Q: What does the Board have to do?

A: The Board of directors oversees the operations of a cooperative. The Board’s job is to make policy and major decisions about the direction of the cooperative’s development. The Board is responsible for guiding the cooperative towards sustainable operations (net income) and achieving its mission, so decisions should be made towards those goals. 

The Board does not have to make every decision. Usually there are management roles filled by staff. Those managers make the decisions in their realm of authority. Boards should expect managers to manage the cooperative’s operations. The Board reviews how well things are working, and makes changes if needed.

Some specific responsibilities of the Board are:

• Making sure that the cooperative follows required legal formalities, like filing annual reports and tax returns;
• Making sure the cooperative gives an annual report to members, if required;
• Making sure board meetings and member meetings happen, including elections for directors.

Q: Do directors have a duty of loyalty?

A: Yes. Directors must exercise their decision-making power in a manner they believe to be in the best interests of the cooperative. In a cooperative, directors are usually members, and as members, they do patronage business with the cooperative. This is not considered a conflict of interest. (See more detail at Corporations Code s. 12373.)

Q: What is a director’s standard of care?

A: To act reasonably. To act as carefully as an ordinary person would. A director may rely on committees and professional advisors if they seem knowledgeable, but if there is a reason to doubt them, the director has a duty to inquire, not turn a blind eye to something that seems like a problem. (See more detail at Corporations Code s. 12371.)

Q: Is it risky to be a director? Can I be held liable?

A: This is usually addressed with indemnification clauses and directors’ and officers’ insurance. “Indemnification” means that if a director is named as a defendant in any lawsuit because of their action in their role as a director, the cooperative must pay the costs of that defense. There is likely an indemnification clause in the articles of incorporation or the bylaws. Read it to find out how your cooperative distinguishes between situations in which the cooperative will pay all costs of defense, and situations in which the behavior was too bad for the cooperative to pay for the harm.

Directors’ and officers’ insurance can be purchased to help a cooperative be able to afford the cost of indemnification.

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This is a discussion of the legal mechanism for using a general business corporation as the legal entity for a cooperative. (This is a long nerdy post for my colleague-friends.) If you just want someone to do this for you, let us know.

First, the goal is to have one member = one vote, and, after any dividends on any preferred shares, which dividends should be limited, remaining net income should be allocated to an undivided reserve and then to members and any other patrons on the basis of patronage.

1. First try with just my own ideas:

In 2019, I converted an Illinois general corporation into a cooperative by amending the articles of incorporation. My strategy was to use the provision of law that says you can determine dividends based on an ascertainable fact outside of the articles. I decided that the ascertainable fact would be the shareholders' patronage. So I amended the articles to say that dividends on common stock would be calculated based on the patronage of the shareholder. In this case, the shareholders' patronage was their labor, and patronage was to be measured by their wages during the applicable time. (This is consistent with the definition of "patronage" = the quantity or value of business done with the cooperative, from Section 1388 of the Internal Revenue Code.)

Here's the language in the amendment describing the common stock:

a. Common Stock: The corporation shall issue not more than one share of Common Stock to any individual. Common Stock shall not be transferable except to the corporation, unless otherwise required by law. Holders of Common Stock shall be entitled to one vote per share. Holders of Common Stock are entitled to receive distributions to shareholders as authorized by the corporation's board of directors, as authorized by Section 9.10(a) of the Business Corporation Act of 1983 or its successor, subject to the following restriction: Amounts distributed to each holder of a share of Common Stock shall be in proportion to the holder's Patronage relative to the total Patronage of all shareholders. For the purpose of this paragraph, "Patronage" means the number of hours worked for the corporation by the shareholder, as recorded in the corporation's official records, multiplied by the shareholder's hourly pay rate in effect at the time the work was performed.

