We continue to get questions regarding how to handle sales to a cooperative and the 20% Section 199A deduction. In theory, the total deduction is rather easy. You take your regular Section 199A deduction and then have a Plus and a Minus. However, the execution of the theory can get a little complex. When the proposed regulations were issued, the IRS stated that the regulations on the cooperative part of the deduction would come later in the year (likely December 29, 2018 if I had a guess). However, the Code is fairly specific in how to calculate the deduction.
You start with your normal calculation of the 20% Section 199A deduction and then:
- Subtract the lesser of:
- 9% of QBI (Qualified Business Income) related to income generated by the cooperative sales (not total income), or
- 50% of wages associated with QBI from cooperative sales (again, not 50% of total wages, but only wages related to the cooperative sales).
This ends up being your Section 199A(a) deduction (what I call the normal deduction). You then take this final number and add to it 20% of the PTP or REIT income (not many farmers have this income). This final deduction is then compared to 20% of ordinary income and the lessor of these two numbers ends up being your normal Section 199A deduction.
Then you compare your taxable income after subtracting the normal Section 199A deduction to the DPAD that flows through from the cooperative (if any). The lesser of these two numbers (typically the DPAD) is called the Section 199A(g) deduction (we simply call this the DPAD) and that it is added to the normal Section 199A deduction to finally arrive at the total Section 199A deduction.
Here is an example of how this all flows and is calculated:
Pat, a Schedule F farmers sells 40% of his corn to the local ethanol plant and 60% of the crop to a cooperative. His net QBI income from farming is $245,000. He pays a hired man $40,000 in wages for the year and for purposes of this example we are assuming no qualified property.
Section 199A(a) Deduction:
The Section 199A(a) deduction is simply $245,000 times 20% or $49,000 (we are assuming taxable income is under the threshold). The reduction for cooperative sales is the lesser of:
- 9% times $245,000 times 60% or $13,230, or
- 50% of wages times 60% or $12,000.
Therefore, we reduce the Section 199A(a) deduction by $12,000 to arrive the normal Section 199A deduction of $37,000. His ordinary taxable income is $200,000 which times 20% is $40,000, so the $37,000 deduction is allowed in full. Note that if there was no reduction for the cooperative sales, the net Section 199A deduction would be reduced from $49,000 to $40,000 due to the ordinary income limitation.
Section 199A(g) Deduction:
The cooperative passed through to Pat a DPAD of $12,750. This number is then limited to 100% of all taxable income minus the Section 199A(a) deduction calculated above. That number is $163,000 ($200,000 minus $37,000), therefore, the $12,750 DPAD is allowed in full.
Total Section 199A Deduction:
The $37,000 Section 199A(a) deduction is then added to the $12,750 Section 199A(g) deduction to arrive at the final Section 199A deduction of $49,750.
Now how does this compare to not having cooperative sales. The calculated amount of the original deduction was $49,000, however, it was limited to $40,000 due to the ordinary taxable income limitation. Therefore, Pat did receive a greater deduction by selling to the cooperative. However, let's assume the cooperative did not pass out any DPAD. In this case, Pat's deduction would be limited to $37,000 which is less. This limit applies even though the cooperative did not pass out any DPAD. You still have to reduce the Section 199A(a) deduction by the lesser of 9% of QBI related to the cooperative sales or 50% of wages paid on cooperative sales.
If Pat had paid no wages, then he would have qualified for the maximum deduction of $52,750. The $40,000 Section 199A(a) deduction would not be reduced since 50% of zero wages is still zero. Therefore, for farmers under the threshold who sell primarily to a cooperative, they do not want to pay any cash wages. They can pay commodity wages which will not reduce the deduction. Only wages subject to withholding will reduce the Section 199A deduction.
Now if Pat had been over the income threshold, then wages are very important. If no wages are paid, then no Section 199A(a) deduction is allowed. In this case, Pat's deduction would simply be the $12,750 DPAD from the cooperative.
As you can see, for most grain farmers, there is no simple rule of thumb indicating whether it is better from a tax standpoint to sell to a cooperative or to a private. That was the intent of the grain glitch fix and as you can see, it likely succeeded. However, farmers who sell to a processing cooperative (such as rice, sugar beets, dairy, fruits and vegetables) likely would see a much greater deduction selling to a cooperative since their DPAD may be substantially higher. In Pat's example, the DPAD from a processing cooperative could easily be five to ten times higher than from a grain marketing cooperative.