Farm Federation Seeks Clarification of QBI Regs for Cooperatives

August 15, 2019

Internal Revenue Service (IRS) Treasury
P.O. Box 7604
Ben Franklin Station, Washington DC 20044
CC:PA:LPD:PR (REG-1118425-18)

RE: Docket ID No.: IRS-2019-0028-0001: Section 199A Rules for Cooperatives and Their Patrons

The American Farm Bureau Federation (Farm Bureau) appreciates this opportunity to offer comments on proposed regulations that provide rules for patrons of cooperatives to calculate their I.R.C. § 199A(a) deduction and rules for patrons of specified cooperatives to calculate the reduction to their Sec. 199A(a) deduction as required by I.R.C. §199A(b)(7).

Farm Bureau is the country's largest general farm organization, representing nearly 6 million member families engaged in every type of crop and livestock production across all 50 states and Puerto Rico. The vast majority of our nation's farms and ranches are operated as sole-proprietorships, partnerships or S corporations that pay their taxes as pass-through businesses. As such the Sec. 199A qualified business income deduction delivers most of the tax benefits provided to them by the Tax Cuts and Jobs Act of 2017.

Farm Bureau finds the proposed cooperative qualified business income deductions (QBID) regulations to be very technical and somewhat confusing. We have identified several areas as needing clarification, and the following comments make recommendations that we believe will help farmers and ranchers who are members of cooperatives to understand and maximize the deduction.

Background On June 18, the United States Department of the Treasury (Treasury) issued proposed regulations providing guidance to cooperatives and their patrons regarding the qualified business income (QBI) deduction under Sec. 199A.¹ The proposed regulations provide rules for patrons of cooperatives to calculate their I.R.C. § 199A(a) deduction and rules for patrons of specified cooperatives to calculate the reduction to their Sec. 199A(a) deduction as required by I.R.C. §199A(b)(7). The proposed regulations also set forth criteria that specified cooperatives must satisfy to qualify for the I.R.C. §199A(g) deduction and describe the steps necessary to calculate the deduction. Rules for calculating Domestic Production Gross Receipts (DPGR), for calculating costs allocable to a specified cooperative's DPGR, and other special rules are also provided.

While the proposed regulations are helpful, several areas of needed clarification remain. That is particularly the case when computing the patron's deduction attributable to business the patron conducts with the cooperative.

No deduction for the cooperative. Under I.R.C. §199A(a), a taxpayer is eligible for up to a 20 percent QBI deduction (QBID) attributable to qualified business income (QBI) derived from a domestic business that is other than a C corporation. Trusts and estates are eligible for the deduction. But, the QBID does not apply to wage income or to C corporate income. A cooperative is deemed to be a C corporation for federal income tax purposes and, thus, cannot claim a QBID. A cooperative, even though it is deemed to be a corporation, is specifically allowed to use the DPAD. It is not the I.R.C. §199A(a) amount, but rather the special 199A(g) DPAD.

A cooperative determines its taxable income after the deduction for patronage dividend distributions and the like. These distributions are not taxed at the cooperative level. Instead, the distributions are taxed at the patron level. All cooperatives can deduct patronage distributions; exempt cooperatives can also deduct non-patronage distributions.² While a C corporation cannot utilize the QBID, I.R.C. §199A has a special rule for patrons that receive patronage dividends — they aren't treated as an exclusion to the patron's QBI.³ In addition, the Treasury has said that for purposes of the trade or business test of I.R.C. §162 (a pre-requisite for QBI), the income is tested at the trade or business level where the income is generated.⁴ This means that the QBID, if any, is claimed at the patron level and not the cooperative level.

Special rule for patrons. As noted, I.R.C. §199A has special rules for patrons of ag cooperatives. These rules stem from the fact that farmers often do business with an agricultural (or horticultural) cooperative. A farmer patron could have QBI that is not tied to patronage with a cooperative and QBI that is tied to patronage with a cooperative. This is a key point to understanding the uncertainty that remains concerning the proposed regulations that await clarification in the final regulations. Accordingly, the definition of “patronage dividends” is critical.

