Introduction to Employee-Owned Cooperatives

The Benefits of the Cooperative Form

Cooperatives are member-owned and democratically controlled businesses that distribute profits based on an equitable patronage system.¹

In addition to ownership, control, and patronage-based profit sharing, most cooperatives adhere to the seven internationally-recognized cooperative principles: (1) voluntary membership, (2) democratic member control, (3) member economic participation, (4) autonomy and independence, (5) education, training and information, (6) cooperation among cooperatives, and (7) concern for the community.²

Currently worker cooperatives represent a relatively small portion of the annual $500 billion dollar U.S. cooperative sector,³ and a similarly small portion of employee-owned businesses in the U.S.⁴ Nonetheless a myriad of studies have demonstrated the distinct advantages that employee ownership presents when compared with traditional investor-owned businesses,⁵ and worker cooperatives often present significant long-term advantages when compared with other forms of employee ownership.⁶ Considering the advantages of employee ownership, it is no surprise that the number of employee-owned businesses has grown in recent years, both in the U.S. and abroad,⁷ and cooperatives have performed particularly well when compared with other firms during the recent recession.⁸

Given the advantages of worker cooperatives compared with investor-owned and other employee-owned forms of business, the relative rarity of worker co-ops is surprising, and is often attributed to workers’ lack of capital and expertise.⁹ But in light of the rapidly changing nature of the economy, the growing interest in worker cooperatives, the constant growth of employee ownership, and the structural advantages presented by worker cooperatives, the worker cooperative sector is only likely to expand in coming years. Given this trend, business and legal professionals should become familiar with the cooperative structure and legal rules that govern cooperative enterprises.

The Legal Definition and Structure of Cooperatives

The legal definition of cooperative varies based on state or federal law. For instance, a cooperative may refer to a particular type of legal business entity, the Cooperative Corporation, whose legal requirements vary from state to state.¹⁰ On the other hand, in some states cooperatives may operate under a number of legal forms, such as cooperative corporations, LLCs, nonprofit mutual benefits corporations, general corporations or general partnerships.¹¹ And for certain federal tax provisions, only C Corporations, including cooperative corporations, may be considered cooperatives.¹²

Although the legal definition of cooperative may vary, cooperatives generally share a common set of operational characteristics: (1) each member has substantially equal control and ownership; (2) members have a functional role in the business; (3) transfer of ownership interest is prohibited or limited; (4) there are strict limits to return on capital investments; (5) economic benefits pass to members on the basis of their patronage; (6) members are not liable for the cooperative’s obligations; (7) businesses services are primarily used by the members.¹³ Nonetheless, businesses that do not exhibit all of these features may still be considered cooperatives for federal tax purposes.¹⁴

Voting and Governance

Unlike investor-owned businesses, in which major business decisions and board elections are made by shareholders with voting power in proportion with the number of shares they own, cooperative members exercise control of the enterprise on a one-member one-vote basis. Cooperatives generally have boards of directors that exercise and oversee corporate duties and owe the company fiduciary duties of care and loyalty. Most worker cooperatives utilize a representative governance structure in which employee-members elect the board of directors. On the other hand, a minority of worker cooperatives are organized as collectives, in which all employee-members serve on the board, and all members vote on key decisions.¹⁵

Patronage Distributions and Capital Distributions

Unlike traditional investor-owned firms, the primary purpose of cooperatives is to benefit their members as patrons, rather than to maximize profits for capital investors. As such, after a cooperative earns a surplus of net revenue, the cooperative either distributes its surplus to members on the basis of their patronage, or retain it as working capital, either by allocating it to members’ capital accounts on the basis of patronage, or by keeping it in an unallocated account.

