Credit Union and Cooperative Patronage Refunds - Filene ...

Credit Union and
Cooperative Patronage Refunds
Joel Dahlgren, JD
Black Dog Co-op Law
Dan Kitzberger
Kitzberger Consulting

Credit Union and
Cooperative Patronage Refunds
Joel Dahlgren, JD
Black Dog Co-op Law
Dan Kitzberger
Kitzberger Consulting

Copyright © 2011 by Filene Research Institute. All rights reserved.
Printed in U.S.A.

Filene Research Institute
Deeply embedded in the credit union tradition is an ongoing
search for better ways to understand and serve credit union
members. Open inquiry, the free flow of ideas, and debate are
essential parts of the true democratic process.
The Filene Research Institute is a 501(c)(3) not-for-profit
research organization dedicated to scientific and thoughtful
analysis about issues affecting the future of consumer finance.
Through independent research and innovation programs the
Institute examines issues vital to the future of credit unions.
Ideas grow through thoughtful and scientific analysis of toppriority
consumer, public policy, and credit union competitive
issues. Researchers are given considerable latitude in their
exploration and studies of these high-priority issues.
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replacing of the best there
is with something still better!
— Edward A. Filene
The Institute is governed by an Administrative Board made
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and priorities are set by the Research Council, a select group
of credit union CEOs, and the Filene Research Fellows, a blue
ribbon panel of academic experts. Innovation programs are
developed in part by Filene i 3 , an assembly of credit union
executives screened for entrepreneurial competencies.
The name of the Institute honors Edward A. Filene, the “father
of the U.S. credit union movement.” Filene was an innovative
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Since its founding in 1989, the Institute has worked with over
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iii

Acknowledgments
We appreciate and are grateful for the time that Brian Prunty from
CoVantage Credit Union, Dennis Hanson from Dow Chemical
Employees’ Credit Union, and Tim Mislansky from Wright-Patt
Credit Union spent with us to discuss each of their credit union’s use
of patronage refunds. We would like to extend a special thank-you to
Callahan & Associates, in particular Nick Connors. Nick is a senior
industry analyst and provided critical data for this project.
iv

Table of Contents
List of Figures
Executive Summary and Commentary
About the Authors
vi
vii
ix
Introduction 2
Chapter 1
Patronage Refunds Are More Than Rebates
(and Co-ops Are More Than IOFs) 6
Chapter 2 Why Do Co-ops Need to Be Profitable? 17
Chapter 3 A Primer on Patronage Refunds (in the Abstract) 21
Chapter 4 Tax Differences between Cooperatives 24
Chapter 5 Use of Patronage Refunds by Other Cooperatives 32
Chapter 6 Credit Union Perspective 41
Chapter 7 Credit Union Implications 49
Appendix 60
Endnotes 65
v

List of Figures
1. Average of 27 Credit Unions Compared with Average of
81 ACAs
2. Contrast Statutes Governing Co-ops
3. Farm Credit Associations
4. Present Value of Patronage Distributions
5. A Comparison of ACA Ratios
6. Potential Tax Effects of Patronage Refunds
vi

Executive Summary and Commentary
By Ben Rogers,
Research Director
Last year, I overestimated my tax liability and thrilled myself (and
my wife) with a refund. When I use my credit union credit card,
I get a monthly 1% cash-back reward. On a different card, I earn
airline miles that I use to fly my family home for Christmas. With
my REI (Recreational Equipment, Inc.) membership, I get back
10% of every dollar I spend at the end of each year. Each of these
cases demonstrates one part, and sometimes both parts, of a powerful
two-pronged formula: an incentive based on my use of a product,
and the psychic gratification of windfall money.
Credit Union and Cooperative Patronage Refunds seeks to illuminate
patronage refunds, a unique tool credit unions and other cooperatives
can use to manage capital levels, return value to membershareholders,
and tie members more closely to the company. The
report examines the details of common refund practices outside
the credit union system and weighs the pros and cons of increasing
the practice among credit unions.
What Did the Researchers Find?
Use rather than ownership is the traditional driver of value at a
cooperative. Using cooperative theory, the authors argue that credit
unions should consider patronage dividends as a long-term commitment
to users. The difference between a cooperative (like a credit
union) and an investor- owned firm shines through in how well the
cooperative rewards members who contribute to its ongoing success.
The report profiles three refund- paying credit unions as well as
several non–credit union cooperatives. Each treats its patronage
dividend differently, but some similarities emerge: By issuing regular
refunds, leaders go beyond rhetoric in considering members as the
owners of the credit union’s capital; members appreciate the periodic
windfall (one study indicates that agricultural co-op members prefer
it to superior prices or interest rates); and credit unions that regularly
pay refunds must be financially disciplined to support a regular
payout.
Finally, the researchers explore patronage refunds as a tax management
strategy. By paying out refunds as cash and as allocated
equity held at the cooperative in the name of members, certain
cooperatives—including grocers, agricultural lenders, and rural electric
companies—minimize their corporate tax burden.
vii

What Are the Credit Union
Implications?
Credit unions, of course, pay member dividends every month in
the form of ordinary interest. Very few, however, offer a consistent
extraordinary dividend. Standard reasons for not paying one include
the following: Earnings are already tight, so it’s unaffordable; paying
an extraordinary dividend once could lead members to expect one
every year and be frustrated without one; and any potential excess is
already reflected in the credit union’s attractive savings and loan rates.
These reasons are all valid, but they are the same reasons any publicly
traded firm with excess capital might use. Nevertheless, the boards of
those publicly traded companies constantly remind themselves that
their shareholders expect real value and can easily take their money
elsewhere. Nothing—not good feelings, not good intentions—says
“please stay” like cash.
Credit unions considering a patronage refund should take steps to:
• Encourage an honest governance and management discussion
over not just the marketing value of a patronage dividend but the
cooperative imperative to return unused capital to members.
• Balance the benefits of any refund between saving members and
borrowing members, both of whom are essential to the credit
union’s health.
• Help set realistic member expectations for future payments and
teach members how to earn a bigger refund in the future.
Back to the REI example above. Like credit unions, this outdoor
supplier cooperative operates a modern company selling familiar
products in an intensely competitive retail industry. Surely its leadership
knows that it could plow its yearly member dividend funds back
into the business by lowering prices 10% across the board. Doing so
might even goose short-term sales. But REI has made a calculated,
long-term choice to compete daily with other retailers on price. Then
the company writes its member- users a yearly reminder of its tangible
cooperative value—in the form of a patronage check.
viii

About the Authors
Joel Dahlgren
Joel Dahlgren has 30 years of experience with cooperatives. He
founded Black Dog Co-op Law (a Minnesota 308B co-op) solo law
practice in 2010 and has been providing legal representation and
business advice to consumer and agricultural cooperatives across the
United States since 1992. Dahlgren is also employed as general counsel
and chief risk officer at a Minnesota farm supply and grain cooperative
since 2010. Prior to law school, Dahlgren was a loan officer at
the St. Paul Bank for Cooperatives (a predecessor to CoBank, ACA),
a federated cooperative owned by its member agricultural co-ops.
Later he was a business service manager on the Member Services staff
of the Cenex/Land O’ Lakes joint venture, providing business and
strategic planning and human resource advice and products for affiliated
member co-ops of Cenex (now CHS Inc.) and Land O’ Lakes
(both are federated agricultural co-ops). Dahlgren holds a bachelor of
science degree from the University of Minnesota and a JD from the
University of Wisconsin–Madison.
Dan Kitzberger
Dan Kitzberger has several years of experience working for nonprofit
organizations. He worked for the Minnesota Council of Nonprofits,
where he provided technical assistance to community and human
service organizations to increase their capacity for civic engagement.
He was a community organizer for Neighborhood Housing Services
in Duluth, where he worked on a variety of projects in low- income
neighborhoods. Since 2009, Kitzberger has worked in the Minnesota
House of Representatives, where he began as an intern, worked as a
legislative assistant during the 2010 legislative session, and currently
works as a constituent services specialist and writer. He attended the
University of Minnesota Duluth and received his bachelor’s in communication
in 2006, followed by his master of advocacy and political
leadership (MAPL), with concentrations in nonprofit advocacy and
public sector leadership, in 2009.
Dan is an independent contractor who has an interest in socially
conscious and sustainable business organizations, including cooperatives.
Dan was engaged by Black Dog Co-op Law to assist with the
preparation and research for this report.
ix

Introduction
There are many ways in which to improve the
condition of mankind but the noblest of them
all is through co-operation.
—George J. Holyoake

Credit Union and Cooperative Patronage Refunds discusses the use of
patronage refunds by credit unions. A patronage refund is an amount
returned to a cooperative’s members at the end of an accounting
period, usually a year. It is paid to members on the basis of how
much they used the cooperative. More use means a bigger refund;
less use means a smaller one.
Twenty-seven credit unions identified in a recent Callahan &
Associates patronage report each generated an annual net income
of $3.5 million (M) 1 on average during the years 2008, 2009, and
2010. These 27 credit unions paid, on average, $822,500 (23%) of
that income to members as a cash patronage refund. At the upper
end, one credit union distributed a cash patronage refund equal to
100% of its earnings. Its actual patronage refund was in excess of
its net income, but by definition a patronage refund cannot exceed
earnings.
We report that these 27 credit unions generated average annual
earnings of $3.5M for the years 2008, 2009, and 2010, whereas
the financial performance reports from the National Credit Union
Administration (NCUA) website report that these same credit unions
averaged $2.7M of earnings for that period. The difference between
the two is the cash patronage refund of $822,500. Credit unions
deduct patronage refunds to calculate net income, but the rest of the
co-op world in the United States includes cash patronage refunds in
cooperatives’ reported GAAP (generally accepted accounting principles)
earnings. We’ve made this adjustment to allow apples-to- apples
comparisons with other cooperatives.
As rebates, patronage refunds may be a good or even a “best” business
practice, but any business—even a bank—can pay a rebate 2 to
its customers. Hence—and this is important—a philosophical difference
exists between cooperatives and investor- owned firms (IOFs),
between credit unions and banks. Co-ops benefit users who capitalize
the co-op in proportion to use. IOFs benefit investors who capitalize
the IOF in proportion to ownership and wealth. So patronage
refunds are more than a rebate. Patronage refunds encapsulate what
3

to us is a philosophical gulf between IOFs and co-ops. We assume
that if you are affiliated with a credit union, this philosophical
distinction drives your business model forward because credit unions
are cooperatives too.
To be clear, this report is not about the virtues of a collective society
as opposed to a society organized around capitalism. Cooperatives—
including credit unions—are the ultimate self-help business organization,
3 and hence they are part of a capitalist system that allocates
money and wealth across the economy through profits and losses.
But cooperatives reward users rather than owners through patronage
refunds distributed to the cooperative’s members on the basis of
patronage (i.e., use). IOFs do not.
Failing to pay a patronage refund is not an existential threat to a
cooperative. As few as 27 credit unions out of more than 7,000 in
the Callahan report regularly paid an annual patronage refund in
each of the last five years. Later in this report we discuss the unresolved
debate about whether to pay patronage refunds, a debate that
is occurring within the board of directors and management of a farm
credit association that is a member of the cooperatively owned Farm
Credit System. Paying patronage refunds is far more accepted and
perhaps even expected for a farm credit association. Thus it will be
obvious that the question of whether to pay a patronage refund is not
an issue limited to credit unions.
We note, however, that Callahan’s study of the 27 credit unions that
paid patronage refunds documented that business growth, member
involvement, and return on assets were all stronger for these 27 than
for the other credit unions. It is very difficult to argue against the
positive impact of paying a patronage refund. Our own experience
with cooperatives paying a patronage refund is positive and entirely
consistent with this conclusion.
The balance of this report will discuss patronage refunds from several
viewpoints. First, we drill down further to explore how patronage
refunds are more than just a rebate, how they relate to capitalization,
and how they are influenced by the principles of subordination of
capital, service at cost, and co-op agency theory. These principles
sum up the philosophical gulf that separates cooperatives and IOFs,
and they drive the distribution of earnings to members and patrons
rather than to investors.
Second, we address the question of why cooperatives—and credit
unions—need to be financially successful and generate earnings.
Third, we discuss patronage refunds in the abstract, without the
application of tax, and then we discuss four tax regimes as applied to
alternative types of open membership cooperatives.
4

Fourth, we examine how members of the Farm Credit System use
patronage refunds.
Fifth, we examine the payment of patronage refunds by three credit
unions.
Finally, we conclude by addressing potential future tax implications
of patronage refunds for credit unions.
As you read this report, it may help to remind yourself from time to
time that we weave the disciplines of finance, accounting, and tax
together with co-op theory. One of the consistent themes and tension
is whether to allocate earnings other than what the co-op pays as
a cash patronage refund.
5

CHAPTER 1
Patronage Refunds
Are More Than Rebates
(and Co-ops Are More Than IOFs)
Cooperative principles govern the use and allocation
of capital. Members who own capital
generally have that ownership acknowledged
and recorded. Cooperatives have to balance the
use, distribution, and accumulation of capital
carefully to serve current and future members.

