Cooperatives in the United States

Introduction
What is a cooperative?
Cooperative characteristics
User-benefits
User-owner
User-control
Limted return on equity capital
Reasons for formation
Business structures
Sole proprietorship
Partnership
General corporation
Limited liability company
Cooperative

Introduction

     A cooperative represents a unique way of organizing a business.  In the United States, there have historically been three basic categories of business structures: sole proprietorship, partnership, and corporation.  Cooperatives are a type of corporation.  Corporations other than cooperatives will be referred to here as general corporations.  A newer type of business structure, the limited liability company (LLC), has also recently emerged in the United States (Frederick).  When referring to all business structures other than a cooperative, the term investor-oriented firm (IOF) will be used.  The term IOF will used when referring to any business firm other than a cooperative.

     Cooperatives are in no way restricted to the agriculture industry or to rural areas.  They can be found in many different sectors of the economy, including credit and financial services, housing, utilities, health care, child care, and insurance.  There are more than 40,000 cooperatives in the United States.  These cooperatives provide products or services that serve one out of every four American citizens (Rapp). 

     Cooperatives, like other business entities, are formed out of economic motivation; there is an identified economic need or opportunity to be met.  A cooperative allows a group of people to achieve economic goals.  By combining their resources in a cooperative, a group of people can achieve objectives that they could not do if they acted alone.  Once started, cooperatives compete with and are subject to the same marketplace demands as other businesses.  There are differences among the basic categories of business structures, however, in areas such as legal requirements, governance, and tax treatment.  These differences are examined later on.

What is a cooperative?

     Although there is no universally accepted definition of a cooperative, it is generally described as a business that is organized, owned and democratically controlled by the people who use its products and services, and whose earnings are distributed on the basis of use rather than investment.  The people who use and own the cooperative are referred to as members.   A cooperative operates for the benefit of its members.  A distinct feature of a cooperative organization is that the role of owner and patron are closely connected.  A patron refers to a person who uses the cooperative.  A cooperative is distinct because there is a linkage between the ownership and the users of the business.  A cooperative is also distinct because it distributes its earnings to members according to the level of business conducted with the company rather than the level of equity investment.

Cooperative characteristics

A cooperative has three general attributes that distinguish it from other types of business structures (Cobia; Frederick).  They are:
 

  • the user-benefits principle
  • the user-owner principle
  • the user-control principle.


     As you can see, the emphasis in cooperatives is on the users of the business, who are also the investors.  In IOFs, the emphasis is on the investors, who might never be users of the business.  One of the key features of new generation cooperatives is to increase the emphasis on the role of users as investors of the business.

The user-benefits principle:

     As mentioned, the cooperative operates for the benefit of its members.  Members represent the people who use and own the cooperative.  Earnings that the cooperative generates during the year are distributed to members according to the level of individual business that they conducted with the cooperative during that year.  Earnings are therefore distributed according to the level of use rather than level of equity investment.

The user-owner principle:

     The people who use the cooperative are its owners.  Since they own the cooperative, the members are responsible for providing equity capital in order to finance the cooperativeís operations.  Typically, members finance their cooperative in three different ways: by direct contribution of membership fees or purchase of equity stock, by allowing the cooperative to allocate some of the net income earned from member business to member equity accounts rather than distribute them in cash, and through assessments on some regular basis such as per unit of product sold or purchased.  There are three main methods by which members finance their cooperative: direct investment, retained patronage refunds, and per unit capital retains.  A member is usually required to make some sort of payment when he joins the cooperative.  This direct investment might be the purchase of a membership share or some sort of common or preferred stock.  A patronage refund occurs once the cooperative determines how much earnings it has generated during the past year.  Once the earnings are calculated, they are distributed to members according to how much business that each one has done with the cooperative during the year.  Members who have done business with the cooperative are called patrons.  These distributed earnings are called patronage refunds.  Usually, not all of the patronage refunds are distributed as cash.  Some of the patronage refunds are retained in the cooperative and allocated to membersí equity accounts instead.  Retained patronage refunds occur when the cooperative does not distribute all of the patronage refunds in cash.  Per unit capital retains can be a financing option for cooperatives that market products that are produced by its members.  In such a situation, the cooperative withholds a portion of sales proceeds due to its members. 

