Friday, January 15, 2021
After many months of delay, the IRS has finally issued final regulations providing guidance to agricultural/horticultural cooperatives and patrons on the I.R.C. §199A(a) and I.R.C. §199A(g) deduction for qualified business income (QBI). The final regulations make several changes to the Proposed Regulations, and are important to patrons of ag cooperatives and return preparers.
The QBI Final Regulations applicable to agricultural/horticultural cooperatives – it’s the topic of today’s post.
The Consolidated Appropriations Act of 2018, H.R. 1625 (Act) became law. The Act contained a provision modifying I.R.C. §199A that was included in the Tax Cuts and Jobs Act (TCJA) enacted in late 2017. I.R.C. §199A created a 20 percent QBI 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 replaced it with the former (pre-2018) domestic production activities deduction (DPAD) of 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 Modification: New I.R.C. §199A(g)
The provision in the Act 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 applied such that the repeal of the DPAD did 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 was allowed for those type of qualified payments. This simple statement created surprising results and added complexity to the computations for determining the proper 2018 QBID. Taxpayers needed to identify sales to non-cooperatives, sales to cooperatives during the year that began in 2017, and sales to cooperatives during the year that began in 2018 to properly compute their 2018 QBID.
Status of Ag Cooperatives and Patrons After the Act
With the technical correction to I.R.C. §199A, where did things stand for farmers?
- The overall QBI deduction cannot exceed 20 percent of taxable income less capital gain. That restriction applies to all taxpayers regardless of income. When income exceeds the taxable income threshold , the 50 percent of W-2 wages limitation and qualified property limit are 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 for those corporations that would have otherwise triggered a 15 percent rate under prior law and benefitted from DPAD in prior years.
- 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 (presently $329,800 (mfj); $164,900 (single, MFS and HH for 2021).
- For farmers that pay W-2 wages and sell to ag cooperatives , 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 taxable income limitation , the QBI deduction will never be less than 11 percent (i.e., 20 percent less 9 percent). If the farmer is above the taxable income limitation 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 the taxable income limitation 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.
After a frustrating 2018 tax season experience with respect to associated IRS Forms and IRS computers not recognizing Forms as submitted in accordance with the instructions for the I.R.C. §199A(g) amount, the IRS issued Proposed Regulations concerning the computation of the I.R.C. §199A(g) amount. REG-118425-18. The Proposed Regulations clarified that patronage dividends include money, property, qualified written notices of allocations, qualified per-unit retain certificates for which a cooperative receives a deduction under I.R.C. §1382(b), nonpatronage distributions paid in money, property, qualified written notices of allocation, as well as money or property paid in redemption of a nonqualified written notice of allocation for which an exempt cooperative receives a deduction under I.R.C. §1382(c)(2). But, dividends on capital stock are not included in QBI. Prop. Treas. Reg. §1.199A-7(c)(1).
Under Prop. Treas. Reg. §1.199A-7(c), patronage dividends or similar payments may be included in the patron’s QBI to the extent that these payments: (i) are related to the patron’s trade or business; (ii) are qualified items of income, gain, deduction, or loss at the cooperative’s trade or business level; and (iii) are not income from a specified service trade or business (SSTB) (as defined in I.R.C. §199A(d)(2)) at the cooperative level. But, they are only included in the patron’s income if the cooperative provides the required information to the patron concerning the payments. Prop. Treas. Reg. §1.199A-7(c)(2). The transition DPAD rules were reaffirmed in Prop. Treas. Reg. §1.199A-7(h)(2) thus validating the related complex calculations on 2018 tax returns.
The patron’s QBID. The amount of a patron’s deduction that can be passed through to the patron is limited to the portion of the patron’s deduction that is allowed with respect to qualified production activities income (QPAI) to which the qualified payments (patronage dividends and per unit retains) made to the patron are attributable. I.R.C. §199A(g)(2)(E). In other words, the distribution must be of tax items that are allocable to the cooperative’s trade or business on behalf of or with a patron. The cooperative makes this determination in accordance with Treas. Reg. §1.199A-3(b). This is, essentially, the former DPAD computation except that account is taken for non-patronage income not being part of the computation.
There is a four-step process for computing the patron’s QBID: 1) separate patronage and non-patronage gross receipts (and associated deductions); 2) limit the patronage gross receipts to those that are domestic production gross receipts (likely no reduction here); 3) determine qualified production activities income from the domestic, patronage-sourced gross receipts; 4) apply a formula reduction (explained below). Prop. Treas. Reg. §1.199A-8(b).
