Tax Essential for Worker-Owned Business

You're starting a business with some people, and you plan to run it cooperatively.  Your business will be worker-owned and worker-managed.  How will you be taxed?
That depends on some choices you make.  Here's a simple overview of your options.  But first, a bit of background.
With a traditional corporation, most of the income is taxed twice.  The corporation pays tax on its income.  Then it pays some of the income to its shareholders, and that income is taxed again as part of the shareholders' income taxes.  A limited liability company (LLC), on the other hand, is a "flow-through" entity.  The income (and loss) "flows through" to the owners, the LLC files an informational return only, and the income is taxed only once as part of the individual owners' incomes.
Some states have laws under which you can incorporate a cooperative corporation.  In a cooperative corporation, stock ownership is spread among the worker-owners, each owner gets one vote, and profits are distributed according to hours worked or some other equitable formula, not according to number of shares owned.  This differs from a traditional corporation, in which owners have as many votes as they have shares, and dividends are based on share ownership, not work.
A cooperative gets better tax treatment than a traditional corporation.  A co-op can subtract from its corporate income the profit assigned to the worker-owners.*  The co-op will pay corporate income tax on whatever profit it retains in the co-op's capital reserve, but most income will "flow through" to the worker-owners, and will be taxed once, at the individual worker-owner's level.
But wait, you say, we can achieve single-level taxation with an LLC.  So why would we incorporate as a cooperative?  That decision depends on non-tax factors, like the size of the company, how easily it can afford administrative requirements, which are greater for corporations, and how valuable it is to you to incorporate under a statute that gives you the structure you want, rather than having to create an unusual LLC agreement.  On the other hand, you may want a custom agreement, not what the co-op statute requires.
Your state may or may not have a statute that's helpful for worker co-ops.  Illinois has a co-op statute for consumer and farmer co-ops, but not worker co-ops.  For an Illinois business to take advantage of the structure provided by a good worker co-op statute, you would need to incorporate (or re-incorporate) in another state, such as Massachusetts or Wisconsin, then get permission to do business in Illinois.  You can achieve the same results by putting your desired co-op structure into your corporation's bylaws or your LLC's operating agreement.  That strategy may feel riskier, and would make more work for your attorney up front, but will save you from having to file two annual reports every year. So your choice between cooperative corporation and LLC will probably be made for non-tax reasons.

But back to taxes.  Another big factor is self-employment tax.  Did you know that self-employment tax is separate from and in addition to income tax?  It's 15.3% of self-employment income,** and it covers social security and medicare tax.  In an employment situation, the employer pays half, and the employee pays half.  If you work for yourself, you pay the whole thing.  If you're part of a worker co-op, you're both the employer and the employee, so you don't care who pays for it, but you do care whether all of your income is subject to self-employment tax.
All of the income from an LLC is subject to self-employment tax.  Income received as dividends, however, is not.  There is an argument that worker-owners in a worker cooperative should be able to receive any income over and above their wages as "dividends," which should not be subject to self-employment tax.  However, the IRS has taken the position that these co-op distributions are subject to self-employment tax.  Some co-op members who did not pay self-employment tax on co-op dividends were audited and then got into disputes with the IRS, so that is not a safe strategy for avoiding self-employment tax.
But wait, there's more: the S corporation.  So called because it's taxed under subchapter "S" of the tax code.  To incorporate as an S corporation, you must meet certain requirements (no more than 100 shareholders, only one class of stock).  It's a flow-through entity--the income is taxed only at the individual level.  Worker-owners can pay themselves a fair market wage, and then receive the rest of the profit as dividends, which are taxed at a lower rate and not subject to self-employment tax.  This different treatment between wages and dividends from an S corporation is not subject to controversy right now.  (The non-tax reason to organize as an S corporation is basically to transfer shares easily.)
The drawback of this for a co-op is that S corporation dividends are based on stock owned, not hours worked.  If you're running your business as a co-op, this would work for you if everyone owns one share, and everyone works the same number of hours and earns the same amount.  This is not how most co-ops work.  The other drawback is that the administrative cost of issuing the paychecks can cancel out the tax savings.
If you're in a state that has a good worker co-op statute, that could be the best choice for you because it creates the structure of a co-op for you.  Then, most of the income will be taxed only once.
If you're in Illinois or another state where you have to DIY a co-op using a corporation, S corporation or LLC, you'll want to organize as an LLC if your company is small/does not earn a lot more than the value of the owners' wages, or if you want more flexibility to distribute profits and losses as you see fit.
Now here's where it gets weird.  An LLC can elect to be taxed as an S corporation by filing certain forms with the IRS.  This would allow an LLC to keep its structure and less formal operating requirements, but still take advantage of the tax savings if there is income that can be distributed as dividends above the fair market value of the workers' wages.
The bottom line: A cooperative corporation, an LLC, and an S corporation, are all entities whose income is taxed once, at the owner level.  Except that in a co-op, the corporation, not the individual owners, pays tax on the profit that's retained in the co-op's reserve.  If the co-op's tax rate is lower than the individuals', this could actually be a tax savings, and a way for some of the profit to grow faster over time with a lower tax burden.  A worker-owner's income is taxed mostly the same way with any of these entities, but the S corporation can give a tax savings in some situations.
Note that every situation is different, and one or another business entity and tax election might work better for you based on your circumstances and your plans.  This article is meant for a general audience, and you should consult your attorney if you need advice choosing an entity or figuring out how to minimize taxes in your particular situation.
*Puget Sound Plywood, Inc. v. Commissioner, 44 T.C. 305 (1965).
**I.R.C. s.1401
IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, please be advised that any U.S. federal tax advice contained in this communication is not intended or written to be used or relied upon, and cannot be used or relied upon, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.