Question

Jim Brown is a dairy farmer in Wisconsin. He had a herd of 200 cows and sells milk to the local farm cooperative. Jim is also a computer whiz and spends two to four hours per day, five days per week trading cattle futures. During the year, he engages in 300 hedge transactions regarding cattle futures. Due to an unforeseen increase in the supply of dairy cattle, Jim's hedging transaction proved to be unprofitable and sustained a loss of $50,000 for the year. Since Jim is actively involved in the dairy business, he deducted the hedging losses as an ordinary and necessary business expense on his Schedule F, Farm income, on his form 1040. The loss reduced his net farm income to less than $300, so he paid no self-employments tax when he filed his return. The IRS is auditing Jim's tax return and proposes to increase Jim's net income from farming by $50,000 and to allow him instead a $3,000 short term capital loss. Jim has asked you to represent him in his dispute with the IRS. What advice would you give Jim?

Answer 1

Solution:

Advice:

• The IRS proposal to increase the net income from farming to $50,000 should be accepted by Jim.
• The refund for STCG (Short Term Capital Loss) of $3,000 should be reported by Jim.

Explanation:

The amount of $50,000 should not be included in Schedule F of form 1040 as the ordinary and business expense as the amount is because of hedging transaction which serves as collateral.

If IRS realises and finds out about the above information, then Jim would be in big trouble facing disputes and penalties from the IRS. The IRS auditing committee is strict and observes every transaction, which leads the above transaction to risk.

The main reason of why he should accept the proposal is that the net income of less than $300 than he recorded and also the capital loss of only $3,000 can be recognised by the IRS. This will have a tax implication of very minimum level even though the amount is taxable.

Therefore, Jimmy should reverse the entry of hedge less of amount $50,000 which he shown as ordinary and business expense to avoid this dispute. He should accept the proposal put forth by the IRS to avoid any penalties because of wrong entry on Form 1040.