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Cooperatives: History, Features, Formation

Cooperatives are business entities established by a group of people who work together to operate, manage, and democratically control a jointly-owned company that meets their shared needs.

History

Cooperatives are rooted in the Industrial Revolution, formed as a reaction to the harsh working conditions that came with large-scale factory work. William King (1786-1865), was an early supporter of the cooperative movement and published “The Cooperator” to spread information about the benefits of starting a small, democratically-controlled business by pooling members’ capital. The Rochdale Society of Equitable Pioneers, formed in 1844, became the model of the modern cooperative in England and the United States. The Rochdale Society codified seven guiding principles for their organization that continue to influence cooperatives today.

When the cooperative movement reached the United States in the mid-19th century, its greatest immediate effect was seen in agriculture. As westward expansion caused a surplus of produce across the country, small cooperatives were organized by farmers to combat the low prices and wide market margins causing them economic distress. After the Civil War, an organization known as the Grange was formed in Fredonia, New York to improve local farming conditions. In less than five years, the Grange grew into a national network of chapters around the country. The Grange openly endorsed the Rochdale Principles and operated as a cooperative. Although the original Grange dissolved in the 1880s, historians agree that the organization led to the formation of hundreds of agricultural marketing, consumer, and purchasing cooperatives in the United States.

The early 1900s saw the first credit union established in the United States as well as the greater development of local and national cooperatives across the nation. The federal government promoted the development of cooperatives, particularly in the agricultural sectors, by exempting agricultural cooperatives from anti-trust laws that would have thwarted the price-setting mechanisms they used. Additionally, the Smith-Lever Act of 1914 created the Cooperative Extension System, a partnership between the U.S. Department of Agriculture and agricultural universities that brought education to local farmers about current developments in agriculture, home economics, and public policy.

The Great Depression brought more federal support to the cooperative movement through the Farm Credit Act of 1933, which created a system of banks for agricultural cooperatives, and the Federal Credit Union Act of 1934, which allowed credit unions to be established under federal law.

After World War II, cooperatives continued to proliferate around the country in response to new social and labor issues. Cooperatives and networks such as the Federation of Southern Cooperatives were used during the civil rights movement to support independent black farmers in the South. During the 1960s and 70s, consumer cooperatives became the entity of choice for the natural food industry and remain very popular in this sector today. Following the economic crisis of 2008, cooperatives were established by city governments to create jobs in Ohio, New York, and California.

Today, cooperatives are found throughout all sectors of the economy. Cooperatives are increasingly used as an entity for modern businesses as they respond to the shift in consumer and employee preferences regarding ethical production, workplace equity, and community engagement,

Varieties

There are four main types of cooperatives: producer, worker, consumer, and purchasing. Producer cooperatives are owned by the producers who join together to streamline production or better market their products. Producer cooperatives are often found in the agriculture sector. Well-known examples include Ocean Spray, Blue Diamond, Land O’Lakes, and SunMaid.

Worker cooperatives are owned by the employees within a company. There are 495 known worker cooperatives in the U.S., but some estimate that there are over 3 million in the world. Cooperative Home Care Associates, a home care agency with over 2,000 workers based in the Bronx, is the largest worker cooperative in the U.S. Another large cooperative of 130 employees is called Equal Exchange, located in Boston and known for pioneering fair trade in the U.S.

Consumer cooperatives are owned by the customers who purchase goods and services from the co-op. Grocery store co-ops are an example of consumer cooperatives. Other examples include credit unions, housing cooperatives, and insurance cooperatives.

Purchasing cooperatives are organizations composed of several small businesses that join together to increase their purchasing power and therefore receive better discounts and offers on products and services. An example of a purchasing cooperative is GoodBuy Purchasing Cooperative, which is composed of independent school districts and charter schools that enter into joint contracts for school supplies.

Common Features

The laws governing the establishment of cooperatives differ by state. However, there are some common features of cooperative ownership derived from the Roshdale Principals.

First, cooperatives are managed by their members. In its purest form, a cooperative is a democratic organization where members actively participate in management decisions. Members own shares in the cooperative, but each member only has one vote no matter the number of shares they hold. Larger cooperatives may elect representatives to a board in order to facilitate oversight functions, hiring decisions, and operational policies.

Second, members contribute capital to the co-op equitably. Generally, the profits (or surplus) of a cooperative remain within the company to further its development and are not redistributed to members. All cooperative members have limited liability for the debts of the cooperative.

Third, cooperatives are autonomous organizations. This means that they are not controlled by larger companies and if they want to enter into agreements with other organizations (including other cooperatives), they must do so on democratic terms.

Incorporation

Not all cooperatives are incorporated, but those that choose to incorporate usually do so under the laws of the state in which they are located. Some states have specific legal entities for cooperatives and some do not. For example, Colorado has been referred to as “the Delaware of cooperative law” because it has an extensive legal framework for cooperative incorporation. This level of regulation is less common in the Northeast, where states generally allow cooperatives to incorporate under another legal entity and provide some special requirements for their operation.