What are “Patronage Dividends”? 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, 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.⁵

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.⁶

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 to which the qualified payments (patronage dividends and per unit retains) made to the patron are attributable.⁷ 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 domestic production activities deduction computation of former I.R.C. §199, except that account is taken for non-patronage income not being part of the computation.

The proposed regulations establish a four-step process for computing the patron's QBID:

• separate patronage and non-patronage gross receipts (and associated deductions);

• limit the patronage gross receipts to those that are domestic production gross receipts (likely no reduction here);

• determine qualified production activities income from the domestic, patronage-sourced gross receipts, and;

• apply a formula reduction.⁸

As for the formula reduction of step four, 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.⁹

Because the test is the “lesser of,” a patron that doesn't pay qualified W-2 wages has no reduction. 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. This corresponds with the Internal Revenue Code (I.R.C.) provision and it mirrors the prior I.R.C. §199 rules for the domestic production activities deduction (DPAD). Under the prior DPAD rules, farmers did not receive the benefit of cooperative sales even if DPAD were not passed out

Aggregation. If a patron has more than a single business, QBI must be allocated among those businesses.¹⁰ The proposed regulations are not clear on how the formula reduction functions in the context of an aggregation election. The proposed and final QBI regulations (non-cooperative) provide a favorable aggregation provision that allows a farming operation with multiple businesses (e.g., row-crop; livestock; etc.) to aggregate the businesses for purposes of the QBID. This is, perhaps, the best feature of the QBI regulations with respect to agricultural businesses because it allows a higher income farming or ranching business to make an election to aggregate their common controlled entities into a single entity for purposes of the QBID. This is particularly the case with entities having paid no wages or that have low or no qualified property. Entities with cash rental income already qualified the income as QBI via common ownership (common ownership is required to aggregate). Once the applicable threshold¹¹ for 2018 ($160,700 for a single filer; $321,400 for married persons filing a joint return) is exceeded, the taxpayer must have qualified W-2 wages or qualified property basis to claim the QBID. Aggregation, in this situation, may allow the QBID to be claimed (assuming the aggregated group has enough W-2 wages or qualified property).

Under the proposed cooperative QBI regulations, if a patron makes an aggregation election 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 proposed cooperative regulations are not clear on this point, but it is recommended that an allocation be made if the rental income was deducted in arriving at QBI for the cooperative on the farm side.

Negative QBI. 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 nine percent amount will always be lower than the W-2 wage amount. Based on the draft form 8995-A, the QBID is to be increased by 9 percent of the AGI amount. Clarification is needed on this point and it is recommended that such clarification be made either in the final regulations or in a change to Form 8995-A or the instructions to the form.

Safe harbor. An optional safe harbor allocation method exists for patrons under the applicable threshold to determine the reduction. Under the safe harbor, a patron must allocate the aggregate business expenses and W-2 wages ratably between qualified payments and other gross receipts to determine QBI.¹² Thus, 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.

Unfortunately, the proposed regulations attempting to illustrate the calculation only mention 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/patron 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 doesn't address how government payments received upon sale of grain are to be allocated. This is a major issue that needs to be clarified. Payments at issue include Conservation Reserve Program payments, Market Facilitation Program payments, Dairy Program payments and other government program payments that a farmer/patron may be participating in. While it seems to be correct that such revenue is not cooperative-related, clarification in the final regulations should make that point if, in fact, that is correct position. In addition, it is recommended that the final regulations address the proper treatment of I.R.C. §1245 recapture that is attributable to past depreciation that was used to reduce cooperative QBI and rents paid via common ownership. Both I.R.C. §1245 recapture and rents paid via common ownership reduced cooperative QBI at the farm level. The recommendation is that I.R.C. §1245 recapture and at least a portion of the commonly owned rental income should also be a part of the cooperative QBI.

