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Published on December 28, 2007

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CHALLENGES ARISING FROM LEGAL RESTRICTIONS ON COOPERATIVES:  CHALLENGES ARISING FROM LEGAL RESTRICTIONS ON COOPERATIVES © Mark J. Hanson Lindquist & Vennum PLLP Minneapolis, Minnesota 612-371-3545 mhanson@lindquist.com  Presentation for Agricultural and Food Cooperatives In Rural Development Washington D.C. June 17, 2004 1898447v1 Slide2:  PRESENTATION OVERVIEW The purpose of this presentation is to look at various federal laws which impede the development of cooperatives in their different forms in the agribusiness industry in which producers and marketers of farm products are patrons. Federal law institutionalized the cooperative structure in the 1920’s when about 30% (32 million) of the people lived on the nation’s 6.5 million farms, a small percentage of the agricultural products were processed, and horses were more common on farms than tractors. The commodity marketing, income model focus of federal cooperative structure is limited as a tool for farmers to collectively address problems and opportunities of the 21st Century. This presentation is biased in that it: Advocates cooperatives should be a favored rural development business structure in which the patrons extract value in addition to profits from collective action in a common business. Focuses on structure from the viewpoint of cooperators. Describes impediments to profitable and successful cooperatives. Slide3:  THREE PRIMARY TYPES OF COOPERATIVES HAVE DEVELOPED Traditional Cooperative (T Coop). Supply farm inputs; process and market farm products. Corporate cooperative, taxation under Subchapter T; deduction for patronage sourced business. Capitalized with patronage equity. New Generation Cooperative (NGC Coop). Processing farm products of members. Corporate cooperative, taxation under Sub T; §521; deduction for patronage (and §521 nonpatronage) sourced business. Capitalized with direct patron investment. Patron Investment Cooperative (PIC Coop). Process farm products of members and others. Unincorporated association, taxed under Sub K, pass-through single tax to members. Capitalized with patron and investor investment. Slide4:  FEDERAL INSTITUTIONALIZATION OF COOPERATIVES Cooperatives were defined about 80 years ago in terms of: Structure (corporate). Owners (farmers). Governance (one vote per member). Profit entitlements (patronage). Business (primarily with members). Benefits (primarily, single level of tax to a corporate entity) and antitrust exemption (to operate) to cooperatives to encourage development. Slide5:  FEDERAL INSTITUTIONALIZATION OF COOPERATIVES ANTITRUST, TAX, DEBT FINANCING, FEDERAL REGULATORY, SECURITIES Capper-Volstead Act the “Magna Charta” of Cooperatives (7 U.S.C. §§291-292) Adopted in 1922 – narrowly defined farmer cooperative. Membership of farmer producers may act together. Association operated for mutual benefit of members “as such producers.” One member one vote or not more than 8% return on capital. Must deal in products of members in greater value than products of nonmembers. Intent was to allow farmers to act collectively to market farm products without antitrust violation or enforcement. Definition of “Cooperative” has had much broader application. Still important especially to some fruit and vegetable cooperatives, but for cooperatives dealing in commodities or where product transfer is at market price or contracted price generally does not apply. Slide6:  FEDERAL INSTITUTIONALIZATION OF COOPERATIVES ANTITRUST, TAX, DEBT FINANCING, FEDERAL REGULATORY, SECURITIES Subchapter T – Taxation of Corporate Cooperatives (Internal Revenue Code §§1381-1388) Deduction of patronage sourced income from taxable income of cooperative. Cooperative not defined, but patronage sourced business deduction available only to corporations operating on a “cooperative basis.” Three principles (Puget Sound Plywood): Democratic control (one member, one vote or voting based on patronage but not capital). Profits allocated on the basis of patronage (not on invested capital). Subordination of capital (interests in equity subordinated to patronage). Slide7:  FEDERAL INSTITUTIONALIZATION OF COOPERATIVES ANTITRUST, TAX, DEBT FINANCING, FEDERAL REGULATORY, SECURITIES Section 521 Exempt Corporate Cooperative (Internal Revenue Code § 521(b)) Advantages: Patronage and nonpatronage sourced income deducted from cooperative corporate taxation as certified by IRS. Dividends (not to exceed 8%) on capital stock deducted from cooperative taxable income. Securities issued by §521 cooperative are exempt from registration under Securities Act §3a(5). Requirements: Producer (farmer) members with one vote per member. Profits and liquidation proceeds distributed on basis of patronage to member and nonmember patrons. Dividends on capital limited to 8% (or state judgment rate). Operated to market farm products (at least 50% from members) and returning profits to patrons, or purchasing supplies and equipment (up to 15% nonmember nonproducers) for farmers on cost plus basis. No authority for