End of Year Tax Planning Considerations for Farmers in 2021
With high crop yields and robust commodity prices, many farmers are closing 2021 with more income than they expected. Likewise, input costs for 2022 are on track to reach record highs. In light of these trends, many farmers may have sought to even out income by deferring income from 2021 into 2022, by prepaying expenses in 2021, or by purchasing depreciable property. This article provides a summary review of special tax planning options that may be applied when filing 2021 returns. A separate post details the impact of COVID-19 relief on farmers' 2021 returns.
Prepaying Expenses
It is often beneficial for farmers who use the cash-method of accounting to prepay for some of their supplies. For example, prepayment may allow them to receive prices that are more favorable or ensure on-time delivery. Subject to certain limitations, farmers who prepay for expenses may also take the deduction for the expense in an earlier tax year. The general rule that cash-basis taxpayers may deduct expenses in the year they pay for them, however, is subject to a number of exceptions. When completing 2021 returns, farmers must ensure that any expenses paid in 2021 for fertilizer, seed, or other similar supplies that they will not use until 2022, are properly deductible.
I.R.C. § 464 limits the amount of the allowable deduction for prepaid expenses. Prepayments subject to these rules include payments for feed, seed, fertilizer, and similar farm supplies not used or consumed during the year. They also include certain payments for poultry.
Specifically, the following limits apply when taking a deduction for prepaid farm supplies.
50 Percent Limit
Prepaid farm expenses cannot exceed 50% of other deductible farm expenses (including depreciation), unless a farm-related taxpayer meets one of the following two exceptions:
- The prepaid farm supplies expense is more than 50% of the other deductible farm expenses because of a change in business operations caused by unusual circumstances OR
- The total prepaid farm supplies expense for the preceding 3 tax years is less than 50% of the total other deductible farm expenses for those 3 tax years.
A farm-related taxpayer is someone who meets one of the following requirements:
- Their main home is on the farm
- Their principal business is farming
- A member of the taxpayer’s family meets one of the other two requirements
No Deposits, Mere Tax Avoidance, or Material Distortion of Income
In addition to the 50% limitation, the cost of supplies purchased in the current year for use in the following year is deductible by a cash basis taxpayer in the current year only if all of the following apply:
- The expenditure is a payment for the purchase rather than a mere deposit.
- The amount is considered a payment and not a deposit if it was made under a binding commitment to accept delivery of a specific quality at a fixed price, and the farmer is not entitled to a refund or a repurchase.
- The prepayment is made for a business purpose and not merely for tax avoidance.
- Several valid business purposes would include securing an assured supply, fixing a price, or securing preferred treatment in the event of shortages.
- The deduction in the tax year of prepayment does not result in a material distortion of income.
- Factors to consider in determining whether there has been a material distortion of income include: customary business practice in conducting the operations, the expense in relation to past purchases, the time of year of the purchase, and the expense in relation to income for the year.
See Rev. Rul. 79-229 and Heinold v. Commissioner, T.C. Memo. 1979-496. Although Rev. Rul. 79-229 discusses prepaid livestock feed, IRS has applied these requirements to all prepaid farm supplies.
Deferral of Crop Insurance or Disaster Related Payments
Farmers who use the cash method of accounting may sometimes defer the recognition of income from crop insurance or a federal disaster program payment if the payment was received in the year that damage or destruction to crops occurred. It should be noted that some farmers received WHIP payments in 2021 for damage incurred during the 2020 derecho. These payments are not eligible for deferral because they were made in the year after the disaster.
To qualify for deferral, the farmer must show that, under normal business practices, income from the sale of the crops would have been included in gross income in a tax year following the year of destruction. For more information on this provision, read this post.
In 2021, IRS updated its Publication 225 to clarify that farmers may defer the recognition of income from payments received from revenue insurance policies if the payments were to compensate for yield loss due to physical damage and not for a decline in price. This corresponds to common interpretation and long-time practice. Prior versions of Publication 225, however, had included a statement that seemed at odds with this practice.
Deferred Payment Contracts
Cash-method farmers must generally recognize income for tax purposes when they actually receive it or when they constructively receive it. Income is constructively received when an amount is credited to the taxpayer’s account or made available without restriction. If constructive receipt applies, the taxpayer does not need to have possession of the income for it to be treated as income for the tax year. For example, after delivering grain for sale, the farmer cannot call the grain elevator and ask them to hold the check until the following year. If the farmer was entitled to receive payment for that sale in one tax year, the income will be deemed to have been constructively received in that year. Income is not constructively received if receipt of the income is subject to substantial restrictions or limitations.
Farmers wishing to spread income more evenly across years may employ the use of deferred payment contracts. A sale under a properly structured deferred payment contract is an installment sale authorized by IRC §453(b). An installment sale is a sale of property where a farmer receives at least one payment after the tax year of the sale. With a properly structured installment sale, there is no constructive receipt in the year of sale. Rev. Rul. 58-162. Cash-basis farmers are eligible to use installment sale reporting because the commodity is not required to be inventoried. Treas. Reg. §15A.453-1(b)(4). For example, a farmer can sell crops or livestock in one year, but defer payment for the commodity until the next year through a deferred payment contract.
Deferred Payment Contracts Provide Flexibility
If a sale qualifies for the installment sales method of accounting, the method must be used unless the farmer elects out. Taxpayers may elect not to use the installment method, by reporting the entire gain in the year of sale, even though they don’t receive the sales proceeds in that year. To make this election, the taxpayer does not report the sale on Form 6252. Instead, the sale is reported on Schedule F or Form 4797. Electing out of the installment method is on a contract-by-contact basis. For this reason, entering into multiple contracts preserves flexibility with respect to electing out for some sales proceeds, but not others.
