On December 22, 2017, President Donald Trump signed the Tax Cuts and Jobs Act into law. This sweeping legislation made major improvements to existing tax policy. As is common with legislation of this complexity and magnitude, technical errors and minor unintended consequences are expected. However, there is one major problem in the law—it concerns a specific part of a new pass-through business deduction, the “grain glitch,” and it must be fixed immediately.
The grain glitch refers to a problem with the new deduction (Section 199A) that makes it possible for some farmers to avoid paying federal tax altogether. It also creates major distortions in agricultural markets by incentivizing farmers to sell to cooperatives instead of other private businesses. This glitch may have ramifications well beyond agriculture.
The root of the problem is the U.S. tax code’s disparate treatment of business income, treating similar businesses differently depending on their legal structure. This Issue Brief provides important background information, explains the problem, and identifies recommendations on how Congress can fix the glitch in the cooperative deduction. However, addressing the inequities in business taxation and the broader problems with the new 20 percent deduction will require a more fundamental re-imagination of how business income is taxed.
In order to understand the grain glitch, it helps to go back to the American Jobs Creation Act of 2004, which created the Section 199 deduction. This deduction provided a tax break for domestic manufacturers and other businesses engaged in production activities (including cooperatives). By enacting this special tax subsidy, Congress used the tax code to pick winners and losers, creating an unwarranted special interest benefit and entrenching an entire industry against any tax reform that would eliminate its subsidy.
In tandem with a steep reduction to the corporate tax rate and a new pass-through deduction, Congress was able to eliminate Section 199 in the Tax Cuts and Jobs Act. The elimination of Section 199, which should never have existed in the first place, concerned farmer cooperatives who had come to enjoy their subsidy. Cooperatives, called co-ops, are member-owned businesses operated for the benefit of members, and are prevalent in agriculture. Many farmers belong to farmer cooperatives, which provide services such as marketing commodities.
Instead of just eliminating Section 199 deductions and lowering tax rates for all businesses, Congress decided to address the concerns of farmer co-ops by developing a new privilege. As a result, Congress added language to the new tax law that created the grain glitch.
The new cooperative deduction was likely not an unintended glitch, at least to the legislators who pushed the specific language. As reported by Politico, “[T]hough that’s been dubbed the ‘grain glitch,’ it was included in the legislation at the insistence of multiple senators despite warnings of its implications.”
What Is the Grain Glitch?
The new Section 199A created a 20 percent deduction to help all pass-through businesses. Pass-throughs are businesses, such as sole proprietorships, partnerships, and S corporations, which pass their income throughto the owners of the businesses. They do not include traditional C corporations. Instead of treating all pass-through businesses equally, Section 199A created special rules for members of cooperatives selling to cooperatives.
Net v. Gross Calculations. The new deduction applies in two different situations. First, it allows households to deduct 20 percent of their “qualified business income,” calculated based on net business income, meaning they must account for business costs. Second, it allows households to deduct 20 percent of their “qualified cooperative dividends,” which include gross sales—business costs are not factored into the calculus.
This distinction creates a major benefit for cooperative members selling to cooperatives, and as a result, a major benefit to any business organized as a cooperative. For example, assume a business has $200,000 in revenue, $100,000 in expenses, and therefore has a net business income of $100,000. The allowed deduction is $20,000 (20 percent of the net business income).
If instead of applying to net business income, the deduction is based on gross cooperative dividends, the 20 percent deduction applies to $200,000 (total revenue) not $100,000 (the net amount). Therefore, the available deduction is $40,000. For farmers selling commodities, they now have a major incentive to sell to cooperatives as opposed to other private businesses, such as grain operators.
Other Preferences for Co-ops. There are two other important preferences for cooperatives included in the new Section 199A:
- Taxable ordinary income. The 20 percent deduction for standard pass-throughs, based on qualified business income, is limited to 20 percent of taxable ordinary income. The 20 percent deduction for qualified cooperative dividends can be applied to 100 percent of taxable ordinary income.
- Wages and investments. The qualified business income deduction is also limited by the greater of either 50 percent of wages paid or 25 percent of wages plus 2.5 percent of qualified property. The qualified cooperative dividends deduction has no such limitation.
