FARM AND RANCH TAXATION AND
INCORPORATION
J. DON REESE
FARM AND RANCH TAXA,TION AND INCORPORATION
The purpo~e of th1~ ' ~~tiele is to give a general overview of the farm and ranch taxa tion
problem~.
It
1~
intended to go into great ',d etail on ,all the problem
a s the subject matter
one a rtiel e .
i~
not
area~
far too broa d to be covered in
The l a st of 'the a rticle de a ls with the pro-
blem tha t more a nd more
f armer~
and
rancher~
as well a s
businesses rela ted to f a rming a nd r a nching a re facing.
is whether or not it would be a dva nta g eous to
u~e
This
the eor-
porate form of ' business and if a corpora te form would b e
desira ble; what type of corpora tion should be
u~ed.
In the study of Farm a nd Ra nch Ta x a tion, the log ical
sta rting point is definition o f k ey terms.
t e rm 1's "farm".
Th e most key
For tax purposes, "farm" is used in the
common a caepted sense de a ling
with farming operations such
,
a s cotton. or feed grain, ;but it also inoludes such a reas
as d a iry, poultry, fruit, truck f a rms, stock f a rms (including horse raising), plantations, a nd r a nching. 1
Often the
diViding line is thin bet~ een whet h er a man is a stock
I
f a rmer or ranoher, but the technioal differenoe ' is of no
consequence , for t a x purposes.
The term "farmer" is further
modified by saying he is an individua l or orga nization operating a farm for ' prot'1t.
For 1neome tax fi11ng purposes, he
2
must f1le as a farmer 1f two-th1rds of h1s gross 1nllome
comes from farm1ng.
All the major bus1ness forms may be
,
used1n farm1ng such as propr1etorsh1p,
partnersh1p, or
,
corporat1on.
Under Reg. ! . 1.61-4 (d) all 1nd1v1du...li!!,
partnerJ!lh1ps, or
aorporat~ons
that cult1vate, operate, or
manage farms for ga1n or prof1t, e1ther as owners or as
tenants, are considered "farmers".
The Hobby or Gentleman Farmer has alw ...ys been a pro-
,
blem in relation to ordinary farm
people operating farms
fo~
tax~tion.
pleasure or
These a re
recreat1on~
commerc1al purposes and not for prof1t.
not for
Under the Tax
Reform Act of 1969 sect10n 183, opera,t1onal losses by
i
these people are not deduct1ble.
section 183
de~ls
The turn1ng pOint of
w1th the def1n1t1on of "for prof1t".
The sect10n prov1des some ,help by stat1ng that there 1s
a presumpt10n 1n favor of ,' the taxpayer 1f he shows a prof1t 1n two or more of the f1ve llonsecut1ve years wh1ch
end w1 ththe taxable year •. two of the last seven years 1 f
he 1s engaged 1n horse rac1ng.
Th1s, however,
~s
means the only way a taxpayer can obta1n re11ef.
by no
There
1s a good 1ndicat1on from the language of the statute, that
. 10.11 a taxpayer need r reallt show 1s
to make a prof1t and he
w~ll
th~t
he is truly try1ng
have estab11shed h is burden
of proof 1f he fa1ls to · f~ll under the prel!lumpt1on,
It
would be advisable, however, for a taxpayer to attempt to
show a profit in at least two years out of five to keep
!
the lOQal revenue agent from examining him.
I
Another souree of tro,u ble in the p,,_st and possibly
more so in the future is the residential farm.
The real
probiem comes about when the person who lives on the farm
turns out also to be a suo'eessful doctor, dentist, lawyer,
etc.
With the current trend in Ameriea for people to want
;
to 11ve 1n the country and raise their ch1ldren there, the
problems concern1ng the ta,x at10n of the1r fa_rm1ng operations continues to grow.
)n Teitelbaun v. Comm., 294 F. 2d
541 (CA-7" 1961) ., an olde'r ease in whieh 70% of the purcha_se
priee of a date farm was ,allocable to th e residence and its
~
improvements, and the records of the farm operations were
intermingled witt residential expenses, losses from farming
-- were not allowed to be deducted.
Also expenses ineurred to
supposedly renovate a ranoh house for ranch hands while the
dentist , got his ranch operation st:o,rted, would not work in
Williams v. U.S., 292 F. Supp. 351 (Wyo., 1968).
The T:o,x Court however in Ellsworth, T.C. 11emo 1962-32."
agrees that just beeause a 'taxpayer wants to live in the
country a nd enjoys that kind of ,life does no't prove he is
not , 1n the, business to
ma~e
I
a profit.
Another
~anger
area
in Texas relative to the property
taxat10n of the residential
,
or other farm:'! close to - th'e oi ty deal:'! with the valuation.
- If the owner of the land. :under the Texas Constitution. is
i
-
prima rily engaged in farming. then his land will be valued
at what it is worth for f a rming.
If he is not prima rily
a farmer or the l a nd is o~ned by a corporation, the land
may be valued in a eeordanee
, with its re a l esta te development potential.
