DRAFT
11/15/00
Tax Planning
and
Management Considerations
for Farmers in 2000
by
George F. Patrick
Extension Agricultural Economist
Purdue University
Cooperative Extension Service Paper No. CESDecember 2000
Table of Contents
TAX PLANNING AND MANAGEMENT CONSIDERATIONS FOR FARMERS IN 2000 . . . . 1
RECENT CHANGES AFFECTING 2000 AND 2001 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Depreciation and Like-Kind Exchanges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Capital Gains Tax Rate Reduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Uniform Capitalization (UNICAP) Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Escape from Accrual Accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
YEAR-END TAX PLANNING CONSIDERATIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Government Payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
INCOME AVERAGING FOR FARMERS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
UPDATES ON RATES, EXEMPTIONS AND DEDUCTIONS . . . . . . . . . . . . . . . . . . . . . . . . . . 9
DEPRECIATION AND EXPENSING . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Section 179 Expensing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Class Lives and Depreciation Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Final Quarter Limitation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Alternative Depreciation Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
SELF-EMPLOYMENT AND SOCIAL SECURITY TAXES . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Social Security Benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
SE Tax-Reduction Techniques . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
TAX CONSIDERATIONS FOR RETIRING FARMERS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Depreciation Recapture and Installment Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Installment Sales and Tax Planning . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
Leasing of Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
TAX PLANNING IN DIFFICULT TIMES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Earned Income Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Net Operating Losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Tax Consequences of Asset Dispositions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Tax Implications of Financial Distress . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
TAX MANAGEMENT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
REFERENCES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
TAX PLANNING AND MANAGEMENT CONSIDERATIONS
FOR FARMERS IN 2000*
George F. Patrick, Professor
Department of Agricultural Economics
Purdue University
Almost every year is an active year as far as tax legislation is concerned. Like previous years, the
year 2000 saw many, many tax proposals introduced in Congress. Repeal of the so-called marriage
penalty and elimination of the estate tax were two of the tax proposals passed and sent to President
Clinton. However, all of the proposed tax law changes were vetoed. In spite of the lack of new legislation,
there are some significant changes for farmers which take effect in 2000 or 2001. These are discussed in
the first section of the paper.
Many Midwestern producers have received or can receive a number of payments from the
government. Assessing the impact of these payments on taxable income is critical for year-end tax
planning. Government payments and the options which producers have are discussed in the second section
of this paper. The paper also includes a discussion of income averaging and new IRS instructions, a review
of depreciation and Section 179 expensing, and recent development in the social security and selfemployment tax area. The paper closes with some issues involved with tax planning in conditions of
financial distress and selected other topics.
RECENT CHANGES AFFECTING 2000 and 2001
Depreciation and Like-Kind Exchanges
Farmers and other business people often trade or swap assets in “like-kind exchanges.” For
example, an old planter may be traded for a new planter or other piece of qualifying farm machinery. Real
estate may also be traded for other real estate. Any gain or loss on a like-kind exchange is not recognized
(reported) for trade purposes. For like-kind exchanges and involuntary conversions on or after January
3, 2000, IRS Notice 2000-4 indicates that one continues to depreciate the basis (remaining book value)
which carries over to the acquired asset using the same life and method. Essentially this treats the basis in
the old asset as if it not been traded. The “boot” portion of the new asset is depreciated over the class life
of the asset.
Under the old tax rules, for trades and involuntary conversions before January 3, 2000, the
adjusted tax basis of the old asset was added to the boot paid for the new asset and the entire amount was
*
For information on specific tax situations, consult a competent tax advisor. Appreciation is expressed to Purdue
colleagues, Freddie Barnard, Howard Doster, Gerry Harrision, Laura Hoelscher, Jess Lowenberg-DeBoer, Alan Miller, Bob Taylor and
to Charles Cuykendall, Cornell University; David Frette, CPA, Washington, IN and David Miller, Ohio State University; for helpful
comments on earlier versions. For a more basic discussion of income taxes and agriculture see, Patrick and Harris, Income Tax
Management for Farmers, NCR#2, MWPS, Iowa State University, 1997.
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depreciated over the life of the new asset. For example, assume that a tractor (7-year property)
purchased for $100,000 in 1996 was traded for a new $100,000 tractor on July 1, 2000 and the farmer
paid $60,000 boot. Effectively the farmer got a $40,000 trade-in allowance for the old tractor. With onehalf year or $6,125 of depreciation being allowed for 2000, the adjusted tax basis of the tractor traded in
would have been $36,755. The $36,755 would have been added to the $60,000 boot for a basis of
$96,755 in the new tractor for depreciation ($96,755 X 10.71% or $10,362 in the year of trade). Thus,
under the old system, the total depreciation deduction for 2000 would be $16,487.
Under the new IRS rules, to the extent that the basis of the old tractor transfers, the new tractor
is depreciated over the remaining recovery period of the tractor using the same method and convention.
The additional basis, the boot, is treated as newly purchased MACRS property. In other words, the old
tractor continues to be depreciated as if it had not been traded. Thus, $12,250 of depreciation ($100,000
X 12.25%) will be claimed on the old tractor in 2000. In addition, the $60,000 boot for the new tractor
will be depreciated over the 7-year recovery period. This results in $6,426 ($60,000 X 10.71%)
depreciation on the new tractor in 2000. The total depreciation under the new system, $18,676, is greater
than the $16,487 under the old system in the year of trade. In 2001, 2002 and 2003, depreciation would
be computed for both the tractor traded in and the new tractor. After 2003, the old tractor would be fully
depreciated and could be taken off the depreciation schedule.
The primary tax effect of the new rules is to allow more rapid cost recovery, at least in the year of
trade. However, the depreciation schedule for an individual who trades machinery and equipment
frequently will be much more complicated. For Section 179 expensing, only the boot portion on a like-kind
trade is eligible to be expensed. Furthermore, only the boot portion is considered in determining whether
more than $200,000 of qualifying Section 179 property was purchased and placed in service during the
tax year. Thus, the treatment is the same under both the new and old rules.
The depreciation recapture rules require that the lesser of the gain realized or the depreciation
previously taken is treated as ordinary income on the sale or other disposition of the asset. In the case of
an asset acquired in a like-kind exchange, the taxpayer is required to include the depreciation on the asset
traded-in to the extent of deferred gain. In the example above, the $40,000 trade-in allowance for the old
tractor has a deferred gain of $40,000 - $36,755 or $3,245. This deferred gain would be included in
depreciation recapture of the new tractor. It appears that these procedures are unchanged by the new
rules.
Capital Gains Tax Rate Reduction
The maximum tax rate on capital gains on qualifying assets held by an individual for more than five
years is reduced. Beginning in 2001, the maximum rate on assets held for more than five years will be 8
percent for individuals in the 15-percent ordinary income tax bracket (a 2001 taxable income of $45,200
or less for married, filing jointly). For example, a couple with a taxable income of $35,000, including a
capital gain of $10,000 on an asset held for more than five years, would be taxed only $800 on the gain
from sales and exchanges after December 31, 2000. If the sale or exchange had occurred before January
1, 2001, the tax would be 10 percent or $1,000.
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For taxpayers in the 28-percent or higher tax rate on ordinary income (a 2001 taxable income of
over $45,200 for married, filing jointly) the maximum 18-percent tax rate applies only to assets acquired
after December 31, 2000. Thus, the reduced capital gain tax rate for individuals in the 28 percent or higher
tax bracket will not become effective until 2006, and then only for assets acquired after 2000. However,
when filing their 2001 tax return, individuals may elect to treat an asset which they had acquired before
January 1, 2001 as if it had been sold on January 2, 2001 and reacquired at fair market value. Tax would
be due on the capital gain associated with the deemed sale and repurchase of the asset, but losses are not
deductible. For example, a couple purchased ABC stock for $10,000 in 1998. On January 2, 2001, the
stock was worth $12,000. If they made the deemed sale and repurchase election, the $2,000 unrealized
capital gain would be taxed at the 20 percent maximum rate and they would pay $400 tax. They would
receive a new holding period beginning January 3, 2001 and a new tax basis of $12,000. If the asset was
sold for $20,000 after the five year holding period, then the capital gain of $8,000 would be taxed at a
maximum rate of 18 percent or $1,440 for a total tax of $1,840. If the election had not been made, the
tax would have been $2,000.
These new rules further complicate tax planning. Note that both the entire capital gain and ordinary
income is included in determining taxable income. The capital gain associated with the disposition of an
asset might increase the income of a taxpayer such that they would not be eligible for the lower maximum
rate. If the time value of money is considered, the tax associated with the deemed sale and repurchase
election to establish a new holding period may more than offset the later tax savings. However, if a
taxpayer has capital losses in 2001, then the “gain” associated with the deemed sale and repurchase may
offset the losses. In other instances, the gain expected after 2001 may be so great that the early payment
of some tax may be worthwhile.
Uniform Capitalization (UNICAP) Rules
IRS has issued final regulations with respect to the capitalization of property produced in the trade
or business of farming with a preproductive period of more than two years. As originally enacted by
Congress, both animals and plants were included. However, repeal of the so-called “heifer tax” excluded
livestock. The regulations specify that it is the average U.S. preproductive period, not an individual
producer’s experience, which determines whether a crop is subject to the UNICAP rules. Some of the
Indiana crops which would be subject to the UNICAP requirements include new plantings of apples,
apricots, blackberries, blueberries, cherries, chestnuts, grapes, nectarines, peaches, pears, persimmons,
raspberries and walnuts. Purchases of established, producing plantings or orchards are not subject to the
UNICAP rules.
Under the UNICAP rules, the costs of planting, cultivation and development are capitalized and
then depreciated over a ten-year period when the plants become productive. Producers who first become
subject to UNICAP rules can elect out of the UNICAP requirements. However, the alternative
depreciation system must be used for all assets used in farming. The alternative depreciation system uses
a longer life and slower rate of depreciation than the regular depreciation allowed for assets used in farming.
