Originally published on Forbes.com.
The most entertaining fallout from the Tax Cuts and Jobs Act has to be what Scott Greenberg of the Tax Foundation refers to as the “Grain Glitch.” He insists that the grain glitch needs to be fixed:
…the “grain glitch” is a major issue that should be fixed. If left in place, the deduction would allow some farmers to effectively become tax-exempt. It could also create major distortions in the agriculture industry, favoring cooperatives over other companies. Most worryingly, it could create a major new hole in the U.S. tax system, allowing a wide range of households and businesses to shield their income from taxes through the use of cooperatives.
It’s A Feature Not A Bug
A sentiment similar to Mr. Greenberg’s seemed to be universal among those who know about the matter. But not anymore. Gary Wertish, President of the Minnesota Farmers Union seems to think that the 199A deduction for patronage dividends is a feature, not a bug, And it is a feature that he and his 14,000 members kind of like.
And even though the National Farmers Union seems content to let the National Council of Farmer Cooperatives negotiate a workout of the glitch with the National Grain and Feed Association, other state farmers unions may also be going with the Minnesota view. They figure that Cargill and the like have gotten a huge tax rate cut, so a big benefit going to farmers who sell to cooperatives is fine. Here is just a little bit of background.
Birth Of A Glitch
In the huge rush to “fix our broken” Tax Code, which is way too complicated, Congress, while simplifying things for lots of people by eliminating many of their itemized deductions, made taxation of business income quite a bit more complicated. As corporate tax rates were drastically cut, there was a view that something had to also be done for people who paid no corporate income tax but still made a lot of money without doing any work themselves. The House tailored a special rate for them, but in something of a reversal of early history the Senate finds itself slightly more accountable to people rather than property, so the Senate engineered a 20% deduction that helps just about everybody who had trade or business income (other than employment income).
There are limits for people with taxable income over $157,500 ($315,000 for joint returns). If the businesses don’t have ample W-2 wages paid or depreciable assets, the deduction will be scaled back. And if they are engaged in a number of fields including health law and accounting, the deduction is phased out over $50,000 above the threshold ($100,000 for joint returns).
The 20% qualified business income deduction (Section 199A) replaced the 9% domestic production deduction (Section 199). Plain old Section 199 was more restrictive only applying to businesses that were making, extracting or growing stuff in the United States and also having a W-2 requirement with no depreciable asset alternative.
Old Section 199 did have one thing that was not included in the version of TCJA that first passed the Senate. That would be a special rule for agricultural and horticultural cooperatives. Cooperatives are allowed to deduct the qualified dividends that they pay to their patrons. Often that means that the cooperative will have no taxable income, which would make the Section 199 deduction pointless. The special rule (Section 199(d)(3)) allowed the cooperatives to pass the deduction through to their patrons.
It appears that having an effect like that special rule was the intent of the little tweak that added to the qualified business income deduction -“20% of the aggregate amount of qualified cooperative dividends of the taxpayer”. Credit for the tweak went to Senators Hoeven and Thune.
Whoa Nelly
The implications of that little tweak are vast. It seems that the only people who recognized how significant it was were those with amber waves of grain in their backyard. The effect of the provision is to give farmers who sell to cooperatives a deduction of 20% of their gross income. Everybody else is getting 20% of their net income subject to the various restrictions. The immediate cause for concern is that the provision puts grain buying concerns that are not cooperatives at a severe disadvantage. The is why it is called the “grain glitch” and there is work being done to fix it.
The Fix May Be In Or Not
I spoke with Zach Clark, Director of Government Relations at the National Farmers Union. He indicates that the view at the national level is that the generous 20% of gross is an “unintended consequence”, but recognizes why the state organizations might feel enthusiastic about maintaining it. Justin Darisse VP of Communications at National Council of Farmer Cooperatives told me that the technical types of NCFC are meeting with their counterparts from the National Feed and Grain Association. NFGA membership is made up of both cooperatives and private operators. The idea is that the fix would be attached to the March 23 spending bill.
I could not get any specifics on what is being proposed. I asked Mr. Darisse who else might be sitting at the table and where the table is for that matter. It appears that the thinking is that the grain people can work something out and the senators will take care of it . But the genie may be out of the bottle.