The user-control principle:

     Members, through their role as owners, control the cooperative.  They exert their control through voting power.  Members vote to elect a board of directors and may vote in other affairs of the cooperative, such as major proposed policy changes.  Generally, control is based on a one member, one vote principle; each member has only one vote in the affairs of the cooperative, regardless of the level of business that he conducts with the cooperative or the level of equity that he has invested.

Other Cooperative Features:

Limited Return on Equity Capital

     In order to ensure that a cooperative allocates its earnings to members according to the amount of business that they transacted with the cooperative during the year rather than level of equity invested, federal and state statutes limit the level of dividends that can be paid on capital.  Most state agricultural cooperative laws limit dividends paid on capital to a maximum of 8 percent (Vogelsang et al).  Limiting the return on equity helps cooperatives to focus on meeting the members' needs in their role as patrons of the cooperative.

Reasons for Formation

     Although there can also be societal reasons for forming a cooperative, cooperatives are started for various economic reasons.  For instance, the following reasons have given as to why cooperatives are organized:
 

  • Improve bargaining and market power.  For instance, many agricultural cooperatives were formed because farmers felt they were being taken advantage of by merchants and railroad companies.  Because the size of their individual operations was small and there were so many of them, farmers did not have a lot of bargaining power when they negotiated as individuals.  By joining together in a cooperative, farmers could increase their market power when dealing with other parties (Torgerson).
  • Reduce costs.  For instance, agricultural supply cooperatives can help to reduce costs of production inputs by buying in large volumes, thus taking advantage of volume discounts.
  • Obtain products and services that are otherwise unavailable.  The U.S. rural electric cooperative system is a classic example.  In the 1930s, only one out of ten farms had electrical power, mainly because existing companies did not want to provide electricity to rural areas.  Due to the low population density and wide geographical areas, existing companies could not profitably provide power to rural areas at reasonable rates (Cobia).  Cooperatives were formed by rural residents to provide at-cost electric service.  Today, rural electric cooperatives operate approximately half of the electrical lines in the U.S. (Frederick; NRECA).
  • Expand new and existing market opportunities.  For instance, many new generation cooperatives are formed to seek out and service emerging niche markets, such as the demand for bison meat.
  • Improve product or service quality.
  • Increase income.


Business Structures

     In the United States, there have historically been three basic types of business structures used to organize a business: sole proprietorship, partnership, and corporation.  A newer type of business structure known as the limited liability company (LLC) has also recently been introduced.  The type of business structure used to organize a business is based on many factors, including the amount of capital required to finance the business, the number of owners involved, and taxation issues.  Legal and accounting professionals are usually consulted to help choose the appropriate structure.  The different business structures are only briefly described here. 

Sole Proprietorship

      A proprietorship is a business that is owned and controlled by one person.  This is the oldest and most common form of business structure in use.  Typical examples of businesses that are operated as proprietorships include farms and small businesses such as restaurants and flower shops.  This type of business structure is used more dominantly in farming than in any other sector of the U.S. economy (Ingalsbe).  As the sole owner of the business, the proprietor is responsible for providing equity capital and making the key managerial and strategic decisions involved in running the business.  He is responsible for all debts and losses that the business might incur; in other words, the owner bears unlimited liability for the debts and losses of the business.  In return for bearing the risk of loss and providing the equity capital, the owner is entitled to any profits that the business generates.  Profits are taxed once, as part of the ownerís income at the applicable personal tax rate. 

Partnership

     A partnership is a business that is owned and controlled by two or more individuals.  Typical examples of businesses that are operated as partnerships include professional law and accounting firms.  Some farms are also operated as partnerships, most commonly between a parent and child.   The rights and responsibilities of each partner are usually described in some sort of partnership agreement.  This agreement will provide the details as to how business decisions will be made and how voting power is allocated among partners.  It will also stipulate how earnings are to be allocated among partners.  Note, however, that a partnership can be found to legally exist even without a written agreement. 

