Worker Cooperatives: Their Time Has Arrived

by Linda D. Phillips

Business Law articles are sponsored by the CBA Business Law Section to apprise members of current substantive law. Articles focus on business law topics for the Colorado practitioner, including antitrust, bankruptcy, business entities, commercial law, corporate counsel, financial institutions, franchising, and securities law.

Coordinating Editors

Trygve E. Kjellsen of Lathrop & Gage LLP, Denver—(720) 931-3145, tkjellsen@lathropgage.com; David P. Steigerwald of Sparks Willson Borges Brandt & Johnson, P.C., Colorado Springs—(719) 475-0097, dpsteig@sparkswillson.com; Curt Todd, Denver—(303) 955-1184, ctodd@templelaw.comcastbiz.net

About the Author

Linda D. Phillips is a member of Dean, Dunn & Phillips LLC. Her practice centers on general business law, including all forms of cooperatives (purchasing, marketing, and worker) and other forms of business entities, contracts, commercial real estate, acquisitions, employment law for employers, collections, and wills and trusts— linda@lawatddp.com

This article provides an overview of the worker cooperative as a business model, including how these cooperatives are formed and their unique characteristics. Tax advantages when selling a company to employees using a worker cooperative also are discussed.

Cooperatives, as business entities, including agricultural, electric, telephone, utility, and consumer cooperatives, have been formed and operated in Colorado since the early part of the 20th century. However, "worker" cooperatives have been largely ignored until recently, perhaps because the business community is not fully aware of their usefulness as a business entity. This article explores the worker cooperative as a business model whose time may have arrived.

Overview of Cooperatives

A cooperative is a form of business entity, distinguishable from standard, for-profit corporations, limited liability companies, and partnerships. A cooperative can be formed for any legitimate business purpose and many well-known companies are cooperatives; Land-O-Lakes, Ace Hardware, and REI (Recreational Equipment Inc.) are just a few.

In Colorado, cooperatives generally are formed under Title 7 of the Colorado Revised Statutes, Articles 55 and 56. The statutes were revised in 1996 to allow for increased flexibility by the incorporators forming cooperatives. Cooperatives may be formed for any lawful business purpose. ¹ They may be organizations with or without stock ² and may have differing classes of membership. ³ The definition of a "cooperative" is similar in both Articles 55 and 56. Article 56 states a cooperative is an entity having the following characteristics: ⁴

1. the business is operated at cost by adjusting prices or by returning net margins on a patronage basis to members and patrons;
2. dividends on stock or interest on equity capital are limited;
3. voting rights are limited to members of the cooperative;
4. business is carried on for the mutual benefit of the members; and
5. members are not liable for any debt, obligation, or liability of the cooperative

In lay terms, a cooperative is an organization formed by a group of people, for their mutual benefit, and with a common purpose, such as group marketing activities, group purchasing, or as the employee–owners of a company. A cooperative is an organization where the members have a say in the governance of the company and is, in some ways, similar to a family-owned business.

A worker cooperative has all of the characteristics mentioned above, but it is formed and operated by the employees of a company for their mutual benefit—essentially jobs. Worker cooperatives are located throughout the United States, from Massachusetts to California and from Minnesota to Texas. ⁵ The employees democratically control the management and operations of the company, with each employee–owner having an equal vote. These cooperatives may be formed in Colorado under Article 56 of Title 7, because the statutes allow formation of a cooperative for any business purpose. The 2011 Colorado Legislature passed a new cooperative statute called the Uniform Limited Cooperative Association Act (ULCAA), ⁶ which would also allow formation of a worker cooperative.

Distinguishing Characteristics

Although the cooperative business model is fairly flexible (the company may be formed with or without stock and the bylaws provide for the management of the company), there are a few characteristics that are unique to cooperatives. These are discussed below.

The characteristic that is most well-known about cooperatives is that the members—or in the case of worker cooperatives, the employee–owners of the cooperative—are limited to one person, one vote. Generally, this means that all employees, no matter their salary, job title, or years of service, are entitled to one vote per person on all matters brought before the membership of the company. ⁷ The Colorado cooperative statutes do allow for proportional voting based on member patronage of the cooperative, the amount of equity held in the cooperative, or a combination of these methods. No member may have more than 2.5% of the total vote; if there is a very small number of members in a company such that one member would have more than 2.5% of the vote, each employee–member is entitled to only one vote. ⁸

One-member, one-vote does not mean that all employees must be involved in every decision made for the company. As with most businesses, a board of directors and management team are provided for in the bylaws of the cooperative to set policy and manage the operations of the company. If the worker cooperative has only five to ten employees, more direct management is possible, with all employees acting as directors and as management personnel.

Giving each employee equal voting power creates an atmosphere where the employee may feel he or she has a stake in the direction and management of the company. The bylaws of a worker cooperative can be very flexible with respect to management operations. ⁹ If provided in the bylaws, the employees can participate in elections of directors and appointment of officers, as well as decision making about product lines and marketing, income and expenses, and profits and losses. A cooperative business model also allows individual employees to build personal assets by having distributions made to employee equity accounts. When an employee retires or leaves the company, his or her equity account can be redeemed by the company over time. In addition, the worker cooperative business model gives employees an enhanced incentive to participate in creating sustainable jobs for themselves and their co-workers.

