A cooperative is a business or organization that is owned and operated for the benefit of those using its services. Profits and earnings generated are distributed among the cooperative members, who are known as user-owners. An elected board of directors typically runs the cooperative while regular members have voting power to control the direction of the cooperative. Members can become part of the cooperative through purchasing shares, although the amount of shares members hold does not affect the weight of their individual votes. Cooperatives are commonly found in healthcare, retail, agriculture, art and restaurant industries.

Forming a Cooperative

Forming a cooperative is different from forming any other business entity. To start, a group of potential members must agree on a common need and a strategy on how to meet that need. An organizing committee then conducts exploratory meetings, surveys, and cost and feasibility analyses before every member agrees with the business plan. Not all cooperatives are incorporated, although many choose to do so. If you decide to incorporate your cooperative, you must complete the following steps:

• File Articles of Incorporation. The articles of incorporation legitimizes your cooperative and includes information such as the name of the cooperative, the business location, purpose, duration of existence, and names of the incorporators, and capital structure. Once the charter members (or the incorporators) file with your state business entity registration office and the articles are approved, you should create bylaws for your cooperative.

• Create Bylaws. While the law does not require bylaws, they do need to comply with state law and are essential to the success of your cooperative. Bylaws list membership requirements, duties, responsibilities and other operational procedures that allow the cooperative to run smoothly. According to most state laws, the majority of your members must adopt articles of incorporation and bylaws. Consult an attorney to verify that your bylaws comply with state laws.

• Create a Membership Application. To recruit members and legally verify that they are part of the cooperative, you must create and issue a membership application. Membership applications include names, signatures from the board of directors, and member rights and benefits.

• Conduct a Charter Member Meeting and Elect Directors. During this meeting, charter members discuss and amend the proposed bylaws. By the end, all of the charter members should vote to adopt the bylaws. If the board of directors were not named in the articles of incorporation, you must designate them during the charter meeting.

• Obtain Licenses and Permits. You must obtain relevant business licenses and permits. Regulations vary by industry, state and locality. Use the Licensing and Permits Tool on the Small Business Administration website to find a list of federal, state and local permits, licenses and registrations you’ll need to run a business.

Cooperative Taxes

A cooperative operates as a corporation and receives a “pass-through” designation from the IRS. More specifically, coops do not pay federal income taxes as a business entity. Rather, the coop members pay federal taxes when they file their personal income tax, paying federal and state incomes tax on the margins earned by the cooperative, with the amount of taxation varying slightly by state. Coops must follow the rules and regulations of the IRS’s Subchapter T Cooperatives tax code to receive this type of tax treatment.

Some coops such as credit unions and rural utility cooperatives are exempt from federal and state taxes due to the nature of their operations.

Advantages of a Cooperative

• Less Taxation. Similar to an LLC, cooperatives that are incorporated normally are not taxed on surplus earnings (or patronage dividends) refunded to members. Members of a coop are only taxed once on their income from the cooperative and not on both the individual and the cooperative level.

• Funding Opportunities. Depending on the type of cooperative you own or participate in, there are a variety of government-sponsored grant programs to help you start.

• Reduce Costs and Improve Products and Services. By leveraging their size, cooperatives can more easily obtain discounts on supplies and other materials and services. Suppliers are more likely to give better products and services because they are working with a customer of more substantial size. Consequently, the members of the cooperative can focus on improving products and services.

• Perpetual Existence. A cooperative structure brings less disruption and more continuity to the business. Unlike other business structures, members in a cooperative can routinely join or leave the business without causing dissolution.

• Democratic Organization. Democracy is a defining element of cooperatives. The democratic structure of a cooperative ensures that it serves its members’ needs. The amount of a member’s monetary investment in the cooperative does not affect the weight of each vote, so no member-owner can dominate the decision-making process. The “one member-one vote” philosophy particularly appeals to smaller investors because they have as much say in the organization as does a larger investor.

Disadvantages of a Cooperative

• Obtaining Capital through Investors. Cooperatives may suffer from slower cash flow since a member’s incentive to contribute depends on how much they use the cooperative’s services and products. While the “one member-one vote” philosophy is appealing to small investors, larger investors may choose to invest their money elsewhere because a larger share investment in the cooperative does not translate to greater decision-making power.

• Lack of Membership and Participation. If members do not fully participate and perform their duties, whether it be voting or carrying out daily operations, then the business cannot operate at full capacity. If a lack of participation becomes an ongoing issue for a cooperative, it could risk losing members.