I spoke about this idea later with my friend, Therese Tuttle. Her first reaction was that this would not work! Because patronage dividends are not a return on capital! And they are treated differently for tax purposes. However, even after thinking about Therese's feedback, I think this approach will work, as long as the co-op works with a CPA to prepare a tax return consistent with this strategy. Here's why:

The corporate mechanism is that the return on stock is a dollar amount based on patronage. This is permitted by corporate law. Normally, dividends on stock come out of the corporation's after-tax income, but Subchapter T of the Internal Revenue Code provides an exclusion for "patronage dividends." Anything that is a "patronage dividend" does not need to be included in a cooperative's taxable income. Allocations to members have to meet certain requirements to qualify as a "patronage dividend," and none of that has to do with the legal mechanism of making the allocation. More simply, even if this is legally a dividend on a share, if it is calculated based on the shareholder's patronage, then it is in reality a patronage dividend, not a return on capital. And this does not conflict with Subchapter T, so it can meet all of the requirements of a patronage dividend and be treated as such. The cooperative just needs to know to ask for this treatment, and the tax return preparer needs to know the requirements of Subchapter T.

So I think this is an OK approach.....

2. and then I learned about an even better-fitting approach.

​I recently learned that Equal Exchange, a large, well-established worker cooperative that imports and sells coffee, chocolate, and other foods, is not organized as a cooperative corporation! It is organized as a general business corporation. The provisions in its articles about patronage dividends are there under the statutory authority to include "provisions not inconsistent with law regarding: ... (ii) managing the business and regulating the affairs of the corporation;" and/or "(iii) defining, limiting, and regulating the powers of the corporation, its board of directors, and shareholders or any class thereof[.]" See Section 2.02 of the Massachusetts Business Corporation Act. It had not occurred to me to use that general authority to authorize allocations that were neither compensation nor dividends on stock, but that is a good idea.

Massachusetts makes its corporate filings available online. The following is quoted from Equal Exchange's restated articles filed in 2020:

Article IV
There are two classes of shares with preferences, limitations and relative rights as defined in the By-laws. Those classes are as follows:

1. Class A Common Stock (Membership Shares)
a. Membership. The Corporation shall have a single class of voting stock, known as Class A Common Stock or a Membership Share(s). Membership Shares may only be acquired and held by those eligible persons as set forth in the Corporation's By-laws.
....
b. Ownership. Each Member shall own one and only one Membership Share, and only Members (as defined in the Corporation's By-laws) may own shares of Class A Common Stock. [....]

c. Rights and Privileges.
i. Voting. .... Each share of Class A Common Stock shall entitle the holder thereof to one vote.
ii. Patronage Rebates. No dividends are paid on shares of Class A Common Stock, but a portion of net earnings or losses of the Corporation shall be allocated to Members on the basis of each Member's patronage, as defined in the Corporation's By-laws.

I have no information about whether this would hold up to a challenge in court, or what level of review it is given by the Massachusetts Secretary of State before filing. I know only that it was filed in 2020.

3. Then I tried to do this for an S-corp, and it didn't work.

Next, I tried to do something similar, but for allocations to shareholders of an S-corp--they want unequal share ownership (with voting and dissolution preferences following share ownership), but equal allocations of profit. So I tried to use this idea for that client in California. Here's what I submitted:

ARTICLE VI: Provisions for the Conduct of the Corporation’s Affairs
Whenever the corporation allocates and distributes its net income to shareholders, which shall be in the discretion of the corporation’s board of directors, the corporation shall make such allocations and distributions equally among the shareholders, without regard to the number of shares owned. Equal rights of shareholders to distributions of net income under this paragraph will be deemed the controlling provision solely for the purpose of determining shareholder ownership percentages for the purpose of Subchapter S of the Internal Revenue Code. Relative ownership interests for all other purposes including shareholder voting rights will be determined based on number of shares owned.

