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Tax Cuts and Jobs Act

Proposed QBI deduction regs for cooperatives and their patrons – Part 2

Thomson Reuters Tax & Accounting  

Thomson Reuters Tax & Accounting  

IRS has issued proposed reliance regs providing, among other things, guidance to cooperatives and their patrons regarding the Code Sec. 199A qualified business income (QBI) deduction as well as guidance to specified agricultural or horticultural cooperatives (Specified Cooperatives) and their patrons regarding the Code Sec. 199A(g) domestic production activities deduction (DPAD). This is part 2 of a two-part article. For part 1 of the article, see Proposed QBI deduction regs for cooperatives and their patrons Part 1.

Prop Reg §1.199A-8 sets forth four required steps to determine the amount of a nonexempt Specified Cooperative’s Code Sec. 199A(g) deduction and provides rules to determine the amount of an exempt Specified Cooperative’s Code Sec. 199A(g) deduction.

1. Patronage/nonpatronage split. The first step requires nonexempt Specified Cooperatives to identify the gross receipts and related deductions (other than a deduction under Code Sec. 199A(g)) that are from patronage sources and from nonpatronage sources.

Specified Cooperatives must separate their patronage and nonpatronage gross receipts and related deductions when determining taxable income and allocating expenses between patronage and nonpatronage income to claim the tax deductions under Code Sec. 1382(b) and Code Sec. 1382(c).

Cooperatives that have gross receipts only from patronage sources will be unaffected. Accordingly, the proposed regs’ requirement to divide patronage/nonpatronage gross receipts and related deductions should not significantly impact the existing allocation requirements applicable to Specified Cooperatives.

2. Identifying patronage DPGR. The second step is for nonexempt Specified Cooperatives to identify patronage gross receipts that qualify as DPGR.

Prop Reg §1.199A-8 points nonexempt Specified Cooperatives to Prop Reg §1.199A-9 for additional information on DPGR. Prop Reg §1.199A-9 does not refer to gross receipts from patronage or nonpatronage business because the rules only provide additional information supplementing the determination of DPGR from dispositions of agricultural or horticultural products. When applying Prop Reg §1.199A-9, which occurs after step 1 in Prop Reg §1.199A-8 (above), the only gross receipts of a nonexempt Specified Cooperative considered would be those derived from patronage sources.

Prop Reg §1.199A-9 is essentially the same as Reg. §1.199-1 and Reg. §1.199-3 issued under former Code Sec. 199, adjusted to apply to Specified Cooperatives.

3. Calculating patronage QPAI. The third step is for nonexempt Specified Cooperatives to calculate QPAI (including oil-related QPAI) from only their patronage DPGR. To do this, nonexempt Specified Cooperatives must determine cost of goods sold (COGS) and other expenses, losses, or deductions that are allocable to patronage DPGR. Nonexempt Specified Cooperatives are directed to consult Prop Reg §1.199A-10 for additional information on making these allocations. Prop Reg §1.199A-10 does not refer to patronage or nonpatronage QPAI or DPGR because it only provides additional information supplementing the QPAI calculation. Prop Reg §1.199A-10 is essentially the same as Reg. §1.199-4 issued under former Code Sec. 199, adjusted to apply to Specified Cooperatives.

4. Calculating patronage Code Sec. 199A(g) deduction. The fourth is for nonexempt Specified Cooperatives to calculate their Code Sec. 199A(g) deduction, which is equal to 9% of the lesser of QPAI or taxable income, and subject to the W-2 wage limitation. Nonexempt Specified Cooperatives are directed to consult Prop Reg §1.199A-11 for additional information on the W-2 wage limitation. Prop Reg §1.199A-11 does not refer to patronage or nonpatronage QPAI, taxable income, or W-2 wages because it only provides additional information supplementing the W-2 wage limitation. Prop Reg §1.199A-11 is essentially the same as Reg. §1.199-2 issued under former Code Sec. 199, adjusted to apply to Specified Cooperatives.

Prop Reg §1.199A-8(c) provides that exempt Specified Cooperatives calculate two separate Code Sec. 199A(g) deductions, one based on gross receipts and related deductions from patronage sources, and one based on gross receipts and related deductions from nonpatronage sources.