Patronage refunds are integral to the larger subject of capitalization.
The discussion in this chapter will be foreign to credit unions and
their members because credit unions’ earnings are not allocated to
individual members. In the abstract, patronage earnings that are not
distributed to members as cash are supposed to be distributed as
allocated equity, which forms the primary source of equity capital for
co-ops.
The theory is that a co-op’s earnings belong to members in proportion
to their use of the co-op. In other words, the earnings do not
belong to the co-op. It follows that if earnings belong to members,
then the earnings should be distributed either as a cash patronage
refund on the basis of use or as equity that is allocated on the co-op’s
books and identified with each member in proportion to the member’s
use of the co-op.
For co-ops generally, then, a corollary to the benefits of paying
patronage refunds to users is that users are expected to provide equity
capital in proportion to their use of the cooperative. In the United
States, most cooperatives obtain equity capital from members by
retaining a portion of patronage refunds as allocated equity. A return
is not usually paid for the use of the capital retained from patronage
earnings, because capitalizing the cooperative is considered an obligation
of membership. 4
If capitalization is an obligation of membership, then one specific
aim is to align capitalization of the co-op with use so that current
members who use the co-op also capitalize the co-op. Obviously, to
redeem allocated equity as members retire or die and no longer use
the co-op, the co-op must know how much equity each member has
provided. The co-op maintains patronage and equity records that
show how much patronage earnings are allocated to and retained
from each member.
The retained earnings of credit unions are not allocated to members.
These earnings form undivided equity (“unallocated” in general
co-op–speak). In other words, we cannot relate members’ business
7

activities with their credit union to the equity retained from each
member’s activities or the income generated from each member’s
activities. Pure co-op theory 5 takes issue with this approach, because
if all earnings belong to members, then all earnings should be
distributed either with cash or with allocated equity. Hence, all or
substantially all of a co-op’s patronage earnings should be distributed
to members on a patronage basis. There should be an observable link
between each member’s use and the member’s capitalization of the
co-op.
This credit union deviation from co-op allocated equity principles
of retaining earnings as undivided equity capital is more dramatic in
a theoretic sense than it is in a practical sense. The following comparisons
of credit unions with agricultural credit associations (ACAs)
illustrate that even though credit unions do not distribute their
earnings with allocated equity or undertake to eventually redeem that
equity, credit unions are quite similar in this respect (and others) to
ACAs, which have been functioning as co-op financial institutions
since as early as 1916.
The Farm Credit System includes 81 ACAs across the country that
provide short- and long-term financing to agricultural producers
(farmers). ACAs operate on a cooperative basis, as does the entire
Farm Credit System. Whereas in a credit union the members hold
the voting control and are eligible to serve on the board of directors,
in an ACA, the farmers are the voting members and are elected to
serve on the board of directors.
The 27 credit unions in the Callahan study distributed on average
23% of their earnings as a cash patronage refund, whereas the
81 ACAs paid 21.5% of their earnings as a cash patronage refund.
The ACAs retained $4.0M per year in allocated equity to capitalize
the ACA, amounting to 18% of their earnings (and redeemed $2.4M
per year on average during those years), while the credit unions did
not distribute any patronage refunds with allocated equity.
ACAs and credit unions each retain substantial portions of their
earnings (60% and 75%, respectively) as permanent unallocated
equity. Even for ACAs, this approach is not consistent with the co-op
Figure 1: Average of 27 Credit Unions Compared with Average of 81 ACAs
Average of 2008, 2009, and 2010 Credit unions % Total ACAs % Total
Cash patronage refund 822,800 23.34 4,836,948 21.56
Patronage refund in allocated equity — 0.00 4,028,708 17.96
Undivided/Unallocated earnings 2,703,149 76.66 13,192,951 58.81
Income tax on co-op’s earnings — 0.00 376,051 1.68
Total earnings (average per co-op) $3,525,949 100.00 $22,434,658 100.00
8

At the dissolution of a co-op, co-op theory calls for the remaining
proceeds to be distributed on the basis of historical patronage
to present and former members, theoretically back to the
beginning of the cooperative.
principle that earnings belong to members rather than the co-op. We
believe, however, this information reveals that ACAs are balancing
that co-op ideal (that earnings belong to members and should be distributed
with allocated equity if they are not distributed with cash)
against the financial reality that these cooperatives simply cannot
generate enough earnings and
cash flow to redeem allocated
equity while maintaining a
viable business organization.
Moreover, it does not follow
that just because patronage
earnings are not allocated as
patronage refunds to members with allocated equity, the resulting
undivided or unallocated equity is not owned by the members.
In other words, the co-op’s earnings do not have to be allocated to
members to demonstrate that the earnings belong to the members.
The three credit unions that we discuss later in the report seem to
have adopted that philosophy even though their earnings are not
apportioned 6 or allocated to members in proportion to use. An even
stronger position would be to educate and communicate with members
about why the co-op does not allocate “their” earnings and how
the co-op uses “their” unallocated equity.
At the dissolution of a co-op, co-op theory calls for the remaining
proceeds to be distributed on the basis of historical patronage to
present and former members, theoretically back to the beginning of
the cooperative. At the dissolution of a credit union, another deviation
from co-op principles occurs when the remaining proceeds
are distributed on the basis of share ownership to the last members
standing.
It is worthwhile to drill down further to explain how this dissolution
issue relates to patronage refunds and why this deviation from co-op
principles is more striking for credit unions than the issue of whether
all or substantially all of the credit unions’ earnings are distributed
with cash or allocated equity.
Co-op Dissolutions: Service at Cost,
Subordination of Capital, and Co-op
Agency Theory
The principles of service at cost, subordination of capital, and the
co-op agency theory direct the co-op’s financial operations from its
incorporation to its dissolution. These principles are ignored when
any dissolving co-op distributes the remaining proceeds to the last
9

members standing on the basis of ownership rather than to present
and former members on the basis of historical patronage.
The co-op agency theory holds that the co-op is an agent of its
members and, therefore, that the co-op’s earnings really belong—
have always belonged—to members and have never belonged to the
co-op. This theory dovetails with the principle of service at cost,
which holds that patronage earnings are rebates, discounts, or price
enhancements when they are allocated and distributed as patronage
refunds in cash or allocated equity to members on a patronage basis. 7
The co-op agency theory and service-at- cost principles support the
favorable income tax treatment of co-ops. If the earnings were never
the co-op’s in the first place, there is no justification for taxing the
earnings at the co-op level. If the earnings are taxed, they should be
taxed at the member level.
Service at cost requires that earnings be distributed on a patronage
basis as patronage refunds to qualify as rebates, discounts, or price
enhancements that reduce “costs” to the members. If the earnings
are distributed on the basis of share ownership, that distribution is
a return on equity rather than a zeroing out of the co-op’s earnings
to the logical conclusion that the costs of products or services are
reduced to breakeven. The service-at- cost principle is not followed if
the co-op’s earnings are distributed on the basis of share ownership.
And what applies to the co-op’s earnings while it is a going concern
also applies to its equity at its dissolution. So in a dissolution, when
credit unions distribute the remaining proceeds on the basis of share
ownership to the last members standing rather than on the basis of
historical patronage to present and former members, they are deviating
from the co-op agency theory and service-at- cost principles.
Distribution of the remaining proceeds at dissolution should be on
the basis of historical patronage going back to the beginning of the
co-op to adhere to these principles consistently. If all the earnings
and remaining proceeds are distributed on the basis of historical
patronage, we can logically conclude that the co-op always operated
at cost from its beginning to its end.
The co-op principle of subordination of capital is also not followed
when credit unions distribute the remaining proceeds on the basis of
share ownership to the last members standing. This principle limits
the financial return paid on equity to investors to a “reasonable”
return for its use. The last members standing at a credit union’s dissolution
benefit disproportionately to all the former members. Not
only is their proportionate equity capital returned as it would be if
the agency and service-at- cost theories were followed using historical
patronage, but the last members standing receive an extraordinarily
large return on that capital when the balance of the dissolution
10

proceeds—in excess of what they were entitled to receive on the basis
of historical patronage—is also distributed to them on the basis of
share ownership.
Although we cannot reconcile this credit union inconsistency with
the co-op principles that should govern at dissolution, it does not
deter us from applying co-op patronage principles to credit unions
while they are operating and going concerns before dissolution. 8
We said earlier that patronage refunds encapsulate what is a philosophical
gulf between cooperatives and IOFs. In the next section we
drill down even further to explore the differences between IOFs and
co-ops and to identify why cooperatives are more sustainable and
operate with a more modest capital footprint than IOFs.
Co-ops Are More Than IOFs
The principles of subordination of capital, service at cost, and co-op
agency theory draw a crucial distinction between IOFs and co-ops.
IOFs are like VELCRO: They attract, use, and hoard capital for their
own benefit. Co-ops are like GORE-TEX: As they generate surplus
working capital, they shed and return capital to members on the
basis of use, either as cash patronage refunds or eventually as redemptions
of allocated equity.
First, consider that an expenditure on an asset that tripled an IOF’s
value is immediately reflected in the value of an IOF’s common
stock. Each investor holding common stock is immediately wealthier.
The IOF continues to look for investment opportunities in which to
deploy capital, and to look for more capital to deploy in those investments.
This process replicates itself over and over. The IOF’s selfinterest
is in attracting more and more capital to feed this process.
Now contrast the impact of that same expenditure on a cooperative
and its members. The allocated equity of members does not appreciate
in value. This equity is still
A natural tension occurs among members in a co-op, where redeemable at no more than
acquiring assets and growing the business necessarily mean its face value to members. No
that cash for redemptions of allocated equity is reduced or member is wealthier as a result
eliminated.
of the expenditure. Neither
the co-op nor its members are
driven or motivated to invest
more and more capital into the co-op. Members might hope that
an expenditure tripling the co-op’s market value would improve the
co-op’s earnings, and perhaps their allocated equity can be redeemed
faster than it would have been, but who knows.
If the expenditure spurs sales growth that increases working capital
requirements, if the asset was financed with term debt requiring
11

epayment, and/or if the asset is one of those expenditures that
begets more expenditures on other assets to supplement the initial
expenditure, there is no assurance that redemptions can be sped up.
The opposite—that redemptions are slowed down—may, in fact,
be true. But, as between an IOF and a co-op, the co-op’s incentives
clearly lean in favor of distributing as much cash as soon as possible
to redeem equity, while the IOF’s incentives clearly lean in favor of
holding on to extra cash and reinvesting it in the IOF.
In fact, an expenditure that triples the co-op’s market value does
not hold the same fascination for a co-op that it does for an IOF. A
natural tension occurs among
members in a co-op, where
The counterweight to members who want redemptions of acquiring assets and growing
equity is usually that the board of directors has a fiduciary the business necessarily mean
obligation to look out for the co-op’s interest in surviving and that cash for rede mptions of
flourishing for future generations.
allocated equity is reduced or
eliminated. This member interplay
pushes management and
the board of directors to carefully examine asset expenditures because
the leadership knows it will be criticized by members who prefer cash
redemptions of their allocated equity over asset expenditures. The
incentives that an IOF operates under to continue investing in assets
to grow the IOF’s value do not exist in a co-op.
Because a co-op’s strongest and most respected members are typically
older, more vocal, and experienced and hold more allocated equity in
the cooperative, their views often carry more weight 9 than the views
of younger members, who care less about redemption of equity and
more about the state of the co-op’s competitiveness, its asset bases,
and the extent to which it is providing for the needs of members. So
the counterweight to members who want redemptions of equity is
usually that the board of directors has a fiduciary obligation to look
out for the co-op’s interest in surviving and flourishing for future
generations.
The only time that a co-op member (or former member) benefits
from the market value of the cooperative is at its dissolution. The
members of the cooperative who purchased an asset tripling the
co-op’s market value would enjoy that added value only if the cooperative
is dissolved, but former members (even members who are
deceased and no longer own allocated equity) would also enjoy that
accretion in value because they are all entitled to a portion of the dissolution
distribution after all allocated equity is first redeemed. The
remaining proceeds are distributed to members and former members
on the basis of historical patronage, theoretically to former members
12

If the co-op’s earnings are not distributed to the member in
cash, they are distributed with allocated equity, each dollar
of equity being identified with a member on the basis of the
member’s proportional use.
going all the way back to the beginning of the cooperative. Again,
this distribution leads to the logical conclusion that the service-atcost
principle was followed through to the very end of the co-op’s
existence.
Second, consider who owns the earnings generated by an IOF and
a co-op. An IOF’s earnings belong first to the IOF. Most of the
profits will be reinvested in the IOF to enhance the value of the firm.
Some IOFs pay dividends 10 on common stock or repurchase shares
if the IOF has excess working capital, but these are not common
occurrences.
Even when dividends or stock repurchases occur, one can argue the
benefits of an IOF as much as any common stockholder because
repurchased shares or dividends paid on stock usually enhance the
long-term valuation of the IOF’s common stock and hence its attractiveness
to investors. Most, if not all, of an IOF’s decisions are driven
by its interest in maximizing its own book value and the value of its
equity.
In contrast, the co-op’s patronage earnings each year belong to members
in proportion to their use of the cooperative in that year rather
than to anyone else. This year’s earnings may belong to a different
cast of members, in different proportions, than next year’s earnings if
the makeup of the membership changes or each member’s use of the
co-op changes from year to year.
The co-op’s entire mission is not to make itself more valuable but
to integrate and serve its members’ lives and businesses. Because
the co-op is considered an agent of the members, it is an extension
of their lives and of their businesses. And because it operates under
the service-at- cost principle, its returns are added to the members’
returns to judge whether the
whole composite return—of
the co-op plus the member—is
successful.
This is why it makes sense when
we read that the Credit Union
National Association (CUNA)
asserted that in 2009 the Wright-Patt Credit union “provided $1,268
in savings throughout the year for households with ‘high use’ of the
credit union.” CUNA said this credit union provided total benefits
of $26.0M to its members in 2009. 11 As a cooperative, Wright-Patt is
viewed as an adjunct to its members rather than as an IOF that is an
island unto itself. This is a key distinction between co-ops and IOFs.
13

If the co-op’s earnings are not distributed to the member in cash,
they are distributed with allocated equity, each dollar of equity being
identified with a member on the basis of the member’s proportional
use. Each dollar of allocated equity that is eventually redeemed is
redeemed at no more than its face value. But in the meantime, until
the allocated equity is redeemed, it does not appreciate in value. In
fact, the longer the co-op uses and holds the equity, the more the
equity is depreciated from the effect of the time value of money.
But as soon as the co-op has surplus working capital, allocated equity
is redeemed and returned to members. The co-op is motivated to
distribute surplus working capital rather than reinvest it in the co-op
because aggrandizing itself over its members benefits no one and is
counter to the philosophy under which the co-op is formed. The
board of directors is motivated to distribute surplus working capital
through equity redemptions because each director—like every other
member—eventually wants that surplus capital if and when the
co-op can afford to return it.
This same dynamic does not exist in an IOF, because the principles
of subordination of capital, service at cost, and co-op agency theory
are not in play. Obviously some investors desire dividends, while
others desire retention of earnings and appreciation in the value of
their holdings. But the IOF decides what to do with its earnings by
reference to their impact on the IOF’s value, not, as a co-op does,
by reference to the extent that the co-op integrates and adds value to
members’ lives or businesses. An IOF is a supplier to customers, not
an agent of its members or an extension of their lives or businesses.
Finally, consider that an IOF’s universe of investors is narrow, limited
by the number of shares of common stock the IOF has issued.
Hence, the number of claims on earnings is finite. A finite number
of shares means that as the value of the business increases, the same
number of shares is now more valuable than before the increase in
the value of the business.
By comparison, an open membership co-op’s universe of members
is dynamic and expanding all the time. The number of claims on
earnings in an open membership cooperative is infinite, limited
only by the number of co-op members and their proportion of the
business of all members combined. Because at the co-op’s dissolution
the remaining proceeds are distributed on the basis of historical
patronage to present and former members, the longer that an open
membership is in business before dissolution, the more claims that
are created from present and former members who are entitled to a
portion of the remaining proceeds at the co-op’s dissolution.
14

