Author’s note: This article is a revision and combination of March 20 and March 21 articles that appeared in Tax Notes Today incorporating corrections and suggestions from Glen Birnbaum, Damien Martin, and Paul Neiffer. Remaining errors are my own.
New code section 199A that provides tax relief for many passthrough business owners is easily one of the most complex components of the Tax Cuts and Jobs Act (P.L. 115-97). The special rules for application of the law to cooperatives and their patrons are the most complex component of section 199A. Now, as the House and Senate voted to pass a $1.3 trillion spending bill that includes a modification to section 199A, Congress will soon make tax rules for cooperatives and their patrons even more complex than they are now. This added complexity is disappointing because it often involves small and midsize farmers and cooperatives for whom compliance costs are particularly burdensome.
If you, like most of our readers, live outside the agricultural news bubble, here’s an overview of the situation (simplistically summarized in Table 1). Ever since Congress enacted the American Jobs Creation Act of 2004 (P.L. 108-357) and added section 199 to the code, farmers that sell to agricultural cooperatives have been tax-advantaged over farmers that sell to other businesses. These advantages were so significantly enlarged by the passage of the TCJA that farmers now will strongly prefer to sell to cooperatives rather than lose tax benefits potentially equal to 20 percent of their gross sales. In addition to annoying many multinationals that buy grain agricultural products directly from farmers, new section 199A threatens to put many small, independent grain elevators out of business. A proposed fix released March 13 would reduce these advantages and in some cases reverse them.
Row (a) of Table 1 shows that under prior law, under current law, and under the March 13 proposal, farmers that sell to private or independent businesses (non-cooperative sales) are eligible for deductions based on the net profit from those sales (after subtracting costs at the individual level). In the context of cooperative taxation, these are sometime referred to as “individual-level” benefits, and they are the same benefit as any qualified nonagricultural business could receive under the general rules of sections 199 and 199A. (Important limitations on these deductions — wage, wage-property, and taxable income limitations at the individual level — are discussed below.) Before 2018, under section 199, the rates applied to eligible profits were 3 percent (2005-06), 6 percent (2007-09), and 9 percent (2010-17). Starting in 2018, under section 199A (and through 2025 when the section expires) the rate has been increased to 20 percent. The March 13 proposal does not change benefits for farmers that sell to businesses other than cooperatives.
Row (b) of Table 1 shows that farmers that sell to cooperatives under prior, current, and proposed law could be eligible for deductions based on their share of gross profit of cooperatives. (Again, important limitations on these deductions — wage limitations at the entity level and taxable income limitations at the individual level — are discussed below.) These are sometimes called “cooperative” or “entity-level” benefits. Under the March 13 proposed modification, the rate will return to 9 percent for the entity-level deduction. Also under the March 13 proposal, in addition to entity-level benefits, farmers that sell to cooperatives would also be eligible for individual-level benefits that involve a two-stage calculation.
Ignoring for the moment income, wage, and property limitations, Table 1 shows that the March 13 proposal would leave section 199A benefits unchanged from current law for sellers to non-cooperatives (20 percent net income from sales). For sellers to cooperatives, the benefit would be changed from 20 percent of sales to a cooperative (under current 199A) to 9 percent of sales to a cooperative plus 11 percent of net income from those sales (under the March 13 proposal).
Type of Transaction | Section 199 | 199A — Current Law | 199A — Modification Proposed March 13 |
|---|---|---|---|
(a) Non-co-op sale | 9% net income from sales | 20% net income from sales | 20% net income from sales |
(b) Sale to co-op | 9% of sales to co-op | 20% of sales to co-op | (9% sales) + (20% net) - (9% net) |
Co-op advantage [= (b) - (a)] | 9% sales - 9% net income from sales | 20% sales to co-op - 20% net income from sales | 9% sales - 9% net income from sales |
Sources: See Table 2. | |||
Got to Know Limitations
Even though you’re probably already confused, we must add more detail because, as we shall see, limitations of the tentatively calculated amounts can matter a great deal. For entity-level calculations, there’s a wage limitation that can significantly curtail farmers’ tax benefits that otherwise would equal 20 percent of their sales to cooperatives. For both individual- and entity-level calculations, the wage limitation that was equal to 50 percent of W-2 wages under prior-law section 199 was changed in section 199A to the greater of (a) 50 percent of W-2 wages or (b) the sum of 25 percent of W-2 wages and 2.5 percent of the unadjusted original basis of certain depreciable property. Under the proposed modification to current law, the entity-level wage limitation would revert to the simpler calculation under prior-law section 199. Wage-property limitations applicable to individual-level calculations under current law and the proposal apply only if taxable income is above statutory threshold amounts of $157,500 for single taxpayers and $315,000 for married couples.