Farmers wishing to enter into deferred payment contracts should ensure that the agreement is a bona fide, arm's-length transaction and that the farmer (or an agent of the farmer) did not have the right to receive payment for the commodity in the year of delivery. To ensure compliance with IRS regulations, farmers should consult with their tax advisors.
Bonus Depreciation and Section 179 Expensing
Farmers who purchased business assets in 2021 have several options to write off the cost of those assets through accelerated cost recovery.
Bonus Depreciation
Bonus depreciation, which is also available in Iowa in 2021, provides a 100% additional first-year depreciation deduction for “qualified property” through 2022. I.R.C. § 168(k). Property eligible for bonus depreciation includes farm buildings, farm equipment, and drainage tile.
This means that if a farmer purchases and places into service a $300,000 piece of equipment in 2021, they can depreciate the entire amount in 2021. “Placed into service” generally means that the machinery is available and ready for use. In other words, if a farmer orders and pays for a new combine in 2021, but it does not arrive until 2022, the farmer cannot take the bonus depreciation deduction in 2021. In contrast, if the combine arrives and the farmer stores it in the machine shed in 2021, the farmer can take the deduction in 2021, even if the farmer did not use the equipment in the 2021 harvest.
Bonus depreciation is available for qualified property used in a trade or business or for income producing activity. It is automatic unless the taxpayer elects out. An election out of bonus is for the entire class. In other words, electing out of bonus for one asset that is five-year property is an election out of bonus for all five-year property. The property can be used or new when purchased. Taxpayers cannot elect out of bonus or revoke an election out of bonus on an amended return. The only way to change your mind is with an expensive private letter ruling. 100 percent bonus depreciation is scheduled to end after 2022. Beginning in 2023, the deduction will generally begin to phase-down as follows:
- 80% if placed in service after December 31, 2022, and before January 1, 2024
- 60% if placed in service after December 31, 2023, and before January 1, 2025
- 40% if placed in service after December 31, 2024, and before January 1, 2026
- 20% if placed in service after December 31, 2025, and before January 1, 2027
Section 179
Another method of accelerated cost recovery for farmers placing business assets into service is the section 179 deduction. I.R.C. § 179 allows taxpayers to immediately expense or write off the cost of tangible personal property (and limited real property) purchased and placed in service in the active conduct of a trade or business. The maximum deduction for 2021 is $1,050,000, reduced $1 for every $1 over the $2,620,000 investment limit. In 2022, the deduction increases to 1,080,000, and the investment limit climbs to $2,700,000. Iowa couples fully with the federal section 179 deduction.
Section 179 can be used for machinery, single purpose agricultural buildings, drainage tile, and storage bins, among other property. It cannot be used to expense multi-purpose farm buildings. Unlike bonus depreciation, section 179 can be applied on an asset-by-asset basis and can be taken in any amount less than or up to the full purchase price. Adding to its flexibility, the section 179 deduction can be taken on an amended return. A section 179 deduction, unlike a bonus depreciation deduction, cannot create a loss. It also cannot be used by those who are not in an active trade or business or certain noncorporate lessors. Farmers should consult with their tax advisors regarding the specific rules of the section 179 deduction.
Beware of Recapture
It is important to remember that depreciated or expensed assets, when sold, usually generate ordinary income tax liability. Depreciation is intended to allow farmers to write off the cost of a business asset over its useful life. Thanks to bonus depreciation and section 179 expensing, these costs are often written off long before the life of the asset ends. If the owner sells the asset while it still has value, IRC § 1245 steps in to “recapture” ordinary income tax on the difference between the current basis of the asset and the sales price. If the sales price exceeds the amount of the depreciation or expensing taken over the life of the asset, that increase is value is taxed at capital gain rates.
The current basis is equal to the original cost, less any depreciation or expensing taken. In many cases, the basis may be zero. In other words, the sale of $100,000 of fully depreciated machinery will result in $100,000 of ordinary income (assuming no increase in value), which is subject to income tax, but not self-employment tax. Section 179 comes with the added requirement that if you stop using the asset predominately (more than 50 percent) in your business, you must recapture the expense deduction taken. This type of recapture is subject to ordinary income tax rates, as well as self-employment tax.
Consider the Trade
Since 2018, the tax code has not allowed tax-deferred trades of personal property. This means that recapture income is recognized upon a trade-in of farm equipment. Although the farmer can use section 179 or bonus to write off the cost of the new equipment, that approach can drive down Schedule F income and lower eligibility for social security and retirement benefits. Those interested in reading more about this issue should review this post.
Vehicles Have their Own Rules
The depreciation and expensing of business vehicles has its own set of rules. To read more about these rules for 2021, read this post.
Charitable Giving
A great option for reducing taxable income is to increase charitable giving. For more information on the gifting of commodities and other charitable options, read this post.
Farm Income Averaging
Farmers can often use farm income averaging to reduce overall tax liability when current year income is high and taxable income from farming from one or more of the three prior tax years was lower. When a farmer makes an income averaging election, income tax liability is reduced in the current year because “elected farm income” is spread out over the prior three tax years. Farm income for the prior three years is increased, but it is taxed at the (hopefully lower) marginal rates available for those prior years. Farm income averaging is beneficial when it results in a lower average marginal tax rate across the impacted tax years. Farm Income Averaging is reported on Schedule J.
Farm income averaging does not impact self-employment tax or net investment income tax liability. Nor does farm income averaging reduce gross income or its impact on the phase-out of deductions or credits. Farmers interested in learning more about farm income averaging can read pages 18-19 of the 2021 Publication 225 or discuss the option with their tax advisors.