Cooperatives that are taxed as partnerships or S-corporations fall under the general tax rules applicable to all partnerships and S-corporations. The Subchapter T rules that apply to incorporated cooperatives do not apply to partnerships and S-corporations.
Reduction in top corporate tax rate
The headline change in the new tax law is the reduction in the top corporate tax rate from 35% to 21%. That change applies to Subchapter T cooperatives. In order to equalize tax rates on other forms of business Congress added a new concept to the tax of a 20% deduction for profits earned in pass through businesses. Pass through businesses include partnerships, S-corporations, trusts, estates, REITs, and sole proprietorships. We will just discuss the application to partnerships and S-corporations.
It is important to keep in mind that the IRS will be issuing further guidance on the new tax law that should clarify some of the details. Also keep in mind that this article is a very short summary. A full discussion would take dozens of pages of technical discussions.
Partnerships and S-corporations both issue K-1s to the owners. The Form K-1 is an attachment to the federal tax return of partnerships, Form 1065, and of S-corporations, Form 1120-S. The income from the K-1 is reported on the individual owner’s Form 1040 and then a 20% reduction will be taken on the Form 1040 as well. The result is that only 80% of profits will be subject to income tax. This rule does not affect the application of self-employment tax.
The 20% reduction will apply only to the profit allocated to the co-op owner on Form K-1. It does not apply to the W-2 income of S-corporation owners or to the guaranteed payment income of partnership owners.
There are many limitations on the ability to take the 20% deduction. One limitation is that the 20% deduction is applied after other reductions in income on the Form 1040 such as the standard deduction, self-employed health insurance deduction or a deductible pension or IRA contribution. For most co-op owners this will not be an important limit since the K-1 income will be small in relation to their W-2 or guaranteed payment income. This is an area where the IRS will be issuing much more guidance on just how the calculation will work.
The other primary limitations on taking the 20% deduction apply only to high income taxpayers. When taxable income exceeds $157,500 for a single taxpayer or $315,000 for a married taxpayer filing jointly there are several limitations. The first is that profits earned in specified service businesses may be ineligible for the 20% deduction. These businesses include “health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its” employees or owners. The second limitation is that for high income taxpayers the 20% deduction is limited to the higher of 50% of the W-2 wages or the sum of 25% of W-2 wages plus 2.5% of the original cost of qualified depreciable property. If either the specified service business or the W-2 and/or property limits apply, the 20% deduction phases out above the taxable income limits mentioned above.
The 20% deduction applies only to profits allocated to an owner on Form K-1 and not to W-2 income in an S-corporation or guaranteed payments income in a partnership. The IRS expects that income paid with the W-2 or with guaranteed payments will be fair compensation for the work performed. There is a long history of rulings and court cases on S-corporation fair compensation. The amount of the profit allocation on the K-1 versus the W-2 wage will depend on the type and size of the business of the co-op. One very rough measure is that the profit allocation should not exceed 25% of total compensation. For instance if W-2 wages or guaranteed payments are $15,000 the profit allocation should not exceed $5,000.
One feature of the 20% pass through deduction is that when the co-op passes through a loss on Form K-1 there will be no 20% deduction for that year and the loss will carry over to reduce the 20% deduction in future years.
Maximize your tax benefit
It is important to be aware of the general rules and to look at your co-op to see if anything should be changed to help maximize the tax benefit. For many co-ops this tax effect will be minimal, but for some others it will be significant and worth doing some planning.
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About the Author
Bruce Mayer, MBA, CPA currently serves as a Partner in the Assurance Department, working primarily on audits and tax returns of cooperatives, nonprofits, employee benefit plans and commercial businesses. Bruce performs audits of all kinds and provides consulting services on taxation of nonprofits and cooperatives. Bruce enjoys helping clients solve problems and providing clients advice on accounting and tax strategies that meet their needs.