3
Escape from Accrual Accounting
Most farmers currently use the cash method of accounting for tax purposes. However, there are
a few producers using the accrual method. In addition, some farmers, such as greenhouses and garden
centers, have been required to account for inventories if the production, purchase or sale of merchandise
is an income-producing factor in the business. Revenue Procedure 2000-22 allows businesses with gross
receipts of $1,000,000 or less to shift to cash accounting for their first tax year ending after December 17,
2000. Thus, taxpayers reporting on the calendar year who wish to take advantage of the chance to change
must do so in 2000. Essentially this change allows taxpayers to deduct the cost of plants purchased for
resale when the item is sold (like feeder livestock). Costs of growing plants, even if the preproduction
period is more than two years, can be deducted for the year in which the cost was incurred. Revenue
Procedure 2000-22 provides information on the procedures to be used to make the change in accounting
methods.
YEAR-END TAX PLANNING CONSIDERATIONS
For farmers using the cash accounting method, when an input is paid for, rather than when that
input is used, determines when the cost is deductible for tax purposes. Expenses which were prepaid in
1999 cannot be deducted in 2000. On the other hand, producers who typically prepay many expenses may
find deductible expenses for 2000 will be low and taxable income higher than anticipated, unless some input
purchases for 2001 are made before the end of 2000. Receipts are generally reported as income the year
in which they are received. Many farmers carried 1999 grain over and did not sell until after January 1,
2000. Some farmers may have sold commodities in 1999, but deferred payment into 2000. In both cases,
these sales would be counted as income in 1999. Other producers may have deferred 1999 crop insurance
payments to 2000. For effective tax planning, it is critical for farmers to review their 2000 year-to-date
receipts and expenses.
For a married couple, because of the standard deduction and personal exemptions, there is no
federal income tax on the first $12,950 of 2000 income. This increases to $18,550 for a family of four; and,
depending on their situation, the family may qualify for the new child tax credit and earned income tax
credit. Unlike many tax provisions, if not used, the standard deduction and personal exemptions for 2000
cannot be carried to another tax year. Thus, if the year-to-date review indicates that adjusted gross income
will be less than this “tax-free” amount, attempts should be made to increase income for 2000 tax purposes.
Delaying purchases or postponing payment for items already purchased until after January 1, 2001 will
reduce expenses for 2000. For assets acquired in 2000, straight-line depreciation and longer lives for
depreciation may be elected; however, no changes are possible for assets already on the depreciation
schedule. Selling some commodities or culling livestock and taking payment before the end of the year
would increase 2000 receipts. Taking the 2001 Production Flexibility Contract payment before December
31, 2000 will increase 2000 income. Simply assuming that 2000 will be a low taxable income year may
lead to poor tax planning. Check your tax situation while there is still time to make potentially money-saving
adjustments.
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Government Payments
Government payments are a significant portion of farm income for many Indiana producers.
Farmers using the cash method of accounting generally report receipts as income when constructively
received and deduct expenses when actually paid. However, farmers may have some control over when
government program payments are received and reported for income tax purposes. This allows some yearend tax planning by producers.
Most producers can put their wheat, corn and soybeans under the marketing loan program with
the Commodity Credit Corporation (CCC). For tax purposes, farmers can treat this loan like any other
loan and not include the proceeds in income. Receipts from the sale of the crop would be reported as
income when the crop was sold. Alternatively, producers can elect to report the CCC loan as income
when received. In this case, the later redemption of the loan results in the farmer having a tax basis in the
redeemed commodity, which is used in determining gain or loss, equal to the amount previously reported
as income. However, once a CCC loan is reported as income when received, all subsequent CCC loans
must be reported as income when received.
Under the marketing loan program, if market prices remain below the loan rate, a producer may
repay the CCC loan at the posted county price (PCP), and there is no interest expense. The difference
between the loan rate and the PCP is referred to as the marketing loan gain. Producers who treated the
CCC loan as a loan must include the marketing loan gain in income when the CCC loan is repaid. The
sales price of the commodity would be included in income if the commodity is sold, and there would be no
feed deduction if the commodity were fed. Producers who reported the CCC loan as income would also
report the marketing loan gain on Schedule F, but not include the gain as taxable income. In this case the
PCP, rather than the loan rate, would be their tax basis for computing gain or loss on the sale of the
commodity. If fed, they could deduct the tax basis as a feed cost.
Farmers can lock in a CCC loan repayment rate based on the PCP for a 60-day period and
speculate on higher cash prices. If the repayment is not made until after January 1, 2001, then the
marketing loan gain income is deferred into 2001.
A loan deficiency payment (LDP) can be claimed by a producer on the commodity produced.
Rather than taking a CCC loan and paying it off, the producer takes the LDP for the difference between
the loan rate and PCP (based on the prior day’s market) on the date the LDP is claimed. Although the
LDP is based on specific dates, farmers do have some control over their reporting of activities which
influences when the LDP will be paid by the Farm Service Agency (FSA) and included in income for tax
purposes.
If grain is harvested and sold when delivered to the elevator, the CCC-709 form is filed with FSA.
Although the LDP rate is based on delivery date, actual payment will not be made until FSA receives
acceptable evidence of production. For producers who store their grain on-farm or in commercial storage,
the LDP is set using the FSA form CCC-666. FSA generally processes these forms and makes the LDP
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payment within 30 days. Thus, producers can establish the LDP, but by delaying reporting to FSA can
defer payment and reporting of income into 2001.
Producers may request their 2001 production flexibility contract (PFC) payments (these are also
referred to as the Agricultural Market Transition Act, AMTA payments) after October 1, 2000. Although
the payments are available to qualifying producers in 2000, because of a special provision enacted by
Congress, these payments are not considered as income until actually received by the producer. Thus,
producers with a low taxable income may want to take their 2001 payment before December 31, 2000.
Producers wishing to defer income into 2001 can delay requesting their payment until after January 1, 2001.
INCOME AVERAGING FOR FARMERS
For tax years beginning after 1997, farmers can choose to average part or all of their “farm income”
over three years. The law was passed in 1997, and made permanent in 1999, and the proposed regulations
detailing the procedures of income averaging were released in October 1999. Instructions for the 2000
Schedule J make a number of changes which are “farmer friendly.”
“Farm income” is based on taxable farm income. It includes all income, gains, losses, and
deductions attributable to any farming business. Gain from the sale or other disposition of land is not
included, nor is timber considered farm income. The instructions for Schedule J indicate that farm-related
items are generally reported on Schedule D, Schedule F, Form 4797, and Schedule E, Part II (Income
or Loss from Partnerships and S Corporations). Thus, farm income from flow-through entities such as S
corporations and partnerships does qualify. The 2000 instructions add wages and other compensation
received as a shareholder in an S corporation engaged in farming. Income reported on Form 4835 by
share lease landowners who do not materially participate in the business for self-employment tax purposes
is also generally eligible.
Farm income averaging is not available to regular corporations, trusts or estates. Cash rent
landowners are also excluded.
The basic concept of farm income averaging is simple and uses Schedule J. A farmer may elect to
average part or all of the farm income in the election year, e.g., 2000, and have that elected farm income
treated as if it have been earned equally over the preceding three base years, 1997 to 1999, and taxed at
the rates for those years. Note that the elected income is spread equally over the three prior or base years.
If one of the three preceding years has a very low income or loss, there is no possibility of allocating more
of the elected farm income to that year. Furthermore, for future income tax averaging, say in 2001, taxable
income for 1998 and 1999 is increased by the previously averaged income. Although income averaging
may reduce the income tax liability of a producer, income averaging has no effect on self-employment tax
liability.
To illustrate income averaging, assume that a farmer (married, filing jointly) has a taxable income
of $123,000 in 2000 and taxable income had been $10,000 each of the three preceding years. Without
6
income averaging, the farmer’s 2000 income tax liability would be $29,251. The last dollars of the farmer’s
income are taxed at the 31-percent marginal income tax rate. However, in the three preceding base years
the farmer’s marginal tax rate was only 15 percent. If the farmer elected to average $81,000 of 2000
taxable income, the 2000 income would be reduced to $42,000. This is close to the top of the 15-percent
tax bracket for a married couple, filing jointly. The $81,000 of 2000 elected farm income would be treated
as if $27,000 had been income in each of the three preceding base years and taxed at that year’s tax rate.
Note that income is not carried back to a prior year, rather the unused tax brackets are brought forward.
Thus, after averaging, taxable incomes in 1997, 1998 and 1999 would be $37,000 each year. In this
example, all of the elected farm income would be taxed at a marginal tax rate of 15 percent, thus the total
income tax would be $18,450. (The 2000 self-employment tax is not affected by the income averaging.)
Total income taxes would be $29,251 without averaging and $18,450 with averaging, for a savings of
$10,801. However, income averaging may make the farmer liable to the alternative minimum tax (AMT).
If the $123,000 was the alternative minimum tax income in 2000, the AMT would be $123,000 minus
$45,000 multiplied by 28 percent or $21,840, reducing the savings to $7,421.
If in 2001, the farmer had another high-income year, the tax saving associated with averaging would
be less. For example, assume that 2001 taxable income was $120,000. The income tax liability would be
about $28,321 (using 2000 rates). If the farmer elected to average $78,000, income in each of the three
preceding years would be increased by $26,000. For 1998 and 1999, taxable income would be the original
$10,000, plus $27,000 from income averaging in 2000, and $26,000 from 2001 averaging, for a total of
$63,000 each year. The 2000 income would be $42,000 after averaging plus $26,000, for a total of
$68,000. In this situation, much of the elected farm income will be taxed at the 28-percent marginal tax rate
rather than the 15-percent rate as in the 2000 income averaging. The total tax liability with averaging would
be $25,767.50, a savings of $2,553.50. It should be noted that other elected amounts might increase the
tax-savings some, but tax savings in 2001 will be much lower than in 2000 because of the effect of the prior
income averaging.
Farmers can elect, subject to some restrictions, the amount and type of income which they wish
to average. Commonly, farmers will have ordinary income from Schedule F and depreciation recapture.