Teresa Castanias led the effort to get the special provision for cooperatives into old Section 199. She thinks that it is possible that there won’t be a fix negotiated.
From what I have seen, negotiations are going nowhere at this point. Everything they try hurts someone, and they are fixated on the “double counting” aspect of this (income to the patron is a deduction for the coop). Current 199A(g) doesn’t have a double counting problem though, so I am not sure why they haven’t worked more from that angle. The 199A(g) benefit should still be pretty good for most ag coops. From what I hear, there is a growing interest in keeping the law as is from all parties involved. Particularly in the farm sector where word is out in the press that the farm income is down to a 12 year low nationwide. I was at an ag coop conference last week, and that was the general mood of the participants that I talked to.
Joe Kristan, one of the earliest tax bloggers, who hung up his keyboard last year, is more sanguine about a fix. He wrote me (making it clear that his opinion should not be attributed to his firm):
It appears Congress will make changes. Both the House Ways and Means Chair and Senator Grassley have stated that changes are necessary and will happen. Grassley carries a lot of weight in ag tax matters.
If they are going to make changes, they will want to make them soon. The longer the delay, the more costly it is to the government and to non-cooperative grain and livestock buyers. It also becomes, as you note, the status quo, and harder to reverse.
Even if they don’t pass it until March, which appears to be the plan, they should come out with text and effective dates as soon as possible to provide certainty, stabilize commodity markets, and prevent the leakage of the co-op break to non-ag industries. There appears to be nothing to stop producers outside the ag world from finding ways to run their production through cooperatives if it appears the new rules will persist.
But There Is More
The provision in old Section 199 was specific to agricultural cooperatives, but, apparently, for no particular reason, there is no such restriction in the provision that the conference committee airdropped into new Section 199A. So included in its improbable beneficiaries are people who receive patronage dividends from worker-owned cooperatives. There are a variety of businesses that have adopted this form including construction trades.
My favorites just for illustrative purposes are bicycle mechanics and house cleaners. Ms. Castanias does not think anybody is looking out for their interests in the current negotiations:
To my knowledge, worker coops have not weighed in. If they have a group that lobbies for them, I don’t know who they are. My understanding is that you need a paid lobbyist to talk to Congress, so that costs money.
I think she is on to something. According to its most recent Form 990 the United States Federation for Worker Cooperation had gross revenue of $124,416. National Council of Farmer Cooperatives is just shy of five million and the National Grain and Feed Association has more than four million.
Of even greater interest is that the provision creates a huge opening for professionals to work around the Section 199A exclusions. Worker-owned cooperatives in the fields of health, law, accounting, etc. are not out of the question.
I had a nice talk with Michael J. Greenwald of Friedman LLP. Friedman has a virtual task force trying to sort out how their clients will be able to take advantage of Section 199A floating ideas such as splitting bill collection out of otherwise disqualified business and turning it into a separate profit center. Mr. Greenwald has been toying with the concept of worker-owned cooperatives for lawyers. He indicated that he along with many others have been feeding questions to the IRS Chief Counsels office. I heard from another source that a Section 199A Q&A is at the top of Chief Counsel’s to-do list. Something tells me there won’t be much on patronage dividends.
Who To Root For?
It is worth noting that the National Council of Farmer Cooperatives and the National Farmers Union have their roots in the Progressive Era, when farmers tired of being told what the costs of their inputs and the price of their output were to be by large corporate interests and got organized. Maybe they will go back to their roots and lend a hand to the nascent worker cooperative movement, which appears to be the unintended beneficiary of a provision meant for agricultural interests. I’m a little excited about figuring out how to turn dental practices and the like into worker cooperatives (It might be easier than you think), but I’m really hoping that the house cleaners and bicycle mechanics will get to keep the small break that they have received.
How Not To Do Tax Reform
The glitch is the result of the way TCJA was pushed through Congress. 1986 was real tax reform. There was a lot of upfront work and it was bipartisan and revenue-neutral. They still needed technical corrections, but those were doable. There was no gaping loophole like this one created, which seems to demand a fix that may be politically infeasible.