Co-ops Get Special Tax Treatment...As They Should
As governments face an era of cuts and austerity, cooperatives once again face scrutiny because of their special tax treatment. This spotlight shines especially brightly on credit unions now, but the general pressure for co-ops to pay their “fair share” of the tax burden is likely to increase. So co-ops must be prepared to address the concerns raised by those who frame their treatment as unfair.
We should consider three issues. First, cooperatives function for an entirely different reason than investor-owned corporations. Second, the loss of the current tax treatment would provide a disincentive for credit unions to retain earnings, thereby increasing the risk of systemic problems. And finally, data shows that the current tax treatment is achieving its intended purpose of returning money into the hands of members, where they can spend it and help revive the struggling economy.
Vive la Différence!
The tax treatment of cooperatives in the United States differs from that of investor-owned firms, for reasons that derive from their unique ownership structure. The different treatment is based on the very different ways that revenues move through co-ops, as contrasted against businesses that function primarily for profit. Rather than passing surplus on to investors whose only agenda is to make a profit, the co-op passes a surplus back to its members whose reason for participation is to meet a need they share with each other. In a co-op, the money is distributed as a by-product, and in the case of a typical investment the money is the whole point of the transaction.
Under Subchapter T of the internal revenue code, any net income that a cooperative derives from serving members is not subject to taxation at the organizational level; instead it is taxed at the owner level when they declare it as income. Since the members own the co-op, net income benefits the members, either as patronage refunds or dividends on capital or as additions to retained earnings which increase value of the members’ ownership interest. The obligation for paying taxes on that income also rests with the member/owners. Subchapter T thus prevents the dual taxation of income at both the organizational and owner level, which exists with many investor-owned companies.
Another factor that should be included in any analysis of tax fairness is that cooperatives have fewer options to raise outside capital, as well as legal limits on dividends that make them less attractive to many investors. So rather than giving an unfair advantage, differential tax treatment serves to even the playing field.
Credit Unions’ Systemic Role
Although the failure of any cooperative is undesirable, the failure of a credit union, as a depository institution, has greater negative impact on members or taxpayers than the failure of a non-financial cooperative. This potential impact places a premium on avoiding the failure or insolvency of credit unions. Hence the importance of capital or net worth: The greater a credit union’s capital, the more able it is to withstand losses and remain solvent.
The tax treatment of credit unions is a special case of cooperative taxation due to their role as financial institutions and their need for retained capital. Income that is passed on to members in the form of dividends on savings and is essentially treated as equivalent to interest paid on deposits at investor-owned banks, i.e., it is taxed at the member level. However, the income retained by credit unions is not taxed, at least until the time of liquidation of the credit union at which point it would be taxed upon distribution.
Unlike other lines of business engaged in by cooperatives, credit unions come to hold a significant amount of their members’ wealth in the form of shares and deposits. When a credit union fails, members must not only find alternative service providers and lose their share of the credit union’s net worth; they also face a substantial write-down on their shares and deposits. And despite the existence of the National Credit Union Share Insurance Fund, which insures deposits in credit unions, the scale of the negative consequences is not actually reduced. Rather, the losses would simply be paid by the share insurance fund and later replenished through higher premiums—or by taxpayers if the losses were systemically very large.
Taxing earnings would reduce the incentive to retain them, lowering the only source of capital or net worth available to credit unions. Capital is the principal buffer that protects a financial institution and its deposit insurance fund from losses. This buffer provides the most important rationale for the different tax treatment of credit unions compared to other cooperatives.
Who Benefits?
There are those who question the efficacy of any sort of “tax preference,” suggesting that the benefits of the tax exemption flow primarily to the operators of the firm rather than the intended beneficiaries, the members. Although this is no doubt a legitimate concern, there is no evidence that this occurs with cooperatives. In fact, two sets of data show that this is not the case, at least with credit unions.
Some may suspect that credit unions are simply pocketing their tax savings without providing benefit to members. However, the Credit Union National Association has for several years analyzed the benefits that members of credit unions receive as a result of being members, comparing the fees and loan rates and savings rates that credit union members pay and receive compared to fees and rates at banks. This analysis shows that credit union members save between $6 billion and $12 billion a year as a result of using credit unions instead of banks, depending on the level of interest rates. Compare that with the $500 million to $1.5 billion that credit unions would pay if they were taxed on the same basis as banks.
Another way credit unions could abuse the tax exemption would be by operating with high expense levels, particularly salaries. Actually, credit union operating expenses are typically the same as or slightly lower than those at banks of similar size and average credit union total compensation of senior executives is quite a bit lower than at similarly-sized banks. Finally, credit union capital ratios compare very favorably with those at banks.
This suggests there is a need for better understanding of the ways that members benefit from co-ops of all kinds.
Not all tax preferences are alike. Some benefit a small, politically powerful interest group. Others encourage socially beneficial behavior. The cooperative tax exemption clearly falls into the second category. The evidence shows that societal benefits of the tax exemption far outweigh the cost of the expenditure.
Bill Hampel is chief economist for the Credit Union National Association. Contact him at
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