Congress has amended Section 199A to correct an inadvertent benefit provided to certain taxpayers related to sales of product to agricultural and horticultural cooperative buyers, and to clarify that qualified business income excludes all capital gain income, not just capital gains derived from investments.
On Friday, March 23, 2018, the Consolidated Appropriations Act, 2018 (the “Act”) was signed into law. The Act contains a number of tax technical corrections, including several modifications to recently enacted Section 199A.
Of particular importance, the Act eliminates the so-called “grain glitch” that created an unintended benefit to agricultural and horticultural cooperatives. As originally enacted, Section 199A(g) provided that certain agricultural and horticultural cooperatives were entitled to a deduction equal to 20 percent of the excess gross income of a specified cooperative over qualified cooperative dividends, subject to a wage and capital limitation. Additionally, recipients of qualified cooperative dividends were generally entitled to a deduction equal to 20 percent of such dividends, similarly subject to a wage and capital limitation. Under amended Section 199A agricultural and horticultural cooperatives will be entitled to a deduction equal to nine percent of the lesser of “domestic production activities income” or the taxpayer’s taxable income for the year. The deduction is further limited to 50 percent of W-2 wages of the cooperative. The cooperative will then have the option of passing the deduction through to its patrons or retaining it for its own use.
Additionally, the Act eliminates the 20-percent deduction on qualified cooperative dividends received by a taxpayer other than a corporation. However, in lieu of a deduction on cooperative dividends, taxpayers will be entitled to a deduction equal to the lesser of 20 percent of net income recognized from agricultural and horticultural commodity sales or their overall taxable income, subject to a wage and capital limitation. The Act also expands the definition of certain items of income and gain excluded from the definition of qualified business income under Section 199A to exclude all items of capital gain whether or not from investment sources.
Discussion of Amended Section 199A
Deduction for Qualified Production Activities Income (Section 199A(g))
As originally enacted, the sale of agricultural and horticultural products to cooperatives created significant economic benefits as compared to sales to non-cooperatives. The original statute therefore created a competitive imbalance between cooperative and non-cooperative buyers. In order to level the playing field, Congress amended Section 199A(g) to provide that a specified agricultural or horticultural cooperative is entitled to a deduction equal to nine percent of the lesser of:
i. The “qualified production activities income” of the cooperative for the taxable year or
ii. The taxable income of the cooperative for the taxable year (calculated without regard to certain patronage dividends, per-unit retain allocations, and nonpatronage distributions).
The total deduction available to the specified cooperative is limited to 50 percent of the W-2 wages of the cooperative for the taxable year.
Further, the agricultural or horticultural cooperative will be able to either pass the deduction through to its patrons, or retain the deduction for its own use. As a result of this option, patrons will be unable to definitively calculate the amount of their total Section 199A deduction until notified by the cooperative. The cooperative is required to identify the portion of the deduction being passed through to the patron in a written notice mailed to the taxpayer.
For purposes of Section 199A(g), the term “qualified production activities income” is the excess of the taxpayer’s domestic production gross receipts over the sum of (1) the cost of goods sold that are allocable to such receipts and (2) other expenses, losses, or deductions which are properly allocable to such receipts. Treasury is directed to prescribe rules for the proper method of allocating these amounts.
Repeal of Deduction for Cooperative Dividends (Section 199A(a))
Amended Section 199A(a), provides that taxpayers other than a corporation will be entitled to a deduction for any taxable year an amount equal to the lesser of:
(1) The combined qualified business income amount of the taxpayer, or
(2) An amount equal to 20 percent of the excess (if any) of (A) the taxable income of the taxpayer for the taxable year, over (B) the net capital gain of the taxpayer for such taxable year.
Under Section 199A(b), the term “combined qualified business income (QBI) amount” is generally equal to the sum of (A) 20 percent of the taxpayer’s QBI with respect to each qualified trade or business plus (B) 20 percent of the aggregate amount of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income. As originally enacted, QBI included certain income generated from qualified trades or businesses but specifically excluded qualified cooperative dividends. The Act eliminates the exclusion of qualified cooperative dividends.
While the amendments to Section 199A are primarily intended to correct the grain glitch, elimination of the deduction for qualified cooperative dividends has more expansive implications. Recently, taxpayers have been considering the ability to elect to be taxed as a cooperative in order to claim the 20-percent deduction attributable to qualified cooperative dividends. In particular, businesses not otherwise eligible for the Section 199A deduction, e.g., corporations or pass-through entities operating a specified services trade or business, were considering this alternative. Now that qualified cooperative dividends are no longer eligible for the 20-percent Section 199A deduction this planning consideration appears to have been eliminated.
Exclusion of Certain Items from the Definition of QBI
Under Section 199A(c)(3)(B), as originally enacted, QBI excluded certain investment items of income, gain, deduction, or loss, including any item of short or long term capital gain or loss. Since the sale of assets used in an active trade or business are not of an investment nature, the originally enacted statute arguably would treat Section 1231 gains and capital gain from the sale of other business assets as QBI. Such treatment would make these gains eligible for the 20-percent Section 199A deduction. The Act removed the word “investment” from the statute. As amended, Section 199A(c)(3)(B) now provides that any item of short- or long-term capital gain or loss shall not be considered QBI. Unfortunately, this change to the statute doesn’t necessarily remove ambiguity around application of this QBI exception in the context of Section 1231 gains and losses or capital gain from the sale of business assets.
Amended Section 199A creates a more level playing field among agricultural and horticultural buyers regardless of taxation as a cooperative. The approach taken in amended Section 199A borrows heavily from former Section 199 and effectively resets the competitive landscape. While amended Section 199A should function as intended, it creates a new layer of complexity due to the introduction of several new terms, definitions, and calculations. As a result, additional guidance will be needed from Treasury to properly implement the new rules.
The elimination of the Section 199A deduction for cooperative dividends will likely prevent business conversions aimed at circumventing the “specified services” limitation applicable to items of qualified business income. While Section 199A as originally enacted appeared to allow for such planning opportunities, Congress has clarified its intent by eliminating this planning opportunity. However, by creating a 20-percent deduction to the sellers of agricultural and horticultural commodity products, e.g., farmers, Congress has preserved the intended benefit for these taxpayers.
As originally enacted, Section 199A excluded from the definition of qualified business income certain “investment” type items of income and gain including capital gains. Since the sale of an active trade or business doesn’t generate investment type gains and losses it wasn’t clear if section 1231 gains and other capital gains generated from the sale of active trade or business assets would be considered qualified business income. Amended Section 199A strikes the word “investment” from the relevant definition. Qualified business income now simply excludes all capital gains.