The Tax Cuts and Jobs Act of 2017 includes several benefits for small businesses, including farmers. The new law provides an opportunity for most farmers to increase some deductions and to have income taxed at generally lower rates. However, as a result of hastily drafted language added in the final stages of the tax legislation, there was a controversial provision that had benefited farmers who sell products to cooperatives.
The Tax Cuts and Jobs Act includes the following changes that should benefit most farmers:
Lower personal income tax rates
– Beginning in 2018, the top income tax rate was reduced from 39.6 percent to 37 percent, and most tax brackets were broadened to allow more income to be taxed at lower rates.
100 percent bonus depreciation
– Assets acquired and placed in service after Sept. 27, 2017, and before Jan. 1, 2023, are eligible for 100 percent bonus depreciation. In addition, used property now qualifies for bonus depreciation. It is important to note that Pennsylvania tax law currently does not allow bonus depreciation. For individuals and pass-through entities, bonus depreciation assets are supposed to be depreciated in a straight line over the regular depreciable life of the assets. Based on a notification from the Pennsylvania Department of Revenue, there would be no Pennsylvania tax depreciation on bonus depreciation assets for regular corporations. Cost recovery will only occur when an asset is disposed. There currently is proposed legislation to fix this problem in the Pennsylvania General Assembly.
Enhanced Section 179 deductions
– Beginning in 2018, the maximum allowable Section 179 deduction has been increased to $1 million, up from the 2017 inflation-adjusted amount of $510,000.
In addition, the phaseout threshold for the deduction has been increased to $2.5 million from the 2017 inflation-adjusted amount of $2,030,000. For Pennsylvania individual and pass-through business purposes, the allowable Section 179 deduction is only $25,000 and the phaseout threshold is $200,000.
Qualified business income deduction for individuals and pass-through entities
– Beginning in 2018, qualified businesses operated by individuals and pass-through entities, such as S corporations and partnerships/LLCs, may be able to claim a tax deduction that is generally equal to 20 percent of the net income from that qualified business, limited to 20 percent of taxable income for the year. This general rule is modified for individuals with taxable income over these threshold amounts – $315,000 for joint returns and $157,500 for all others – and there are further restrictions on specific service-type businesses, such as doctors, attorneys, accountants, and consultants.
For individuals above the taxable income thresholds, the qualified business income deduction is limited to the lesser of 20 percent of the net income from the qualified business or the greater of 50 percent of W-2 wages with respect to the qualified business or the sum of 25 percent of W-2 wages with respect to the qualified business plus 2.5 percent of the unadjusted basis of all qualified property (generally the cost basis of fixed assets).
The overall deduction cannot exceed taxable income less net capital gains for the year.
For a farmer with annual taxable income below the taxable income thresholds, this new rule could result in a tax deduction equal to 20 percent of net farm income. Assuming the 20 percent amount is not further limited by net taxable income (after net capital gains), this could be a decent benefit for many farmers.
The benefit is potentially less favorable for farmers with taxable income above the threshold amounts, especially for a family farm that pays little or no W-2 wages and may not have significant qualified property. Here are a few examples.
– Farmer A is married and has net farm income on Schedule F of $300,000 and taxable income of $250,000. This is a family farm with zero W-2 wages, and there are qualified assets of $1 million. Since taxable income is below the taxable income threshold of $315,000, the wage limits do not apply. Therefore, the deduction is 20 percent of net farm income, or $60,000 ($300,000 x 0.20), limited to 20 percent of taxable income or $50,000 ($250,000 x 0.20). The allowable deduction is $50,000.
– Same facts as Example 1, except taxable income is $420,000. Since the taxable income is above the taxable income threshold amount, the wage limits apply as follows: The deduction is the lesser of 20 percent of net farm income ($60,000) or the greater of 50 percent of W-2 wages (0) or 25 percent of W-2 wages plus 2.5 percent of qualified property (0 + $25,000 [2.5 percent of $1 million]). The deduction is limited to $25,000.
