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Selected issues in farm taxation.

Although much of farm taxation is generic--i.e., general tax concepts apply as much to farm operations as to any other business--there are a number of taxation issues that apply specifically to farms and ranches.

Attempts to Avoid Self-Employment Tax

Farmers have a great incentive to make payments of, or gifts of, crops in the bin or livestock on the hoof in order to avoid self-employment tax.|1~ If successful, the farmer either has a deduction from income or, if a cash-basis taxpayer, simply less income. Meanwhile the recipient will not be subject to the self-employment tax.

Lately, the IRS has taken a dim view of such strategies. In a recent letter ruling, the IRS denied a rather sloppy attempt by a farmer to make a gift of soybeans to his wife. In June, 1988, the farmer delivered soybeans from his 1987 crop to an elevator. The grain was stored with the farmer listed as "patron" and his wife's handwritten name at the bottom of the receipt. Later the farmer executed a statement before a notary public which read, "To whom it may concern, this paper is to ascertain that a gift has been made from |the farmer~ to |his wife~ of old crop soybeans in the amount of 40x bushels. Said grain is presently stored in a grain bin at a grain elevator. This paper releases the grain to C so that the recipient can sell the grain any time prior to September 1, 1988."

Unfortunately, the check was issued to the farmer and he deposited it in their joint account. Ten days later, upon discovering the "error," the wife transferred the money into her personal savings account. On a joint return, the farmer and his wife reported a zero basis in the grain and reported the sale as a capital gain.

The IRS ruled that the "gift" was "nothing more than an artifice and a device to reduce self-employment tax..." The IRS further noted that: the farmer stood to benefit from the transaction (it was deposited in the joint account); he did not divest control of the soybeans (his name was listed on the grain elevator receipt); there was no physical delivery to the wife; and finally, that the transaction had no economic substance.|2~

In summary, this was an unusually clumsy attempt to avoid self-employment taxes; there should at least be a completed delivery of the property, and the donor should not receive subsequent benefit. Even with all the t's crossed, this type of transaction is certain to be closely scrutinized by the IRS and the IRS has a number of weapons at its disposal, e.g., the assignment of income doctrine.

Crop Insurance Proceeds and Federal Disaster Payments

Final regulations have been issued detailing how to elect to include crop insurance proceeds in gross income in the year following the taxable year of damage or destruction. For years ending after December 31, 1969, a taxpayer on the cash basis method may elect to defer insurance proceeds paid because of crop damage until the year following receipt, provided that under this established business practice, the income from the crops would have been reported the next year. However, if the proceeds are not received until the year following receipt, no deferral is available.|3~ Even if payments are received for damage to two or more crops, only one election is necessary. However, a separate election must be made for each separate trade or business.|4~

The election is made by attaching to the return a statement that includes the taxpayer's name and address, a declaration that the election is being made under Sec. 351(d), identification of the crops destroyed, cause of destruction and dates thereof, total payments itemized with respect to each crop and date, and the name of the insurance carriers.|5~

The IRS also clarified the tax status of Federal disaster payments. Previously, in Rev. Rul. 75-36 the IRS had ruled that such payments were not in the nature of insurance but were instead in the nature of guaranteed income and thus not eligible for deferral. However, the new ruling allows deferral of payments received under Federal disaster assistance acts if the underlying crop would have under normal business practice been sold the next year.|6~

Deferred Payment Contracts

Cash basis farmers often wish to defer income from grain but want the grain off their farm. One strategy is to enter into a deferred payment contract with the grain elevator. In a deferred payment contract, the seller transfers possession and title of the grain to the elevator, with payment to be made at a later date. A special form of the deferred payment contract is a price-later contract which lets the seller select the day of pricing. To be valid under current administrative and judicial rulings, the contract should have these features:

* The deferral period should not extend beyond the end of the year following the year in which the contract is entered into; otherwise the IRS may assert distortion of income.

