Cooperatives

Overview

A cooperative is a favored choice for farmers market owners who value a community-oriented approach and want to share the decision-making process.

Cooperatives are owned by and operated for the benefit of the people who use them. Cooperatives begin with a community of people coming together around a shared goal—such as consumers who want access to more fresh and local foods, farmers and other local vendors who want to market and sell their products together, or a combination of both. Democracy is a defining characteristic, as cooperatives are governed by the principle of “one member-one vote.” This means that no single member can dominate the decision-making process. On the other hand, cooperatives can be more challenging than other types of entities to manage, as achieving agreement on key decisions can be time consuming.

Cooperatives are created by filing paperwork with the state in which the farmers market is located. The cooperative is a for-profit business structure and, as such, taxes are generally owed on any profits. Cooperatives generally receive a “pass-through” taxation designation from the Internal Revenue Service (IRS), which means that the cooperative itself does not pay federal income taxes; rather, the owners (called “members”) themselves pay taxes on any distribution of profits or dividends they receive.

The cooperative’s profits are generally distributed to members based on their use of the cooperative—for example, how much the farmer-members each sell or how much the consumer-members each purchase through the farmers market. This is known as the patronage dividend. Various federal income tax advantages are available for patronage dividends if certain criteria are met. Overall, determining how to fulfill the cooperative’s tax obligations can be rather complex.

Defining Characteristics

Key characteristics that distinguish a cooperative from a sole proprietorship or partnership:

Formation paperwork. Although not complex, steps must be taken to form a cooperative.
Annual maintenance. Annual paperwork, which usually involves an annual fee, is required to maintain the cooperative.
Personal asset protection. A cooperative with proper set-up and maintenance procedures generally offers its owners protection for their personal assets from business liabilities. However, business assets are always available to satisfy business liabilities.
One member-one vote. For a partnership, the majority owner’s vote generally controls the outcome, whereas for cooperatives, every voting member has one equal vote.

Key characteristics that distinguish a cooperative from a corporation:

One member-one vote. Decision-making for corporations is based on number of shares or ownership interests, whereas for cooperatives, every voting member has one equal vote regardless of how much they’ve invested in the operation.
Fundraising may be challenging. The “one member-one vote” structure of a cooperative may deter members from contributing capital to the farmers market because a larger investment does not result in any greater decision-making power as it would for a corporation.
Pass-through taxation. Corporations have to pay taxes on profits, and the individual owners also have to pay taxes on any distribution of profits they receive. A cooperative corporation can avoid this double taxation under certain scenarios through what’s called the patronage dividend under Subchapter T of the federal tax code.
More leniency regarding paperwork. Corporations are required to appoint officers and adopt bylaws, whereas in some states, some cooperatives are not required to do so. However, whether required or not, both cooperatives and corporations should appoint responsible persons and create bylaws to preserve owners’ liability protection.
Greater number and type of owners allowed. Cooperatives are allowed to have an unlimited number of owners, as compared to the S Corporation limit of 100. Cooperatives can have owners that are not real persons, such as trusts and Limited Liability Companies (LLCs); S Corporations cannot.

Key characteristics that distinguish a cooperative from a nonprofit:

Exclusive ownership and control. As with any for-profit business structure, the owners ultimately control all farmers market assets (although responsibility for day-to-day matters can be delegated to volunteers and employees).
Exclusive rights to profits and losses. As with any for-profit business structure, the farmers market owners have exclusive rights to all profits or losses that the farmers market as a whole generates (not the profits or losses generated by individual vendors).
Donations not tax-deductible. As with any for-profit business structure, if the farmers market plans to receive donations from organizations or community members, donations will not be tax deductible for the donor.
For-profit business structure. A farmers market organized as a cooperative is considered a for-profit business whether or not the market actually generates a profit. The perception of being a “business” may be beneficial in some circumstances but not in others.
Limitations on use of volunteers. As with all for-profit business structures, cooperatives are limited in their ability to legally use volunteers and unpaid staff. To learn more, click here.

Key characteristics that distinguish a cooperative from an LLC:

Employment laws are presumed to apply. Generally, LLC members are considered owners and not employees. However, members of a cooperative are often presumed to be “employees” and will often need to comply with employment laws. A farmers market organized as a cooperative may be required to pay its members minimum wage for any hours worked and get workers’ compensation coverage.
Requires strong member base. An LLC can function fine with just one or a few members who take a leading role. The success of a cooperative is based on the participation and engagement of its members. If members are disengaged, the cooperative cannot operate at its most efficient or effective level.