Repeal of former Section 199 deduction
– Another important provision in the Tax Cuts and Jobs Act is the repeal of old Section 199 – the domestic production activity deduction (DPAD). This provision provided a deduction of 9 percent of net income from qualified production activities, including farming. A new Section 199A is not really related to, or limited to, production activities, but rather is intended to give sole proprietors and owners in pass-through entities a similar effective income tax rate reduction as the new law provided for corporations. Therefore, it is confusing and somewhat unfortunate that Congress did not establish a different code section number for the new qualified business income deduction (QBID).
The old DPAD amount was limited to 50 percent of W-2 wages and could not reduce taxable income below zero. The 50 percent wage limit was across the board, with no relief for taxable incomes below a threshold amount.
Since new Section 199A is a 20 percent deduction that is not subject to a wage limitation for taxable incomes below the threshold amounts, it appears that in most situations Section 199A will be more beneficial to most farmers than the former Section 199.
The Cooperative Controversy
In the final Senate version of the Tax Cuts and Jobs Act prior to the Conference Committee session to finalize the bill, three senators – John Hoeven (R-N.D.), John Thune (R-S.D.), and Pat Roberts (R-Kan.) – added special language to Section 199A that specifically benefits farmers who are patrons of cooperatives and sell their products to the cooperative.
This special provision provides that a patron of a cooperative can calculate the QBID as 20 percent of qualified cooperative dividends received from the cooperative, limited to the patrons overall taxable income reduced by net capital gains. This provision is not affected by the wage limitations for taxable income over the threshold amounts.
The controversy stems from the definition of qualified cooperative dividends, which is sufficiently broad to include all payments the patron receives from the cooperative. Therefore, unlike farmers who are not cooperative patrons and calculate their deduction as 20 percent of net farm income, farmers who are cooperative patrons get to calculate their QBID as 20 percent of gross income.
As a result, many cooperative patrons may be able to reduce their taxable farm income to zero.
For example, assume the same facts as Example 1 above, but that the farmer is a cooperative patron and has $3 million of qualified cooperative dividends. For purposes of calculating the basic general deduction of 20 percent on net farm income, the farmer would reduce the farm income by the amount of qualified cooperative dividends. Therefore, the QBID is equal to the sum of:
- The lesser of qualified business income – 20 percent of farm income of $300,000 less $3 million of qualified cooperative dividends (zero), or 20 percent of taxable income (less net capital gains and qualified cooperative dividends) – 20 percent of $250,000 of taxable income reduced by $3 million of qualified cooperative dividends (zero)
- Plus the lesser of 20 percent of qualified cooperative dividends – 20 percent of $3 million ($600,000), or taxable income reduced by net capital gains ($250,000)
The farmer can deduct $250,000 and reduce taxable income to zero.
This beneficial result for farmers who are cooperative patrons compared with farmers who are not members of a cooperative created an uproar in the agricultural community. There has been considerable coverage, including by The Wall Street Journal
, and the Tax Foundation.
Almost everyone, including Sens. Hoeven, Thune, and Roberts, agrees there needed to be a correction. There was speculation that a fix was to be included in a recent continuing resolution to keep the government funded.
As a result of the considerable media coverage and significant lobbying efforts by agricultural trade groups, Section 199A has been modified. The Consolidated Appropriations Act passed on March 23, 2018, included provisions to eliminate the special benefit for farmers who are members of a cooperative. The law was changed to allow cooperatives to calculate, and elect to pass through to members, a DPAD amount the same as under prior IRC Section 199. While this may still be somewhat beneficial to members of cooperatives, it generally retains the same rules for cooperatives as under prior law and does remove the apparently unintended significant benefit to cooperative members.
Barry D. Groebel, CPA, is a tax partner at Herbein + Company Inc. in Reading. He can be reached at firstname.lastname@example.org or on Twitter @bdgroebel.
Bryanna L. Fredericks, CPA, is a manager at Herbein + Company. She can be reached at email@example.com.