The principles of subordination of capital, service at cost, and the
co-op agency theory work together to make co-ops more sustainable,
more just, and more beneficial to society than IOFs. A co-op does
not, in theory, hoard or hog capital, nor does it have an insatiable
appetite for capital like an IOF.
Balancing Co-op Principles against
the Financial Realities of Equity
Redemptions
The tension between allocating earnings and building up expectations
for redemptions of equity must be acknowledged and managed
by the co-op’s board of directors. Is retaining 60%–75% of earnings
as undivided or unallocated equity really a significant deviation from
co-op principles?
One way to manage this tension is to balance the co-op principles of
subordination of capital, service at cost, and the co-op agency theory
with the finance principle that no business organization—co-ops
included—should voluntarily create obligations that detract from
the organization’s mission or weaken it financially. In other words, a
co-op is like any business organization in that it needs strong capital
structures.
Finance principles cause or should cause the co-op’s leadership to
make informed judgments about how much of the co-op’s earnings
are distributed with allocated equity. Each dollar of earnings
distributed with allocated equity might create one dollar more of
expectation that this equity will eventually be redeemed. The co-op’s
leadership should want to soften or even eliminate the tension
between making necessary expenditures and redeeming equity.
Circling back to the beginning of this chapter, where we said that
both ACAs and credit unions deviate from the co-op principle that
earnings belong to members when they retain 60%–75% of earnings
as undivided or unallocated equity, the most logical response to that
criticism is that credit unions and ACAs are simply balancing co-op
principles with finance principles. ACAs and credit unions are being
logical when they distribute what they can as a cash patronage refund
each year, and when they avoid allocating equity that cannot be
redeemed in a reasonable time.
ACAs and credit unions—like banks—are some of the most leveraged
business organizations across the entire economy. These co-ops
are likely to be the least able to redeem allocated equity if they follow
only more traditional co-op principles and do not consider finance
15

principles. When we discuss other co-ops’ use of patronage refunds,
we will note the pressure that AgGeorgia puts on itself by allocating
much of its income as patronage refunds that members expect will
eventually be redeemed.
If the cooperative is not profitable or has no earnings, we never get
to the issues of subordination of capital, service at cost, or the co-op
agency theory. We need earnings before we can apply these principles.
So as important as these principles are, the more important
immediate point is to address why co-ops must be profitable.
16

CHAPTER 2
Why Do Co-ops
Need to Be Profitable?
Is comparing banks and credit unions a fruitful
endeavor? Yes, because they compete with each
other, and both need to be profitable to remain
relevant, to return value to shareholders, and to
grow. But they should go about it in different
ways.

A recent post to the Filene Research Institute’s website posed the
question: Why do credit unions compare themselves to banks or
even worry about return on assets? One could argue that cooperatives
should not compare themselves with IOFs or that cooperatives could
operate economically on a shoestring, out of a shoe box, inside a steel
shed—a most utilitarian approach. It is also argued that cooperatives
do not have to worry about financial comparisons so long as money
flowing into the cooperative is just one penny more than money
flowing out.
For cooperatives—including credit unions—there are always at least
three criticisms of this philosophical position. First, it is impractical
to operate or manage any business organization of any size that
close to the edge. Second, most
members expect that their
Cooperatives must generate enough earnings to compete with shares (and entitlement to undivided
earnings; more on that
IOFs by maintaining and growing the cooperative’s base of
capital assets and its business. So even if the cooperative does later) will be safeguarded by the
not raise capital in private capital markets, it is likely to have its board of directors and management.
Members understandably
own business objectives that must be financed with the cooperative’s
earnings and equity.
expect that the cushion will be
more than a penny. The board
must pay attention to earnings
because members have legal recourse to sue the board if they suffer
losses from a breach of the board’s fiduciary obligations.
Third, some cooperatives are regulated by government agencies
(NCUA for credit unions; FCA [Farm Credit Administration] for
farm credit associations) and required to maintain minimum standards
of financial strength. In addition, some cooperatives join
together to raise capital from private markets. These cooperatives
must maintain strong financial standards so that the notes and
bonds sold by their agents are attractive to investors in those markets.
For example, the National Rural Utilities Cooperative Finance
18

While cooperatives cannot escape the imperative that confronts
any business organization to generate profits, cooperatives are
different and, in principle, more sustainable than IOFs because
co-ops do not hoard capital.
Corporation (CFC) and the Federal Farm Bank Funding Corporation
(BFC) issue tens and hundreds of billions of dollars in securities
annually to provide capital for rural electric cooperatives and farm
credit associations, respectively.
Those securities are secured by loans to rural electric cooperatives
and farm credit associations, respectively. The latter, in turn, makes
loans to farmers and agricultural cooperatives. If those rural electric
cooperatives and farm credit associations do not attain and maintain
standards of financial strength, their agents will pay more in private
capital markets to raise capital,
or worse, their agents won’t be
able to raise any capital.
In addition, cooperatives must
generate enough earnings to
compete with IOFs by maintaining
and growing their base
of capital assets and their business. So even if the cooperative does
not raise capital in private capital markets, it is likely to have its
own business objectives 12 that must be financed with the cooperative’s
earnings and equity. Boards of directors and management are
accountable to use the co-op’s equity efficiently and effectively.
Yes, a cooperative can operate as close to breakeven as possible, without
aiming to make any earnings or profits. But unless these cooperatives
operate very conservatively with little or no risk, they are more
prone to financial failure because it is impossible to make decisions
that well—to be right that often—and hence, impossible to avoid
the cumulative weakness created from wrong decisions. 13
So while cooperatives cannot escape the imperative that confronts
any business organization to generate profits, cooperatives are different
and, in principle, more sustainable than IOFs because co-ops do
not hoard capital.
The incentives that drive IOFs and cooperat ives oppose each other.
For either business organization, management and the board of
directors are accountable to use equity capital from members or
investors efficiently and to maximize the returns paid to members
or investors according to their expectations, respectively. The IOF’s
incentives drive it to retain and reinvest capital for the benefit of the
IOF. The cooperative’s incentives drive it to pay cash to members and
patrons and to retain only what is needed to finance the cooperative’s
growth objectives, which are all aimed to benefit members rather
than the cooperative.
19

Our response to the blog post question about co-op profitability
would be the following:
Thank you for your comments. Credit unions need profits to sustain
themselves, so if a comparison with a bank is helpful for identifying
areas of inefficiency, that comparison is not objectionable. We
know you will appreciate hearing that credit unions are not capital
hogs, and that their genetic makeup—being from the family of
cooperatives—is to return unneeded earnings and capital to members
in the form of patronage refunds. Cash is returned to members as
soon as possible because there is no incentive for the co-op to hoard the
cash for itself, or for members to leave their equity in the co-op hoping
that it will appreciate in value. The same thing cannot be asserted
about the expected behavior of an IOF bank. Consequently, the more
successful a cooperative is, the more capital that it returns to its users
on the basis of patronage.
In this chapter we addressed the issue of why cooperatives need earnings
and how the cooperative’s business objectives are geared toward
the financial and economic benefit of members rather than the
cooperative. In Chapter 3 we will address the mechanics of patronage
refunds in the abstract. In Chapter 4, we will apply the requirements
of four alternative co-op tax regimes to the payment of patronage
refunds.
20

CHAPTER 3
A Primer on Patronage Refunds
(in the Abstract)
Credit unions are open membership cooperatives
that can grow membership and corresponding
capital in relation to the number of
potential members available. Capital distribution
decisions stem from careful deliberation by
the board.

The subject of this chapter is a theoretical open membership cooperative.
The focus of this report, in fact, is directed at open membership
cooperatives. Open membership means there are no limitations
on the number of members who can join the cooperative or do
business with it. The allocated equity that members earn from doing
business with open membership cooperatives does not appreciate in
value. When allocated equity is redeemed, the co-op pays no more
than the face value of the allocated equity.
In contrast, the common stock in a closed membership cooperative
can appreciate in value if the cooperative is financially successful.
Closed membership cooperatives limit membership because the
co-op’s physical plant size is defined. An ethanol cooperative, for
example, produces a finite number of gallons of ethanol, and it needs
a finite number of bushels of corn to produce that ethanol. The
cooperative does not sell more stock or approve new members after
its membership is of sufficient size to produce and deliver enough
corn to supply the cooperative’s ethanol production capabilities.
We have already said that a cooperative’s earnings belong to members
rather than the co-op. Patronage refunds are distributed from the
co-op’s GAAP patronage- sourced income. Assuming that all earnings
are, in fact, generated from transactions with or for members,
then all of the co-op’s income is theoretically available to allocate to
members on a patronage basis.
Capitalization of the cooperative naturally occurs proportionate to
each member’s use of the cooperative. Earnings are distributed in
cash to the extent possible but are retained by the cooperative as allocated
equity to finance its need for equity capital. The cooperative’s
need for equity turns on its growth objectives, its plans to borrow
debt capital, and its desire to redeem equities allocated from previous
years’ earnings. The cooperative aims to generate enough earnings
and surplus cash flow to align ownership with use by redeeming the
allocated equity of former, retired, or deceased members.
22

Equity redemption policies are adopted by the board of directors
minimally to maintain an alignment between each member’s equity
capitalization and his or her use of the cooperative. The board of
directors is not required to redeem any allocated equity. Case law
generally supports the board’s discretion to redeem allocated equity,
but it also appears that courts are inclined to order redemptions if
they conclude that the co-op had surplus working capital that it did
not need. Redemption policies include the redemption of allocated
equities when a member or former member dies. For more successful
cooperatives, the redemption of allocated equities occurs when
a member reaches a certain age (e.g., age 70) or by year of allocation
(e.g., in 2011, the co-op redeems equities that were allocated in
1990).
Some boards of directors adopt base capital plans that tie the amount of allocated equity to the
member’s use of the cooperative. When the member’s use increases, the member’s base capital
requirement also increases, and more of that member’s patronage distribution is retained, or
redemptions to that member are slowed to build up the member’s base capital.
Some bo ards of directors adopt base capital plans that tie the amount
of allocated equity to the member’s use of the cooperative. When
the member’s use increases, the member’s base capital requirement
also increases, and more of that member’s patronage distribution is
retained, or redemptions to that member are slowed to build up the
member’s base capital. When the member’s use of the cooperative
decreases and thus less base capital is required, then retained earnings
are reduced or redemptions of allocated equity are increased to
reduce the member’s level of base capital.
So far we have discussed patronage refunds in the abstract. Next we
will drill down into the tax mechanics of patronage refunds.
23

CHAPTER 4
Tax Differences between
Cooperatives
Governed by different statutes, credit unions
and other cooperatives operate under a mix of
tax obligations. The distribution and accounting
of patronage dividends is a key component
affecting the corporate tax liability of
cooperatives.

In this chapter, we will review four tax regimes that are applied to
cooperatives. The first is Subchapter T, which applies to the widest
variety of cooperatives. The second is 26 U.S.C. 501(c)(12),
which applies to rural electric cooperatives. The third is 26 U.S.C.
501(c)(1) as applied to Federal Land Bank Associations under
12 U.S.C. 2098. 14 The fourth is 26 U.S.C. 501(c)(14), which applies
to state- chartered credit unions.
The key points of distinction among these tax regimes include
(1) whether the co-op is treated as tax exempt or nonexempt,
(2) whether earnings (and which ones—patronage earnings only or
nonpatronage earnings too) are apportioned to individual patrons,
(3) when the co-op pays cash to members, (4) when members pay
income tax on income allocated to them from their co-op, and
(5) whether the co-op is required to give notice of patronage allocations
to members.
The tax exemption under which state-chartered credit unions operate does not require credit
unions to allocate or apportion their earnings to individual members. Credit unions’ equity is
undivided. Members have no idea how much of their own transactional activity with the credit
union contributes to the credit unions’ equity.
On a continuum moving from left to right in Figure 2, Sub-T
co-ops are most regulated, and state- chartered credit unions are least
regulated by their tax statutes, in how closely they must follow co-op
principles. The tax exemption under which state- chartered credit
unions operate does not require credit unions to allocate or apportion
their earnings to individual members. Credit unions’ equity is
undivided. Members have no idea how much of their transactional
activity with the credit union contributes to the credit unions’ equity.
Credit union members do not expect any equity to be redeemed,
ever.
The relevance of including a discussion of rural electric cooperatives
under 501(c)(12) may not become apparent until much later in the
25

Figure 2: Contrast Statutes Governing Co-ops
Federal Land Bank
Sub-T co-op Rural electric co-op
(and federal
credit unions)
State-chartered
credit union
Statute 26 U.S.C. 1382 26 U.S.C. 501(c)(12) 501(c)(1) 26 U.S.C. 501(c)(14)
Exempt or nonexempt Nonexempt Exempt Exempt Exempt
Are patronage earnings
allocated or apportioned
to individual members?
Notification of allocation
to member required?
When does member pay
income tax, if ever?
Is patronage earnings
part of capitalization of
co-op?
How are proceeds
distributed at dissolution
of co-op or credit union?
When are income taxes
paid by the co-op or
credit union?
Yes. Must be allocated
to qualify for tax
deduction allowed for
patronage-sourced
earnings. “Allocation”
is apportionment plus
“notice.”
Yes. Co-op is required
to give specific written
notice of member’s prorata
allocated patronage
earnings.
In the year that member
received qualified written
notice. Members pay tax
on entire distribution even
though no more than 20%
is paid in cash (if business
with co-op was taxable as
income or deductible as
expense).
Yes. Allocated equity is
usually major portion of all
equity capitalization. This
equity is redeemed as and
when co-op has excess
working capital.
On basis of historical
patronage. Articles and/or
bylaws may limit length of
look back.
On all nonpatronagesourced
income and
patronage income that is
not allocated.
Not required. Minimum
requirement is to maintain
records showing each
member’s interest in
co-op’s earnings and equity.
Some notify members of
apportionment of each
member’s pro-rata portion
of patronage earnings.
No. But recommended
practice is to specifically
notify members of pro-rata
portion of apportioned
earnings. Notification is
seen as opportunity to
communicate about co-op
values.
Upon redemption of
allocated equity in cash
paid to the member by
co-op (if purchase was for
tax-deductible business
purpose).
Yes. Apportioned and
allocated equity is usually
major portion of all equity
capitalization. This equity
is redeemed as and when
co-op has excess working
capital.
On basis of historical
patronage. Articles and/or
bylaws may limit length of
look back.
If more than 15% of
income arises from
unrelated nonmember
business.
Not required. If the
earnings are not
apportioned, the earnings
are accounted for in an
unallocated surplus.
No. Practice is mixed.
Some do notify but others
do not notify. Notification
seen as an opportunity
to communicate with
members about co-op
values.
Upon redemption of
allocated equity in cash
paid to the member by
co-op (if loans or services
were for tax-deductible
purpose).
Mixed. Some promote
member ownership of
allocated equity capital,
but others are silent about
that feature of co-op’s
capitalization.
Land Banks—usually
historical patronage, and
governed by articles of
incorporation or bylaws.
(Credit unions—to
members on basis of share
ownership).
Never.
No. Earnings are
unallocated. Most earnings
are accounted for as
“undivided earnings.”
No. But notice of cash
patronage refunds is
seen as an opportunity
to communicate with
members about co-op
values.
Upon receipt of cash
refund paid to member
by credit union (if loans
or services were for taxdeductible
purpose).
No. Equity is all
unallocated. On the other
hand, we know that
members’ businesses
generated earnings that
make up the undivided
equity.
Governed by state law
where incorporated rather
than federal law.
If more than 15% of
income arises from
unrelated nonmember
business.
report, when we discuss tax implications for credit unions. Rural
electric co-ops will be particularly relevant then because their tax
exemption has been criticized even more harshly than that of credit
unions. Moreover, in cases where members are litigating the redemption
of their allocated equity, rural electric cooperatives are of interest
26