Massachusetts

In Massachusetts, there is no separate legal entity for a cooperative, but cooperatives may be incorporated under Mass. Gen. Laws ch. 156B, the Massachusetts Business Corporation Law. The organization of business cooperatives is governed by Mass. Gen. Laws. ch. 157, which allows seven or more people to organize a cooperative for “any agricultural, dairy or mercantile business on the co-operative plan.” Such a cooperative must distribute “its earnings or profits among its workmen, purchasers and stockholders at such times and in such manner as its by-laws prescribe, but at least once in every twelve months,” in the form of a dividend.

Business cooperatives may be established with or without capital stock. If a business cooperative has stock, no single stockholder can hold shares amounting to more than $1,000, and all stockholders must have only one vote, regardless of the number of shares. Massachusetts law further requires that the stock “not be less than one hundred dollars nor more than five million dollars.” No single stockholder can own more than one-tenth of the total number of shares issued. Additionally, each year a business cooperative must set aside at least ten percent of its net profits in a reserve fund until there is at least thirty percent of its paid-up capital stock in that reserve fund.

Purchasing cooperatives are governed by Mass. Gen. Laws. ch. 157, Section 3A, which allows seven or more persons to organize themselves into a purchasing (“direct-charge”) cooperative as long as the cooperative functions with “no provision for earnings, the accumulation of capital, or operating costs.” Operating costs are met by levying a “direct-charge” on members on a pro-rata basis. This is a charge akin to a membership fee. Purchasing cooperatives do not require capital stock, but if they do have stock, they are required to follow the laws governing business cooperative stock as set forth above.

Housing and employee cooperatives are subject to slightly different rules.

Housing cooperatives are governed by Mass. Gen. Laws ch. 157B. In Massachusetts, three or more people may form a cooperative for the purpose of developing, acquiring, owning, and operating multi-family housing on a cooperative plan.  Housing cooperatives are generally subject to the same stock limitations that no single stockholder can own more than 10% of the issued stock, with the exception of housing cooperatives having less than ten units, “in which case each stockholder shall own an equal number of shares of the capital stock issued and outstanding.”  Still, no member can have more than one vote.

Employee cooperatives are governed by Mass. Gen. Laws c. 157A, under which any business corporation can elect to be governed as an employee cooperative by stating so in its articles of incorporation. In an employee cooperative, members must be part or full-time employees. Employee cooperatives must issue a class of voting stock designated as “membership shares,” which they make available for a fee. Each member is entitled to only one membership share and has all of the rights and responsibilities of a shareholder under Mass Gen. Laws 156B.

Generally, cooperatives in Massachusetts must contain the word “co-operative,” with the exception of employee cooperatives which have the choice to do so. Following cooperative principles, if a cooperative chooses to delegate leadership duties to directors or other officials, the bylaws must be changed to that effect, but only after a notice of the change is given to members and directors and approved by a two-thirds vote at an annual meeting or by annual elections.

Other New England States

Rhode Island has a specific entity for worker cooperatives and the four other types of cooperative structures that can be organized as a for-profit or nonprofit entity. Similar to Massachusetts, New Hampshire provides for cooperative incorporation under its general business law for organizations of “[f]ive or more persons, a majority of whom are residents of this state [to] form a nonprofit cooperative association with or without capital stock . . . for the purpose of acquiring, producing, building, operating, manufacturing, furnishing, exchanging, or distributing any type or types of property, commodities, goods, or services primarily for the benefit of its members who are ultimate consumers.” Vermont also permits “[f]ive or more persons, a majority of whom are residents of this State, [to] form a nonprofit, cooperative association, with or without capital stock.” Maine also does not have a separate legal entity for cooperatives and provides that they must be incorporated under the business corporation laws. However, like Massachusetts, Maine does have specific provisions governing consumer cooperatives, producer cooperatives, housing cooperatives, and employee cooperatives.

Currently, it is rare for people to incorporate a cooperative in a cooperative-friendly state, such as Colorado, and then register it as a foreign company doing business in Massachusetts. Searching the Massachusetts Secretary of State website, there is not a single example of this. However, no provisions expressly disallow it. The Articles of Incorporation requirements under Colorado law only require that the applicant file the principal address of the cooperative, but does not specify that the address must be in Colorado. Massachusetts requires that foreign corporations file a certificate of registration and does not restrict the entity type that can register. Moreover, there are cooperatives incorporated in other states that have registered as foreign corporations in Massachusetts. Thus, incorporating a cooperative in Colorado and registering it to do business in Massachusetts could be a viable option for people who want to establish a cooperative under a more extensive framework.

Whether a cooperative is incorporated under a specific cooperative structure, or a general business entity, the steps to incorporate remain largely the same: file your articles of incorporation, create bylaws, create a membership application, host a meeting of charter members to adopt the bylaws, obtain relevant permits and licenses to do business from the state, and hire employees.

