by Attorney Deborah Groban Olson

Executive Director, Center for Community Based Enterprise

313-331-7821 dgo@esoplaw.com

Workshop at US Federation of Worker Co-opsAnnual Conference, Chicago, IL June 1, 2014

What is a Worker Co-op?Usually a • for-profit business • jointly owned and democratically controlled• by its worker owners• limited return on equity investment• operated on the Int’l Co-op Alliance Principles

(1996) originating from the Rochdale Principles (1844)

Principles are the defining core of a worker co-op Many different legal structures are used due to business needs and state laws

International Co-op Alliance Principles (1996)

1. Voluntary and Open membership. 2. Democratic member control. 3. Member Contribution to Capital. 4. Autonomy and independence. 5. Education of members and public in cooperative principles. 6. Cooperation between cooperatives. 7. Concern for community.

Common Features of Worker Co-ops

•Usually include all full-time workers & majority ownership•One vote per person•Surplus returned on the basis of patronage not equity•Member supermajority vote on selling to outsider•Some tax benefits•Capital financing can be difficult•Michigan securities exemption for non-profit co-ops

Issues to Consider

• Liability Protection • Need for outside investment• Incentive for selling owner if conversion• Tax treatment• Ease of operation/accounting• Settled law• Employee vs. Owner• Using the word “cooperative”

Worker Co-op Structure Options• Cooperative under state law

• Partnership

• Corporation (S or C)

• LLC

• L3C

• Non-profit tax exempt corporation

• ESOP organized on co-op principles

• Additional status options:

• Eligible Worker Owned Co-op – IRC §1042(b)

• B Corp status – B Lab or state law

State Worker Co-op Laws• Many states limit use of the word “cooperative” or

“co-op” in company name to those incorporated under a state co-op statute

• Some states have worker co-op laws• Mass, CA, PA (See State Worker Co-op Laws as of 2012 www.c2be.org/resources)

• Some, like Wisconsin, have a well developed general co-op law that can be used for worker co-ops

• In some states you might use the agricultural co-op or consumer co-op laws

• Some have no co-op laws – or you may choose to create co-op features within a C or S corporation, an LLC or L3C

• Legal definition of “organized on a co-op basis” is case law

New Generation or LLC/Co-opWisconsin’s Chapter 193, “co-op LLC law” authorizes the creation of membership

interests for investors who are not patrons of the cooperative.

• Investor members’ voting rights may not exceed a total of 49% but the

bylaws may provide investor members with the power to veto certain

unusual decisions such as merger or dissolution

• Investors’ may not receive more than 70 percent of the profit allocations and

distributions of the cooperative.

• A Chapter 193 co-op may elect to be taxed as a partnership under Subchapter

K of the Internal Revenue Code, or as a cooperative under Subchapter T

However, some experienced Wisconsin Co-op attorneys prefer to use the well

structured traditional co-op law, Chapter 185, that also allows for different classes

of members, called “divisions” with different rights

Eligible Worker Owned Co-opAn EWOC is special type of co-op (IRC §1042) that permits selling owners to

defer payment of capital gains tax on the proceeds of the stock they sell to a

worker co-op, if the proceeds are reinvested in domestic stock. If the reinvestment

stock is in the owners’ estate upon death, the family never pays the capital gains

tax.

To qualify as an EWOC, a worker co-op must have these features:

• A majority of the co-op’s members must be company employees;

• A majority of the co-op’s voting stock must be owned by co-op members;

• A majority of the board of directors must be elected by the members on a 1

vote per person basis, and

• A majority of earnings and losses are allocated to members on the basis of

their work, their capital contributions or a combination of both.

Worker Co-op Accounting & TaxTax advantages of co-ops under Subchapter T of the IRC• Surplus attributable to member-labor is not subject to the corporate

double tax. • Surplus allocated to members on the basis of their patronage is

taxable to the members but not to the co-op.• Some co-ops generate revenue from both members and non-

members.