nonfarmer members. Outside capital limited to fixed rate of return of 8%. Restrictions on patrons, patronage sourced business, and capital limit competitive business operations. Slide8:  FEDERAL INSTITUTIONALIZATION OF COOPERATIVES ANTITRUST, TAX, DEBT FINANCING, FEDERAL REGULATORY, SECURITIES Marketing Act of 1929 (12 U.S.C. §1141) Definition of “cooperative” used in other federal laws (12 U.S.C. §1141j) Requirements Defined as Association in which “farmers act together” similar to Capper-Volstead Requirements, except one vote per member and dividends do not exceed 8%, and business with nonmembers is not greater in value than business with members. Also applies to farm supply cooperatives. Application Cooperative bank financing. Agricultural Fair Practices Act. Securities Act of 1934 Reporting Requirements. Cooperative exemption from Perishable Agricultural Commodities Act. Cooperative exemption from trucking regulation under the Interstate Transportation Act. Slide9:  FEDERAL INSTITUTIONALIZATION OF COOPERATIVES ANTITRUST, TAX, DEBT FINANCING, FEDERAL REGULATORY, SECURITIES Securities Laws 1933 Act (Offer and Sale of Securities) §3a(5) offer of §521 cooperative securities exempt from registration. Producer farmer members; One vote per member; Dividends on capital limited to 8%; Distributions based on patronage. 1934 Act (Public Reporting Requirements) Required public quarterly and annual reporting. Cooperative defined under Marketing Act of 1929; Farmer members; One vote per member; Dividends on capital limited to 8%; Business with nonmembers not to exceed business with members. The narrow definition of cooperatives for purposes of registered offerings and public reporting requirements deny many cooperatives the Securities exemptions for registration and reporting to raise new invested capital. FEDERAL LAW/POLICY IMPACT ON COOPERATIVES:  FEDERAL LAW/POLICY IMPACT ON COOPERATIVES FEDERAL LAW Prescribes Members: Farmer or Producer Prescribes Governance: One Vote Per Member Prescribes Financial Rights: Distributions Based on Patronage Restricts Return on Capital: Generally Limited to 8% of Invested Capital Limits Corporate Tax Benefit of Patronage Deduction IMPACT Producer membership pool is shrinking Capital options limited Liquidity restricted Restricts aligned industry participants Discourages Members with large patronage or potential investment Excludes or deters patron or nonpatron investment that is not commensurate with patronage Patrons need to expand deliverable production to invest greater amounts Very limited opportunities for investment capital 8% is deductible in §521, but taxable to nonexempt cooperatives Further processing and manufacturing subject to double tax (~65% state and federal) Encourages transition or formation of unincorporated association (PIC Coop or LLC) FEDERAL LAW/POLICY IMPACT ON COOPERATIVES:  FEDERAL LAW/POLICY IMPACT ON COOPERATIVES FEDERAL LAW (cont.) Taxes Liquidation Profits as Ordinary Patronage Income Taxes Transition of Cooperative to PIC Coop or LLC as Liquidation of Coop Assets and Recontribution by Members to New Entity Exempts Defined Cooperatives from Securities Registration and Financial Reporting IMPACT (cont.) Corporation, or PIC Coop, or LLC Shareholder/Members generally receive capital gain treatment (potential tax rate difference of 35% vs 15%) Encourages successful corporate cooperatives to transition to other business structures Double tax on unrecognized gain to cooperative and members with no new gain or cash Makes transition to more efficient tax business structure expensive Many cooperatives do not fit definitions Expensive and time consuming securities registration process designed for publicly traded corporations is a poor fit for cooperatives Many start-up businesses choose alternative business structure, LLC; private placement offering Slide12:  COOPERATORS AND FARMING CONTINUES TO CHANGE Farming operations – multi-commodity to single business purpose; land acquired, not inherited way of life. Marginal tax rates of commercial farmers increasing, cash patronage expectations increasing. Liquidity expectations – equity at exit from farming; revolvement demands increasing; growing amount of capital held by nonpatrons. Just 3% of the nation’s farms (70,600 with annual sales of $500,000 or more) produced 62% of the nation’s agricultural products. Slide13:  FUTURE PATRONS CONTINUE TO DECLINE TRADITIONAL COOPERATIVES: Current Patrons Provide the Capital for Ongoing Business Needs and to Retire the Capital of Former Patrons. WHERE WILL THE PATRONS COME FROM? WHO WILL REVOLVE FORMER PATRONAGE EQUITY? Slide14:  FEDERAL SECURITIES LAWS LENGTHY AND EXPENSIVE REGISTRATION PROCESS REQUIRED TO OFFER SECURITIES UNLESS SECURITIES CAN BE OFFERED THROUGH A REGISTRATION EXEMPTION. TRENDS TO PRIVATE PLACEMENT EXEMPTION TO ACCREDITED INVESTORS ($1,000,000 Net Worth or $200,000 Income). Only 1% to 5% of farmers likely to meet test. Most farm operators excluded from investment/marketing opportunity. Slide15:  FOUR STRUCTURE OBJECTIVES FOR SUCCESSFUL COOPERATIVES GOAL: STRENGTHEN INCOME/GROWTH BUSINESS MODEL Tax Efficiency – Single-level