Under prior-law section 199, tax benefits were limited to 9 percent of taxable income (starting in 2010) for both individual- and entity-level calculations. Under current law, individual benefits for non-cooperative sales are limited to 20 percent of taxable income less capital gains. In sharp contrast, benefits for sales to cooperatives are limited to 100 percent of income. Under the March 13 proposal, limitations equal to both 9 percent and 20 percent of taxable income (less capital gains) come into play (as described in Table 2). Cooperative benefits that are passed through to farmers are not subject to wage limitations at the individual level.
Here are some other assumptions about calculations in this article (for readers who can still stand it). Individual taxpayers are assumed to have no capital gains, no other (nonagricultural) qualified business income, and no distributions from real estate investment trusts or from master limited partnerships. It’s also assumed that farmers sell 100 percent of their product or none of their product to a cooperative. (They could sell to both a cooperative and to a (non-cooperative) independent business, and that, of course, would be even more complicated, including cost allocations.) Even though they aren’t required to distribute all profits to their patrons (and often don’t because they need to increase capital), it’s assumed here that agricultural cooperatives pass through 100 percent of their profits to patrons. Further, all business sales of agricultural cooperatives and of farmers are assumed to be related to domestic qualified agricultural and horticultural activities. Finally, readers should be warned that regulations have not yet been written for section 199A and the March 13 proposal, which at the time of this writing had not been formally introduced and was just circulating in draft form. But that could change without notice. Now for some examples.
Type of Transaction | Section 199 | 199A — Current Law | 199A — Modification Proposed March 13 |
|---|---|---|---|
Sale to private/independent (non-cooperative) purchaser | [INDIVIDUAL-LEVEL CALCULATION] 9% of QPAI* (qualified net income at individual level) subject to 50% W-2 wage limitation at individual level and 9% of taxable income limitation at the individual level | [INDIVIDUAL-LEVEL CALCULATION] 20% of QPAI (qualified net income at individual level) subject to wage-property limitation (if individual taxable income exceeds statutory threshold) and subject to limitation equal to 20 percent of modified taxable income limitation | [INDIVIDUAL-LEVEL CALCULATION] 20% of QPAI (qualified net income at the individual level) subject to wage-property limitation (if individual taxable income exceeds statutory threshold) and subject to limitation equal to 20 percent of modified taxable income limitation |
Sale to agricultural cooperative (entity-level deduction passed through to seller) | [ENTITY-LEVEL CALCULATION] 9% of allocable share of distributed co-op QPAI calculated without deduction for qualified payments to patrons (co-op gross income). Co-op Section 199 deduction subject to co-op 50% W-2 wage limitation and limitation equal to 9% of co-op taxable income calculated without deduction for patronage dividends. No wage or income limitations at individual level on passed through deductions. | [INDIVIDUAL-LEVEL CALCULATION #1] 20% of qualified cooperative dividends subject to limitation equal to 100 percent of modified taxable income limitation | [ENTITY-LEVEL CALCULATION] 9% of allocable share of distributed co-op QPAI calculated without deduction for patronage dividends (co-op gross income). Co-op section 199A deduction subject to co-op 50% W-2 wage limitation and to 100% of individual income limitation; PLUS [INDIVIDUAL-LEVEL CALCULATION #1] 20% of QPAI (qualified net income at the individual level) subject to wage-property limitation (if individual taxable income exceeds statutory threshold) and subject to limitation equal to 20 percent of modified taxable income limitation; LESS [INDIVIDUAL-LEVEL CALCULATION #2] 9% of QPAI (qualified net income at individual level) subject to 50% W-2 wage limitation at individual level and 9% of taxable income limitation at the individual level |