This got rejected. I wanted the tax preparer to be able to rely on the corporation's organizing documents to make equal allocations for the purpose of Subchapter S of the tax code. This language did not successfully frame the allocations as *not* dividends on stock. Because every share of the same class has to have equal rights as every other share of that class, these articles had to be changed (by removing this section) before resubmitting.

4. Alix used this strategy for a Washington co-op, and it did work.

Meanwhile, my friend Alexandra at https://aligned.law/ used this strategy in Washington State.
[I am going to ask Alix for the language that did get accepted in Washington. Coming soon, hopefully.]

5. Delaware Corporation for a start-up ... as a cooperative.

I am now working on this for a client that wants to organize as a Delaware corporation for other reasons, but wants to be a worker cooperative. So here's what we're going to submit:

Article 5: Additional provisions for the management of the corporation’s business and the conduct of its affairs:
a. One Member One Vote. The stock of the corporation may only be acquired and held by those persons who are eligible according to the corporation's bylaws. Each shareholder may hold one and only one share of common stock.

b. Allocations. At least once per fiscal year and at any time and from time to time as determined by the corporation’s board of directors (the “Board”), after the Board has provided for a reasonable reserve, the corporation’s net earnings or losses from Patronage Net Income (as that term is used in Subchapter T of the Internal Revenue Code or its successor (“Subchapter T”) shall be allocated to the shareholders in proportion to the shareholders’ relative Patronage, as “Patronage” is defined herein and as that term is used in Subchapter T. “Patronage” shall mean the quantity of labor or service done with or for the corporation by the shareholder, as measured by [insert client's way of measuring, e.g. hours worked], provided that such measurement may be modified by any bylaw or policy of the corporation under which the Patronage of the shareholders may be determined without ambiguity. Such allocations are not dividends on stock, and may take the form of Patronage Dividends or Non-Qualified Written Notices of Allocation, as those terms are used in Subchapter T. Net income not from Patronage may be allocated as dividends on stock.

I am going to submit this for filing shortly, and we'll see whether it gets accepted or not by the Delaware Secretary of State.

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The prevailing wisdom is that for worker cooperatives owned by people who do not have employment authorization in the United States, their co-op should be organized as a limited liability company (LLC), with every member playing a meaningful role in management, and no probationary work time when they are not a member. (See this operating agreement--with cartoons!--re how this is put into practice, and check out this legal guide for a discussion.)

It is legal for any resident of any country to own a business in the US, and a business owner can work for their own business. It is not legal for a US company to hire as an employee someone without work authorization. This is why co-ops with undocumented worker-owners need to do what they can to make sure the law will see them as owners, not employees.

I used to hear this view stated repeatedly without citation to specific authority. So in 2020, when I was advising a co-op that expected that it might someday have undocumented worker-owners, I did a deep dive into the case law around when business-owners are considered owners, and when they considered employees.

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People who are starting a social enterprise sometimes ask if there is some special legal entity for social enterprises.

Their past experience in a nonprofit has left them disenchanted, and they want to do something different, and they also do not want to become an extractive for-profit corporation that is so profit-driven that it is willing to engage in harmful behavior.

So they wonder if there is something else.

There is no single “social enterprise” legal entity. Social enterprises choose one or more of the available legal entities under state law, and these are: cooperative, benefit corporation, general business corporation, limited liability company, low-profit limited liability company, or non-profit corporation. (Cooperatives can include general cooperative corporation, agricultural cooperative corporation, and limited cooperative association. Illinois has a limited worker cooperative association.) The choice among these depends on which goal is most important to you.

A cooperative prioritizes shared ownership. Cooperatives are owned and democratically governed by their members, and members are people who do some kind of business with the cooperative. Members share in profits or savings in proportion to their relative quantity or value of business done with the cooperative (their "patronage"). This could mean that workers democratically govern their workplace and share in profits on the basis of how much they worked. Or it could mean that all customers or users have a vote, and net income is returned to customers as a refund. Co-op founders often have the attitude that member ownership puts the entity in a right relationship with its workers, producers, customers, or users, and this is deeper and more important than being a benefit corporation.

