As the business leaders and economic engines of their communities, U.S. farmers and ranchers play a vital role in revitalizing America. They possess the capital reserves needed to invest in new value-added ventures, and the willingness to diversify outside of raw commodity production. What they currently lack are business structures that facilitate large-scale, complex, capital intensive ventures. “Growers need business entities that are tax-efficient, raise capital easily and offer investors liquidity,” says Mark Hanson, a Minneapolis-based attorney who specializes in co-op law. “Yet securities laws are woefully inadequate for those purposes.

New-vintage manufacturing, processing, and value-added co-ops formed in the last two decades have evolved faster than the laws that support them. Some 35 states still retain the original co-op laws drafted in the 1920s which were designed to give growers purchasing power through supply or marketing cooperatives, not to structure processing ventures, Hanson notes. Cooperatives gained popularity by being a corporation that could deduct patronage-sourced income from taxation at the corporation (cooperative) level. While the advantage would apply to feed sales, it is unlikely that profits from blankets and clothing made from corn-based fabrics and other ingredients would be considered “patronage sourced income.” As a result, those non-patronage source profits would likely be subject to double tax first at the cooperative and then when dividends are distributed to the members. That means the co-op form can be a high-tax structure for value-added ventures because the entity pays corporate tax up to 40%, then co-op members pay income tax and 15% Social Security tax on their distributions.

In practice, growers are increasingly frustrated with the limitations of traditional cooperative structure. When business grew so fast that it could not source enough high-quality durum from local members, Dakota Growers, a Carrington, N.D., cooperative was forced to switch to a regular corporation. The process was expensive, but it freed the plant to source durum anywhere. Among common problems:

• Restrictions on outside investors. Federal law exempts Sec. 521 co-ops from some federal securities registration requirements (a long and expensive process). A Sec. 521 co-op must have members who are producers of the commodity used by the ventures and they receive a patronage based on their delivery of the commodity to the cooperative. A producer may want to invest $50,000 in a value-added venture, but cannot commit to a corn delivery of 50,000 bu. because of the way his operating loan is financed. Another farmer close to retirement would need to sell his investment when he retires, as he is no longer a corn producer. Both of these individuals are barred from co-op membership.

• Starved for equity capital. The main method for a traditional co-op to raise capital is to retain earnings from current patrons. That’s one reason why today’s traditional co-ops have eroded capital during downturns in the farm economy. Co-ops can raise capital by offering preferred shares, but they are typically limited by law to pay no more than 8% interest on the shares (principal may or may not be repaid). That’s not enough incentive for venture capitalists to fund risky ventures like $60 million processing plants.

• Lack of liquidity. The “graying” farm population poses demographic problems for co-ops, just as it does for the Social Security system. About one-third of all co-op equity is owned by retired or nonactive members. Currently, co-ops don’t have enough young members to buy out the over-65-year-old generation. So much of the nation’s co-op equity is illiquid and probably worth pennies on the dollar. A growing number of co-ops don’t even have the cash to redeem equities on the death of a member, well past the time when the patron ceased to use the co-op’s services.

• One-man, one-vote issues. The co-op principle of one-man, one-vote rarely appeals to shareholders who underwrite the bulk of an investment. In practice, someone who invests $500,000 wants a bigger voice than someone who risks only $5,000.

Limited liability companies (LLCs), a business form taxed as a partnership but with the liability protection similar to a corporation, offer some improvements over cooperatives by allowing for nonfarmer investment. However, even this option exhibits some weaknesses. Language to differentiate rules for patrons and passive investors can become complicated. Another issue is that ownership interests cannot be widely traded, so investors cannot easily exit ownership: Federal law requires that no more than 8% of an LLC stock can be sold in any given year, or it will be treated as a publicly traded partnership subject to very expensive Securities and Exchange Commission regulations and corporate tax consequences.

No matter what business type is selected, involving owners from across state lines can add significant logistics to an offering. If all the investors are from the same state, a federal securities exemption allows state law to apply. This works for some projects, but if investors cross state lines, then federal law comes into play. One way to avoid some of this regulation is to have private placement where only sophisticated investors participate; they need to have net worths above $1 million or $200,000 of income for the past three years along with knowledge and skill to evaluate such investments. These requirements prevent many producers from investing in private-placement ventures.

Finally, the formation of entities to attract capital in value-added ventures is a fairly specialized part of the legal profession and requires additional insurance by law firms. Attorneys’ fees for such special services can run as high as $800 an hour and total fees to complete an offering can sometimes exceed $500,000 per project.

To address some of these inadequacies, at least four states (Wyoming, Minnesota, Iowa and Tennessee) have adopted a hybrid business form that blends the advantages of a co-op with a limited liability structure. Under Wyoming’s Processing Cooperative law, for example, the new structure has the flexibility to sell processed products without tax to the co-op, thereby passing income, losses, and tax credits through to members. The co-op also has the ability to enlist passive investors who do not have delivery obligations. Minnesota’s so-called 308B cooperative offers similar terms.