of tax applied to income allocated to members or entity. Ease of Raising Capital – Securities registration and public financial reporting requirements commensurate with size and structure of organization and offering (with proper disclosure, no registration or reporting unless publicly traded securities). Equity Liquidity – Owners can exit and transfer their ownership interests when they decide to do so and broad pool of buyers are eligible to purchase. Transition Flexibility – Flexibility to change ownership and operational structure as competitive business environment and ownership needs change without tax of unrealized gain or registration of securities to existing owners. Slide16:  ALTERNATIVE FEDERAL POLICY/LAW CONSIDERATIONS Define Cooperative Beneficiaries (Cooperators) Rather Than Business Structure. A cooperative is an association (which may be a corporate structure) in which producers of agricultural products control the governance of the association, receive profits or margins of the association based on business done for or with the association as determined and agreed upon by the producer patrons. Slide17:  ALTERNATIVE FEDERAL POLICY/LAW CONSIDERATIONS Define Efficient Single Level Tax Allocation for Growth/Income Model. A cooperative shall allocate all taxable income of the cooperative to the cooperative or to the members of the cooperative, as determined by the cooperative. Income allocated to the cooperative taxed as provided for corporations under Subchapter C. Income allocated to members as provided under Subchapter K. A cooperative is not subject to Publicly Traded Partnership Rules except to the extent interests in the cooperative are publicly traded on an exchange. A cooperative may convert, merge, or otherwise transition to another legal entity as a tax-free reorganization, provided any gain subject to taxation as a cooperative will be subject to taxation when realized in the new entity. Slide18:  ALTERNATIVE FEDERAL POLICY/LAW CONSIDERATIONS Provide Securities Registration and Reporting Exemptions that Facilitate Investment by Producers and Aligned Investors. Require cooperative to disclose information and risks in federal securities format. Require notice filing to SEC and states where offering is conducted. Offering is exempt from registration to: Existing or new patrons Aligned investors Agricultural producers Persons or businesses in the trade or business related to the cooperative’s trade or business Qualified rural residents and businesses within the rural trade area of the cooperatives (residing in cities of 70,000 persons that are not suburbs of metropolitan areas) to the extent of 25% of annual income or 10% of net worth with investment not to exceed $50,000 per individual or $100,000 per business entity [state approved] Integrated existing federal securities exemptions, e.g. accredited investors Up to 35 persons or entities not meeting above requirements Exempt cooperatives from public financial reporting requirements provided: Equity or debt of cooperative is not publicly traded; and Cooperative reports annual and quarterly financial information to its members. Slide19:  ALTERNATIVE FEDERAL POLICY/LAW CONSIDERATIONS Provide For Equity Liquidity By Authorizing Transfer and Exchange of Equity Interests. For traditional cooperatives nonpatron (former patron) patronage equities are growing portion of cooperative equity. Patronage equities should be transferable to third parties at ordinary gain or loss based on issuance allocation amount. Cooperatives should be allowed to redeem patronage equities that are more than three years old without tax consequences to the cooperative. Federal law should authorize one or more exchanges for debt and equity (including patronage equity) instruments of cooperatives and producer controlled entities. NASDAQ and NYSE type exchanges are not a fit for cooperative and producer controlled entities. Internet technology and defined equity and debt instruments would allow cooperators and agricultural producers to transfer equity and debt instruments at modest costs. Slide20:  SUMMARY Eighty years ago federal law/policy institutionalized cooperatives on a producer member, commodity marketing, income based model with little or modest capital needs. Current federal law/policy serves that business model very well. Capital needs of cooperatives and liquidity needs of cooperators as well as the desire for blended income/growth business model has led cooperators to seek alternatives to cooperatives because the federal restrictions on cooperatives and their members do not justify the limited benefits. From a tax perspective the LLC and PIC Coop single level tax and capital gain on sale of assets is more desirable than the limited, patronage source deduction and ordinary income treatment of gain on sale of assets. Federal law/policy should focus on a cooperative income/growth business model that will benefit rural communities. Meaningful structural benefits will stimulate economic growth and broaden participation of rural populations and business in cooperatives.

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