ecause they are being challenged more than any other type of cooperative
to live up to the ideal that cooperatives are not capital hogs.
Under any of these four tax regimes, members pay income tax on
patronage distributions only if the transaction that gave rise to the
patronage distribution is taxable
income (like the sale of corn
Under any of these four tax regimes, members pay income tax to a co-op where the proceeds
on patronage distributions only if the transaction that gave from the sale are taxed) or a
rise to the patronage distribution is taxable income or a tax- tax- deductible expense (like the
deductible expense.
payment of interest on a loan
that is used to finance a business).
In either case, the patronage
refund is also taxed. Only members of Sub-T co-ops, however,
pay income tax on the entire patronage distribution before they have
received all the cash.
Subchapter T Cooperatives
(26 U.S.C. 1382 et al.)
The broadest cross section of cooperatives is taxed under Subchapter
T and described as nonexempt (“Sub-T” or “nonexempt”). This
group includes but is not limited to natural food cooperatives, bargaining
cooperatives, cable television cooperatives, most agricultural
cooperatives, a minority of rural electric distribution cooperatives,
and some electric generation and transmission cooperatives.
Sub-T cooperatives are faced with the choice of either paying income
tax or paying a cash patronage refund of at least 20% of allocated
patronage earnings to members. Sub-T cooperatives are treated like
corporations in that they pay income tax on nonpatronage- sourced
income 15 and on patronage earnings that are not allocated to patrons.
The cooperative is allowed a tax deduction for patronage earnings
that it allocates to patrons on the basis of their proportional patronage
of the cooperative.
Three conditions are necessary in order to receive a patronage tax
deduction under Subchapter T for income allocated to patrons.
First, an obligation to allocate income to members must have existed
at the time of the members’ transaction with the cooperative. This
obligation is usually found in the bylaws, but it can be in an agreement
as well. Second, the allocation must be from profits or income
realized from transactions with the members for whom the allocation
is made. Third, the allocation must be made ratably to the members
whose patronage created the income from which the allocation is
made. 16
27

Patronage earnings that are allocated and distributed to patrons must
be “paid” within eight and one-half months of the cooperative’s fiscal
year end, the outside limit of the statutory time allotted to file the
cooperative tax return. At least 20% of this distribution must be paid
with cash or by qualified check.
The balance (up to 80%) of the allocation is distributed and “paid”
to patrons with qualified written notices of allocation (QNAs). 17
The written notice advises the
patron that a finite amount of
In Subchapter T cooperatives, a tax deduction is allowed to the patronage earnings (up to 80%
cooperative for patronage earnings that it allocates to patrons of allocated patronage earnings)
on the basis of their proportional patronage of the cooperative. was allocated on the cooperative’s
books to the patron on
the basis of the patron’s proportional
patronage of the cooperative. Patrons are required to consent
18 (most often contained in the bylaws, but consent can also be
obtained by endorsement of a qualified check or separate agreement)
to report these earnings on their tax returns.
Sub-T co-ops report payments to patrons who receive a distribution
of patronage earnings in cash and QNAs of $10 or more on form
1099-PATR. Consumers do not pay income tax if the transactions
from which the patronage income arose were for personal, living,
or family expenditures that were not tax deductible. In fact, some
consumer cooperatives may apply for and receive an exemption from
filing 1099-PATRs. 19 If, however, the member’s transaction with the
cooperative produces taxable income or a tax deduction, the income
reported on a 1099-PATR must be reported on the member or
patron’s tax return as well.
Sub-T cooperatives are not required to redeem allocated equities.
Case law from across the United States upholds the authority of a
board of directors to determine for itself, at its sole discretion, when
to redeem allocated equities. Some of these cases, however, also
intimate that the board cannot just retain surplus working capital
without redeeming allocated equity. This is consistent with the view
that cooperatives do not exist to hoard capital.
Sub-T cooperatives are required to maintain patronage records so
that in the event of dissolution of the cooperative, the remaining
proceeds can be distributed on the basis of historical patronage.
28

Rural Electric Cooperatives
(26 U.S.C. 501(c)(12))
Like credit unions, most rural electric cooperatives are exempt from
income tax rather than nonexempt like a Sub-T co-op. At least 85%
of rural electric cooperatives’ income must be from member business,
or the unrelated business income tax is imposed if more than 15%
of their income is derived from nonmember sources. Exempt rural
electric cooperatives—again, like credit unions—are not required
to allocate or distribute income to members in the year the income
is generated by the rural electric. Further, rural electrics can allocate
patronage and nonpatronage or unrelated income to members.
But unlike credit unions, rural electrics must at least maintain books
and records showing to whom each year’s earnings would be allocated
on the basis of patronage, and the interest of each member in
the cooperative’s equity. The
National Rural Electric Cooperative
Association (NRECA)
At least six lawsuits have been initiated against rural electric
cooperatives to redeem equity to members. The lawsuits are not goes further, recommending
evidence that rural electric cooperatives are hoarding capital, that rural electric cooperatives
but that is what is at issue in this litigation.
administer and account for their
earnings from members like a
Sub-T co-op. 20 Hence, rural
electric cooperatives are encouraged to annually notify their members
of the amount of earnings apportioned to the member on the rural
electric cooperative’s books.
The NRECA makes this recommendation to rural electric cooperatives
to (1) protect rural electric cooperatives’ tax exemption under
501(c)(12), because notification solidifies the record- keeping aspect
of the tax exemption, (2) position rural electric cooperatives to argue
for a Sub-T tax deduction if their 501(c)(12) exemption is denied
by the IRS, and (3) create an opportunity for communication with
members about cooperative values. 21
Rural electric cooperatives are not required to file Form 1099
information returns to report payments of patronage dividends, 22
although these cooperatives may use 1099-MISC to report payments
of $600 or more. Unlike in the case of Sub-T cooperatives,
where patrons consent to report their allocated portion of patronage
refunds in the year the earnings were generated even though up to
80% of the patronage income is noncash, members of rural electric
cooperatives do not pay income tax until they receive a cash redemption
of their allocated equity from the rural electric cooperative, and
then only if the expenditure for electricity was tax deductible.
29

When rural electric cooperatives are dissolved, and after payment of
all creditors and equity credits, the remaining proceeds are distributed
on the basis of historical patronage in keeping with the co-op
principles of subordination of capital, service at cost, and the co-op
agency theory of earnings.
The NRECA is and has been proactive in encouraging rural electric
cooperatives to ratchet up the priority of redeeming capital credits.
In 2005, the NRECA reassembled a task force and updated its guide,
“Capital Credits Task Force Report, a Distribution Cooperative’s
Guide to Making Capital Credits Decisions.” This guide supports
the idea that rural electric cooperatives must manage their equity
capital more proactively and redeem equity credits on a systematic
basis.
Rural electric cooperatives are being challenged in lawsuits 23 to live
up to the idea that they are not capital hogs. At least six lawsuits have
been initiated against rural electric cooperatives to redeem equity to
members. The lawsuits are not evidence that rural electric cooperatives
are hoarding capital, but that is what is at issue in this litigation.
In each case, the board of directors is alleged to have failed to redeem
equity credits according to its fiduciary obligations. These boards of
directors may be ordered to redeem equity credits if the plaintiffs can
prove these rural electric cooperatives have surplus working capital
that is not required for present or future capital requirements. The
oddity is that most boards of directors of cooperatives—including
rural electric cooperatives—are driven by a strong moral compulsion
to redeem allocated equity sooner rather than later. As we said
earlier, co-ops are not driven to hoard capital. Hence, we would not
be surprised that these rural electric cooperatives simply do not have
sufficient surplus working capital to redeem lots of allocated equity.
In addition, these plaintiffs may also need to overcome the presumption
that equity credits do not vest or confer ownership in members
until the board of directors affirmatively resolves to redeem the
equities. This, parenthetically, is a point of contrast with Sub-T
cooperatives, where, under the consent provisions discussed above,
ownership of the equities vests immediately in members upon allocation
of patronage income to members.
Federal Land Bank Associations
(501(c)(1) and 12 U.S.C. 2098)
Federal Land Bank Associations (“Land Banks”) are tax exempt (as
are federal credit unions under 501(c)(1)) because they exist under
an act of Congress. Land Banks may, but are not required to, allocate
or apportion income (patronage or nonpatronage and unrelated
30

income) on a patronage basis to members, maintain patronage
records, or pay a cash refund. 24 Members pay income tax only upon
the receipt of cash the Land Bank pays as cash refunds or to redeem
allocated equity. Further, these co-ops are not subject to the unrelated
business tax.
Land Banks are closely regulated by the FCA. Regulations include
direction about how farm credit associations distribute income and
manage their capital. For example, the FCA regulates the capitalization
provisions contained in Land Banks’ bylaws (12 CFR
615.5220), the distribution of earnings (12 CFR 615.5215), and
the implementation of co-op principles by farm credit associations
(12 CFR 615.5230).
Credit Unions (26 U.S.C. 501(c)(14))
State credit unions are exempt from income taxation under 501(c)
(14), while federal credit unions are exempt from income tax under
501(c)(1). Even though credit unions operate on co-op principles
of democratic control and subordination of capital, they are not
required to maintain records or apportion earnings individually from
member business.
At dissolution, federal credit unions distribute remaining funds on
the basis of share ownership at the time of the dissolution. 25 The
dissolution provisions of the
statutes and law of the state in
Credit union dissolutions are unlike dissolutions of other cooperatives
in that the last credit union member standing benefits is chartered will govern its dis-
which a 501(c)(14) credit union
disproportionately to former members who have died or who solution and the distribution
no longer have a share account.
of remaining proceeds after all
creditors and superior claims
are paid. We have not reviewed
the statutes of all 50 states, but it appears that based on a sampling
of statutes from Iowa, Kentucky, North Dakota, and Wisconsin,
state statutory requirements are likely to follow the federal scheme
in 12 CFR 701.6. 26 Credit union dissolutions are unlike dissolutions
of other cooperatives in that the last credit union member standing
benefits disproportionately to former members who have died or
who no longer have a share account.
Credit unions report payments of dividends to holders of share
accounts for payments in excess of $10 on form 1099-INT. Credit
unions also report mortgage interest refunded with form 1098.
31

CHAPTER 5
Use of Patronage Refunds
by Other Cooperatives
In this chapter we compare and contrast
Georgia- based AgGeorgia Farm Credit ACA
and Wisconsin- based Badgerland Financial
ACA. These associations illustrate widely differing
views of patronage refund philosophies.
Some argue that cooperatives pay out their
dividends in better everyday rates. Others argue
that the co-op should reward member- owners in
a more measured, visible way.

The annual reports of AgGeorgia Farm Credit ACA and Badgerland
Financial ACA (individually an “association” or collectively “associations”)
can be found on their websites. 27 Each of these associations is
a member of the Farm Credit System. Selected financial information
is contained in Figure 3. Figure 4 evaluates the value of patronage
refunds received by the members of AgGeorgia and Badgerland.
The Farm Credit System is cooperatively owned and operated by
agricultural producers. System institutions provide financing for
members who are engaged in production agriculture. Federal Land
Bank Associations were the first system institutions chartered by
Congress in 1916. These associations provide their members—
agricultural producers—with long-term credit for purchases of land
and long-lived assets. By 1947, Land Banks had repaid all government
capital.
The Federal Intermediate Credit Bank and related Production Credit
Associations were chartered by Congress in 1933. These associations
Figure 3: Farm Credit Associations
Average of 2007, 2008, and 2009 AgGeorgia Badgerland
Income statement (thousands)
1. Not allocated $7,555 $32,876
2. Total patronage refund distributed with QNAs $15,189 $5,476
2a. Refund portion paid in cash $5,069 (33%) $5,476 (100%)
2b. Refund portion paid with allocated QNAs $10,120 (67%) $0
2c. Refund portion paid with allocated NQNAs $1,707.0 $0
3. Net income $24,451 $38,352
4. Gross interest income $74,346 $118,634
Balance sheet (000’s omitted)
5. Common stock $4.0 $7.0
6. Allocated equity $82.5 $0
7. Unallocated equity $90.7 $405.2
8. Total equity (fiscal year end 2009) $177.1 $412.2
9. Redemption of allocated equity $13.3 $0
33

Figure 4: Present Value of Patronage Distributions
Badgerland AgGeorgia
1. Patronage distribution allocated to members $1.00 $5.00
2. Allocated equity $0.00 $3.35
3. Cash portion paid by co-op $1.00 $1.65
4. Member taxes paid $(0.35) $(1.75)
5. Member net cash position year 1 $0.65 $(0.10)
6. Present value of redeemed equity at 5% cost of capital $0.00 $2.26
over 8 years
7. Member net cash position after redemption of equity
year 8
$0.65 $2.16
provide their members—again,
agricultural producers—with
short-term credit for crop and
livestock enterprises and for
purchases of farm machinery.
By 1968, all government capital
was repaid.
Originally, the system’s associations
were operated separately
from one another, but in the
late 1980s they were consolidated
under the same management
structures into ACAs. Each ACA has at least two subsidiary
lending institutions: a Federal Land Credit Association (Land Bank)
and a Production Credit Association (Credit Association).
Federal Land Banks were—and inside of an ACA, still are—exempt
from income tax under 501(c)(1) because they are federally chartered
organizations. Production Credit Associations are nonexempt
cooperatives under Subchapter T. From the provision for income tax
in the audits of AgGeorgia and Badgerland, respectively, approximately
60% of these ACAs’ income is generated by their Land Banks
(tax exempt) and 40% of their income is generated by their Credit
Associations (nonexempt under Subchapter T).
Later in this chapter, we also discuss a third ACA. However, the
officers of this ACA requested that we not disclose their names or
the identity of the ACA, because the board of directors and senior
management are engaged in an ongoing discussion about whether
the ACA will pay patronage refunds. The chief financial officer we
spoke with is concerned that identifying the ACA might diminish
the openness of the deliberations currently under way and/or suggest
that senior management is biased either for or against the payment of
patronage refunds.
FCA—Regulatory Agency of ACAs
The FCA regulates AgGeorgia, Badgerland, and the other 79 ACAs,
and it establishes capital adequacy ratios for these associations.
Figure 5 contains the 2009 ratios for AgGeorgia and Badgerland,
the FCA minimum ratio, and the ratios for the combined 81 ACAs
as of December 31, 2010. Capital ratios are also provided for the
unnamed ACA that we will discuss later in this chapter.
FCA regulations prohibit the inclusion of more than two percentage
points of allocated equities in the calculation of the core surplus
ratio. 28 Further, the regulations also prohibit in the calculation of
34

