Question

Joseph conducts an plumbing business. With a view to future retirement he purchases 20ha of land and plants native wildflowers that he plans to harvest and sell. As a preliminary measure he arranges to clear the land and plough in compost. It is expected that the first commercial crop will not be harvested for five years. He incurs interest on a loan to finance the land purchase, land preparation costs, fertilizer costs and costs of acquiring native seedlings. Advise Joseph of the tax consequences of the venture. You must cite the relevant case law and legislation

Answer 1

Introduction

The Understanding of basic concepts and applications of federal income tax law are crucial because the amount of taxes owed often affects economic benefit of the choice selected.

What's included in farm income and what expenses are deductible from the income? Can a tractor purchase be justified when you take into account depreciation? What will you owe in taxes if you sell some of your cows? How will hiring your spouse change the amount of taxes you pay?

The farmer it is important for you to have at least a basic understanding on how ever federal income taxes affect your business. It's imperative to keep appropriate and sufficient records and estimate the taxes due to the IRS. Consulting with an accountant, bookkeeper, or other tax/finance professional will help you understand and appropriately assess impacts of a decision on your income tax liability. These professionals are part of the management team of a well-run business and their advice should be sought when needed.

Who is a Farmer? What is a Farmer?

Under tax law, a farmer is defined as someone who operates a farming business with the intent of making a profit. However, there are special provisions in the tax code that further restrict who qualifies as a farmer in order for the individual to take advantage of the benefits provided under the provision.

A farm is described by the Internal Revenue Service (IRS) as a business that undertakes farming activities and produces income reportable on Schedule F (Form 1040), the Profit or Loss from Farming.

Several references in the IRS tax code describe farming activities, with minor variations among them. These references often refer to cultivating land and the raising or harvesting of agricultural or horticultural commodities.

Perhaps one of the more direct references can be found on the front cover of the Farmer's Tax Guide, IRS Publication 225: "You are in the business of farming if you cultivate, operate, or manage a farm for profit, either as owner or tenant. A farm includes livestock, dairy, poultry, fish, fruit, and truck farms. It also includes plantations, ranches, ranges and orchards."

Special estimated tax rules apply for qualified farmers. If more than two-thirds of an individual's gross income is from farming in the current or prior year, then the qualifying farmer is allowed to make a single estimated tax payment by the fifteenth of the month following the close of the tax year, or pay the full income tax liability by the first of the third month following the close of the tax year. Non-qualifying farmers, like other non-farm businesses, must pay estimated tax payments on a quarterly basis throughout the tax year.

Farm Income

Income from normal farm business operations is reported on the Schedule F (Form 1040). Part I is for farms using the cash method of accounting; Part III is for farms using the accrual method (Part II is used to report expenses and will be discussed in the next section).

Farm income includes the sales of both raised and grown farm products, sales of farm products purchased for resale, income received from custom work and farm-related services, distributions from cooperatives, barter income (at fair market value), refunds, and reimbursements.

Most agricultural program payments, reported to recipients and the IRS on Schedule 1099-G, Certain Government Payments, are taxable and need to be added to income on Schedule F (Form 1040). Expenses associated with the agricultural practice or project supported by these payments usually offset the money received.

As a rule, farm loans aren't reported as income. However, a farmer who pledges all or part of production to secure a Commodity Credit Corporation (CCC) loan can treat the CCC loan as the crop sale and report loan proceeds as income in the year received.

If a farmer chooses to report the CCC loan as income, then the amount reported becomes the basis in the commodity. Any subsequent sale of crop above the basis is additional income; a sale below the basis is a loss. If the crop is fed to livestock, then the basis can be deducted as a farm expense.

Farm Expenses:

Ordinary and necessary expenses associated with producing farm products and providing services are reported on Part II of Schedule F (Form 1040), which lists more than twenty deductible items, including chemicals, seeds and plants, fertilizers and lime, feed, gasoline and fuel, repairs and maintenance, labor hired, insurance, interest, rent, depreciation, utilities, veterinary and breeding, and supplies.

The costs of items purchased for resale, including livestock, aren't shown on Part II of Schedule F (Form 1040). Instead, the costs of items to be resold are subtracted from gross sales in the year of sale on Part I of Schedule F. This procedure is followed for reporting costs of items resold even if a farmer has adopted the cash method of accounting.

Machinery and building repairs and maintenance are deducted in the year paid; the purpose of repairs is to keep the property in operating condition. Improvements to machinery and buildings must be capitalized and depreciated. Improvements add to a property's value, prolong its useful life, and/or adapt it to a different or new use.

Payments for some expenses such as utilities, property taxes, interest, and insurance may be partly personal and partly business. The personal portion isn't deductible, but the business portion should be added to expenses on Schedule F (Form 1040). Although there is no official allocation method, a reasonable approach must be used to allocate the expense between personal and business use when there is a single payment.