This is a very important eonsideration that
ma y b e easily overlooked.
The next major area to discuss in Farm and Rnnoh
Taxation deals with what are the appropriate methods of
accounting .
The - two majol' methods are Clash a nd acorual
a coounting .
Reg. 8 1.446~1(a).
- ,
The cash method of a e ooun-
ting is probably the most widely used.
"Since the e a rly
d a ys of the income tax, a gricultural t a xpa yers u sing t he
cash method of a ccounting have been permitted to deduot
eosts ,of growing crops and livestoak in the year in wh ich
the costs were pa id even though the sale of the ero p s or
livestock Was reportable in a subsequent year. a nd in some
eases at capital gains rates.,,2
According to the Senate
Fina nce oommittee. the cas, h methcd of a ccounting often
causes a distortion of ineome a nd the only properly a e-
,
counting method is acorual accounting, but Congress h a s not
seriously considered -:a : foroed change to this point.)
Once
a taxpayer has eho:olen the ca:olh method or accrual method of
accounting he may not :oIwitah accounting method:'! without
Rog. 1.446-1 (0).
con:!!ent of the Conuni:!!:!!ione'r .
A~
notod earlior
mo~t
farmor~
are on the
ea~h
method
of aceounting where they ' r 'eport income when received I>.nd
cla im deduction:!! when paid ...nd
di~rega. rd
inv.,ntorie~.
The
ca~h method of aeeounting ha~ long been a ~ourcc for ~ome
~mall de g re e of tax planni'ng for the farmer.
Many a farmer
,
ha ~
held
hi~
not be ~o great in a bump~r year.
rai~er
ha ~
~o
cotton until !next year
tha t hi:!! imeome will
AI:!!o, many a live~tock
bought feed ahead of time to get an
expen~e
right off in a year when cattle price~ were high.
are v e ry
~imple,
but effeetive
tool~
to keep a
income on a~ low a ba~i~ ~~ PO~~ible.4
of t h e
ca~h
~y~tem
i:!! it.!! ,.!!implicity.
I
T h e~e
farmer'~
The main a dvantage
1'1""ny of today'.!!
f a rmer.!! a nd rancher.!! h a ve ,;enoug h other thing.!! to do be.!!ide.!!
keeping a complicated .!!et of book.!!.
Th i.!! a long with the
timing of expen.!!e:!! and inoome noted above a re ma jor rea.!!on.!!
for using this method.
zing
inere a ~e~
Other
re a son~
deal with not reali-
in inventory value that are realized in the
accru/il,l acoounting method;
AI~o
the
ea~h
method of aceoun-
ting i:!! a good reflection of the farmer'.!! true liquidity • .
!
The aocrual method of aeo9unting a~ noted above truly from
an accounting .!!tand point best reflects the income and expentidure.!! of the farmer.
Items are taxable to the farmer
when earned or u.!!ed regardle.!!~ of wh en the' money i~ received
.
,
6
or pa1d out.
Often wh e n the ab ove noted method of timing
1n t h e cash method of a ccounting is used improperly through
carelessness or a number of good years come in a row, a t a xp a yer may h a ve to pay t a x on more tha n one
ye ~ r's
income.
The ' o ld farmer tha t held h1s cotton over ma y ha ve a second
bumper crop as well a l! a pr1ce increa.l!e a nd be caught selling
t wo crops 1n one year.
The accrua l method of a ccounting
does a way with this problem.
Also a farmer c a n eell hil! crop
or livestock when they a re re a dy to be sold and doel! not have
to worry about holding the crop a nd possible price inereal!el!
or d e ere a l!el!.
Also a f a rmer c a n sh ow e xp e ns e in a y e a r th a t
h e inc u r r ed t he
p a.y it off.
~ x pe n Be
r egA r d l e s~
of wh en he was a b l e to
All in all, even though the accrual method of
aceounting is for aceounting purposes, the most sound, ths
cash method of accounting will probably continue to be the
-mol!t prevalent.
The Tax Reform Act all!o hal!
~ffeoted
especially in regard to farm 101!1!0s.
farm acoounting
Section 1251 of the
code requires a farmer to maintain an "exoel!s ., deduotions
a coount" to reeord hil! farm lossel!. '· ·: "In the case of individuals ; farm losses would be added to EDA only 1f the taxy- ay_tl~
ha s - more than $ 50,000 of nonfarm income for the year
and only to the extent farm losses for the year exceed
$25.000."5
The purpol!e of this seetion is to convert oapi-
tal gains into ordinary inoome to . the
exten~ ~ubjeet
to the
above limits, a taxpayer's farm losses have been off-set
against nonfarm income.
This
m~ans
that upon the ,sale,
exehange, or conversion of, farlll property, the gain realized
--upon the sale will be treated as ordinary .income to the extent of . i.the balanoe " in t'he exccss deduction account (EDA).
The EDA aeoount fluetuates .a.nd a taxpayer can subtract from
EDA (1) an amount equal to farm net income for such year.