Farmers market owners who are inspired by the underlying community-oriented and democratic principles of a cooperative also have the option of forming an LLC. The LLC’s flexibility allows for a one member-one vote structure and provides the option to be taxed like a cooperative at the federal level (i.e., under Subchapter T of the Internal Revenue Code). One benefit of the LLC is that its flexibility allows for future structural changes as the farmers market evolves. In addition, accountants and tax attorneys tend to be more familiar with the ins and outs of LLCs than cooperatives and therefore LLCs can be easier to set up and maintain.

Getting Started

Creating a cooperative is slightly different than forming any other business entity. Typically, the process begins with a group of people coming together to strategize on how they can address a shared goal. For example, a group of consumers may want to start a farmers market so they can enjoy more convenient options for purchasing locally-grown foods. A group of farmers may want to organize a farmers market to more efficiently sell their products. The people within this initial group are considered the charter members. They set the intention to commit to cooperative principles, including one member-one vote, and a mission to serve the needs of the members.

The group could simply work together to implement their strategy in a cooperative way without officially forming a cooperative entity. In that case they would usually be considered a general partnership for legal purposes. To receive the added benefits and protections of a business entity, the group may decide that it’s in their best interest to file the necessary paperwork in their state to officially form a cooperative. This is what’s generally known as an incorporated cooperative or cooperative corporation.

A) File articles of incorporation

Formally creating a cooperative is accomplished as soon as the articles of incorporation are filed with and accepted by the state. The articles of incorporation are generally a short document, just one or two pages long, that lists very basic information, including the name and purpose of the cooperative, the name and address of the charter members or directors if already designated, and where the cooperative is located. The document will also require that a “registered agent” be named. The registered agent is the person who will officially receive notice of a lawsuit in the event the farmers market is sued. Generally, the articles of incorporation are filed with the state’s secretary of state. Many states provide easy-to-fill forms that can be accessed online, complete with detailed instructions. A few states do not provide a form and may require a paper filing by mail. Most states charge a fee for filing articles of incorporation, which can vary from $100 to $1,000 or so.

After the cooperative files the articles of incorporation and pays the filing fee, the state will review the paperwork and let the cooperative know whether it is approved. Common reasons paperwork may not be approved include submitting a name already in use or not providing the correct fee. Once the paperwork is approved, the incorporated cooperative exists.

B) Create bylaws

Even though most state cooperative statutes do not actually require it, most charter members create bylaws for their cooperative. The bylaws list membership requirements, duties, responsibilities, and other operational procedures that allow the cooperative to run smoothly. While the voting must be based on one member-one vote, other significant issues still need to be addressed. For example, will big decisions be made by majority vote or will a consensus be required? How will profits and losses of the cooperative business be apportioned to the members for tax purposes? What happens if a member leaves or a new member wants to join? Cooperatives that are made up of multiple interests, such as both farmers and consumers, may also want to consider having different classes of members with different rights and duties. The bylaws are the place to specify such details. If no bylaws are in place, the cooperative must abide by its state’s default statutes, which may or may not be in the best interest of the farmers market.

C) Develop a membership application and agreement

In addition to the bylaws, cooperatives may also want to create a membership application and agreement that outlines the benefits and responsibilities for the members. This agreement serves to establish shared expectations so that everyone is on the same page. The membership agreement would detail any membership fees and other expectations, such as any requirements to help with market operations. After all, a cooperative is owned and operated by the members, so each member will likely need to contribute some time and energy to ensure the market runs smoothly. The membership agreement could also include market rules, such as what days and times the market operates, booth sizes, whether the market is an organic or producer-only market, and so on.

The next step is to conduct a charter meeting to formally adopt the bylaws and membership agreement, and to elect a board of directors and officers. The board of directors serves as the main governing body of the cooperative. If the farmers market is small, it may be that the members decide they all want to be on the board. This is referred to as a collective board. If it is larger, they may want to elect just a few members to represent the interests of all members on day-to-day or bigger decisions. Major decisions, such as amending the bylaws and electing the board, are typically made by all the members based on the one member-one vote principle. The cooperative must also have at least three officers: a president, a secretary, and a chief financial officer. The officers are responsible for carrying out specific administrative duties.

