Top Five Ways Tax Reform Impacts Dairy Industry
We have just witnessed the most sweeping change in tax law since 1986. It is too early to make dramatic changes to your farm operation in response to the new tax code, but dairy producers should understand several changes that could affect their operations.
1. Section 199A
Under the new tax law, if a dairy farm sells all of its product to a non-cooperative, the farm will qualify for a tentative deduction equal to 20 percent of net farm income. This deduction may be limited if the farmer’s taxable income is more than $315,000 (married filing joint or $157,500 single). In that case, the limit will be the greater of:
- 50 percent of wages paid by the farmer, or
- 25 percent of wages paid plus 2.5 percent of the cost of certain fixed assets.
Once that number is determined, the final limit is 20 percent of the net of taxable income less capital gains (for example, cull cows that were raised and not purchased) and cooperative distributions.
The deduction for selling products to a cooperative is simpler. The deduction is the total payments received from the cooperative (including non-cash qualified patronage dividends) times 20 percent. The only limit is 100 percent (not 20 percent) of the net of taxable income minus capital gains. However, lawmakers are considering a revision of Section 199A which may affect a farmer’s deduction.
2. Capital gains
One of the potential limitations to the 199A deduction is that income is reduced by capital gains. This limitation may provide an obstacle for dairy farmers to reduce their taxable income. Under the old rules, the domestic production activities deduction (DPAD) could be used to offset gains from selling raised breeding stock.
Under the new rules, the Section 199A deduction cannot be used to offset these gains. One possible fix is to sell raised breeding stock before 24 months to a related entity. This creates ordinary income that Section 199A can offset.
For example, ABC dairy receives $10 million from its co-op. Its taxable income before the deduction is $1 million on Schedule F and $1 million of Section 1231 gains (the gain on selling cull cows). The gross Section 199A deduction is $2 million, but only the Schedule F $1 million income can be reduced. The dairy will owe tax on the $1 million Section 1231 gains. However, if the dairy sells all of its breeding stock before 24 months, then taxable income will be zero.
This part of Section 199A may substantially change in the near future, so the industry will be awaiting further guidance.
3. Loss carryforwards
Net operating losses (NOLs) incurred in years before and in 2017 are subject to a two-year carryback (five years for farm losses) limitation and are allowed a 20-year carryforward. For years starting in 2018 and after, there is no limitation on the amount of 2017 and earlier losses that can be used to offset income in a given year. Post-2017 NOL carryforward losses are limited to 80 percent of the succeeding taxable income. In addition, carrybacks are no longer allowed with a notable exception for farm losses. Farmers are allowed to carry losses back two years.
Separately, a net business loss incurred after 2017 is limited to $500,000 (married filing joint) or $250k (single). The excess loss is added to NOL carryovers.
4. Limit on interest expense
There is no limit on deducting interest if your gross receipts are less than $25 million (average computed on prior three years and includes related parties). Farming operations with receipts exceeding this test will only be able to deduct their interest expense limited to 30 percent of adjusted net income. This adjusted net income adds back interest, taxes, depreciation, and amortization until 2022. After that date, depreciation and amortization are not added back (i.e., adjusted net income will be earnings before interest). To avoid this limitation, the farm operation can elect to use a slower depreciation schedule when depreciating farm depreciable assets with a recovery life of 10 years or greater, but can’t claim bonus depreciation on those assets.
5. Entity selection
The new law changes the tax rate for C corporations to 21 percent. Depending on how you managed your taxable income over the years, this could either be a higher rate or lower rate than you have paid in the past. Before 2018, tax brackets increased as your taxable income went up. You could have been taxed at rates anywhere from 15 percent for taxable income less than $50,000, and up to 39 percent for income between $100,000 and $335,000. With the new rate, many farmers are asking if they should be a C corporation.
Several items will need to be considered in both the short and long term before making that decision:
- Do shareholders expect to take dividends out of the company?
- Are the owners’ living expenses being deducted by the corporation?
- How long do the current owners expect to own the corporation?
- What assets are owned inside the corporation?
- Will the entity generate income taxed as capital gain?
You should discuss all the possible ramifications of changing the tax structure with a tax professional who understands the advantages and disadvantages of the various tax structures.
How we can help
CLA’s agribusiness professionals will be monitoring developments on these topics as the IRS issues regulations to interpret the new code. Dairy producers should seek a qualified tax professional for guidance on how to limit tax exposure under the new law. The law provides opportunities that could be beneficial to many agribusinesses.