The Role of Federal and State Policy in Formation and Success of Cooperative Businesses

1. The Role of Federal and State Policy in Formation and Success of Cooperative Businesses Dave Swanson 612-343-8275swanson.dave@dorsey.com Agricultural and Food Cooperatives in Rural Development: Implications of Business Dynamics for Public Policy June 16-17, 2004

2. Definitions of Cooperative • Tax Law Definition • Capper-Volstead Definition for Farm Coops • Borrowing Eligibility – CoBank, CFA, NCB • Coop Trade Association Eligibility Standards • Rochdale Principles • State & Federal Securities Laws Common Theme:Allocate Margins by Patronage

3. Evolution in Organizational Models Generally • Historical model: tax neutrality (partnerships and tax-exempts) v. limited liability (corporations) • Current model: increasing options to combine tax neutrality with limited liability and more emphasis on public (highly liquid) v. private (less liquid) ownership

4. Comparison of “Traditional” and “New Generation” Coops Traditional Cooperative • Open Membership • Voluntary Membership • Low Up-Front Membership Cost • Retain Margins/Revolve Patronage Equities

5. Comparison of “Traditional” and “New Generation” Coops New Generation Cooperatives • Limited Membership • High Up-Front Membership Cost • Longer-Term Contractual Commitment • Shares Are Traded • Margins Are Distributed

6. Tax Attributes of Coops • Subchapter T • Patronage Sourced Income Deduction • Operation on a “Cooperative Basis” • Patronage Allocation (pre-existing duty) • Democratic Control • Subordination of Capital • Mutuality of Interest • 20% Cash Distribution in 8½ Months • Sourcing of Income/Expense

7. Tax Attributes of LLCs • Pure Pass-Through of Tax Attributes to Members • No Patronage Requirement (but it’s allowed) –– facilitates non-member equity • Publicly Traded Partnership Rules • Self-employment Tax • Passive Activity Loss Limitations

8. Is Capper Volstead Critical? • Capper-Volstead Does Not Mandate Cooperative Label • Price Fixing Exemption & Allows Market Power Unless Undue Price Enhancement • Joint Venture Analysis for New Ventures • Importance for Common Marketing Pools

9. Securities Law Attributes of Coops • Section 521 Exemption • Forman case • Blue Sky Exemptions

10. The Equity Limitation • Patronage based earnings distribution limits the pool of potential “investors” • Limits on preferred stock as an equity source • Dividend allocation rule • State law limits on dividend rate • Joint ventures as an equity source -Tax and securities issues for new coops -Cost and complexity

11. Cooperative Conversions • EExisting Coops → conversion to LLC • potentially a taxable transaction for • coop & members

12. Cooperative Conversions Conversion Examples: Dakota Growers Pasta Minnesota Corn Processors South Dakota Soybean Processors

13. Choice of Entity For New Ventures– Coop v. LLC It’s an “Art” Not a “Science”

14. Coop May be tax neutral (but with limits) Outside equity limits LLC Tax neutral Outside equity flexibility Choice of Entity For New Ventures– Coop v. LLC • The Tax / Equity Flexibility Factor

15. Securities Registration Cost 521 Exemption Intra-State Private Placement Tax Credits — Ethanol Blue Sky Exemptions Borrowing Eligibility Importance of Non-Producer Investment Special Program Eligibility Nature of the Farm Product Involved Nature of the Market and End Products Choice of Entity For New Ventures– Coop v. LLCSome Driving Factors

16. Some Other Coop Strengths & Weaknesses STRENGTHS • Common interests (other than profit) can promote long-term view in decision-making • Potential to achieve greater market power • Greater potential to share know-how?

17. Some Other Coop Strengths & Weaknesses WEAKNESSES • Limits on farmer-owners’ ability to access equity and appreciation (especially traditional coops) • Problems with retiring farmers (especially NEWGEN coops)

18. An Idea for Redefining Federal Cooperative Policy Primary Farmer Benefit Test v. Cooperative (or 100% Farmer Ownership) Test