The Tax Cuts and Job Act of 2017 is the most dramatic change to the U.S. Tax Code since 1986. This wide-reaching, complex tax reform passed in such a hurry at the end of 2017 that many business owners, including farmers, are still trying to figure out what the law’s impact will be on their 2018 tax returns. Below are some of the key changes most likely to affect farmers:
Individual Income Taxes: Standard Deduction and Bracket Changes
The Tax Cuts and Jobs Act replaced the old individual brackets (10%, 15%, 25%, 28%, 33%, 35%, 39.6%) with a new set of brackets (10%, 12%, 22%, 24%, 32%, 35%, 37%). While most taxpayers see some reduction in overall tax rates, the biggest rate reductions accrue to taxpayers in the former 39.6% tax bracket (over $418,400 for single taxpayers and over $470,700 for married filing jointly).
The new tax law also eliminates the personal exemption and nearly doubles the standard deduction, to $12,000 for single taxpayers and $24,000 for married filing jointly taxpayers. The theory behind increasing the standard deduction is it should make tax filings simpler, as fewer taxpayers will benefit from itemizing.
Corporate Tax Rate Lowered…For Some
The change to the corporate tax rate was touted as one of the biggest selling points of the Tax Cuts and Jobs Act. Under prior tax law, the top corporate tax rate was 35%. The new law drops that rate down to 21%.
In practice, the new corporate tax rates only benefit medium-to-large corporations. Corporations with around $80,000 or less taxable income actually pay tax at a higher effective rate than under previous law. This is because the new 21% tax rate is a flat rate, whereas the old corporate tax regime had graduated rates. The top tax rate under the old tax law was in fact 35%, but that rate only applied to taxable income in excess of $10 million. Under the old law, the first $50,000 of corporate income was taxed at only 15%.
Many farming operations taxed as C-Corporations fall within this income range, and some even actively plan to achieve net income under $100,000 specifically to take advantage of the lower tax brackets.
Qualified Business Income Deduction
The drafters of the Tax Cuts and Jobs Act wanted to provide a benefit similar to the corporate tax rate reduction to businesses organized as sole proprietorships or “pass-through” entities, namely partnerships, S-Corporations and most LLCs. This couldn’t be accomplished by lowering a tax rate, because pass-through entities are not subject to income tax at the entity level. Instead, the income and deductions of the pass-through business are divided among the business’s owners and flow through to each owner’s individual tax return.
Thus, the Qualified Business Income Deduction was born. The Qualified Business Income Deduction is a completely new concept to the Tax Code. At its most basic level, the Qualified Business Income Deduction is a deduction equal to 20% of all “qualified business income” generated by a pass-through entity and flowing to an owner’s tax return.
However, as with many tax deductions, the devil is in the details. The definition of “qualified business income,” phase-outs and other restrictions make this section of the tax law extremely complicated. Also, unlike the corporate tax rate reduction, the Qualified Business Income Deduction will sunset in five years unless re-approved by Congress.
Qualified business income is especially complicated to calculate for farmers, due to how sales to co-ops are treated. This section has already been amended once, to fix a major drafting error in the original law. In the latest issue of DIRT Magazine, David Kim discusses this issue in more detail—New Section 199A Qualified Business Income Deduction for Farmers: Is COOP Still Worthwhile?
Section 179 allows taxpayers to expense most types of tangible personal property used in a business in the year it is purchased rather than depreciating it over time. This deduction is especially important to farmers, as grain bins and single-purpose agricultural or horticultural structures can take advantage of Section 179 as well. This includes buildings like hog or chicken facilities, milking parlors and commercial greenhouses.
Previously, a taxpayer could expense up to $500,000 in new and used machinery and other qualifying property, subject to a phase-out beginning for taxpayers who spent more than $2 million on Section 179 property in one year.
Under the new Section 179, a taxpayer can expense up to $1 million in qualifying property, and the phase-out begins for taxpayers who spend more than $2.5 million in qualifying purchases in one year.
Changes to bonus depreciation are even more significant than the changes to Section 179, and in some ways decrease Section 179’s importance at least through the end of 2022.
Bonus depreciation used to permit depreciating 50% of a qualifying asset’s cost in the first year in is put into service. This benefit was only available for new property with a depreciation recovery period of 20 years or less, plus certain improvements to non-residential real estate.
The Tax Cuts and Jobs Act increased bonus depreciation to 100% of the asset’s cost and expanded to include both new and used property. However, unlike Section 179, the changes to bonus depreciation will phase down 20% each year after 2022 and fully sunset at the end of 2027 if not renewed by Congress.
Tax-Free Exchanges of Personal Property Eliminated
Section 1031 of the Internal Revenue Code used to allow a taxpayer to trade or exchange property for property of “like kind” without paying capital gains tax on the transaction. The theory behind Section 1031 like-kind exchanges was it didn’t make sense to tax someone if they were going to put the “income” from the “sale” of a piece of property right back into other, similar property used in their business.
Under the previous Code, personal property exchanges were more restricted than real property exchanges. Tax-free personal property exchanges were still very common in agriculture when trading machinery.
The revised Section 1031 limits like-kind exchanges to real property. This means that the trade-in value of equipment will at least in theory be taxable gain—which makes the changes to Section 179 and bonus depreciation even more important.
State and Local Tax Deductions Limited
In previous years, taxpayers could deduct state and local taxes property taxes and either sales or income taxes in unlimited amounts on their Federal tax returns. Under the new tax law, the state and local tax deduction for income tax on wages, property tax on personal residences and similar non-business items is capped at $10,000.
State and local taxes directly related to a business activity are still deductible as business expenses, so farmers should still be able to deduct property tax on farmland, sales tax on farm machinery and vehicles, and other local and state taxes attributable to the farming operation.
Income Interest Deduction Limited
The Tax Cuts and Jobs Act limits most businesses’ ability to deduct interest as a business expense, but the limitation will seldom apply to farmers. Under the new law, the deduction for interest paid on business-related debt is capped at 100% of the taxpayer’s income from business interest, plus 30% of adjusted taxable income.
However, the limitation does not apply to any business, including farming businesses, that averaged less than $25 million in gross receipts over the previous three years.
Large farmers and cooperatives can also elect for the income interest limitations not to apply, if they also agree to use the alternative depreciation system to stretch out the depreciation recovery period for assets with a recovery period of 10 years or more.
Cash Accounting for Farmers Remains
Generally, businesses have to use either the cash method or accrual method when filing taxes. Under the cash method, income is considered received when the taxpayer receives payment; on the other hand, accrual method requires income to be recognized when the taxpayer first earns the income. Most farmers rely on the cash method of accounting as a part of their tax planning strategy, using prepaids and deferred payment contracts to manage when income and deductions are recognized.
Under the new law, any business that averaged less than $25 million in gross receipts over the previous three years can use the cash method. The Tax Cuts and Jobs Act also retained an existing exception permitting large farmers operating as partnerships or S-corporations to use the cash method.
This information is general in nature and should not be construed for tax or legal advice.