In the past few years there seems to be more interest in issuing non-qualified written notice of allocation (nonqualifies). Some regional cooperatives have been issuing nonqualifies to its members. The local cooperative must decide how it is going to record these nonqualified written notice of allocation and how they should be handled in its local patronage allocation. In this article I will provide some background as to the difference between a qualified written notice of allocation and non-qualified written notice of allocation. Each cooperative should study their own situation with their tax advisor or auditor before deciding whether to issue nonqualified written notice of allocation.

Each year a cooperative determines its net earnings. After reviewing its capital needs, it decides the amount of patronage refunds to distribute to its patrons. The cooperative has three options when distributing patron refunds: Cash, qualified written notice of allocation and non-qualified written notice of allocation. Through the patronage refund distribution, the cooperative accomplishes the single tax treatment. The central feature of cooperatives federal income tax liability is that net margins are not taxable to both the cooperative and the patron if they are distributed or allocated to the patrons on the basis of business done with the cooperative

Subchapter T contains a definition of a patronage refund. The code uses the term "patronage dividends" instead of "patronage refunds". The code defines a patronage refund as "An amount paid to patron by an organization...

1. On the basis of quantity or value of business done with or for such patron.

2. Under an obligation of such organization to pay such amount which obligation existed before the organization received the amount so paid (pre-existing obligations), and

3. Which is determined by reference to the net earnings of the organization from business done with or for its patrons."

Most cooperatives pay at least some of their patronage refunds in cash (money). The cash portion of a patronage refund is deductible by the cooperative in the year the margin being returned was earned. It is taxable income to the patron in the year received.

Members of the cooperative usually authorize their cooperative to retain at least a portion of their patronage refunds each year as additions to equity capital. The cooperative must send each patron a written statement reporting the amount of that patron's patronage refund for the year within eight and one half (8½) months after the close of its tax year. This statement is called a written notice of allocation.

The written notice of allocation may be qualified or nonqualified. There are requirements that must be met in order to "qualify" a written notice of allocation. These are:

1. The written notice must be part of a patronage refund package of which 20% or more is paid in cash.

2. The patrons must have consented to include the face value of the notice in their taxable income. The patron consent requirement is satisfied in one of three ways:

a. Bylaw consents. By being a member of a cooperative with a bylaw that clearly states that membership in the cooperative constitutes such consent. The member must receive a copy of the bylaws and written statement explaining the bylaws consent.

b. Individual written consent. The patron can sign a written consent form before the end of the taxable year in which the patronage occurs.

c. Qualified check. The patron can consent by endorsing and cashing a "qualified check". A qualified check is a specially prepared bank check, which if endorsed and cashed, establishes patron consent to include the entire refund as taxable income.

The cooperative may for various reasons, elect not to meet all the requirements to qualify a written notice of allocation. A written notice that for any reason does not meet the requirements for qualified status is called a "nonqualified written notice of allocation".

When a nonqualified notice is issued, the cooperative is not entitled to an immediate deduction from gross income (cooperative pays the tax on the face amount of the notice) and the patron recipient is not required to include as income in the year received the stated dollar amount of the allocation. The deduction by the cooperative and income recognition by the patron take place in the taxable year in which the nonqualified notice is redeemed.

The computation of the deduction upon redemption is completed using the "Look-back" rule contained in 1383(a) (2). General rule is that the tax in the year of redemption will be the lesser of:

1. the tax computed with redemption as deduction, or

2. an amount equal to the tax for the year of redemption without including the redemption amount as a deduction, minus the decrease in tax for the year the nonqualified was issued, if that years tax is recomputed treating the nonqualified as qualified.

Cooperatives may use nonqualifled written notice of allocation for several reasons:

1. Used so that the cooperative, not the patron, is subject to tax until cash is distributed to the patron.

2. Used as part of a loan strategy.

3. Used to hedge a risky tax position.

4. Used to create taxable income if credits can be used.

5. Used to allocate income represented by nonqualified written notice received from a regional cooperative.

6. Used to allocate income that is not subject to tax at the cooperative level.

7. May be used to deal with the issues created by the differences between book and tax income.

There are some problems in using nonqualified written notice of allocation as a tax-planning tool. Some of them include the following:

1. In order to have a tax benefit at the cooperative level; the unqualified written notice must be redeemed in cash.

2. Redemption must be carefully studied. Look-back can be mandatory; rules for the year for taking redemptions into account and dealing with aggregating redemptions can be complicated.

3. Patron expectations vs. tax planning desire are often hard to coordinate.

4. No interest element on the nonqualified written notice of allocation.

5. The statute of limitations does not begin to run on a controversial position until the notices are redeemed and the return reporting the redemption is filed.

6. State tax problems. The state laws may not allow for nonqualified written notice of allocation redemption, so the cooperative may not be able to get state tax back.

7. Bylaws in their current form may not address the issuance and redemption of nonqualified written notice of allocation. Also if redemption policies or plans are outlined in bylaws, make it clear that qualified written notice of allocations may be redeemed on different cycles than nonqualified. Bylaws may need to be amended to allow for nonqualified allocations.

8. Nonqualified allocations must be made as patronage dividends and redeemable at some future date. They can not be a form of permanent capital to issuing cooperative.

a. A written notice of allocation must have a right of redemption.

b. Nonqualified cannot be excluded from redemption plans, however they need not be the same as qualified. If the cooperative does not intend to redeem nonqualified, the IRS could have grounds for stating that the company is not "operating on a cooperative basis".

Many cooperatives in the past have not considered using unqualifled notice of allocations. Cooperatives may need to consider using nonqualified allocation as they continually get pressure from the members to pay a higher cash patronage dividends. Cooperatives should study the patronage refund methods with their tax advisor. The use of nonqualified written notice of allocation may be beneficial to the cooperative as well as its patrons.

Reprinted from the
Small Cooperative Business Forum