The ”wages” issue. As noted, the farmer-patron must reduce the “patron’s QBID” by a formula that is the lesser of 9 percent of QBI that relates to qualified payments from the cooperative, or 50 percent of the patron’s W-2 wages paid that are allocable to the qualified payments from the cooperative. I.R.C. §199A(b)(7)(A)-(B). In Notice 2019-27, 2019-16 IRB, the IRS set forth various methods for calculating W-2 wages for purposes of computing the patron’s QBID. See also Prop. Treas. Reg. §1.199A-11. Because the test is the “lesser of,” a patron that pays no qualified W-2 wages has no reduction. Remember, however, under I.R.C. §199A(b)(4) and Prop. Treas. Reg. §1.199A-11(b)(1), wages paid in-kind to agricultural labor are not “qualified wages” but wages paid to children under age 18 by their parents are.
I.R.C. §199A(b)(7) requires the formula reduction even if the cooperative doesn’t pass through any of the I.R.C. §199A(g) deduction (the deduction for a patron) to the patron for a particular tax year. If the patron has more than a single business, QBI must be allocated among those businesses. Treas. Reg. §1.199A-3(b)(5). The Proposed Regulations do not mention how the formula reduction functions in the context of an aggregation election. For example, if an aggregation election is made to aggregate rental income with income from the farming operation, must an allocation be made of a portion of the rental income as part of the formula reduction?
The formula reduction applies to the portion of a patron’s QBI that relates to qualified payments from a cooperative. If the patron has negative QBI that is associated with business done with the cooperative, the 9 percent amount will always be lower than the W-2 wage amount.
An optional safe harbor allocation method exists for patrons with taxable income under the applicable threshold of I.R.C. §199A(e)(2) to determine the reduction. Under the safe harbor, a patron must allocate the aggregate business expenses and W-2 wages ratably between income from qualified payments and income from other than qualified payments to determine QBI. Prop. Treas. Reg. §1.199A-7(f)(2)(ii). Unfortunately, the example contained in the Proposed Regulations not only utilized an apparently unstated “reasonable method of allocation,” but also an allocation of W-2 wage expense that doesn’t match the total expense allocation.
The amount of deductions apportioned to determine QBI allocable to qualified payments must be equal to the proportion of the total deductions that the amount of qualified payments bears to total gross receipts used to determine QBI. The same proportion applies to determine the amount of W-2 wages allocable to the portion of the trade or business that received qualified payments.
The part of the Proposed Regulations attempting to illustrate the calculation only mentions gross receipts from grain sales. There is no mention of gross receipts from farm equipment, for example. Based on the language of Prop. Treas. Reg. §1.199A-7(f)(2)(ii), gross receipts from the sale of equipment and machinery should be included in the calculation and the farmer would have to allocate gross receipts from equipment sales between patronage and non-patronage income. Indeed, in prior years, depreciation may have been allocated between patronage and non-patronage income. Likewise, the example didn’t address how government payments, custom work, crop insurance proceeds or other gross receipts are to be allocated.
This meant that the patron must know the qualified payments from the cooperative that were allocable to the patron that were used in computing the deduction for the patron at the cooperative level that could be passed through to the patron. This information is contained on Form 1099-PATR Box 7.
A patron with taxable income above the threshold levels that receives patronage dividends (or similar payments) from a cooperative and is conducting a trade or business might be subject to the W-2 wages and “unadjusted basis immediately after acquisition” (UBIA) limitation. In that instance, the patron is to calculate the W-2 wage and UBIA limitations without regard to the cooperative’s W-2 or UBIA amounts. Prop. Treas. Reg. §1.199A-7(e)(2). That means the cooperative (unlike a RPE) does not allocate its W-2 wages or UBIA to patrons. Instead, a patron allocates (by election) W-2 wages and UBIA between patronage and non-patronage income using any reasonable method based on all the facts and circumstances that clearly reflects the income and expense of each trade or business. Prop. Treas. Reg. §1.199A-7(f)(2)(i).
The patron’s QBID that is passed through from the cooperative (which is not limited by W-2 wages at the patron level) is limited to the patron’s taxable income taking into account the non-patron QBID which is limited to 20 percent of taxable income not counting net capital gains. Any unused patron-QBID is simply lost – there is not carryover or carryback provision that applies.
Identification by the cooperative. A cooperative must identify the amount of a patron’s deduction that it is passing through to a patron in a notice that is mailed to the patron via Form 1099-PATR during the “applicable payment period” – no later than the 15th day of the ninth month following the close of the cooperative’s tax year. I.R.C. §199A(g)(2)(A); Prop. Treas. Reg. §1.199A-8(d)(3); I.R.C. §1382(d).
A patron uses the information that the cooperative reports to determine the patron’s QBID. If the information isn’t received on or before the Form 1099-PATR due date, no distributions from the cooperative will count towards the patron’s QBI if the lack of reporting occurs after June 19, 2019. Prop. Treas. Reg. §1.199A-7(c)(3); Prop. Treas. Reg. §1.199A-7(d)(3).
