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Preparing tax returns for farmers and ranchers requires specialized knowledge of tax rules and provisions that apply only to those in the business of farming. Individuals, partnerships, and trusts and estates generally report farm income and expenses on Form 1040, Schedule F. Taxpayers use this form to calculate net gain or loss from farming. Gains or losses from the sale of farm assets are reported on Form 4797.
Whether income is “farm income” depends upon the operations being conducted and the activities of the person conducting it. Different definitions of farming apply to different tax provisions. This article highlights key rules for reporting farm income.
For tax purposes generally, all individuals, partnerships, or corporations that cultivate, operate, or manage farms for gain or profit, either as owners or tenants, are farmers. Treas. Reg. §1.61-4(d). Income derived from these activities is “farm income” reported on Schedule F. The term “farm” “embraces the farm in the ordinarily accepted sense,” and includes stock, dairy, poultry, fruit, truck farms, plantations, ranches, and all land used for farming operations.
Courts have long reasoned that cultivating, operating, or managing a farm for profit means that the owner or tenant must (1) participate to a significant degree in the farming process and (2) bear a substantial risk of loss in the process. See, e.g. Duggar v. Commissioner, 71 T.C. 147 (1978). Under this definition, a person who operates a feedlot for profit would be considered a farmer, but a supplier of fertilizer would not. Although the supplier engages in the activity for a profit and bears a substantial risk of loss, he does not cultivate, operate, or manage a farm for profit as an owner or tenant. He is, instead, in the business of merchandising or sales.
John provides custom planting services to farmers throughout his region. He owns his own equipment and hires employees to assist him. John does not own or rent a farm. His only purpose for owning the equipment is to provide custom planting services. John is paid on a per acre basis for his services. Is John a “farmer” for tax purposes?
Answer: Although John is engaged in farming-related activities, he is not a farmer for tax purposes and will not report his income on Schedule F. John is not raising or growing the crop, nor does he own or lease the land on which he plants the seed. John is providing the service of planting. He will report his income and expenses on Schedule C.
Note that if John owned or leased a farm on which he conducted farming activities, incidental custom planting work for others would be considered part of his farming operation, and he could report his income from the custom work on Schedule F.
Sue entered into a contract with Hogs, Inc. to conduct a farrow-to-finish operation. Sue owns the buildings used in the operation. Hogs, Inc. owns the hogs and provides the feed. Sue provides all of the care for the hogs. Sue is paid on a per-head basis. She is also paid an incentive for meeting certain production goals. Is Sue a “farmer” for tax purposes?
Answer: Yes. Sue should report her income on Schedule F because she is materially participating in the farming operating and she bears significant production risk. The answer would be different if Sue were not directly providing the care for the hogs or if she bore no financial risk in the operation.
Individuals, partnerships, estates, trusts, and S corporations must operate a farm for profit or monetary gain to qualify as a “farmer” for tax purposes. A taxpayer conducts an activity for profit if he or she does so with an actual and honest profit objective. As noted above, only “farmers” report income and expenses on Schedule F. Those taxpayers engaged in “hobby” farming are not engaged in the activity for purposes of earning a profit and are thus not “farmers” for income tax purposes. “Hobby” farming includes activities engaged in primarily for sport or recreation. Such individuals report their income from these hobby activities on Form 1040, line 21. Taxpayers can only deduct the expenses of carrying on hobby activities if they itemize deductions on Form 1040, Schedule A.
Deductions for hobby-related expenses may not offset income from other activities. In deciding whether a taxpayer has operated a farm for a profit, courts consider the following nonexclusive factors: (1) The manner in which the taxpayer carried on the activity; (2) the expertise of the taxpayer or his or her advisers; (3) the time and effort expended by the taxpayer in carrying on the activity; (4) the expectation that the assets used in the activity may appreciate in value; (5) the success of the taxpayer in carrying on other similar or dissimilar activities; (6) the taxpayer's history of income or loss with respect to the activity; (7) the amount of occasional profits, if any, which are earned; (8) the financial status of the taxpayer; and (9) whether elements of personal pleasure or recreation are involved. Treas. Reg. § 1.183-2(b).
Facts: John, a CPA and attorney, inherited a timber and some other farmland from his mother. John worked up to 40 hours a week in the evenings and weekends from mid-April to September each year to maintain the property. He cleared fence rows and creek areas, tore down a barn, bush-hogged, cleared underbrush, filled ditches, and removed weeds. He planted about 1,000 trees a year, including ornamental and maple, walnut, and white oak trees. He performed all of the work on the farm himself. He did not raise crops or livestock.
John did not have a budget, a business plan, or a separate bank account for the farm. He did not take farming or agriculture courses. John believed that the timber from the walnut trees he planted would be harvestable in 30 years, timber from the white oak trees would be harvestable in 50 to 70 years, and the walnut trees would provide a cash crop about 5 years after planting.