* Generally, it is best to avoid elective elements in the contract, i.e., an election to receive part of the proceeds before the end of the year). If there is an elective element (and this is risky) it is important that the sales price not be fixed for the payments that are deferred. The IRS announced in 1987 that they were reexamining deferred payment contracts for producers. To date nothing has been published, but they were expected to try to tighten up this area. In a 1987 letter ruling, the IRS denied deferral of income from a price-later contract that was executed by a sharecrop landlord. The IRS reasoned that a sharecrop landlord receives income in-kind at the time of delivery of the crops to the landlord. Because a sale did take place, the IRS ruled that "...the special privilege granted to sharecrop landlords of deferring recognition of the rental income is necessitated by the absence of cash with which to pay the tax prior to a sale. However, once a sale is established, this deferral privilege does not serve the intended purpose. Thus, there is no reason to continue the preferential treatment accorded crop shares beyond their disposition."|7~

However, the IRS recently received a setback in court in its efforts to challenge deferred payment contracts. In Applegate, the taxpayer, a sharecrop landlord in Illinois, entered into a price-later contract which provided that the seller could fix the price at any time but no later than one year from the date of the contract. Rather than assert constructive receipt of the income (as in PLR 8726007 discussed above), the IRS attacked Applegate's price-later contract on the grounds that an installment sale had not occurred because the terms amounted to debt which was payable on demand.

Probably their change of tactics reflects the weakness of the logic in PLR 8726007 as well as their desire to attack price-later contracts for all sellers, producers as well as landlords. In any event, the Tax Court held that the requirement in the contract that payment be made no later than a definite time meant that the contract was not a demand obligation.|8~ The Seventh Circuit upheld the Tax Court, giving considerable weight to its view that the term "payable on demand" refers to an option of the seller to require immediate payment of a fixed or computable amount, rather than an option to select a date of sale with the amount dependent on market prices on that day.|9~

Although this case is good news for taxpayers, farmers should be cautious about deferred payment contracts, not only because of uncertainty about the IRS position but because in many states the farmer is merely a general creditor of the elevator. Thus, should the elevator becomes insolvent, state insurance funds may not cover the contract.

Incorporating Farms: Beware of Zero Basis Assets

More and more farms and ranches are being incorporated because of the many tax and non-tax advantages, such as meals and lodging and other fringe benefits, ease of transfer for estate planning purposes, and limited liability. Under Section 351 an incorporation is generally tax-free to both the transferor and the transferee.|10~ However, farmers who have been using the cash basis method of accounting should be wary about transferring certain zero basis assets, such as growing crops, crops in the bin, and calves and pigs.

The confusion arises as to who pays tax on the income when the assets are ultimately sold. The corporation will have a zero basis in the assets and generally it would report the income when sold. However, the IRS has used the assignment-of-income doctrine as well as Section 482 (the allocation of income power) to tax the income to the transferor (the farmer) instead of the corporation. Since case law is rather murky in this area, it makes sense to avoid transferring to the newly formed corporation growing and stored crops as well as such zero basis livestock as raised calves and pigs.|11~

Care should also be taken not to transfer property with a mortgage in excess of the basis of all the property transferred. In that event, the excess of the debt over the basis will result in taxable income to the transferor.|12~

Example: Smith transfers 400 acres of farmland worth $600,000 (but encumbered by a $250,000 mortgage) to a corporation in exchange for common stock. The land cost Smith only $100,000. He also transferred machinery with a basis of $8,000. Smith must recognize gain of $250,000 - 100,000 - 8,000 = $142,000.

Sale of Livestock Due to Drought or Disease

Farmers often are forced to sell livestock due to drought conditions. Section 451 permits the election of a one-year deferral of income from these forced sales in two instances:|13~

(1) If an extra number over the usual number of the livestock crop, i.e., calves, lambs, pigs, colts, etc., is sold.

(2) If an extra number over the usual number of livestock held for productive purposes, i.e., breeding, draft, dairy or sporting purposes, is sold (this provision applies to sales or exchanges after 1987).

The drought conditions must have resulted in the area being designated as eligible for assistance by the Federal government.|14~

Example: Jones raises 400 head of calves per year. Normally he sells 325 head and retains 75 head for replacement purposes. He also generally culls 60 cows from his herd and sells them. In 1992, due to a severe drought, he sold all 400 head of his calves and 160 head of cows. The income from 75 of the calves and 100 of the cows could be deferred until 1993 if Jones so elects.

