There are a number of special rules that apply to cooperatives for purposes of calculating the Section 199 Domestic Production Activities Deduction (DPAD). For instance, cooperatives that market agricultural or horticultural products for their patrons are treated as having manufactured, produced, grown or extracted (MPGE) any agricultural or horticultural products that its patrons have MPGE. Cooperatives are also allowed, at their discretion, to pass through all, some or none of their DPAD to their patrons. Patrons may then deduct the DPAD, without regard to the taxable income limitation, in the taxable year in which they receive written notice of the amount of their (DPAD) from the cooperative. The pass through provision of the Section 199 Regulations is extremely important to cooperatives and their patrons because it allows for flexibility and ensures that, with proper planning, none of the cooperative’s DPAD will go unused.
Section 199 limitations
Generally DPAD is limited to 9% of the lower of qualified production activities income (QPAI) or taxable income. In addition, DPAD is also limited to 50% of the taxpayer’s production W-2 wages paid during the year and properly allocated to domestic production gross receipts (DPGR). Further, DPAD is not allowed to create or increase a net operating loss (NOL). For most taxpayers, the 50% of W-2 wage limitation seldom comes into play, since the 9% limitation based on QPAI or taxable income usually result in a lower DPAD limitation. The fact that the DPAD cannot create or increase a NOL, often times means that for many taxpayers some or all of their DPAD can’t be used. Additionally, there is no allowance for the carry over or carry back of DPAD limited due to the NOL provision, it is simply lost.
Cooperative limitations and the pass through
For a cooperative, the QPAI and taxable income limitations (for purposes of calculating its DPAD) are computed without taking into account any deductions for patronage dividends, per-unit retain allocations and non-patronage distributions under IRC Section 1382(b) and (c). As such, the DPAD limitation based on the lower of those two limitations is often extremely large. Because of the above rule, a cooperative’s DPAD, unlike that of other taxpayers, is often limited to 50% of its production W-2 wages properly allocated to DPGR (which is usually the lowest of the three limitations for a cooperative). Even so, the cooperative’s DPAD based on the wage limitation is still likely to be relatively large in relation to its taxable income (after its patronage deduction) and if not for the pass through provision of Section 199, much of the cooperative’s DPAD could go unused, since DPAD cannot create or increase an NOL. However, in light of the pass through provision, the cooperative or its patrons, through proper tax planning, should always be able to use its entire DPAD. Therefore, it is important that the cooperative focuses on using the most advantageous method allowed for determining its W-2 wage limitation, in order to maximize its DPAD.
W-2 Wages and the limitation
W-2 wages, for purposes of the limitation, are based on the calendar year ending with or within the taxpayer’s year. So for a fiscal year taxpayer, the calculation of W-2 wages is made as of December 31 of the calendar year that falls within the fiscal year. The methods for calculating W-2 wages are provided by Revenue Procedure 2006-47. The first step in determining the limitation is to calculate W-2 wages using one of three methods (Unmodified box method, Modified box 1 method or Tracking wages method).
The differences in the three methods are fairly subtle, but using the most advantageous method is the first step in maximizing the cooperative’s wage limitation.
Once W-2 wages have been calculated using one of the methods above, the next step is to allocate them to DPGR. Under Regulation 1.199-2(e)(2) taxpayers may use "any reasonable method that is satisfactory to the Secretary based on all the facts and circumstances." Additionally the Regulations provide two safe harbor allocation methods, the wage expense safe harbor and the small business simplified overall method safe harbor.
The wage expense safe harbor provides that taxpayers using the Section 861 method or the simplified deduction method for allocating costs for QPAI use the same method under this safe harbor for allocating wages to DPGR. Therefore wages are allocated to DPGR under this safe harbor method by multiplying wages by the percentage derived by dividing wage expense included in QPAI by total wage expense included in taxable income.
Taxpayers that use the small business simplified overall method to allocate costs for QPAI may use the small business simplified overall method safe harbor to properly allocate wages to DPGR. Wages are allocated to DPGR under this safe harbor method by multiplying wages by the percentage derived by dividing DPGR by the taxpayer’s total gross receipts.
After calculating W-2 wages and properly allocating them to DPGR, the next step is to calculate the wage limitation. Assuming DPGR relates to patronage and non-patronage activities, the limitation will need to be apportioned between patronage and non-patronage activities. If the cooperative uses a separate entity approach for calculating DPAD for patronage and non-patronage activities, the above rules will need to be applied to determine separate wage limitations for patronage and non-patronage DPAD. Again there is an opportunity to use the method resulting in the largest DPAD for the cooperative.
As illustrated above there are numerous factors that should be considered by cooperatives in properly calculating and maximizing the wage limitation, whenever DPAD is limited by W-2 wages. It is also important to consider the impact the wage limitation, as well as the QPAI and taxable income limitations, may have on other tax elections (such as bonus depreciation) when engaging in tax planning for cooperatives. Now is the time to speak to your Baker Tilly tax professional who can help you maximize your DPAD under IRS Regulations, in conjunction with your overall tax planning activities.