     As owners, the partners are responsible for providing equity capital to the business.  There can sometimes be two types of partners: general and limited.  Limited partners provide equity capital to the business in exchange for the opportunity to share part of the earnings that the partnership may generate.  Limited partners are not permitted to be involved in managing the business, however, and in return for this passive involvement they are permitted limited personal liability in the debts and losses that the partnership may incur.  General partners provide equity capital and participate in the management decisions that the cooperative undertakes.  Each general partner is personally liable for the debts and losses of the partnership.  Profits of the partnership are taxed once, as part of the partnersí incomes at the applicable personal tax rates.

General Corporation

     A cooperative is a type of corporation.  For our purposes, corporations other than cooperatives are referred to here as general corporations. A general corporation is a legal entity that operates like an artificial person; it has the right to own property, enter into contracts, buy and sell products and services, borrow money, and be held liable for debts and other damages.  Corporations account for most of the business activity conducted in the U.S. (Cobia).  They range in size from small businesses owned by one person to large multinational organizations owned by thousands of people.  Equity capital is raised by selling shares to investors.  Ownership of a general corporation occurs by purchasing shares of the corporationís stock.  Owners are known as shareholders.  The amount of votes that each shareholder receives is tied to the number and class of stock that he or she owns.  In contrast to a sole proprietor or general partner, shareholders of a general corporation have limited liability for any losses or debts that the business incurs; they are only liable to the extent of the equity amount they have invested in the business.  In return for providing equity to the corporation, shareholders are entitled to receive any dividends that the corporation may distribute.  The amount of dividends each shareholder receives is based on the number and class of shares that he or she owns.  Profits of a general corporation are taxed twice, once at the corporate level at the applicable corporate tax rate, and again at the shareholder level when profits are distributed as dividends, at the applicable personal tax rate. 

Limited Liability Company

     A limited liability company (LLC) is a newer type of business structure used in the U.S. that combines features of the other structures.  In particular, the LLC combines the single tax treatment of a partnership with the limited liability for owners found in a corporation.  Similar to a cooperative, the owners of an LLC are referred to as members. The rights and responsibilities of the members are described in an operating agreement. This agreement will provide the details as to how business decisions will be made and how voting power is allocated among members.  The LLCís members are usually the ones who provide equity capital to the business.  The operating agreement stipulates how earnings are to be allocated among members.  In an LLC, earnings (or losses) are usually allocated according to the memberís level of equity investment.  Similar to the owners of a corporation, liability of the LLCís members is usually limited to their level of equity investment in the business.  Similar to the partners of a partnership, the earnings of an LLC are taxed once, at the member (owner) level.  The LLC does have the option, however, to elect to be taxed as a general business corporation (Frederick).

Cooperative

     As mentioned, a cooperative is a particular type of corporation.  Cooperative members, like shareholders of a general corporation, have limited liability for the losses and debts of the business.  Their liability is limited to the amount of equity the member has invested in the cooperative.  The primary difference between a cooperative and the other types of business structures described here relate to ownership and the distribution of earnings.  The owners of a cooperative are the people who use its products or services in some capacity: they are the patrons of the business.   In a sole proprietorship, partnership, and general corporation, the owners might never be patrons of the business.  For instance, a person might own shares in a general corporation such as Archer Daniels Midland, and thus be an owner of the company.  That same person, however, might never conduct any business with ADM.  In contrast, a person might be a member (and therefore an owner)of a cooperative such as Cenex Harvest States.  That same person will use the services provided by the company.  For instance, he may market his grain through the cooperative.  Thus, a cooperative is distinct because there is a linkage between the ownership and the users of the business.  A cooperative is also distinct because it distributes its earnings to members according to the level of business conducted with the company rather than the level of equity investment.

References

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