Good News and Bad News For Dairies
Most dairy operations market their milk through cooperatives. Under current rules, a cooperative is able to pass out a Domestic Production Activities Deduction (DPAD) to the dairy which can be substantial. There is no limit on the type of income that this deduction can offset other than it cannot create a net operating loss for the taxpayer.
The Media references this as the Section 199 deduction and the new Tax Act creates a new Section 199A 20% business deduction. The old Section 199 deduction was based on 9% of net business income and will be eliminated. Although the new Section 199A deduction does not replace it, the Media tends to call this the new replacement.
Most dairies have two sources of farm income. The first source of income is net income or loss from producing and selling milk. The second source of income is from selling their cows, usually after three or four years. These cows are usually born on the farm and have no tax cost basis and if they are at least two years old when sold, the gain from selling the cow will be treated as long-term capital gains (in most cases). Dairy farmers typically report little or no profit from producing and selling milk, but will have a fairly large amount of gain from selling their cows. Once the DPAD is passed through from the coop to the dairy, most dairy farmers will end up owing little or no tax. Let’s look at an example:
A dairy produces and sells about $13 million of milk, sells $1 million of cows and receives a DPAD from the coop of $900,000. On the tax return, the farmer reports zero income on his Schedule F, a net long-term capital gain of $1 million and DPAD deduction of $900,000. This reduces his adjusted gross income to $100,000 and after deducting their itemized deductions and personal exemptions, the married couple reports total taxable income of $75,000. Since this is all net long-term capital gains, the couple owes no federal income tax.
The new Section 199A deduction can no longer be passed through from the coop to the farmer. However, the farmer is allowed to take his/her sale of milk to the coop and multiply these sales by 20% to arrive at their new business deduction. Now, this looks like a good deal to the dairy farmer. In our example above, the dairy has sales of $13 million. 20% of $13 million is $2.6 million. This is a much larger deduction than the old $900,000 DPAD. However, the new law has a limit on the deduction. The old Section 199 deduction was limited to taxable income of the taxpayer before the DPAD. The new limit is taxable income of the taxpayer before the Section 199A deduction less net long-term capital gains. Let’s see how this will affect our farmer:
The farmer still has $13 million of sales and sells $1 million of cows. His taxable income limitation is $975,000 (the old $75,000 of taxable income plus the $900,000 DPAD). $975,000 minus $1 million of cow sales equals a negative $25,000. The farmer will get no Section 199A deduction and will owe tax on $975,000 of long-term capital gains or roughly $175,000 of tax. Under current law, the farmer owed no tax. Under the new law, he owes $175,000 even though his “deduction” went from $900,000 to $2,600,000.
The bottom line is that a farmer will be able to generate additional Schedule F income and will have it much of it offset by the new Section 199A deduction, but will not be able to eliminate tax on the sale of cows. Let’s take a look at one last example.
The same dairy now generates Schedule F income of $750,000 and cow sales of a $1 million. The new Section 199A deduction will still be $2.6 million, but the new limit will be $1,725,000 (the old 975,000 limit plus $750,000 of Schedule F income) minus the cow sales of $1 million for a net allowed deduction of $725,000. The dairy has wiped out most of the income from his Schedule F, however, this income is now subject to self-employment tax and the dairy still owes capital gains tax on the cow sales resulting in net tax owed of over $200,000.
As you can see, this can be a very complicated calculation and when the media says this is a wonderful deduction for certain taxpayers, you always have to say “It Depends”
Paul Neiffer is a certified public accountant and business advisor specializing in income taxation, accounting services, and succession planning for farmers and agribusiness processors. Paul is a principal with CliftonLarsonAllen in Walla Walla, Washington, as well as a regular speaker at national conferences and contributor at agweb.com. Raised on a farm in central Washington, he has been immersed in the ag industry his entire life, including the last 30 years professionally. Paul and his wife purchase an 180 acre ranch in 2016 and enjoy keeping it full of animals.
Reclassify the cows as 1231 assets.