The Tax Cuts and Jobs Act has significantly transformed our federal tax code. It lowered the corporate income tax rate from a maximum rate of 35% to a flat rate of 21%. It also created a new deduction, IRC Section 199A, to apply to income earned from pass-through business activities.
This new deduction impacts millions of taxpayers, including farmers who operate a sole proprietorship, S corporation or partnership, along with those who are members of a cooperative or have an interest in a real estate investment trust (REIT) or a qualified publicly traded partnership.
Despite its tremendous impact, 199A is perhaps the most obscure provision in the new law. Until we receive guidance from the Internal Revenue Service on many of its provisions, we won’t know for sure how it will apply.
One section of the new 199A deduction has created quite a stir in the ag community. The law, as written, provides that the deduction for member income from cooperatives is calculated differently than the deduction for other farm income, including that from commodities sold to a non-cooperative.
Bill gives co-ops preferential treatment
This technical difference creates a significant advantage for many member farmers who market their commodities through a co-op as opposed to selling them to a non-cooperative buyer. It is likely that some difference in the calculation was intended to offset the loss of the Section 199 deduction (also known as the domestic production activities deduction, or DPAD), which was eliminated by the new tax act. It appears that the extent of the discrepancy, however, was unintentional.
The offices of Sens. John Hoeven, R-N.D., and John Thune, R-S.D., who supported inserting the qualified cooperative dividend provision into the tax bill in the hours before its passage, have both stated there was no intent to favor one business over another. As written, however, that’s exactly what the provision does.
To understand the issue, we must first understand how the new 199A deduction works. Subject to many limitations, taxpayers can generally take as a deduction: 20% of their “qualified business income” (QBI), in an amount up to 20% of their taxable income (minus capital gain). Additionally, taxpayers can generally deduct 20% of their “qualified cooperative dividends” up to the amount of their taxable income (not including capital gain income).
It is the difference between how these two calculations work that has created the controversy. We’ll examine each in turn.
• Deduction for qualified business income (non-cooperative or non-member sale). The first deduction allowed under Section 199A applies where a farmer sells commodities to a non-cooperative, or a non-member sells a commodity to a cooperative. QBI is generally equal to net business income. It does not include income from qualified REIT dividends or qualified cooperative dividends. It also excludes wages, reasonable compensation, guaranteed payments, interest income, dividend income or capital gain. QBI for a farmer not selling commodities to a cooperative would generally equal net Schedule F income.
The 199A deduction for QBI is subject to several limitations. The tentative deduction will equal 20% of QBI for single taxpayers with taxable income of $157,500 or less ($315,000 for MFJ). For taxpayers with income above that level, the tentative 20% deduction is generally limited to 50% of W-2 wages paid or the sum of (25% of W-2 wages paid plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property).
The tentative deduction is then subject to a second limitation, one for taxable income. The final QBI deduction is limited to 20% of taxable income, which factors in itemized deductions or the standard deduction.
For example, if a farmer sold $200,000 of grain to an ethanol plant and had $150,000 in expenses, the QBI deduction would be the lesser of the following:
0.20 × $50,000 (net business income) = $10,000 (tentative deduction)
0.20 × ($50,000 − $12,000 standard deduction) = $7,600 (taxable income limitation)
In this example, the farmer can take a $7,600 Section 199A deduction and will have $30,400 in taxable income stemming from the grain sold to the ethanol plant. This equates to $4,084 in tax.
• Deduction for qualified cooperative dividends (cooperative member sale). As the code is currently written, the 199A deduction for qualified cooperative dividends is calculated much differently.
The deduction is generally equal to 20% of qualified cooperative dividends, limited only by 100% of taxable income. There is no wage limitation for qualified cooperative dividends. The definition for qualified cooperative dividends includes most member income from cooperatives, including patronage dividends and per-unit retains paid in money (PURPIM). Gross grain sales by a member to a cooperative, for example, are typically reported to the member on 1099-PATR as PURPIM.
Thus, if the same farmer from the above example is now a member of a cooperative and sells his grain to a cooperative, his deduction is much higher. It is the lesser of the following:
0.20 × $200,000 (gross grain sales) = $40,000
100% of taxable income ($50,000 − $12,000 standard deduction) = $38,000
In other words, the farmer who is a member of a co-op and markets his grain to that co-op will have a $38,000 deduction from his $38,000 in taxable income. In this example, he will pay no tax on his grain sale.
What’s ahead for this issue?
As of late January, much uncertainty surrounds this provision. On Jan. 12, USDA issued a press release stating that the unintended consequences of the current language result in a disadvantage for the independent operators in the same industry. The release also states: “The federal tax code should not pick winners and losers in the marketplace. We applaud Congress for acknowledging and moving to correct the disparity, and our expectation is that a solution is forthcoming. USDA stands ready to assist in any way necessary.”
It seems likely that a provision to correct the significant discrepancy between the tax treatment of income from co-op sales and sales to firms that aren’t co-ops will be included in a future funding bill or perhaps a technical corrections bill. It is not clear, however, exactly how this “correction” would work. It is also not clear how IRS will interpret this provision, either as written or as modified.
Until we have further clarification, it is premature for farmers and others affected by the 199A provision to change business practices in light of the impact of this new deduction. We are tracking this important information closely. Updates will be posted immediately at calt.iastate.edu.
Tidgren is staff attorney and assistant director for the Center for Ag Law and Taxation at Iowa State University. Contact her at [email protected].