Push back is already starting on the new Tax Act proposal. It is likely that by next week, multiple changes will have happened to the bill and we are now waiting for the Senate to release their bill. However, let's dig into some of the provisions with special significance to farmers.
- Bonus Depreciation has now been upgraded to allow used assets to qualify for bonus depreciation. Since bonus depreciation applies to all property with a depreciable life of 20 years or less, this now means that all farm property (other than land) purchased through January 1, 2023 will qualify for 100% expensing. This includes special purpose structures such as hog confinement buildings, dairy parlors and any other farm building.
- Section 1031 exchanges will only be allowed for real estate and eliminated for personal property. However, since all equipment and farm buildings are allowed to be fully depreciated in the year of purchase, the elimination of 1031 exchanges for personal property is a moot point (at least until 2023). Under current law, a farmer may want to not do an exchange on a farm building since the gain would be taxed at ordinary/capital gain rates, but not subject to self-employment tax. Under the new proposal, farmers with gains from business property may be subject to self-employment tax on the gain, but they would get an offset on self-employment income from deducting the purchase of a farm building in full. Therefore, it may become a wash. It appears that the self-employment parts of the Tax Act may have some issues with the wording. We shall see if there is an update to the wording in the self-employment section.
Right now, we know that they have specifically removed from the Code the exemption for rental real estate and limited partnership income not being subject to self-employment tax. Therefore, some or all of this income will now be subject to self-employment tax.
These first two provisions discussed are good things for farmers. Now for a potentially bad thing. Many farmers have created C corporations to take advantage of the lower 15% tax rate on the first $50,000 of income. The Tax Act eliminates this and replaces it with a flat 20% tax rate including the first $50,000 of income. Second, many of these corporations provide housing to their employees. This housing is typically 100% deductible by the corporation and tax-free income to the employee. The Tax Act retains the deduction by the corporation; however, it limits the amount of housing allowed tax-free by the employee to $50,000 annually and only one residence per employee (likely based on fair value not cost) and phases-out this out if the employee's income exceeds $120,000. Now this would not be too bad for most farmers since they usually do not provide housing worth more than $50,000 per year and their wage income usually is less than $120,000. However, the kicker is that housing provided is now taxable compensation to any 5% owner of the corporation. This means that for all of our farmer owned corporations providing housing to their owners will now need to include this as income on their personal income tax return. The Tax Act is silent on whether this is a compensation deduction to the corporation. It appears it is simply extra income to the owner. Let's look at an example:
ABC Farm Corporation owns a house that costs it $25,000 a year to maintain (including depreciation). This home is provided to the owner of the corporation as a current tax-free fringe benefit. If the new Tax Act goes into affect, the corporation would continue to deduct the costs of maintaining the home, however, the owner would report the "value" of the home provided to them as additional income on their personal tax return.
If this Tax Act goes through it may appear that many of our farm operations may want to switch to a C corporation from their current structure. However, there will likely be guidelines from the IRS requiring some minimum amount of compensation being paid from the corporation to the shareholder for services provided. This requirement is to make sure that some part of the income earned inside the corporation that is really for services provided by the owner is pushed out to the owner and then taxed at up the 39.6% regular individual tax rate. In the past, most of our fights with the IRS regarding C corporations involved too much compensation to owners. Now the fight will be on whether there is too little compensation.
Also, if the corporation is allowed to deduct 100% of business purchases inside the corporation, this will likely generate a large loss carryforward to offset income in future years. But this loss carryforward is only allowed to offset 90% of taxable income during that year, so a corporation will need to pay income tax unless they continue to purchase fixed assets. We still do not want to place farmland into a corporation since it will be subject to a double-tax; however, under the new Tax Act, this farmland rental income may become subject to self-employment tax and if farmers have historically been under the wage base amount, this will result in an extra 15.3% tax on part or all of this income. The income tax may be limited to 25%, but add in self-employment tax of 15.3% and now the farmer is in a 40% tax bracket; whereas under current law they may have only been in a 25% tax bracket with no self-employment tax being owed.
This really is too soon to know all of the ramifications and we know that there will be changes to this bill (by the House and the Senate) and tax reform may not happen. As I said yesterday, the final bill may end up being worse. We will keep you posted.
Editor’s Note: Paul Neiffer provides analysis and insight to farmer tax questions for sister publication, Top Producer.