Any piece of significant taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. legislation is bound to contain some errors and unintended consequences. In the case of the Tax Cuts and Jobs Act, passed last December, one major problem with the bill has already emerged: an exceedingly generous deduction for businesses that sell to cooperatives.
The new deduction has been termed the “grain glitch,” because it would result in a dramatically lower tax bill for farmers who sell grain to co-ops. Indeed, the Wall Street Journal has highlighted how the deduction could potentially let “some farmers reduce their taxable income to zero.”
Now, several news sources are reporting that Congress is considering taking action to fix the “grain glitch” in the near future. Apparently, there is a possibility that Congress may add language to an upcoming government funding package (perhaps the next continuing resolution), with the purpose of modifying and scaling back the deduction for businesses that sell to cooperatives.
This is a welcome development; 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.
Understanding the New Deduction for Businesses that Sell to Cooperatives
To understand the “grain glitch,” it’s necessary to take a step back and discuss one of the major provisions in the recent tax bill: the newly created section 199A. This section establishes a new deduction for households that receive income from pass-through businesses, such as partnerships, S corporationAn S corporation is a business entity which elects to pass business income and losses through to its shareholders. The shareholders are then responsible for paying individual income taxes on this income. Unlike subchapter C corporations, an S corporation (S corp) is not subject to the corporate income tax (CIT). s, and sole proprietorships.
Interestingly, though, the new section 199A offers households a deduction for two separate items. The first portion of the section allows households to deduct 20 percent of their qualified business income, calculated on a net basis and subject to a number of limitations. However, the second portion of the section allows some households to instead deduct 20 percent of their qualified cooperative dividends, calculated on a gross basis and subject to fewer limitations.
The first thing to notice here is that the new section 199A treats businesses differently if they receive dividends from a cooperative. To define some terms here: a cooperative is an organization run for the mutual benefit of its members, and dividends are the payments that cooperatives make to their members. For example, one typical model for farmers’ cooperatives is for farmers to sell produce to the co-op, which then delivers the produce to market; farmers who sell more produce to the co-op receive more dividends.
The biggest difference between co-op members and other businesses, under section 199A, is how they are allowed to calculate the deduction they receive. Specifically, companies are allowed to deduct 20 percent of the net amount of their “qualified business income,” but are allowed to deduct 20 percent of the gross amount of their “qualified cooperative dividends.”
What does this distinction mean? Imagine a business that earns $300,000 in revenue and incurs expenses totaling $200,000. The business’s net income is $100,000 – its revenue minus its expenses. But the business’s gross incomeFor individuals, gross income is the total pre-tax earnings from wages, tips, investments, interest, and other forms of income and is also referred to as “gross pay.” For businesses, gross income is total revenue minus cost of goods sold and is also known as “gross profit” or “gross margin.” is $300,000 – the total amount of revenue it has collected, without taking expenses into account.
Because of this distinction, the deduction for co-op dividends is much more generous than the deduction for other business income.
Consider two identical businesses with $300,000 of revenue and $200,000 of expenses, where one business is a regular pass-through businessA pass-through business is a sole proprietorship, partnership, or S corporation that is not subject to the corporate income tax; instead, this business reports its income on the individual income tax returns of the owners and is taxed at individual income tax rates. , while the other business receives all its income as co-op dividends. The regular business would be entitled to a deduction of up to $20,000 (or 20 percent of the business’s net income of $100,000). By contrast, the co-op member would be entitled to a deduction of up to $60,000 (or 20 percent of the business’s gross amount of qualified cooperative dividends).
| Regular Business | Co-op Member | |
|---|---|---|
|
Revenue |
$300,000 | $300,000 of qualified cooperative dividends |
|
Expenses |
$200,000 | $200,000 |
|
Net Income |
$100,000 | $100,000 |
|
Deduction under §199A |
$20,000 | $60,000 |
The ability for businesses that sell to co-ops to claim a deduction based on their gross dividends is the most important reason why this provision is so generous. However, it is not the only factor. The deduction for co-op dividends is also exempt from a number of limits and safeguards that generally apply to section 199A.
For instance, a household is only allowed to claim the “qualified business income” deduction up to 20 percent of its taxable ordinary income, but can claim the “qualified cooperative dividends” deduction up to 100 percent of its taxable ordinary income. Additionally, while the “qualified business income” deduction is limited based on each business’s wages and investments, the deduction for “qualified cooperative dividends” is subject to no such limits.
All in all, the new deduction for businesses that sell to co-ops is extremely generous. And this preferential tax treatment could turn out to have some major negative consequences if Congress does not act.