A benefit corporation prioritizes the commitment to creating a social benefit or reducing a harm, and to being accountable for trying to create that benefit or reduce that harm. The legal meaning of a benefit corporation is that directors have a duty to consider many factors such as creating the benefit, and doing good rather than harm to employees, the community, the environment, etc. Directors are not supposed to make decisions based only on financial gain, and they are not liable to shareholders for making decisions in which the goal of creating profit is balanced against the attempt to do good. (Cooperatives are certainly also allowed to, and do, make decisions with the interests of workers, customers, the community, and the environment, in mind.)

The limited liability company (LLC) is a general-purpose, flexible entity. The financial and governance rights of owners can be customized in the operating agreement. An LLC can be a good fit for any profit-generating enterprise that has a small number of owners, or that wants customized ownership and financial rights that don’t fit corporate law requirements. An LLC is often used for small worker cooperatives.

Note: There is generally little harm done if a start-up founder forms their own LLC to start. The downside is the cost of having a partnership tax return prepared, and legal fees to convert to a corporation later if necessary. In contrast, if a founder starts forms their own corporation, and if the corporation has assets, you cannot "go back to" pass-through tax status without the assets being deemed distributed to owners for tax purposes.

A non-profit prioritizes being able to receive grants, if it has a charitable purpose and applies for charitable tax status with the IRS on Form 1023. Charitable organizations can pay salaries to employees, but cannot pay dividends or share profits with anyone. If receiving tax-deductible grants is most important, and if there is no need to distribute profits above salaries, then consider a non-profit corporation.

Let’s boil it down: Is receiving charitable gifts and grants important? If yes - consider a non-profit. If no, will you have a founder-owned company that is committed to creating a benefit, and willing to back up that commitment with public reports? That sounds like a benefit corporation. Or, will you have a worker-owned entity where all workers have a path to membership and share profit on the basis of how much they work? That is a worker cooperative. Or is this a cooperative to be owned by customers, or producers?  That is a consumer co-op or an agricultural co-op. Or maybe a general-purpose legal entity does the job, and you can carry on your social enterprise with your trusted business partners using an LLC or corporation.

There are layers of detail that don’t fit into a short blog post, so if you would like to discuss legal entity choice for a social enterprise, feel free to reach out.

This is general information, not legal advice.

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You're starting a business with some people, and you plan to run it cooperatively.  Your business will be worker-owned and worker-managed.  How will you be taxed?
That depends on some choices you make.  Here's a simple overview of your options.  But first, a bit of background.
With a traditional corporation, most of the income is taxed twice.  The corporation pays tax on its income.  Then it pays some of the income to its shareholders, and that income is taxed again as part of the shareholders' income taxes.  A limited liability company (LLC), on the other hand, is a "flow-through" entity.  The income (and loss) "flows through" to the owners, the LLC files an informational return only, and the income is taxed only once as part of the individual owners' incomes.
Some states have laws under which you can incorporate a cooperative corporation.  In a cooperative corporation, stock ownership is spread among the worker-owners, each owner gets one vote, and profits are distributed according to hours worked or some other equitable formula, not according to number of shares owned.  This differs from a traditional corporation, in which owners have as many votes as they have shares, and dividends are based on share ownership, not work.
A cooperative gets better tax treatment than a traditional corporation.  A co-op can subtract from its corporate income the profit assigned to the worker-owners.*  The co-op will pay corporate income tax on whatever profit it retains in the co-op's capital reserve, but most income will "flow through" to the worker-owners, and will be taxed once, at the individual worker-owner's level.
But wait, you say, we can achieve single-level taxation with an LLC.  So why would we incorporate as a cooperative?  That decision depends on non-tax factors, like the size of the company, how easily it can afford administrative requirements, which are greater for corporations, and how valuable it is to you to incorporate under a statute that gives you the structure you want, rather than having to create an unusual LLC agreement.  On the other hand, you may want a custom agreement, not what the co-op statute requires.
Your state may or may not have a statute that's helpful for worker co-ops.  Illinois has a co-op statute for consumer and farmer co-ops, but not worker co-ops.  For an Illinois business to take advantage of the structure provided by a good worker co-op statute, you would need to incorporate (or re-incorporate) in another state, such as Massachusetts or Wisconsin, then get permission to do business in Illinois.  You can achieve the same results by putting your desired co-op structure into your corporation's bylaws or your LLC's operating agreement.  That strategy may feel riskier, and would make more work for your attorney up front, but will save you from having to file two annual reports every year. So your choice between cooperative corporation and LLC will probably be made for non-tax reasons.

