A key provision of the Tax Cuts and Jobs Act (TCJA) is the new 20 percent deduction for qualifying business income for pass-through entities. While this deduction is beneficial for pass-through entities, additional provisions for cooperative members are potentially more beneficial. The deduction generally is referred to as the pass-through entity deduction, but it also is available to farmers who file Schedule F.
As a rule, pass-through entities are entitled to a deduction for 20 percent of their qualifying business income. However, this deduction cannot exceed the greater of:
- 50 percent of W-2 wages paid by the business
- 25 percent of W-2 wages paid by the business plus 2.5 percent of the initial tax basis (not reduced by depreciation) of qualified property
In addition, pass-through entities may deduct 20 percent of qualified cooperative dividends, which are defined as patronage dividends, per-unit retain allocations, and qualified written notices of allocation. This 20 percent deduction is allowed without regard to the amount of wages or cost of property of the pass-through entity. As a result, pass-through entities that sell to cooperatives could have a significantly lower tax liability than entities that do not sell to cooperatives.
For illustration, assume a pass-through entity is a member of a cooperative. The pass-through sells all $50 million of its production to the cooperative, has $35 million cost of goods sold, and has $5 million of other deductions for a profit of $10 million. Because the 20 percent deduction for sales to cooperatives is not subject to the limitation on wages or cost of property, the pass-through entity potentially gets a tax deduction for up to 20 percent of its top-line sales revenue, which in many cases will result in no taxable income.
|Qualified business income||$0|
|20% deduction for qualified business income||$0|
|Qualified cooperative dividends||$50 million|
|20% deduction for qualified cooperative dividends||$(10 million)|
|Taxable income before pass-through entity deduction||$10 million|
|Pass-through entity deduction||$(10 million)|
Not Just Agricultural Cooperatives
The TCJA states that qualified cooperative dividends are those amounts received from organizations described in IRC Sections 501(c)(12) and 1381(a), which means the pass-through entity deduction for qualified cooperative dividends applies to all cooperatives, not just agricultural cooperatives. While articles about and assessments of the tax reform changes focus largely on the agricultural sector, the effects of the pass-through entity deduction could affect other industries.
What About Other Taxes?
Active participants in partnerships generally are subject to self-employment tax. While the pass-through entity deduction is available for income tax, it does not appear to reduce self-employment tax. Individual owners of pass-through entities that are not active participants in the trade or business generally are subject to the 3.8 percent tax on net investment income. Similar to the self-employment tax, the pass-through entity deduction is not available for the tax on net investment income.
Comparable businesses that do not sell through cooperatives generally get less benefit from the pass-through entity deduction. Congressional tax writers are aware of this difference and have proposed amendments in an attempt to equalize the tax benefit. Those proposals so far have not brought about consensus for a specific remedy. It remains to be seen what the ultimate remedy will be.