Looking at new Code Section 199A
More questions than answers
August 2018 Footnote
Tell me if you've heard this before: Clarity is needed.
Passage of the Tax Cuts and Jobs Act in December brought with it a 20-percent deduction for qualified business income (QBI) under new Code Section 199A, replacing the old 9 percent Section 199 domestic production activities deduction (DPAD). Designed to provide pass-through entities with a deduction roughly corresponding to the reduction in the corporate tax rate, Section 199A is anything but a model of clarity.
What does Section 199A do?
Generally, Section 199A provides taxpayers with a 20-percent deduction for Schedule C and pass-through income. But, it's not quite that simple. The deduction is limited to the greater of 50 percent of the W-2 wages with respect to the trade or business, or the sum of 25 percent of the W-2 wages plus 2.5 percent of the unadjusted basis of depreciable property.
An exception is that no deduction is permitted with respect to the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees. What, exactly, is a "trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees?" Nobody knows. That phrase appears only one other place in the Code (Section 1202(e)(3)(A)) and has never been definitively interpreted in any regulation, ruling or case.
But fear not, there's an exception to the exception. Specified service businesses can generate the 20-percent deduction as long as the taxpayer's taxable income is below certain levels ($315,000 for joint-filers, $157,500 for others). In fact, for those taxpayers, the W-2 wage limit does not apply, either. If taxable income exceeds those amounts, the deduction is not eliminated entirely but is phased-out over the next $100,000 or $50,000 of taxable income (for joint filers and others, respectively).
But there's the exception to the exception to the exception. Even if the deduction survives the gauntlet of the limitations described above, it cannot exceed 20 percent of the excess of taxable income for the year over net capital gain. This limitation is supposed to ensure that the 20-percent deduction is not taken against income that is already taxed at preferential rates.
There's also an additional provision layered on top of -- but still subject to -- these exceptions (and the exception to the exceptions). In addition to the basic deduction, a separate deduction is allowed for 20 percent of qualified REIT dividends, publicly-traded partnership income and (prior to changes made by the Consolidated Appropriations Act in March) co-op patronage dividends. Thus, as originally enacted, a farmer who is a joint-filer with a taxable income less than $315,000 could take a deduction equal to 20 percent of net farm income less qualified co-op distributions (QCD) plus 20 percent of the QCD received (limited to the farmer's taxable income less net capital gains).
Then it gets complicated. QCD includes not only patronage dividends, but also per-unit retain allocations, the definition of which is somewhat nebulous under the Code. However, at least one IRS ruling treats grain and other commodity sales as unit-retains. Thus, it would appear that the separate deduction would have been allowed for commodity sales to co-ops but not for sales to other entities.
The 'grain glitch'
Because the deduction for co-op dividends under the original version of the law was more generous than the deduction for other business income, there would have been an incentive for farmers to sell their products to co-ops rather than to private or investor-owned companies. Minnesota, it should be noted, has the largest number of agricultural co-ops headquartered in any state, and has the largest share of production marketed by co-ops.
All of this gives rise to what has come to be known as the "grain glitch." The grain glitch arises because, under the old Section 199, the DPAD could be passed through by co-ops. The original version of the new Section 199A provided a bigger deduction to co-ops, but it was not directly passed on to patrons, while the patrons themselves received an enhanced QBI deduction.
But, alas, we needn't fret about the grain glitch because Congress "fixed" it in the Consolidated Appropriations Act signed into law in March. Instead of the 20-percent deduction calculated based on gross sales, now the co-op patron is subject to a new bifurcated calculation and a hybrid 199A deduction. The revised approach gives the co-op patron a deduction that essentially blends the new 199A deduction with the old 199 DPAD deduction. Farmers will now reduce their QBI deduction related to co-ops by the lesser of 9 percent or 50 percent of the W-2 wages allocable to them with respect to the co-op.
Agricultural and horticultural co-ops themselves are now permitted a deduction equal to the lesser of 9 percent of qualified production activities income or 50 percent of the W-2 wages paid by the co-op. The taxable income of the co-op is computed without regard to any deduction relating to patronage dividends, per-unit retain allocations, and nonpatronage distributions. The co-op can then pass some, all or none of this deduction through to the co-op patrons.
Some co-op patrons will benefit from this change, some will not. Most will want to have a bottle of aspirin handy when they go about figuring out their 2018 tax situation.
Milling through the process
The new and improved approach works like this: First, patrons calculate the 20 percent 199A QBI deduction that would apply if they had sold the commodity to a non-co-op. The patron then subtracts from that initial 199A deduction whichever of the following amounts is smaller: 9 percent of net income attributable to co-op sales or 50 percent of W-2 wages related to income from the co-op. If the patron does not pay W-2 wages to any employees, no reduction is required.
After this subtraction is applied, the patron gets to add an additional "DPAD-like" deduction (if any) passed through to them by the co-op pursuant to Code Section 199A(g)(2)(A). The determination of the amount of this new "DPAD-like" deduction will range from 0 to 9 percent of the co-op's QPAI attributable to that patron's sales.
The final amount passed through to the patron is at the discretion of the co-op. The overall amount a co-op can choose to pass through to its members cannot exceed 50 percent of the value of the wages the co-op pays to its employees. A farmer who operates a pass-through business and sells product to a co-op will not know the full value of their deduction until it is decided what share of the co-op's deduction will be retained or passed back to patrons. Special rules are provided for cooperatives with oil-related qualified production activities income.
Several other aspects of Code Section 199A remain unclear, among them the definition of QBI, the aggregation method for calculation of QBI, the deductible amount for a pass-through entity with business in net loss, qualification of wages paid by an employee leasing company, and the application of the rules to an owner of a fiscal year pass-through entity. Although the AICPA and others have requested immediate guidance from the IRS, regulations are not expected until the fall at the earliest.
Charles A. Borek practices law in Maryland and is CEO of The Borek Group, LLC, a CPE development firm.
CCH has answers
Still looking for resources covering qualified business income? CCH is your source for 199A laws, cases, news and more.
Related CPE programs
Tax Advisers Update
Jan. 4, 2019 | St. Paul | 8.0 CPE, 8 IRS CE, 6.5 CLE