D) Follow best business practices

Farmers market owners who create a cooperative should consider two other best business practices. Because a cooperative creates a clear distinction between the business and the business’s owners, it is important that the members (as the owners) maintain that distinction. The most important way owners can maintain that distinction is by keeping a separate bank account exclusively for the farmers market’s activities. Mingling the cooperative’s money with individual members’ personal funds makes it more likely that a court would not respect the cooperative’s existence—and might decide that members’ personal funds are available to satisfy business liabilities. Cooperative members should also keep careful track of their annual obligations to the state. Most states require cooperatives to submit an “annual report,” which is generally accompanied by a fee. Failure to submit the report or pay the fee can result in the cooperative being “dissolved.”

Liability Protection Comes with Incorporation

Incorporated cooperatives provide personal liability protection, which means that the members’ personal assets are not available to satisfy business liabilities. If the business is sued or incurs debt the business cannot pay off, only business assets are available to fulfill that liability. (Limited Liability Companies (LLCs), corporations, and incorporated nonprofits also provide this benefit.) Conversely, if the cooperative is not formerly incorporated with the state, it would be considered a general partnership and members’ assets would be available to fulfill that liability.

Example

Cooperative Liability

Let’s say Abundant Harvest Farmers Market Cooperative sets up a welcome station at the farmers market where the members answer questions about the market, sell gift certificates and T-shirts to customers, and offer free water. One day, as members Andre and Raj were managing the vendor station, a customer went to get some water and tripped over the rope that tied the tent down. The injured person then sued the farmers market for the injury. Because Abundant Harvest is a cooperative corporation, the lawsuit is properly filed against the cooperative itself and not against Andre or Raj individually. Ideally, the cooperative would also have business insurance and would immediately notify the insurance company to take over the lawsuit and pay on any settlement. But, let’s say the market either does not have insurance or the liability exceeds the policy limits. In this case, the injured person might seek the farmers market’s assets. The injured person could claim everything the farmers market owns as compensation for the injury. But, the injured person could not claim things that Andre and Raj or other members of the cooperative possess—such as their houses, retirement funds, vehicles, or other assets. The fact that the members’ personal assets are not available to the injured person is a primary benefit of an incorporated cooperative.

The cooperative’s personal liability protection has limitations

Shielding the member’s personal assets from business liabilities sounds very positive, and it is, but there are limitations to this protection. It’s important to remember that all of the business’ assets are still available to satisfy business liabilities. The farmers market might have assets such as a vehicle, vending supplies, a valuable lease or other resources—these or the money from the sale of them can be taken by creditors. For this reason, a cooperative corporation is not a substitute for business insurance. Business insurance is the only way to protect business assets.

A second limitation to bear in mind is that the personal asset protection is the most solid when cooperative members follow best business practices including keeping personal and business funds separate, properly capitalizing the operation, and fulfilling duties such as annual reports with the state government. Failure to do these things makes it easier for creditors to argue that cooperative members didn’t earn the protections the cooperative can offer.

In certain cases, a member of a cooperative can be held personally liable for a wrongful act that he or she commits during the course of business. For example, if a person commits a crime during the course of business (like fraud), he or she will be held personally liable for it.

Likewise, courts have found that while a cooperative member is not liable for wrongs committed by the cooperative just by virtue of being a cooperative member, if he or she was directly involved in committing the wrong (for example, let’s say Andre of Abundant Harvest Farmers Market Cooperative intentionally placed the rope in front of the person who tripped over it), then he or she may have personal liability for those actions. In other words, having an entity such as an incorporated cooperative (or an LLC, corporation, or incorporated nonprofit) provides the strongest limited liability protection to members with respect to the farmers market’s contractual obligations and debts.

Of course, creditors, banks, and vendors are very familiar with the liability protections offered by an incorporated cooperative. As a result, many banks and creditors will insist on a personal guarantee before they extend credit to a cooperative. Especially if the cooperative has very few assets, lenders are aware that very little will be available to satisfy debts. When an owner personally guarantees a debt or credit, he or she is, of course, personally responsible.

Follow best business practices to preserve personal liability protection

Farmers market owners wishing to rely on the liability protection of an incorporated cooperative should keep these key business practices in mind at all times:

Don’t intermingle finances—keep business bank accounts separate from personal ones.
Consider putting an “operating agreement” in place (where not already required) to demonstrate that the business is legitimate in terms of having a purpose and manner of functioning beyond the day-to-day whims of the owner.
Research any state-specific fiduciary duties (i.e., duty of care and duty of loyalty) of cooperative members. Where applicable, satisfy these duties.
Research and satisfy any other annual state duties such as report filing and fee payments.