As an alternative to electing the one-year deferral, farmers who must sell livestock at a gain because of drought or disease could elect to use the involuntary conversion rules of Section 1033. If the livestock are sold due to drought, only livestock held for productive use are eligible and only to the extent of the excess sales over the usual sales.|15~ The rules are more liberal for livestock sold or destroyed because of disease. All livestock are eligible, regardless of the reason held.|16~ Assuming that a timely replacement is made (two years following the close of the year of sale), the gain may be postponed until or unless the replacement livestock are sold. Qualified replacement property for this purpose must meet the functional use test e.g., replacing dairy cattle with beef cattle would not be a qualified replacement.

Example: Assume the same facts as in the previous example. If Jones intends to replace his extra 100 cows sold by December 31, 1994, he could (and would probably prefer) to elect to use the involuntary conversion rules rather than the one-year deferral. However, for the calves, only the one-year deferral is available.

Passive Activity Rules for Farm Landlords

Landlords who cash rent their land may be able to deduct rental losses up to $25,000 per year. The deduction is phased out as AGI exceeds $100,000 and is reduced to zero at an AGI of $150,000.|17~ The landlord, however, must meet the "active participation" test. If the landlord deals directly with the tenant and approves all material repair and maintenance expenditures, this test should be met. However, if cash rented land produces net income instead of a loss, the income will not be passive if (as will likely be true) less than 30% of the unadjusted basis of the property is subject to the allowance for depreciation.|18~ Thus, the rental income could not be used to offset passive losses from other sources.

Sharecrop arrangements are treated in the temporary regulations as joint ventures rather than as rental activities.|19~ Therefore sharecrop landlords are not eligible for the $25,000 rental loss deduction discussed above. Losses from sharecrop arrangements will be passive losses unless one of the seven material participation requirements is satisfied.|20~ However, retired farmers and their surviving spouses are given a break; they are deemed to have satisfied material participation rules.|21~ Therefore, their sharecrop rental losses will be fully deductible as active business losses.

When landowners hire others to custom farm, the landowner is not engaged in a rental activity but rather in a business. The passive loss regulations would govern whether the income or loss is passive or active. If the landowner hires a professional farm management company to act on his behalf, the activities of the farm management company could not be included in determining material participation or active participation requirements (activities of an agent may not be counted by the principal). Therefore, it would be difficult to meet even the active participation requirement.

Tax planning in this area is especially important. Before property is leased, the management responsibilities of the landlord should be decided and the lease should clearly reflect those duties.

References

1 See Maydew, Gary L., "Non-Cash Payments to Farm Workers to Avoid FICA Taxes--Is the IRS Cracking Down?" Taxes, Jan., 1992, pp. 53-54.

2 PLR 9210004 (Nov. 29, 1991)

3 Reg. 1.451-6(a)(1)

4 Ibid

5 Ibid

6 Rev. Rul. 91-55, 1991-2 CB 321

7 PLR 8726007 (March 23, 1987)

8 Applegate v. Comr., 94 TC 696 (1990)

9 Applegate v. Comr., 92-2 USTC para. 86, 185, (7th Cir., 1992)

10 IRC 351(a)

11 For more details, see Maydew, Gary L., "Incorporating the Family Farm May Generally Be Done Tax-free," Journal of Agricultural Taxation & Law, Spring, 1992.

12 IRC 357(c)

13 IRC 451(e)

14 Ibid

15 IRC 1033(e)

16 IRC 1033(d)

17 IRC 469(i)

18 Temp. Reg. 1.469-2T(f)(3)

19 Temp. Reg. 1.469-1T(e)(3)(vii)

20 See Temp. Reg. 1.469-5T

21 IRC 469(h)(3); Temp Reg. 1.469-5T(h)(2)

Gary L. Maydew is an associate professor in the accounting department at Iowa State University in Ames, Iowa.
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Author:Maydew, Gary L.
Publication:The National Public Accountant
Date:Dec 1, 1993
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