The 199A Deduction: A Look at the Qualified Cooperative Dividend
Update: On March 13, 2018, Senators Grassley, Hatch, Roberts, Thune, and Hoeven issued a joint statement, including the following:
After discovering an unintended consequence that created an inequity within the agricultural business community, we’ve worked extensively with stakeholders, our colleagues and the administration to develop a solution that will level the playing field and ensure the nation’s cooperatives, independent small businesses and publicly traded firms can fairly benefit from pro-growth tax reform. The stakeholder-driven agreement announced today achieves this goal and restores balanced competition within the marketplace. We’re committed to working with our colleagues to act swiftly on the measure and get it signed into law as soon as possible.
A description of the proposed fix is found here. It is expected that the fix will be included as part of the omnibus bill that will be voted on by March 23, 2018.
Update: On January 11, 2018, Bloomberg reported that Senators Thune and Hoeven, sponsors of the cooperative provisions discussed in this post, stated that the law, as written, had unintentional consequences. Senator Thune's office said that there was no intent to "unfairly tip the scales in favor of marketing to one type of business entity or another." Both Senators vowed to find a reasonable solution. Senator Thune told reporters in Washington on Thursday, "Right now in terms of the technical fixes, this is the one that probably needs to get fixed the most."
On January 12, 2018, USDA issued a press release with this statement, “The aim of the Tax Cuts and Jobs Act was to spur economic growth across the entire American economy, including in the agricultural sector. While the goal was to preserve benefits in Section 199A for cooperatives and their patrons, the unintended consequences of the current language disadvantage the independent operators in the same industry. The federal tax code should not pick winners and losers in the marketplace. We applaud Congress for acknowledging and moving to correct the disparity, and our expectation is that a solution is forthcoming. USDA stands ready to assist in any way necessary.”
The Tax Cuts and Jobs Act lowers the corporate income tax rate from a maximum rate of 35 percent to a flat rate of 21 percent. To ensure that other businesses weren’t left without a break, the Act also creates a new deduction, IRC § 199A, to apply to income earned from other business activities. The new deduction impacts millions of taxpayers, including those who operate a sole proprietorship, S corporation, or partnership and those who are members of a cooperative or have an interest in a real estate investment trust or a qualified publicly traded partnership. Despite its tremendous impact, § 199A is perhaps the most obscure provision in the new law. During the next several weeks we will address specific parts of this provision in separate posts.
Today, we will discuss an issue that has been flooding our mailboxes during the past week: the treatment of "qualified cooperative dividends," specifically how this new provision impacts farmers who market their commodities through a cooperative of which they are a member, as opposed to sell them to a non-cooperative buyer.
Without IRS guidance on this issue, it is impossible to know how these provisions will be interpreted. With that in mind, however, we’ll turn to the Code, doing our best to explain the new § 199A, as written.
To understand the issue, we must first understand, at a general level, how the new § 199A deduction works. Keep in mind that the deduction is full of nuance and complexity. We will no doubt receive hundreds of pages of IRS guidance on this new deduction alone.
But at its core, the § 199A deduction works like this (for purposes of the issues under discussion today):
(1) Subject to many limitations, taxpayers can generally take as a deduction, up to the amount of 20 percent of their taxable income (not including capital gain income), an amount equal to 20 percent of their “qualified business income.” (2) Additionally, taxpayers can generally deduct, up to the amount of their taxable income (not including capital gain income), an amount equal to 20 percent of their “qualified cooperative dividends.”
It is the difference between the two calculations and the limitations that apply to each respectively that draw our focus today.
Deduction for Qualified Business Income (Non-Cooperative or Non-Member Sale)
“Qualified business income” (QBI) is defined as “the net amount of qualified items of income, gain, deduction, and loss with respect to any qualified trade or business of the taxpayer. Such term shall not include any qualified REIT dividends, qualified cooperative dividends, or qualified publicly traded partnership income.” 199A(c). Nor does QBI include wages, reasonable compensation, guaranteed payments, interest income, dividend income, or capital gain. IRC § 199A(e)(4).
The deduction for QBI is calculated by first determining “combined qualified business income.” § 199A(a)(1). Section 199A(b)(1) generally instructs that “combined qualified business income”* is the LESSER of:
- 20 percent of the taxpayer’s QBI OR
- The LARGER of: [50 percent of W-2 wages for the trade or business OR the sum of (25 percent of W-2 wages PLUS 2.5 percent of the unadjusted basis immediately after acquisition of all qualified property]
The second bullet point can be called the “wages limitation.” There is an exception from the wages limitation for taxpayers whose taxable income (computed without regards to the new § 199A deduction) does not exceed $157,500 (single) or $315,000 (married filing jointly). Above that amount, the deduction phases out over the next $50,000/$100,000 of income. If the wages limitation does not apply, "combined qualified business income" simply equals 20 percent of the taxpayer’s QBI.