But back to taxes.  Another big factor is self-employment tax.  Did you know that self-employment tax is separate from and in addition to income tax?  It's 15.3% of self-employment income,** and it covers social security and medicare tax.  In an employment situation, the employer pays half, and the employee pays half.  If you work for yourself, you pay the whole thing.  If you're part of a worker co-op, you're both the employer and the employee, so you don't care who pays for it, but you do care whether all of your income is subject to self-employment tax.
All of the income from an LLC is subject to self-employment tax.  Income received as dividends, however, is not.  There is an argument that worker-owners in a worker cooperative should be able to receive any income over and above their wages as "dividends," which should not be subject to self-employment tax.  However, the IRS has taken the position that these co-op distributions are subject to self-employment tax.  Some co-op members who did not pay self-employment tax on co-op dividends were audited and then got into disputes with the IRS, so that is not a safe strategy for avoiding self-employment tax.
But wait, there's more: the S corporation.  So called because it's taxed under subchapter "S" of the tax code.  To incorporate as an S corporation, you must meet certain requirements (no more than 100 shareholders, only one class of stock).  It's a flow-through entity--the income is taxed only at the individual level.  Worker-owners can pay themselves a fair market wage, and then receive the rest of the profit as dividends, which are taxed at a lower rate and not subject to self-employment tax.  This different treatment between wages and dividends from an S corporation is not subject to controversy right now.  (The non-tax reason to organize as an S corporation is basically to transfer shares easily.)
The drawback of this for a co-op is that S corporation dividends are based on stock owned, not hours worked.  If you're running your business as a co-op, this would work for you if everyone owns one share, and everyone works the same number of hours and earns the same amount.  This is not how most co-ops work.  The other drawback is that the administrative cost of issuing the paychecks can cancel out the tax savings.
If you're in a state that has a good worker co-op statute, that could be the best choice for you because it creates the structure of a co-op for you.  Then, most of the income will be taxed only once.
If you're in Illinois or another state where you have to DIY a co-op using a corporation, S corporation or LLC, you'll want to organize as an LLC if your company is small/does not earn a lot more than the value of the owners' wages, or if you want more flexibility to distribute profits and losses as you see fit.
Now here's where it gets weird.  An LLC can elect to be taxed as an S corporation by filing certain forms with the IRS.  This would allow an LLC to keep its structure and less formal operating requirements, but still take advantage of the tax savings if there is income that can be distributed as dividends above the fair market value of the workers' wages.
The bottom line: A cooperative corporation, an LLC, and an S corporation, are all entities whose income is taxed once, at the owner level.  Except that in a co-op, the corporation, not the individual owners, pays tax on the profit that's retained in the co-op's reserve.  If the co-op's tax rate is lower than the individuals', this could actually be a tax savings, and a way for some of the profit to grow faster over time with a lower tax burden.  A worker-owner's income is taxed mostly the same way with any of these entities, but the S corporation can give a tax savings in some situations.
Note that every situation is different, and one or another business entity and tax election might work better for you based on your circumstances and your plans.  This article is meant for a general audience, and you should consult your attorney if you need advice choosing an entity or figuring out how to minimize taxes in your particular situation.
*Puget Sound Plywood, Inc. v. Commissioner, 44 T.C. 305 (1965).
**I.R.C. s.1401
IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, please be advised that any U.S. federal tax advice contained in this communication is not intended or written to be used or relied upon, and cannot be used or relied upon, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

