Farm Credit Watch: Time to Rethink Taxation of FCS, Ag Co-ops

By Bert Ely

Hopefully an unintended consequence of the major tax legislation enacted in December will be the triggering of a fundamental review of the taxation of the FCS and agricultural co-ops relative to banks and other investor-owned businesses. The intent of this review should be to eliminate differences in the tax treatment of ag-related businesses due solely to their form of ownership. What should trigger this review was the tax legislation’s addition of a new section 199A to the Internal Revenue Code. As a Jan. 9 Wall Street Journal article reported, this new provision “allows farmers to deduct up to 20 percent of their total sales to cooperatives, letting some farmers reduce their taxable income to zero.”

According to the Journal article, this provision could sting large agribusinesses, such as Cargill and Archer Daniels Midland, in addition to smaller private operations as farmers increase their grain sales to ag co-ops to capture the tax savings offered by Section 199A. A subsequent Wall Street Journal article (Feb. 15) reported that while investor-owned grain companies are trying to get Section 199A modified so as to reduce its negative impact on them, they may set up their own co-ops so that they can remain competitive with the traditional ag co-ops in purchasing grains from farmers. Although not mentioned in the article, possibly the ag co-ops set up by the grain companies will be able to begin borrowing from CoBank, the only FCS institution authorized to lend to ag co-ops.

Efforts are underway in Congress to modify Section 199A so as to reduce, if not eliminate, the unintended effects it is having on agriculture. However, the longer this section is in effect, the harder it will be to modify or repeal it because grain companies as well as farmers and those who finance agriculture will have adapted to it and therefore will resist efforts to modify it. The furor that Section 199A has created should trigger a congressional review all aspects of agricultural taxation, including the highly favorable tax treatment the FCS has long enjoyed. While the tax-rate reductions Congress just enacted have helped somewhat to reduce the FCS’s tax advantages on loans secured by real estate, as reported in last month’s FCW, the FCS still enjoys a substantial tax advantage over commercial banks, which is magnified by the FCS’s favorable funding-cost advantage by virtue of being a GSE.

FCA chairman okay with deferring loan principal repayments
In last month’s FCS, I reported that FCS of America (FCSA), which serves all of South Dakota, Iowa, Nebraska, and Wyoming, had sent a letter to some of its member/borrowers offering to “defer the principal portion of all payments due in 2018 on your fixed or variable rate real estate loan(s).” Several bankers and other ag-finance experts echoed the concern I expressed about the wisdom of FCSA’s offer. One banker even suggested that a deferral of a loan’s principal repayments should cause the loan to be classified as non-performing or otherwise impaired.

Much to my surprise, Dallas Tonsager, the chairman and CEO of the Farm Credit Administration (FCA), in a Jan. 30 speech to the Farm Credit Council (the FCS trade association), effectively endorsed what FCSA has offered to its borrowers and encouraged other associations to do the same thing. Specifically, Tonsager stated that at a meeting last year, “I learned that some associations are giving some of their borrowers the option to defer the principal portion of their 2018 payments. This gives these producers the chance to re-amortize the outstanding balance over the remaining life of the loan. It also gives them additional working capital, which in turn gives them the flexibility and time to make needed adjustments to their operations.”

It appears that Tonsager is suggesting that FCS associations engage in loan restructuring without calling it that, which would have the effect of underreporting loan-quality issues within the FCS. Given that the USDA has forecast another decline in farm income in 2018, to a level less than half the record income farmers earned in 2013, “there’s a lot of stress and a lot of duress on the farms today,” as Agriculture Secretary Sonny Purdue stated during a recent hearing of the House Agriculture Committee. Has the FCS begun to mask the effect of that stress and distress on its borrowers by encouraging farmers to defer repayment of loan principal? In recent testimony to the House and Senate Agriculture Appropriations Subcommittees, Tonsager noted that four FCS associations “were under supervisory actions,” which suggests that borrower distress is beginning to surface in FCS associations. Encouraging the deferral of principal repayments could unwisely delay the FCA’s recognition and acknowledgement of additional credit-quality problems within the FCS.

FCA chairman again suggests changes in FCS structure
In his Farm Credit Council speech, Tonsager touched on an issue — the structure of the FCS — he previously has addressed, as I have reported in prior FCWs, most recently in the February and May 2017 issues. He asserted that while the FCS “has been in a constant state of renewal since its inception in 1916, as it continues to evolve, we must evaluate how any proposed change could impact the integrity and cooperative structure of the [FCS].” In particular, he stated that “we must consider how the change might affect the relationship between the funding bank and its associations.” What Tonsager is implying, but seems unwilling to state explicitly, is that the FCS’s two-tier structure — four regional banks funding 68 associations of widely varied size — is obsolete. Do the larger associations, for example, need to fund themselves through one of the four banks when they could just as easily deal directly with the Federal Farm Credit Banks Funding Corporation, the FCS’s link to the capital markets? Further consolidation within the FCS, particularly at the bank level, will heighten this issue because the strength of the joint-and-several liability of the FCS banks for debt issued by the Funding Corporation will be questioned if the number of banks — not so long ago there were twelve — shrinks to three or even two.

While Tonsager has repeatedly questioned the FCS’s structure, but noticeably without offering any restructuring proposals, it is most troubling that he views this issue as something to be addressed only within the FCS, as he suggested when he told Council members that “your members and stakeholders must have confidence that structural changes are in the best long-term interests of the [FCS] and those it serves.” By implication, Tonsager said that all others with interests in rural America, including commercial bankers, as well as the taxpayers backing the FCS, should be excluded from any discussions about restructuring the FCS. That should not be the case. Instead, every party with an interest in the health of agriculture and rural America should be involved in a very public discussion of the structure of the FCS, possibly in conjunction with a discussion of its tax status, as suggested above.

About Bert Ely

Bert Ely
Bert Ely is a consultant specializing in banking issues. He writes ABA's monthly Farm Credit Watch email bulletin.
More from Bert Ely >