On Wednesday, August 8, 2018, the IRS issued proposed regulations on the new Section 199A rules. This new guidance helps clarify many of the gray areas that arose from the Tax Cuts and Jobs Act (TCJA). But what exactly do the proposed regulations entail, and if implemented, how would they affect ag producers? First, let’s start from the beginning and explain some of the most important terms used in the Internal Revenue Code.
An Overview: Clarifications and Definitions of Key Terms
Qualifying as a “Trade or Business”
The proposed regulations define the term, “trade or business,” as one that is defined under Code Section 162. This is bad news for cash rent landlords and possibly crop-share landlords, since they generally do not meet this criterion and won’t be able to take advantage of the 199A rules. The only way a landlord could qualify as a trade or business is if they are willing to provide enough management and/or services in a crop-share agreement that would subject their income to self-employment tax. However, there may be a way around this definition with aggregation rules, which we will address later.
Qualified Business Income
Now that we have defined what the IRS means by trade or business, let’s look at the term, “Qualified Business Income” (QBI). We already know that capital gains were excluded from QBI, but what about other gains on the sale of property? The proposed regulations state that Section 1231 gains and losses are excluded from QBI, to the extent they are included in the computation of capital gains and losses. If 1231 gains are recaptured as ordinary income, however, they will be included in QBI. This could be problematic for dairy farmers and others who sell raised livestock that are held for 24 months or more. But there is good news, too — according to the new guidance, it appears Section 1245 gains/losses, ordinary gains/losses and Section 1250 gains/losses (to the extent they are treated as ordinary) will be included in QBI.
It is also clear that the IRS will allow individuals to take the 199A deduction on fiscal-year pass-through income. For instance, if you own an interest in a farm partnership with a tax year ending September 30, 2018, you will be allowed to utilize the 20% deduction on your 2018 tax return assuming you don’t have any other limitations. For the purposes of 199A, the IRS will assume that you earned all income from the partnership on the last day of its tax year. There was some speculation that taxpayers wouldn’t be able to take advantage of the 199A deduction on a fiscal-year farm partnership’s income until 2019.
What Are the Aggregation Rules?
Under the new guidance, owners can aggregate related businesses for the purposes of Section 199A. Aggregation means that multiple trades or businesses can be treated as one for the calculation of the deduction, rather than on an entity-by-entity basis. The aggregated businesses would be able to use another business’s W-2 wages and unadjusted bases of qualified property when computing the 20% deduction limitation.
Initially, when Congress passed the TCJA, it appeared that farm owners who structured their businesses in two separate entities — one owning the real estate, and the other owning the farm operations entity — would benefit from restructuring. This clarification means that restructuring will not be necessary for most owners. As long as the aggregation rule is applicable, it can be made on an annual basis.
To be considered related businesses, owners must meet these qualifications:
- The same person or group of persons, directly or indirectly, must own 50% or more of each of the businesses. The businesses must meet the control test the majority of the tax year.
- The businesses must share the same tax year.
- None of the businesses can be considered a “specified service trade or business.”
- The businesses that are intended to be aggregated must satisfy two of the following three items:
- The businesses must be in similar lines of business or provide items that customarily go together.
- The businesses must share facilities or other centralized business elements (e.g., employees, information technology, etc.).
- The businesses must be interdependent upon one or more of the businesses in the aggregated group (i.e., one business sells product to another).
Many of our agriculture clients have some type of service revenue every year; the IRS has carved out a taxpayer-friendly definition for businesses that have this situation. If the business has less than $25 million in average gross receipts, the service revenue can be ignored if it is less than 10% of the business’s overall income for the year. If the business has more than $25 million in average revenue, the percentage drops to 5%.
It’s a Bit More Complicated for Non-Qualifiers
If an aggregation election is not made or the group of businesses owned by a taxpayer doesn’t qualify for aggregation, calculating the deduction will be a little more complicated. The 20% deduction is calculated on a business-by-business basis if every member of the group has income in the current year. If one business has a loss but the taxpayer has QBI overall, the loss is allocated against the income of the other businesses on a pro-rata basis.
Let’s consider an example — John Smith owns three partnership interests, and the income/loss that is passed through is as follows:
- John’s share of Partnership A income is $100,000.
- John’s share of Partnership B income is $100,000.
- John’s share of Partnership C loss is $100,000.
Half of the loss that is passed through from Partnership C will be allocated to Partnership A’s QBI with the other half allocated to Partnership B’s QBI. This could have a major impact on a taxpayer’s 199A deduction, and it emphasizes the importance of making an aggregation election when possible.
For an overview of the basic calculation for the 199A deduction, check out Partner Curt Barnekoff’s article, Section 199A Deduction: A Summary and Update. Curt’s article focuses on the calculation of the 20% deduction against taxable income.
The Treatment of Carryforward/Carryover Losses
There’s another pro-taxpayer item that came out of the proposed regulations for the new Section 199A deduction: Any loss incurred before January 1, 2018, will not offset QBI generated after January 1, 2018, in terms of computing the 20% deduction. This also includes passive losses, basis and at-risk carryovers that were generated prior to January 1, 2018.
However, if a taxpayer generates negative QBI in 2018, that negative is carried over, similar to a net operating loss, to offset future QBI. Net operating losses generated from sources other than QBI amounts do not affect how QBI is computed.
Below, we’ve provided a couple of examples demonstrating how these rules actually work. (For simplicity, we haven’t accounted for any W-2 or unadjusted basis of qualified property limitations.)
John Smith, a Schedule F farmer, has a net operating loss of $100,000 carrying into the 2018 tax year, in which his Schedule F reports $200,000 of income. John’s QBI for purposes of computing the 20% deduction is calculated as $40,000, assuming he has enough ordinary taxable income from other sources.
Assume John had a $50,000 loss on his Schedule F in 2018. Then, in 2019, John shows $75,000 of income; his QBI is $25,000 for 2019 and his deduction equals $5,000. The carryover of $50,000 from 2018 to 2019 will happen regardless of whether John has a net operating loss in 2018. Keep in mind that these rules can become complicated if you throw multiple businesses into the mix.
Now that we have guidance from the IRS on one of the biggest pieces of the TCJA, you should start to plan for and execute certain strategies that can help you maximize the Section 199A deduction. This article only covers certain topics that were clarified in the proposed regulations — so if you would like additional details on the potential changes or need help evaluating how they apply to your unique situation, contact your Wipfli relationship executive or email me at firstname.lastname@example.org.