The Tax Cuts and Jobs Act provides a new pass-through business deduction for noncorporate taxpayers, i.e., partnerships, S corporations and sole proprietors, including farming income reported on IRS Schedule F and Form 4835, Farm Rental Income and Expenses. The deduction, which is available for the 2018–2025 tax years, generally is equal to 20 percent of the domestic qualified business income (QBI) from each qualified business activity, subject to limitations. While this new 20 percent deduction is available to a wide range of businesses, this article focuses on the farm industry to highlight a difference created under the current statute between those who sell and market their commodities through a member cooperative and those who sell to other organizations.
The calculation of this new deduction includes specific treatment for qualified cooperative dividends (QCD), defined to include any patronage dividends received in cash, per-unit retain allocations (commodity sales to the cooperative) and any qualified written notices of allocation that are included in gross income during the tax year. For purposes of the calculation, the deduction is based on gross revenue for QCDs rather than on a net income basis, as is the case for other sources of qualified income.
While the provision outlining the calculation of this deduction is complex and we’ll likely need further guidance from the U.S. Department of the Treasury to interpret aspects of it, the pass-through business deduction calculation for farming businesses can be broken down into these three steps:
Determine the portion of the deduction attributable to income derived from sales to noncooperative entities. This portion of the deduction is equal to the lesser of A or B below:
- Twenty percent of the taxpayer’s combined QBI, i.e., the net amount of items of income, gain, deduction and loss with respect to each qualified trade or business. QBI doesn’t include investment income or reasonable compensation or guaranteed payments to owners. It also doesn’t include QCDs, which are considered in Step 2 below.
The amount calculated in this step may be limited for taxpayers with taxable income exceeding $157,500 and $315,000 for single and married filing jointly (MFJ), respectively. Once these thresholds are exceeded, the deduction is limited to the lesser of 20 percent of the combined QBI or the larger of 50 percent of the W-2 wages paid by the trade or business or 25 percent of the W-2 wages plus 2.5 percent of the unadjusted basis immediately after acquisition of all qualified property. The limitation phases in over the next $50,000 (single) and $100,000 (MFJ) of taxable income once the threshold amounts—indexed for inflation annually—are exceeded.
- Twenty percent of the excess of taxable income less QCDs over the sum of any net capital gain.
Calculate the portion of the deduction attributable to income derived from sales to member cooperatives. For this part of the deduction, the taxpayer takes the lesser of A or B below:
- Twenty percent of the aggregate amount of QCDs received for the taxable year
- Taxable income less any net capital gains
The pass-through business deduction equals the sum of the amounts calculated in Steps 1 and 2.
The following examples illustrate how the deduction amount differs based on the amount of QCDs received by the farmer.
A married taxpayer with a farming business has $300,000 of net farm income reported on Schedule F, no capital gains or other sources of income and $276,000 of taxable income before consideration of the new pass-through business deduction. To arrive at the $300,000 of net farm income, the taxpayer had $700,000 of per-unit retain allocations from a cooperative, for sale of grain to the cooperative, and $400,000 of farm-related expenses. Since the taxpayer is below $315,000 of taxable income, the limitation based on wages doesn’t apply.
Since the per-unit retain allocation meets the definition of a QCD for purposes of the calculation, subtract the $700,000 from the net farm income to arrive at a loss of $400,000 of QBI. The amount calculated for this step is limited to zero; note overall losses are treated as a loss for purposes of the calculation in subsequent years.
Take the lesser of $140,000 (20 percent times $700,000 QCDs) or $276,000 (net taxable income).
The total deduction is equal to $140,000 ($0 calculated in Step 1 plus $140,000 calculated in Step 2).
We have the same facts from Example 1, except the taxpayer only received $50,000 of per-unit retain allocation from a cooperative due to fewer grain sales to the cooperative and more sales to noncooperatives.
The taxpayer’s combined QBI is calculated as the lesser of $50,000 ($300,000 farm income minus $50,000 cooperative dividends times 20 percent) or $45,200 ($276,000 taxable income minus $50,000 cooperative dividends times 20 percent).
Take the lesser of $10,000 (20 percent times $50,000 cooperative dividends) or $276,000 (net taxable income).
The total deduction is equal to $55,200 ($45,200 calculated in Step 1 plus $10,000 calculated in Step 2).
The above examples demonstrate that this provision of the new tax law appears to create an advantage for farmers who sell grain to cooperatives instead of other organizations—member farmers who sell or market more of their commodities through a cooperative receive a larger pass-through business deduction. However, the senators sponsoring the provision have indicated this result wasn’t intended and expressed a desire to correct language in the current provision to remove this apparent disparity. As a result, the calculation of the pass-through deduction could change for farmers heading into the 2018 growing season, requiring additional analysis as new information is released.
The effect of this provision will vary based on the facts and circumstances for each taxpayer. Contact Adam or your trusted BKD advisor to determine the effect and any planning opportunities specific to your situation.