Figure 5: A Comparison of ACA Ratios
FCA ratio* FCA minimum 81 ACAs Badgerland AgGeorgia Unnamed
Permanent capital 7.00% 13.46% 12.70% 13.75% 16.20%
Total surplus 7.00% 12.93% 12.40% 13.50% 16.00%
Core surplus 3.50% 12.18% 12.40% 10.47% 16.00%
*Standards imposed by the Farm Credit Administration, the regulatory arm that provides oversight to the Farm Credit System and individual
institutions like Badgerland and AgGeorgia.
the core surplus ratio the inclusion of any allocated equities that are
scheduled or intended to be retired during the next three years. 29
Consequently, these regulations are a disincentive for associations to
distribute earnings with allocated equity to their members.
AgGeorgia Patronage Refunds
AgGeorgia’s average annual net income was $24.5M over the past
three years, and it has allocated and distributed 70% of that income
($15.1M with cash and QNAs) to members on the basis of patronage.
AgGeorgia has distributed 33% of that distribution in cash, and
the balance of earnings is retained as allocated equity.
Because these earnings were distributed with QNAs, and because
we assume the interest paid to AgGeorgia was deductible on the tax
returns of its members, AgGeorgia’s members also report this patronage
income on their tax returns. Only the cash patronage distribution
from the Land Bank subsidiary is reported on the members’ tax
returns, whereas the cash and noncash allocated equity distributions
from the Production Credit Association subsidiary are reported on
members’ tax returns.
We assume that AgGeorgia’s board of directors and management has
made a calculated decision that paying 33% of the distribution in
cash is sufficient to at least pay the income taxes that most members
will owe to federal and state governments on these patronage distributions.
Recall that the interest payments that members make to
AgGeorgia are likely to be tax deductible to the member as a business
expense, so patronage income must be reported as taxable income as
well.
Because AgGeorgia distributes patronage refunds with QNAs that
its members pay income tax on, AgGeorgia’s members undoubtedly
have high expectations that AgGeorgia will redeem that equity
sooner rather than later. Just under half of all of AgGeorgia’s total
earned equity ($82.5M; see Figure 3, row 6) is allocated to members.
AgGeorgia’s average annual redemption expenditure over the past
three years was $13.3M. Hence, AgGeorgia could redeem all of its
allocated equity in as little as seven years (see Figure 3, row 6 divided
35

y row 9). All in all, this is a very aggressive posture for a financial
co-op.
Significantly, AgGeorgia’s patronage refund philosophy is pressuring
its capital position. As a percentage of its total loans, the cash that
AgGeorgia pays to redeem allocated equity and its cash patronage
refund (at 1.9%) is three to four times the average paid by other farm
credit associations (.49%) or the 27 credit unions in Callahan’s study
(.5%).
Badgerland Patronage Refunds
Badgerland’s average annual net income was $38.4M over the past
three years (see Figure 3, row 3). Badgerland allocates and distributes
only 14% of its income on a patronage basis, but its entire distribution
is 100% cash; its average annual patronage refund is $5.5M.
The balance of Badgerland’s earnings is not allocated, and hence it
is used to build Badgerland’s unallocated equity. Because Badgerland
does not distribute any earnings with allocated equity, all of its
equity is unallocated (undivided) and its members do not expect that
Badgerland will redeem equity to them (see Figure 3, rows 6 and 7).
Approximately 40% of earnings is related to Badgerland’s nonexempt
Production Credit Association and, therefore, exposed to corporate
income tax.
Badgerland’s members are in a stronger cash position than AgGeorgia’s
members in the year they receive the cash patronage distribution
from each association (see Figure 4, row 5) because whatever
AgGeorgia’s members receive is paid to federal and state governments
when AgGeorgia’s members pay their income taxes.
In contrast, Badgerland members probably keep 67 cents of every
dollar of patronage refund after they pay their income tax obligations
from the 100% cash patronage refund they receive from Badgerland.
However, AgGeorgia’s members fare better in the long run after the
earnings distributed with QNAs are redeemed. The present value of
AgGeorgia’s patronage distribution is stronger than Badgerland’s (see
Figure 4, row 7) by a factor of more than three to one.
Impact on Adequacy of Capital
Position
The patronage refund philosophies of AgGeorgia and Badgerland
affect their compliance with FCA capital management guidelines.
Because all of Badgerland’s equity is unallocated (except for the
capital stock that members purchase when they borrow money; see
Figure 3, row 5), the calculation of its core surplus ratio, which was
36

12.40% at its 2009 fiscal year end, is not diluted by allocated equity
(see Figure 3, row 6).
On the other hand, at 10.47%, AgGeorgia’s core surplus ratio is considerably
softer than Badgerland’s ratio. Not only do the FCA regulations
prohibit the inclusion of more than two percentage points of
allocated equity in the calculation of the core surplus ratio, but the
FCA could argue that AgGeorgia intends to redeem $40M over the
next three years based on its average redemption of $13.3M the past
three years.
Juxtaposing the philosophies of Badgerland and AgGeorgia illustrates
the choices that each co-op makes about patronage refunds, capital
structure, and the payment of corporate income tax. AgGeorgia pays
far less income tax than Badgerland. Each dollar that AgGeorgia
distributes as a patronage refund (with QNAs, both the cash portion
and the allocated equity portion) reduces its taxable income by a
dollar for its nonexempt Subchapter T subsidiary. At the same time,
every dollar that AgGeorgia allocates with QNAs builds up member
expectations that this equity will eventually be redeemed, sooner
rather than later. In contrast, Badgerland has not created an expectation
among its patrons that it will redeem equity every year, or at any
time, and accordingly, Badgerland’s capital position is stronger than
AgGeorgia’s position.
This observation brings us back to a point we made in Chapter 1
in regard to building strong capital structures by not allocating
patronage refunds and how allocating earnings puts pressure on the
cooperative to redeem equity capital. AgGeorgia’s board of directors
and management must have concluded that they are not pressuring
AgGeorgia’s capital position too much by allocating so much income
and then redeeming that equity within seven or eight years. It is difficult
for us to conclude that this approach will accrue to AgGeorgia’s
benefit over the long run because its patronage philosophy is depleting
capital that may be needed for growth.
Like any business organization, co-ops might pursue short-term
objectives that are not aligned with their long-term interests. It could
be that AgGeorgia is one of those organizations.
A Farm Credit Association’s Patronage
Refund Debate
In the course of our research, we encountered a farm credit association
(virtually identical to Badgerland or AgGeorgia but operating in
a trade territory far from either of those associations) where an ongoing
debate is the issue of whether to pay a patronage refund. This
association’s 2010 year-end loan volume was over $3 billion (B). Like
37

Badgerland, all of this association’s equity is unallocated except for
approximately $8.0M of common stock. Its net income has nearly
doubled in the last five years.
This association is stronger than either Badgerland or AgGeorgia. At
its 2009 fiscal year end, its core surplus ratio was under 14%, and it
grew stronger in 2010 when the ratio reached 16%. Obviously this
association—which we agreed to leave unnamed—is in a position
to pay a patronage refund if the board approves it. The association’s
chief financial officer summarized the debate as follows.
Those Arguing “No Patronage Refund”
A portion of this association’s board of directors takes the position
that it operates on a cooperative basis every day even though the
association does not pay a patronage refund. These directors say that
the very existence of the association acts as a competitive force to
keep other lending institutions’ rates comparable to the association’s
rates and cost of services. That being true, these directors are not
in favor of paying a patronage refund. Members, they would argue,
already receive a patronage refund.
These directors also contend that it is unnecessary to charge higher
interest rates or prices for services only to return some of those earnings
in cash as a patronage refund. Obviously the association’s growth
is strong and it appears unnecessary to prime it further. In fact, no
one on the board of directors takes the view that a patronage refund
would improve the association’s rate of growth.
Those Arguing “Pay a Patronage Refund”
On the other side is a portion of directors who are in favor of paying
a patronage refund. These directors’ position is that co-ops are
supposed to pay a patronage refund. These directors also believe
that paying a patronage refund ties members more closely with, and
deepens their loyalty to, the association.
If Paid, Pay Patronage Refund in Cash; No Allocated
Equity
If there is a consensus within the board of directors, it is that a
patronage refund, if paid, should be entirely cash. All of the directors
are farmers and hence very familiar with agricultural cooperatives.
These directors do not like the idea of receiving an allocation of
patronage refunds but not receiving a large enough cash patronage
refund to pay the income taxes those members will owe state and
federal governments on that patronage income. 30
38

The CFO’s View; Similarity to Credit Unions
If the CFO voted today, he would probably vote in favor of paying a
patronage refund. The beneficial effect of paying a patronage refund
is that it provides the association with one more mechanism to manage
the level of its capital.
• • •
This debate raises issues similar to those of a credit union board
considering a patronage refund. The answer hinges on directors’ philosophies
about the need for capital- intensive growth and whether it
is better to reward members for their business every day or to declare
extraordinary dividends annually.
Business challenges remain in paying out a regular refund, but
initiating one is likely to build member loyalty and provide
opportunities to communicate with members about co-op
values.
Are AgGeorgia, Badgerland, and the
Unnamed Association Capital Hogs?
Badgerland is arguably overcapitalized because its core surplus is
much stronger than AgGeorgia’s or the FCA guide of 3.5%. Badgerland
could, however, quickly counter that surplus by ratcheting
up its 100% cash refund allocation from 14% (see Figure 3, row 2a
divided by row 4) of its income to 15%, 16%, or even higher.
In other words, the strength of Badgerland’s approach to patronage
refunds and capital management over AgGeorgia’s is that Badgerland
can change directions quickly. If Badgerland encounters prosperity, it
can increase the 100% cash patronage refund above 14% of income.
Alternatively, if Badgerland encounters financial stress, it can quickly
retreat back to distributing 14%
of income, or lower, with its
100% cash patronage refund.
In contrast, we could argue that
AgGeorgia not only is overcapitalized
but is diminishing
its capital by operating more
closely to pure co-op patronage principles. Between redemptions and
cash patronage refunds, AgGeorgia is paying out approximately three
times the amount of cash as a percentage of total loans as the average
of the 81 ACAs in the Farm Credit System, and seven times the
amount of cash paid by Badgerland.
The issue with AgGeorgia is that its patronage refund approach is
difficult to change quickly without affecting member expectations.
AgGeorgia’s earnings had been in decline for two years at the end
of 2009, so the pressure to conserve capital could be building. But
39

AgGeorgia’s members probably expect AgGeorgia will adhere to its
present redemption cycle of approximately seven years. The longer
AgGeorgia redeems on a seven- year cycle, the higher and more firm
members’ expectations will be.
Compared to Badgerland or AgGeorgia, the unnamed association
is strikingly overcapitalized. Its core surplus ratio grew from 14%
to 16% while it was growing its loan volume by 10% in 2010.
The implementation of a cash patronage refund program could be
expected to strengthen the association’s effectiveness in managing its
capital position. Initiating a patronage refund program is also likely
to build member loyalty and provide opportunities to communicate
with members about co-op values.
40

CHAPTER 6
Credit Union Perspective
From cooperative principles and outside examples
to actual credit union practices, this chapter
describes patronage refunds at three credit
unions. Each is slightly different, but all three
emphasize members’ inherent right to the excess
capital and membership benefits of giving tangible
reminders of members’ ownership.

All three credit unions use their patronage programs as differentiators
from local competitors. Credit union executives and
their staffs use the payment of patronage refunds as occasions
for their credit unions to communicate with members about
co-op values.
In this chapter we will discuss the use of patronage refunds by
CoVantage Credit Union, Dow Chemical Employees’ Credit Union,
and Wright-Patt Credit Union, Inc. Each of these credit unions pays
a patronage refund to its members.
Executives at each credit union stressed that patronage refunds are
only paid to members in good standing, a crucial point we need to
emphasize. In each case, we were told that limiting the payment of
patronage refunds to members in good standing is an important
practice because members respond to the payment as an incentive to
manage their business relationship with the credit union in a way so
that the member avoids disqualifying
himself or herself from
receiving the patronage refund
when it is declared.
One of the recurring themes in
this chapter is that the leadership
of each credit union views
the credit union’s earnings as
belonging to the members (and in one case to employees as a specific
stakeholder group), and hence that the leadership is accountable
to members as stakeholders. The leadership of these credit unions
feels that the credit unions’ earnings belong to members (and other
stakeholder groups) regardless of whether the earnings are allocated
to members on the credit union’s books.
All three credit union executives said their credit union’s patronage
program is a differentiator that set their credit union apart from
competitors. Earlier in this report we discussed how other cooperatives
use the payment of a patronage refund as an opportunity to
communicate with their members about the value of the cooperative
form of business organization. All three executives and their staffs use
the payment of patronage refunds as occasions for their credit unions
to communicate with members about co-op values. A sampling of
their newsletters and websites is shown in the appendix.
42