The example contained in the Proposed Regulations not only utilizes an apparently unstated “reasonable method of allocation,” but uses an allocation of W-2 wage expense that doesn't match the total expense allocation. In addition, the example, as written, does not meet the requirement of the regulations to “clearly reflect income” without an explanation of how the cost allocation has been accomplished. A taxpayer using the approach of the example would certainly fail the requirement of the regulations upon audit. While the proposed regulations illustrate that a taxpayer can use any reasonable method as long as it is consistent and clearly reflects income, the example in the proposed regulations is unclear. The recommendation is that the final regulations provide clear examples of reasonable methods of allocation that clearly reflect income. Farmers and their tax counsel will rely on examples in the final regulations to establish a reasonable allocation that will withstand IRS scrutiny. Such examples should provide clear guidance.

Farmer/patron over the threshold. A higher income patron 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. For a farmer/patron with taxable income over the applicable threshold, the QBID is capped at 50 percent of W-2 wages or 25 percent of W-2 wages associated with the business plus 2.5 percent of the “unadjusted basis immediately after acquisition” (UBIA) of all qualified property. 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.¹³ That means that the cooperative does not allocate its W-2 wages or UBIA to patrons.¹⁴ 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.¹⁵ An example in the proposed regulations illustrate that an allocation might be by the number of bushels of grain that the patron sells during the year to various buyers — cooperatives and non-cooperatives. Additional examples of appropriate allocations would be helpful, particularly because once an election is made with respect to an allocation approach, it applies to all subsequent years.

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 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. 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.¹⁶

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, 2019.¹⁷ It is recommended that the final regulations contain relief for patrons from a cooperative's negligence in failing to timely provide the required information to any particular patron.

Is the Patron's Business an SSTB? The proposed regulations indicate that a patron must determine whether the trades or businesses it directly conducts are specified service trades or businesses (SSTBs).¹⁸ The cooperative must report to the patron the amount of tax items from an SSTB that the cooperative directly conducts (based on the application of the gross receipts de minimis rule of Tress. Reg. §1.199A-5(c)(1)) that is used to determine if a trade or business is an SSTB. The patron is to then determine if the distribution from the cooperative can be included in the patron's QBI (based on the patron's taxable income and the phase-in range and threshold that applies to an SSTB). The cooperative must report to the patron the amount of SSTB income, gain, deduction, and loss in distributions that is qualified with respect to any SSTB directly conducted by the cooperative on an attachment to or on the Form 1099-PATR (or any successor form) that the cooperative issues to the patron, unless otherwise provided by the instructions to the Form.¹⁹ Again, the suggestion is that the final regulations provide relief to patrons negatively impacted by a failure of a cooperative to provide the necessary information on a timely basis.

Conclusion

The proposed cooperative QBI regulations are very technical and somewhat confusing. However, clarity can be provided in the final regulations on several points:

• How allocations are to be treated when a patron has multiple businesses and makes an aggregation election: We recommend that an allocation be made if the rental income was deducted in arriving at QBI for the cooperative on the farm side.

• How the formula reduction functions when the patron has negative QBI from cooperative business: We recommend that such clarification be made either in the final regulations or in a change to Form 8995-A or the instructions to the form.

• The proper computation of gross receipts under the safe harbor and how farm program payments are to be treated: We recommend that gross receipts from the sale of equipment and machinery should be included in the calculation and that a farmer/patron allocate gross receipts from equipment sales between patronage and non-patronage income. Likewise, clarification in the final regulations should be made that revenue from farm programs is not cooperative-related. In addition, it is recommended that the final regulations address the proper treatment of I.R.C. §1245 recapture that is attributable to past depreciation that was used to reduce cooperative QBI and rents paid via common ownership. Our recommendation is that I.R.C. §1245 recapture and at least a portion of the commonly owned rental income should also be a part of the cooperative QBI.

• Patron relief from any late-provided information from a cooperative that is necessary for the patron to claim a QBID: We recommend that the final regulations contain relief for patrons from a cooperative's negligence in failing to provide timely the required information to any particular patron.

Sincerely,

Paul Schlegel
Vice President
Public Affairs
American Farm Bureau Federation
Washington, DC