We know that current Tax Act will change and it may not even happen. However, I am going to show some examples of how self-employment (SE) tax will affect many farm situations. For purpose of these examples, I am ignoring the effect of an increase or decrease to the 1/2 SE deduction on page one of Form 1040. I am simply showing the net SE tax differences between current law and the proposed Tax Act as currently written.
Example - Schedule F Farmer
Ben is a schedule F farmer with $100,000 of normal farm income each year. Under current law, he pays about $15,300 of SE tax. Under the new law, he would only pay SE tax on a maximum of 70% of this income or $10,710. He would save about $4,600. Additionally, if he has purchased a fair amount of new equipment and has at least $1.2 million of "adjusted basis" in his farm assets, then none of his income would be subject to SE tax, thus saving $15,300 each year. This assumes that the deemed rate of return is at least 8% (Fixed 7% per code plus short-term AFR). We are not sure if adjusted basis includes regular depreciation (we assume it does). We know it does not include Section 179 or bonus depreciation. This means we will have another set of depreciation schedules to keep track of.
Example - Passive Investor in a Farm Operation
Let's assume that Ben is a limited partner in a farm partnership that generates the same $100,000 of net income. He is not actively involved in the operation. Under current law, none of the income is subject to SE tax. Under the new proposal, it is likely that Ben will owe $15,300 of SE tax (at least based on our and other interpretation of the Act). Additionally, there is some guidance that Ben would also face the Net Investment Income Tax on this income if he is over the threshold. In that case, he would owe an extra 3.8% or $3,800 (which he would owe under current law anyway). There is a current provision that states income subject to SE tax is not subject to the NIT tax. However, we have read that the writers of the Act purposely subjected this type income to both SE tax and the NIT tax. We shall see on this.
Example - Schedule F Farmer with Self-Rental
Let's assume that Ben is still a Schedule F farmer, but instead of reporting $100,000 of Schedule F income, he reports $30,000 and pays cash rent to an LLC owned by him and his wife of $70,000. Under current law, he pays about $4,500 on his Schedule F income but does not pay any SE tax on his cash rent income. Under the new Act, his SE income on his Schedule F is reduced to about $3,150; but he will owe about $10,500 on his cash rent income. This results in a net SE tax increase of about $9,150.
Example - Cash Rent or Crop Share Landlord
Let's assume Ben is a cash rent or crop share landlord earning a net of $100,000 per year. Under current law, none of this income is subject to SE tax. Under the new Tax Act, it appears that all of this income may be subject to SE tax or $15,300 of additional SE taxes.
Example - S Corporation Farmer
Let's assume Ben farms as an S corporation. He pays himself a salary of $30,000 per year and the S corporation has ordinary farm income of $70,000. Under current law, his net SE (payroll) tax is about $4,500. Under the new Act, we take the net S corporation income of $70,000, add back the salary paid of $30,000. This equals $100,000. 70% of this income is subject to SE tax less the $30,000 already paid to Ben. This results in additional SE tax of about $6,120 (($70,000-$$30,000)X15.3%).
Example - S Corporation Farmer with Commodity Wages
Let's assume the same example as the last one, but Ben pays himself a commodity wage. Under current law, no SE tax is owed. With the new Act, it is assumed these wages will be treated the same as in the Domestic Production Activities Deduction rules and will not be allowed as an offset against the 70% calculation. Therefore, Ben will owe SE (payroll) taxes on $70,000 of income or about $10,700.
Example - C Corporate Farmer
Same Facts as the S corporation. Under current law and proposed Tax Act, there would be no change to the SE (payroll) taxes owed. There is no separate calculation of the 70/30 on a C corporation. However, under current law, the corporation would pay a 15% tax rate on the first $50,000 of corporation income. Under the new Act, this increases to a flat 20% tax. Therefore on the first $50,000 of income, the corporation would owe an extra $2,500 of income tax. But on the net $20,000 of income, the corporation would owe 20% instead of 25% for a net reduction of $1,000. The net total increase in tax would be $1,500. Remember that if the corporation paid cash rent income to Ben or to LLC/Partnerships owned by Ben, this income would be subject to SE tax.
Example - C Corporation Farmer with Tax-Free Housing
Many of our C Corporation Farmers also provide a tax-free fringe benefit to their owners in the form of housing. 100% of this housing is deductible by the corporation and non-taxable to the owner. Under the proposed Act, this housing would continue to be deductible, however, all of the value of the housing would be additional compensation to the owners (we assume it would be included as compensation with a reduction in the housing costs). Let's assume that Ben's corporation provides a nice house with a value of $35,000. This would result in additional SE tax of about $5,400 plus he would owe additional personal income tax of about $8,750 (if in a 25% tax bracket).
I could provide many more examples, but I believe that these examples cover many of our farm operations. The bottom line is about the only winner in the new Tax Act is the Schedule F farmer who has never set up an entity for cash rent of their farmland. Almost every other farm situation will see a SE tax increase and it can be material.
We will keep you posted.