Recent developments in farm taxation.

Farm and ranch income can fluctuate widely due to market prices, the weather, change in supply and demand and a host of other factors. To protect agricultural producers from the corresponding wide swings in tax liability, the Taxpayer Relief Act of 1997 (TRA '97) enacted farm income averaging, which allows individuals engaged in the business of farming to compute their current tax liability by averaging farm income over the prior three years. While the TRA '97 initially allowed only farm income averaging for tax years 1998-2000, the Tax and Trade Relief Extension Act of 1998 (TTKEA '98) permanently extended this treatment.

Beginning in 1998, an individual engaged in a farming business can elect to treat all or a portion of his taxable income attributable to farming as "elected farm income." One third of this elected farm income is carried back to each of the three previous years, and the income tax is recalculated for those years. The current-year tax liability is determined by combining the producer's current-year tax liability (excluding the elected farm income) and the increase in tax liability for each of the three prior tax years (taking into account one-third of elected farm income for each year).

"Farm business" includes a trade or business involving the cultivation of the land or the raising and harvesting of any agricultural or horticultural commodity (such as the raising or harvesting of crops and trees bearing fruit) and the raising, shearing, feeding, caring, training and management of animals. "Elected farm income" means the amount of taxable income attributable to any farming business and includes gains from the sale or other disposition of property (other than land) used for a substantial period in the trade or business of farming. Income averaging is not available for estates and trusts and does not apply to the self-employment (SE) or alternative minimum tax.

NOL 

The TTREA '98 provides for a five-year net operating loss (NOL) carryback period for farming losses. Previously, the carryback period was two years; the carryforward period remains at 20 years. The five-year carryback applies regardless of whether an area is declared a Presidential disaster area or the loss is attributable to a casualty or a theft. A farming loss is the amount by which farming business deductions exceed attributable income. (A farming business has the same definition as for farm income averaging.) A farming loss cannot exceed a taxpayer's total NOL for the year, and the amount attributable to a farming loss is treated as a separate NOL from the remaining portion of the NOL for the tax year. A taxpayer can elect out of the five-year carryback period for the farming loss and be subject to the two-year carryback or the 20-year carryforward. This provision is effective for tax years beginning in 1998.

Farm Production Flexibility Contract Payments

Under the Emergency Farm Financial Relief Act of 1998, taxpayers enrolled in production flexibility contracts have the option to elect to receive all of their fiscal-year 1999 payments as early as October 1998. This option potentially results in the constructive receipt of income in 1998, even if the taxpayer elects to receive the payments in 1999. The TTREA '98 requires the inclusion of these production flexibility payments in income when the actual amount is received, without regard to a farmer's option to receive payment in another period.

Conservation Reserve Program Payments

Wuebker, 110 TC 431 (1998), held that Conservation Reserve Program (CRP) payments were not subject to SE tax and were properly reported as rent income. This is a significant departure from previous IRS rulings and cases. Previously, the Service stated that CRP payments received by a farmer or rancher who materially participated in the operation were subject to SE tax. (Material participation means that an individual is involved to a material degree in the production or management of livestock or crops.) Typically, retired farmers or ranchers receiving CRP payments were not subject to SE tax, as they did not materially participate in the operations.

In Wuebker, the taxpayer bid all his tillable farmland to the CRP program, and continued to farm rented land (cropshare) and raise laying hens on land contiguous to the CRP land. The taxpayer reported the CRP payments (less taxes and mortgage interest) as rental income not subject to SE taxes. The crop-sharing and income from the laying hens were reported as SE income.

The taxpayer argued, and the court agreed, that the CRP contracts, statutes and regulations repeatedly and consistently referred to the annual payments as "rental payments" and that, absent any language to the contrary, the plain definition of "rent" should be used. The IRS argued that the CRP payments were directly related to the taxpayers' active trade or business of farming, causing the payments to be subject to SE taxes. The Tax Court rejected this argument, stating that once the payments were determined to be rent, the relationship between the CRP payments and the trade or business of farming, or how active the farmer was in this trade or business, was irrelevant.

The court stated the CRP payments were for land-use restrictions (rent) rather than labor for services (SE income). SE income is defined as gross income less deductions in carrying on a trade or business; rent is defined as compensation for the use or occupancy of property.

While it is expected that the Service will appeal Wuebker, taxpayers may want to consider filing amended returns for all open years in which CRP payments were reported as SE income.

EIC and Capital Gains

The earned income credit (EIC) is reduced or disallowed if a taxpayer's earned income and modified adjusted gross income exceed a certain level. The EIC is also disallowed if investment income exceeded $2,200 in 199.6 and $2,250 in 1997. Investment income includes interest, dividends and capital gains.

In the past, the IRS took the position that gain from the sale of assets used in a trade or business (e.g., gain from the sale of raised breeding livestock) was capital gain to be included in the above income limit for investment income test purposes. Most tax practitioners strongly felt that raised breeding livestock, while affording capital gain treatment when sold for most purposes under the Code, was not, by definition, a capital asset for EIC purposes. Thus, gains from the sale of these assets should not be considered capital gains for the investment income test.

Rev. Rul. 98-56 states that the capital gain from the sale of raised breeding livestock is not disqualified income for purposes of computing investment income. This ruling indicates that taxpayers no longer have to include this gain as investment income. Taxpayers should consider filing amended tax returns for 1996 and 1997, if applicable.

FROM MARTIN PHILLIPS, CPA, RAPID CITY, SD