For those taxpayers and farmers who are over the threshold amount ($157,500 for singles and $315,000 for married couples), the amount of W2 wages paid by each company becomes very important. We have posted on this numerous times, but the general rule is once you are fully over the threshold, your Section 199A deduction is limited to 50% of W2 wages paid or 25% of wages paid plus 2.5% of qualified property.
But what wages count? The IRS concurrently with the release of proposed regulations also released Notice 2018-64 and the answer is spelled out there. The taxpayer can elect one of three methods to compute wages (this is based on W2 wages for the calendar year):
- Method #1 - You report the lessor of Box 1 wages (taxable wages) or Box 5 wages (Medicare wages). Since children wages are included in Box 1, but not Box 5, most farmers will not want to elect this method if they pay wages to their children. Commodity wages are not included in Box 5, so those wages will not count either.
- Method #2 - You will report wages in Box 1, subtract any wages not subject to income withholding and then add any employee deferrals to pension plans such as a 401k deferral. This allows a farmer to deduct kid wages that have no FICA tax owed since they are reported in Box 1 and are subject to withholding. Again, grain wages do not qualify since they are not subject to income tax withholding.
- Method #3 - You will trace all of your wages based on whether they qualify for the deduction or not. This will be the most difficult method.
Most farmers will choose Method #2 since it allows them to include kid wages and any employee deferrals. This will usually result in the maximum amount of W2 wages for farm operations.
Let's look where kid wages or wages to a spouse may help the farmer increase their Section 199A deduction.
Farmer Eric and his wife Beth operate as a Schedule F which generates about $100,000 of net income each year. They rent ground from their LLC which generates $500,000 of net rental income each year. Currently, Eric pays no wages to any person. They have elected to aggregate the farm and LLC together as one business. Their tentative Section 199A deduction is $120,000 (($100,000 $500,000) X 20%). However, since the farm has paid no wages, the deduction is limited to zero (we are assuming no qualified property).
Now lets assume that Eric pays his two sons wages of $20,000 each or $40,000 total for all of the summer work and help with spring planting. This reduces the tentative 199A deduction by $8,000 but the overall limit allowed is only $20,000 ($40,000 X 50%). By paying $40,000 of wages to his kids, he reduces his taxable income by (1) $40,000 for wages paid to kids, by (2) $20,000 of Section 199A deduction and (3) increases it by 1/2 of the reduction in Self-Employment tax paid of $3,000. Since he is in a 27% tax bracket, the net income tax savings is about $21,000 plus $6,000 of self-employment tax savings. The kids will owe about $1,600 of tax on their wages (the first $12,000 are tax free).
Since Eric is under the wage base amount, he can pay a wage to his spouse and the net effect on their self-employment/payroll tax will be the same. In this case, he elects to pay his wife $60,000 of wages. This brings qualified business income down to $500,000 which creates a tentative 199A deduction of $100,000. His old limit with the kids was $20,000. It is now increased to $50,000 (50% of $100,000 of total wages paid to kids and spouse). This reduces their tax by another $11,100.
Simply by paying his family $100,000 of wages, Eric and Beth are able to reduce their overall tax burden by about $38,000. Now this assumes the children and spouse have provided value of at least that amount to the farm operation (we all know that Beth is worth at least that much).
The ability to pay wages to family members and the ability to aggregate businesses with W2 wages with rental entities with no wages is a great benefit allowed under the new proposed regulations. We will provide additional planning in other posts to come.
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