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Tax law may prompt look at farm structures

Some farmers who have kept their income low could actually see a tax increase because of the new law.

Despite a common misconception that seems to be repeated at cocktail parties and environmental activist meetings all over the country, most American farms are not controlled by giant corporations.

And, while the reverse of that is true, the underlying situation may have implications for growers and their tax advisors, according to Kristine Tidgren, an attorney and director of the Center for Agricultural Law and Taxation at Iowa State University.

“We have a number of C corporations out there in the agricultural world, and one of the largest changes made by the Tax Cuts and Jobs Act of 2017 was to permanently lower the maximum corporate tax rate from 35 percent to 21 percent,” said Tidgren, speaker for a University of Arkansas Systems Division of Agriculture webinar (https://bit.ly/2yDBHPV).

“But, again, this particular change only applies to C corporations. And, overwhelmingly, most of our agricultural businesses are not C corporations, although we do have some. And to those that we do have, I want to point out this was not a rate cut for everybody.”

Tidgren, who received her Juris Doctorate degree from the University of Texas, said some farmers who have kept their income low could actually see a tax increase because of the new law. That’s because the old tax law, even though the top rate was 35 percent, provided a graduated tax rate structure.

“If your income was below $50,000, you were only taxed at a rate of 15 percent. The new law says that from zero up, it’s 21 percent. So, if you’re in that situation where you have a C corporation, and your income is typically below, let’s say $80,000, it’s really important for you to assess with your tax advisor if there may be another option for you.”

Converting to S Corporation

That could be converting to an S Corporation, although such a conversion doesn’t come without tax ramifications of its own, she says.

“One thing about conversion to an S Corporation, we often worry about the ‘big’ tax, the built-in capital gains tax, because we have a look back period under the federal system of five years. After you’ve converted from a C to an S corporation, during that five-year period, if you sell property that has built-in gains, you have to pay tax on that.”

In 2017, that was at the then highest corporate tax rate of 35 percent. “In 2018, what we called the big tax back isn’t quite so big anymore because it’s 21 percent,” she noted. “It’s the top corporate tax rate. So again, just something to consider, things to talk through with your tax advisors.”

As noted at the beginning of this article, most agricultural producers are not operated as C corporations. Most are partnerships, sole proprietorships, S corporations or some other business structure.

“Perhaps you have an S corporation. So, you have an LLC but most LLCs are taxed as partnerships,” she said. “If you’re in a pass-through structure, the lowering of the corporate tax rate doesn’t help you at all, right?”

Since the majority of businesses in the U.S. are not corporations, congressional leaders had to try to figure out how to help those constituents; that is, business owners taxed on individual tax returns.

Different income situations

“They all have different income situations,” Tidgren said. “You can’t just give them a simple new rate. What they came up with was a deduction that you’ve likely heard of — the Section 199A deduction. It is designed to allow you to take a 20 percent deduction against your taxable income for the business income that you generate.

“It applies to what we call qualified business income, and that is income you receive in the business from your LLC, if you’re taxed as a partnership, your S Corporation, if you get it from your partnership or a sole proprietorship.”

Basically, the new 199A deduction is intended to lower the effective tax rate for pass-through businesses. For an individual in the highest tax bracket of 37 percent, the 20 percent deduction would mean that qualified business income would effectively be taxed at a 29.6 percent rate.

Unlike the change in the corporate tax rate, which is permanent until Congress changes it, the new 199A deduction is scheduled to expire or “sunset” in 2026. “We kind of joke that just as soon as we sort of get it all figured out, it’s scheduled to go away,” says Tidgren.

Any explanation of the new QBI deduction has to start with it only applies to qualified business income. That is defined as the net amount of income gain, deduction and loss with respect to any qualified trade or business.

“Qualified trade or business has meaning, and it has a pretty significant meaning,” she said. “It doesn’t include wages; so, you don’t get to take this deduction against money that you earn as an employee. You don’t get to take it for reasonable compensation as a S corporation shareholder or for the guaranteed payments you get as a partner in a partnership.

Significant exclusion

“It doesn’t apply to interest income, annuity income, dividend income or capital gains. And it also doesn’t include any Section 1231 gain or loss that’s taxed using capital gains rates. So, that’s a pretty significant exclusion. The other significant thing that has a lot of uncertainty is the fact that the income has to be earned in a trade or business.”

The problem is that tax specialists don’t have a really good definition of that. “Where we have the most uncertainty with respect to whether something is a trade or business is with respect to rental income right,” says Tidgren. “So, if I own property and I rent it out to somebody, is that a trade or business, or is that a personal investment? If it’s considered just an investment, then I don’t get the 199A deduction. If it’s considered a trade or business, I get the deduction against my rental income.”

In August, the IRS said it would use the IRC Section 162 definition of what is a trade or business. That left tax specialists “reeling” because there is no concrete definition of what a 162 trade or business is. “By definition courts make these determinations on a case-by-case basis after a highly factual inquiry,” she said.

The IRS did help in one area and that is with self-rentals — you own an agricultural business and you rent your property to your agricultural business that is “commonly controlled,” meaning 50 percent or more of the owners are the same. In that case, you will get to take the Section 199 deduction.

“That is a really helpful bit of clarity because in the agricultural context a lot of times we’re dealing with parents, grandparents and children renting property to the farming operation, and all of those people, parents, grandparents, children are considered to be the same person in that context,” she said.

“So that’s one area the IRS provided clarity. Where they didn’t provide clarity was with rentals to unrelated parties. I cash rent my farm ground. Is that a trade or business? If I crop share my farm ground, maybe, maybe not? Again, the key definition we have from the Supreme Court is to be engaged in a trade or business the taxpayer has to be involved in the activity with continuity and regularity. A sporadic activity, a hobby, an amusement or diversion will not qualify.”

For more information on the University of Arkansas Food and Agribusiness Webinars, go to https://bit.ly/2E2BEla.

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