Like a nonexempt Specified Cooperative, an exempt Specified Cooperative earns patronage income that is not taxed to the extent of any Code Sec. 1382(b) deduction for patronage distributions made to patrons. Exempt Specified Cooperatives are also not taxed on any nonpatronage income to the extent of any Code Sec. 1382(c) deduction for nonpatronage distributions.

Unlike the usual taxation of C corporations, the Code Sec. 1382 deductions allow an exempt Specified Cooperative to be treated more like a passthrough entity by reducing the exempt Specified Cooperative’s patronage and nonpatronage income. It is therefore appropriate that the exempt Specified Cooperatives may take a Code Sec. 199A(g) deduction on both patronage and nonpatronage income that could be deducted under Code Sec. 1382(b) and Code Sec. 1382(c)(2).

To calculate the two Code Sec. 199A(g) deductions, an exempt Specified Cooperative is required under Prop Reg §1.199A-8 to perform steps two through four (above) twice, first using only its patronage gross receipts and related deductions and second using only its nonpatronage gross receipts and related deductions. An exempt Specified Cooperative cannot combine, merge, or net patronage and nonpatronage items at any step in determining its patronage Code Sec. 199A(g) deduction and its nonpatronage Code Sec. 199A(g) deduction.

Code Sec. 199A(g)(5)(E) contains a special rule for Specified Cooperatives with oil-related QPAI, which requires a reduction by 3% of the least of oil-related QPAI, QPAI, or taxable income of the Specified Cooperative for the tax year. The language of this rule is the same as the language used in former Code Sec. 199(d)(9).

The proposed regs include rules for oil-related QPAI that are similar to those contained in proposed regs (Preamble to Prop Reg REG-136459-09) relating to the Code Sec. 199 deduction published in 2015 (see, IRS issues proposed regs on Sec. 199 domestic production activities deduction) (2015 Proposed Regulations).

The 2015 Proposed Regulations included rules related to a taxpayer’s determination of oil-related QPAI (with respect to which no comments were received). Although not finalized, the 2015 Proposed Regulations are the only existing guidance concerning a taxpayer’s determination of oil-related QPAI. The preamble to the 2015 Proposed Regulations includes an explanation of the reasons supporting the proposed provisions, and these reasons continue to apply. These include the determination that gross receipts from transportation and distribution of oil are not included in the calculation of oil-related QPAI, unless the gross receipts are considered DPGR under the de minimis rule or an exception for embedded services now contained in Prop Reg §1.199A-9.

Gross receipts from transportation and distribution are not included in QPAI and DPGR (unless an exception applies), and therefore it is appropriate to exclude such gross receipts when calculating oil-related QPAI.

Regarding the rules for passing Code Sec. 199A(g) deductions to patrons (discussed above), Prop Reg §1.199A-8 further provides that a Specified Cooperative that receives a Code Sec. 199A(g) deduction as an eligible taxpayer can take the deduction only against patronage gross income and related deductions, or pass on the deduction to its patrons that are eligible taxpayers.

The proposed regs do not allow an exempt Specified Cooperative to pass through any of the Code Sec. 199A(g) deduction attributable to nonpatronage activities because no QPAI is attributable to any qualified payments. Prop Reg §1.199A-8 is essentially the same as the rules of Reg. §1.199-6, adjusted to include other provisions of the Code Sec. 199 final regulations as well as proposed rules set forth in the 2015 Proposed Regulations.

Prop Reg §1.199A-8(f) provides guidance regarding circumstances in which a Specified Cooperative is a partner in a partnership as described under Code Sec. 199A(g)(5)(B). The proposed regs provide that the partnership must separately identify and report on the Schedule K-1 to the Form 1065, U.S. Return of Partnership Income, (or any successor form) issued to its partner, unless otherwise provided by the instructions to the Form, the Specified Cooperative’s allocable share of gross receipts and related deductions. This allows the Specified Cooperative partner to apply the four steps in Prop Reg §1.199A-8 (discussed above) required to calculate its patronage Code Sec. 199A(g) deduction (or patronage and nonpatronage Code Sec. 199A(g) deductions in the case of an exempt Specified Cooperative).