Eliminating All Federal Income-Tax Liability
This special treatment allows farmers to avoid paying federal income tax altogether. The Tax Foundation provides a useful illustration of this point:
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 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.
Impact of the Grain Glitch
As should be expected, private businesses that are not cooperatives want to compete and are therefore looking into the possibility of reorganizing their businesses. If farmers are only willing to sell to cooperatives, this could be devastating to those companies that are not cooperatives.
In a February 21, 2018, letter to congressional leadership, 87 Republican Members explained that Section 199A “has resulted in a dramatic competitive imbalance impacting numerous agricultural value chain stakeholders including grain handlers, feed mills, seed companies, ag retailers, biofuels producers, banks, livestock marketers, and dairy processors. Left unchecked, Section 199A’s uncompetitive impacts will ripple across many industries.”
Section 199A may also have a direct impact on industries outside agriculture. The special provision for cooperatives was not limited to agricultural cooperatives. There is a possibility that other industries could form cooperatives to take advantage of the benefits, including setting up worker cooperatives for lawyers, accountants, and other professionals.
What Congress Should Do
Congress needs to take immediate action, such as in the upcoming omnibus spending bill expected to be passed in March. Timely action is necessary to head off strategic tax planning that encourages businesses to change their legal structures and further harms those businesses that have been put at an artificial disadvantage. This harm may very well result in private companies going out of business and lost jobs.
Fortunately, there is wide recognition of the problem and the need to fix it. The question is really how to fix the glitch not whether to fix it. Even Senators John Hoeven (R–ND) and John Thune (R–SD), who reportedly pushed for a special cooperative benefit, have recognized the need to limit the deduction.
Specifically, Congress should:
Treat those who benefit under Section 199A equally. The pass-through deduction for qualified business income is poor tax policy on its own merits; the addition of the cooperative deduction makes it that much worse. If Section 199A deductions are to exist, they should be applied as equally as possible. This means that cooperatives, farmers, and other agricultural businesses should be treated just like other pass-through businesses. It also means that Section 199A should be applied equally within the agricultural sector, instead of creating market distortions and favoritism as it does now.
Congress should repeal the special treatment of cooperative dividends. The deduction for those selling to cooperatives should be based on net income, not gross sales.
Apply any fix retroactively. Regardless of when a fix becomes law, it should apply to the beginning of this year. Members of Congress quickly determined, albeit after the fact, that this provision was a mistake and it never should have existed in the tax bill in the first place. Nobody should benefit or suffer from this mistake.
Refuse to reinsert the old-law Section 199 just for cooperatives, or otherwise seek to provide cooperatives with pre–Tax Cuts and Jobs Act favoritism. Some have proposed reinserting Section 199 for cooperatives, as it existed before tax reform. Such a move would be a major substantive change that would be far from a “fix.” It also would ignore the will of Congress in passing the Tax Cuts and Jobs Act: Congress sought to eliminate the Section 199 deduction. Reintroducing a special subsidy for a politically favored industry would perpetuate a culture of using the tax code to support industries that have political power in Washington.
Instead of reinserting Section 199 for cooperatives, some legislators may seek to manipulate the recently enacted tax reforms so that cooperatives have a level of benefits equivalent to what they had in the old Section 199. Actually determining the value of an equivalent benefit and then designing a new system for cooperatives to access the new subsidy will only create additional complexity and could result in additional glitches.
The grain glitch is the most high-profile problem stemming from the new Section 199A deduction for pass-through businesses. Narrowing the cooperative deduction to net income is really only a patch, not a fix, in a new system that is rife with similar inconsistencies. The broader 20 percent deduction is itself a tax privilege, which has no consistent policy rationale and arbitrarily favors certain types of businesses over others. A true fix will have to wrestle with the inherent inequities that arise from having two different business tax schemes. Holistic business tax reform should remove the 20 percent deduction in favor of a system that equalizes business taxation by integrating the corporate and individual tax codes.
—Daren Bakst is Research Fellow in Agricultural Policy, and Adam N. Michel is Policy Analyst in Tax and Budget Policy, in the Thomas A. Roe Institute for Economic Policy Studies, of the Institute for Economic Freedom, at The Heritage Foundation.