CoVantage Credit Union
CoVantage Credit Union is based in Antigo, Wisconsin, and operates
nine branch offices in 17 counties (15 in Wisconsin, 2 in Michigan),
most of which are rural and considered to be populated by a
largely blue- collar workforce. CoVantage recently opened its third
branch in the greater Wausau area, the largest community in which
it does business. CoVantage also operates about a half dozen Kids
Credit Unions in Middle Schools across its trade territory. But of the
$850M in assets, less than $125M is from the Wausau membership.
As of December 31, 2010, CoVantage had just over 62,000 members
(6% of potential members), 215 full-time employees, and total loan
volume of $651.0M. Membership grew by 5.98% in 2010. Brian
Prunty is CoVantage’s chief executive officer.
CoVantage is one of the 27 credit unions in Callahan’s database that
paid a patronage refund in each of the last five years, and is in the
top 10 of those 27 credit unions on a number of measures. CoVantage
is 3rd in five-year loan growth, five-year member growth, and
five-year share growth; 5th in one-year loan growth; 7th for its 2004
and 2009 return on assets (ROA); and 10th for its dividend payment
as a percent of total shares (in dollars).
CoVantage’s average cash patronage refund over the last three years
totals $1,341,936, and its earnings (including the refund) averaged
$6,939,880 during that time. So over the past three years,
CoVantage has paid an average of 19.34% of its earnings in cash on
a patronage basis to members, ranking it 19th out of the Callahan 27
for its interest refund as a percentage of earnings.
CoVantage has paid a cash
The leadership of credit unions must evaluate what they are patronage refund since 1981. Its
doing and how well the credit union is performing before they 19th-place ranking for the size
determine whether the credit union can justify paying bonuses of patronage refund as a percentage
of earnings suggests that
or rebates on top of what it is paying for share deposits or
charging for products and services.
paying a patronage refund is not
everything or the only thing.
Many factors determine the
success of any person or business. More important than the size of
the patronage refund is what it says about the business organization.
CoVantage’s patronage refund is consistent with its overall philosophy
that it is a financial co-op that belongs to its members.
Employees view members as the real owners. CoVantage exists
to help its members. Like any credit union, CoVantage does not
allocate its earnings—and equity—to members on the basis of share
ownership or loan volume, but it acts like it does. Hence, CoVantage’s
earnings “belong” to its members, which makes it less difficult
to pay a cash patronage refund to members.
43

The capital accumulated through earnings is considered commonwealth,
and since it’s a financial cooperative, there has to be some
benefit to ownership. Prunty acknowledges that a 10% capital target
demands significant fiscal discipline to be able to meet all the credit
union’s obligations. He is fortunate to have a board of directors
that finds CoVantage’s patronage refund program indispensable.
According to Prunty, the board is the driver of CoVantage’s patronage
refund payments. And since the board represents the members,
one cannot help but conclude that members are the wellspring from
which this patronage refund co-op philosophy emanates.
CoVantage tailors its patronage refund program to recognize the
contributions of members at all stages of their financial lives. It
acknowledges that in a member’s younger years, he or she is more
frequently a borrower, and thus it pays a 4% rebate on interest paid.
As members age, they can receive a savings bonus of up to 4% on
interest earned. Both of these expenditures are expenses on CoVantage’s
income statement and hence reduce CoVantage’s ROA.
CoVantage is an aggressive marketer, but its use of, for example,
bonus payments on debit cards or other profitable services does
not go as far as the programs of Dow Chemical or Wright-Patt.
Prunty noted that the rates the credit union pays on share deposits
are already the highest or second highest in the market. Prunty’s
comments highlight the fact that the leadership of credit unions
must evaluate what they are doing and how well the credit union
is performing before they determine whether the credit union can
justify paying bonuses or rebates on top of what it is paying for share
deposits or charging for products and services.
This notion echoes the earlier debate of the unnamed farm credit
association. The argument of some of the directors is that the association
is already providing a patronage refund in charging relatively
modest fees and rates and, therefore, is a competitive force that
provides economic and financial benefits without paying a patronage
refund.
Prunty says that when CoVantage’s portfolio is compared with
credit unions that don’t offer patronage refunds to their members,
CoVantage’s loan portfolio is of higher quality. In addition,
CoVantage members who went through bankruptcy reaffirmed their
debt 60% of the time in 2010 and 50% in 2009. He believes this is
due in part to the patronage refund program.
44

Dow Chemical Employees’ Credit
Union
Dow Chemical Employees’ Credit Union is located in Midland,
Michigan. As of December 31, 2010, Dow Chemical had just over
55,000 members (95% of potential members), 124 full-time employees,
total assets of $1.35B, and total loan volume of $482.0M. Membership
grew by 1.03% in 2010. Dennis Hanson is Dow Chemical’s
chief executive officer.
Dow Chemical is one of the 27 credit unions in Callahan’s database
that paid a patronage refund in each of the last five years. Dow
Chemical is in the top 10 of those 27 credit unions on a number
of measures: second in total assets, fifth in total loans, ninth for its
2009 ROA, fifth in member relationships, and seventh for 2009 real
estate loan penetration.
Dow Chemical has missed paying a cash patronage refund only once
in the last 50 years. Its average annual cash patronage refund over
the last three years was $3,807,972, and its earnings (including the
refund) averaged $11,559,969 during that time. So over the past
three years, Dow Chemical has paid an average of 32.94% of its
earnings in cash on a patronage basis to members, ranking it 11th
out of the 27 credit unions for size of refund in relationship to Dow
Chemical’s earnings.
Dow Chemical’s patronage refund (loan interest refund) amounts
to 15% of interest paid on loans. The patronage refund is not set at
15%, but it consistently works out to approximately 15% of interest
paid.
In addition to the patronage refund, Dow Chemical also pays
bonuses on its share deposits and debit cards. These bonuses have
averaged $3.5M annually. Dow Chemical has paid a bonus on share
deposits for 7 consecutive years and 10 of the last 15 years. This
bonus averages 15% of share deposits as well. Including share deposit
and debit card bonuses, Dow Chemical distributes 63% of its earnings
with cash each year.
Like CoVantage, Dow Chemical’s patronage refund is consistent
with its overall philosophy that it is a financial co-op whose earnings
belong to its members. Dennis Hanson is the fourth CEO of Dow
Chemical. Dennis told us that if the authors replaced him tomorrow,
his board of directors would absolutely require and expect us, as new
management, to toe the line on patronage refunds. After 50 years,
the payment of a patronage refund is a cultural imperative that is
nearly impossible to change.
45

As we visited with Hanson, it was difficult to ignore the institutional
tone that is created from paying a patronage refund to members.
Patronage refunds championed by the board and management make
member ownership feel more real for members. Hanson emphasized
that, aside from the issue of being accountable to members, the
important thing to note is that patronage refunds are a differentiator
and distinguish the credit union from IOF firms.
Wright-Patt Credit Union, Inc.
Our conversation with Tim Mislansky, senior vice president and
chief lending officer, may have been the most exciting because the
payment of patronage refunds is a relatively new practice at Wright-
Patt Credit Union, Inc. Mislansky told us that patronage refunds
were not necessarily top of mind at Wright-Patt until its management
determined that they were a mechanism for managing the
credit union’s capital growth.
Management had been trying to control the credit union’s growth in
capital by lowering service fees and other rates. But as fees and rates
were lowered, the credit union’s capital and its success continued to
grow, which prompted some directors to tease whether management
had solved Wright-Patt’s issue of excess capital.
Wright-Patt management requested that Callahan consultants
provide information about patronage refunds for management’s
consideration. Management had already developed a sophisticated
stakeholder model including (1) members, (2) employees, and
(3) the Credit Union. Management proposed that Wright-Patt dovetail
patronage refunds into its stakeholder model, and the Board of
Directors reviewed and adopted management’s recommendation.
Wright-Patt is not identified in the Callahan 27 credit unions,
and Mislansky brought to our attention that not all credit unions
separately account for patronage refunds from dividends in the call
reports that are submitted to the NCUA. Wright-Patt reports its
patronage refund with the dividends it pays on shares.
Wright-Patt is located in Fairborn, Ohio, and operates 24 branch
offices. As of December 31, 2010, Wright-Patt had over 202,320
members (15% of potential members), 428 full-time employees,
total assets of nearly $2.0B, and total loan volume of $1.12B. Membership
grew by 8.59% in 2010. Douglas Fecher is Wright-Patt’s
chief executive officer.
Wright-Patt’s average annual cash patronage refund over the last
three years was $3,751,478, and its earnings (including the refund)
averaged $19,867,464 during that time. So over the past three years,
Wright-Patt has paid an average of 18.88% of its earnings in cash on
46

a patronage basis to members, ranking it 20th out of the 27 credit
unions for size of refund in relationship to Wright-Patt’s earnings.
Parenthetically, we may be overstating Wright-Patt’s ranking, because
its patronage refund includes dividends paid on share deposit
accounts and flat fee payments on specific products and services,
whereas the other credit unions paid patronage refunds in the more
narrow sense that the payments were tied to proportional use of the
credit union. This issue will be amplified later in this section.
Wright-Patt’s management begins to model its December 31 capital
position in October each year and by November the board of
directors and management begin to settle on a number for patronage
refunds. By late November or early December, the Wright-Patt
leadership has settled on a patronage number.
Management is as concerned about the size of the patronage refund
as compared to prior years as it is about the size of the patronage
refund compared to interest earned. For purposes of this discussion,
we’ll assume that management recommended and the board
approved a patronage dividend of $4.0M.
The first consideration is to reward profitable products and services
like debit cards, online electronic banking, receipt of statements
electronically, and use of Wright-Patt’s financial planning and broker
services. Between one-fourth and one-third of the total patronage
dividend is paid to members who used these products and services.
Mortgage lending is included in flat charges because some mortgages
are sold off while others are held by the credit union. Wright-Patt’s
management does not want to prejudice those members whose mortgages
are sold, because the member has no control over that decision.
These patronage refunds are flat payments to each member who used
these products and services. We’ll assume that $1.0M was allocated
for these patronage refunds.
The second consideration is to distribute the remaining patronage
dividend of $3.0M to members on the basis of shares and to members
on the basis of their loans from Wright-Patt. If we assume that
Wright-Patt has $1.0B in loans and $1.5B in share deposits, each
qualifying member receives $.0012 cents per dollar of share deposit
and per dollar of loan balance. Mislansky indicated that this portion
of Wright-Patt’s patronage refund has been 7–10 basis points on
deposits and loans.
If its program was graded for adherence to co-op principles, all of
Wright-Patt’s patronage refund program would not qualify as a true
patronage refund, because a portion of it is paid as a flat fee that is
not related to the amount of business each member did with Wright-
Patt. Moreover, as with all credit unions, the payment of a dividend
47

on share deposits is not a patronage refund, because it is paid on the
basis of investment in Wright-Patt in contrast to use based on borrowings
from the credit union.
This is not to criticize Wright-Patt’s program but only to highlight
that in a report about patronage refunds, we must pay attention to
whether the payment was made on a patronage basis or the member’s
use of the credit union. In fact, Wright-Patt’s program highlights
the advantage of paying patronage refunds under 501(c)(14) rather
than, for example, Subchapter T. Under 501(c)(14), Wright-Patt is
allowed to be more creative in how it distributes its patronage payments
to members. Subchapter T would force a far narrower concept
of patronage on Wright-Patt because a patronage tax deduction is
allowed only for payments made on the basis of each member’s proportional
use of Wright-Patt.
Mislansky says that patronage refunds are a differentiator that distinguishes
Wright-Patt from IOF banks that compete in the credit
union’s market. Mislansky says that Wright-Patt’s membership grows
substantially each year after its patronage refunds are announced and
paid. The idea that patronage refunds are a differentiator resonates
with us, but on more levels than just whether patronage refunds are
good ideas as rebates. As we said earlier, we believe that patronage
refunds highlight the philosophical gulf that separates co-ops from
IOFs.
48

CHAPTER 7
Credit Union Implications
Cooperatives, including lending cooperatives,
are quite used to the practice of paying regular
patronage refunds. Most credit unions are not.
This chapter synthesizes the findings from earlier
in this report and offers suggestions to credit
unions considering a refund program.

Patronage Refunds: A Differentiator?
In 2009, Brian Briggeman of the Federal Reserve Bank of Kansas
City and Quatie Jorgensen of the University of Arizona wrote
an article entitled “Farm Credit Member- Borrowers’ Preferences
for Patronage Payments,” which appeared in Agricultural Finance
Review. This article reviewed studies that analyzed the preferences of
member- borrowers from Farm Credit Services of East Central Oklahoma.
The conclusion was that members strongly preferred patronage
refunds compared to lower fixed- interest rates, particularly when
given the option of one or the other. In fact, on average, memberborrowers
were even willing to pay higher interest rates in order to
receive a patronage refund.
The 2010 Callahan & Associates study also spoke to the influence of
patronage refunds on membership growth. Credit unions that offer
patronage refunds, through interest refunds, report much higher
annual member growth rates—both for a single point in time (over
the course of 2009) and over a five-year period. In addition, longterm
loan growth appears to be an additional strength for credit
unions offering interest refunds. While the 12-month loan growth
for both groups would be lower due to the economic conditions in
2008 and 2009, the five-year average annual growth of 8.4% for the
patronage refunds group is 30% higher than the other group’s rate of
5.8%.
Capital Management Tool
To us, there seems little doubt that credit unions will need to focus
on capital accumulation in the years ahead. Earnings are needed to
build balance sheet strength, ward off adversity, and attract the kinds
of secondary capital (preferred stock, debentures, etc., from members)
that credit unions have lobbied for. Patronage refunds are the
necessary tool that demonstrates to members that the cooperative is
socially and fiscally responsible with the member’s money. When the
cooperative has too much capital, it will be returned as patronage
refunds or equity retirements.
50

We encourage you to have your credit union’s articles of incorporation
and bylaws reviewed by legal counsel for the specific purpose of
learning whether your credit union might be prohibited from paying
a patronage refund. Our concern arises from the fact that at dissolution,
credit union statutes appear to favor share ownership over
historical patronage.
If the owners of shares in the credit union are the beneficiaries of the
remaining proceeds in dissolution, the question arises whether they
could object to any payment that is not paid on the basis of ownership
while the credit union is operating. We recommend that you
discuss with your legal counsel whether your credit union should
amend its articles and bylaws to specifically allow payments of
patronage refunds on a patronage basis any time prior to a dissolution
vote.
Future Tax Considerations
Nothing on the horizon points to any modification of the federal tax
exemptions that apply to federal or state- chartered credit unions. In
this section, we consider two alternatives: (1) that credit unions are
taxed under Subchapter T and (2) an argument for why 501(c)(14)
and 501(c)(1) tax statutes will not be touched.
The Case for Subchapter T
From time to time, the General Accounting Office (GAO) prepares
reports on tax- exempt business entities. In 2005, the GAO prepared
a report on credit unions that, aside from reciting the arguments for
and against the tax exemption, contained no recommendations for or
against the tax exemption.
In 1983, the GAO issued a report recommending that Congress
consider taxing rural electric cooperatives under Subchapter T. The
recommendation was not adopted by Congress, but in this section
we consider what would happen if the GAO made the same recommendation
for taxation of credit unions. Assuming that Congress
acted on the GAO recommendation this time, we apply Subchapter
T to the 27 credit unions in the Callahan study.
Figure 6, a modification of Figure 1, shows these 27 credit unions
under 501(c)(14) and then compares this with two scenarios under
Subchapter T. One scenario shows these credit unions allocating
40% of patronage- sourced income (and paying a cash patronage
refund of 20% of the total allocated) and paying taxes (federal and
state) on the other 60%. The other scenario shows these credit
unions allocating 100% of patronage- sourced income and paying no
income tax.
51

