Journal Entry (Reflection)

ARE 132: COOPERATIVE BUSINESS ENTERPRISES

Prof. Kiesel

Allocation of Losses Like IOFs, cooperatives sometimes incur

operating losses Too many years of losses can force a co-op

to become bankrupt Ways to allocate losses

Charge against past allocated equity Charge against unallocated equity (most

common) Cash collection (send bills—very rare)

Co-op Member Payment Methods

Members of supply & retail cooperatives usually receive refund checks after fiscal year closing

Members of marketing cooperatives are also paid for delivering raw product to the cooperative, which processes and markets it Various ways that members of marketing

co-ops can be paid for their deliveries

Co-op Member Payment Method: $ on Delivery

 Many co-ops, especially grain & oilseed co- ops, pay cash for commodities on delivery

 Raw product is then processed & sold  Net income remaining after expenses is

refunded to members  Provides immediate cash payment to

members  Co-op takes title & assumes risk

Commercial Market Value (CMV)

Approximates price paid if commodity sold directly to Investor Owned Firm (IOF)

Relatively common for fruit & veg marketing co-ops

Some cooperatives will pay CMV upon delivery

CMV is reported as part of “cost of goods sold” and/or used to compare with co-op’s return

When crop is processed & gets sold out, net income determined & patronage return paid

Back to Economic Theory

Paid as if price taker and selling to IOF firm

 Usually maximizes member delivery payment  Usually minimizes co-op net income &

patronage returns--close to breakeven pricing  Requires co-op to have significant operating

capital  Puts co-op at risk for losses

Commercial Market Value (CMV) (Cont.)

Key Concepts: Marketing Margin

 Marketing margin will typically include the costs of the following:  Assembly of the raw products from the farm  Processing  Distribution  Retailing

 Alternatively, break margin down into costs for inputs (e.g. labor, capital, energy, materials, etc.) and mark up

𝑃𝑃𝑡𝑡∗ = (𝑃𝑃𝑟𝑟 -M)/K 𝑃𝑃𝑡𝑡∗ as maximum farm price

𝑃𝑃𝑟𝑟 as retail price

M as margin

K as conversion factor

1. Margin Reduction

 Two possible ways to lower margin: 1. Cooperative might face lower prices for some

inputs used in marketing 2. Cooperative might market the product more

efficiently than presently done  Three advantages of internalizing transactions

1. Internalization creates common incentive among parties

2. Disputes within organizations can be resolved quickly

3. Information flows more freely

2. Market Power Avoidance  Opportunistic behavior results in trading partners

attempting to exercise short-term market power over farms  Monopsony power  Monopoly power  Oligopoly power  Price discrimination

 Potential leverage exercised by bargaining associations (e.g. Cooperatives): 1. Play marketing firms off against each other, causing them

to bid up prices 2. Threaten to withhold product from private handler by

forming cooperative to directly process and sell product

3. Influence Consumer Prices

 Two possible avenues: 1. Cooperative might be able to restrict flow of farm

product to the market 2. Cooperative might be able to improve quality of the

finished product or offer value-added products

Oversupply(relative to demand) at heart of American agriculture’s financial dilemma in many markets

Marginalization

Demand to Wholesaler

MR to Wholesaler

Double - Marginalization

Marketing Year

 Agricultural crops processed as inputs/ingredients for (food) products

 Value of crop not known at harvest but becomes known after product sold to consumer (before new harvest)

 12 month period (often begins Sept 1 and ends Aug 31) Advance payment at harvest Second payment as value becomes known

(4-6 month) Final payment at end of year

Pool Payments  Key elements of pooling:

Sharing of risks, expenses & revenues Payment of an average price Possible adjustments for product quality, and for

time & location of delivery

 Distributions of patronage refunds to specific pools for members’ deliveries

 Unique to ag marketing cooperatives  Used extensively by fruit, vegetable, nut, rice & dairy

cooperatives  Co-op can have single or multiple pools

Operating Procedures for Pooling

 Producers sign marketing contracts for their crops—often with an “exclusive” clause

 Contracts transfers all authority over marketing decisions from producer to co-op

 Initial advance payment to producer upon delivery of product

 When most or all product sold, close pool; Determine total value, including estimated value of remaining inventory

Operating Procedures for Pooling (Cont.)

