A board of directors hires an auditing firm to conduct an audit. As part of the audit process, the board is informed as to the dollar value of income derived from business done with members on a patronage basis and the dollar value of income derived from business that was not done on a patronage basis. The board, with input from management, has to decide how to distribute these two types of income, and has many options from which to choose.
The easiest decision is the distribution of business that is not derived from patronage done with members. An example of this might be purchases done at a convenience store, such as fuel or in-store purchases. The cooperative owns the convenience store and members may do business there on a patronage basis, but it would be expected that nonmembers do business there as well. This income from nonmembers is not derived from
patronage and is consequently the same as income of a non-cooperative corporation. Thus, the tax treatment is the same. The cooperative pays corporate taxes on this income and retains it as equity in the form of retained earnings in the same way as a non-cooperative corporation. In this case, the cooperative retains it as Unallocated Equity. A board could choose to distribute this income to its members as dividends just like a non-cooperative corporation would do. In that case, the income would be taxed twice—as corporate income and as individual income. A common practice by boards of directors is not to allocate this nonmember income and to retain it as equity.
The board has many choices on how to distribute income derived from members on a patronage basis. The goal is to implement the service at cost principle because that is how the member participates in the benefits from the cooperative. These Patronage Refunds are allocated distributions of net income to members in proportion to the value or quantity of their patronage. The distribution process is often referred to as the allocation decision. Allocating income to members as patronage refunds is especially compelling for income that arises from patronage business with members. The board must make a decision on how to allocate this income in the form of Patronage Refunds.
UNALLOCATED EQUITY is sometimes referred to as permanent capital and is similar to retained earnings in a non-cooperative corporation because it is permanently on the balance sheet as equity until the corporation is dissolved. It is equity which will never be subject to redemption by the board of directors, while their allocated equity may be redeemed. The amount of unallocated equity, as a percentage of total equity, has been increasing in most cooperatives in recent years for a number of reasons, which include advice from cooperative lenders who are required because of financial regulations to have additional permanent capital and are requiring the same of their members.