Figure 6: Potential Tax Effects of Patronage Refunds
27 Credit Unions as Exempt, Allocated 40% under Sub-T, and Allocated 100% Under Sub-T
Average of 2008, 2009, and 2010 501(c)(14) % Total Sub-T: 40% % Total Sub-T: 100% % Total
Cash patronage refund 822,800 23.34 282,076 8.0 822,800 23.34
Patronage refund in allocated equity — 0.00 1,128,304 32.0 2,703,149 76.66
Undivided/Unallocated earnings 2,703,149 76.66 1,184,719 33.6 — 0.00
Income tax on co-op’s earnings — 0.00 930,850 26.4 — 0.00
Total earnings (average per co-op) $3,525,949 100.00 $3,525,949 100.00 $3,525,949 100.00
Allocate and Distribute 100% of Patronage Refunds
Income tax is not owed under this Subchapter T scenario, because
we assume that all income is patronage sourced (generated from
transactions with members) and that all patronage income is allocated
to members on the basis of patronage. 31
The 27 credit unions in the Callahan study are already distributing
enough cash to qualify for tax treatment under Subchapter T. A minimum
of 20% cash refund is required by Subchapter T. These credit
unions paid 23.34%. Credit unions would prepare 1099-PATR
information returns, but we expect that many credit unions could
apply for and receive an exemption from reporting 1099-PATRs. 32
The bigger issue for these credit unions is whether they would be
able to redeem allocated equity, and whether there would be pressure
to redeem this equity. At the end of their first year operating under
Subchapter T, these credit unions would have allocated equity totaling
$2.7M dollars. If year two were identical, allocated equity would
total $5.4M at the end of that year. You can see how allocated equity
would quickly build up and grow from year to year. If these 27 credit
unions had been allocating earnings all along, each credit union
would, on average, have $54.0M of allocated equity as of December
31, 2011.
A 50-year equity redemption cycle, for example, applied to $54.0M
of allocated equity implies an annual equity redemption obligation
of $1.08M per credit union among the Callahan study credit unions.
Hence, these 27 credit unions would be expected to redeem more
than $1.20 of allocated equity for every $1.00 of patronage refunds
paid in cash, an objective that most likely is all but impossible for
these credit unions. So what would these credit unions do if they
operated under Subchapter T and were faced with that allocated
equity but could not redeem it?
These 27 credit unions would not redeem allocated equity unless
and until they had surplus working capital to allow redemptions of
equity. In fact, if the board of directors determined that the credit
52

union was unlikely to ever consistently redeem enough allocated
equity to, at a minimum, redeem the equity of deceased members,
the credit union should develop a communication plan that explains
why no redemptions of equity could be made by the credit union.
We expect that a significant part of that communication plan would
be centered around the notion that the credit union provided significant
benefits as a competitor in
the market and that this alone
The wisest approach would be to proactively manage expectations
by educating members about what, exactly, they could union’s inability to redeem
is enough to justify the credit
expect from the credit union.
equity on a regular basis. An
aid to this plan is that most
of the credit unions’ members
would not pay income tax on these patronage distributions, because
in most cases, the loans are for personal or family financing and not
tax deductible to the member. Hence, the patronage income is not
included in the member’s income, either.
If equity redemptions occurred, we expect that the equity of the
credit unions’ oldest members would be redeemed first. We also
expect that the estates of deceased members would request redemption
of equity. These credit unions are not obligated to redeem the
equity. However, the wisdom of an education and communication
plan to explain why the equity is not redeemed can easily be seen.
If the equity is not redeemed, it would be assigned to the deceased
member’s heirs, or the member’s estate could make a tax- deductible
gift of the equity to a charity, perhaps to a 501(c)(3) owned by the
credit union.
Those members who obtain business loans from the credit union
or who obtain real estate mortgages with tax- deductible interest are
likely to pay tax on patronage distributions from the credit union.
These members may be the most highly motivated to push the board
of directors and management of the credit union to redeem their
allocated equity. The argument of these members would be that a
23% cash patronage refund is not large enough to pay the income
taxes that they owe to federal and state governments. At present,
under 501(c)(14), these members do not have that criticism, because
under this exemption, the cash refund is the entirety of the income
taxed by federal and state governments. Under Subchapter T, however,
the credit unions’ business members would pay tax on both the
cash patronage refund and the allocated equity used to distribute
earnings to these members.
These credit unions must be careful to manage members’ expectations
about equity redemptions. If the income is allocated to members,
members often expect that the equity will be redeemed sooner
53

ather than later, particularly if the member is a business entity that
would pay income tax on the patronage distributions of income
(cash and noncash) to members. The wisest approach would be to
proactively manage expectations by educating members about what,
exactly, they could expect from the credit union. We would have the
same concerns about this scenario as we expressed for AgGeorgia
earlier in this report. Each of the 27 credit unions in the Callahan
study would have followed the co-op principles to the letter. Each
dollar of patronage earnings would have been allocated to members
just as those principles call for. On the other hand, by allocating
every dollar of patronage earnings, these credit unions would
also have overcommitted their capital, creating more obligations to
redeem allocated equity than we could reasonably expect from any
of the 27 credit unions, while also expecting each to retain capital to
finance its normal growth and expansion.
Allocate and Distribute 40% of Patronage Income
Another strategy these 27 credit unions could adopt under Subchapter
T is to allocate and distribute less than 100% of patronage
earnings to members. For this section, we assume these credit unions
each allocated 40% of their patronage earnings rather 100%. Comparing
the Sub T: 100% with the Sub T: 40%, each $1.00 of income
tax a credit union paid to federal and state governments, it would
reduce its allocated equity redemption obligation by $1.70.
While a strategy of allocating less patronage earnings and paying
more income tax might be useful for Badgerland to conserve its capital,
or helpful for AgGeorgia to begin conserving more of its capital,
it may not be as useful or helpful for any co-op taxed under Subchapter
T whose members are only or primarily consumers, including
credit unions. The taxation of the income of consumers who
are unlikely to deduct the interest they pay to credit unions—other
than interest they pay on mortgages—creates a dynamic that is quite
distinguishable from the taxation of the income of businesses who
deduct the interest they pay as a business expense.
Recall that under Subchapter T patrons pay income tax on the entire
distribution, both the cash and the allocated equity. All income—
both cash and allocated equity—are reported on the 1099-PATR
information return as income. Under either Sub-T scenario in
Figure 6 above, however, for every dollar of patronage earnings
allocated to a consumer, the consumer does not owe any income
tax on April 15. The consumers’ expenditures at the credit union
(other than mortgage interest) are not deductible. Consequently, the
patronage earnings that are allocated are not income for the consumer
even though a 1099-PATR was reported to the IRS. Even so
the consumer receives a minimum of a 20% cash patronage refund,
54

and the consumer is money ahead over an IOF even if none of the
balance of up to 80% of the allocation is ever redeemed to the consumer
member.
The business member of a co-op that is taxed under Subchapter T
pays income tax on the entire distribution of cash plus allocated
equity. Assume that each business member pays tax at a marginal
rate of 35%. For every dollar of income that is reported to on
1099-PATR to the IRS, the business pays income tax of 35 cents.
If the co-op pays only a 20% cash refund, the business member is
in a deficit position of 15 cents for each dollar of patronage income
that is allocated to the member. Hence, business members are most
likely to complain to the board of directors and management that the
co-op is not paying enough cash and/or redeeming equity quickly
enough to justify a co-op membership.
Allocating less than all of the patronage income and paying income
tax on the balance is not the only strategy that a co-op might adopt
to help the co-op manage the amount of capital that is available to it.
A Subchapter T co-op may also consider paying business members a
higher cash patronage refund than consumer members to differentiate
between consumers and businesses. In addition, a Subchapter T
co-op could also distinguish between consumers and businesses by
redeeming the allocated equity of businesses more quickly than it
redeems the allocated equity of consumers.
At the end of the day, any Subchapter T co-op’s board of directors
and management must evaluate and determine how much capital
its co-op can devote to redemptions of allocated equity. That determination
will depend on the co-op’s need for capital. Its growth. Its
potential. Its risk of sustaining losses. Its ability to attract outside
capital. Its ability to generate earnings.
The important thing for a Subchapter T co-op is to arrive at a
redemption program that makes sense to the co-op and its members.
A redemption program should be consistent with the varying
tax positions of its members. The program should be sustainable
but also challenge the co-op and its members. The program should
reward patronage more than it rewards ownership. And finally, the
program should be capable of being communicated to members in a
way that makes sense to members.
Examining the Tax Exemption
In 1983, the GAO suggested that Congress consider an evolution
of rural electric cooperatives from 501(c)(12) to Subchapter T, but
Congress did not act on the GAO’s suggestion.
In its 1983 report, the GAO contended that the tax exemption was
difficult to administer and that industrial and commercial members
55

of the cooperative were deducting the expense of purchasing electricity
but escaped the payment of tax on equity credits if and when the
credits were redeemed.
The GAO also contended that cooperatives were not redeeming
equity credits quickly enough. In fact, the GAO stated that some
rural electric cooperatives had no intention of ever redeeming any
credits.
The experience of rural electric cooperatives does not translate easily
to credit unions. The primary criticism of rural electric cooperatives
was that they had no intention of redeeming allocated equity
to members. That criticism does not exist for credit unions, because
they do not distribute earnings with allocated equity.
However, the GAO’s 2005 report on credit unions—like the 1983
report on rural electric cooperatives—suggests that tax exemptions
can never be conclusively presumed safe from attack. The following
conclusions can be drawn about credit unions:
• The 27 credit unions in the Callahan study are doing more to
protect the tax exemption from attack than are credit unions that
do not pay cash patronage refunds.
• 501(c)(14) offers far more flexibility in paying patronage refunds
than does Subchapter T, for example. Wright-Patt’s creativity in
how it uses “patronage” refunds is noteworthy. Flat payments for
profitable products and services, and variable payments for interest
paid on loans and for dividends received on share deposits are
permitted by 501(c)(14) but would not be permitted by Sub-T.
Better to take advantage of the current flexibility and strengthen
the tax exemption by using it creatively.
• Credit unions are cooperatives. It is always worthwhile to ratchet
up the co-op’s efforts to encourage member participation and
involvement in the cooperative.
• Credit unions can prepare for battles over their tax- exempt status
by communicating with members about the benefits of cooperatives
and by educating members about the principles of cooperation.
When the bullets start flying, it’s better to have the army
already motivated for battle rather than just beginning to motivate
the troops.
• Patronage refunds (and eventually redemption of equity credits
for those cooperatives that allocate earnings but redeem them
later) bring the co-op membership experience—and the reason
for the co-op’s existence—full circle. We expect that, like the
farmers and agricultural producers that prefer patronage refunds
56

to low interest rates, credit union members would hold similar
preferences for the payment of annual patronage refunds.
• There is something about consistent patronage refunds that
matures the cooperative in the eyes of its members. It’s like the
co-op has confidence in its membership and in its viability. The
co-op is serious about financial success and wants to provide
the goods and services that will make it profitable.
• We think that co-ops that make money and pay patronage
refunds are more likely to survive and flourish as businesses than
co-ops that do not have the same emphasis on profitability or
accountability to members.
• Co-ops have a story to tell, particularly when they pay patronage
refunds. The members of the American Bankers Association
(ABA) would never willingly operate with the deep member
involvement that is encouraged under co-op principles. The
relevant audience of an IOF bank is limited to its common
stockholders, whereas the relevant audience of a co-op is all of its
customers or members. IOF banks do not subject their capital
plans to customer scrutiny or think it necessary to explain to
customers why the bank was investing in growth rather than in
equity redemptions, why the firm did not pay a patronage refund,
why the patronage refund decreased in size, or why that product
or this service could not be provided at a lower overall price.
• IOF banks would never accept as one of their primary objectives
the return of surplus capital to customers. The inclination of IOF
banks is to hoard and use capital rather than return it. Co-ops are
not as glitzy as IOF banks. The discipline that management must
execute and the leadership required of a co-op is more onerous
than that needed for an IOF. But the rewards—the intangibles—
of affiliating oneself with an organization that is operated for the
benefit of its members rather than the organization’s own pocketbook
are immensely rewarding. We heard as much from Prunty,
Hanson, and Mislansky in our interviews for this report.
• Timing is everything. With the Basel capital requirements and
the state of the economy, boards of directors and management
must make educated, wise decisions about when to implement a
patronage refund program.
Similar to the experience of rural electric cooperatives, the more that
regulators and investor- owned competitors see that the cooperative’s
membership is vibrant, informed, and supportive of the credit union,
the more difficult it is for the tax exemption to be attacked.
57

Patronage Refunds and Capital
M anagement
In a conversation about patronage refunds, capital management,
and the 501(c)(14) tax exemption, it is worthwhile to consider
OmniAmerican Credit Union. OmniAmerican completed a conversion
from a credit union to an IOF bank on January 1, 2009. Half of
its stock is now owned by 60 institutional investors. To us, conversions
of cooperatives, and their accompanying loss of member- owned
capital, are a significantly larger issue on the horizon than the modification
or loss of the 501(c)(14) tax exemption. Patronage refunds
could be the difference that thwarts conversions. 33
Arguably the two most important changes in OmniAmerican’s financial
metrics between its status as a credit union and its status now as
an IOF bank are that (1) its equity capital almost doubled through
the conversion and public sale of its common stock, and (2) its
income is now an eighth of what it was when OmniAmerican was a
credit union.
OmniAmerican Credit Union generated $10.0M of net income in
its last full year as a credit union (2004), but OmniAmerican Bancorp
generated only $1.6M of net income in 2010. OmniAmerican’s
average net income as a credit union was $9.2M for the years 2002,
2003, and 2004, and it was on the rise; OmniAmerican generated
$8.4M in 2002.
If OmniAmerican had remained a credit union and had begun distributing
a patronage refund equal to 20% of its earnings (approximately
equal to the 27 credit unions in the Callahan study) starting
with its 2004 year end, it would have distributed $14.0M in patronage
refunds to its members by December 31, 2010. OmniAmerican
would already have distributed a fifth of the wealth that was created
in its conversion to an IOF. And that wealth would have been distributed
to 250,000 members.
Do you prefer $2.0M per year being distributed as a patronage
refund to 250,000 OmniAmerican Credit Union members, or would
you rather have 60 institutional investors benefiting from half of the
$50M–$70M of new capital that was raised through the conversion
and sale of stock? Do you prefer that those 250,000 members hold
an unredeemed lottery ticket worth $50M–$70M pre- conversion,
or would you rather those 60 institutional investors chase down and
corral $25.0M–$35.0M of capital for their own benefit?
58

