The Consolidated Appropriations Act of 2018 (“CAA”) passed Congress and was signed into law by President Trump on March 23, 2018. The $1.3 trillion spending bill was “must pass” legislation that avoids a government shutdown. The massive 2,232 page bill covers numerous spending measures, but also contained some tax provisions. One of the key tax items of the deal was the qualified business income deduction for farmers (pursuant to Section 199A) and special rules related to cooperatives.
The Tax Cuts and Jobs Act (the Act) was signed into law on December 22, 2017. This legislation is the most comprehensive tax reform since the Tax Reform Act of 1986. The Act impacted farmers, cooperatives, and non-cooperatives.
Signature elements of the Act included a reduction in the corporate tax rate from 35% to 21%. In addition, the Act establishes a corresponding tax benefit for pass-through entities. The newly created section 199A qualified business income deduction gives owners of S Corporations, Partnerships/LLCs, and Sole Proprietors (including Schedule F farmers) a deduction up to 20% of qualified business income.
Qualified income from all activities is aggregated and should show up as one number on the taxpayer’s individual tax return. The Conference Committee Report suggests that if a taxpayer has multiple businesses, the tests discussed below will be applied to each business separately.
To claim deduction, taxpayers must first determine the sum of the following two items:
- The lesser of:
- The taxpayer’s “combined qualified business income amount,” (defined below); or
- 20% of the excess, if any, of the taxable income of the taxpayer for the tax year over the sum of the taxpayer’s net capital gain and the taxpayer’s aggregate qualified cooperative dividends, plus
- The lesser of:
- 20% of the taxpayer’s aggregate qualified cooperative dividends; or
- The taxpayer’s taxable income minus the taxpayer’s net capital gain.
A taxpayer’s “combined qualified business income amount,” for a tax year is generally the lesser of:
- 20% of the taxpayer’s qualified items of income, gain, deductions, and loss relating to any qualified trade or business of the taxpayer; or
- A “W-2 wages/qualified property limitation,” which is the greater of:
- 50% of the W-2 waves with respect to the qualified trade or business; or
- The sum of 25% of the W-2 wages paid with respect to the qualified trade or business, plus 2.5% of the unadjusted basis of all qualified property of the trade or business.
The W-2 wages/qualified property limitation described above does not apply if the taxpayer’s taxable income for the year is equal to or lesser than a threshold amount of $157,500 (a $315,000 threshold for a joint return). If a taxpayer’s taxable income exceeds these thresholds, a phase-out and additional limitations apply. Some taxpayers might consider filing separate returns to enhance this deduction, however, further IRS guidance might curb this strategy.
The Act provided cooperative patrons whose taxable income did not exceed the above thresholds, with a simpler and potentially larger deduction. The deduction is calculated by multiplying all payments from a cooperative times 20%; but the deduction was limited to the lesser of taxable income minus capital gains. In some situations, the deduction could eliminate the taxpayer’s taxable income. This provision has generated significant attention because of the potential unintentional impact to non-cooperative grain elevators (and was often referred to as the “grain glitch”). Congress has spent the last few months searching for a solution to repair potential unintended effects of the Act.
Changes Made by the Consolidated Appropriations Act
The CAA bill contains the long awaited “fix” related to provisions that created an unfair advantage for agricultural producers who sell their products to cooperatives. Significant provisions discussed above have been modified by the CAA and these will be addressed below along with some of the new complexities.
Under changes of the CAA, farmers that sell to cooperatives will no longer be eligible for a deduction equal to 20% of total sales to cooperatives. The fix is in. These farmers must now go through a multi-step complicated calculation. The deduction for taxpayers who sell to cooperatives is calculated as follows:
- Step 1: 9% of designated qualified payments passed through from cooperatives.
- Step 2: Add 20% of net farming profit reduced by the lesser: of 9% of designated qualified payments passed through from cooperatives; or 50% of allocable wages.
The limitation with respect to the 20% deduction has been modified to 20% of net income minus capital gains. Further limitations apply if taxpayer’s taxable income exceeds the threshold levels discussed above.
The CAA does not eliminate a potential advantage for farmers to sell their crop to cooperatives, although the benefits have been significantly reduced. Congress has further complicated the law, thus a detailed analysis is needed to determine if an advantage still exists.
Further, recall that farmers who sold to non-cooperatives in the past and who did not pay wages were not eligible for the 9% DPAD. Now after the Act, they are eligible for a potential 20% deduction.
Let’s Explore How the Act and the CAA Impacted Cooperatives
The maximum corporate tax rate was reduced from 35% to 21% by the Act beginning in 2018. As a practical matter, most cooperatives (prior to 2018) were able to eliminate a substantial percentage of their taxable income through a combination of the domestic production activities deduction and cooperative distributions. The Act reduced the incentive for cooperatives to make distributions because cooperative distributions were excluded from the definition of “qualified business income.” The CAA, however, repealed the rule that excluded cooperative dividends from qualified business income, and thus cooperative patrons will be able to use the distribution in calculating the 20% deduction.
The CAA restores the deduction for income attributable to domestic production activities at the cooperative level. The deduction for cooperatives is the lesser of: 9% of qualified production activity income; or taxable income. The deduction is further limited to 50% of W-2 wages.
The Joint Committee in Taxation (“JCT”) in Congress provided a thorough explanation of the law before the Act, changes made by the Act, and changes made by the CAA. They also included several useful examples. Please click here for a link to the JCT explanation on these changes and see pages 7-29 of this PDF.
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We recognize the immense complexity of this law. We are working tirelessly to study legislation, understand Congressional intent and learn from public comments IRS officials make as they discuss these laws publicly. We anticipate that IRS will issue administrative guidance in 2018 and request public comments, followed by issuance of regulations in future years. So many tax planning opportunities exist. Please consult your Sikich tax advisor for assistance.