 Operating, processing & administrative expenses are allocated & deducted

 Any excess over previous payments is then distributed to members

 Capital retain is withheld

Cooperative Taxation: Single Taxation

Co-ops use a single tax principle  Either the co-op or patron pays the tax, usually

not both Treatment is similar to partnerships, LLCs  In contrast, IOF corporations are taxed

twice  First at the corporate level, and again by

stock holders on dividends (or capital gains)  IRS uses the “Pass Through” taxation

theory  It assumes the co-op is an extension of the

members’ businesses—farm, ranch, hardware store, grocery store, etc.

Cooperative Taxation: Sub-Chapter T

 Sub-Chapter T of the Internal Revenue Code applies to “any corporation operating on a cooperative basis”

 Sub- Chapter T allows normal business deductions and certain patronage refunds & per-unit retains to reduce the co-op’s taxable income

Qualifying for Subchapter T

Requires “Operating on a cooperative basis” : Subordination of capital Democratic control Earnings shared on patronage basis Additional requirements: Treat all patrons alike 50%+ of business done with members

Subchapter C Firm Tax Illustration

Pre-tax Net Income $1,000,000

Corporation Tax @ 40% (400,000)

After-tax Net Income 600,000

Dividend 600,000

Personal Tax @ 34% 204,000

Net Net to Shareholders 396,000

Cooperative Tax Illustration

Pre-tax Net Income $1,000,000

Patronage (1,000,000)

Taxable Income 0

Patronage Refund 1,000,000

Personal Tax @ 34% 340,000

Net Net to Members 660,000

Sexton an Sexton (1986): Part I

Longstanding debate if tax treatment is unfair as other corporations are subject to double-taxation

Traditional defense: Stresses non-profit character Patronage earnings are not profit

distributions but merely year end price adjustments

Subchapter T tax treatment is fair and consistent with the rest of the tax code

Sexton an Sexton (1986): Part I

 Comparison to corporate taxes needs to consider special deductions  Exceptions for capital gains

60% of long-term not offset by losses excluded from taxable income

 Exclusions for dividends received Exclude up to 85% of dividends received

 Comparison to S corporations (Sole proprietorship, and partnerships) rather than operation at cost argument (corporate taxes as exception rather than norm)

 Comparison to vertically integrated corporations  Internal transactions (Patronage) are not taxed

Sexton an Sexton (1986): Part II

Has the cooperative tax advantage been harmful to the economy?

1)Has cooperatives’ market power shown an alarming rate of increase?

2)Do co-ops that have a large market share use their size to harm consumers and the economy? Could they if they wanted to?

There is no basis to the contention that co- op’s tax treatment has or will be harmful to the economy.

Sexton an Sexton (1986): Part II

Statistical evidence does not indicate pattern of market power Market share of 4 largest cooperatives modest

(and smaller than percent of four largest non- cooperatives in Agricultural supply, and other industries)

Not supported by data (other than federally supported marketing orders) Many procompetitive effects (e.g. forming

cooperative when they face monopoly, or when no for-profit will serve the market)

Market Concentration For Agricultural Input Industries (Fuglie et al 2012, and ETC group 2013)

Sexton an Sexton (1986): Part II

Statistical evidence does not indicate pattern of market power Restricting membership and controlling output not

supported by data (with exceptions, e.g. Blue Diamond, federally supported marketing orders) Limited evidence of price discrimination

Sexton an Sexton (1986): Part II

Statistical evidence does not indicate pattern of market power Restricting membership and controlling output

not supported by data (with exceptions, e.g. federally supported marketing orders) Limited evidence of price discrimination

Sexton an Sexton (1986): Part II

Statistical evidence does not indicate pattern of market power Farmers form cooperatives when

they face market power or no for profit-enterprise will service the market

Summary: Taxes

 Subchapter T applies to any type of co-op; it enables co-ops to practice “pass through” income

 As public policy, Subchapter T provides favorable treatment of co-ops (as compared to corporations), Tax rules reinforce co-op principles Tax treatment is fair and consistent with tax code

 Tax advantage contributed to cooperative growth, but not at expense of the economy overall