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Transcript:
Let’s say you’re starting a business, or adding owners to an existing business, and you like the idea of the business being a cooperative.  When you’re at this stage, I think it’s useful to get clear on the basics: what is it, that defines a cooperative?

I’m Sarah Kaplan.  I’m a lawyer for cooperative and other businesses.  Please don’t rely on this as legal advice.

A cooperative is a business or social enterprise that is owned and democratically controlled by its members.  Depending on the kind of cooperative, Members may be the workers, the consumers (food cooperative) or producers (farmer cooperative).

Members invest in and own the business.

Members control the business, democratically, usually one member one vote.

Members share the income, mostly or totally based on each member’s contribution to or use of the cooperative.

Cooperatives can organize using various legal entities—they can be cooperative corporations, LLCs, or even general corporations.  Not for profit corporations can use some of the aspects of cooperatives, like democratic control by workers.  It’s not the choice of legal entity that makes something a cooperative.

I personally believe it’s a good thing for any business to include some or all of the elements of a cooperative into its business structure.

If you are founding a business that will have a large number of users or people who will contribute to the business in some way, and if you’re someone who believes our economy should be more just and equitable, you might be thinking about forming as a cooperative as a way to share income with those users or people who contribute to the business.  I suggest that you think about it this way: in a cooperative, the members own equity in the business, and the members ultimately control the business, either by voting in the affairs of the business, or by voting for members of the Board of Directors.  Is that the ownership structure that’s right for this business?

FAQ:
Q: If you have outside investors, can you still be a cooperative?
A: The short answer is yes, it’s possible, and many cooperatives do.

Q: I have a specific vision—can I set up the rules, and then have members join?  Is that still a cooperative?
A: It could be, but remember, in a cooperative, members will be able to elect directors that control the business, so the directors _could_ depart from your vision eventually.  In a cooperative, members are ultimately in control.

Q: I’m doing business with some friends, and we make decisions democratically.
A: If you share profits in proportion to your work, or in proportion to how much product or service you provide, then you are acting just like a cooperative.

Q: We have employees who are not members.  Can we distribute the profits from non-member labor to the members only?
A: It’s common for worker co-ops to have non-member employees—usually there is some training or probation period before admitting a new member.  I would say that to be considered a cooperative, most or all of the employees must have the option of becoming a member.  California Cooperative Law requires that in a worker cooperative, at least 51% of workers must be worker-members or candidates.

Legal definitions of cooperative:
For cooperatives that form under California’s Cooperative Corporation Law, the class of members that controls the co-op has one vote for each member.  The law does not define how members own equity, but it requires net income to be shared in proportion to each member’s use of the cooperative (which could be hours worked, purchases made, or produce marketed and sold by the cooperative).

For cooperatives that form under Illinois’ Co-operative Act, ownership must be spread out among the members because no one may own or control more than 10 shares of the co-op’s stock.

A cooperative is also defined by the Internal Revenue Code as a business that is “operating on a cooperative basis.”  That means: the business must be democratically controlled by its members; net income must be shared on the basis of patronage (business done with or for the cooperative); and capital must be “subordinated,” which means that the members, not capital investors, are primarily in control and receive the benefit of the cooperative.

​“The U.S. Federation of Worker Cooperatives calls any enterprise that is worker-owned and worker-controlled a worker cooperative.”  Melissa Hoover, Another Workplace is Possible, at 243, chapter 14 in Jenna Allard and Carl Davidson, ed., Solidarity Economy: Building Alternatives for People and Planet.

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