Members

The members themselves own and operate the cooperative and have ultimate responsibility for governance. The one member-one vote principle is generally the foundation for how the cooperative is controlled and how major decisions are made. Nevertheless, cooperatives have some flexibility in how the day-to-day governance is structured, including delegating certain responsibilities to specific persons. The cooperative writes down these rules and procedures in the bylaws, which is the document that outlines how the internal affairs of the cooperative are to function. Most if not all states require incorporated cooperatives to have bylaws in place.

Directors and officers

Most states also require that incorporated cooperatives have a board of directors and officers. The board of directors is a group of members who serve as the main governing body. They generally set the goals and strategies of the cooperative. Depending on the size and complexity of the farmers market, the board of directors might even play a role in the day-to-day decisions. Typically, all of the cooperative’s members will elect the board where each member has one equal vote. In some smaller cooperatives, the members may decide that they want all of the members to serve on the board. This is often referred to as a collective. Either way, the bylaws are where the members specify the scope of authority, rights, and responsibilities of the board.

Most states also require incorporated cooperatives to have at least three officers: a president, a secretary, and a treasurer or chief financial officer, which are generally also elected by all of the members based on the one member-one vote principle. The officers take on specific administrative responsibilities which are described in the bylaws. For example, the president generally presides over meetings, can appoint committees, and might have the authority to sign documents on behalf of the farmers market. The secretary is usually responsible for keeping meeting minutes and letting members know about meetings and other events, and the financial officer is typically responsible for managing the finances and usually has the authority to sign checks.

Bylaws

Creating detailed bylaws that outline who has authority to make which decisions is an excellent business practice and reinforces the legal protection offered by an incorporated cooperative. Fundamentally, members are an integral part of the governance of a cooperative. Members control the activities of a cooperative either directly, by voting at meetings, or indirectly, by electing a board of directors and officers.

Succession Planning

It’s important for markets to think proactively about leadership changes before they happen. Keeping files organized and in one place can help create an easy, go-to spot for finding answers about the market and for ensuring continuity during transitions. Learn more about how you can prepare for smooth transitions in Recordkeeping.

Patronage dividends

Cooperatives are eligible to receive some special treatment for federal taxation. A cooperative can reduce its tax exposure by issuing what are known as “patronage dividends” (also referred to as “patronage refunds”) to “patrons,” or members of the cooperative. A patronage dividend is basically a refund to the cooperative’s members who purchase goods from or provide services to the cooperative.

For example, farmer-members may receive a patronage dividend based on the percentage of sales they brought to the farmers market in a given tax year. Or, consumer-members may receive a patronage dividend based on the percentage of products they purchased from the farmers market in a given tax year. Worker-members may receive a patronage dividend based on the hours worked.

When filing its federal tax returns, a cooperative may deduct the amount of the patronage dividends it issues from its gross income. In effect, this income passes through to the individual members, who must report and pay taxes on it on their individual tax returns at the dividend rate. The cooperative itself pays no taxes on these earnings. However, any earnings that the cooperative makes by selling goods or services to nonmembers must be reported on the cooperative’s income tax return. These earnings will generally be taxed at the corporate rate.

Patronage dividends have to abide by very specific requirements. These are set forth in the Internal Revenue Service's (IRS’s) Subchapter T cooperatives tax code. The IRS requires that patronage refunds must be directly associated with the usage or value of business done for that particular patron or member. Identifying income that can be distributed as a patronage dividend and calculating those dividends in a manner that qualifies for the federal tax deduction can be very, very complex. Be sure to seek the assistance of a tax attorney or accountant that is familiar with the cooperative tax code when calculating the amount that each member of the cooperative receives each year.

Note too that cooperatives are not required to issue patronage dividends to all members. It can define classes of members that receive more or less than another class or nothing at all. For example, these classes can be based on membership type, such as farmer-members, consumer-members, and worker-members, or other criteria. However, this can complicate things for tax purposes, so be sure to consult expert advice before designating such classes.

Presuming that patronage dividends are issued correctly, the members who receive patronage dividends must report that income and pay taxes on it through their individual tax returns. The cooperative will need to issue a 1099-PATR, Taxable Distributions Received from Cooperatives to each member who receives at least $10 in patronage dividends, and file all 1099-PATR with the IRS. For Instructions for Form 1099-PATR click here.

If the farmers market earns income from selling products or services to nonmembers, or if it does not properly follow the protocol for issuing patronage dividends, it must prepare and file Form 1120-C with the IRS and pay taxes on all earnings not reported as patronage dividends. Other forms may be required depending on how the farmers market cooperative is structured.