For three successive tax years, John and his wife, a teacher, reported a nearly $10,000 loss on Schedule F. This offset their other income, which was only about $70,000 for each of the tax years, even though John worked full-time at his tax practice.
Is John a farmer entitled to offset his “farming” losses against his off-farm income?
Result: In a case with very similar facts, the Tax Court disallowed the taxpayer’s loss and upheld the imposition of a 20% accuracy-related penalty.
There is no evidence that John has a bona fide plan to ever make a profit from planting and growing trees, he has not sought advice as to how to operate his farm profitably, there is no evidence that John expects the appreciation of the value of his trees to exceed his annual losses, and he has never received income from his farm. Although the off-farm income of John and his wife is not high (thus showing that the farming activity was not likely initiated merely to offset income), that factor alone is insufficient to establish a profit motive.
Facts for this example were adapted from Mitchell v. Comm'r, T.C. Memo. 2001-269.
IRS has conducted very limited Schedule F audits in recent years. Concerned about taxpayers improperly reporting hobby losses on Schedule F, IRS recently launched a pilot program to monitor taxpayer compliance. In an internal memorandum dated February 27, 2017, the Director of the Small Business/Self-Employed Division of the IRS announced a new pilot program auditing a select number of individual tax returns reporting Schedule F expenses.
The Director detailed in the memo that the Brookhaven Campus will be conducting detailed, targeted audits of 50 2015 returns that include Schedule F expenses. The audits are to be conducted between April 1, 2017, and April 1, 2018. The memo stated that, pending the outcome of the pilot, the guidance may be incorporated into the Internal Revenue Manual. Targeted for the pilot audit program are those returns with high W-2 income, but also Schedule F expenses. These returns are most likely to include start-up costs or a hobby loss where enjoyment—not business—is the main focus of the activity.
The memo’s guidance contains specific directives for examining Schedule F expenses, including determining:
Practitioners should be careful to interview taxpayers with respect to farming activities that are not generating a profit. Horse-related activities, ranch operations, and new or experimental endeavors are particularly susceptible to audit, as are farms run by someone with high off-farm W-2 wages. Substantial accuracy-related penalties can be assessed if losses are incorrectly reported on Schedule F. See IRC § 6662(a), (b).
As noted above, the definition of farming varies for different tax provisions. Special income tax rules applying to farmers (many with their own definitions of that term) include the following.
This list was adapted from Philip Harris, Small Farm Tax Guide, Rural Tax Education, Appendix A: “Special Tax Provisions for Farmers.”
Farmers must report their operating income and expenses on Schedule F (Form 1040). Net farm profit or loss is reported on line 34. Individuals also report this amount on Form 1040, line 18, and Schedule SE (Form 1040), line 1a. Net farm income is subject to self-employment tax.
Income from the sale of farm products raised and sold by a farmer is reported on line 2 of Schedule F. This includes income from the sale of grains, vegetables, fruit, bedding plants, milk, calves, raised market livestock, eggs, and hay. Expenses for raising commodities are deducted as they are incurred.
Note that crop share (or livestock share) rental income for a materially participating farmer is also reported on line 2 of Part 1 of Schedule F. It is not reportable as income until reduced to cash or cash equivalent.
Income from the sales of livestock or other items purchased for resale is reported on line 1a of Part I of Schedule F. The cost (or basis) of the livestock is reported on line 1b and subtracted from the sales price to arrive at gross income, reported on line 1c. Note that the costs of livestock purchased for resale aren’t deductible in the year of purchase unless the purchase and sale occur in the same year.
Election to Defer Income. IRC §451(e)(1) allows cash method farmers to elect to defer the reporting of income from certain livestock sold on account of drought, flood, or other weather-related conditions for one year. The weather-related condition must be severe enough to designate the taxpayer’s area eligible for federal assistance. For the taxpayer to qualify for the election, the taxpayer’s principal trade or business must be farming (as defined in IRC § 6420(c)(3)). The taxpayer must also show that the livestock would not have been sold if the drought, flood or other weather–related condition had not occurred. The taxpayer may only defer the income for sales that occurred in excess of his “usual business practices.”
The election to defer income from sales precipitated by drought, flood, or other weather-related condition is made by attaching a statement to the return. An election to defer income based upon this provision is made separately for each broad generic classification of animals (e.g., hogs, sheep, poultry, and cattle) for which the taxpayer wishes the provision to apply. Separate elections cannot be made solely because of the animals' age, sex, or breed. Treas. Reg. §1.451-7(d). The election to defer must be made by the due date of the return (including extensions) for the tax year of the sale. Treas. Reg. §1.451-7(g). Once made, an election to defer income under this provision can only be revoked with IRS consent.