* QPAI is qualified production activities income Sources: Section 199 [repealed]; reg. section 1.199-6; section 199A; statutory language of proposed modification to 199A released March 13, 2018; and “Modified Farmer and Cooperative Deductions Under New Section 199A,” released March 13, 2018. | |||
Example 1
Frank the farmer sells $500,000 of grain to an independent or private buyer. He has $400,000 of business costs of which $270,000 is W-2 wages. The original basis of his qualified depreciable property is $250,000. He has other (non-farm) net income of $15,000. Under current-law section 199A and the March 13 proposal, he’s entitled to a 20 percent deduction on net income from grain sales subject to a taxable income limitation. As shown in Table A-1, his net income from grain sales (qualified production activities income) is $100,000. His taxable income is $115,000. Because his taxable income is below threshold amounts, the wage limitation doesn’t apply. His taxable income limitation doesn’t apply either because his taxable income exceeds his QPAI. His section 199A deduction under current law and the March 13 proposal is $20,000.
Farmer’s grain sales | $500,000 |
|---|---|
Farmer’s W-2 wages paid | $130,000 |
Farmer’s other costs | $270,000 |
Farmer’s QPAI | $100,000 |
Other income | $40,000 |
Other deductions | $25,000 |
Taxable income | $115,000 |
Original basis of qualified depreciable property | $250,000 |
Deduction is lesser of the following two (because taxable income below threshold): | |
(1) 20% of QPAI | $20,000 |
(2) 20% of taxable income | $23,000 |
(3) Wage-property limit: The greater of: | |
(3a) 50 percent of W-2 wages | $65,000 |
(3b) 0.5 of (3a) and 2.5% property | $38,750 |
Section 199A deduction amount | $20,000 |
Example 2
Florence the farmer has all the same facts as Frank except that she sells $500,000 of grain to an agricultural cooperative under current-law section 199A. The section 199A deduction for Florence is 20 percent of qualified cooperative dividends, which is 20 percent of $500,000, or $100,000. Because her taxable income is $115,000, the taxable income limitation doesn’t apply.
Example 3
Florence the farmer makes $500,000 of grain sales to an agricultural cooperative, but this time it’s under the March 13 proposed modification to current-law section 199A. Her $500,000 sale of grain is 5 percent of the $10 million total sales by farmers to the cooperative, of which she is a patron. The cooperative has $3 million of costs of which $600,000 is W-2 wages. (Cooperative wages are 4.6 percent of sales by the cooperative.) The cooperative also has qualified depreciable property of $1 million. As shown Table A-3, under the proposed modification to 199A, her cooperative (as under prior-law section 199) multiplies QPAI by 9 percent, which would have yielded $900,000 of deductions for cooperative patrons except that the wage limitation of $300,000 (50 percent of $600,000 of wages paid by the cooperative) applies. Florence’s 5 percent share of that $300,000 is $15,000.
Farmer’s grain sales | $500,000 |
Farmer’s W-2 wages paid | $130,000 |
Farmer’s other costs | $270,000 |
Farm net income | $100,000 |
Other income | $40,000 |
Other deductions | $25,000 |
Taxable income | $115,000 |
Original basis of qualified depreciable property | $250,000 |
Deduction is lesser of the following two: | |
(1) 20% of qualified cooperative dividends | $100,000 |
(2) Taxable income | $115,000 |
Section 199A deduction amount | $100,000 |
But wait, there’s more. Under the proposed modification, Florence is also entitled to a benefit calculated at the individual level in two stages. The first stage is the same as Farmer Frank’s calculation shown in Example 1 (Table A-1), which yields an additional $20,000 of section 199A deduction. That amount is reduced by a second-stage individual-level calculation shown in Table A-4. It is a 9 percent calculation of an individual benefit as would be calculated under prior-law section 199. The wage limitation and taxable income limitations are not binding, so the amount is just 9 percent of QPAI or $9,000.
