There continues to be some confusion on many of the details related to Section 199A (I know this is a shock to everyone :-) ). Here are some quick thoughts and answers on some of the confusing details:
Section 1245 Recapture
Starting this year farmers will not be able to trade-in farm equipment without recognizing gain on the sale of the tractor. Most if not all of this gain will be what we call Section 1245 depreciation recapture. For example, assume you buy a tractor for $300,000 and depreciate it down to zero. You then trade it in for a new tractor costing $400,000 with a trade value of $200,000. You now have a $200,000 Section 1245 gain (you are recapturing the depreciation you took on the tractor). If the trade value was $350,000, you would have Section 1245 recapture of $300,000 and Section 1231 gains of $50,000.
Now how does this gain get recognized in calculating the Section 199A 20% deduction. The Section 1245 gain is treated as business income similar to what would show up on a Schedule F. You will add the Schedule F income plus the Section 1245 gain and this is what you will calculate your deduction on. However, currently the IRS indicates you cannot treat the Section 1231 gains as qualified business income (QBI) if the gain is treated as capital gains. Only if it is ordinary income will you get the deduction. We are trying to get the IRS to change their opinion on this. We will have to wait and see.
As an example, let's assume the farmer nets $100,000 on his Schedule F and has a $200,000 gain from selling the tractor. QBI will be $300,000 and the tentative deduction is $60,000 ($300,000 times 20%).
As an added concern, we don't think many farmers currently understand how "ugly" their Form 1040 may look if they do a fair amount of equipment trades. In many cases, they may have a large amount of income on Form 4797 (related to gains on equipment trades), but a very large loss on Schedule F. For example, let's assume the farmer wants to show about $100,000 of net farm income. She has trade gains of $500,000 during the year. She now has to create $400,000 of Schedule F loss to net $100,000 of income. Note that the loss will mean the taxpayer will not be able to deduct any retirement plan contributions since she has no earned income. This may create a reason to have an farm equipment entity to "trap" gains and related depreciation to keep Schedule F income as a reasonable level for retirement plan contributions and social security planning purposes.
When Do I Worry About Wages?
We get many questions on this topic. If you are under the threshold ($157,500 and $315,000 (MFJ) of taxable income), then wages and qualified property does not matter assuming you have no sales to a cooperative. In this case, you simply add up all of your QBI and multiply by 20%. Your final deduction is the lesser of 20% of QBI or 20% of ordinary taxable income.
If you are over the threshold, then your deduction may be limited to 50% of wages.
Finally, if a farmer sells to a cooperative, then wages are always in the calculation. If income is under the threshold, then the deduction is equal to 20% of QBI minus the lesser of:
- 9% of QBI related to cooperative income, or
- 50% of wages related to cooperative income.
As an example, assume our farmer has $300,000 of QBI of which 75% is related to cooperative income and total wages are $50,000. Her deduction is $60,000 minus the lesser of:
- 9% of 75% of $300,000 or $20,250, or
- 50% of 75% of $50,000 or $18,750.
Final 199A deduction is $41,250. However, lets assume there are no wages. In this case, the deduction remains at $60,000 since 50% of zero is zero.
This may lead some farmers to consider reducing wages and doing more custom farming. However, is the net tax benefit worth the extra cost and hassle of doing custom farming or creating a new custom farming entity. Remember, if you are single, the maximum value of reducing wages to zero is $157,500 times 9% times 24% or about $3,400. If you are married, it would be twice this amount. That savings may not offset extra administrative costs or extra cost for custom farm expenses.
Now, if you are over the threshold, you have to have wages to get any deduction whether selling to a cooperative or not. So, in our example above, wages of $50,000 may limit the actual Section 199A deduction to only $25,000 and then you would reduce it by $18,750 to arrive at $6,250 final deduction. If you had no wages, you get no deduction (other than 2.5% of your qualified property).
Also, any DPAD that is received by the farmer from the cooperative is added to any of the numbers calculated above.