Famers can deduct the costs of using an automobile or light truck in their business using the standard mileage rate method or actual expense method. The standard mileage rate is set by the IRS and adjusted periodically to reflect changes in vehicle operating and ownership costs. Current standard mileage rates can be found on the IRS website (irs.gov) by searching for "standard mileage rates." In general, the number of business miles driven must be substantiated with records, like a logbook; but, farmers are allowed to claim 75 percent of a car or light truck use as business related without keeping records if the vehicle is used most of the normal business day in connection with farm operations.

A farmer who uses the cash method of accounting is allowed to deduct prepaid farm supplies in the year purchased. This deduction is limited to 50 percent of all other farm expenses for that year. This limit doesn't apply to "farm-related" taxpayers under either of two exceptions.

A farm-related taxpayer is one whose main home is on a farm or whose principal business is farming or a taxpayer who is related to someone meeting either of these criteria. One exception is if there was a change in business operations as result of unusual circumstances. The second exception is if the total prepaid supplies expense for the preceding three tax years is less than 50 percent of other total deductible farm expenses for those three tax years.

In the case of prepaid livestock feed, further conditions must be met for the prepaid expense to be deductible in the year purchased. The prepayment must be for the purchase of feed, not just a deposit. The prepayment must be for a business purpose, not just to reduce tax liability. The deduction resulting from the prepayment must not materially distort income.

Rent or lease payments for equipment and buildings are deductible farm expenses. If a lease agreement is set up in a similar manner to an installment sales contract, then the rental amount will be treated as loan payments by the IRS. The farmer will be allowed to only deduct the portion of the rent deemed interest and deduct depreciation for the asset purchased, if applicable.

Most short-term leases are clearly deductible because the farmer has neither the right to buy the property nor any equity interest in the property at the end of the lease term. Longer, multi-year lease agreements will likely receive more scrutiny from the IRS in determining both the lessor's and lessee's intent.

Farmers can also choose to deduct costs incurred for certain soil and water conservation expenses on farmland rather than add those costs to the basis of the land. Eligible deductible conservation expenses include leveling, grading, terracing, contour furrowing, and fertility restoration of land; constructing diversion channels, drainage ditches, irrigation ditches, earthen dams and ponds; and eradicating brush and planting windbreaks.

The deduction for soil and water conservation expense is limited to 25 percent of gross income from farming, with excess qualifying expenses carried forward to future tax years. Expenses normally depreciated aren't eligible for the deduction. The election to deduct soil and water conservation expenses applies to similar expenses incurred in subsequent tax years. A taxpayer must receive permission from the IRS to change this election.

The interest charged on a loan is a cost associated with borrowing and is a deductible expense if the loan was related to farm operations. For a loan used to acquire both personal and business assets, a farmer needs to determine the portion of interest charges applicable to the farm business.

Sole proprietors may not deduct any charge for their labor associated with operating the farm. Net farm profit on Schedule F (Form 1040) is considered the sole proprietor's income and is reported as such on his/her personal tax return. This is also true for other "pass through" entities-- namely, partnerships and limited liability companies not taxed as corporations. Even though they may file forms different from the sole proprietor, business profits pass through the business to the owners' personal tax forms.

Depreciation:

Depreciation is a means of recovering the investment in certain business property. Business property is depreciable if it has a useful economic life exceeding one year and wears out with use and/or becomes obsolete over time.

Machinery, equipment, purchased breeding animals, livestock facilities, barns, fencing, greenhouses, and storage structures are common examples of depreciable property found on farms. Farmland isn't depreciable since it doesn't have a definite life, nor is a home because it is personal property.

The Modified Accelerated Cost Recovery System (MACRS) is used to calculate the correct depreciation deductions for federal income tax purposes. To determine the depreciation allowed, you need to know the "basis" of your property, when the property was placed in service, and the property's class. Basis is the owner's investment in property. A property's initial basis depends on how the property was acquired. The basis of purchased property is generally the property's cost. For property acquired as a gift, the donor's basis commonly becomes the recipient's basis in the property.

The basis of inherited property, property constructed by an owner, property received in a tax-free exchange, and personal property converted to business use are all figured differently. A depreciable property's basis is the amount available for depreciation deductions under MACRS.

Depreciation begins when a property is placed in service. A property is placed in service when it is ready and available for its specific use in farm operations. A hay baler delivered to a farm in December begins depreciation the year delivered, even though it probably won't be first used until the following spring. The depreciation of fruit trees and grapevines begins when the plants first produce fruit for commercial sales even though they were likely purchased several years earlier. Depreciation of immature, purchased breeding livestock begins when they are first bred.

Tax Management:

Key goals of tax management are to:

• preserve the benefits associated with deductions and exemptions
• minimize income tax paid over time, not just in the current year. Tax management starts with understanding the relationship of gross income to adjusted gross income and taxable income.