They may also have Section 1231 gains reported on Form 4797 which are treated as long-term capital
gains. In the 1997 tax year, capital gain income was taxed at the lower of the taxpayer’s regular tax rate
or 28 percent. In contrast, for 2000, the maximum tax rate on long-term capital gains is 20 percent. A
farmer can elect to average ordinary income and allocate 2000 farm capital gain income (unless offset by
non-farm capital losses) to the 2000 year. For example, assume a producer has $50,000 of Schedule F
net income, $30,000 of farm Section 1231 gains and no non-farm income or losses. The farmer could elect
to average up to $50,000 of farm income and allocate all of the Section 1231 gain to 2000. All of the
elected income would be ordinary income and allocated equally to the three prior years. However, if the
farmer elected to average $60,000 of farm income, at least $10,000 would be Section 1231 gains. In this
situation, one-third of the elected Section 1231 gain would be allocated to each of the prior years and taxed
according to the “rules” for that year.
Farmers who are subject to the alternative minimum tax (AMT) in a year will not reduce their tax
liability for that year by filing Schedule J. In some instances, use of Schedule J may make a farmer subject
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to AMT, and the farmer will not receive all of the potential benefit from income averaging. Furthermore,
in most instances, the AMT associated with income averaging does not result from deferral items (e.g.,
depreciation adjustments) and does not result in an AMT credit for regular tax purposes in a future year.
Instructions for the 2000 Schedule J allow negative taxable incomes to be entered in the base years.
Instructions for previous years had not allowed negative numbers. Any elected farm income would resulted
in a positive taxable income in the base years. Farmers who income averaged in 1998 or 1999 and who
had a negative taxable incomes in base years can file an amended return. Farmers with a negative taxable
income in the base years who did not income average in 1998 or 1999 can also file an amended return and
use Schedule J. Special worksheets are included in the instructions.
The decision to average income in a year is an irrevocable election, except as provided by the
Secretary of the Treasury. However, if a producer amends a prior year’s return or an adjustment is made
by the IRS, those changes allow an individual to reconsider income averaging for the year affected.
Income averaging does not affect earned income credit or other tax benefits generated in a prior
year. Income averaging does not affect tax calculations and computations of prior years. Effectively, the
unused portions of the lower marginal tax rate brackets of the prior years are brought forward to the
election year.
Income averaging can be used even if it does not reduce tax liability for the current year. An
individual might be in a situation in which taxable incomes in the three base years were very low. If 2000
farm income were averaged, this might not reduce the 2000 tax liability. However, reducing 2000 income
for future income averaging might increase potential tax savings for an individual who expected a
substantially higher farm income in a future year. For example, a married individual might have taxable
income of $25,000 in 2000 and very low taxable incomes in the 1997 to 1999 period. Electing to average
the $25,000 of farm income in 2000 would not reduce the tax liability because the income would be taxed
at the 15-percent rate for prior years. However, the taxable income for 2000 could be reduced to $0,
which could benefit future income averaging. If taxable income had been negative in any of the base years,
1997-1999, then income averaging in 2000 might reduce taxes and reduce 2000 taxable income to $0.
Income averaging will have the greatest attraction for farmers whose income in one year is much
higher than in the preceding three years. Beginning farmers with limited income in prior years could be in
this situation. Individuals do not have to have been in farming in the base years to qualify for farm income
averaging. Farm families whose off-farm income increased sharply would be eligible to average their farm
income and perhaps reduce their current tax liability. Note that only farm income is eligible for income
averaging. Retiring farmers and others disposing of assets may also be able to take advantage of income
averaging. Depreciation recapture on machinery, equipment, buildings, and purchased breeding stock is
reported as ordinary income. The disposition of these assets in one year may result in a high marginal tax
rate and benefits from income averaging. Dispositions of assets for up to a year after an individual ceases
farming are presumed to be within a reasonable time and would be eligible for farm income averaging.
Depending on individual circumstances, dispositions of assets over longer periods may also be acceptable
for income averaging. Income averaging may also be helpful for an individual in a situation in which the usual
8
year-end tax planning strategies do not apply. However, income averaging is not likely to substitute for
regular year-end tax planning and keeping taxable income relatively stable from year-to-year.
9
UPDATE ON RATES, EXEMPTIONS AND DEDUCTIONS
The tax brackets and rates for the married, filing jointly status for 2000 are in Table 1. An additional
tax, a 10-percent surtax, is imposed on taxable incomes in excess of $288,350. Thus, the maximum tax
rate is 39.6 percent for some individuals. The effective maximum tax rate is actually even higher for many
of these taxpayers, because their personal exemptions and itemized deductions are being phased out by
other provisions of the tax law. The tax brackets for 2001 will be increased about 3 percent as an
adjustment for inflation. For example, the beginning of the 28 percent tax rate is $45,2000 for a married
couple, filing jointly in 2001.
Table 1.
Taxes and Tax Rates for Married, Filing Jointly in 2000
Taxable Income
Pay
Plus Percent on
Excess
$0-43,850
$0
15 percent
$43,850-105,950
$6,577.50
28 percent
$105,950-161,450
$23,965.50
31 percent
$161,450-288,350
$41,170.50
36 percent
Over $288,350
$86,854.50
39.6 percent
On Amount Over
$0
$43,850
$105,950
$161,550
$288,350
To arrive at taxable income, taxpayers can reduce their adjusted gross income by their personal
exemptions and the larger of their standard deduction or itemized deductions. These amounts for 2000 and
2001 are:
Personal exemption
Standard deductions
Married, filing jointly
Single
Over 65/blind (married) an additional
Over 65/blind (single) an additional
Individual claimed as dependent by another
(or earned income plus $250 unearned income up to a
maximum of $4,350 in 2000 and $4,550 in 2001)
2000
$2,800
2001
$2,900
$7,350
$4,400
$850
$1,100
$700
$7,600
$4,550
$900
$1,100
$750
Thus, a married couple, filing jointly, with two dependents and claiming the standard deduction
could have an adjusted gross income of $18,550 in 2000 and $19,200 in 2001 without having a federal
income tax liability.
DEPRECIATION AND EXPENSING
Legislation in 1997 made only minor changes in expensing and depreciation. First, as indicated in
Table 2, Section 179 expensing increases gradually from $20,000 in 2000 to $25,000 for tax years
beginning after December 31, 2002. Second, it was clarified that horses which meet the qualifications of
10
Section 179 do qualify for Section 179 expensing. Like other property, horses must be used in a trade or
business to qualify for Section 179 treatment. Third, the alternative minimum tax (AMT) adjustment for
depreciation was repealed for property placed in service after December 31, 1998. Thus, for assets
purchased in 1999 and later years, the same depreciation schedule can be used for regular tax and AMT
calculations.
Table 2. Section 179 Expensing Allowed
Taxable year beginning
2000
2001-02
after 2002
Maximum expensing election
$20,000
$24,000
$25,000
Section 179 Expensing
Farmers and others in an active trade or business can elect to treat the cost of up to $20,000 of
qualifying property purchased during 2000 as an expense (rather than as a depreciable capital expenditure).
Although the annual expensing limit increases in the future, other limitations remain the same. Tangible
personal property used in a trade or business qualifies if it would have been eligible for investment tax
credit. (Currently, reference is made to Section 1245 property which does include horses.) Purchased new
or used property can be expensed. However, only the “boot” portion paid on trades is eligible for
expensing. Property previously used by the purchaser is not eligible for expensing. Inherited property or
property acquired from a spouse, ancestors, or lineal descendants is also not eligible for Section 179
expensing.
The entire Section 179 expensing deduction can be taken on one large item, reducing the basis for
cost recovery. Alternatively, several small items can be completely written off in the year of purchase. Less
than the full $20,000 expensing deduction can also be used. The amounts expensed are treated the same
as depreciation when the property is sold or traded, and for depreciation recapture purposes. If a Section
179 expensing election is made, notations regarding the specific allocations should be made on the
depreciation schedule. If no allocations are specified, IRS prorates the expensing election among all eligible
assets.
The expensing deduction is phased out on a dollar-for-dollar basis if over $200,000 of qualified
property is placed in service during a tax year. Only the boot portion on like-kind trades is considered for
the $200,000 limit. For example, if a farmer buys $205,000 of machinery in 2000, the maximum Section
179 expensing allowed would be $15,000 that year ($20,000 - $5,000). An individual is not allowed to
elect the full $20,000 and carryover the $5,000 excess. However, if the boot portion of the $205,000
purchase with a like-kind trade-in was only $150,000, then the full $20,000 expensing could be elected.
The expensing deduction is also limited to the taxable income from any active trade or business
before any Section 179 expensing. A farmer's and/or spouse's off-farm wage or business income can be
combined with Schedule F loss so that aggregate taxable income would be positive. This would permit a
11
Section 179 expense for an asset acquired by the farm business. Gain or loss from the sale of livestock,
machinery and business assets reported on Form 4797 is also included in taxable income for Section 179
purposes. Recent regulations also clarify that “suspended losses” are not considered in determining the
taxable income limit.
For example, a farmer with a net income from active trades and businesses of $2,600 would be
limited to a Section 179 deduction of $2,600. If more than $2,600 of qualifying property had been
purchased in 1999, the excess could be carried over to 2000 or later years. The amount carried over to
2000 could be deducted, assuming sufficient taxable income, even if no qualifying property has been
purchased in 2000. However, the total Section 179 expensing cannot exceed $20,000 (the new limit) in
2000, even with carryovers. The carryover Section 179 expensing is used after “new” Section 179
expensing for 2000 is used.
Example: Assume that $10,000 of qualifying assets has been purchased in 1999, but taxable
income of the business was only $3,100. Thus, only $3,100 would be allowed as Section 179 expensing
in 1999, and $6,900 would be carried to 2000. In 2000, taxable income is $32,000 and $15,000 of
Section 179 qualifying property is purchased. The 2000 Section 179 would be limited to $20,000 ($5,000
of the carryover plus $15,000 of new purchases). The remaining $1,900 of 1999 purchases ($6,900 minus
$5,000) could be carried to 2001.
