Monday, March 26, 2018
Late last week, the Congress passed, and the President signed, the Consolidated Appropriations Act of 2018, H.R. 1625. This 2,232-page Omnibus spending bill, which establishes $1.3 trillion of government spending for fiscal year 2018, contains a provision modifying I.R.C. §199A that was included in the Tax Cuts and Jobs Act (TCJA) enacted last December and which became effective for tax years after 2017. I.R.C. §199A , known as the qualified business income (QBI) deduction, created a 20 percent deduction for sole proprietorships and pass-through businesses. However, the provision created a tax advantage for sellers of agricultural products sold to agricultural cooperatives. Before the technical correction, those sales generated a tax deduction from gross sales for the seller. But if those same ag goods were sold to a company that was not an agricultural cooperative, the deduction could only be taken from net business income. That tax advantage for sales to cooperatives was deemed to be a drafting error and has now been technically corrected.
The modified provision removes the TCJA’s QBI deduction provision for ag cooperatives and replaces it with the former (pre-2018) I.R.C. §199 for cooperatives. In addition, the TCJA provision creating a 20 percent deduction for patronage dividends also was eliminated. Also, the modified language limits the deduction to 20 percent of farmers’ net income, excluding capital gains. The Joint Committee on Taxation estimates that the provision modifying I.R.C. §199A will raise $108 million over the next decade.
Today’s blog post examines the modification to I.R.C. §199A.
The Domestic Production Activities Deduction
In general. I.R.C. §199, the Domestic Production Activities Deduction (DPAD) was enacted as part of the American Jobs Creation Act of 2004 effective for tax years beginning after 2004. While often referred to as a “manufacturing” deduction, the DPAD was available to many businesses including those engaged in agricultural activities. Except for domestic oil-related production activities (for which the deduction is limited to six percent), for tax years beginning after 2009 and before 2018, the DPAD is equal to the lesser of 9 percent of the taxpayer’s qualified production activities income for the year; 9 percent of the taxable income of the taxpayer (for an individual, this limitation is applied to AGI); and 50 percent of the Form W-2 (FICA) wages of the taxpayer for the taxable year. Former I.R.C. §§199(a)(1) and (b)(1). The deduction was from taxable income, subject to an overall limit of 50 percent of current year Form W-2 wages that were associated with qualifying activity employment. The DPAD was allowed for both regular tax and alternative minimum tax (AMT) purposes (including adjusted current earnings). However, it was not allowed in computing SE income, and it could not create a loss.
Pass-Through Entities. In general, the DPAD was not claimed by pass-through entities (such as S corporations, partnerships, estates or trusts) when computing taxable income. Instead, the DPAD was applied at the shareholder, partner or beneficiary level. The pass-through entity would provide the necessary information required to compute the DPAD as a footnote on Schedule K-1. A taxable income limitation applied at the shareholder/partner level with each shareholder/partner separately computing the DPAD on its individual income tax return.
Note: While the DPAD was not claimed by a pass-through entity, estates and trusts were eligible for the DPAD if the income was not passed through to the beneficiaries.
Agricultural Cooperatives. Agricultural cooperatives could also claim the DPAD. However, the amount of any patronage dividend or per-unit retain allocations to a member of the cooperative that were allocable to qualified production activities were deductible from the member’s gross income.
Members of agricultural cooperatives included the DPAD for their distributions from the cooperative. The rules for cooperatives provided in §199(d)(3) and Treas. Reg. §1.199-6 applied to any portion of the DPAD that is not passed through to the cooperative’s patrons. In addition, a cooperative’s qualified production activities income was computed without taking into account any deduction allowable under IRC §1382(b) or (c) relating to patronage dividends, per-unit retain allocations, and nonpatronage distributions.
The TCJA Provision As Applied to Agricultural Cooperatives
For tax years beginning after 2017, the DPAD is repealed. In it place, for taxable years beginning after December 31, 2017, and before January 1, 2026, the TCJA creates (as applied to an agricultural or horticultural cooperative) a deduction equal to the lesser of (a) 20 percent of the excess (if any) of the cooperative’s gross income over the qualified cooperative dividends paid during the taxable year for the taxable year, or (b) the greater of 50 percent of the W-2 wages paid by the cooperative with respect to its trade or business or the sum of 25 percent of the W-2 wages of the cooperative with respect to its trade or business plus 2.5 percent of the unadjusted basis immediately after acquisition of qualified property of the cooperative. I.R.C. §199A(g). The cooperative’s section 199A(g) deduction may not exceed its taxable income (computed without regard to the cooperative’s deduction under I.R.C. §199A(g)) for the taxable year.
As for the impact of I.R.C. §199A on patrons of ag cooperatives, effective for tax years beginning after 2017, there is no longer a DPAD that a cooperative can pass through to a patron. However, as noted above, the deduction is 20 percent of the total of payments received from the cooperative (including non-cash qualified patronage dividends). The only limit is 100 percent of net taxable income less capital gains. For sales to a non-cooperative, the deduction is 20 percent of net farm income.
Impact on cooperatives. The provision in the Omnibus bill removes the QBI deduction for agricultural or horticultural cooperatives. In its place, the former DPAD provision (in all practical essence) is restored for such cooperatives. Thus, an ag cooperative can claim a deduction from taxable income that is equal to nine percent of the lesser of the cooperative’s qualified production activities income or taxable income (determined without regard to the cooperative’s I.R.C. § 199A(g) deduction and any deduction allowable under section 1382(b) and (c) (relating to patronage dividends, per-unit retain allocations, and nonpatronage distributions)) for the taxable year. The amount of the deduction for a taxable year is limited to 50 percent of the W-2 wages paid by the cooperative during the calendar year that ends in such taxable year. For this purpose, W-2 wages are determined in the same manner as under the other provisions of section 199A (which is not repealed as applied to non-cooperatives), except that “wages” do not include any amount that is not properly allocable to domestic production gross receipts. A cooperative’s DPAD is reduced by any amount passed through to patrons.