Taxation

Generally, cooperative entities are taxed via pass-through taxation at the state level, which means that the members of the cooperative claim and pay tax on the profits of the cooperative in accordance with their equity interests when they file their personal income tax returns. Thus, cooperative entities may avoid the double-taxation to which corporations are subject. In Massachusetts, only cooperatives without capital stock receive pass-through tax treatment. Cooperatives with capital stock are taxed as corporations under Mass. Gen. Laws ch. 63.

On the federal level, there are three sets of special rules for cooperatives. First, farmer cooperatives are subject to special deductions rules that often allow them to maintain a taxable income of zero. Second, Subchapter T cooperatives, which can be in any line of business, pay tax on any earnings it retains within the cooperative and is able to deduct the amount distributed to its members using Form 1120-C, thus avoiding the double taxation to which corporations are subjected. However, members still pay federal income tax on the amounts distributed to them.

Whereas these first two sets of rules provide tax benefits to cooperatives through deductions, the third set of special rules, under I.R.C. 501(c)(12), provides the ultimate benefit of exemption from federal income tax. Benevolent life insurance associations, ditch or irrigation companies, telephone companies, electric companies, and “like organizations” may be eligible for federal tax exemption under I.R.C. 501(c)(12). “Like organizations” is not defined in the I.R.C. or the regulations, but the IRS has issued guidance on this stating that it is limited by the kinds of organizations specified in I.R.C. 501(c)(12). Thus, to obtain federal tax exemption under 501(c)(12), an organization must meet three requirements: (1) the company must be organized and operated as a cooperative; (2) it must conduct activities described in I.R.C. 501(c)(12) and the regulations; and (3) it must derive 85 percent or more of its income from members.

Lastly, cooperatives can generally elect to be taxed as Corporations under I.R.C. § 1361(b)(1) if they meet the following criteria: (1) it has no more than 100 shareholders (but all members of a family are counted as one shareholder); (2) all shareholders are individuals, estates, or certain described trusts (shareholders cannot be corporations or partnerships); (2) all shareholders are U.S. citizens or resident aliens; and (4) it has only one class of stock. Cooperatives organized as LLCs can also elect to be taxed as an S Corporation rather than as a C Corporation or T Corporation if they meet these criteria. Thus, the S-Corp election is a great option for smaller cooperatives that meet the above criteria and do not qualify for tax exemption under 501(c)(12).

 

Conclusion

The cooperative structure is not without drawbacks. Cooperatives often have difficulties obtaining capital through investors, possibly because of the one-vote per member governance structure, which does not reflect traditional notions of efficient decision-making power that corporate entities use. Relatedly, co-ops are not going to make members (or investors) rich—that’s just not how they are structured. Profits are usually retained and reinvested in the cooperative in a sustainable manner, rather than redistributing large sums to members. Additionally, co-ops struggle to provide health insurance and other benefits to employees.

Still, cooperatives provide many benefits to their owners and surrounding communities. When consumer cooperatives are located in low-income areas, they provide increased access to goods and services at lower prices. Furthermore, there is evidence that the cooperative structure results in increased business survival and profitability. Cooperatives consistently pay employees above minimum wage and provide more growth opportunities within the cooperative as compared to a corporation, increasing employee loyalty. Increased business retention allows communities to develop and stabilize local economies, keeping wealth within the community and benefitting local residents. In fact, scholars point to cooperatives’ stability and membership base as factors that increased resilience to the financial crisis of 2008, which saw far fewer cooperative banks close than traditional banks. Ultimately, the cooperative structure is a powerful tool for combatting the growing wealth gap and for investing in local communities.

 

Erica Hudson is a third-year law student at Case Western Reserve University School of Law and was a Legal Extern at the Arts & Business Council of Greater Boston in the spring of 2021.

 

Helpful Resources:

Lynn Pitman, University of Washington: Center for Cooperatives, History of Cooperatives in the United States: An Overview (Dec. 2018).

Mass. Gen. Laws. chs. 156B, 157, 157A, 157B

Cooperative identity, values & principles, International Cooperative Alliance.

What is a Co-op?, National Cooperative Business Association.

Worker Cooperative FAQ, Democracy at Work Institute.

Co-ops Matter: The ABCs of Co-op Impact, Urban Institute (Dec. 2018).

U.S. Small Business Administration, Choose Your Business Structure: Cooperative, Tory Burch Foundation.

Ellie Anzilotti, More U.S. Business Are Becoming Worker Co-ops, Here’s Why, Fast Company (May 21, 2018).

Nature and characteristics of business cooperatives, 15 Massachusetts Practice Series, Legal Forms § 8:7 (5th ed.).

Minsun Ji, Business Conversion to Employee Ownership in the US: ESOPS and Worker Cooperative Conversion (Feb. 2020).

How Worker Co-Ops Are Creating Economic Stability In Uncertain Times

Johnston Birchall & Lou Hammond Ketilson, Resilience of the Cooperative Business Model in Times of Crisis, International Labour Organization (2009).

Michael Seto & Cheryl Chasin, General Survey of I.R.C. 501(C)(12) Cooperatives And Examination Of Current Issues

 

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