 427 (U.S. Tax Court 1969).

17. Nonqualified written notices of allocation (NQNAs) are also

used to distribute and “pay” the patronage earnings to patrons.

The cooperative pays income tax on the NQNAs initially. If

and when NQNAs are redeemed (no later than at dissolution,

if not sooner), the patron pays income tax and the cooperative

receives a tax benefit equal to the tax it paid earlier. In this way,

single taxation is preserved.

18. Patronage earnings from transactions relating to personal,

living, or family purposes are not taxable. More later in this

Page 76: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

67

section on the exemption from filing 1099-PATRs for “con-

sumer” cooperatives.

19. 26 CFR 1.6044-4: “If 85 percent of its gross receipts for the

preceding taxable year, or 85 percent of its aggregate gross

receipts for the preceding three taxable years, are derived from

the sale at retail of goods or services of a type which is generally

for personal, living, or family use.”

20. Only the allocation of member- related patronage earnings is

deductible under Sub-T.

21. National Rural Electric Cooperative Association and National

Rural Utilities Cooperative Finance Corporation, Capital Cred-

its Task Force Report, January 2005.

22. Treas. Reg. § 301.6044–2(b)(2)(iii).

23. Coop Litigation News Publishing, “Coop Litigation News.”

coop-litigation.com.

24. Because each ACA operates a Credit Association subsidiary

that is taxed under Subchapter T, and because Sub-T co-ops

must allocate patronage- sourced income or maintain patronage

records, each ACA can be expected to follow a similar record-

keeping process for its Land Bank subsidiary.

25. 12 CFR 701.6.

26. Examples include Iowa Code § 533.404, Kentucky Statutes

286.6-705, Wisconsin Code 186.18, and North Dakota

6-06.1-08.

27. www.aggeorgia.com; www.badgerlandfinancial.com. The finan-

cial information discussed in this report is taken from each

association’s 2007, 2008, and 2009 fiscal year-end audits.

28. 12 CFR 615.5330.

29. 12 CFR 615.5301(b)(2)(ii).

30. See our earlier discussion at note 6.

31. See discussion above on Subchapter T. Key qualifications

include (1) preexisting obligation in the bylaws, (2) board of

directors declares patronage refund, (3) within 8½ months

following fiscal year end, prepare and send qualified written

notices of allocation and qualified payment constituting at least

20% of the allocation in cash, and (4) build out accounting

program to allow tracking of each member’s allocated equity.

32. See note 18 about cooperatives that primarily provide goods or

services for family, personal, or living needs.

33. It is not that all conversions of co-ops are ill conceived. Con-

versions or demutualizations of co-ops with large equity

redemption obligations improve their financial metrics because

they are no longer required to devote huge capital resources

Page 77: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

68

to redemptions. Think Diamond Walnut Growers in Cali-

fornia. On the other hand, one wonders who benefited from

the OmniAmerican conversion other than management and

institutional investors.

34. Wright-Patt Credit Union, Inc., “Dividend Calculation,”

www.wpcu.coop/patronagedividend/ DividendCalculation.aspx

(retrieved 4/27/2011).

Page 78: Credit Union and Cooperative Patronage Refunds · PDF fileCredit Union and Cooperative Patronage Refunds ... Credit Union and Cooperative Patronage ... returned to a cooperative’s

Credit Union and

Cooperative Patronage Refunds

Joel Dahlgren, JDBlack Dog Co-op Law

Dan KitzbergerKitzberger Consulting

ideas grow here

PO Box 2998

Madison, WI 53701-2998

Phone (608) 231-8550

www.filene.org PUBLICATION #242 (7/11)