CAUTION: Reducing taxable income of a business to $0, as in the example above, is
generally not good tax management. Using Section 179 expensing to reduce the income subject to
tax below the personal exemptions and standard deduction “wastes” potential future depreciation
deductions. Farmers should review their 2000 tax situation before claiming the maximum Section
179 deduction.
For individuals involved in partnerships and/or S corporations, the Section 179 expensing and
taxable limitations apply to both the business and the individual level. For example, George and David are
equal partners in DG Partnership. In 2000, the DG partnership acquires $100,000 of qualifying property
and elects a $20,000 Section 179 deduction which passes through to David and George. If David and
George are not involved in other businesses, each would be limited to a $10,000 Section 179 expensing
deduction. However, if David is also involved in a sole proprietorship, his total Section 179 for 2000
expensing is limited to $20,000. David would qualify for the additional $10,000 Section 179 deduction only
if his sole proprietorship made qualifying investments and the income limitations were met. If George had
been involved in three partnerships, each expensing $10,000, George would be limited to a $20,000
deduction, and the remaining $10,000 would be lost rather than carried over.
With Section 179 expensing there is a trade-off between the tax deductions for income and selfemployment tax purposes in one year versus tax savings spread over several years. Expensing a seven-year
MACRS class asset gains the tax savings in one year rather than over the eight years of the recovery
period. The time value of money and expected future income are important in making the expensing
decision. The present value of tax benefits from expensing is generally higher for assets with longer
MACRS lives, like drainage tile. Thus, the expensing election is usually applied to qualifying property which
12
has the longest life and is the least likely to be resold or traded. However, expensing may not reduce taxes
for the farmer who expects income to increase and the marginal tax rate to be higher in the future. Both
income and SE taxes should be considered in making decisions with respect to the Section 179 expensing
election. Because of reduced taxable incomes, many farmers with low taxable incomes may decide to forgo
Section 179 expensing for 2000.
13
Class Lives and Depreciation Rates
The Technical and Miscellaneous Revenue Act of 1988 (TAMRA) affected both the class life of
some assets and the rate of depreciation for property used in farming. The system is called MACRS
(Modified Accelerated Cost Recovery System), and the 150-percent declining-balance method applies
to most property acquired by farmers after 1988.
Three-year MACRS property includes breeding hogs and the tractor units of semi-trailers for
over-the-road use.
Five-year MACRS property includes cattle held for breeding or dairy purposes, computers and
some construction equipment. Congress specifically included automobiles, pickups and other trucks in the
five-year class. Special depreciation limitations and recordkeeping requirements apply to passenger
vehicles. For passenger vehicles acquired in 2000, the maximum combined depreciation and Section 179
expensing deduction is $3,060. This increases to $5,000 in the second year, $2,950 in the third year, and
$1,775 thereafter. If business use is less than 100 percent, the maximum deductions are reduced
accordingly. Pick-ups and other trucks with a gross vehicle weight exceeding 6,000 pounds are not subject
to the depreciation and Section 179 limits discussed above.
Seven-year MACRS property includes most agricultural machinery and equipment. Grain bins,
fences and general office equipment are also included in this seven-year class.
Ten-year MACRS property includes single-purpose agricultural and horticultural structures
placed in service after 1988, fruit trees and vineyards. For orchards and vineyards placed in service after
1988, depreciation is on the straight-line method. Allowable depreciation for pre-1989 acquisition of these
assets is calculated using the double declining-balance (200-percent declining balance) method, shifting to
straight line to maximize depreciation.
Deductions by year, as a percentage of the initial depreciable basis, for assets acquired after 1988
are shown in Table 3. These MACRS percentages have built in the “half-year convention” for the year of
purchase. The equivalent of six months’ depreciation is allowed whether an asset is placed in service on
January 1 or December 31. If a $100,000 asset were purchased in 2000, the first year’s depreciation
allowed would generally be $25,000 for three-year MACRS property, $15,000 for five-year property,
$10,710 for seven-year property, or $7,500 for ten-year property. The “half-year” convention is also used
for the year of disposition. For example, if a tractor acquired in 1996 is sold in 2000, the fifth recovery
year, allowable depreciation for 2000 would be one-half of the 12.25 percent in the table. As discussed
previously, if an asset is traded in a like-kind exchange, one continues to depreciate the basis in old asset.
Depreciable land improvements, such as field tiling, are assets in the 15-year MACRS class.
Farm buildings, such as general purpose barns and machinery sheds, are20-year MACRS property. The
150-percent declining-balance method with a shift to straight-line depreciation, to maximize the
depreciation deduction, is used for property in the 15- and 20-year MACRS classes.
14
Rental houses and apartment buildings acquired in 1987 and later years will have a 27.5-year life.
Nonresidential real property such as office buildings, factories and stores will have a 31.5-year life if
acquired before May 13, 1993 and 39 years if acquired on or after May 13, 1993.
Table 3.
MACRS Depreciation Deduction Percentages for Property Used in Farming by
Class-Life of MACRS Property Acquired after1988
Class-Life of MACRS Property
Recovery
3-Year
5-Year
7-Year
10-Year
1
25.00
15.00
10.71
7.50
2
37.50
25.00
19.13
13.88
3
25.00
17.85
15.03
11.79
4
12.50
16.66
12.25
10.02
5
--
16.66
12.25
8.74
6
--
8.33
12.25
8.74
7
--
--
12.25
8.74
8
--
--
6.13
8.74
9
--
--
--
8.74
10
--
--
--
8.74
11
--
--
--
4.37
Source: Internal Revenue Service, Depreciation, Pub. 534, 1993 and How to Depreciate Property, Pub. 946, 1995.
Final Quarter Limitation
A special limitation on depreciation applies if more than 40 percent of the total depreciable bases
of property acquired in a tax year is placed in service during the last three months of the year.
Nonresidential real property and residential real property is excluded from this calculation. This “final
quarter limitation” affects all assets acquired during the tax year and may substantially reduce the amount
of depreciation allowed, especially on end-of-the-year purchases.
Example: Assume a $100,000 combine was the only asset acquired during 2000 and it was placed
in service after October 1. Then only one and one-half months of depreciation would be allowed. Instead
of deducting $10,710 of the “half-year” depreciation, one could deduct depreciation for only one and onehalf months or $2,680. The depreciation not allowed in the year of purchase would be taken in later years,
thus the total depreciation is not affected. For example, 20.85 percent would be allowed in the second year
15
for the combine subject to the final quarter limitation in the year of purchase. For further details see IRS
Publication 946, “How to Depreciate Property,” Table A-18, page 85. This publication has other tables
which can be used to determine the appropriate percentage for each depreciation situation.
Determination of whether the final quarter limitation applies is made after any Section 179
expensing. Whether Section 179 expensing is elected, which assets are selected for expensing and whether
the entire $20,000 allowance for 2000 is used may have a considerable impact on the depreciation for the
year. It must be possible to avoid application of the limitation by electing to apply Section 179 expensing
to depreciable assets acquired in the final quarter of the year.
Example: Assume a farmer acquired a $25,000 machine in the first quarter, a $30,000 machine
in the second quarter and a $45,000 machine in the last quarter of the year. If there was no Section 179
expensing, the final quarter limitation would apply, and a “mid-quarter convention” would apply to all assets
purchased that year. Each asset is treated as if it had been acquired on the mid-point of the quarter it was
placed in service. Depreciation for this seven-year property would be computed, using percentages from
IRS Pub. 964 Tables A-15, A-16, and A-17, as:
$25,000
$30,000
$45,000
$100,000
x
x
x
18.75 percent =
13.39 percent =
2.68 percent =
TOTAL
$4,687.50
$4,017.00
$1,206.00
$9,910.50
Example: Assume the farmer elected $20,000 Section 179 expensing on the $45,000 machine
acquired in the last quarter. Then only $80,000 of qualifying property would have been acquired and only
one-third in the fourth quarter. The 40-percent test would not be satisfied, and the half-year convention
would apply to all of the purchases. Depreciation would be computed using the percentages from Table
4 above as:
$25,000
$30,000
$25,000
$80,000
x
x
x
10.71 percent =
10.71 percent =
10.71 percent =
TOTAL
$2,677.50
$3,213.00
$2,677.50
$8,560.00
In this instance, the combined depreciation and expensing deduction would total $28,560.00.
The depreciation regulations generally allow one-half year's depreciation in the year of acquisition
and one-half year of depreciation in the year of disposition. For assets subject to the mid-quarter
convention as a result of the final quarter limitation, depreciation in the year of disposition would be allowed
to the mid-quarter of disposition. However, the regulations indicate that if one purchases and disposes of
an asset within a tax year, the transaction is assumed to occur on the same day, and one receives NO
depreciation on that asset. Only those assets that were acquired during the year and are “on hand” at the
end of the year are considered for the 40-percent test.
16
Alternative Depreciation Methods
Section 179 expensing and use of the MACRS table results in a producer recovering the cost of
the depreciable assets as rapidly as possible. However, if taxable income is low or negative, the tax saving
effect of this depreciation may be largely “wasted.” For example, if taxable income is low, the income tax
savings on another dollar of depreciation may be 15 percent or nothing. However, if the depreciation
deduction were postponed until a year when income was higher, the savings could be 28 percent or more.
Producers have limited flexibility with respect to depreciation. Once a producer begins depreciating
an asset using a method, that method must be continued for the life of the asset. However, decisions with
respect to methods can be made when the asset is placed in service. Table 4 compares the annual
depreciation deductions for the 7-year MACRS method and straight-line depreciation over the alternative
10-year life (Alternative MACRS). Under regular MACRS, nearly 60 percent of cost recovery occurs
within the first four years. In contrast, with alternative MACRS, 65 percent of cost recovery is left after four
years.