To qualify for taxation under Subchapter T:• Benefits of operation to members• Democratic control by members – one member one vote• Earnings returned in proportion to patronage

Example: Sub Chapter T Tax Benefit

Co-op A has 15 members and 3 non-member employees (in their probation period - not yet been admitted as members)Co-op must determine how much of its surplus was generated from the work of the• members versus the non-members. • Only the portion generated from the members is exempt

from the corporate double tax.

Worker Co-op Member & Collective Capital Accounts

• When members join a co-op, they make an initial capital contribution. This is the starting

balance in the member's capital account. The capital account is not a separate bank

account but is accounted for on the books of the co-op and is basically the property of

the member, though the funds are kept in the co-op's account.

• The co-op has rules about how and when the members can get the contents of their

capital account back out of the co-op. Usually, a member does not get his/her capital

back until he/she leaves the co-op. Often when he/she leaves the co-op, the balance in

the capital account converts to a loan from the departing member to the co-op and the

co-op pays it back over time.

• At the end of each year, the co-op determines whether its revenue exceeded expenses.

If there was a surplus of revenue over expenses, the co-op may decide to retain a

portion of the surplus in a “collective account” as a reserve.

• The collective account is separate from the member capital accounts (compare to

LLCs and S Corp where this cannot happen). The co-op may pay tax on earnings not

allocated to members.

• After setting aside a reserve in the collective account, if there is still additional surplus,

the co-op will pay patronage dividends to its members.

• Patronage is usually calculated based on hours worked.

Patronage Dividends & Capital Distribution• The co-op can choose to pay the entire patronage dividend in cash, or it may pay a

portion in the form of a Written Notice of Allocation (WNA).

• Use of WNAs allows the co-op to retain more cash within the co-op. Unlike the

surplus allocated to the collective account, WNAs are allocated to the member

capital accounts and become the property of the members.

• Co-op sets policy as to when members may withdraw these funds as cash from

their accounts. WNAs are usually redeemed on a rolling basis.

• Some co-ops pay interest on the balance in the member capital account.

• The members pay income tax on the ENTIRE patronage dividend, regardless of

whether it was received in cash or in the form of a WNA.

• If members receive less than 20% of the patronage dividend in cash, the WNA is

nonqualified and the co-op may not benefit from the Subchapter T exemption from

double tax. The member does not pay tax on a nonqualified WNA until he/she

receives it in cash.

• Losses may also be allocated to member capital accounts as determined by the co-

op.

Securities Exemptions• Some states (MI) provide special securities exemptions for sale

of co-op memberships

• In non-profit co-op

• Thus best to create worker co-op under consumer co-op law

in MI

• Using LLC law requires more detailed disclosure

• Federal law holds that sale of co-op membership is not sale of a

security

• Securities laws regulate the sale of business interests to

particularly to “unsophisticated investors”

Partnership• Automatically created when a group of people get together to

run a business – no filing required

• No liability protection for partners – each partner is

personally liable for any liabilities or debts of the partnership

• Pass through entity for tax purposes

• Partners are not employees

• Some states have limited liability partnership laws, but in most

cases these are now structured as LLCs

C Corporation• Traditional business corporation, taxable at company and shareholder levels

• Shareholder primacy (vs. stakeholder statutes)

• Liability protection for owners (shareholders)

• Owners that work in the company are employees

• No self employment tax

• Employment law applies

• Likely traditional preferred stock or bonds used when outside investors are

needed

• Dividends must be in proportion to stock ownership

• Biggest complaint about corporations: double tax

Alternatives

• S election – taxed like a partnership

• Special tax treatment for co-ops – SubChapter T & some state laws

• ESOP portion of S corporation – pays no federal income tax

S Corporation• No tax at corporate level – tax liability passes thru to members, except ESOP

• Phantom income problem

• Unlike C Corp can’t have multiple classes of stock

• Special requirements to maintain S Corp status:

• No more than 100 shareholders

• Shareholders must be individuals; citizens, legal residents, ESOP or

certain trusts

• Only one class of stock (different voting rights not considered a different

class)

• Failure to meet these requirements results in automatic loss of S status

• Owners are employees – no self employment tax

• Tax on ESOP allocations to members is paid upon retirement or termination

of employment

Employee Stock Ownership Plan (ESOP)

ESOP (Employee Stock Ownership Plan) is:

• an employee benefit plan and trust

• Invested primarily in employer stock

• highly tax-favored

• employees share ownership in their company as trust beneficiaries

• allocates shares to each eligible employee every year

• gives employees increasing ownership stake as they accumulate

seniority

• distributes these shares to employees, usually sometime, after

they leave the company, to fund their retirement.