In the worker cooperative context, a worker’s patronage is typically determined on the basis of the number of hours the member worked or on the basis of how much he or she earned in wages. A minority of cooperatives also choose to distribute their net earnings on the basis of capital contributions. Unlike capital distributions, however, patronage distributions are tax-deductible to the cooperative.¹⁶

Capital Structure, Capital Accounts

Most cooperatives have a capital structure that consists of individual member capital accounts.¹⁷ This capital account structure is similar to a partnership’s capital structure, in which profits pass through to its partners. However, unlike a partnership that passes all profits through to partners, a cooperative corporation may also retain a portion of its surplus in an additional unallocated capital account for the cooperative’s general business and administrative use.¹⁸

This unallocated capital account, combined with its individual member capital accounts, comprise the book value of the company.¹⁹ As an internal source of financing, the cooperative can then draw from either the unallocated capital account, which is usually subject to corporate tax rates under Subchapter T, or the undistributed portion of individual member capital accounts, which are generally not taxed at the corporate level.

Types of Legal Entities

While worker cooperatives can operate under a number of different entities, worker cooperatives are most commonly organized as either cooperative corporations or LLCs. Although formation requirements for a cooperative corporation vary from state to state, the cooperative corporation is often considered the entity that best incorporates cooperative principles of democratic ownership and control.²⁰ That is because most cooperative state statutes provide for member participation in governance, and provide for distribution on the basis of member patronage. On the other hand, an LLC is also a great vehicle for creating cooperative enterprise, as this entity is a flexible contract-based structure in which LLC members can easily ensure cooperative principles are codified in the LLC Operating Agreement. While both LLCs and cooperative corporations present great potential vehicles for cooperative enterprise, there are important differences between the two business forms. For instance, because of the contractual basis for LLC operating structures, LLCs are more flexible when it comes to permitting variations in governance structure. LLCs are also more flexible when it comes to member employment status, as it is easier to structure an LLC so that members can be classified as partners, rather than employees.

Governance Structure

Cooperative corporations often do not present the same risk of future abandonment of the cooperative principles, since many cooperative statutes have democratic member participation as a permanent governance feature. At the very least, most cooperative corporation codes require that the Board be elected and members make other major decisions.

LLCs have incredibly flexible governance structures, which can present great options for small cooperatives. This flexibility is especially beneficial to those that wish to operate without the formalities required of a corporate board of directors. However, a risk with LLCs is that, while the Operating Agreement can easily be crafted to include cooperative principles of one-member one-vote, it may be easy for future LLC members to revert to a non-cooperative governance structure by simply amending the Operating Agreement. Thus, an LLC that wants to stay committed to cooperative principles in the long-term should make some provisions of the Operating Agreement difficult to change.

Employment Status

The choice of entity can impact a determination of whether members are employees and must adhere to applicable employment laws. Examples of applicable employment laws include payment of minimum wage, deduction of payroll taxes, provision of workers’ compensation insurance, payment of overtime, and verification of cooperative members’ legal authorization to work in the United States. For some cooperatives, especially new ones that do not have much access to capital, these requirements can be financially burdensome.

The test of who is an employee versus who is a partner of the business is described in the Employment Law section of this guide. Under some states’ laws, choosing to structure as an LLC weighs more strongly than a corporation in favor of the argument that members are partners, rather than employees.

Deciding to Convert into a Cooperative

Worker cooperatives present economic advantages for worker members, consumers, and the local communities in which they reside. Cooperatives help keep money circulating locally, thus providing communities with a greater degree of economic autonomy, they afford members with greater job security, foster community and worker happiness, and are conducive to environmental responsibility, since they are so rooted in local communities.²¹ Thus businesses that are trying to foster these values should consider the cooperative form.

The decision to form or convert an existing business into a cooperative typically involves additional considerations beyond future competitive advantages. Business owners considering converting into a cooperative should also consider whether the business’ workers are open and committed to cooperative principles and prepared to assume a more active role in business management.²² Additionally they should assess whether the appropriate financial circumstances exist to enable conversion. In assessing whether and how to convert into a cooperative, professional assistance from legal, financial and accounting professionals can prove essential.

The next section covers the mechanics of conversion, highlighting four possible ways for people to sell a business to their employees, and form an employee-owned cooperative.