The “Grain Glitch” Could Make Some Farmers Tax-Exempt
Given that cooperatives are especially prevalent in the agriculture industry, some of the initial commentary on the deduction for businesses that sell to co-ops has centered around how the provision will affect farmers. It turns out that, in some scenarios, the deduction could be large enough to wipe out a farmer’s federal income tax bill entirely.
Imagine a farmer that sells $2 million worth of grain a year to a co-op, earns no other income, and incurs $1.6 million worth of expenses throughout the year. The farmer would end the year with $400,000 of income, which presumably ought to be subject to federal taxes. However, the farmer would also be able to claim a deduction of $400,000 (or 20 percent of the $2 million in cooperative dividends the farmer receives). As a result, the farmer would be able to wipe out his entire taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. using the section 199A deduction, ending up with no federal tax liability whatsoever.
This result is a direct consequence of the design of the deduction for businesses that sell to cooperatives. Because the size of the deduction is determined by a gross measure, and is only limited to 100 percent of a household’s taxable ordinary income, there’s nothing stopping the deduction from being large enough to wipe out a household’s entire tax bill.
There is no compelling reason why any farmers, or any for-profit business, should be exempt from federal taxes. On the contrary, the tax code should try to be neutral between economic activities, and not offer tax preferences to any sectors of the economy.
The “Grain Glitch” Could Create Distortions in the Agriculture Industry
Consider a farmer who had been planning on selling $1 million of grain in 2018 to a co-op, and also $1 million of grain to a private business. The farmer has $1.6 million in total expenses, so his net profit on the sales to the co-op is $200,000, and his net profit on the sales to the private business is $200,000.
After the passage of the recent tax bill, the farmer might decide to take a second look at where to sell his products. After all, the $1 million of sales to the co-op would result in a deduction of $200,000 for the farmer. Meanwhile, if the $1 million of sales to the private business would only result in a deduction of up to $40,000 (or 20 percent of the $200,000 in net profit).
As a result, the new section 199A creates a strong incentive for farmers to sell to co-ops, rather than private businesses – an issue that has been noted frequently in the press coverage of this provision. According to some reports, some private companies are now considering forming co-ops of their own, in order to avoid losing their market share entirely, as a result of the new tax law.
The “Grain Glitch” Could Open Up a New Hole in the Tax Code
Imagine a household which owns several properties in New York City and makes over $1 million in rental income each year. The household is interested in reducing its federal taxes. As a result, it decides to purchase a share in a farm in North Dakota, which is organized as a pass-through business.
The farm isn’t profitable – far from it. Every year, the farm sells $20 million of grain to a co-op, but also has $20 million in annual expenses, meaning that the farm typically ends the year without any profit. The owners of the farm are eager to let an interested buyer purchase a share of their unprofitable business, and they offer a 10 percent stake in the farm for the price of $100,000.
The household now owns 10 percent of the North Dakota farm, so its share of the farm’s “qualified cooperative dividends” is $2 million. As a result, the household can claim a deduction of $400,000 (or 20 percent of the household’s share of the farm’s qualified cooperative dividends). If the household falls into the 37 percent bracket, that deduction could lead to $148,000 in tax savings for the household.
As a result, in this hypothetical scenario, the household would be able to gain a tax benefit of $148,000 each year, for the one-time price of $100,000. As far as I’m aware, there is nothing in the text of section 199A that prevents the household in question from employing this particular tax avoidance technique.
Needless to say, allowing high-income households to shield their income from taxation through the use of cooperatives would be an undesirable outcome.
Options for Fixing the “Grain Glitch”
If left unchanged, the “grain glitch” could create an extremely lucrative new method of tax avoidance, which would narrow the federal tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. and create unfair advantages for some taxpayers. There are several steps Congress could take to limit the damage from this provision:
- Require that households compute the deduction for “qualified cooperative dividends” based on net income from sales to cooperatives, rather than gross dividends from cooperatives.
- Limit the deduction for “qualified cooperative dividends” to 20 percent of a household’s taxable ordinary income, rather than allowing households to use the deduction to offset 100 percent of their income.
- Eliminate the separate treatment of “qualified cooperative dividends” altogether. Instead, businesses that sell to cooperatives would be allowed to count net income from sales to cooperatives as “qualified business income,” and would be subject to the limits and safeguards that apply. This may be a difficult political lift, though, given that the recent tax bill seems to reflect an intent to create some sort of special treatment for businesses that sell to co-ops, for better or worse.
Any of these steps would make the new deduction for businesses that sell to co-operatives significantly less prone to abuse.