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Sources Of Permanent Capital For Cooperatives

Permanent capital provides financial stability for cooperatives. It consists of all the capital reserves that are unallocated to members. Unallocated equity can be defined as: ”The share of net margin (savings) from member and/or non-member business retained by the cooperative for operating purposes. This is considered permanent capital in that there is no obligation to redeem this equity to current or past members unless the cooperative is dissolved” (University of Wisconsin Center for Cooperatives).

Such permanent reserves provide a financial buffer during times of economic recession without having to impair member equity. They create a stronger balance sheet for obtaining loans or lines of credit. Cooperatives pay income taxes on the earnings retained for these reserves.

Different types of cooperatives will have widely varying needs for capital. Cooperatives also have different methods of acquiring permanent capital depending on their type and scope of business operations. This brief review of how different types of cooperatives access capital outside of member equity indicates its importance for financial stability.

How Cooperatives Raise Permanent Capital

Cooperatives that require members to purchase a share of membership stock have that financial asset as permanent capital. It is not redeemed back to the member until they leave the cooperative. Yet, these membership stock purchases are often relatively small, although some cooperatives require a substantial direct investment from members (Frederick 44-1).

Another source of permanent can be obtained from nonqualified member equity. Nonqualified equity is from income that, although designated for potential distribution to members, a cooperative is required to pay taxes for the year it was earned.

In later years when nonqualified equity is redeemed, members incur the taxes, and the cooperative receives a credit for its earlier tax payments. Cooperatives may retain some of this nonqualified equity as permanent capital and are not credited for the taxes they had paid on that amount. On qualified equity, members, but not the cooperative, are responsible for paying taxes for the year it is allocated. All qualified equity must be distributed to members at some point in time (Frederick 44-1).

Essentially, any resource that generates revenue not derived from member purchases or work, can provide permanent capital (Frederick 44-2). One example is leasing land or facilities during an offseason from members’ use to renters outside of a cooperative’s operations. Cooperatives can have revenue from service fees, interest income not derived from member patronage, or from subsidies related to clean energy or environmental practices.

For many types of cooperatives, the most common source of permanent capital is retained earnings from nonmember business. Retail consumer cooperatives often have significant revenue from nonmember customers. Agricultural cooperatives have input supply sales, as well as farm product marketing services to nonmembers domestically and internationally. What is considered nonmember business for purposes of taxation can be different depending on the type of cooperative.

Some, or all earnings from nonmember business may not be retained and instead distributed to members. Distributed nonmember earnings to members are taxed twice, paid by the cooperative and again upon distribution to members.

Nonmember Investors and Preferred Stock

Cooperatives without nonmember business find it more difficult to raise permanent capital. Credit Unions are one example. In recent years they have been allowed to obtain subordinated debt from nonmember accredited investors who provide permanent capital as an unsecured type of investment (NCUA). Each issuance, based on a credit union’s member lending activity, provides capital to support more lending for members. Renewed sources of this capital become readily available with a portfolio of new member loans and subsequent issuances.

In recent years several cooperatives with special financial demands have offered preferred stock to the public as a means of increasing their permanent capital. Nonmember preferred stock investors in cooperatives have no voting or any other governance rights.

There are different ways to offer preferred stock to members and nonmembers. The largest cooperative in the US, CHS, has listed preferred shares on the Nasdaq market since 2007. Its preferred stock market capitalization is about $328 million. Unlike most cooperatives, CHS has a complex business and substantial need for permanent capital.

Smaller cooperatives operating in sectors other than agriculture have also offered preferred stock. An example is the Butte Food Co-op in Montana. Their preferred stock is available to members and nonmembers in their community. In contrast to a large offering on the Nasdaq exchange, access can be provided locally either through the cooperative or managed by a local intermediary such as an accounting firm.

Using preferred stock has benefits but can involve risks of losing member control (GEO Collective, 2023). The worker cooperative, Equal Exchange, issues preferred stock to members and nonmembers but has safeguards for sustaining cooperation. It has a provision in its bylaws that if the cooperative were to be sold, it cannot be for profit. If a sellout were to occur, proceeds would be distributed to other cooperatives. This safeguard is like that used by many European worker cooperatives.

Collective Reserves from Members and Community

Worker cooperatives in some European countries often source permanent capital from member earnings and because they are designated as indivisible reserves, they are taxed at lower rates. Indivisible reserves are transferred to other cooperatives or local communities in the event of demutualization or closure. Some of the background to this approach is discussed in a GEO article (GEO 2024). Under current US tax laws retained earnings for a reserve are taxed. Yet prior to 1951, farmer cooperatives were not taxed on earnings retained for a capital reserve. This policy was intended to support their financial stability and growth (Pachel).