Proposed Regs—DPGR. The proposed regs are based on Reg. §1.199-3 issued under former Code Sec. 199, but remove provisions that would not apply to the disposition of agricultural or horticultural products.

DPGR includes the gross receipts that a Specified Cooperative derives from marketing agricultural or horticultural products for patrons. Code Sec. 199A(g)(4)(B) treats marketing Specified Cooperatives as having MPGE any agricultural or horticultural product in whole or significant part within the United States if their patrons have done so.

The proposed regs allow attribution to apply as provided in Code Sec. 199A(g)(4)(B) because the statute does not distinguish between types of patrons. However, the proposed regs do not allow a Specified Cooperative to pass through to a C corporation any of the Code Sec. 199A(g) deduction of the Specified Cooperative attributable to the disposition of such agricultural or horticultural products. This is because, under Code Sec. 199A(g)(2)(D), taxpayers taxed as C corporations are not eligible to claim a Code Sec. 199A(g) deduction from the Specified Cooperative.

The proposed regs incorporate the rules from Reg. §1.199-1(d)(1) through Reg. §1.199-1(d)(3) and Reg. §1.199-1(e), issued under former Code Sec. 199, as applicable. These rules relate to the allocation of gross receipts between DPGR and non-DPGR, and the determination of whether an allocation method is reasonable.

Further, the rules include provisions permitting Specified Cooperatives to treat de minimis gross receipts as DPGR or non-DPGR without allocating such gross receipts, and a provision permitting the use of historical data to allocate gross receipts for certain multiple-year transactions.

The definition of the term MPGE is included in Prop Reg §1.199A-9 and is generally consistent with the definition in Reg. §1.199-3(e)(1). However, the proposed regs revise the rule in Reg. §1.199-3(e)(2) by removing the concept of minor assembly.

With respect to the phrase “by the taxpayer” as used in Code Sec. 199A(g)(3)(D)(i), the proposed regs adopt the rule from Reg. §1.199-3(f)(1) as applicable, rather than the rule in the 2015 Proposed Regulations. In a contract manufacturing arrangement, this means that a Specified Cooperative must have the benefits and burdens of ownership of the agricultural or horticultural product during the period in which the MPGE activity occurs in order for the Specified Cooperative to be treated as engaging in such MPGE activity.

The remainder of the rules in Prop Reg §1.199A-9 are based on the existing regulations in Reg. §1.199-3. These rules should be interpreted in a manner consistent with the interpretation under former Code Sec. 199.

Prop Reg §1.199A-10 provides guidance on the allocation of costs to DPGR Prop Reg §1.199A-10 provides rules for allocating a taxpayer’s COGS, as well as other expenses, losses, and deductions properly allocable to DPGR. These proposed regulations are based on and follow the Code Sec. 199 regulations in Reg. §1.199-4.

Prop Reg §1.199A-11 provides guidance regarding the W-2 wage limitation on the Code Sec. 199A(g) deduction.

A notice of proposed revenue procedure, Notice 2019-27, which proposes a draft revenue procedure providing three proposed methods that Specified Cooperatives may use for calculating W-2 wages, is being issued concurrently with these proposed regs. The guidance contained in the notice of proposed revenue procedure is necessary because changes may be made to the underlying Form W-2, Wage and Tax Statement, on a more frequent basis than updates to the regulations under Code Sec. 199A(g), for regulatory and statutory reasons independent of Code Sec. 199A. The three proposed methods for calculating W-2 wages in the notice are substantially similar to the methods provided in Rev Proc 2006-47, 2006-2 CB 869 (relating to the Code Sec. 199 deduction), and Rev Proc 2019-11, 2019-9 IRB 742 (relating to the Code Sec. 199A(a) deduction).

Under the proposed regs, W-2 wages for the purpose of the wage limitation in Code Sec. 199A(g) are generally determined in a manner that is similar to the manner in which W-2 wages are determined for the purpose of the deduction under Code Sec. 199A(a) (i.e., using the definition of W-2 wages under Code Sec. 199A(b)(4)), with three significant differences.