Table 4. Depreciation Alternatives for $100,000 7-year Property Acquired in 2000
MACRS
Alternative MACRS
Year
Depreciation
Remaining
Balance
Depreciation
Remaining
Balance
2000
10,710
89,290
5,000
95,000
2001
19,130
70,160
10,000
85,000
2002
15,030
55,130
10,000
75,000
2003
12,250
42,880
10,000
65,000
2004
12,250
30,630
10,000
55,000
2005
12,250
18,380
10,000
45,000
2006
6,130
6,130
10,000
35,000
2007
---
0
10,000
25,000
2008
10,000
15,000
2009
10,000
5,000
2010
5,000
0
SELF-EMPLOYMENT AND SOCIAL SECURITY TAXES
17
Self-employment (SE) taxes are larger than income taxes for many farmers. The SE tax has no
personal exemptions or standard deduction and applies to $400 or more of earnings from self-employment.
The SE tax rate is higher than the income tax rate for 2000 taxable incomes of less than $43,850 if married,
filing jointly. Both the SE and social security taxes have two parts. Of the 7.65- percent social security tax
rate which both employees and employers pay, 6.2 percent is social security and 1.45 percent is for the
medicare hospital insurance tax. For the SE tax, the corresponding rates are 12.4 percent for social security
and 2.9 percent for medicare.
The maximum earnings subject to these two different taxes have been separated. The maximum
earnings subject to social security taxes are $76,200 in 2000 and $80,400 in 2001. Thus, the maximum
social security portion will increase from $9,448.80 in 2000 to $10,371.60 in 2001. As a result of the
Revenue Reconciliation Act of 1993, there is no limit on the earnings or wages subject to medicare hospital
insurance tax of 2.9 percent. Thus, an individual earning an additional $1,000 will pay an additional $29
of medicare hospital insurance.
Net earnings for SE, the amount on which the tax is computed, is 92.35 percent of net farm profit
on Schedule F. One-half of the SE tax paid is deducted from income in arriving at taxable income. These
adjustments are made to put self-employed individuals and employees on a similar basis. Thus, the effective
SE tax rate is about 14.2 percent for an individual in the 15-percent income tax bracket and 13.2 percent
for those in the 28-percent bracket.
Caution: Retired farmers drawing social security benefits, with carryover grain to sell, must
also consider the effect on taxability of their social security benefits. Sales of carryover grain are
subject to income and self-employment tax, although this income does not reduce social security
benefits. In some cases, the effective tax rate on the last dollar of income from grain sales may
exceed 60 percent. This occurs because 50 and 85 percent of social security benefits become taxable
above certain incomes. Schedule F net income in the $45,000 to $80,000 range tends to have very
high effective tax rates for retired farmers.
Social Security Benefits
The Social Security system provides benefits in addition to old-age benefits for self-employed
individuals. If an individual becomes disabled, a covered individual becomes eligible for disability payments.
Benefits may also be provided to surviving spouses and to dependent children under 18 years of age if the
covered individual dies.
Because social security coverage provides benefits in addition to old-age benefits, many farmers
want to ensure that they are covered for these other benefits. Payments under the optional method will
contribute toward an individual's “currently insured” status. For survivor benefits, an individual must have
been covered for six of the 12 quarters preceding the quarter of death. To be “fully insured” an individual
needs one quarter of coverage for each year since 1951, or since turning 21, whichever is later. Once 40
quarters of coverage are obtained, an individual is fully insured permanently, even if the person was not
covered for six of the last 12 quarters.
18
Farmers who have SE earnings of less than $400 and more than $2,400 of gross income (receipts)
from farming may elect to pay SE tax on $1,600 of earnings under the farm optional method. These farmers
receive credit for only two quarters, not four quarters, in determining social security benefits in 2000.
Payments under the optional method will increase earnings for calculation of the earned income credit. In
some situations, this may result in, or increase, the earned income credit for a family and thereby reduce
the net cost of qualifying for social security coverage.
The earnings necessary to qualify for a quarter of coverage increases to $830 in 2001. Thus, in
2001, farmers using the optional farm method will qualify for only one quarter of coverage. These farmers
risk losing their “currently insured” status for disability benefits.
Benefits paid under social security will increase about 3.5 percent in 2001. The average retired
worker's monthly benefit will increase from about $816 in 2000 to $845 in 2001. For the average couple,
benefits will increase from $1,362 to $1,410 per month. Supplemental security income payments to the
disabled will also increase from a maximum of $512 in 2000 to $530 in 2001.
The amount which an individual under age 65 receiving social security benefits may earn without
a reduction in benefits increases from $10,080 in 2000 to $10,680 in 2001. Benefits are reduced by $1
for every $2 earned over the maximum earnings limit if the individual is under age 65. In 2000, Congress
eliminated the earnings limit that previously applied to individuals 65 to 69 years of age. Benefits are not
reduced for individuals who continue to work after age 65. However, the earnings are subject to the selfemployment or social security taxes.
The social security benefits which an individual receives are determined primarily by their Average
Indexed Monthly Earnings (AIME) over a 35-year period. An individual's AIME is based on past earnings
with adjustments for inflation. Benefits for an individual becoming eligible for retirement in 2000 are
calculated using the formula: 90 percent of the first $561 of AIME, 32 percent of the next $2,820, and 15
percent of any amount over $3,381 of AIME.
Example: The monthly benefit for an individual with an AIME of $3,500 would be calculated as:
90 percent of $561
= $504.90
32 percent of $2,820
= $902.40
15 percent of $119
=
$ 17.85
$1,425.15
Because of the formula used to calculate retirement benefits, the return on higher levels of selfemployment income decreases. The additional benefits associated with an AIME of above $3,400
($40,800 annually) are quite low. Thus, many farmers would like to limit their SE earnings and SE taxes.
SE Tax-Reduction Techniques
There are four major ways in which farm families have attempted to reduce the amount of earnings
for SE tax purposes. These include:
a. Rental of real estate to a separate business entity
19
b. Rental to a spouse
c. Non-cash wages to spouse and employees
d. Gifts of commodities
IRS is challenging these techniques, often successfully, when the transactions lack economic substance or
independent significance aside from tax avoidance.
Rental of Real Estate to a Separate Business Entity- A common means of controlling income
which is considered as earnings for SE tax purposes has been for the landowner to rent land to a business
entity in which the landowner materially participates. Often the business has been incorporated, and the
landowner receives a salary as an employee of the corporation and rent. Historically, only the salary would
be considered earnings for social security tax purposes, and the rental payments would be subject only to
income tax.
In a recent court case [Mizell v. Commissioner, T.C. Memo 1995-571,70T.C.M. [CCH Dec. 51,
013 (M)](1995)], a father rented land, for one-quarter share of the crop, to Mizell Farm. Mizell Farm was
a partnership of Mr. Mizell and his three sons. Each of the partners materially participated in the farm
partnership. If rental income is derived under an arrangement which provides for material participation of
the landowner in the farm operation and material participation actually occurs, then the rental income under
this arrangement is considered earnings for self-employment tax purposes. In the Mizell case, the Tax Court
considered the leases, the partnership agreement and the general understanding between the father and sons
as the “arrangement.” Thus, based on the facts of this case, the Tax Court found that the rents received
were earnings for self-employment tax purposes.
The IRS has taken positions, LTR 9637004, May 1, 1996 and FSA 19917008, December 10,
1999 which extended the findings of the Mizell case to farm corporations. A recent Tax Court case
[McNamara v. Commissioner, T.C. Memo. 1999-333 (October 4, 1999)] supported the IRS position in
a farm corporation renting land to an individual participating in the farm operation. These combined with
the Court case discussed in the next section, indicate little support for the exclusion of rental payments from
self-employment earnings when the landowner materially participates in the farm operation. Legislative
proposals have been introduced to resolve this problem for producers, but they have not gotten out of the
House and Senate committees.
Rent to a Spouse - On many farms, the real estate may be jointly owned by the farmer and
spouse. In some instance, the farmer paid cash rent to the spouse, deducting the rent on Schedule F, and
reducing earnings for self-employment tax. However, two recent Court cases [Vicent E. Bot, et ux.v.
Commissioner, T.C. Memo 1999-256] and [Hennen v. Commissioner, TC Memo 1999-306 (September
16, 1999)] found that the rental payments were earnings for self-employment tax purposes when the spouse
materially participated in the farm operation.
If the spouse does not participate in the farm operation and owns the property individually, there
is a stronger basis for the payment of rent not being considered as earnings from self-employment. A written
lease with reasonable rental payments at least annually would provide documentation. The
20
landowner/spouse should receive the rental payment and make tax, insurance and other related payments
from a separate account which is not used for the farm business. The farmer should issue a Form 1099MISC for the rent payments which are reported on the landowner/spouses Schedule E. If there is a
mortgage on the property, it should be in the landowner/spouse’s name, although the farm operator could
guarantee the loan. However, any participation by the landowner/spouse in the farm operation is likely to
make the arrangement unacceptable for self-employment tax avoidance to the IRS.
The Bot, Hennen and McNamara cases are being appealed to the 8th Circuit Court of Appeals.
The IRS has a number of additional cases in Tax Court which are being held pending the outcome of the
appeals.
Noncash Wages to Spouse and Employees- Under I.R.C. Section 3121 (a)(8)(A), agricultural
wages paid in any medium other than cash are exempt from FICA (social security), FUTA (federal
unemployment) and income tax withholding. This was a contentious issue, especially in the Indianapolis
District, for several years. A task force met in 1993 to develop guidelines with respect to the payment of
noncash wages to agricultural employees. The guidelines were published as Market Segment
Understanding, “Noncash Renumeration for Agricultural Labor,” on December 20, 1994 and stress the
“substance over form” aspect of such transactions. Although not binding on any party, the guidelines do
provide useful information for those concerned about in-kind payments. In many respects, the guidelines
are very similar to “good” arrangements suggested in the past. For a further discussion, see Patrick, “Tax
Planning and Management for Farmers in 1998,” Cooperative Extension Service, Purdue University, CES
Paper No. 316, December 1998.
Gifts of Commodities - In some instances, farm operators have made gifts of commodities with
the idea of reducing SE tax. Gifts may be made to spouses, other family members, or charitable
organizations. If the gift is made to a spouse or family member during the year in which the commodity is
produced, expenses on Schedule F should be reduced by an amount representing the expenses of
producing the donated commodity (Reg. Sec. 1.170A-1(c)(4)). Although income is not reported, expenses
are reduced, and there is only a limited tax benefit to the gift. If the gift is made in the year after the
commodities are produced, no adjustment of expenses is generally made, and tax savings are considerably
higher. However, control of the commodity must be given up to avoid the “assignment of income” doctrine.