Cooperative grain sales | $13,000,000 |
Cooperative W-2 wages | $600,000 |
Cooperative other costs | $2,400,000 |
Patronage dividends | $10,000,000 |
Cooperative QPAI (no deduction for dividends) | $10,000,000 |
Cooperative deduction is the lesser of the following: | |
9% times QPAI | $900,000 |
50 percent of W-2 wages | $300,000 |
199A deduction amount | $850,000 |
Farmer’s share | 5% |
Grain sales to cooperative | $500,000 |
Section 199A deduction allocable to farmer | $15,000 |
Putting this all together for Farmer Florence, under the March 13 proposal, Florence’s total section 199 deduction is $15,000 plus $20,000 minus $9,000, which equals $26,000.
Farmer’s grain sales | $500,000 |
Farmer’s W-2 wages paid | $130,000 |
Farmer’s other costs | $270,000 |
Farmer’s QPAI | $100,000 |
Other income | $40,000 |
Other deductions | $25,000 |
Taxable income | $115,000 |
Deduction is least of the following three: | |
(1) 9% of QPAI | $9,000 |
(2) 9% of taxable income | $10,350 |
(3) 50 percent of W-2 wages | $65,000 |
Section 199 deduction amount | $9,000 |
Overview
By now if you’re a normal human, you’re lost in the weeds. Let’s take it back up to 10,000 feet. Panel B of Table 3 summarizes the results from the examples described above. Because the rules applied to non-cooperative sales don’t change, the deduction amount for that type of transaction remains at $20,000 under current law and under the proposal. There is, however, a significant reduction in the deduction for sales to a cooperative from $100,000 to $26,000. Thus, in this particular example, the proposal would seem to work as intended by reducing the disproportionate advantages of sales to cooperatives over sales to independent businesses.
But you can’t rely on a lone example because facts and circumstances facing individual farmers and individual cooperatives can easily vary in ways that significantly change potential tax benefits. For example, the wage limitation that applies to cooperatives can be a significant factor. According to Department of Agriculture data, in 2016 wages as a percentage of total cooperative sales varied by industry from 12.99 percent (cotton gins) to 1.27 percent (livestock). For grain and oilseed cooperatives, the average was 4.17 percent. The national average was 4.8 percent (Agricultural Cooperative Statistics 2016, Rural Development Service Report 80, Table 25). For the example in this article summarized in Panel B, wages paid by the cooperative were assumed to be 4.6 percent of sales. Panel A of Table 3 assumed that wages were equal to 8.5 percent of sales, the same percentage as the sole example in Reg.1.199-6. Some prominent experts have suggested percentages could be significantly lower. And so Panels C and D, respectively, assume wages equal to 2 and 1 percent of sales.
Type of Transaction | 199A — Current Law (2018-2025) | 199A — Modification Proposed March 13 |
|---|---|---|
A. Cooperative Wages Equal 8.5% of Sales | ||
(a) Non-co-op sale | $20,000 | $20,000 |
(b) Sale to co-op | $100,000 | $36,943 |
Co-op advantage [= (b) -(a)] | $80,000 | $16,943 |
B. Cooperative Wages Equal 4.6% of Sales | ||
(a) Non-co-op sale | $20,000 | $20,000 |
(b) Sale to co-op | $100,000 | $26,000 |
Co-op advantage [= (b) -(a)] | $80,000 | $6,000 |
C. Cooperative Wages Equal 2% of Sales | ||
(a) Non-co-op sale | $20,000 | $20,000 |
(b) Sale to co-op | $100,000 | $17,500 |
Co-op advantage [= (b) -(a)] | $80,000 | -$2,500 |
D. Cooperative Wages Equal 1% of Sales | ||
(a) Non-co-op sale | $20,000 | $20,000 |
(b) Sale to co-op | $100,000 | $14,250 |
Co-op advantage [= (b) -(a)] | $80,000 | -$5,750 |
Sources: Calculations for Panel B are described in text and detailed in appendix Tables A-1 through A-4. Spreadsheet with calculations for Panels A, C, and D (and calculating deduction for any changes in assumptions you may like to make) are available from martysullivan@comcast.net. Please use subject “Grain Glitch Spreadsheet.” | ||
Comparing the panels in Table 3, we see that as cooperative wages decline, so do benefits to sellers of cooperatives under the proposed modification. And it’s entirely possible for deductions for sales to independent businesses — if individual profitability is high and cooperative wages are low — for the modification to reverse the advantage in current law from favoring sales to cooperatives to favoring sales to independent business. Again, it must be stressed, the results and conclusion may differ significantly based on circumstances that vary widely across the agricultural community. (See footnote in Table 3 about obtaining a spreadsheet in which you may change assumptions.)