Consumer and farmers’ cooperatives

If the farmers market qualifies as a consumer cooperative or a farmers’ cooperative, it may be eligible for special tax treatment. The farmers market would be designated a consumer cooperative if it mainly provides retail sales of goods or services for its members as opposed to the general public. The members would then be exempt from filing federal taxes. To receive this designation, the cooperative would need to file Form 3491, Consumer Cooperative Exemption Application. If the IRS determines that the exemption applies, the cooperative would not need to issue Form 1099-PATR and the members would have no tax federal obligations for any patronage refunds they receive. State taxes may or may not still apply.

In addition, a farmers market may qualify as a farmers’ cooperative under section 521 of the tax code. Basically, farmers’ cooperatives can deduct dividends paid on capital stock, which are special earnings. They can also deduct distributions of non-patronage income (i.e., income they earn by selling their products or services to nonmembers) that are given to patrons on a patronage basis. To qualify as a section 521 farmers’ cooperative, the farmers market must meet a long laundry list of eligibility requirements regarding how the cooperative is organized and how it operates.

For example, the primary activity must be to market the products of members and other producers, the value of products marketed for members must exceed that of products marketed for nonmembers, substantially all of the cooperative (at least 85%) must be owned by producers who have used the cooperative’s services during the past tax year, and so on. This is not an exhaustive list. A full list of eligibility requirements for a farmers’ cooperative can be found here. Farmers markets are encouraged to consult with a licensed attorney for more information about the eligibility requirements.

To receive the designation of a farmers’ cooperative, the farmers market cooperative will need to apply by filing IRS Form 1028. This is yet another very complex area of the tax code. It’s best to speak to a tax attorney or accountant to clarify the financial implications and to assess whether the farmers market cooperative may be eligible.

The above provides a brief overview of the federal income requirements for a cooperative. A cooperative will also need to abide by state tax obligations, which vary from state to state. The best place to seek guidance is through a tax attorney or accountant, or to contact the state’s department of revenue.

Employer Identification Numbers (EINs) Are Required

An incorporated cooperative is required to get an EIN, regardless of whether it has employees. For more information on EINs, click here.

Governing Law Varies by State

Cooperative members are generally free to make their own rules of operation, through their bylaws and membership agreements. The bylaws are where the members write down how they want the cooperative to be governed. The bylaws should also describe how the cooperative’s profits and losses are to be allocated and distributed to the members, which is particularly significant for tax purposes. If a cooperative has bylaws that do not address a specific topic, then state law lays out basic rules for how the cooperative will run.

Laws governing cooperatives vary from state to state. For instance, states may provide for cooperative formation under a general incorporation statute, a specific cooperative incorporation statute, or under a special Agricultural Cooperative Associations Act. In addition, a number of states, including Colorado, Kentucky, Nebraska, Oklahoma, Utah, Vermont, Wisconsin, and the District of Columbia, allow for the formation of unincorporated cooperative associations similar to limited partnerships. Farmers market owners who are considering forming a cooperative are encouraged to consult with an attorney familiar with cooperative laws in their state to find out more about specific requirements and options.

How is cooperative membership different from nonprofit membership?
Where can I learn more about cooperatives?

How is cooperative membership different from nonprofit membership?

Many farmers markets have market “members,” but the legal meaning of that term is not the same for every type of business structure.

All cooperatives have members. By law, in a cooperative, members are owners and decision-makers (usually through the one member-one vote principle). State law sets out the members’ fundamental rights and obligations.

By contrast, nonprofits may or may not have members. If they do, most of the rights and obligations of members in a nonprofit are determined by the organization’s bylaws, with minimum requirements set out in state nonprofit incorporation law. For more on member nonprofits, see "Members are legally defined as voting members" here.

Back to questions

Where can I learn more about cooperatives?

There are many resources available for learning more about cooperative business structures. The University of Wisconsin–Madison Center for Cooperatives website provides general information about coops, including the Cooperative Principles, a history of coops, specific types of coops, and other important coop topics such as governance, benefits, finance, legal and taxation, among others.

The National Cooperative Business Association CLUSA International supports cooperative enterprises by highlighting the economic impact that cooperatives have on an international scale and has resources, such as coop services, toolkits and a robust webinar archive.

Cooperatives for a Better World provides relevant resources and organizations to look into for specific coop sectors, such as agricultural coops (including the National Council of Farmer Cooperatives) and food coops (including the National Coop Grocers).

CooperationWorks! is a national network of coops (organizational and individual members) and people working in cooperative development. They provide board trainings, business planning, and other resources for new and growing coops.