Under the technical correction, the definition of a “specified agricultural or horticultural cooperative” is limited to organizations to which part I of subchapter T applies that either manufacture, produce, grow, or extract in whole or significant part any agricultural or horticultural product; or market any agricultural or horticultural product that their patrons have manufactured, produced, grown, or extracted in whole or significant part. The technical correction notes that Treas Reg. §1.199-6(f) is to apply such that agricultural or horticultural products also include fertilizer, diesel fuel, and other supplies used in agricultural or horticultural production that are manufactured, produced, grown, or extracted by the cooperative.
Note: As modified, a “specified agricultural or horticultural cooperative” does not include a cooperative solely engaged in the provision of supplies, equipment, or services to farmers or other specified agricultural or horticultural cooperatives.
Impact on patrons. Under the new language, an eligible patron that receives a qualified payment from a specified agricultural or horticultural cooperative can claim a deduction in the tax year of receipt in an amount equal to the portion of the cooperative’s deduction for qualified production activities income that is: 1) allowed with respect to the portion of the qualified production activities income to which such payment is attributable; and 2) identified by the cooperative in a written notice mailed to the patron during the payment period described in I.R.C. §1382(d).
Note: The cooperative’s I.R.C. §199A(g) deduction is allocated among its patrons on the basis of the quantity or value of business done with or for the patron by the cooperative.
The patron’s deduction may not exceed the patron’s taxable income for the taxable year (determined without regard to the deduction, but after accounting for the patron’s other deductions under I.R.C. §199A(a)). What is a qualified payment? It’s any amount that meets three tests: 1) the payment must be either a patronage dividend or a per-unit retain allocations; 2) the payment, must be received by an eligible patron from a qualified agricultural or horticultural cooperative; and 3) the payment must be attributable to qualified production activities income with respect to which a deduction is allowed to the cooperative.
An eligible patron cannot be a corporation and cannot be another ag cooperative. In addition, a cooperative cannot reduce its income under I.R.C. §1382 for any deduction allowable to its patrons by virtue of I.R.C. §199A(g). Thus, the cooperative must reduce its deductions that are allowed for certain payments to its patrons in an amount equal to the I.R.C. §199A(g) deduction allocated to its patrons.
Transition rule. A transition rule applies such that the repeal of the DPAD does not apply to a qualified payment that a patron receives from an ag cooperative in a tax year beginning after 2017 to the extent that the payment is attributable to qualified production activities income with respect to which the deduction is allowed to the cooperative under the former DPAD provision for the cooperative’s tax year that began before 2018. That type of qualified payment is subject to the pre-2018 DPAD provision, and any deduction allocated by a cooperative to patrons related to that type of payment can be deducted by patrons in accordance with the pre-2018 DPAD rules. In that event, no post-2017 QBI deduction is allowed for those type of qualified payments.
With the technical correction to I.R.C. §199A, where do things now stand for farmers?
- The overall QBI deduction cannot exceed 20 percent of taxable income. That restriction applies to all taxpayers regardless of income. If business income exceeds $315,000 (MFJ; $157,500 all others), the 50 percent of W-2 wages limitation test is phased-in.
- The prior I.R.C. 199 DPAD no longer exists, except as resurrected for agricultural and horticultural cooperatives as noted above. The 20 percent QBI deduction of I.R.C. §199A is available for sole proprietorships and pass-through businesses. For farming businesses structured in this manner, the tax benefit of the 20 percent QBI deduction will likely outweigh what the DPAD would have produced.
- While those operating in the C corporate form can’t claim a QBI deduction, the corporate tax rate is now a flat 21 percent. That represents a tax increase only for those corporations that would have otherwise triggered a 15 percent rate under prior law.
- For C corporations that are also patrons of an agricultural cooperative, the cooperative’s DPAD does not pass through to the patron.
- For a Schedule F farmer that is a patron of an agricultural cooperative and pays no wages, there are two steps to calculate the tax benefits. First, the cooperative’s DPAD that is passed through to the patron can be applied to offset the patron’s taxable income regardless of source. Second, the farmer/patron is entitled to a QBI deduction equal to 20 percent of net farm income derived from qualified non-cooperative sales, subject to the taxable income limitation ($315,000 MFJ; $157,000 all others).
- For farmers selling to ag cooperatives that also pay W-2 wages, the QBI deduction is calculated on the sales to cooperatives by applying the lesser of 50 percent of W-2 wages or 9 percent reduction limitation. Thus, for a farmer that has farm income beneath the $315,000 threshold (MFJ; $157,500 all others), the QBI deduction will never be less than 11 percent (i.e., 20 percent less 9 percent). If the farmer is above the $315,000 amount (MFJ; $157,500 all others), the 50 percent of W-2 wages limitation will be applied before the 9 percent limitation. This will result in the farmer’s QBI deduction, which cannot exceed 20 percent of taxable income. To this amount is added any pass-through DPAD from the cooperative to produce the total deductible amount.
- For farmers that sell ag products to non-cooperatives and pay W-2 wages, a deduction of 20 percent of net farm income is available. If taxable income is less than net farm income, the deduction is 20 percent of taxable income less capital gains. If net farm income exceeds $315,000 (MFJ; $157,500 single), the deduction may be reduced on a phased-in basis.
- The newly re-tooled cooperative DPAD of I.R.C. 199A may incentivize more cooperatives to pass the DPAD through to their patrons.