In 2017, Randi’s pasture flooded during a severe rain event. Randi’s area was declared a federal disaster area. As a result of the flood, Randi sold 150 beef cattle, including 100 she would not have sold until 2018 had it not been for the flood. Randi received $270,000 for the cattle she sold.
Because Randi is a cash basis farmer, IRC §451(e)(1) allows her to defer for one year the income she received from the 100 head she sold due to the flood. Randi may report $180,000 of her income [(100/150) x $270,000 = $180,000] in 2018 instead of 2017 by attaching a statement to her timely filed 2017 return, including the following information:
Randi Sharpman, 9786 Rio Way; North Granger, Iowa 50498
Note that for IRC §451(e)(1) to apply, the livestock does not always have to be raised or sold in an area directly affected by a weather-related condition Rather, the taxpayer must show that the weather-related condition affected the water, grazing, or other requirements of the livestock. For this to apply, the taxpayer must show that the cost of feed, water, or other weather-impacted requirement of the livestock was substantial in relation to the total costs of holding the livestock.
Election to Postpone Gain for Involuntary Conversions. IRC §1033(e) allows farmers to postpone gain on livestock (other than poultry) held for any length of time for draft, breeding, or dairy purposes when they are sold because of a weather-related condition. This deferral provision does not apply to livestock used for sporting purposes.
To postpone the gain, the taxpayer must generally purchase replacement livestock within two years of the end of the tax year of the sale. If the taxpayer’s area has been declared eligible for federal assistance, however, that replacement period is extended to four years. IRC §1033(e)(2)(A). In addition, Congress has granted the Secretary of the Treasury discretion to extend the replacement period for taxpayers impacted by prolonged drought. Each September, IRS issues a notice publishing the list of counties that were not drought free for the prior year. If an area is on that list, an extended replacement period applies. Generally, the replacement period is extended until the end of the taxpayer's first tax year ending after the first drought-free year.
The replacement livestock must be of the same kind as the original livestock (i.e. breeding heifers must be purchased in exchange for breeding heifers, not dairy). Only livestock sold in excess of the number the taxpayer would normally sell under usual business practices, in the absence of weather-related conditions, are considered involuntary conversions eligible for gain deferral.
The election to defer the payment of tax on the gain by purchasing replacement livestock is made by not reporting the deferred gain on the tax return and by attaching a statement showing the details of the involuntary conversion, including:
It is Stan’s usual business practice to sell five raised breeding heifers during the year. In 2017, Stan sold 20 breeding heifers for $28,200 because of a drought. His basis in the animals was $0. Because of the weather-related event, Stan may elect to postpone the $21,150 gain (15/20 x $28,200) on 15 of his animals by treating their sale as an involuntary conversion.
Stan will attach a statement to his 2017 return stating:
Drought conditions evidenced by the attached rainfall report forced the taxpayer to sell 20 breeding heifers rather than his usual 5. The raised animals have a zero tax basis. 20 animals sold for $28,200. Pursuant to IRC § 1033(e), the taxpayer elects to defer recognition of gain on the extra 15 animals that were sold because of the drought. Deferred gain = (15/20) x $28,200 = $21,150.
When Stan purchases 15 replacement breeding heifers in 2019, his basis in them will be $0, plus any price he must pay for the animals in excess of $21,150 (the deferred gain). He must attach to his 2019 return a statement including:
If Stan pays less than $21,150 for the replacement heifers, he must amend his 2017 return to pay tax on the difference between the amount paid and $21,150. He will owe interest on this unpaid tax, but he will not incur an accuracy-related penalty.
Various weather-related event may qualify for relief under the above weather-related sales provisions, including flood, tornado, drought, or hurricane.
Cooperative distributions include patronage dividends and per-unit retain allocations. The cooperative reports these distributions to the IRS on Form 1099-PATR. Distributions are taxable to the recipient whether or not they are paid in cash. The taxpayer reports the amount of the distribution on Schedule F, line 3a. These include patronage dividends, non-patronage distributions, per-unit retain allocations, redemptions of nonqualified written notices of allocation, and per-unit retain certificates.
Taxpayers report only taxable dividends on Schedule F, line 3b. To calculate the taxable amount, the farmer subtracts from the amount on line 3a the amount of patronage dividends received from buying personal or family items, capital assets, or depreciable assets. The amount of these non-taxable dividends must be subtracted from the cost or other basis of these items.
Josh bought milk production equipment from his local cooperative for $4,500. Josh began taking depreciation deductions for the seven-year MACRS property. In the following year, Josh received a patronage dividend from the cooperative in an amount of $400 for purchasing the machine. Josh will reduce the basis of the machine by the amount of the dividend and adjust his depreciation deductions accordingly.
