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Gregory McKee, NDSU Agribusiness and Applied Economics Department, Published July 12 2013

Spotlight on Economics: What is a cooperative?

Cooperatives are corporations that are owned, controlled, and used primarily by the customers it serves. Regular cooperative members invest funds in the cooperative that are used to purchase assets. Those assets enable the cooperative to conduct business operations within a given market.

As market conditions faced by a cooperative change, cooperative business leaders may seek funds to make additional investments or to maintain the ability to compete within a given region.

Sometimes the pace or type of change makes it attractive for cooperatives to form relationships with other corporations, such as through joint ventures, in order to serve their members.

A key feature distinguishing cooperatives from other types of corporations is how its income is taxed. By virtue of a typical firm's objective to generate profits, income earned by most firms is subject to federal income tax.

In contrast, cooperatives are not-for-profit entities that pass all income to their patrons on a pro rata basis during a period of time. Federal income tax laws consider cooperatives as legal extensions of their members and exempt cooperatives from corporate income tax.

The difference in the income tax liability of cooperatives and other types of corporations affects the incentives for other firms to form joint ventures with cooperatives. Research shows that cooperatives may enjoy higher rates of return and lower risk than companies that pay corporate income tax.

Computer simulations of a $25 million grain and oilseed marketing joint venture show that a cooperative may earn $5 million more and face almost half the business failure risk of an investor-owned partner firm during a 10-year period. Higher returns and lower risk for a cooperative may explain why most joint ventures formed by cooperatives are formed with other cooperatives.

However, a recent U.S. Department of Agriculture survey shows that input supply and grain marketing cooperatives are forming an increasing number of ventures with firms not organized as cooperatives.

Savvy negotiations between cooperatives and their noncooperative partners can result in agreements making joint ventures more attractive for a variety of corporation types. Agreement terms may include:

- How management of the venture is conducted

- How policies are to be made that govern the venture

- How and when profit is shared

- Preference for one or more participants in the venture to purchase the grain or oilseed

- The opportunity of one partner to purchase another partner's interest in the venture

Computer simulations show that combinations of terms exist that redistribute venture income and risk so that cooperatives and other corporate types may find the income distribution more equitable, but at increased risk.

For example, lump sum transfers of income from the venture to a noncooperative partner followed by the equal distribution of the remaining venture income increases the net value of the venture for the noncooperative firm and the associated risk of business failure. However, it has the reverse effect for the cooperative.

Alternatively, purchase guarantees to a downstream grain or oilseed processing partner in the venture increases the value of the venture for the noncooperative firm but with smaller increases in business failure risk from the cooperative's point of view.

In summary, the corporate structure of a joint venture with partners matters. The income tax liability of cooperatives, when compared with other types of corporations, may discourage noncooperative firms from forming joint ventures with cooperatives. A variety of agreement terms, established when starting the venture, can be used to reallocate the benefits of a proposed venture.

Gregory McKee is an associate professor and director of the Quentin Burdick Center for Cooperatives in the NDSU Agribusiness and Applied Economics Department.