Taxation of a Worker Cooperative

A worker cooperative has a unique income tax structure and receives potential favorable tax treatment from the Internal Revenue Service (IRS). A cooperative tax structure is similar to that of a partnership, but there are specific federal statutes that prescribe how a cooperative should be taxed if it is going to call itself a cooperative. A cooperative can receive favorable tax treatment under Subchapter T of the Internal Revenue Code (Code) if the company is operating on a cooperative basis. ¹⁰ In general, this section of the Code allows a company to decrease its taxable income by not taking into account or deducting amounts paid to members of the cooperative as patronage dividends. ¹¹

The net margins (the term used by cooperatives for profits) generated by the patrons (the workers/members) are not taxed at the cooperative level, but instead are allocated to the patrons on an annual basis, similar to a partnership distribution. The allocation is made to the patrons based on their use of the cooperative, rather than based on an investment, as it might be in a corporation or other form of business entity. At least 20% of the allocation to the patrons must be in cash, and the remainder—also allocated to the patrons—can become patronage equity. The patronage equity is retained on the books of the cooperative in an account for the patron, until redeemed at some time in the future.

The patrons receive a 1099-PATR from the cooperative, reporting the allocation (both cash and non-cash allocations) and the patrons are responsible for paying the income tax on that income. Sometimes, the cooperative will make non-qualified allocations to its members and in this instance, the income tax is paid by the cooperative. The regulations for receiving this favorable tax treatment are fairly extensive and this article is intended only as an introduction. Persons interested in additional information about taxation of cooperatives are encouraged to review the statutes and to read a set of books from the U.S. Department of Agriculture that discuss cooperative taxation. ¹²

Forming a Worker Cooperative

Strategic business planning often involves the decision of what form of business entity to use for a particular business—for example, whether to use a C corporation, an S corporation, a limited liability company, a partnership, or some other type of business enterprise. A cooperative can be formed by employees getting together, filing articles of incorporation, and generally following the Colorado cooperative statutes for creating a cooperative. However, a business entity that has been in operation for some time can be converted to a cooperative using the Colorado conversion statutes. ¹³ A company's existing employee–shareholders can convert their stock into one share of common stock with voting rights, and the remaining shares can be converted into preferred stock with premium dividends but no voting rights. The governance rights would change from each employee–shareholder voting according to the number of shares owned to each employee–owner having one vote.

Exiting a Worker Cooperative

Strategic business planning should take into account the methods business owners might use to exit a business. An owner can leave a business by selling it to family members or third parties, merging it into a larger organization, selling it to employees through an employee stock ownership plan (ESOP), or by simply closing the shop. However, one often overlooked method that business owners, especially small to medium-sized business owners, might consider is having the employees form a worker cooperative. The owner then can sell the business to the cooperative. In the alternative, an existing corporation or limited liability company can be converted into a cooperative enterprise.

A business owner who has worked for many years building a company wants to be compensated for the effort. He or she also wants to see the company continue in good hands. The owner often sees the exit from the business as a retirement plan. When strategizing for the best exit plan, the owner usually is advised to think about trying to sell the company to a third party or having a family member take over the business. These are familiar methods for exiting a business. However, selling the business to a third party may be difficult in a down economy, and selling the business to family often does not compensate the business owner for building the company. Having the company's employees purchase the business is another option and can be accomplished through an ESOP or through the creation of a worker cooperative.

The advantages to this type of exit strategy are numerous. For the employees, a purchase of the business would mean job stability, more control over their careers, higher morale, and usually better productivity. Unlike an ESOP, where the employees are simply beneficiaries of a trust holding their stock, with little management authority, in a worker cooperative the employees can directly operate the business. Through year-end distributions of net margins, the employee–owners build up equity accounts that act as their retirement plans.

Also, unlike an ESOP, there are no added administrative costs in forming or maintaining a worker cooperative and the regulatory environment is much less strict. A cooperative is a business model, not an investment model, and therefore it is governed by state incorporation statutes and federal tax statutes.

Selling to a worker cooperative is a business exit strategy that allows the owner to see that the business will continue, while also getting compensated for creating and growing the business. If the sale to employees is completed over a number of years, the owner could continue with management and training until the sale is finished. The employees could be trained in the responsibilities of ownership and management, giving the owner assurance that the company will continue as planned. The sale of the company to the employees could take place on a designated date or over a substantial period of time (such as five to ten years). This would allow the employees to pay the entire purchase price over several years. In addition, there is possible favorable tax treatment for the selling owner under Code § 1042. ¹⁴ .

