Meet Cathy, the Cooperative Development Institute’s new answerwoman! She can take on any co-op questions you might have, big or small. Today we address the questions: “What is the maximum dividend rate that co-ops can offer on preferred stock? What are the implications of issuing preferred stock vs. raising capital through member or supporter loans?” See all of Cathy’s answers and ask your own on her home page. This blog post was written by Margaret Bau, Cooperative Development Specialist at USDA Rural Development Wisconsin, and CDI’s own NEROC Program Director Andy Danforth. Margaret originally wrote much of this content in response to a query following the webinar, Converting Businesses to Worker Cooperatives—Real World Lessons Learned.
Dividend rates for preferred shares
For years I had been under the impression that the IRS set the maximum return rate at 8% (under subchapter T, which is the section of the IRS code that governs businesses that operate on a cooperative basis—see the end of this post for the relevant IRS code). That isn’t quite accurate (though it is a good guide). Little did I realize that state law (rather than the IRS code) dictates the maximum legal rate for stock dividends. It appears most states cap interest rates at 8% (including my home state of Wisconsin). But there may be some states that allow for higher rates. At the end of this article is the information from the IRS guide, which says the maximum rate is 8% or the state’s maximum, whichever is higher.
When the board decides upon the parameters for the preferred stock offering, it is important to examine what the local market will bear. To the community investor or co-op member, preferred stock has terms and restrictions that are similar to a certificate of deposit (CD) or money market at local banks. Generally, preferred stock rates of return are higher than a bank CD but lower than what’s available in the stock market. For the co-op, preferred stock interest rates are substantially lower than a commercial loan or a line of credit. Right now, offering interest at 4%-5% is probably a fair rate of return to both the community investor and the co-op. Occasionally for some start-ups with lots of community support, I have seen rates at 0% (basically a refundable grant from very supportive folks and members) to the 1%-2% range (to cover the cost of inflation). Back in 2006-2007, an 8% rate of return would have seemed relatively low. Today 8% would be an outrageously high dividend rate.
A co-op board gets to decide what rate they will set for a particular preferred stock series (and they need to stick with the agreed rate for the duration of that series). Co-ops can offer several preferred stock series over time. For example, a new co-op may offer series A at 5% to fund start-up expenses. After that is paid off, the same co-op may wish to purchase a building, so they offer preferred stock series B at 4%. Ten years later the co-op may wish to update equipment, so they offer preferred stock series C at 4.5%. By January 31 of each year, the co-op must send all preferred stock holders an IRS statement called a 1099 DIV that details their investment activity. Investors should be counseled not to file their taxes until after receiving the 1099 DIV document.
As long as I’m on this topic, please allow me to share a little more information.
What attracts co-ops to preferred stock
Preferred stock is non-voting stock. So what makes it “preferred”? The name refers to the order in which investors are paid out of the co-op’s earnings. Generally, commercial bank loans are paid first, then friendlier loans, then preferred stock holders, and lastly “common stock” or “class A” or “voting” shares — i.e., members. Members are paid last to ensure that, as the only ones voting and controlling the co-op, they put the financial interest of their other creditors before their own. Preferred shareholders are next-to-last — meaning that in a bad year, if a co-op cannot make dividend payments, it is not obligated to.
Most people who purchase co-op preferred stock are amateur investors – they believe in the mission of the co-op and want to invest in their local community. It is important for the co-op board to be extremely clear to community investors and co-op members about the risk associated with preferred stock. The key phrase to remember is that “redemption of preferred stock is at the discretion of the board of directors.” The co-op board has a fiduciary responsibility to annually assess the co-op’s financial health, and then based on that information, decide how preferred stock holders will be paid that year. For example in good years, the co-op may pay preferred stock holders in cash. In lean years, the co-op may pay preferred stockholders in additional stock (with compound interest). If the co-op has years of solid financial stability, the co-op may buy back preferred stock from the investors (essentially “paying off the community loan”).
