Unique Tax Rules For Farmers and RanchersGloria Dsouza
So you want to be a farmer? Farming is not an easy profession. It requires long, hard days, during planting and harvest seasons. Then there is the constant worry about various infestations, weather, poor crop production, lack of rain, equipment issues, price fluctuations. You get the point. Farming requires a passion unlike any other profession. Passion is a hard intangible to come by. This is why many heirs sell the farmland they inherit to developers for a quick, one-time profit. The heirs simply can not find the passion for farming that their parents and grandsparents had. But if you're reading this article, you clearly have a passion for farming. so lets get started.
A farm includes the growing of grain, cotton, fruit, sod and tobacco. It also includes the raising of livestock for food, dairy and poultry. It includes fish grown and raised, as well as plantations, ranches and orchards. A ranch is considered by the Internal Revenue Service to be a large farm, primarily used to raise horses, beef cattle, sheep or other specialty livestock.
Farmers and ranchers are one of the few manufacturers to be exempted from using the accrual method of accounting, and are permitted to utilize the cash method of accounting. The cash method can be advantageous to farmers and ranchers by allowing for the deferral of income and acceleration of expenses. The cash method allows taxpayers to target an optimum level of net income, which translates into an ability to manage their income tax burden from year to year. The cash method requires revenue to be recognized in the year when cash is received and expenses are paid. The cost of livestock and other items purchased for resale can only be deducted in the year the sale occurs (ie the year cash is received). Similarly, the purchase of seeds and young plants bought for further development (further growing) may be valued as an expense when incurred (when paid) as long as such expenses are reported consistently from one year to the next.
Deferral of Income – General Rules
Farmers and ranchers typically sell their products under deferred arrangements which call for payment in a year subsequent to the year the sale actually takes place. Such arrangements allow farmers to avoid current taxation of such sales.Crop-share landlords include in their income, as rent, their percentage of the crop in the year the crop is converted into cash by the farmer. If the landlord materialically participates in the production or management of the farm, the income is subject to self employment tax (15.3% current). In such case, the landlord reports their share of the crop as farm income, which is reported on Schedule F and then Schedule SE. If the landlord does not materially participate, their share of the crop is considered to be a rental activity and reported on Form 4835. Factors which determine whether or not a landlord materially includes their involvement in management of the farming activity and decisions as to when and what to plant, the rotation of crops and the type of machinery to be used. The Internal Revenue Code allows farmers who participate in insurance arrangements, which compensate for weather-related damage to crops, or farmers who are eligible for government disaster and drought assistance payments to elect to defer crop insurance proceeds and such government payments received to the tax year following the year of the destruction or damage. The farmer must treat such payments received in a consistent manner from one year to the next.
Deferral of Income – Crop Revenue Coverage and Disaster or Disease Events
Farmers often buy a form of insurance called Crop Revenue Coverage. Essentially, a farmer sets up the insurance contract to guarantee a certain level of revenue from the crop. Any shortfall is reimbursed under this insurance arrangement regardless of the event causing the loss. To the extent a farmer receives any such insurance proceeds, which are not attributable to the destruction or damage to crops, such proceeds must be reported in the year received. If there is a destruction or damage event, such insurance proceeds may be deferred to the year following the destruction or damage as long as a Section 451 (d) deferral election is made by the farmer. This election is a one-time election, which requires consistent treatment from one year to the next. Similar income deferral rules apply with respect to livestock damages as a result of drought, flood or other weather-related conditions. Cash basis farmers have up to four years after a disaster event year, in a federally declared disaster area, to elect a one-year deferral on income election, on the forced sale of livestock. This is known as a 453 (e) (3) election. Livestock destroyed or sold or changed because of disease are considered an involuntary conversion. Any income received in such cases is eligible for a one year deferral (deferred to the year following the year of the disease event).
Prepaid farm expenses are defined as amounts paid for feed, seed, fertilizer or similar farm supplies, to the estimated the expenditure item has not actually been used or consumed during the current tax year. If the prepaid items exceeded 50% of other deductible expenses, such excess prepaid expenses are not allowed to be deducted during the current year and must be deferred to any outstanding year in which they are actually used or consumed (usually in the following tax year) . This expense deferral requirement is ignored if the farmer's cumulative prepaid farm expenses for the prior three years is less than 50% of the farmer's cumulative deductible farm expenses for that same three year period.
Fertilizer Expense Reporting Options
Farmers producing crops normally incur significant fertilizer and soil nutrient expenses. These costs often have a long-term impact and arguably could represent costs that should be capitalized (treated as a fixed asset and amortized). The IRS allows farmers to elect to annually expense such fertilizer amounts, rather than capitalize them. This increases the farmer's expenses for the year, and thus reduces their taxable income. The choice is very easy to make. The farmer simply claims a deduction for fertilizer each year on line 19 of Schedule F. Conversely, the decision to capitalize such fertilizer supplies is made for a particular year by decreasing to claim the current year deduction and then opting instead to amortize such expenses.
Soil and water Conservation Expenditures
Farmers may deduct in the current year all expenses associated with soil or water conservation or for the prevention of erosion. Such expenses include treating or removing earth, including leveling, conditioning, grading, terracing, contour furrowing or restoration. It also includes construction, control and protection of diversion channels, drainage or irrigation ditches, earthen terraces and dams, watercourses, outlets and ponds. The amount which may be deducted instead of capitalized to the basis of the farmland, is limited to 25% of the farmer's gross farm income. This income includes gross receipts from farming, as well as gains from the sale of livestock held for draft, breeding or dairy purposes. Any excess conservation expense above this 25% threshold may be transported forward to the next year, but it is once again subject to the 25% gross farm income limitation test. Amounts required to be transported forward, may be transported forward indefinitely until used in full.
Uniform Capitalization Rules for Farmers
in general, the Internal Revenue Code Section 263A uniform capitalization rules (UNICAP) require direct costs and an allocable portion of certain indirect costs to be capitalized to farm inventory costs (thus decreasing current year expenses and increasing taxable income). For farmers, the UNICAP rules only apply to plants and animals with a preproductive period (not able to produce fruit, vegetables, offspring, dairy etc.) of more than two years. Thus, all plants and animals with a preproduction period of two years or less are exempt from the application of the UNICP rules. This rule primarily impacts orchards and vinelands.
There are many other tax nuances associated with farming, but we have covered the main areas. It is important to secure the services of a CPA firm which specializes in farming activities. Farming is such a unique practice area and, as you can see, is a bit complicated. Not having a specialist in this niche will result in lost tax benefits or negligent tax filings.