The ABA is eager to gripe about the credit unions’ tax exemption,
but nowhere on its website does the ABA wrestle with these ethical
charter conversion issues or the laudatory social and economic
benefits that accrue to members of credit unions over IOF banks.
The ABA either does not see or ignores the fact that credit unions are
more sustainable than IOFs, that credit unions do not hoard capital
for their own use, and that credit unions return unneeded capital to
members.
59

Appendix
Exhibit A: 2007 Newsletter Article
Announcing the Patronage Dividend
at CoVantage Credit Union ($861M,
Antigo, Wisconsin)
$1.4 Million Rebated to Members
Over 14,000 CoVantage members will “step into cash” when their
loan interest rebate checks arrive in next week’s mail. This year’s 5%
rebate will provide the largest payback ever, and will put a record
$1.4 million back into the hands of credit union member-owners.
If you’re new to CoVantage, getting a rebate from the place you have
your loan may be unheard of. But, members with a history of borrowing
here see it as a valued reward for their patronage. And, this
year’s rebate marks the 26th year that directors have determined there
is sufficient net income to provide this benefit.
Here’s how the rebate works. If you had a loan with CoVantage during
2007, and all of your payments are current, you’ll automatically
receive a check returning 5% of the interest you’ve paid. No application
required! So, if you paid $5,000 in interest on your CoVantage
home loan during 2007, you’ll receive a rebate for $250! This year
we have enhanced our program to combine the interest paid on all
loans under one account number. Because we send checks only when
the rebate totals at least $5.00, this improvement will allow even
more members to get their rebate. (Student loans are not eligible for
the rebate.)
The loan interest rebate is just one way members receive exceptional
value from their credit union. Throughout the year we work to keep
loan rates low, charge fewer fees than others, and pay market- leading
rates on deposits. To ensure our rates and fees are competitive, we
monitor what others are offering. And while some may have special
rates and gimmicks, we are confident that CoVantage is one of the
best when it comes to overall member value.
To give you an outsider’s viewpoint, we would like to share that out
of [thousands of U.S. credit unions] we were ranked in the top 1%
for “Return to Savers.” This ranking was provided by an independent
consulting group, and is a measure of the deposit services a credit
union provides.
As a member- owner of CoVantage Credit Union, you deserve the
best from your credit union. Staff, management, and directors are
committed to ensure that each and every member receives outstanding
value.
60

Exhibit B: 2011 Newsletter Article
Announcing Patronage “Rebates
and Rewards” to Members of Dow
Chemical Employees’ Credit Union
($1.4B, Midland, Michigan)
Report from the President/CEO:
Exceeding Expectations in Troubled Times
$5.7 million returned in rebates and rewards
Although the lingering effects remain from one of the worst financial
events in modern memory, Dow Chemical Employees’ Credit Union
(DCECU) posted another banner year in 2010. In this unfortunate
climate where bank and credit union failures exceeded the prior
year’s results, DCECU continued to thrive.
How is it that DCECU was able to take lemons and turn them into
lemonade? What was this recipe for success? It’s really quite simple—
don’t stray from the Core Values you’ve established, and stick to
your Mission. Through conservative, principles- based decisionmaking,
your credit union returned another $5.7 million back in
the form of Loan Interest Rebates, Member Saver Rewards and
other rebates to DCECU member- owners on top of very competitive
loan and deposit rates! (emphasis in original)
DCECU’s leadership has worked tirelessly during these difficult
economic times. Numerous financial forecasts have been reviewed,
contingency plans have been created based on varying interest rate
and economic scenarios, expenses have been carefully controlled, and
investments and capital expenditures have been scrutinized.
Based on the above, one might conclude DCECU has been unaffected
by the recent negative events. While not entirely true,
DCECU is very proud of its foresight in the slight modification of
its loan underwriting criteria when negative signals began to appear.
The results—DCECU has performed superbly versus other similar
financial institutions. And, while loan delinquencies were up slightly
from one year ago, losses have been well- contained and have even
fallen slightly year-over-year.
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Due to careful planning and prudent financial stewardship,
DCECU’s Board of Directors declared the following for 2010:
• 15.00% Loan Interest Rebate that entitles borrowers in good
standing* to receive a portion of the total interest paid on all
eligible** DCECU loans
• 15.00% Member Saver Reward that entitles depositors in good
standing* to receive a portion of the dividends/interest earned on
all DCECU shares/deposits
• A VISA®
Check Card rebate*** for users in good standing*
These rebates and rewards were paid on January 1, 2011 (excluding
VISA®
Credit Card rebates, which will be deposited to Share/Savings
accounts in January) to members in good standing* via deposit to
their Prime Share accounts.
I would like to thank you personally for your continued support of
Dow Chemical Employees’ Credit Union and for utilizing the many
services we offer. Because we are a not-for- profit financial cooperative,
the more members use these services, the more all members
benefit. We look forward to serving you in 2011 and will share more
of the positive news that’s happening at DCECU throughout the
year.
As always, please do not hesitate to contact me or any of the
DCECU staff in person, by phone . . . or via e-mail through our
website at www.dcecu.org. Remember, DCECU is your credit union.
Sincerely,
Dennis M. Hanson
President/CEO
*Defined as those members who had at least $5 in their Share Account on December 31, 2010, have no delinquent accounts, have not had
adverse collection activities on their accounts and have not had accounts charged off.
**Ineligible loans include certain DCECU auto loans and mortgages, as well as VISA ® accounts with TravelFree Rewards, CashBack Rewards or
Transaction Rebates.
***For members who utilized the DCECU VISA ® Check Card during 2010, the rebate is 0.125% (.00125) for signature-based transactions, calculated
on net sales, and $0.01 for PIN-based transactions for each time the card was used during the year. Using your VISA ® Check Card helped
DCECU reduce operating expenses and operate more efficiently.
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Exhibit C: 2011 Website
Announcement of Membership
Dividend at Wright-Patt Credit Union,
Inc. ($2.1B, Fairborn, Ohio) 34
Dividend Calculation
Why It Pays to USE Your Credit Union!
Giving over $4 million back in the form of a Special Patronage Dividend
to our member- owners puts people before profits and showcases
the success of our credit union cooperative. We’re not here to
profit from our members—we don’t charge big fees to make a quick
buck like big corporations often do.
When we have a successful year, we pay for our operations, invest in
products and services to better serve you, and put some away for a
rainy day fund. Then we return any excess earnings to you.
How Can I Find Out My Share of the Dividend?
This year’s $4 million Special Patronage Dividend was automatically
deposited to eligible members’ TrueSaver accounts on January 4th,
2011. You can find your share by checking your TrueSaver account
(see history tab) through WPCU’s Home Banking or Mobile Banking.
If you’re not already enrolled in online Home Banking, sign up
now by calling our Member Help Center.
2010 Special Patronage Dividend Calculation
The Special Patronage Dividend calculation was based upon the
accounts and services you used with Wright-Patt Credit Union in
2010. By using services like mobile banking, financial planning,
WPCU loans and mortgages, you contribute to the credit union
cooperative and your payment will reflect that usage. The idea—the
more you use your credit union, the more you benefit!
Last year, the average member earned $22.94.
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Think of how much more you, and other members, could be earning
and saving by moving all of the accounts and services you have
somewhere else over to Wright-Patt Credit Union.
By trusting WPCU with more of your accounts and telling your
friends and family members all the ways WPCU is crazy about our
members, you’ll help the credit union grow—and help us on the way
to paying another Patronage Dividend next year.
Qualifying members received:
• 0.09% (0.0009) of your average daily balance of your deposits
(includes business share balances)
• 0.09% (0.0009) of your average daily balance of your loans
(excludes business loan balances)
• Earn $100 for a business loan relationship
• $45 for each first mortgage loan
• $5 for each financial planning relationship
• $5 for an active debit card
• $5 for being enrolled in eStatements
• $5 for active Call-24, Home Banking, or Mobile Banking
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Endnotes
1. Based on call reports from the NCUA website for the years
2008, 2009, and 2010.
2. Nonrecurring tax- deductible rebates are allowed only in the tax
year that the rebate is paid. Recurring rebates are deductible in
the year that the liability is fixed and determinable. Regs. Secs.
1.461-5(b)(1)(ii), (b)(1)(iii), and (b)(3).
3. A point that should please capitalists and socialists alike but not
communists.
4. Obviously, to attract capital, the cooperative must pay a reasonable
rate of return to third parties for the use of equity as in
preferred stock or debt as in subordinated debentures.
5. This is a point of disagreement with several academics in the
co-op community with whom we are familiar. It’s not clear to
us exactly why these academics resist the idea that a co-op’s
financial metrics may not reasonably allow it to allocate all
patronage earnings and redeem all the allocated equity while
it is simultaneously maintaining, building, and capitalizing its
business. Our sense is that it conflicts so violently with their
progressive point of view. One cannot help conclude that these
academics would argue that if a co-op allocates the income,
then surely it can redeem the equity. We know of nothing in a
co-op’s DNA that allows that indulgence.
6. In co-op tax-speak, apportionment is different from allocation.
Apportionment is to assign earnings and equity to members on
the co-op’s books without notification to the member. Allocation
is apportionment plus notification to the member, and
under Subchapter T, allocation also carries with it the vesting
of the equity in each member to whom patronage earnings are
distributed with allocated equity.
7. Revenue Revisions, 1947–1948: Hearings Before the Comm. on
Ways and Means, 80th Cong., pt. 4, at 3136 (1948).
8. Some bylaws call for the distribution of all or part of the
remaining proceeds to nonprofit or tax- exempt organizations
as a way of honoring a commitment to the cooperative form of
business organization.
9. Co-ops are democratically controlled on a one member–one
vote basis. Older members have bigger voices because they are
respected, and they are respected if they have lots of allocated
equity because they have loyally supported the co-op over the
years.
10. Financial firms in the S&P 500 paid an annual dividend of
1.1% of capital in 2010 and 1.4% through March 31, 2011. In
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contrast, the 27 credit unions paid a cash patronage refund that
was 1.62% of their average equity over the years 2008, 2009,
and 2010. An IOF dividend is taxable income to the recipient,
whereas a co-op’s cash patronage refund is not taxable income
to the recipient if the refund is paid from transactions that were
not themselves deductible from or includable in income. But
recall too that the credit union’s earnings belong to the members,
not the credit union, and it would be unnatural for the
earnings to be exposed to income tax at a level other than at the
member level.
11. Wright-Patt Credit Union, Inc., “Wright-Patt Credit Union
Saved Members $26 Million in 2009 Says Credit Union
National Association,” wright4youmortgage.com/news/
10-04-21/Wright-Patt_Credit_Union_Saved_Members_
26_Million_in_2009_Says_Credit_Union_National_
Association.aspx.
12. Cooperatives are considered to be the ultimate self-help organization
in the United States and around the world. In fact,
since 1995, the United Nations General Assembly has annually
recognized “International Day of Cooperatives,” a day that
reaffirms and celebrates the role of cooperatives in economic,
social, and cultural development. Each annual celebration has
a theme; in 2010 it was “Cooperative Enterprise Empowers
Women.”
13. We do not distinguish among members, the board of directors,
and management. Each stakeholder group is as prone to wrong
decisions as the others.
14. Federal credit unions are tax exempt under 501(c)(1) as well.
Both Land Banks and federal credit unions are chartered by the
federal government.
15. Nonpatronage earnings do not arise from business done with
or for patrons. For the balance of this section on Subchapter T,
we will discuss these tax features as though the cooperative
generated only patronage- sourced income.
16. Union Cooperative Exchange v. Commissioner of Internal
Revenue, 58 T.C. 427 (U.S. Tax Court 1969).
17. Nonqualified written notices of allocation (NQNAs) are also
used to distribute and “pay” the patronage earnings to patrons.
The cooperative pays income tax on the NQNAs initially. If
and when NQNAs are redeemed (no later than at dissolution,
if not sooner), the patron pays income tax and the cooperative
receives a tax benefit equal to the tax it paid earlier. In this way,
single taxation is preserved.
18. Patronage earnings from transactions relating to personal,
living, or family purposes are not taxable. More later in this
66

section on the exemption from filing 1099-PATRs for “consumer”
cooperatives.
19. 26 CFR 1.6044-4: “If 85 percent of its gross receipts for the
preceding taxable year, or 85 percent of its aggregate gross
receipts for the preceding three taxable years, are derived from
the sale at retail of goods or services of a type which is generally
for personal, living, or family use.”
20. Only the allocation of member- related patronage earnings is
deductible under Sub-T.
21. National Rural Electric Cooperative Association and National
Rural Utilities Cooperative Finance Corporation, Capital Credits
Task Force Report, January 2005.
22. Treas. Reg. § 301.6044–2(b)(2)(iii).
23. Coop Litigation News Publishing, “Coop Litigation News.”
coop-litigation.com.
24. Because each ACA operates a Credit Association subsidiary
that is taxed under Subchapter T, and because Sub-T co-ops
must allocate patronage- sourced income or maintain patronage
records, each ACA can be expected to follow a similar recordkeeping
process for its Land Bank subsidiary.
25. 12 CFR 701.6.
26. Examples include Iowa Code § 533.404, Kentucky Statutes
286.6-705, Wisconsin Code 186.18, and North Dakota
6-06.1-08.
27. www.aggeorgia.com; www.badgerlandfinancial.com. The financial
information discussed in this report is taken from each
association’s 2007, 2008, and 2009 fiscal year-end audits.
28. 12 CFR 615.5330.
29. 12 CFR 615.5301(b)(2)(ii).
30. See our earlier discussion at note 6.
31. See discussion above on Subchapter T. Key qualifications
include (1) preexisting obligation in the bylaws, (2) board of
directors declares patronage refund, (3) within 8½ months
following fiscal year end, prepare and send qualified written
notices of allocation and qualified payment constituting at least
20% of the allocation in cash, and (4) build out accounting
program to allow tracking of each member’s allocated equity.
32. See note 18 about cooperatives that primarily provide goods or
services for family, personal, or living needs.
33. It is not that all conversions of co-ops are ill conceived. Conversions
or demutualizations of co-ops with large equity
redemption obligations improve their financial metrics because
they are no longer required to devote huge capital resources
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to redemptions. Think Diamond Walnut Growers in California.
On the other hand, one wonders who benefited from
the OmniAmerican conversion other than management and
institutional investors.
34. Wright-Patt Credit Union, Inc., “Dividend Calculation,”
www.wpcu.coop/patronagedividend/ DividendCalculation.aspx
(retrieved 4/27/2011).
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ideas grow here
PO Box 2998
Madison, WI 53701-2998
Phone (608) 231-8550
www.filene.org PUBLICATION #242 (7/11)