When determining your gross income, net farm profit from Schedule F (Form 1040) is added to wages, interest received, and other sources of income. Adjustments or "above-the-line" deductions are subtracted from gross income to arrive at your adjusted gross income. Adjusted gross income is reduced by personal and dependent exemptions and either the standard or itemized deduction to arrive at taxable income.

Above-the-line deductions include a portion of the self-employment tax paid, cost of self-employed health insurance, certain retirement plan contributions, student loan interest, higher education tuition costs and fees, moving expenses, and the domestic production activities deduction. These adjustments and others are listed on the bottom half of the first page on Form 1040, U.S. Individual Income Tax Return.

Itemized deductions are allowable personal expenses such as state and local taxes, home mortgage interest, gifts to charities, and dental and medical expenses that exceed 7.5 percent of adjusted gross income. Schedule A (Form 1040), Itemized Deductions is used to report these deductions. If you elect to not itemize deductions, then a standard deduction based on your filing status and age applies.

If you reduce net farm profit on Schedule F (Form 1040) to zero or near zero, this may result in "losing" the benefit of offsetting taxable income with your deductions and exemptions. This is especially true if you report little nonfarm or interest income.

Minimizing tax liability over several years is often the better approach to managing taxes compared to only focusing on your current year's obligation. Various techniques may be employed to either reduce or increase net farm profit reported to the IRS in a given year. Since some choices must be made before the close of the tax year, the initial step in managing income tax liability is to estimate your farm receipts, expenses, and net profit in November before transactions for the year are finalized.

An anticipated high net farm profit may be reduced before year-end by either postponing sales or accelerating expenses. Delaying delivery of products until January or later would shift sales to the following year; however, a check you receive from a customer must be reported in the year it was received because it was made available on receipt and recognition can't be postponed.

Under the cash method of accounting, year-end purchases of feed, fertilizer, chemicals, and similar supplies are deductible if certain conditions are met as discussed earlier. Other tactics for accelerating expenses are paying outstanding balances on supplier accounts and making needed repairs in the current year. Certain expenses can't be accelerated even if they are prepaid; these include interest, rent, insurance, and real estate taxes.

If net farm profit is expected to be too low to take advantage of adjustments and exemptions, profit may be increased by accelerating sales and postponing expenses before the end of the year.

Other tactics for managing income taxes include choosing whether or not to use the Section 179 expense deduction, choosing the method of depreciating purchases, varying contributions to retirement plans, reporting certain sales under the installment method, electing to report farm income using farm income averaging, electing to postpone reporting the gain on sales livestock due to weather-related conditions, and shifting income by employing family members. Finally, when making decisions about changing taxable profit, it's important to keep in mind the marginal tax rates and any changes being proposed for the upcoming years.

Schedule F and the Income Statement

Schedule F (Form 1040) resembles a farm's income statement (also known as the profit and loss or earnings statement). Net farm profit on Schedule F (Form 1040) will equal accounting profit on an income statement provided the farmer reports to the IRS on an accrual basis and depreciation claimed approximates the actual decrease in depreciable asset values.

Accounting to profit for a sole proprietor represents your return for your labor and management efforts and your equity in the business. For a partnership, accounting profit equals returns to the partner's labor and management and to the partner's equity. Accounting profit for a corporation equals returns to shareholder's equity since all labor and management costs have typically already been deducted.

If you report to the IRS on a cash basis, then adjustments to receipts and expenses may be needed in order to get a true picture of accounting profit. Cash receipts need to be adjusted for any change in end-of-the-year values compared to start-of-the-year values for product inventory and accounts receivable. Cash expenses will also need to be adjusted for changes in ending versus beginning values for supplies inventory, vendor accounts, and prepaid expenses. These changes can be determined by comparing values for current assets and current liabilities on the farm's beginning and ending balance sheets for the year.

Depreciation claimed on Schedule F (Form 1040) also needs to be reviewed. If an accelerated portion of the cost of machinery or other depreciable assets is deducted in the first or early years, then the tax depreciation claimed will overstate the decrease in the asset's value due to wear and tear. Accelerating depreciation may be a wise decision for tax management purposes, but accounting profit will be understated. Decreasing depreciation to a reasonable deduction on the income statement would provide a more realistic measure of actual profit.

When comparing your tax returns to an income statement, an additional item to consider is breeding livestock. Sales of breeding livestock and dairy animals are often considered part of receipts on an income statement. For taxes, these sales may be reported on Form 4797. Moreover, changes in raised breeding livestock inventory are commonly taken into account in determining net profit.

The Keeping complete and accurate records will help you not only support the information you report to the IRS but assess business progress and make realistic plans. The reason for preparing a Schedule F (Form 1040) is to determine net farm profit for tax purposes, but a business income statement estimates returns to your labor, management, and equity. Understanding the difference is crucial.