In recent years seventeen states and Puerto Rico have enacted worker cooperative incorporation statutes that provide authority for a permanent, collective reserve, as documented by Meegan Moriarty, Rural Development, USDA. As stated in the Massachusetts statute, the first to be enacted by a state: “The articles of an organization or by-laws may authorize assignment of a portion of retained net earnings and net losses to a collective reserve account. Earnings assigned to the collective reserve account may be used for any and all corporate purposes as determined by the board of directors.”

Other states have adopted an unincorporated approach based on standards developed in 2007 to enact A Uniform Limited Cooperative Association. This approach is in addition to the alternative of organizing cooperatives as Limited Liability Corporations (LLCs). When cooperatives organize as LLCs it can be difficult to protect against investors gaining control of a cooperative even though they are not participants or patrons of the business. In a Uniform Limited Cooperative Association, participating members and patrons have embedded statuary protections that make it easier to retain control.

Public interest in expanding the domain of investment in worker cooperatives by nonmembers without issuing preferred stock has led to relatively recent legislation in cooperative incorporation statutes. In 2015 the California Assembly Bill 816 provides for worker owned businesses to be established in their bylaws as capital account cooperatives. Such worker cooperatives can establish unallocated capital accounts that may include nonmember community investors. A board of directors determines how the unallocated reserves are to be used.

Nonmembers may invest in capital shares if they reside in what is defined as the community of a worker cooperative so that registration with the Securities Exchange Commission is not required. In contrast to preferred stock, investments in an unallocated capital account are not obligated to pay dividends but may do so. Such investments by community investors are often called “patient capital.”

Limiting Nonmember Workers

Worker cooperatives have mostly relied on members as a source of permanent capital. Such cooperatives have limited access to earnings from the work of nonmembers. They often have new employees work in an apprentice capacity to determine if they are good prospects for membership but including nonmembers as employees over long periods of time is not widely practiced. Yet, cooperatives such as those in the Mondragon, Spain have used nonmember workers for more than just apprenticeship considerations (GEO 2022). In some cases, there are exigencies that need nonmember workers. But most worker cooperatives either do not have nonmember employees or allow them to a very limited extent.

The use of nonmember workers is controversial. The importance of having only members as workers in a cooperative business goes back to the principles articulated by Phillipe Buchez in 1831 (Lambert). In his statement of cooperative principles, he established indivisible reserves to be annually financed from member earnings. He offered an additional principle on the importance of limiting nonmembers in a worker cooperative. In his words: “The association would not be allowed to employ non-affiliated labor to its account for more than one year; at the end of this time admission of as many new workers as the increase of activity would necessitate, would become compulsory.” In other words, nonmembers may work in a cooperative for one year and are then either admitted as members or let go.

Summary

Several initiatives for increasing access to permanent capital for cooperatives emerged in recent decades. Credit Unions have started using subordinated debt based on their member lending activities. Since 2007 several cooperatives across all sectors have offered preferred stock to members and nonmembers. Recent cooperative incorporation statutes have provided for investments by community nonmembers into collective reserves without requirements of dividend payments.

For almost two centuries, worker cooperatives in Europe have held indivisible reserves and in recent decades receive favorable tax treatment. Lower taxes are justifiable and, in the US, would incentivize cooperatives across all sectors to hold indivisible reserves.

There will continue to be innovations in business organization and in new types of investment products. As cooperatives seek access to permanent capital, they must maintain adequate safeguards for member ownership and control.

Acknowledgement

Meegan Moriarty, Rural Development, USDA provided comments on an earlier draft related to defining permanent capital, taxation, and the use of the Uniform Limited Cooperative Association.

References

Frederick, Donald (2013) Income Tax Treatment of Cooperatives: Background. USDA/Rural Development, CIR 44-1.

Frederick, Donald (2005) Income Tax Treatment of Cooperatives: Patronage Refunds and

Other Income Issues. USDA/ Rural Development, CIR 44-2.

GEO Collective (September 7, 2022) An interesting conversation about Mondragon.

GEO Collective (April 3, 2023). Should a Worker Co-op Have Investor Owners?: A GEO Livestream Clip. Grassroots Economic Organizing (GEO). https://geo.coop/articles/should-worker-co-op-have-investor-owners.

GEO Collective (May 27, 2024) Benefits of Indivisible Reserves and their Connection to Communities.

Lambert, Paul (1963) Studies in the Social Philosophy of Co-operation. French edition published in 1959, English edition published by Co-operative Union, LTD., UK and Cooperative League of the USA, Chicago.

NCUA, National Credit Union Administration (March 2023) NCUA Board Approves Final Subordinated Debt Rule to Support ECIP Participation.

Pachel, Israel (1970) The Organization and Operation of Cooperatives. Joint Committee on Continuing Education of the American Bar Association, 4th edition.

University of Wisconsin Center for Cooperatives. Co-op Glossary. https://uwcc.wisc.edu/about-co-ops/co-op-glossary/

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