As for early redemption on the part of a preferred stockholder, this is a delicate balance. As a board, you need to make sure the redemption won’t harm the co-op. But investors are also our friends and neighbors who may be in a difficult financial situation. When meeting with a potential investor, stress that the co-op is looking for a five-year investment to try and minimize the temptation for early redemption. A co-op board should probably develop a policy on emergency redemption.
To deter investment purely for speculation, the co-op preferred stock interest rate is capped (by state law) and all members are allowed one vote in co-op decision making (regardless of the investment amount). Co-ops incorporated in states with co-op-friendly statutes (such as Wisconsin and Minnesota) are generally exempt from filing with the Securities & Exchange Commission (SEC) as long as the preferred stock is only offered within the state and isn’t widely advertised. Co-op-friendly states have done this since it is assumed that co-ops maintain good transparency and communication with their members and holders of preferred stock are closely associated with the co-op. Under these conditions disclosure via a third party (the SEC) isn’t necessary.
Preferred stock is a form of additional equity to cooperatives. It counts as an asset on the co-op’s balance sheet. If the co-op needs additional financing, the co-op can approach a lender with this equity on hand (which generally increases the willingness of a lender to make a loan). When dealing with a lender, preferred shares can be used to increase the capital available that can be leveraged by a lender. A sophisticated lender will see it as a “mezzanine” (in-between) level of capital that frees up hard assets and cashflow as collateral.
How to have your mezzanine capital and eat it too
Preferred stock is not the only way to add non-voting equity to a cooperative’s balance sheet. Member or community supporter loans that are appropriately constructed as to term, payment of interest, and subordination to senior lenders, can also be seen as equivalent to equity. Another difference that might make preferred stock attractive, the ability to suspend payment–i.e., to pay only if and when the co-op is actually profitable–can be built in to the loan agreement through legal construction. Such “royalty loans” are a way for the lender to share the risk of the investment more equitably with the borrower. It may be necessary to properly educate lenders on how to view “debt” as closer to “equity”.
While many cooperatives have utilized preferred stock, they could also have constructed member loans to be similar in terms of being subordinate to other indebtedness, with the ability to defer interest and change maturities depending upon the conditions at hand. The significant difference is that dividends co-ops pay on preferred shares are not tax deductible, while interest (including interest that is accrued and unpaid) is tax deductible. When a co-op issues preferred shares, it is essentially taking a large part of the tax burden of those dividends and placing it on the cooperative, and by extension its member-owners. Given that corporate tax rates increase pretty quickly, a preferred stock paying 6% dividends may have the same costs as a member/supporter loan or note at 8% or 9%.
Because of the substantial tax consequences to the cooperative of issuing preferred stock, it would probably be best to consider how to achieve similar benefits from properly constructed loans. The pool of investors, and their motivations, would likely be largely the same, but the financial benefits to the co-op could be greater.
Happy Tax Day!
Here is the text of the IRS subchapter T language concerning co-op stock dividend rates:
Capital Stock and Stock Dividends
- The dividend rate on all stock must not exceed the legal rate of interest in the State of incorporation or 8-percent per annum, whichever is greater, on the value of the consideration for which the stock was issued (not par value). The prohibition is strictly construed. Thus, the issuance of a nontaxable stock dividend to shareholders does not increase the “value of the consideration for which the stock was issued” (Revenue Ruling 68-169), unless additional consideration is paid to the cooperative.
- Outside capitalization may be accomplished by issuing nonvoting common stock, nonvoting preferred stock, bonds or other evidences of indebtedness.
- The restriction upon capital stock ownership does not apply to nonvoting stock, provided the holders of such securities do not participate in profits upon dissolution or otherwise beyond the regular fixed dividends or interest payments. See IRC section 521(b)(2) and Treas. Reg. 1.5211(a)(2).
- Of course, the dividend rate limit applies to all classes of stock. See IRM 18.104.22.168.5.2(2) above, concerning the dividend rate.
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