As year-end approaches, taxpayers and their advisers are in new territory. Last December, Congress passed the biggest set of changes to the tax law since 1986. Most of the changes from the Tax Cuts and Jobs Act have been in effect since the beginning of this year.
How all these changes will impact 2018 tax returns is still not entirely clear, but this month, we answer a few common questions as farmers turn from their fields to focus on tax and business planning.
I’ve heard there are a lot of tax changes in 2018, could you give me a quick synopsis of some of the biggest changes that apply to farmers? The changes would entail the following:
• Most individual income tax rates are lower through 2025, meaning most farmers will have their income taxed at a modestly lower rate. For example, in many cases, income that was taxed at a 28% rate is now taxed at a 24% rate, and the highest marginal tax rate has been reduced from 39.6% to 37%.
• The standard deduction has been almost doubled through 2025, meaning married producers can deduct $24,000 as a standard deduction, singles can deduct $12,000, and many fewer taxpayers will itemize deductions.
• Farmers with children will see the child tax credit double from $1,000 to $2,000 per qualifying child under 17, and a new $500 credit is available for dependents above 16 years old. Many more taxpayers will be eligible for the new child tax credit because the income phase-out threshold for the credit has been increased from $110,000 to $400,000 for married couples. These changes are in place through 2025.
• The 100% deduction for meals provided to employees for the convenience of the employer has been decreased to 50% through 2025. After that, the deduction is eliminated.
• Farmers may deduct (at federal level) 100% of the cost of new or used equipment using bonus depreciation through 2022. This applies to property placed in service after September 27, 2017. The federal Section 179 deduction has been increased to $1,000,000. Iowa does not recognize bonus depreciation, and the 2018 Section 179 limit in Iowa is $70,000 for individuals and $25,000 for corporations.
• New machinery purchased in 2018 is now depreciated over five years instead of seven years. Farmers will also use a faster 200% declining balance method of depreciation for new or used equipment purchased in 2018.
• The corporate tax rate has been permanently changed from a graduated rate quickly climbing to a top rate of 35% to a flat rate of 21%. Although most corporations will see lower tax rates in 2018, C corporations may see a tax increase if their taxable income is below $80,000.
• The 9% Domestic Production Activities Deduction (DPAD) was repealed, and a new 20% deduction has been created for pass-through business owners and sole proprietors through 2025. Some adjustments to this credit are made for sales by patrons to agricultural and horticultural cooperatives. These co-ops may also pass through a deduction to these business owners that is very similar to the old DPAD.
• Farm net operating losses can now be carried back only two years instead of five years, and these losses can only offset up to 80% of taxable income.
• Other key changes include a new excess business loss disallowance, increased availability of cash accounting, and limitations on business interest deductions with gross receipts of $25 million or more.
Tell me about the 9% deduction for income from domestic production? This was the Domestic Production Activities Deduction that was repealed beginning in 2018 by the new tax law. Congress decided DPAD was no longer needed in light of the new 20% deduction.
Could you provide a brief explanation of how the new 20% deduction may impact a farmer? Often called the 199A deduction or the QBI deduction, the new provision generally allows owners of a sole proprietorship or a pass-through business to take a 20% deduction against their “qualified business income,” with some limitations.
This means a farmer with net Schedule F income of $50,000 may be able to deduct $10,000 and pay tax on only $40,000 of that income. If taxable income is below $157,500 for single taxpayers or $315,000 for those who are married filing jointly, calculating the 20% deduction is straightforward, unless you have sales to a cooperative.
If your income is above those amounts, your deduction will depend on the amount of W-2 wages you pay and the unadjusted basis of the depreciable property you’re using in your business. If you pay no wages and have no depreciable property, you will have no deduction at all if your income reaches $207,500 if you’re single and $415,000 if you’re married filing jointly.
What if I am a patron of a cooperative? Last March, Congress made changes to avert some potential market distorting effects of the new tax law as it was originally passed. Because of these changes, patron farmers who market their commodities through cooperatives should be in roughly the same tax position as farmers who market their grain elsewhere. The 199A deduction, however, is calculated differently for income received from patron sales to a cooperative.
Generally, a patron who doesn’t pay W-2 wages to employees will calculate the 199A deduction like anyone else for the net income received from the sale of the commodity. In addition, the patron may receive a separate deduction passed through from the co-op similar to the old DPAD. In other words, such farmers have the potential of receiving more than a 20% deduction for their income from commodities marketed through co-ops.
Patrons who pay W-2 wages to employees have a different calculation. They first calculate the 199A deduction like everyone else but must then subtract from that amount, whichever is less: 50% of W-2 wages paid or 9% of their net income from the sale. This means some of these farmers will start with an 11% deduction.
But they may also receive a separate pass-through deduction from the co-op that is very similar to old DPAD. In other words, they may end up receiving about the same deduction as those farmers who market through a non-cooperative. And the cooperative pass-through deduction is limited only by 100% of taxable income, while the rest of the 199A deduction can’t exceed 20% of taxable income minus capital gain.
What about my rental income? Can I take the new 20% deduction against that income? One of the areas of greatest uncertainty with respect to the new tax law is how the 199A deduction will apply to rental income. IRS proposed regulations issued Aug. 8 did little to answer those questions. The proposed regulations state that the rental activity must be a “Section 162” trade or business to qualify. The problem is that the law does not give a clear definition of which rentals fall into that category. It’s clear that a farmer materially participating in a crop share farm lease would be eligible for the deduction. Most Conservation Reserve Program income should qualify as well.
The proposed regulations also allow the deduction for most self-rental income (rental income received from a commonly controlled entity). It is not clear, however, when or if a cash rent lease or a non-materially participating crop share lease will qualify for the deduction. With so many acres rented under such arrangements, this is a pressing question. We are hoping that final regulations will clarify these issues. We do not advise changes to farm leases to become eligible for this deduction until we receive final guidance.
This is a short summary of only some key provisions impacting agriculture in 2018. For more information, visit the CALT website. It’s very important that farmers meet with their tax advisers as soon as possible to discuss the impact of the new law on their business, including whether any restructuring may be beneficial.
Tidgren is an attorney and director of the Center for Ag Law and Taxation at ISU. Contact her at [email protected].