As with other gifts, the donee also receives the donor’s basis in the commodity.
Gifts to a Spouse to avoid SE tax have not been allowed by IRS. The facts discussed in LTR9210002, illustrate some difficulties in attempting to make a gift. A husband and wife jointly owned land,
and the husband rented additional land. The wife said her involvement in the farm was limited to monthly
bookkeeping. Soybeans were delivered to elevator in June by the husband, and half were sold. The rest
were stored with husband's name listed as patron and the wife's name written below. The soybeans were
transferred to the wife in July by a notarized statement with stipulation they could be sold any time prior to
September 1. The soybeans were actually sold after September 1, and the check made out to the wife was
deposited in their joint account by the husband. Later the wife transferred the funds to her account.
21
Gifts to a spouse are not likely to be recognized as gifts for tax purposes if the spouse participated
in the farm operation in any way or owned property used by the farmer. Deposit of proceeds in a joint bank
account, even if not the farm account, is likely to be fatal to the gift. Providing any guidance in the gifting
agreement about disposition of commodity or not having sales documentation that names the spouse as the
seller (i.e., patron of a cooperative) also causes problems.
Gifts to Other Family Members have a higher probability of surviving IRS examination than gifts to
spouses, but they also may be examined carefully. If the family members are employed or involved in the
business, the gift is likely to be viewed as compensation. The gift commodity should be a prior year's
production and not have any sale commitments. Transfer of the commodity must be clearly distinguished
from the sale, with the donee bearing the risk of any loss and having control of the use of the proceeds.
Charitable Contributions of commodities may reduce taxes for cash basis farmers, especially those
who cannot itemize deductions. Donation of a commodity produced in a prior year results in the deduction
of expenses in the prior year and no income in the year of gift. It is important that the commodity be
transferred to the charity and not merely sold on the charity's behalf. Transfer of the commodity to the
charity should be separate from the sale of the commodity. If delivered to an elevator, the storage receipt
should be made out to the charity. The receipt should be sent to the charity with a cover letter indicating
they can treat the commodity as they see fit. The check should not be issued until the elevator receives
instructions from the charity. Form 8283, Noncash Charity Contributions, would not need to be filed,
because no charitable contribution deduction will be taken by the farmer.
Example: In February 2001, a cash basis farmer delivers 1,400 bushels of 2000 corn with a market
value of $3,000 to the local elevator and sends the storage receipt to the church with a letter indicating the
church may use the grain as they like. If the farmer had sold the grain for $3,000 and paid the taxes, how
much would be left to contribute to the church?
SE tax 15.3 percent x $3,000 x 0.9235 =
$423.89
Federal tax 15 percent x ($3,000 - 211.94) =
418.21
State and local tax 4.4 percent x ($3,000 - 211.94)
121.67
$3,000 - 964.77 = $2,035.23
If the charitable contribution had been made in 2000, the year the commodity was produced, the
farmer could deduct the lesser of the fair market value of the commodity or basis in the property.
However, the farmer must reduce the tax basis of the commodity by the expenses claimed on Schedule F.
This would reduce the tax basis to zero. Thus, there would be no charitable contribution to be claimed.
The tax savings would be the same as in the example above.
TAX CONSIDERATIONS FOR RETIRING FARMERS
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Farmers considering retirement are often looking for ways to transfer assets to other family
members or use their farm assets for retirement income. This is an area in which careful planning before
assets are transferred can be very helpful.
Depreciation Recapture and Installment Sales
If machinery and equipment (Section 1245 property) are sold for more than their adjusted tax
bases (remaining book value), the gains are taxable. Section 1245 property also includes single-purpose
agricultural and horticultural facilities, tile, grain storage, fences, water wells, and purchased breeding stock.
The difference between the adjusted basis and original cost basis is depreciation recapture and is taxed as
ordinary income, although it is not subject to self-employment tax. Only the gain, if any, in excess of the
original cost basis is taxed as capital gain. For example, if a tractor purchased for $25,000 in 1976 is fully
depreciated (an adjusted basis of $0), then the first $25,000 of the sales price is ordinary income, and only
the amount received in excess of $25,000, if any, would be capital gain income.
To avoid a large tax bill in the year of sale, some cash basis farmers may consider an installment
sale of machinery and equipment. However, under the installment sales rules, the entire amount of Section
1245 depreciation recapture is taxable in the year of sale, regardless of the amount of sale proceeds
received. For example, a farmer sells a line of machinery with an adjusted basis of $75,000 on an
installment sale for $250,000 and receives a $50,000 down payment. If the machinery had originally cost
more than $250,000, then all of the gain would be depreciation recapture. The gain of $175,000
($250,000 sale price - $75,000 basis) is included as ordinary income, taxable in the year of sale, even
though only $50,000 was received.
New rules apply to taxation of the gain on general purpose farm buildings and most depreciable
non-farm real estate (Section 1250 property) held more than 12 months and disposed of after July 27,
1997. If a Section 1250 asset is sold for more than its adjusted basis (remaining book value), the gain is
taxable. Depreciation taken in excess of straight-line depreciation is taxed as ordinary income. This gain
would be recaptured in the year of sale, even if sold on installment sale basis. The straight-line depreciation
would be Section 1250 recapture. Although this is reported as capital gain income rather than ordinary
income, it is taxed at the lower of the taxpayer’s regular tax rate or 25 percent. However, it is not
recaptured in the year of sale on an installment sale. Only the gain in excess of the original cost basis would
be taxed at the maximum tax rate of 20 percent for long-term capital gains (10 percent for individuals in
the 15-percent regular tax bracket).
When land is sold on an installment sale, the gain is reported as taxable income only as the
payments are received. For example, 80 acres of bare land which a farmer had purchased for $900 per
acre were sold for $1,800 per acre. The $900-per-acre gain represents 50 percent of the $1,800 per acre
sales price, thus only 50 percent of each payment received, excluding interest, is taxable income. The
interest is reported as taxable interest income.
Installment Sales and Tax Planning
23
The installment sale of farm real estate may be very useful from an income tax planning standpoint,
but may have some disadvantages for estate planning, especially if family members are involved. First, the
installment sale prior to death results in the fair market value of the note being included in the estate and
subject to federal estate tax and Indiana inheritance tax, if inherited by someone other than the spouse. The
disadvantage of this is that the basis of the obligation is not “stepped-up,” and gains continue to be reported
as income by the estate (income in respect of a decedent) or the estate’s beneficiaries. In the example in
the previous section, the 50-percent gain would continue to be reported as income by the heirs to the
contract. Second, if the buyer and seller are related parties, the gift or cancellation of an installment
obligation is considered income to the seller. For example, in a worst case type scenario, if the buyer (son)
is unable to make the payments and the seller (father) forgives the debt, the seller is treated as if he had
received payment in full and is taxed on the gain although it was not received. Third, if the installment
contract is canceled by the seller's will, the gain is recognized by the estate in its final return. It should be
noted that the “disadvantages” in some situations may be “advantages” in special circumstances. For
example, the sale fixes the value of the transferred asset and thereby transfers any subsequent appreciation
in value to the purchaser.
Installment sale income, whether the return of basis, gain or the interest portion, is not considered
as earnings for self-employment tax or social security benefit purposes. However, the gain and interest
portions do become part of modified adjusted gross income for determining the taxability of social security
benefits. Thus, with the lower capital gain tax rates, an installment sale may be less attractive from a tax
planning standpoint.
Leasing of Assets
Leasing of machinery and equipment with an option to buy, especially to family members, is
commonly suggested to reduce or avoid the depreciation recapture associated with its sale. If real estate,
machinery and equipment are rented jointly, the income and expenses are reported on Form 4835 (if a
share rental) or on Schedule E (if a cash rental). Neither arrangement is subject to SE tax or included in
the annual earnings test. However, the situation may be different if the lease involves an entity in which the
lessor is materially participating as discussed in the “Self-Employment and Social Security Taxes” section.
Reporting of income and expenses associated with the rental of personal property, when real estate
is not included in the same transaction, is unclear. Rental of personal property, such as machinery, should
be reported on Schedule C, according to IRS instructions. Income reported on Schedule C is considered
as income from a trade or business, is subject to SE taxes and is included for the annual earnings test for
social security benefits. Income from rental of real estate reported on Schedule E is rental income, is not
subject to SE tax and is not included for the annual earnings test. According to the Schedule E instructions,
if the rental of personal property is not a business, the receipts and expenses can be reported on Form
1040. If it is not possible to rent the machinery with the real estate, a retiring farmer should avoid engaging
in the rental activity with “continuity and regularity,” to avoid having the activity considered a trade or
business.
TAX PLANNING IN DIFFICULT TIMES
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Earned Income Credit
The earned income credit (EIC), also called the negative income tax, was enacted to provide tax
relief to low-income individuals. Unlike many tax credits, the EIC is refundable. That is, taxpayers who
have no tax liability can receive a refund equal to the amount of the credit. The EIC is based on the earned
income, not adjusted gross income (AGI). The EIC increases with earned income up to a predetermined
level and then is phased out. The number of qualifying children (younger than 19 or 24 if a full-time student)
living with taxpayer also affects the amount of the EIC. For taxpayers without children who are at least age
25 but under age 65 at the end of 2000 (or their spouse if filing jointly), the EIC increases with earned
income to a maximum of $353 for earned incomes of $4,610 to $5,770 and is completely phased out for
incomes of over $10,380. For taxpayers with one qualifying child, the maximum credit is $2,353 for
earnings of $6,920 to $12,690 and is completely phased out for incomes of over $27,413. With two or
more qualifying children, the maximum EIC is $3,888 for earnings of $9,720 to $12,690, with the phaseout completed at $31,152.
For EIC purposes, earned income includes wages, salaries, and earnings from self-employment.