Section 1042 Tax Treatment

Code § 1042 allows the owner of a business to sell his or her stock to a worker cooperative with resulting favorable tax treatment. To qualify for the favorable treatment under § 1042, the proceeds from the sale of the owner's interest in the company must be reinvested in a "qualified security," and the gain then is deferred and recognized as a long-term capital gain only to the extent that the amount realized on the sale exceeds the cost to the owner of the qualified replacement property. ¹⁵

Specific requirements must be met before § 1042 is available to the seller. To qualify for § 1042 treatment, there is a four-step process:

1. The sale of the company's stock must be to an eligible worker-owned cooperative or to an ESOP. ¹⁶
2. The worker cooperative must own at least 30% of the total value of all outstanding stock, or of each class of outstanding stock, immediately after the sale. ¹⁷
3. The taxpayer (either the owner or the cooperative) must file a written statement with the IRS consenting to the application of §§ 4978 and 4979A with respect to the owner or the cooperative. ¹⁸
4. The taxpayer's holding period with respect to the purchased qualified securities must be at least three years (determined as of the time of the sale). ¹⁹

The first step is satisfied by the formation of a cooperative under Title 7, Article 56, of the Colorado statutes. The second step requires some financial planning on the part of the owner and the employees who will be purchasing the business. The owner must determine the value of the company, which may require the services of a business valuation professional. Then, the employees must find a way to purchase at least 30% of the business the first year of the sale. This may require the employees to obtain a loan or other funding sources for the initial payment. The remaining 70% of the purchase can occur over a number of years, as determined by the parties.

The funds received by the owner for the sale of the business must be invested in qualified replacement property for a minimum of three years. "Qualified replacement property" is defined in the Code, but the definition is a little cumbersome. Generally, it is any security issued by an active domestic corporation that is not issued by the company being sold and that does not have passive investment income in excess of 25% of the gross receipts of the corporation for the preceding tax year. ²⁰

Code §§ 4978 and 4979(a) concern tax on certain dispositions by cooperatives and generally provide that there will be a tax imposed if the cooperative sells the securities it purchased from the owner before the three-year holding period provided in step 4 above is concluded.21 Of course, a tax professional should be consulted concerning whether a 1042 election is appropriate in the particular circumstances.

Example

As a simplified example of how this might work, suppose that a company has ten employees and the owner wishes to sell the company for an agreed-on value of $750,000. All of the employees wish to purchase the company from the current owner (although it is possible to sell the company to fewer than all employees). The employees form a worker cooperative and purchase the entire company from the owner.

They purchase at least 30% ($225,000) in cash on the date of sale and sign promissory notes to the owner for the remaining 70%. The owner uses the $225,000 to purchase qualified replacement property to be held for at least three years. The owner and the employees are now owners of the cooperative, each with one vote and each with the power to participate in the management of the company. As part of the agreement between the owner and the new employee–owners, it could be provided that the owner retains certain management authority until more of the notes are paid.

Over a period of years (all agreed), either the cooperative itself or the employees can pay for the remaining ownership interests. Payment can be made from net margins or by the employees making additional capital contributions.

Eventually, the owner is paid in full and can retire, knowing that his or her company will continue in an approved manner. The community has not lost a business, the employees have job stability, and their families have the knowledge that a nest egg is growing in the company. When an employee leaves the company or retires, the cooperative can redeem his or her equity account over a period of time or all at once, as agreed by the employee–owners.

Conclusion

The worker cooperative is a flexible business model that can be used by any group that is interested in creating a democratic decision-making company that benefits the employee–owners with job security, a sense of accomplishment, and possible retirement income. In today's economy, many small business owners would like to retire or at least start planning their retirement. However, they may find that there are very few opportunities to sell their businesses to a third party, and family members may not want to continue the company. By selling a business using a cooperative model to employees who have the knowledge and enthusiasm to continue to provide products or services, an owner can feel good about passing the business along to someone else.

Notes

1. CRS § 7-56-201.
2. CRS § 7-56-201(e) and (f).
3. CRS §§ 7-56-301 et seq.
4. CRS § 7-56-103(6).
5. See www.usworker.coop/about/memberlist.
6. SB 191 adds a new Article 58 to CRS Title 7.
7. CRS § 7-56-305(2).
8. CRS § 7-56-305(3).
9. CRS § 7-56-208.
10. Subchap. T, 26 U.S.C. § 1381(a).
11. 26 U.S.C. § 1382(b).
12. Frederick, "Income Tax Treatment of Cooperatives, Parts 1 through 5," USDA Rural Development, Cooperative Information Report (2005).
13. CRS §§ 7-90-201 et seq.
14. 26 U.S.C. §§ 1042 et seq.
15. 26 U.S.C. § 1042(a)(3).
16. 26 U.S.C. § 1042(b)(1).
17. 26 U.S.C. § 1042(b)(2).
18. 26 U.S.C. § 1042(b)(3).
19. 26 U.S.C. § 1042(b)(4).
20. 26 U.S.C. § 1042(c)(4).
21. 26 U.S.C. §§ 4978 and 4979(a).

As published in The Colorado Lawyer, Vol. 40, No. 9, September 2011