Patronage

What Is Patronage?

Patronage, in the context of cooperative finance, refers to the practice by which cooperative organizations return a portion of their net income to their members based on the amount of business each member conducted with the cooperative, rather than on their equity investment. Unlike traditional corporations that distribute profits to shareholders as dividends based on stock ownership, a cooperative distributes its surplus to its members, who are also its users or customers, in proportion to their level of engagement or "patronage." This unique approach distinguishes the financial structure of a cooperative and underpins its member-owned and member-controlled philosophy. Patronage aims to reduce the effective cost of goods or services for members or increase the price paid for products supplied by members. These distributions are often called patronage refunds or patronage dividends.

History and Origin

The concept of patronage is deeply rooted in the history of the cooperative movement, which emerged in the 19th century as a response to industrialization and to empower individuals through collective economic action. The Rochdale Pioneers, a group of textile workers in England, are widely credited with establishing the foundational principles of modern cooperatives in 1844, including the distribution of surplus based on patronage. In the United States, the cooperative model gained significant traction, particularly in the agricultural sector. Organizations like the National Cooperative Business Association (NCBA CLUSA), founded in 1916 as the Cooperative League of America, played a crucial role in promoting and developing cooperative enterprises and their distinctive financial practices, including patronage. National Cooperative Business Association

Key Takeaways

• Patronage is the distribution of a cooperative's surplus earnings to its members based on their volume of business with the cooperative.
• It serves to reduce the effective cost for members or increase their returns.
• Unlike traditional corporate dividends, patronage is tied to usage, not ownership shares.
• Patronage refunds can be paid in cash, retained earnings, or other forms of equity.
• The practice reinforces the member-owned and member-controlled nature of cooperatives.

Formula and Calculation

The calculation of a patronage refund typically involves determining the cooperative's total net income and then allocating a portion of that income back to members based on their individual patronage. While specific formulas can vary based on a cooperative's bylaws and the type of business, the core principle remains proportional distribution.

A simplified formula for an individual member's patronage refund is:

Here:

• Member's Business Volume refers to the dollar amount of purchases made by the member from the cooperative, or products sold by the member to the cooperative, over a specific period.
• Total Cooperative Business Volume is the total business conducted by all members with the cooperative during the same period.
• Distributable Net Income is the portion of the cooperative's net income that the board of directors decides to allocate as patronage refunds after accounting for reserves and other capital needs.

Interpreting the Patronage

Interpreting patronage involves understanding its impact on the borrowers or patrons and the cooperative's overall financial health. For members, a patronage refund effectively lowers the cost of the goods or services they received or increases the price for goods or services they provided. For instance, if a farmer borrows from a cooperative lender, a patronage refund reduces their effective interest rate. For the cooperative, the decision to distribute patronage is a critical aspect of its capital structure management. The amount and form of patronage—whether cash or retained equity—reflect the cooperative's profitability and its strategy for building and maintaining member equity.

Hypothetical Example

Consider "Green Acres Supply," a farmer-owned agricultural cooperative. In a given year, Green Acres Supply generates $1,000,000 in net income. Its board decides to distribute 60% of this as patronage refunds, totaling $600,000. Farmer Jane purchases $50,000 worth of supplies (e.g., seeds, fertilizer) from Green Acres Supply during the year, while the cooperative's total sales to all members were $10,000,000.

To calculate Farmer Jane's patronage refund:

1. Determine Farmer Jane's proportion of business:
   $50,000 (Jane's business) / $10,000,000 (Total cooperative business) = 0.005 or 0.5%

2. Calculate Farmer Jane's patronage refund:
   0.005 * $600,000 (Distributable Net Income) = $3,000

Farmer Jane receives a $3,000 patronage refund. This refund effectively reduces the overall cost of the supplies she purchased from the cooperative during the year. The cooperative might pay a portion of this in cash and retain the remainder as allocated equity for Farmer Jane, strengthening the cooperative's financial base.

Practical Applications

Patronage is a cornerstone of the cooperative business model across various sectors, including agriculture, finance, utilities, and retail. In the agricultural sector, farmer cooperatives distribute patronage to their members based on their volume of crops sold through the cooperative or supplies purchased. Financial cooperatives, such as credit unions and some Farm Credit System associations, commonly use patronage refunds to return earnings to their member-borrowers, effectively lowering their borrowing costs or increasing their earnings on deposits. For example, some Farm Credit associations regularly return significant portions of their profits to their members, demonstrating patronage as a tangible financial benefit. Farm Credit of the Virginias

From a taxation perspective, qualified patronage dividends are generally deductible by the cooperative when calculating its taxable income, provided certain IRS requirements are met, as outlined in publications like IRS Publication 525. This allows cooperatives to avoid double taxation on the portion of their income distributed as patronage.

Limitations and Criticisms

While patronage offers distinct advantages, it also presents certain limitations and faces criticisms. One primary challenge for cooperatives is balancing the immediate financial benefit to members through cash patronage with the need to retain earnings for future growth, investment, and maintaining adequate capital. Regulations, such as those from the Federal Register concerning banks for cooperatives, often stipulate limits on how much net savings can be allocated to unallocated reserves versus patronage.

Another critique can arise from the potential for internal conflicts between members who prefer higher cash refunds and those who prioritize strengthening the cooperative's financial statements through retained patronage. Additionally, some academic research indicates that cooperatives, particularly in agricultural marketing, face challenges related to cooperation and commitment among members, which can impact the effectiveness of patronage distribution and overall cooperative performance. Revista de Administração da UFSM Members might seek immediate gratification over long-term strategic needs of the cooperative.

Patronage vs. Dividends

The terms "patronage" and "dividends" both refer to distributions of earnings, but they originate from fundamentally different organizational structures and are allocated based on different criteria.

While patronage benefits members based on their active participation and business volume, dividends compensate shareholders for their financial investment and associated return on investment. This distinction highlights the user-centric nature of cooperatives versus the investor-centric nature of traditional corporations.

FAQs

What is a patronage refund?

A patronage refund is a portion of a cooperative's surplus earnings returned to its members based on how much business they did with the cooperative during a specific period. It is designed to lower the effective cost of services or goods for the members.

How is patronage different from a stock dividend?

Patronage is distributed based on a member's usage or business volume with a cooperative, while a stock dividend is distributed based on the number of shares an investor owns in a traditional corporation. Patronage reflects active participation, whereas a dividend reflects capital investment.

Are patronage refunds taxable?

Yes, generally, patronage refunds, especially those paid in cash or through qualified written notices of allocation, are considered taxable income to the recipient in the year they are received. Cooperatives typically issue IRS Form 1099-PATR to report these distributions.

Can cooperatives retain patronage instead of paying cash?

Yes, cooperatives can and often do retain a portion of patronage refunds as allocated member equity. This retained patronage serves as a form of capital for the cooperative, helping it to finance operations, make investments, and strengthen its financial position. The cooperative commits to repaying this retained patronage to members at a future date, as governed by its bylaws.

Why do cooperatives use patronage?

Cooperatives use patronage to adhere to their fundamental principle of operating for the benefit of their members. By returning surplus earnings based on usage, patronage ensures that the financial benefits of the cooperative's success accrue to those who actively use its services, reinforcing the member-owned and democratic nature of the organization.