Question

Taxation problem:

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

Farmers include all individuals, partnerships, or corporations cultivating, operating, or managing farms for gain or profit as owners or tenants. However, taxpayers engaged in forestry or timber raising are not farmers.

Farmers, like other taxpayers, are subject to a variety of taxes at all levels of government. At the Federal level, these include income taxes, social security and self-employment taxes, and estate taxes. At the state and local level, the most significant taxes are on property and income. Other taxes such as excise taxes, corporate income taxes, and retail sales taxes are significant for only a small number of farmers.

The Federal income tax is a progressive tax imposed on net income. Taxable income is computed by subtracting allowable adjustments, deductions, and personal exemptions from total income. Numerous provisions of Federal income tax law allow taxpayers to reduce their tax liability if they undertake certain tax-favored activities. Farmers benefit from both general tax provisions available to all taxpayers and from provisions specifically designed for farmers.

A farmer’s gross income includes amounts received in cash plus anything of value received instead of cash.

The following aid payments are included in income:

Fertilizer and lime received under government programs are included at the value figured in the program.
Payments under the Dairy Termination Program are taxable as gain or loss on the sale of the dairy cattle as additional amount realized or as ordinary income as replacement for milk production receipts.
Buyouts of peanut quotas under the Farm Security and Rural Investment Act of 2002.
Payments from the National Tobacco Settlement Trust to landowners, producers and tobacco quota owners, are compensation for lost revenue due to decreased tobacco demand, and are taxable as ordinary income.
Payments to terminate tobacco quotas under the Farm Security and Rural Investment Act of 2004.
Payments to growers under the Fair and Equitable Tobacco Reform Act of 2004.
Illegal irrigation subsidies, i.e., the excess of the amount required to be paid for any federal irrigation water delivered to the taxpayer during the tax year, over the amount paid for the water.
First handler payments and inventory protection payments made by the Community Credit Corporation under the Food Security Act of 85 that exceed the cost of the cotton giving rise to the payments, are included in gross income.
Rents for leasing out upland cotton acreage allotments made under the Agricultural Adjustment Act are ordinary income to the farmer to whom the allocation was made.
Commodity certificates under government conservation, production flexibility, etc. programs are included in gross income, at their full amount.
Reimbursements under Disaster Assistance Act are included in gross income, according to the farmer’s accounting method.

A farmer who operates a farm for profit is entitled to deduct from gross income necessary expenses, all amounts actually expended in the carrying on of the business of farming. The farmer’s accounting method generally controls the proper time for deducting the business expense.

A farmers’ business expenses include:

rent paid for farm;
taxes and tax preparation fees;
labor;
repairs;
marketing quota penalties paid for marketing crops in excess of marketing quotas, unless deducted from the amount paid by the buyer to the farmer (who includes only the net amount received in income);
egg-laying hens, and plants, chicks, etc., bought for resale;
feed;
fertilizer;
car and truck expenses;
maintaining houses and furnishings for tenants and hired help, including costs for heat, light, insurance, repairs, and depreciation;
interest on farm mortgages and other obligations incurred to carry on farm business;
educational expenses to maintain and improve farming skills;
ordinary tools of short life (one year or less) or small cost, such as hand tools, shovels and rakes; and
premiums on fire, storm, crop, theft, liability, and other insurance on farm business assets.

Individuals engaged in a farming business may elect to use income averaging to compute their tax for a tax year. An electing individual’s tax for the year will equal the sum of:

a tax computed on taxable income reduced by elected farm income, plus
the increase in tax imposed would result if taxable income for the three previous tax years (base years) were increased by an amount equal to one-third of the elected farm income.

An individual engaged in a farming business can make a farm income averaging election to compute his/her current year (election year) income tax liability by averaging, over the prior three-year period (base years), all or a portion of the individual’s current year electible farm income.

Making the income averaging election may result in a lower tax if the farmer’s current year income from farming is high and his/her taxable income for one or more of the three earlier years was low. It may be to a farmer’s advantage to include less than the full amount of his/her income from farming in his/her elected farm income, depending on the farmer’s tax bracket for the current and the three earlier tax years.

Determining the tax liability for the election involves computation of the tax that would be imposed, if:

taxable income for the election year were reduced by EFI, and
taxable income for each of the base years were increased by one-third of EFI.

The reduction and increases required for this computation don’t affect the actual taxable income for either the election year or the base years. So, for each of those years, the actual taxable income is determined without regard to any hypothetical reduction or increase required for computing the tax for the election year.

To compute the amount, all allowable deductions (including the full amount of any net operating loss carryover) are taken into account in determining the taxable income for the base year even if the deductions exceed gross income and the result is negative. But if the result is negative, any amount that may provide a benefit in another tax year is added back in determining base year taxable income.

An individual doesn’t have to have been engaged in a farming business in any of the base years in order to make a farm or fishing income averaging election.

A farmer does not have to pay the estimated tax if s/he files his/her return and pays the tax on or before March first of the following year. If s/he doesn’t file his/her return and pay the tax on or before March first, s/he need only make one estimated tax payment for the year, which is due on or before January fifteen of the following tax year. A farmer or fisherman may avoid penalty by paying hundred percent of the previous year’s tax. The underpayment penalty is based on the difference between the amount of estimated tax s/he paid by the due date and two third of the actual tax for the year.