Three months after the signing of the 2017 Tax Cuts and Jobs Act tax reform legislation, we now have the first big change to that legislation. The Grain Glitch fix is in. Retroactively.
How We Got Here
When Congress reduced the top corporation tax rate from 35 percent to 21 percent, they also wanted to do something for pass-through businesses. The result was the new Sec. 199A deduction. Now up to 20 percent of the net “qualified business income” (QBI) of taxpayers with business income on a 1040 can be excluded from tax. This new provision replaces old Sec. 199 Domestic Production Activities Deduction (DPAD), which provided a similar 9 percent deduction, but was limited to a more narrow range of business income.
As part of the negotiations that resulted in new Sec. 199A, agricultural co-ops worked to preserve aspects of the old DPAD rules. The result of those efforts, as provided in the tax reform bill as enacted, allowed farmers to deduct 20 percent of their gross sales to cooperatives.
This original version of Sec. 199A quickly disrupted commodity markets. The tax advantage of selling product to only cooperatives could have made grain farming a tax-free business for many farmers. Under the newly enacted rules, there was so much tax advantage to farmers from selling only to cooperatives that non co-op buyers began to have trouble buying grain. Non co-op buyers faced a need to pay large premiums to offset the tax advantage of selling to co-ops. Many smaller grain buyers said they faced extinction. Also, because this benefit was not limited to farm-related co-ops, tax planners began to see advantages for cooperatives for their non-farm clients. All this put pressure on Congress to design a fix.
The Fix Arrives
The fix was introduced in the “omnibus” government spending bill, the Consolidated Appropriations Act, 2018, signed into law on March 23. In return for eliminating the 20 percent deduction for gross sales to cooperatives, the Appropriations Act adds Sec. 199A(g), which creates a revived 9 percent DPAD type deduction available only to agricultural co-ops. This new deduction can be taken at the same time as the 199A QBI deduction, but the combined deduction is limited to a maximum 20 percent of qualified income.
How Section 199A Works for Farmers Now
For farmers who don’t sell to cooperatives, Sec. 199A remains unchanged. Farmers at lower income ranges compute their business income from farming and deduct 20 percent off the top in computing their taxable income. The 20 percent QBI deduction is limited for farmers at higher income levels. Single farmers with taxable income (before the QBI deduction) in excess of $207,500, and joint-filing farmers with incomes in excess of $415,000, can only deduct QBI to the extent of 50 percent of the wages paid in their farming business, or, if greater, the sum of 25 percent of the wages paid plus 2.5 percent of the gross cost of depreciable property in the business. This limit is phased in starting at $157,500 of taxable income for single filers and $315,000 for joint filers.
It should be noted that this 20 percent deduction can only offset ordinary income. Many livestock breeding operations have significant capital gains from selling breeding animals, and the QBI deduction cannot reduce this. The QBI deduction is subject to an overall limit of 20 percent of ordinary taxable income. But the new Sec. 199A(g) puts a little twist on this limitation.
How the Sec. 199A DPAD Deduction Works
The Appropriations Act adds new subsection “g” to Sec. 199A. This subsection allows a 9 percent “deduction for income attributable to domestic production activities of specified agricultural or horticultural cooperatives.” This new deduction resembles the old Sec. 199 DPAD deduction; and, like the old deduction, this is subject to a limit of 50 percent of W-2 wages paid by the cooperative.
Also like old Sec. 199 DPAD, cooperatives can pass the new Sec. 199A(g) DPAD through to their patrons by making “qualified payments” and allocating the deduction in writing to the recipients. The recipients of the qualified payment deductions may use them to offset all of their taxable income. Therefore, unlike the Sec. 199A QBI deduction, the Sec. 199A(g) DPAD can offset both capital gains and ordinary income.
But some caution is in order. The co-op passed-through DPAD comes with a catch. The 20 percent deduction that would otherwise be available to farmers is reduced by 9 percent of the “qualified business income … as is properly allocable” to the qualified payments (or by a lesser amount if the co-op’s deduction is reduced by the W-2 wage limit). This ensures that the combined benefit is limited to 20 percent of qualified income.
What About Sales to Cooperatives Earlier This Year?
The new Sec. 199A(g) “fix” is made effective as if it were part of the original 2017 tax reform legislation. That means taxpayers who sold their grain to co-ops before the Appropriations Act was signed into law on March 23, 2018, do not get to exclude 20 percent of the gross sales proceeds from tax in 2018. Instead, the rules outlined above apply, including the possible distribution of the 9 percent DPAD by the cooperatives.
Is There Still a Co-op Advantage?
Some farm taxpayers may still have an advantage from selling to co-ops. Livestock operations in particular may benefit because the capital gains they can generate can be offset by the 9 percent Sec. 199A(g) DPAD. Other co-op patrons may be worse off if the W-2 wages paid in the cooperative fail to support the entire 9 percent deduction. Industries whose cooperatives have high wage costs will see the biggest benefits. The fruit packing industry, for example, tends to be more labor intensive than grain elevators.
Unfortunately, as complex as this article may seem, it really is a simplified summary. The details can make a big difference. There remain important unanswered questions about the new Sec. 199A deduction and the Sec. 199A(g) “fix.” That’s why Eide Bailly will continue to closely monitor IRS activity related to these changes and provide follow-up information as necessary. If you have questions about this, or other areas of tax legislation, please contact your Eide Bailly tax professional.