A limited liability company (LLC) is a hybrid legal structure providing the limited liability features of a corporation with the tax efficiencies and operational flexibility of a partnership. The “owners” of an LLC are called “members.” Depending on the state, the members can be a single individual (one owner), two or more individuals, corporations or other LLCs. Unlike shareholders in a corporation, LLCs are not taxed as separate business entities, rather all profits and losses are “passed through” the business to each member of the LLC. The LLC members then must report the profits/losses on their personal federal tax returns in the same manner owners of a partnership would do.

Forming an LLC

Each state has slight variations as to how to form an LLC; however, they all follow the same basic principles:

• Choose a Business Name. You must follow three rules when naming your LLC: (1) it must different from an existing LLC in your state; (2) it must indicate that it’s an LLC (for example “LLC” or “Limited Company”); and (3) it must not include words restricted by your state (for example, “bank” and “insurance”). Your business name is automatically registered with your state when you register your LLC so there’s not a separate registration process.

• File the Articles of Organization. The “articles of organization” is a basic document that legitimizes your LLC and includes information such as your business name, address and the names of its members. In most states, you file the Articles with the Secretary of State. Some states require you file with a different office, such as the State Corporation of Commission, Department of Commerce and Consumer Affairs, Department of Consumer and Regulatory Affairs, or the Division of Corporations and Commercial Code. There may also be an associated filing fee.

• Create an Operating Agreement. Most states don’t require an operating agreement; however, having an operating agreement is highly recommended for multi-member LLCs because it structures the LLC’s finances and organization, and provides rules and regulations for optimal operation. The Operating Agreement typically includes percentage of interests, allocation of profits and losses, members’ rights and responsibilities, and other provisions.

• Obtain Licenses and Permits. Once your business is registered, you must obtain the required business licenses and permits. Regulations vary by industry, state and locality. Use the Licensing and Permits Tool on the Small Business Administration website to find a listing of federal, state and local permits, licenses and registrations required for your business.

• Announcing Your Business. Some states, such as Arizona and New York, require the extra step of publishing a notice in your local newspaper about your LLC. Check with your state’s business filing office for requirements.

LLC Taxes

According to the federal government, an LLC is not a separate tax entity, so the business itself is not taxed. Rather, all federal income taxes are passed on the LLC’s members and are thus paid through their personal income tax. While the federal government doesn’t tax income on an LLC, some states do. Check with your state’s income tax agency.

Since the federal government doesn’t recognize an LLC as a business entity for tax purposes, all LLCs must file a corporation, partnership or sole proprietorship tax return. Certain LLCs are automatically classified and taxed as a corporation by federal tax law. Visit IRS.gov for guidelines on how to classify your LLC.

An LLC that is not automatically classified as a corporation can choose their business classification. To choose a classification, an LLC must file Form 8832. This form is also used if an LLC wants to change its classification status. Read more about filing as a corporation or partnership and filing as a single member LLC at IRS.gov.

Depending on your LLC’s classification, you should file the following tax forms:

• Single Member LLC: Form 1040 Schedule C like a sole proprietor.
• Partners in an LLC: Form 1065 partnership tax return like owners in a traditional partnership.
• Filing as a Corporation: Form 1120, the corporation income tax return.

Combining the Benefits of an LLC with an S-Corp

You can always request S-Corp status for your LLC. You’ll have to make a special election with the IRS to have your LLC taxed as an S-Corp using Form 2553. You must file prior to the first two months and 15 days of the beginning of the tax year in which the election is to take effect. An attorney can advise you on the advantages and disadvantages of changing to an S-Corp status.

The LLC would remain a limited liability company legally, but for tax purposes it would be treated as an S-Corp. Contact your state’s income tax agency about the tax requirements and if they recognize elections of other entities such as the S-Corp.

Advantages of a Sole Proprietorship

• Limited liability: Members of an LLC are protected from personal liability for business decisions or actions of the LLC. If the LLC incurs debt or is sued, the members’ personal assets are usually exempt. Remember that limited liability means “limited” liability in that members are not necessarily protected from wrongful acts, including those of their employees.

• Less recordkeeping: The operational ease of an LLC is one of its biggest advantages. There is less registration paperwork and smaller start-up costs compared to an S-Corporation.

• Sharing of profits: Members distribute the profits as they see fit so there are fewer restrictions on profit sharing.

It’s up to the members to decide who has earned what percentage of the profits or losses.

Disadvantages of a Proprietorship

• Limited life: In many states, when a member leaves an LLC, the business is dissolved and the members must fulfill all remaining legal and business obligations in order to close business. However, you can include provisions in your operating agreement to prolong the life of your LLC should a member choose to leave the business.

• Self-employment taxes: Members of an LLC are considered to be self-employed and must pay the self-employment tax contributions towards Medicare and Social Security. The entire net income of the LLC is subject to this tax.