What Are Cooperative Distributions and How Are They Taxed?

Cooperative distributions are payments a cooperative makes to its members out of the surplus generated by their business with the organization, allocated in proportion to each member’s patronage rather than by shareholding, and under Internal Revenue Code Subchapter T (sections 1381 through 1388) they are generally taxed only once: either the cooperative deducts the distribution and the member reports it as income, or the cooperative pays tax on the retained earnings and the member reports nothing until the money is eventually paid out in cash. Whether that single tax hits this year or years later depends on the form the distribution takes.

Patronage Dividends

The most common cooperative distribution is the patronage dividend. Under section 1388, a payment qualifies as a patronage dividend only if it is based on the quantity or value of business the member did with the cooperative, paid under an obligation that existed before the cooperative earned the income, and calculated by reference to net earnings from business with members.¹ That pre-existing obligation usually sits in the articles of incorporation or bylaws.

Allocation is proportional to use. A grain elevator distributes based on bushels delivered. A purchasing cooperative allocates by the dollar value of supplies each member bought. Payments funded by business with nonmembers do not count as patronage dividends, and neither do amounts drawn from earnings attributable to other patrons who received less for substantially identical transactions.¹

Per-Unit Retain Allocations

The second type of distribution is the per-unit retain allocation, which applies to products marketed through the cooperative. Unlike a patronage dividend, a per-unit retain is a fixed amount per unit of product handled, set by agreement between the cooperative and the member without reference to net earnings.¹ A dairy cooperative might withhold a set dollar amount per hundredweight of milk delivered, whether or not the year was profitable.

Because per-unit retains are detached from earnings, cooperatives can use them to raise equity in lean years and can make allocations before the fiscal year closes. They also avoid arguments about whether the source income was patronage or nonpatronage, since per-unit retains can only involve funds from marketing a member’s products.²

Qualified and Nonqualified Written Notices

When a cooperative keeps part of a distribution as working capital instead of paying it all in cash, it issues a written notice of allocation (or, for per-unit retains, a certificate) documenting the amount. Whether that notice is “qualified” or “nonqualified” drives the entire tax timeline.

Qualified Notices

A written notice of allocation is qualified when the member has consented to include the full face value in taxable income for the year received, even though most of the money stays with the cooperative.¹ For patronage dividends, there is also a 20 percent rule: at least 20 percent of the total dividend must be paid in cash or by qualified check, or the notice cannot be qualified regardless of consent. Qualified per-unit retain certificates carry no comparable cash requirement.²

Consent is usually built into the cooperative’s bylaws, so that membership itself supplies consent once the member has received a copy of the relevant bylaw. A member can also sign a written consent or endorse a qualified check within 90 days after the close of the payment period.¹

With a qualified notice, the cooperative deducts the full amount in the year the patronage occurred, and the member picks up the full amount as income that same year, even if only 20 percent arrived as cash.

Nonqualified Notices

A nonqualified written notice is one the member has not consented to include currently. The cooperative gets no deduction when it issues the notice; the retained earnings stay in the cooperative’s taxable income. The member reports nothing until the cooperative later redeems the notice in cash, at which point the member includes the redemption amount in income and the cooperative claims a deduction under section 1383’s special computation.³

How the Cooperative Is Taxed

Subchapter T rests on a single-tax principle for patronage-sourced income: it is taxed at the cooperative level or the member level, but not both. The cooperative reduces its taxable income by qualified patronage dividends and qualified per-unit retain allocations paid during the payment period, including cash payments, the face value of qualified notices, and other property distributed to members.⁴ Section 521 farmers’ cooperatives can also deduct dividends on capital stock and certain nonpatronage distributions paid on a patronage basis.

The payment period begins on the first day of the cooperative’s taxable year and ends on the fifteenth day of the ninth month after year-end.² For a calendar-year cooperative, that means September 15 of the following year. Distributions made after the payment period lose their deduction for the year the patronage occurred.

Income from sources outside member business, such as investment returns, rental income, or transactions with nonmembers, does not get single-tax treatment. Non-patronage income is taxed at the cooperative when earned and taxed again at the member when distributed. That double layer is why cooperatives structure operations to keep as much income as possible on the patronage side.