Once “combined qualified business income” is determined, that amount is then subject to a second limitation, one for taxable income. Pursuant to § 199A(a)(1), the taxpayer’s ultimate QBI deduction is limited to the LESSER of:
- Combined qualified business income (20 percent of QBI or wages limitation) OR
- 20 percent of (taxable income minus net capital gain minus qualified cooperative dividends)
So we will illustrate with an overly simple example: Let’s take a single farmer with net Schedule F income of $120,000 and no other income. Assume that the income comprises $300,000 in grain sales (to a non-cooperative) and $180,000 in expenses:
“Combined qualified business income” would be $24,000 (20 percent of $120,000) and the 199A deduction would be limited to the LESSER of $24,000 or [20 percent x (taxable income** = ($120,000 – $12,000 (standard deduction)) or $21,600], which is $21,600. (Note that the wages limitation does not apply because the farmer’s taxable income is below $157,500).
In this example, the farmer’s taxable income for the year (after applying the 199A deduction) would be $86,400.
Deduction for Qualified Cooperative Dividends (Cooperative Member Sale)
The calculation of the deduction for the qualified cooperative dividend is much more streamlined.
A “qualified cooperative dividend” is defined as “any patronage dividend (as defined in section 1388(a), any per-unit retain allocation (as defined in section 1388(f))***, and any qualified written notice of allocation (as defined in section 1388(c), or any similar amount received from a [pre-subchapter T organization].” IRC § 199A(e)(4). Thus, “qualified cooperative dividend” encompasses per-unit retains paid in money (PURPIM), as well as traditional patronage dividends. It does not include nonqualified allocations, which are not included in the member’s gross income.
IRC § 199A(a)(2) specifies that the taxpayer may take as a deduction the LESSER of:
- 20 percent of the aggregate amount of the qualified cooperative dividends of the taxpayer for the taxable year OR
- Taxable income minus net capital gain
That’s it. There is no wages limitation or other calculation. It thus appears that the farmer receiving a qualified cooperative dividend may deduct 20 percent of the amount of that dividend, limited only by taxable income minus net capital gain.
In other words, under this interpretation, if a member farmer receives $300,000 as a per-unit retain paid in money (PURPIM) from a cooperative for a sale of grain (reported in box 3 of 1099-PATR), that farmer could first calculate the tentative deduction by taking 20 percent of $300,000 for a sum of $60,000. The farmer would then compare that to taxable income (minus capital gain) for the year. If that was $108,000 ($120,000 net Schedule F income - $12,000 standard deduction), the farmer could take the full $60,000 deduction, meaning that final taxable income for the year would be $48,000.
It should be noted that the combined deductions for qualified business income and qualified cooperative dividends also cannot exceed taxable income minus net capital gain.
What does this mean?
A plain reading of the text of the new law would suggest that it provides a significantly larger § 199A deduction to some member farmers marketing their products through a cooperative than to farmers selling to a non-cooperative. But it is too early to tell if this interpretation will be implemented. Seemingly plain readings of the code are sometimes transformed by IRS regulation. It is also possible that Congress could "fix" this provision. Section 199A(f)(4) instructs the Secretary of the Treasury to prescribe regulations necessary to “carry out the purposes” of the law, including those “requiring or restricting the allocation of items” under the law. Significantly disparate treatment of similar activities may warrant administrative consideration of the “purposes” of the law.
As noted above, we’ve only touched on a very small corner of this difficult provision. It is hard to tell when and how the guidance will begin streaming in.
*We are not addressing REIT dividends or qualified publicly traded partnership income, which is also included in this section, yet calculated a bit differently.
**See §11011(b)(3) and 199A(e)(1).
*** IRC 1388(f) defines Per unit retain allocation as “any allocation, by an organization to which part I of this subchapter applies, to a patron with respect to products marketed for him, the amount of which is fixed without reference to the net earnings of the organization pursuant to an agreement between the organization and the patrons.”
The Center for Agricultural Law and Taxation does not provide legal advice. Any information provided on this website is not intended to be a substitute for legal services from a competent professional. The Center's work is supported by fee-based seminars and generous private gifts. Any opinions, findings, conclusions or recommendations expressed in the material contained on this website do not necessarily reflect the views of Iowa State University.