Final Regulations (TD 9947)
On January 14, 2021 the IRS issued Final Regulations on the cooperative QBI issue. The Final Regulations make several changes to the Proposed Regulations. One clarification that likely won’t impact many farmers requires a cooperative to separately determine the amounts of qualified items that relate to non-specified service trades or business (SSTBs) and those that relate to SSTBs when making distributions to patrons. Treas. Reg. §§1.199A-7(c)(3) and (d)(3). The cooperative is to report the net amount of qualified items from non-SSTBs in distributions to patrons without delineating on a business-by-business basis. Once a patron receives the information from the cooperative, the patron will have to determine if the qualified item is includible in the patron’s QBI under Treas. Reg. §1.199A-7(c)(2) and whether the qualified item from the SSTB is includible in the patron’s QBI based on the threshold rules of I.R.C. §199A(d)(3). Treas. Reg. §1.199A-7(d)(3)(i).
Under the Proposed Regulations, a question existed whether a patron needed to include gain on selling farm equipment, farm program payments, self-rentals, or other similar income sources in calculation of the I.R.C. §199A(g) amount. The Final Regulations didn’t answer the question. Under the Final Regulations, when calculating the I.R.C. §199A(b)(7) reduction, a patron is to use a “reasonable method” to allocated income between that from qualified payments and that not coming from qualified payments, based on all of the facts and circumstances. Treas. Reg. §1.199A-7(f)(2)(i). Basically, that means that a farmer/patron can make their own decision with respect to including or excluding such items. The only requirement is that a “reasonable method” be utilized.
The final regulations specify that a farmer/patron that aggregates a rental real estate busines and a farming business that does business with a cooperative is to exclude the rental income when calculating the I.R.C. §199A(b)(7) reduction for the patron’s aggregated trade or business. Similarly, the patron is to allocate rental expense against qualified payments when computing the reduction only to the extent rental expense is related to the qualified payments from the cooperative. Preamble to TD 9947.
On the wage issue, qualified payments need not be reduced if the cooperative was limited by the 50 percent of wage limitation.
The Final Regulations provide an example of the effect of negative QBI on the I.R.C. §199A(b)(7) reduction, pointing out that negative QBI from a cooperative results in no adjustment to the reduction computation:
“A farmer conducts two types of agricultural businesses (A and B). Assume the farmer treats A and B as one trade or business for purposes of the [I.R.C. §199A(a)] deduction. The farmer conducts A with non-Specified Cooperatives and B through a Specified Cooperative. The farmer generates $100 of qualifying income through A and receives $100 of qualifying income from a Specified Cooperative in B, all of which is also a qualified payment. The farmer has $180 of qualified expenses. For purposes of the [I.R.C. §199A(a)] deduction, the farmer’s QBI ($20) from the trade or business is used to calculate the deduction, resulting in a $4 deduction. The farmer then must determine if there is any [I.R.C. §199A(b)(7)] reduction to this amount. The farmer reasonably allocates its qualified expenses for purposes of calculating the I.R.C. §199A(b)(7)] reduction and determines $110 of the qualified expenses are allocable to B (and $70 to A). The farmer will use only QBI from B to calculate the [I.R.C. §199A(b)(7)] reduction because that is the only QBI properly allocable to qualified payments. Farmer’s QBI for purposes of [I.R.C. §199A(b)(7)(A)] is negative $10, resulting in a $0 [I.R.C. §199A(b)(7)] reduction (regardless of W-2 wages under [I.R.C. §199A(b)(7)(B)]). ((Preamble to TD 9947)).”
The IRS, in the Final Regulations, maintained its position that cooperatives must calculate two separate deductions – one for patronage and another for nonpatronage activities. The IRS takes the position in the Final Regulations that nonpatronage income is excluded from the calculation of the deduction, which reduces the overall value of the deduction for cooperatives and patrons. Income or deductions is from patronage sources if it comes from a transaction that facilitates the cooperative’s marketing, purchasing or services. If a transaction is merely incidental to the cooperative’s operation, the income or deduction is from nonpatronage sources.
The IRS claims that the Form 8903 instructions make it clear that separate calculations are necessary for the patronage section of I.R.C. §199A(g) deductions and nonpatronage I.R.C. §199A(g) deductions. However, there is no support for the IRS position in the statute’s legislative history for the disparate treatment of patronage and nonpatronage source income. Likewise, the Tax Court (in both Memorandum and Full opinions) has rejected the IRS approach for computing the former domestic production activities deduction of I.R.C. §199 on which I.R.C. §199A is based. Growmark, Inc. v. Comr., T.C. Memo. 2019-161; Ag Processing, Inc. v. Comr., 153 T.C. 34 (2019).
The Final Regulations are generally applicable to tax years beginning after January 19, 2021, but can be used for earlier tax years. Otherwise, for tax years beginning on or before January 19, 2021, the Proposed Regulations apply.
The Final Regulations do clarify a couple of issues that were unclear in the Proposed Regulations. However, the Final Regulations do not answer the question of whether gain from certain various sources of income for a farmer/patron in the I.R.C. §199A(g) computation.