Now that the dust has settled on the 2018 tax season (for the most part!), it is time to continue fine-tuning tax strategies for Northeast agricultural producers. One of the easiest ways to maximize the 199A deduction is to ensure the farmland being utilized in the operation qualifies for the deduction.
There are three ways for farmland to qualify for the 199A deduction. The land can either be 1) rented to a commonly controlled entity, 2) fall under the safe harbor, or 3) be considered a trade or business. Let’s explore these three options below.
1. Common Control
The hurdle in understanding ‘common control’ is whether or not the farmland is rented to a trade or business conducted by the farmer or to a flow-through entity, which is commonly controlled by the farmer (i.e. a “self-rental”).
This begs the question of what exactly is common control. Essentially, this means that the same people, directly or indirectly, own 50 percent or more of each entity. Indirect ownership includes the following:
- Ownership by a spouse, siblings, parents, grandparents and lineal descendants (such as kids)
- Owning 50 percent or more of the issues and outstanding shares of an S-Corporation
- Owning 50 percent or more of the capital or profits of a partnership (or LLC taxed as a partnership)
Example: Mom and Dad own Land, LLC as 50/50 members. They rent that farmland for $150/acre to Farm, LLC, which is owned by Jr. and Dad at 10 and 90 percent, respectively. Since the Land, LLC is being rented to a commonly controlled entity, the rental payments will qualify as Qualified Business Income (QBI).
Most family farm rentals should qualify as QBI under the common control test above.
2. Notice 2019-07
Another way a rental may qualify for QBI is through Notice 2019-07, which contains a safe harbor that requires the rental to meet all of the following requirements:
- Separate books and records are maintained for each rental (or the combined enterprise if grouped together);
- 250 or more hours of rental services are performed (financial activities generally do not count)1;
- The taxpayer maintains contemporaneous records.
3. Trade or Business
If the two methods above do not get the taxpayer to QBI, the rental may still qualify for the deduction by being considered a trade or business (as defined in the tax code). This is a fact-specific inquiry that requires a profit motive in an activity that is “considerable, regular and continuous.” Generally speaking,
- Material participation farm rentals (reported on schedule F) will qualify
- Schedule E triple net leases are not likely to qualify
- Form 4835 crop share leases may or may not qualify depending on the circumstances
C to S Corporation Conversion Opportunity
One of the important updates that occurred in the final regulations excluded C-Corporations from the “self-rental” scenarios described above. What this means is that the rental arrangement would have to qualify under the safe harbor or as its own trade or business to be considered QBI.
In other words, the following fact-pattern will not provide for the rental income to be considered QBI under the self-rental rule:
However, converting the C to an S-Corporation will now cause that rental income to be considered QBI (assuming the self-rental rules are followed):
The conversion from a C to S-Corporation is quite nuanced and requires guidance from an experienced agricultural tax professional. However, most farms have found the conversion to be advantageous.
The 199A deduction on farmland is a great tax benefit. However, there are situations that require adequate planning and documentation in order to optimize the deduction. For those situations, especially those C-Corporate rentals, now is the time to optimize the situation for the 2019 tax season.
1 See Notice 2019-07 for a list of excluded activities.