For farmers, earned income also includes the depreciation recapture on the disposition of purchased
breeding, draft or dairy livestock, machinery and equipment, and farm buildings. Taxpayers are disqualified
from the EIC if their investment income exceeds $2,400. Investment income includes interest, dividends
and gains on the sale of nonbusiness capital assets such as stocks, bonds or other assets held for investment
purposes. Gains from the sale of raised livestock and business assets treated as capital gain income are
included neither in investment income nor in earned income. This was clarified by the IRS in late 1999 for
1996 and later tax years.
Farmers with very low or negative earnings from self-employment, such as a loss on Schedule F,
may still qualify for EIC if they elect to pay self-employment tax under the optional farm method. Farmers
may elect to pay the 15.3 percent self-employment tax on $1,600 or a tax of $244.80. This provides two
quarters of credit for social security retirement and disability benefit purposes in 2000. If the farmer had
no other earned income, the EIC for 2000 would be $124 with no children, $553 with one qualifying child,
and $650 with two or more qualifying children. Thus, many farm families can provide for continued social
security coverage for disability and survivor benefits at little or no out-of-pocket cost.
Net Operating Losses
Some Midwestern producers will find in their year-end tax planning that their farm expenses will
exceed farm income on Schedule F for the 2000 tax year. The Schedule F loss of a producer is generally
not the same as a net operating loss (NOL) for income tax purposes. An NOL can be carried back to prior
tax years to generate a tax refund or carried forward to offset income taxes in future years. Although the
NOL concept is quite simple, actual calculations of the NOL deduction and NOL carryover can be quite
complex. This complexity arises because various tax benefits must be removed by modifying the deductions
of the loss year and modifying the income in the carryover year as well as all intervening years. Because
of these modifications, the tax benefits of the loss may be reduced significantly. Before briefly discussing
these modifications, the possible loss situations and general strategies for producers are addressed.
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Loss Situations and General Strategies
When farm expenses, including depreciation, exceed farm income on Schedule F, a farm loss exists.
For sole proprietorships, partnerships and S corporations, the farm loss flows through to the individual
owners. (For C corporations, a loss remains at the corporate level and is not discussed here.) For the
individual, these farm losses can create three different situations.
First, if the farm family has other income (such as gains from the sale of cull breeding stock or other
assets or income from an off-farm job) which is equal to or greater than the farm loss, then the loss is
allowed in full for the year in which it occurs and there is no NOL.
Farmers who purchased depreciable assets in 2000 have some flexibility with respect to
depreciation. They may be able to reduce the size of their 2000 farm loss by using straight-line depreciation
methods and alternative useful lives on these assets. Also, major repairs done during the year could be
capitalized rather than deducted as current expenses. The tax deductions associated with these adjustments
will be recovered in future years.
Second, if the farm loss is greater than other income, the adjusted gross income must be
recomputed to remove some tax benefits. For example, in determining the NOL deduction, personal and
dependency exemptions are not allowed and itemized deductions may be limited. If the recomputed
adjusted gross income is greater than the loss, there is no loss to be carried back or forward to other tax
years.
Third, if the loss is greater than the recomputed adjusted gross income, there is an NOL which can
be carried to another tax year. Farmers have three alternatives to consider. They may elect to carry the
NOL back two years, carry a farm NOL back five years or carry the NOL forward up to 20 years. If the
carryback period is used, the NOL may create a refund of part or all of the income taxes paid by offsetting
taxable income in the carryback year. If carrying back the NOL will not result in tax refunds, an election
to use only the 20-year carryforward period can be made on a timely filed return, and the carryforward
will be available to reduce taxes in future years. In all of these cases, the NOL reduces taxable income for
income tax purposes, not the earnings for self-employment taxes. The best strategy with respect to the
carryback versus carryforward decision is generally the one which provides the greatest tax savings for a
family’s specific situation. In general, one should forgo the NOL carryback period if carrying back the
NOL would not result in a tax refund.
Calculating and Distributing the NOL
To determine the NOL and the portion of it which can be deducted in another year, a number of
adjustments are necessary. Form 1045 is used for calculating the NOL and reporting the adjustments.
Basically business income, including non-farm wages, less business losses is adjusted in two ways. First,
nonbusiness deductions (i.e., standard or itemized deductions) are deductible for computing an NOL only
to the extent of nonbusiness income (i.e., interest, dividends, pensions and capital gains from nonbusiness
investments). Second, capital losses are deductible for computing the NOL only to the extent of capital
26
gains. After making these adjustments, the NOL which can be carried to the first carryback or
carryforward years has been determined.
In general, the 2000 NOL available for carryback must first be used to offset income of two years
ago, 1998, if the two-year carryback is elected. If the five-year farm NOL carryback is elected, a 2000
NOL would offset income from 1995. If the timely filed election is made to forgo the carryback period,
then the NOL would be carried forward to the year 2001.
The income of the first carryback or carryforward year must also be modified to determine the
amount of the loss that is absorbed. Personal exemptions are not allowed in determining modified taxable
income. The capital loss deduction is limited to the amount of capital gain included in income. Deductions
based on or limited by a percentage of adjusted gross income (e.g., medical expenses) must also be
recomputed to reflect the modified adjusted gross income. If the NOL is not fully absorbed (used up) by
the modified taxable income of the first carryback year, then the amount which was not absorbed can be
carried forward to the next eligible year (1999 for the two-year carryback and 1996 for the five-year
carryback). Similar modifications of the income for that year are also necessary to determine the amount
of the NOL to be absorbed in that year. These intervening year modifications can eat up much of the tax
benefit of an NOL carryback or carryforward. One tax planning objective should be to try to minimize the
number of intervening year modifications required to use up the NOL.
If an individual wishes to forgo the carryback and carry the 2000 NOL forward, the election must
be made on the timely filed 2000 tax return. Generally, the election to forgo the carryback period would
be made in situations in which a carryback of the loss would result in little or no tax refund. In future years,
the income adjustments discussed above will be needed to determine the amount of the NOL absorbed.
If the election to forgo the carryback is not made on the 2000 return, the individual must carryback the
NOL before any remaining NOL may be carried forward. The election to forgo the carryback is made by
attaching a statement with the taxpayer’s name and social security number indicating that the taxpayer elects
to forgo the carryback period under IRC Section 172(b)(3)(C) for the NOL shown on the return.
The carryback and carryforward provisions of the NOL can be affected by other tax law
provisions. A shift between joint and separate returns, divorce, marriage, or other changes in filing status
can involve additional complications. In general, an individual’s NOL is only allowed to offset that
individual’s income.
Tax Planning Summary
When an NOL is likely to occur, a producer has some options. First, year-end tax planning to
adjust receipts and expenses may enable the producer to avoid the NOL. If an NOL cannot be avoided,
it is important to plan for the use of the NOL before the 2000 tax return is filed. This allows some
determination of the final size of the 2000 farm loss through depreciation choices and evaluation of the
election to forgo the carryback period. The calculations associated with computing an NOL and the amount
absorbed in a carryback/carryforward year can be complex and time consuming. Although some tax
benefits will be lost in the recalculation of income, other benefits will be gained. The best use of an NOL
27
will depend on an individual’s circumstances and may require considerable analysis of the alternatives.
Competent tax advice, analysis and planning are essential to make the most of your operating loss.
Tax Consequences of Asset Dispositions
Some farmers may sell assets to reduce debt and/or to improve cash flow. If a nonbusiness asset,
such as a stock, bond or other property held for investment purposes is sold for less than its adjusted basis,
there is a capital loss. The loss will be short- or long-term depending on whether the asset was held for 12
months or less or for more than 12 months. Short- and long-term capital losses are first used to offset any
capital gains with the same holding period. Then, if necessary, short-term losses can be netted against longterm gains (or vice versa). If there is a net capital loss, the deductible loss is limited to $3,000 annually, and
any remaining loss is carried forward indefinitely to future tax years and netted against any capital gains in
those years. If an individual has both short- and long-term losses in a year, the short-term loss is deducted
first, up to the $3,000 annual limit. Losses which are carried forward retain their short- or long-term
character. Considerable attention should be paid to properly characterizing gains and losses.
If the nonbusiness asset is sold in 2000 at a gain, the gain will normally be a capital gain. The capital
gain will be short- or long-term depending on the holding period of the asset. A short-term gain would be
taxed at the individual’s ordinary income tax rate, which could be as high as 39.6 percent. For a long-term
capital gain, the maximum tax rate is 20 percent (10 percent for individuals paying the 15 percent ordinary
income tax rate). A capital gain on the sale of an asset is not considered earnings for self-employment tax
purposes.
If a business asset is sold, the tax treatment is somewhat different. First, if the asset is sold at a loss,
the loss is a Section 1231 loss, and there is no limit on the amount of the loss which can be deducted. For
example, if a parcel of land had been purchased for $150,000 and was sold for $125,000, the entire
$25,000 loss would be deductible in the year of sale. Second, if the asset is sold for more than its adjusted
basis, there would be a gain. For Section 1245 property (e.g., machinery and equipment, grain bins, and
single purpose structures), if Section 179 expensing and/or depreciation had been taken on the asset, gain
would be recaptured as ordinary income (rather than capital gain income) to the extent of the amount of
Section 179 expense deduction and depreciation taken. Any remaining gain would be a Section 1231 gain.
For raised livestock held for breeding, dairy or draft purposes for the required holding period (more than
24 months for cattle and horses and more than 12 months for other livestock), the tax basis would generally
be $0, and the entire net sales price would be Section 1231 gain. This gain would be treated as capital gain
income and taxed at the lower capital gains rate to the extent that there were no Section 1231 losses in the
previous five years. If the individual had a Section 1231 loss which had not been offset by Section 1231
gains within the previous five years, the gain would be ordinary income to the extent of the previous loss.
Once previous Section 1231 losses are offset, any additional Section 1231 gains are treated as capital
gains.
