Internal Capital Accounts: Overview
The ownership structure is the basic building block of any enterprise. It determines what stake each owner has in a company, as well as how authority, responsibilities, risks, and rewards are distributed in a firm. It also determines how an owner enters and leaves the company. In a worker co-op, an individual member’s share of the value of the firm should be tracked using a system of internal capital accounts.
This is quite different than a traditional corporation where the net worth is reflected in the value of stock. As a conventional firm grows and becomes more valuable, the value of each owners stock increases in value as well. By recording the value in a share price, the appreciated value of these stocks might make them too expensive for new members to purchase. Historically, using capital shares rather than capital accounts, has led successful worker cooperatives to sell off because new workers couldn’t afford to buy into the company.
The internal capital account system addresses this issue by shifting the function of carrying the net worth of the company away from the shares and into the internal capital accounts. Increases in net worth will increase the balance in members’ accounts, due back to them eventually in cash. The membership share, however, doesn’t substantively change in value, enabling new members to pay an affordable membership fee when they join. At any given time, members may have differing claims on the company’s net worth, but they all have the same membership rights and only one membership share each. This worker cooperative structure is designed to create a business that is multi-generational in nature in order to sustain the democratic corporate structure over time.
In a conventional corporation, dividends are distributed according to each shareholder’s capital investment and number of shares, so they are called “capital dividends.” In a cooperative, dividends are allocated according to contributed labor or “patronage,” so they are called “patronage dividends.” Patronage dividends in a worker cooperative differ from capital dividends in a number of ways:
- They represent a return on labor patronage rather than a return on capital investment,
- Payment of patronage dividends (unlike capital dividends) is ultimately tax deductible by the corporation if the requirements of Subchapter T of the Internal Revenue Code are met, and
- A corporation may allocate a patronage dividend partially or entirely on paper, and retain the profits for a period of time to use for any corporate purposes.
The Membership Share
The Net Income Split
An internal capital account cooperative treats its net income quite differently from a standard corporation. Net income is split into two portions — individual net income and collective net income. The individual net income is allocated to an account that is designated to be paid out to the individual members, in other words, the individual member has a claim to the value tracked in this account. The collective net income on the other hand, is designated to be controlled by the cooperative as a whole. No individual member has a claim to the value associated with this account (except in the case of the dissolution or de-mutualization of the coop). It is recommended that coops specify how this split will occur in their by-laws, however, the Board of Directors can make this decision on a year by year basis as well.
It’s important to remember that when a co-op uses accrual accounting their net income is different than the cash they earned from the business during the same year. When the coop ‘splits’ its net income, they’re not actually putting money into an account, rather, they’re tracking it in a certain account in their accounting software or their ledger.
Normally, corporations are taxed on their total net income. However, because of a special Federal tax provision for cooperatives called Subchapter T (this is why coops are sometimes referred to as “T-Corporations”), cooperatives only pay federal corporate income tax on the collective net income and avoid what is referred to as double taxation. Individual net income ultimately avoids the Federal corporate income tax. It is taxed at the individual level, but it avoids the ‘double taxation’ of the typical corporate structure. (click here for more information on Subchapter T.)
Without this tax benefit, a co-op that made $50,000 would pay much more in taxes. If the federal tax rate was 15% and the co-op made $50,000 in net income they would have to pay $7,500 in taxes. Because only half of the income is taxed at 15%, however, the coop only pays $3,750, cutting its tax bill in half. The more a co-op distributes to the individual accounts, the less its tax obligation. However, that money eventually has to be paid out to the members in cash, so careful planning is necessary to ensure your co-op can meet its obligations.
The total amount of individual net income is called the patronage dividend. The amount a member patronizes the coop with his or her labor determines their share of the net income (or loss). Labor patronage is usually determined by the percentage of the total hours a given member worked. The patronage dividend can be paid out in cash or in a note called a written notices of allocation to a member’s internal capital account. The membership, or the Board of Directors, decides how much of the individual net income to pay out in cash and how much to retain in members internal capital accounts.
With $25,000 of individual net income, the board decides to pay out half in cash and half in written notices of allocation. In both cases, the members’ patronage dividend is paid out in proportion to the total hours worked. So if one member worked 6% of the total hours, she would receive 6% of the patronage dividend. In our example, therefore, she would get a check for $750 and a written notice of allocation for $750 to be recorded in her internal capital account, indicating that she had a claim on $750 of the coop’s retained earnings. Remember, the co-op doesn’t have an actual bank account with $750 for that member, the funds are co-mingled and the business can use that money for legitimate business purposes. The value is the internal capital account simply states that the member has a right to that amount in the future.
Qualified Versus Non-Qualified Written Notices of Allocation
The ‘paper’ or non-cash portion of the patronage dividend that is paid out to members is issued using a “Written Notice of Allocation” – essentially a statement that tells the member the current value of their internal capital account, and what new contributions have been made during the last year. Each co-op electing to be taxed under Subchapter T must issue a written notice of allocation each year. There are two types, however, and each has an impact on the taxes both members and the co-op must pay.
Qualified Notices of Allocation: When a co-op that is electing to be taxed under subchapter T distributes its patronage dividend using a qualified notice of allocation, it pays no corporate income tax. However, the members that receive that dividend pay income tax on total value of the patronage – both the cash they receive and the amounts allocated to their internal capital account. As a consequence, co-ops are required to pay out a minimum of 20% of the patronage dividend in cash to ensure members can pay their income tax obligation.
Non-Qualified Notices of Allocation: Co-ops can also elect to issue allocations to member’s internal capital accounts using a Non-Qualified Written Notice of Allocation. A “Non-Qualified” Written Notice is any Written Notice of Allocation of Patronage Dividends which fails to satisfy any one of the qualification conditions — ordinarily the 20% cash payment component.
So if a Written Notice of Allocation was issued for the entire Patronage Dividend due to a Member, it would be Non-Qualified, since the co-op would have failed to distribute at least 20% of the Patronage Dividend in cash. Members do not pay personal tax on Non-Qualified Written Notices, but the co-op does have to pay corporate tax on that portion of the net income. In a later year, when such notices are paid out in cash to the Members, the Members pay personal tax and the cooperative deducts the amount of the cash payout, thus capturing the tax benefit in this later year.