Patronage dividends

What Is Patronage Dividends?

A patronage dividend is a distribution of profits paid by a cooperative to its members, based on the volume of business they conduct with the cooperative rather than their ownership stake. This concept is fundamental to cooperative finance, differentiating co-ops from traditional corporations. Patronage dividends are essentially a refund or rebate of an "overcharge" on goods or services purchased by members. The distribution of patronage dividends reflects the cooperative's commitment to serving its members' needs rather than maximizing profits for external shareholders. These dividends are typically declared from the cooperative's financial surplus generated through member transactions.

History and Origin

The concept of patronage dividends is deeply rooted in the history of the cooperative movement, which emerged in response to the economic and social conditions of the Industrial Revolution. Early cooperatives, particularly the Rochdale Society of Equitable Pioneers in England (formed in 1844), established principles that included distributing surpluses back to members in proportion to their purchases. This practice aimed to foster economic self-help and democratic control among members. In the United States, cooperative organizations appeared early on, with Benjamin Franklin establishing a mutual fire insurance company in 1752. The cooperative movement saw significant growth, particularly in agriculture, throughout the 19th and 20th centuries, as a means for farmers and consumers to gain greater control over their economic circumstances.⁶ The distribution of patronage dividends became a defining characteristic, embodying the principle of "member economic participation" as articulated by the International Co-operative Alliance (ICA).⁵

Key Takeaways

• Patronage dividends are profit distributions from a cooperative to its members.
• The amount of a patronage dividend is directly proportional to a member's usage of the cooperative's services or purchases.
• These dividends are considered a return of an "overcharge" rather than a traditional return on investment.
• For the cooperative, qualifying patronage dividends can often be deducted from its taxable income, avoiding double taxation.
• Patronage dividends can be paid in various forms, including cash payments, merchandise credits, or written notices of allocation.

Formula and Calculation

The calculation of patronage dividends varies by cooperative but generally follows a similar structure. It involves distributing a portion of the cooperative's net income derived from member business back to its members. The formula can be expressed as:

Where:

• (\text{Patronage Dividend}_M) = The patronage dividend allocated to a specific member (M).
• (\text{Member Purchases}_M) = The total value of purchases made by member M from the cooperative during the period.
• (\text{Total Member Purchases}) = The aggregate value of purchases made by all members from the cooperative during the period.
• (\text{Distributable Surplus}) = The portion of the cooperative's net income from member business that the board of directors designates for distribution as patronage dividends.

This formula ensures that members who transact more business with the cooperative receive a larger share of the distributable surplus.

Interpreting the Patronage Dividends

Patronage dividends are a tangible manifestation of the cooperative principle of "member economic participation." When a member receives a patronage dividend, it signifies their direct financial benefit from the cooperative's successful operations and their active involvement in its trade or business. These dividends reinforce the cooperative's purpose of serving its members, as opposed to generating profits for external investors. For individual members, a larger patronage dividend indicates higher engagement with the cooperative's services or products, leading to a greater share of the shared surplus. The interpretation of a patronage dividend is thus tied to the member's activity and the cooperative's financial health, as reflected in its balance sheet and income statement.

Hypothetical Example

Consider "Green Harvest Co-op," an agricultural cooperative that supplies seeds, fertilizers, and equipment to its farmer members. In a given year, Green Harvest Co-op generates a distributable surplus of $500,000 from its member-related business activities. Farmer Alice spent $100,000 on supplies from the co-op, while the total purchases by all members amounted to $10,000,000.

To calculate Farmer Alice's patronage dividend:

In this scenario, Farmer Alice would receive a $5,000 patronage dividend, reflecting her proportional contribution to the cooperative's business volume. This dividend might be issued as a cash payment or a credit towards future purchases.

Practical Applications

Patronage dividends are prevalent in various types of cooperatives, including agricultural cooperatives, consumer cooperatives, utility cooperatives, and credit unions. For instance, agricultural cooperatives often return profits to farmer members based on the volume of crops marketed through the co-op or supplies purchased from it. Consumer cooperatives, like grocery co-ops or outdoor retailers, frequently issue patronage dividends as a percentage of a member's eligible purchases. Recreational Equipment, Inc. (REI), a prominent consumer cooperative, explicitly details how it distributes patronage dividends in its bylaws, noting that these are returned to active members in proportion to their purchases.⁴

From a tax perspective, patronage dividends offer a unique advantage. Under U.S. tax law (specifically Subchapter T of the Internal Revenue Code), qualified patronage dividends paid by a cooperative can be deducted from the cooperative's gross income, effectively avoiding corporate-level taxation on that portion of its earnings.³ This enables cooperatives to operate more efficiently and pass benefits directly to their members. For the patron (the member receiving the dividend), the tax treatment depends on the nature of the transaction. If the dividend relates to personal purchases, it is generally not taxable income. However, if it relates to trade or business expenses that were previously deducted, or to the purchase of capital assets that were subsequently depreciated, it may be taxable or reduce the asset's basis.² Cooperatives are generally required to report patronage dividends of $10 or more to the IRS using Form 1099-PATR.¹

Limitations and Criticisms

While beneficial for members, patronage dividends do have certain limitations. The primary limitation for members is that the distribution of a patronage dividend is not guaranteed and depends entirely on the cooperative's profitability and its board of directors' decision to declare a dividend. If a cooperative experiences a loss or decides to retain all surpluses for reinvestment or building member equity, no patronage dividend may be paid.

From an operational standpoint, managing and calculating patronage dividends can be complex, especially for large cooperatives with numerous members and diverse transactions. Ensuring accurate tracking of individual member patronage and correctly applying tax regulations requires robust accounting systems. Furthermore, members might sometimes prefer immediate price reductions over deferred patronage dividends. There can also be challenges in communicating the value and tax implications of patronage dividends to members, leading to potential confusion or undervaluation of the benefit. For the cooperative, there are strict IRS rules that must be followed for patronage dividends to be deductible from their gross income.

Patronage Dividends vs. Stock Dividends

Patronage dividends and corporate dividends (often called stock dividends) are both distributions of profits, but they differ fundamentally in their basis and purpose.

The key distinction lies in the underlying relationship: patronage dividends are tied to a member's transactional activity, while stock dividends are tied to equity ownership. This difference reflects the core operational philosophies of cooperatives versus investor-owned corporations.

FAQs

Are patronage dividends always paid in cash?

No, patronage dividends are not always paid in cash. While cash payments are common, cooperatives may also distribute them in the form of merchandise credits, equity allocated to a member's internal account (often called "written notices of allocation"), or other property. The form of payment is typically decided by the cooperative's board of directors.

Are patronage dividends taxable income for the recipient?

For the recipient, the taxability of patronage dividends depends on what the dividend relates to. If it's for personal purchases, it's generally not taxable. However, if the dividend relates to deductible trade or business expenses, or the purchase of property subject to depreciation, it may be taxable or result in a basis adjustment. Cooperatives usually issue Form 1099-PATR to report these distributions.

What happens if a cooperative doesn't make a profit?

If a cooperative does not generate a financial surplus from its member business activities in a given period, or if its board of directors decides to retain all profits for other purposes (such as reinvestment or reserves), then no patronage dividends will be declared or distributed for that period. The payment of patronage dividends is contingent on the cooperative's profitability and board approval.

How do patronage dividends benefit cooperative members?

Patronage dividends benefit cooperative members by providing a direct financial return based on their engagement with the cooperative. This reduces the effective cost of goods or services purchased from the cooperative. It also reinforces the member-centric nature of the cooperative model, ensuring that the economic benefits flow back to those who utilize its services.