On March 23, 2018, President Trump signed the $1.3 trillion omnibus spending bill (also referred to as the Consolidated Appropriations Act, 2018), keeping the federal government open and appropriating funding through September. Among the highlights of the spending package are large appropriations for defense, infrastructure, fighting the opioid epidemic, as well as addressing gun control. However, buried deeper within the bill are tax provisions, including technical corrections intended to fix the so-called "grain glitch."

What is the Grain Glitch?

The Tax Cuts and Jobs Act (the “TCJA”), passed in December of 2017, represented a major overhaul of the U.S. Tax Code. A centerpiece of the TCJA was the new Section 199A, providing a deduction for income from specified flow-through businesses. The new Section 199A was broken down into two parts: a deduction for Qualified Business Income, and a deduction for Qualified Cooperative Dividends.

Qualified Business Income

The deduction for Qualified Business Income (“QBI”) provided (and still provides) that a taxpayer may deduct 20% of net income from certain flow-through entities (including partnerships and LLC’s taxed as partnerships), subject to various limitations, including a restriction applied based on the W-2 wages paid by the business and the basis of the business assets. Additionally, the QBI deduction is limited to 20% of the taxpayer’s taxable income for the year, meaning the QBI deduction can, at most, reduce taxable income by 20%.

Qualified Cooperative Dividends

In addition to the QBI deduction, the new Section 199A allowed a deduction of 20% of a taxpayer’s qualified cooperative dividends (“QCDs”) received from an exempt or nonexempt cooperative. The definition of QCD’s included patronage dividends as well as per-unit retains, often referred to as per-unit retains paid in money (“PURPIMs”). At the most basic level, PURPIMs are the payments by a cooperative to a member for its agricultural production. The inclusion of PURPRIMs as QCDs caused the so-called "grain glitch" in the new Section 199A.

By including PURPIMs as QCDs, a farmer is eligible to deduct 20% of those PURPIMs received from a cooperative during the tax year, on a gross basis, without first subtracting the farmer’s production costs. The deduction for these QCDs was not made subject to any wage or basis limitation, or to any limitation on the taxpayer’s total taxable income, meaning the farmer could potentially reduce taxable income down to zero.

The Grain Glitch Problem

The result of the different treatment of QBI and QCD deductions meant that a farmer selling to an independent, non-cooperative firm could deduct as QBI 20% of net income from operations. However, by selling to a cooperative, a farmer could deduct 20% of the gross amount of sales to the cooperative as QCDs.

For example, consider a farmer with $400,000 in gross sales of product, and $300,000 in expenses. If the farmer sold to a non-cooperative, the farmer’s deduction under Section 199A would be equal to 20% of the $100,000 net income -- $20,000. However, if the farmer sold to a cooperative, the farmer could deduct 20% of the $400,000 of gross sales, equaling a deduction of $80,000. In addition to the large difference in available deductions, the farmer selling to a cooperative would not be subject the limitations based on wages, and the farmer’s deduction would not be subject to the 20% cap based on the farmer’s taxable income.

This incentive to sell to a cooperative represented a significant consequence of the new Section 199A, and put non-cooperatives at a competitive disadvantage as farmers began learning of this new treatment. After the "grain glitch" became apparent to the public, Congress negotiated a fix which was included in the omnibus spending package.

How do the Technical Corrections Address the Grain Glitch, and What is the Impact Going Forward?

The overarching intent of the provisions in the omnibus spending bill addressing the so-called "grain glitch" was to restore the competitive landscape of the agricultural marketplace, placing cooperatives on more equal footing with other independent firms. After some horse-trading, Congress decided to address the so-called "grain glitch" by eliminating the QCD concept, and instead allowing farmers the 20% deduction based on net Qualified Business Income. In doing so, the deduction is now made subject to the various limitations imposed on QBI, including a limit to 50% of W-2 wages paid by the business (or alternatively 25% of such wages and 2.5% of the business’ qualified property), and also limited to 20% of the farmer’s taxable income, meaning the QBI deduction cannot reduce taxable income by more than 20%. Note that the QBI deduction phases out over certain income thresholds.

Domestic Production Activities Deduction

In addition to deleting the QCD provision, the bill restores the former Section 199 domestic production activities deduction (the “DPAD”) for cooperatives, allowing a deduction of 9% the qualified production activities (limited to 50% of the W-2 wages of the cooperative), generally passed through from the cooperative to the members. As a reminder, this deduction is calculated on a net basis, subtracting cost of goods and expenses from the gross receipts from production. To address the reinstatement of the 9% DPAD, which is generally passed through from a cooperative to the members, the bill reduces the QBI deduction by the lesser of (i) the 9% of the qualified business income from the cooperative, or (ii) 50% of W-2 wages of the cooperative. 

To summarize, a cooperative member’s total deduction after the technical corrections will equal the 9% DPAD as passed through by the cooperative, plus the 20% QBI deduction (modified as set forth in the preceding paragraph to avoid double-counting the 9% DPAD). Seemingly, Congress’ approach was intended to provide farmers with the same benefit of the QBI deduction as other taxpayers, but in doing so also reinstate the popular 9% DPAD.

Retroactivity and Eligibility

The changes to Section 199A are made retroactive to January 1, meaning farmers who sold to cooperatives in the first few months of 2018 prior to the technical correction will not be permitted to claim the QCD deduction based on gross sales. Additionally, as a reminder, C-corporations are not eligible for the deductions in Section 199A, and therefore may benefit from evaluating an ownership restructuring to seek the new deductions of Section 199A.