Legal Perspective
December 15, 2006
BY Todd J. Guerrero and Mark J. Hanson
As biodiesel entrepreneurs and aficionados, you likely know that many of the early biofuels projects started as value-added, farmer-owned cooperatives. These are entities where farmers, as owners of the business, add value to their crops by delivering to the cooperative, which transforms the commodity into a biofuel sold in the marketplace. By transforming the commodity into biofuels, the farmer-owned cooperative was seeking a higher return than was likely by simply selling the raw commodity. While the cooperative business structure is being used less in biofuels projects than before, it nonetheless remains an important component of the biofuels industry. To many nonfarmers, however, the way in which cooperatives work remains somewhat of a mystery.
What is a Cooperative?
While there is no single all-encompassing definition, the tax code states that any corporation "operating on a cooperative basis" may claim status as a cooperative. Somewhat surprisingly, the tax code doesn't define what it means to be "operating on a cooperative basis." Based on various court and Internal Revenue Service rulings, in order for a company to be operating on a cooperative basis, the majority of the company's earnings must originate from business that is "done with or for each patron."
In the context of biofuels cooperatives, this has traditionally meant that members of the cooperative (i.e., its patrons) have agreed to deliver soybeans or corn to the cooperative, which then converts the grain into biofuels. The income from the sale of the biofuels is considered to be "patronage-sourced income," since the source of income came in large part from the delivery of the grain to the co-op by its farmer-patrons.
Cooperative Advantages
Operating as a cooperative has certain operational advantages in the context of the biofuels industry. A primary advantage is that it assures availability and access to feedstocks. As the biofuels industry moves toward cellulosic feedstocks, a dedicated feedstock supply will become increasingly important. With a farmer-owned cooperative, the member-owners are obligated by contract to deliver feedstock to the cooperative. While the cooperative is typically required to pay market price for the feedstock, its assured supply usually makes the cooperative better able to address feedstock shortages, price volatility or both.
A second, and probably the primary, advantage to the cooperative structure versus other corporate business structures is favorable tax treatment. Corporations are subject to double taxation. The corporation is taxed first on its own taxable income, and second when the earnings and profits are distributed to shareholders, who incur tax liability on that income. In a cooperative enterprise, however, earnings are considered to "flow through" the cooperative to its patron members as "patronage refunds," leaving no taxable income to be paid by the cooperative. Instead, the tax is paid by the member patron, but not the cooperative.
The single tax principle applies only if income sources and a distribution of earnings are cooperative in nature. That is, in the context of biofuels cooperatives, the income must have some relationship with the business done with or for each patron. It also requires that the cooperative distribute its earnings to its members based not on the amount or proportion of the members' equity-cooperative basis investment in the firm, but instead based on the annual amount of grain it delivered to the cooperative relative to amounts of grain delivered by other members.
Mark Hanson and Todd Guerrero are members of the Agribusiness & Energy Practice Group of Lindquist & Vennum PLLP, a leading provider of legal assistance on biofuels projects throughout the country. For more information, visit www.lindquist.com or call (612) 371-3211.
What is a Cooperative?
While there is no single all-encompassing definition, the tax code states that any corporation "operating on a cooperative basis" may claim status as a cooperative. Somewhat surprisingly, the tax code doesn't define what it means to be "operating on a cooperative basis." Based on various court and Internal Revenue Service rulings, in order for a company to be operating on a cooperative basis, the majority of the company's earnings must originate from business that is "done with or for each patron."
In the context of biofuels cooperatives, this has traditionally meant that members of the cooperative (i.e., its patrons) have agreed to deliver soybeans or corn to the cooperative, which then converts the grain into biofuels. The income from the sale of the biofuels is considered to be "patronage-sourced income," since the source of income came in large part from the delivery of the grain to the co-op by its farmer-patrons.
Cooperative Advantages
Operating as a cooperative has certain operational advantages in the context of the biofuels industry. A primary advantage is that it assures availability and access to feedstocks. As the biofuels industry moves toward cellulosic feedstocks, a dedicated feedstock supply will become increasingly important. With a farmer-owned cooperative, the member-owners are obligated by contract to deliver feedstock to the cooperative. While the cooperative is typically required to pay market price for the feedstock, its assured supply usually makes the cooperative better able to address feedstock shortages, price volatility or both.
A second, and probably the primary, advantage to the cooperative structure versus other corporate business structures is favorable tax treatment. Corporations are subject to double taxation. The corporation is taxed first on its own taxable income, and second when the earnings and profits are distributed to shareholders, who incur tax liability on that income. In a cooperative enterprise, however, earnings are considered to "flow through" the cooperative to its patron members as "patronage refunds," leaving no taxable income to be paid by the cooperative. Instead, the tax is paid by the member patron, but not the cooperative.
The single tax principle applies only if income sources and a distribution of earnings are cooperative in nature. That is, in the context of biofuels cooperatives, the income must have some relationship with the business done with or for each patron. It also requires that the cooperative distribute its earnings to its members based not on the amount or proportion of the members' equity-cooperative basis investment in the firm, but instead based on the annual amount of grain it delivered to the cooperative relative to amounts of grain delivered by other members.
Mark Hanson and Todd Guerrero are members of the Agribusiness & Energy Practice Group of Lindquist & Vennum PLLP, a leading provider of legal assistance on biofuels projects throughout the country. For more information, visit www.lindquist.com or call (612) 371-3211.
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