How Members Are Taxed

A member includes in gross income the amount of any qualified patronage dividend paid in cash, any qualified written notice of allocation, any other property received, and any qualified per-unit retain certificate. Receive a $5,000 patronage dividend as $1,000 cash and a $4,000 qualified notice, and the full $5,000 is income this year. Nonqualified notices and nonqualified per-unit retain certificates stay off the return until the cooperative redeems them for cash.⁵

Personal Use Is Not Taxable

Patronage dividends tied to purchases that are personal, living, or family expenses are not taxable to the member.⁵ The refund of part of a nondeductible household purchase price is not income. A consumer’s rebate from an electric cooperative or a credit union is generally tax-free. A farmer’s dividend from a grain marketing cooperative, by contrast, is ordinary business income.

Form 1099-PATR

The cooperative files Form 1099-PATR for any member who received at least $10 in patronage dividends or other taxable distributions during the year.⁶ Boxes on the form split the distribution into its parts:

Box 1: patronage dividends paid in cash, qualified written notices, and other property.
Box 2: nonpatronage distributions from section 521 farmers’ cooperatives.
Box 3: per-unit retain allocations paid in cash and qualified certificates.
Box 4: federal income tax withheld through backup withholding.
Box 5: redeemed nonqualified written notices and per-unit retain certificates.
Box 6: the member’s share of the section 199A(g) deduction passed through.

Farmers report cooperative distributions on Schedule F. Other business owners use Schedule C. The reported amounts should line up with the 1099-PATR; mismatches are a common audit trigger.⁶ If the member has not provided a valid Taxpayer Identification Number, the cooperative must withhold 24 percent as backup withholding, shown in Box 4 and claimable as a credit on the member’s return. Filing Form W-9 with the cooperative at enrollment avoids the issue.

The Section 199A(g) Pass-Through

Specified agricultural or horticultural cooperatives, meaning those engaged in manufacturing, producing, growing, extracting, or marketing agricultural or horticultural products, can claim a domestic production activities deduction under section 199A(g) and pass part of it through to patrons.⁶ The allocated deduction cannot exceed 9 percent of the qualified payments reported in Box 7. The cooperative has to designate the deduction in a written notice within the payment period and reduce its own section 1382 deduction by the amount passed through. C corporations that are not themselves specified cooperatives cannot claim it.

Getting Retained Equity Back

When distributions come as notices rather than cash, members eventually receive that money through a redemption. How soon depends on the method the cooperative’s board has adopted, and redemption can take years.

Revolving fund: the cooperative retires the oldest equity first on a fixed revolving cycle, keeping equity concentrated among current, active patrons.
Percentage-of-all-equities: a set percentage of all outstanding allocated equity is redeemed each year, distributed proportionally rather than by age.
Base capital plan: the cooperative calculates a required equity holding for each member based on recent patronage; those above their base receive redemptions, those below may need to invest more.
Special redemptions: outside the normal cycle for events such as death, retirement or reaching a set age, leaving the service area, or documented financial hardship.

The board sets timing and method within the cooperative’s bylaws and its financial position.⁷ Redemption of a qualified notice is not a taxable event, because the member already reported the income when the notice was issued. Redemption of a nonqualified notice is fully taxable in the year the cash arrives.

Which Cooperatives Subchapter T Covers

Subchapter T applies to section 521 farmers’ cooperatives and to any other corporation operating on a cooperative basis, a category broad enough to include purchasing cooperatives, worker cooperatives, and housing cooperatives.⁸ Three types are excluded even when they operate cooperatively: mutual savings banks, insurance companies subject to Subchapter L, and cooperatives furnishing electric or telephone service to rural areas. Those organizations have their own tax provisions elsewhere in the code, so the rules described here do not govern their distributions.

1
Office of the Law Revision Counsel. 26 USC 1388 – Definitions; Special Rules
2
United States Department of Agriculture. Distributions, Retains, Redemptions, and Patrons’ Taxation
3
Office of the Law Revision Counsel. 26 USC 1383 – Computation of Tax Where Cooperative Redeems Nonqualified Written Notices of Allocation
4
Office of the Law Revision Counsel. 26 USC 1382 – Taxable Income of Cooperatives
5
Office of the Law Revision Counsel. 26 USC 1385 – Amounts Includible in Patron’s Gross Income
6
Internal Revenue Service. Instructions for Form 1099-PATR
7
United States Department of Agriculture. Managing Your Cooperative’s Equity
8
Office of the Law Revision Counsel. 26 USC 1381 – Organizations to Which Part Applies