On June 18, 2019, the IRS released proposed regulations related to the 199A deduction allowed for certain specified agriculture and horticultural cooperatives (specified cooperatives) and their patrons. At 156 pages, it’s not a short read!
The “grain glitch” fix passed in March of 2018 had created gray areas that caused many ag producer tax returns to be extended. Now that we have some additional guidance, we have a better idea of the impact of the new tax law.
For additional background on the basic calculation of the 199A deduction for cooperatives and their patrons, please see my previous article: New Section 199A Deduction for Cooperatives and Their Patrons.
This new article will focus on the items in the proposed regulations that answer some of the major questions we had when the law was first passed.
What is a specified cooperative?
A specified cooperative is a cooperative that deals in: agricultural, horticultural, viticultural, dairy products, livestock and products thereof, products of poultry and bee raising, edible products of forestry, and all products raised or produced on farms and processed or manufactured products within the meaning of the Cooperative Marketing Act of 1926.
In addition, agricultural and horticultural products include fertilizer, diesel fuel and other supplies used in agriculture and horticulture industries, but only if the cooperative manufactures, produces, grows or extracts those products. In the case of a marketing or processing cooperative, the cooperative is deemed to manufacture, produce, grow or extract the products that the patrons supply to the cooperative. These specified cooperatives will have new reporting requirements going forward.
New cooperative reporting guidelines
The IRS has proposed all specified cooperatives must report to the patron all payments paid to the patron that will be considered qualified payments under 199A. Not all payments received from a cooperative are considered qualified for 199A, as some of these still fall under the old domestic production activities deduction (DPAD) at least for this first year, and potentially a year or two more if the cooperative uses pool accounting.
There are also payments a cooperative can make to patrons that are treated more like dividends received, comparable to those a shareholder receives from any other C Corporation. Some of the payments may also pertain to a specified service trade or business of the cooperative, and those payments will also need to be reported to the patron to properly calculate the 199A deduction.
This is good news for ag producers because it is hard for them to know which payments qualify from the specified cooperative. From a cooperative perspective, we are still unsure whether the form 1099-PATR will be modified to accommodate this new information that must be reported or whether the 1099-PATR needs to have an attachment explaining the different buckets of payments the patron received during the year. If I were going to bet, I would imagine the IRS will modify the Form 1099-PATR. We’ll have to see whether the IRS will have enough time to get a new form out by January 31, 2020, when the 2019 forms will be due to be mailed to patrons.
Once the patrons have all this information from the cooperative, they will need to calculate their individual 199A deduction.
The patron’s calculation
One of the biggest questions out there with this new deduction was how expenses and W-2 wages were going to be allocated between sales to a cooperative and other qualified receipts that are eligible for the 199A deduction. It’s quite common for producers to have both during the year.
If you are a producer that has taxable income under $157,500 ($315,000 for married filing joint), the IRS has provided a safe harbor method that allocates wages and other expenses as a ratio of cooperative sales to total sales and vice versa for sales and other income from other sources. The regulations provide the below example to further illustrate the safe harbor method:
P is a grain farmer that has $50,000 of qualified business income (QBI) related to his grain trade or business for 2019, which consists of $20,000 of qualified gross income received from a specified cooperative and $180,000 of gross income from sales to an independent grain elevator.
P’s total expenses for the year are $150,000 (including $50,000 of W-2 wages). P is eligible to use the safe harbor method for allocation expenses and wages. Using the safe harbor method to allocate his $150,000 of expenses, P allocates $15,000 (which includes $5,000 of W-2 wages) of the expenses to the qualified cooperative payments, or 10% of total expenses; 10% is the ratio of $20,000 of sales to a specified cooperative to total sales of $200,000.
What if you have taxable income above these thresholds? It is a little less clear for those taxpayers. The IRS proposes the taxpayer use any reasonable method to allocate these items.
The example given in the regulations for an appropriate method is to allocate expenses and W-2 wages based on the number of bushels, barrels, etc. sold to a cooperative versus the amount sold to other sources. This will put more of a tracking burden on producers, but it probably is the best method to use because it most closely reflects a good allocation of expenses. If there is another more reasonable method in the industry you are operating in, you will just need to have good facts and circumstances to justify the method you are using.
This wraps up the first part of the 199A calculation for patrons of specified cooperatives. Now let’s get into the second part calculated at the cooperative level.
The cooperative’s calculation of the 199A(g) deduction
The second deduction allowed to patrons (if passed out by the cooperative) is very similar to the old domestic production activities deduction (DPAD). The IRS has promised from the beginning this deduction will be very similar to previous DPAD law. The proposed regulations reference a lot of the regulations that were released when DPAD was originally enacted into the tax law for explanation of terms used for this deduction.
The deduction is equal to the 9% of qualified production activities income (QPAI) of a specified cooperative limited to the lesser of 50% of W-2 wages paid by or allocated to the cooperative or the cooperative’s taxable income before any deduction for patronage dividends. It does depend on the type of cooperative to determine how much of your income is considered qualified. If you are an exempt specified cooperative (cooperative organized under section 521), you can take the deduction on patronage sources and non-patronage sources. If you are a non-exempt specified cooperative, you can only take it on patronage source QPAI.
Once the cooperative computes the deduction, it has the choice to use the deduction itself or pass it out to its patrons based on the patron’s level of activity with the cooperative during the year. The cooperative has until the 15th day of the ninth month after the cooperative’s year end to provide written notice to the patron of the amount of 199A(g) deduction they will be eligible to claim.
It took a long time for the IRS to issue these proposed regulations, and there are still some clarifications and gaps to fill in. However, we are one step closer to understanding how the IRS wants patrons to calculate their 199A deduction. Hopefully the final regulations are passed quickly after the comment period.
This has been a very high-level overview of the main points of the proposed regulations. There are many other topics covered in the regulations that weren’t addressed, particularly from the cooperative’s point of view. For more information, please contact me at 715.858.6924 or email@example.com, or reach out to your Wipfli relationship executive.