ESOPs – pro & conAdvantages

• Ownership can transition to employees over time

• Can own any % of Company

• Easier to finance

• Can have 1 vote per person & allocations based on hours worked

• Many tax benefits to seller, company & employees for C & S corporations• Contributions of stock are tax deductible to company

• Contributions to pay for stock purchase principal and interest are deductible

• Stock dividend distributions can be deductible

• Capital gains deferral for seller

Disadvantages• ERISA Plan - Employees vote stock through a trust

• Allocations usually based on pay

• May have substantial or limited EO voting & voice

• Trustee is actual owner/ employee is plan beneficiary• Trustee decides about sale to outsider

• Trustee’s obligation is to workers as retirees

• Annual valuation and legal expenses

Example of Co-op style ESOP MBC Ventures(MBC)

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•Started in 1851

•Part of PPG Industries since 1904

•1990 became 100% worker owned USW co-op style ESOP

MBC ESOP with co-op values

Sees itself as long term community asset

Must retain competitive edge to continue Maintains cash reserves

Reinvests in company

Balances risk- protecting investment of older workers & jobs needs of younger worker

Involve workers in all major decisions

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Maryland Brush: co-op governance structure in a 100% S corporation ESOP4 internal board members

MBC president

Local union president

1 selected by salary group

1 selected by wage group

3 external board members 1 appointed by USW district director

1 appointed by MBC president

1 nominated by USW, affirmed by MBC

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Mature markets problem – Maryland Brush finds solar product

Specializes in custom designed power brushes for: Steel industry

Nonferrous metals industry

Truck Tire retread industry

Industrial distributor market

Special machinery market

Welding industry

By 2007 - Maryland Brush Company knew it needed to diversify outside of the brush industry

Found new solar energy product

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2010 MBC bought Photensity with S Corp ESOP savings

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Now called “Skylouver”

LLCs & L3CsLLCs - limited liability same as corporation

• taxed like partnerships

• can elect to be taxed as corporations

• owners (members) are not employees

• member managed vs. manager managed

• all earnings subject to self employment tax (guaranteed payments

and profits)

• phantom income problem

• cannot have unallocated equity – all equity is allocated to member

capital accounts

• very flexible & easy to form

• co-op features created in operating agreement

Low Profit LLC = LC3L3Cs are LLCs:

• For profit but with a primary social purpose

• designed to attract foundation investments & some market rate

investments to serve social purpose

• can only be formed in a few states (MI is one)

• Can provide stakeholder instead of shareholder primacy

• similar purpose as B corp in states without formal B corp

Example: Ingenuity US, L3C

Ingenuity US, L3C (IUS) is

• a Detroit based, community innovation broker and business developer

• focused on building patient, community-focused capital and cooperative business

resources

• providing a supportive ecosystem for sustainable, locally rooted and employee

owned businesses,

• that provide jobs with limited barriers to entry for Detroiters with limited formal

education where employees build skills and leadership on the job.

• the for-profit arm of the Community Economy Group which includes the non-

profit Center for Community Based Enterprise (C2BE)

• adapting proven models of cooperative economic and social practices, to help

accelerate Detroit’s transformation to a sustainable and inclusive local economy.

• C2BE created the Detroit Community Cooperative (DCC) - a network connecting

a wide-variety of like-minded Detroit businesses.

IngenuityUS, L3C MissionIngenuity US is building a co-operative of business, non-

profits and individuals founded on our values, enabling a

vibrant, rooted, growing, sustainable community in

Detroit.

