Understanding the Repeal of the Dividend Allocation Rule

Phil Kenkel

Bill Fitzwater Cooperative Chair

Oklahoma State University

The possibility of paying dividends on the stock that members hold in a cooperative has been discussed for many years by both academics and practitioners.  A recent permutation of this topic is the concept of redeeming equity in the form of a dividend paying stock.  The American Jobs Creation Act of 2004, (the same act that gave us the Section 199 tax credit), effectively repealed what has been called the Dividend Allocation Rule.  This change made it more feasible for cooperatives to pay dividends on capital stock.

The basic premise of Subchapter T of the IRS code is that income distributed by the cooperative to its members is deductible either at the time of distribution (cash and qualified stock) or at the time the equity is redeemed (non-qualified stock).  This achieves pass through taxation on earnings that are distributed as patronage distributions.  Prior to the 2004 changes to the dividend allocation rule, a cooperative that paid dividends on capital stock had to reduce the earning that could be available for patronage distribution by the amount of the dividend paid on the stock.  (There was a further adjustment for member-non-member business.)  The effect was to increase the cooperative’s tax since the cooperative was taxed on a portion of its earnings that would otherwise qualify for a patronage distribution deduction.

Section 312 of the American Job Creation Act of 2004 amended the dividend allocation rule by stating that “net earnings shall not be reduced by amounts paid during the year as dividends on capital stock…This allowed cooperatives to pay dividends on stock without reducing patronage distributions.  It should be noted that this change does not make dividends paid on capital stock deductible.  Most forms of cooperatives, like other U.S. corporations are not allowed to deduct dividends paid to stockholders.  The exception is cooperatives qualifying for Section 521 (sometimes called exempt cooperatives) which is a much more restrictive class of cooperatives.    Most agricultural cooperatives do not meet the Section 521 requirements and therefore cannot deduct dividends paid on stock, even if that stock is held by members.

The reform of the dividend allocation rule puts paying stock dividends to members in a middle grown in terms of tax efficiency.  They do not create a tax deduction for the cooperative in the same manner as patronage distributions.  In that sense they are paid with after tax income, just like dividends in investor corporations.  On the other hand, they no longer reduce patronage allocations so a cooperative can effectively eliminate taxable income through patronage distributions and/or available tax credits.  A cooperative can also pay dividends with non-patronage earnings, which would be taxed in any case.  In that case the cooperative is using the after tax portion of non-patronage income for dividends rather than adding it to retained earnings.  From the patron’s point of view, the dividends received by the cooperative may be able to be classified as a “qualifying dividend”.  If so, they would be taxed at the capital gains tax rate (15% for most tax payers) and would be exempt from self employment taxes.  As always, cooperatives and patrons should check with their tax professionals for information specific to their circumstance.

In my next newsletter I will discuss the advantages of redeeming equity in the form of dividend bearing stock and some of the issues it creates.