Competitive Balance?
It wasn’t long after the Christmas holiday that farm state senators realized their generosity to some constituents may have put other constituents out of business, and in response they proclaimed their commitment to promptly resolving that unintended consequence. Finally, on March 13 five Republican senators — Orrin G. Hatch of Utah, Chuck Grassley of Iowa, Pat Roberts of Kansas, John Thune of South Dakota, and John Hoeven of North Dakota — released a joint statement announcing they had an agreement that provided “fair tax treatment for all agricultural business.” On the same day House Ways and Means Committee Chair Kevin Brady, R-Texas, stated in a press release: “The solution reached today will restore the competitive balance that has long existed in the marketplace.”
It was not an easy task to get this far. Politically, negotiators have had to walk a tightrope. On the one hand, farmers who sell to cooperatives would like to keep potentially generous section 199A deductions. (See, for example, Mark Watne, “Don’t Get Rid of Tax Provision for Farmer-Owned Cooperatives,” AgWeek, Jan. 31, 2018.) On the other hand, private and independent purchasers that can range in size from small, family-owned grain elevators to Fortune 100 multinational corporations don’t want to be shut out. In a joint statement also released March 13, the National Council of Farmer Cooperatives (which realized the benefits gained for its members and their patrons were not politically sustainable) and the National Grain and Feed Association (whose members were at both ends of the uneven field created by section 199A) announced their support for the proposal. The technical tax drafting was almost as difficult as the politics. NGFA President and CEO Randy Gordon explained that “the stakeholder concepts on which this legislative language is based have been analyzed and reanalyzed in excruciating detail by tax experts representing both cooperative and private/business, as well as Congressional staff experts.”
One unspoken but fundamental difficulty with this whole episode is that the tax treatment of cooperatives and their patrons has been fundamentally flawed at least since enactment of section 199 in 2004. Because in many cases the new law magnified those economic inequities to politically intolerable levels, change is required. But this area of the law will always be a mess as long as sales to cooperatives are treated differently than other sales. In other words, neutrality should be the guiding principle.
Why should Florence the farmer who sells to co-ops receive different tax benefits than Frank the farmer selling to a private or independent company? For that matter, why should Florence the farmer netting $115,000 a year get a different tax advantage than Mike the mechanic, Ellen the engineer, or any other small business owner that nets $115,000 a year? Why should farmer tax benefits from section 199A depend so critically on wages paid by the cooperative to which they sell?
History helps us understand how we arrived in this awkward situation. Originally, farmers who sold their product for export to cooperatives received tax benefits under the domestic international sales company rules because they didn’t directly export. The cooperatives themselves that actually did the exporting couldn’t use tax benefits because they were tax exempt. The fix eventually evolved into a set of special rules for cooperatives, which provided generous benefits that could be passed through to their farmer patrons. (Prior analysis: Tax Notes, Jan. 15, 2018, p. 287.) But the whole premise for special rules for cooperatives — the need to support export sales — went out the window when section 199 was enacted as a benefit for all domestic production (irrespective of where the product was sold). For the sake of neutrality and simplicity, farmers selling to cooperatives should get the same treatment as farmers selling to other entities. But it would be political suicide for farm state legislators to take back even more than they are proposing now after they gave away so much in December.