Möbel Link Furniture, an

IUS company

IUS ValuesWe believe:• Every person desires and deserves dignity.

• Children are raised and educated by communities.

• Meaningful work, at living wages, is the foundation of dignity.

• Meaningful work includes participation in making decisions that affect ones’ work.

• Making good decisions about work requires acquiring necessary knowledge and skills.

• Workers and managers are equally responsible for creating an educated workforce.

• Self-respect and respect for others is the basis of community.

• People build community by working together for common aims, playing together, eating together and

taking care of each other.

• Globalization of the economy is destroying much of the basis of community.

• All the skills and resources necessary to build a vibrant, sustainable community are available in

Detroit and SE Michigan.

• Embracing change, and high quality, continuous education are necessary for building and sustaining

an enterprise based community.

• Employee and community-based ownership provide long-term stability to enterprise-based

communities.

• Creation and maintenance of such a community welcomes partnerships with privately owned

businesses that respect our values.

• Our products will be earth and community friendly.

Self Employment Tax on Worker Co-op Patronage Dividends

“Over the past few years, IRS Examination (audit function) undertook correspondence “audits” of several members of worker cooperatives asserting the position that the member’s patronage dividends are subject to self-employment (SE) tax. Attorney Greg Wilson fought these cases asserting that patronage dividends were not subject to SE tax for various reasons. Eventually, an attorney for the IRS – IRS Counsel’s Office – in San Francisco, asked the IRS National Office for guidance on this issue. It appears that the IRS National Office concluded that patronage dividends paid by worker cooperatives are indeed not subject to SE tax and dropped the cases where it was asserting SE tax applied to worker coop patronage. But the IRS arrived at this conclusion because they determined the worker/members are employees of the cooperative and employees generally cannot receive both employment and self-employment compensation from the same entity. Continuing with this theme, the IRS then hinted that its position might be that patronage dividends paid by worker coops should be subject to employment taxes at the cooperative level –instead of SE tax – like a bonus paid to an employee. Where the IRS is going with this now is unclear. “ 2009 Atty. Jenny Kassen

Tax Exempt Non-Profit 501c3Incubated Co-ops, such as Evergreen, often have a central non-

profit entity that has foundation or other investors who want to

• invest in a non-profit

• with a board that includes parties other than the workers

• or begins with no worker members

• protect their social capital from being distributed to

individual members upon demutualization of the co-op

• May serve as launching pad for for-profit incubated worker

co-ops after training, etc.

Benefit “B” Corporation• Is a status that can be held by a non-corporation

• Generally is not based on state statute, except in Hawaii & a few states that have “B” Corp

statues

• B Lab has created a set of standards for certifying “B” corporations

• Many states, like Ohio, have “constituency” statutes that permit the corporate charter to have

language that allows the board to consider interests of stakeholders other than solely the

shareholders

To become a B Corp in a “constituency” statute the corporate charter must require the board of

directors to consider “such factors as the Director deems relevant, including, but not

limited to, the long-term prospects and interests of the Company and its shareholders, and the social,

economic, legal, or other effects of any action on the current and retired employees, the suppliers

and customers of the Company or its subsidiaries, and the communities and society in which the

Company or its subsidiaries operate, (collectively, with the shareholders, the “Stakeholders”),

together with the short-term, as well as long-term, interests of its shareholders and the effect of the

Company’s operations (and its subsidiaries’ operations) on the environment and the economy of the

state, the region and the nation.”

Resources•US Federation of Worker Co-ops

• Center for Community Based Enterprise,

www.c2be.org/StateWorker Co-op Laws as of 2012

• Arizmendi Association of Cooperatives

• www.wagescooperatives.org

• www.esoplaw.com

•National Cooperative Business Association

•International Cooperative Alliance

•University of Wisconsin Cooperative Extension

•Circle Pines Center

For more information contact

www.esoplaw.com34

www.esoplaw.com

www.workerownerlaw.com

dgo@esoplaw.com

(313) 331-7821