We continue to get several comments and questions regarding Section 199A. This post is simply a collection of our responses for the most recent ones. Before starting with our comments, I would like to point out in our last blog that the two year rule applies for selling raised breeding stock that is cattle or horses. If you sell other raised breeding stock, then you only need to hold it for one year for Section 1231 capital gains rates to apply. Now for our comments.
"How will the land owner who receives a crop share rent be affected when he sells that grain to a cooperative?"
Under the old law, a crop share landlord was entitled to their share of the DPAD from the cooperative. Under new Section 199A, the crop share landlord should also receive a similar Section 199A "DPAD" from the cooperative. Whether the crop share landlord will also receive the other Section 199A 11-20% net deduction will need further guidance from the IRS. The Code refers to a trade or business. Based on many Private Letter Rulings, etc. we believe that a crop share landlord should rise to the level of at least a trade and thus should receive the 11-20% Section 199A deduction. But this may also mean that the landlord receives no net deduction since their taxable income may be too high. Here is an example:
Walter, an unmarried crop share landlord, has taxable income of $300,000 which is all from his crop share. He receives a DPAD from his cooperative of $5,000. He would qualify for gross 20% deduction of $60,000 on his crop share income, however, since his taxable income is over the fully phased-in threshold of $207,500 ($157,500 plus $50,000) and he has no wages paid or qualified property, he nets none of this deduction. His taxable income becomes $295,000. If Walter was married, he would be entitled to the full $60,000 deduction plus the $5,000 dropping his taxable income to $235,000.
"Please opine on the rational for the wage penalty. It makes zero sense to me based on old Sec 199, when paying wages increased a farmer’s DPAD."
The perception is that there is a penalty for farmers who sell to a cooperative that have wages as compared to the old Section 199. However, the reality is that under old Section 199, any of the net farm income related to the portion received from a cooperative did not qualify for the DPAD deduction. So it did not matter if the farmer had wages or not. Under the new Section 199A, the answer is of course "It Depends". Farmers who are under the threshold amount will be "penalized" by a reduction in their net Section 199A deduction as their wages increase. However, at a minimum they will still receive 11% of net farm income (under the old 199 rules they received zero on cooperative net income) plus the DPAD that flows through from a cooperative. So based on old versus new, they are at least 11% of net farm income better off than they were under the old 199 rules. Now we know that many farmers and their tax preparers took both a 9% DPAD deduction plus the cooperative DPAD on this same income, but that was not the actual rule. Now, if you are farmer who exceeds the threshold, you are much better off having wages since if you don't have wages, you get no Section 199A deduction anyway (unless you have a high amount of Qualified Property). An example is as follows:
Patty, a married farmer, has net farm income of $300,000 from selling to a cooperative. She pays no wages. Under the new Section 199A rules, she is entitled to a deduction of $60,000 plus a $5,000 DPAD from the cooperative for a net deduction of $65,000. Now let's assume she is not married. In this case, she is now over the threshold and receives no $60,000 deduction. She is only entitled to the $5,000 from the DPAD. Now, let's assume she pays out $50,000 of wages. If she is married, this drops her deduction of $35,000 (`,000 minus 50% of wages) plus the $5,000 DPAD. If she is single, this drops her deduction to only the $5,000 DPAD since she does not have enough wages. Her normal limitation is 50% of wages which is $12,500 which is the maximum deduction she would have selling to a either cooperative or a private plus we now have to reduce it by the lessor of 9% of net farm income or 50% of wages which brings it to zero. Selling to a private would net her a $12,500 deduction while selling to a cooperative only nets her a $5,000 deduction.
One item that may provide some relief to our farmers is that the limitation also provides for 2.5% of qualified property limitation which most farmers will have a fair amount of. However, for purposes of these examples, I am leaving that out to show comparability.
Therefore, what are some of the strategies that a farmer may want to use to maximize their deduction. Here are a few (however, guidance from the IRS is required before implementing many of these):
- If you are under the threshold and sell to a cooperative, minimizing cash wages is the way to go. Perhaps paying commodity wages (if employees understand this) or hiring custom work may make some sense. However, if you are under the threshold amount, the total amount of deduction will likely be fairly minor and you are in a very low tax bracket. Making major changes to your farm operation to maximize this deduction will likely not make much economic sense. Remember to not let the tax tail wag the economic dog.
- If you are over the threshold amount, maximizing your qualified property to create that 2.5% limit may be the key. As that grows, it allows you to reduce your wages paid to allow for the maximum deduction.
- If you are in a farm operation that requires a large amount of wages to process your crop such as a dairy, orchard, sugar, etc. then joining or creating cooperative will likely provide you the largest net Section 199A deduction. You will need to review this with your tax advisor to determine how much savings.
- If the IRS does not allow farmers to group their farm operation with their farmland real estate, then we may need to restructure the farm into one "tax" entity. We need IRS guidance on this.
- If you sell to both a cooperative and a private, you may be able to pro-rate labor to each of these operations. If the economic structure is appropriate, you may be able to optimize this allocation. But this cannot be arbitrary.
As we receive guidance from the IRS, we can give more concrete details on planning opportunities, but there are some of the ones that should hold up.