First, Code Sec. 199A(g)(1)(B)(ii) provides that W-2 wages are determined without regard to Code Sec. 199A(b)(4)(B), which excludes from the definition amounts not properly allocable to QBI for purposes of Code Sec. 199A(c)(1).

Second, W-2 wages under Code Sec. 199A(g) do not include any amount that is not properly allocable to DPGR.

Third, W-2 wages under Code Sec. 199A(g) generally do not include any remuneration paid for services in the commonwealth of Puerto Rico and other U.S. territories. Specifically, Code Sec. 199A(g)(1)(B)(ii) provides that W-2 wages are determined in the same manner as under Code Sec. 199A(b)(4), and Code Sec. 199A(b)(4)(A) defines wages as amounts described in Code Sec. 6051(a)(3) and Code Sec. 6051(a)(8). The amounts described in Code Sec. 6051(a)(3) are “wages as defined in Code Sec. 3401(a).” Code Sec. 3401(a)(8) generally excludes from the definition of wages in Code Sec. 3401(a) wages paid with respect to employment in the commonwealth of Puerto Rico and other U.S. territories. Therefore, wages paid with respect to employment in the commonwealth of Puerto Rico and other U.S. territories are generally not W-2 wages within the meaning of Code Sec. 199A(b)(4)(A). This contrasts with the Code Sec. 199A(a) deduction for which Code Sec. 199A(f)(1)(C)(ii) allows certain taxpayers with QBI from sources within the commonwealth of Puerto Rico (Code Sec. 199A(f)(1)(C)(ii) applies only to Puerto Rico and not to other U.S. territories) to compute Code Sec. 199A(b)(4) W-2 wages without regard to Code Sec. 3401(a)(8).

Since the Code Sec. 199A(g) deduction is determined based on QPAI, not QBI, Code Sec. 199A(f)(1)(C)(ii) does not apply to the deduction under Code Sec. 199A(g).

Prop Reg §1.199A-12 provides guidance on the application of Code Sec. 199A(g) to an EAG under Code Sec. 199A(g)(5)(A)(iii) that includes a Specified Cooperative.

Unlike the Code Sec. 199 deduction, the Code Sec. 199A(g) deduction is limited to Specified Cooperatives. The proposed regs address how the rules separating patronage and nonpatronage income and deductions apply in the context of an EAG.

Prop Reg §1.199A-12 provides that in the case of nonexempt Specified Cooperatives, attribution between the members of an EAG is allowed provided the DPGR and related deductions are patronage. In the case of exempt Specified Cooperatives, attribution is allowed in all events because exempt Specified Cooperatives are allowed to take a separate 199A(g) deduction on both their patronage and nonpatronage income.

Prop Reg §1.199A-12 also provides certain rules for partnerships owned by an EAG as described in Code Sec. 199A(g)(5)(A)(ii).

Prop Reg §1.1388-1(f) sets forth a definition of patronage and nonpatronage that is consistent with the current case law under Code Sec. 1388. Specifically, the proposed reg adopts the directly related test, which is a fact specific test for determining whether income and deductions of a Cooperative are patronage or nonpatronage.

In light of the TCJA, IRS proposes to remove the Code Sec. 199 regulations (Reg. §1.199-0 through Reg. §1.199-9) and withdraw the 2015 Proposed Regulations because the regulations interpret a provision of the Code that has been repealed for tax years beginning after December 31, 2017.

Applicability dates. The proposed regs are proposed to apply to tax years beginning after the date the final regs adopting the proposed regs are published. But taxpayers may rely upon the proposed regs, in their entirety, before that date. (Prop Reg §1.199A-7(h), Prop Reg §1.199A-8(h), Prop Reg §1.199A-9(k), Prop Reg §1.199A-10(i), Prop Reg §1.199A-11(h), Prop Reg §1.199A-12(j), Prop Reg §1.1388-1(g))

References. For QBI deduction allowed for patrons receiving qualified payments from specified agricultural or horticultural cooperatives for 2018–2025, see FTC 2d/FIN ¶L-4316United States Tax Reporter ¶199A.21.

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