Government payments made to farmers under agricultural programs such as agricultural risk coverage (ARC), price loss coverage (PLC), approved conservation practices, livestock indemnity payments, or livestock forage disaster payments are reported to the IRS and to the farmer on Form 1099-G. These payments are reported by the taxpayer on Schedule F, line 4a.
Payments for certain conservation projects or depreciable improvements may qualify for a cost-sharing exclusion from income.
Payments received under the Conservation Reserve Program are generally reported as income on line 4b of Schedule F. This income is usually subject to self-employment tax. In 2008, Congress specifically provided that taxpayers receiving old age or survivor’s benefits or disability benefits are exempt from paying self-employment tax on their CRP payments. IRC § 1402(a)(1). Consequently, farmers or non-farmers who receive social security or disability benefits do not pay self-employment tax on that income.
Additionally, in 2014, the United States Court of Appeals for the Eighth Circuit ruled that CRP payments made to a non-farmer (someone not materially participating in a farming activity) were not subject to self-employment tax. Morehouse v. Commissioner, 769 F.3d 616 (8th Cir. 2014), rev'g 140 T.C. 350 (2013). In 2015, however, IRS declared that it would only follow the 8th Circuit’s ruling for cases where the payments were made to a person not engaged in farming and were paid prior to January 1, 2008. October 13, 2015, Action on Decision, IRB 2015-41.
Note that Morehouse, should provide a non-farmer receiving CRP payments in the 8th Circuit (which includes Arkansas, Iowa, Minnesota, Missouri, Nebraska, North Dakota, and South Dakota) with substantial authority for taking the position that no self-employment tax is due on that income. A taxpayer taking this position would report the payment on Schedule E as rental income. IRS has stated that it will challenge this position if discovered, but if substantial authority is found, the taxpayer is exempt from an underpayment penalty, even if the IRS were to prevail in a challenge.
Social security or disability recipients should report CRP payments on the Form 1040 Schedule F, Line 4b. They should then back out the amount of the CRP payment on Line b of Form 1040, Schedule SE, to exclude the payment from SE tax liability.
While loans are not typically included as income, IRC § 77 allows farmers to elect to treat Commodity Credit Corporation (CCC) loans as income if the farmer has used a commodity as collateral for the loan. If such an election is made, the farmer includes the amount of the loan in his or her gross income for the taxable year in which the proceeds of the loan were received. This income is reported on line 5a of Schedule F (Form 1040). The election is made by attaching a statement showing the details of the loan to a timely filed return. The election applies to all subsequent returns, unless revoked. To revoke the election, the taxpayer files a Form 3115 with his or her return. IRS consent is automatic.
Farmers can elect to postpone reporting some or all crop insurance income until the year following receipt of the income if the following conditions are met:
To make this election, the taxpayer reports the amount of the crop insurance proceeds on line 6a of Schedule F but does not include the amount as taxable income on line 6b. The taxpayer then checks the box on line 6c and attaches a statement including the following:
An election is binding for the year unless the IRS approves a request to change it. Deferral is not allowed for proceeds received from revenue insurance policies.
As discussed above, custom hire work conducted by a non-farmer is reported on Schedule C, not Schedule F. Custom hire work conducted by a farmer, however, may generally be reported on line 7 of Schedule F.
Note that there is no bright line rule regarding how much custom work may be conducted by a farmer before a Schedule C should be filed for that activity. If the custom work is more than incidental, however, a Schedule C should be considered.
Income related to the farming operation, but not reportable elsewhere, is reported on line 8 of Schedule F. This income includes:
Farmers receiving income from the disposition of their assets do not report this income on Schedule F. Rather, they report such sales on Form 4797.
IRC §1301 provides that taxpayers “engaged in a farming business or fishing business” may be able to average all or some of their farm income by using unused tax brackets from the 3 prior years (base years) to calculate the tax on the current year’s income. The amount of farm income the taxpayer chooses to have taxed at the prior years’ available rates is called “electible farm income.” For purposes of this provision, “farming business” is defined as “a trade or business involving the cultivation of land or the raising or harvesting of any agricultural or horticultural commodity.” Income attributable to the business of farming may be included in electable farm income. This includes not only net farm profits calculated on Schedule F, but also net farm income from a partnership, S corporation (including wages), or LLC. Wages from a C corporation are not included. Electible farm income may also include gains from the sale of property regularly used in a farm business for a substantial period. Timber may not be included.
Taxpayers use Schedule J (Form 1040) to make the income-averaging election and to calculate the tax on the electable farm income using the prior three years’ rates.
Income averaging may give farmers a lower tax if the current year’s income is high and the taxable income (which includes income from farming) from one or more of the 3 prior years was lower.
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