For Section 1250 non-residential real property (e.g., general purpose barns and machine sheds),
gain to the extent of accelerated depreciation such as ACRS or MACRS minus straight line depreciation
is recaptured as ordinary income. For Section 1250 residential real property (e.g., house used for hired
labor or rental houses) there is no accelerated depreciation for assets placed in service after 1986. Gain
28
to the extent of the straight-line depreciation taken on both residential and non-residential real property is
subject to a special maximum tax rate of 25 percent (15 percent for individuals in the 15-percent ordinary
tax rate bracket).
Capital gains and Section 1231 gains are not considered as earnings for self-employment tax
purposes. The depreciation recaptured as ordinary income is also not considered as earnings for the selfemployment tax. On the other hand, deductible capital losses and Section 1231 losses do not reduce
earnings from self-employment.
Tax Implications of Financial Distress
Significant income tax consequences often result from asset transactions and loan restructuring
associated with financial distress. First, as discussed in the previous section, a producer typically must
recognize a gain or loss from the disposition, including transfer to a lender, of an asset. Second, because
of debt write-down or debt forgiveness by a lender, the borrower’s financial situation is improved. Unless
the lender intends to make a gift to the borrower or one of the exceptions discussed below applies, the
discharged debt is treated as income (discharge of indebtedness income) to the debtor. Unfortunately, many
producers do not realize the tax consequences of asset transfer until well after the transaction is completed.
One exception occurs when the seller of an asset under an installment contract reduces the
purchase price to the original purchaser. This purchase price adjustment is not treated as discharge of
indebtedness income to the buyer. For example, if the seller reduces the price of a tract of land sold under
contract from $250,000 to $200,000, there is no discharge of indebtedness income to the buyer. The seller
would reduce the selling price to $200,000 and calculate the gain or loss on any future payments based on
this new selling price. The buyer’s tax basis in the property would also be reduced to $200,000.
A second exception occurs when the borrower would have been allowed a tax deduction for the
payment, if it had been paid. Purchases of inputs and accrued interest would be the typical situations. For
example, assume a producer had purchased fertilizer on credit from the supplier and was unable to pay the
bill. If the fertilizer supplier wrote off the bill, the producer would not have discharge of indebtedness
income because the producer would have been allowed a deduction for the fertilizer bill if it had been paid.
Similarly, if a producer had a loan in which it was specified that payments went first to accrued interest,
forgiveness of debt by the lender (to the extent of accrued interest) would not result in discharge of
indebtedness income. If accrued interest is rolled over and added to the principal of a new loan
(capitalized) and is later forgiven by the lender, the accrued interest is not discharge of indebtedness
income. Thus, farmers who have restructured loans with accrued interest in the past and then have debt
forgiven may be able to avoid recognizing income for tax purposes. It is important to keep meticulous
records in order to be able to document that what the lender may treat as principal debt discharged is
actually accrued interest. Many lenders do not keep track of accrued interest if it has been refinanced as
principal. In some instances, the refinanced debt will specify that payments go first to accrued interest. This
may lead to a difference between interest actually paid and the interest reported by the financial institution.
The other exceptions involve debtors who are in bankruptcy, or insolvent, when the debt is
discharged. It should be noted that the IRS now includes the value of property exempt from creditors by
29
state law in the insolvency calculation (LTR 9932013, May 4, 1999). Solvent debtors with qualified farm
indebtedness (generally indebtedness incurred which is directly related to farming and 50 percent or more
gross receipts from farming) also avoid recognition of income if that debt is discharged. However, all of
these individuals must generally “pay the price” of avoiding the recognition of income. The “price” is
reduction of the tax attributes of the individual in the following order: NOLs, general business credit,
minimum tax credit, capital loss carry-overs, basis reduction of assets, passive activity losses and credit
carry-overs, and foreign tax credit carry-overs. Implementing the reduction of tax attributes is a complex
procedure which involves choices and may require very complex tax advice.
Some producers assume that filing bankruptcy will resolve their financial problems and allow them
a “fresh start.” Generally this is true for both Chapter 7 (liquidation) and Chapter 11 (reorganization)
because a new taxable entity is established and most liabilities become debts of the bankruptcy estate.
However, a farmer may have assets for which the debt exceeds the value of the asset. Because these
assets will not generate net proceeds for the bankruptcy estate, the trustee may “abandon” the assets. This
results in the asset and the associated debt going back to the debtor. The lender may simply take the asset
in satisfaction of the debt. However, the borrower is treated, for income taxes, as having sold the asset for
the value of the loan. Commonly, this generates a taxable gain, and the borrower has no proceeds to pay
the tax due. Under Chapter 12 (reorganization for family farmers), no new taxable entity is created, and
some of the tax planning opportunities, such as a short year federal return offered by Chapter 7 or 11
bankruptcy, are not available. Legislation authorizing Chapter 12 bankruptcies has expired and Congress
has failed to reauthorize it. Thus, no new filings under Chapter 12 are possible at the current time.
The tax consequences associated with financial distress can be complex and unexpected for
producers. Some problems can be avoided or minimized by advance tax planning. However, each situation
is unique and must be analyzed carefully. Because many tax professionals have limited experience and
expertise in this area, they may suggest that producers consult with individuals who specialize in these areas.
In Indiana, the Farm Counseling Project provides free financial and legal/counseling to an individual who
derives at least 25 percent of their gross income from the sale of farm products and are financially troubled.
The Farm Counseling Project offices are:
St. Joseph County
1-800-288-6581
Tippecanoe County
1-800-545-2296
Bartholomew County
1-800-298-1612
TAX MANAGEMENT
Low commodity prices do NOT necessarily imply low taxable incomes for farmers in 2000.
Assuming that 2000 will be a low taxable income year may lead to poor tax planning. Most farmers use
the cash method of accounting. Farm expenditures are normally deductible when paid. Receipts are
generally reported as income in the year in which they are received. As a result, farmers have the
opportunity to review their year-to-date receipts and expenses and make potentially money-saving
adjustments for taxes. But that window of opportunity closes for all practical purposes with the end of a
farmer’s tax year. So now is the time to review and adjust if necessary.
30
One's tax management goal should be maximizing after-tax income over time, not minimizing taxes
in any one year. Some people get so concerned about saving a few dollars in taxes this year that they miss
the big picture. Because of low income, many farmers may simply assume that they will not have a tax
problem, instead of viewing that as a tax planning opportunity. This year may be such a planning
opportunity for some farmers.
Keeping taxable income relatively stable year-to-year has been a key to effective income tax
management in the past because of progressive tax rates. With the recent increase in the number of tax
rates and surtaxes, the benefits from keeping income even year-to-year are increasing again. Wide swings
in taxable income are likely to result in higher taxes, although income averaging may help. The amount of
income which is “tax free” because of personal exemptions and the standard deduction has increased due
to law changes and inflation. One should plan to report at least this “tax-free” amount of income each year.
Self-employment taxes are larger than income taxes for many farmers, and may be more difficult to manage.
As a minimum, individuals should tally their receipts and expenditures before the end of the tax year.
This allows year-end tax planning. Depending on the income situation, additional sales may be made before
December 31, 2000 or delayed into 2001. The 2001 production flexibility contract payment can be
collected now or after January 1, 2001. Section 179 elections can also have a major impact on taxable
income. December purchases of inputs such as feed, fertilizer, and chemicals to be used in 2001 can also
affect the taxable income. Although delivery of inputs purchased before December 31 is not required for
a tax deduction, a purchase rather than just a deposit must be made.
Deferral of income and income taxes can still be an effective tax management strategy. If income
taxes are deferred, even for a year, this is an interest-free loan from the government. Although the estimated
tax payments required to avoid penalties have been increased to 90 percent of the tax liability, farmers
continue to have an exception. If two-thirds or more of gross income is from farming, farmers can pay the
tax due by March 1 and avoid estimated tax penalties. Although farmers must pay by March 1, the due
date of their return for many other purposes, such as retirement plan contributions, is April 15.
Tax implications of major decisions should still be considered before the transactions are finalized.
Installment sale contracts often have tax benefits. Tax-free or “like-kind” exchanges, such as the trade-in
of machinery and equipment, may reduce taxes, but farmers need to consider both income and SE tax
impacts. Because of the complexity of the tax laws and regulations, competent professional tax advice is
generally a very worthwhile investment.
REFERENCES
Biebl, Andrew R. and Robert Ranweiler, Planning Opportunities in Farm Taxation, American Institute
of Certified Public Accountants, May 1994.
Commerce Clearing House,1996 Tax Legislation: Law and Explanation, Chicago: CCH Incorporated,
1996.
31
Commerce Clearing House, 1999 Tax Legislation: Law and Explanation, Chicago: CCH Incorporated,
1999.
Harris, Philip E., 2000 Farm Income Tax School Workbook, University of Illinois Cooperative Extension
Service, November 2000, 714 pages.
Harris, Philip E. and Zoel W. Daughtrey, “Agricultural Tax Issues and Form Preparation,” Tax Insight
LLC, October 1999, 351 pages.
Harl, Neil E., Agricultural Law Digest, Agricultural Law Press, P.O. Box 50703, Eugene, OR, 97405,
various issues.
Internal Revenue Service, Farmer's Tax Guide, IRS Publication 225, November 2000.
Internal Revenue Service, Depreciation, IRS Publication 534, 1995.
Internal Revenue Service, How to Depreciate Property, IRS Publication 946, 1995.
Patrick, George F., “Tax Planning and Management Considerations for Farmers in 1998,” Purdue
University Cooperative Extension Service Paper No. 316, December 1998, 36 pages.
Patrick, George F. and Philip E. Harris, Income Tax Management for Farmers, NCR-2 Revised 1997,
Midwest Plan Service (MWPS), Iowa State University, 1-800-522-3618.
Research Institute of America, RIA’s Complete Analysis of the Taxpayer Relief Act of 1997, New
York: Research Institute of America Warren, Graham and Lamont, 1997.
Research Institute of America, IRS Restructuring and Reform Act of 1998, New York: Research
Institute of America Warren, Graham and Lamont, 1997.
Copies of IRS publications may be obtained by calling 1-800-TAX-FORM (1-800-829-3676). Forms
and publications are available at <http://www.irs.ustreas.gov/plain/forms.pubs/index.html>.
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