(2) an amount necessary to adjust the acoount for deductions
which did not result in the reduction of the taxpayer's income tax for the taxable year or any preeeeding years, plus,
() ' an amount equal to the sum of amounts treated as ordinary
ineome through a sale or exchange of the farm property that
would under pre 1969 have b een capital gains income.
The
EDA is still an unclear area a nd for a further discussion
I refer you to, The Tax Lawyer, Vol. 2), page 495, where the
article by Griffith and JGY deal with the problem in more
detail.
IRS Sec. ! 1251.
Any disouseion of farm a nd ranch t a xation and accounting
usually leads into the ma jor a re a of concern dealing with
. inventory valuations, depreoiation of livestock, a nd treatment of proceeds frGm sale of livestock.
As noted e a rlier,
..the inventory valuation problem does not exist for, the cash
method form, but 1t does ex1st to a very large degree for the
acerual method farmer.
Th, e farmer ue1ng the acerual method
of accounting has four major alternatives: 6
(1) The east
method · whieh is most traditional: (2) Tho lower of cost or
market method which is similar to the eost method; ()
The
farm-prioe method under whioh each itcm is valued at market
priee less the estimated direct oosts of disposition; (4)
Unit-livestook-prioe method used only for livestook where all
raised livestock is inoluded in inventory and valued aceouding to kind and age at a standard unit priee for each animal
within eaoh group.
All of these methods are approved by the
Treasury Regulations.
A farmer may not, however, .include in
inventory growing or standing orops beoause of the. tremendous
problem of valuation.
Although the cost method of valuation
is traditional. the more modern or better approaoh would seem
to be through thc farm-prioe method.?
Depreciation has long been a tax saving tool for the
farmer.
A farmer can depreeiate his capital assets and this
ineludes his basici breeding herd, ,livestook held for draft,
sporting or dairy purposes.
This also means under Section
12)1 (b) these animals upon sale would be eligible for capi-
tal gains treatment. 8
This scotion provides that in order
for any gain on the sale of horses or oattle to result .in
oapital gain where the animals were held for draft, dairy,
breeding, or sporting purposes, the horses or cattle must
have been held for at least two years. 9
This two year holding
9
perlod has , stopped the oft'e n praotioed but inoorreet method
of , holdlng bull Cilr helfer !o alves for 'j ust ,12 months to get
capl tal gain troa tment who,n sold. 10
makes it impractloal for
. thls long betore sale.
II.
The two year periCild
tarmer or rancher to hold hls oalves
Also lf an anlmal ls not held for this
two year perlod, upon sale there ls a reoapture under Seetlon
1245 mal!;lng all the prevl0,usly taken depreelatlon re-eaptured
as ordinary lncome. ll
Beeause of thls seotlon, lt is lmportant
that a tarmer or ranohernot buy bulls or cows and declde he
doesn't 11ke them and sells
, wlthin a two year perlod.
It
would be a good rule as a :buyer's gulde to deolde that , l t you
,
are going to buy that bull or oow, plan t() keep them for two
years at least.
Another key area to ,keep ln mlnd ln handllng your
, breedlng herd ls that under seotlon 10)1 of the eode an exehange of 11vestook of dlfferent sexes ls not a 11ke klnd
, exchange. 12
Thls ,l1mits ~he pract1ee of tradlng cattle dlreotll
between ranchers.
-t.o~ , -a-bul1
It ls stl11 all rlght to exohange a bull
,o r a cow for a cow, but never should opposlte sexes
be exchanged. l )
The exehange of cattle me,y be a good tax
savlng tool tor a rancher :who wants a new blood 11ne for hls
herd and flnds another rancher ' ln the same sltuatlon.
Here
ranchers eould ' exchange bulls, or oows with no tax consequences.
In the discusslonot farm and ranoh taxatlG1n, the areas
of depreclatlon of capl tal assets, lnvestment aredl t , and ' "
re-eapture are basics
tha~
must be considered.
It is im-
portant that a farmer or ranoher keep good reoords in regard
to the depreciation he takes on his assets.
Regardless of
whether a farmer is a cash method or accrual method bookkeeper. depreoiation can be taken.
In fact if the deprecia-
tion is not taken, the IRS will take the Tiew it should haTe
been taken when it eomes time
to sell the asset.
,
First of
all, depreciation is allowed only on property used in the
trade or business or held for the produotion of income.
The
farm or ranoh land itself is of Clourse not depreoiable.
Also
depreciation is not allowed on the farmer's personal residence
or auto used only personaily • 14
the trade 'or business.
These items are not u,sed in
In de ciding what t he useful life of
the I).sset is, the best sta rting point 1s t he Tre a sury's gui deline lives.
ZO~-:i:bove-
Some of the more important guide11ne l1ves Dre
or below the follow1ng :
1.
Office furn1ture, f1xtures, ms.chines
2.
A1rcraft
J.
Auto and l1 ght trucks'
4.
Improvements such
, as fences
5.
Cattle
7 yr.
6.
Horses
10 yr.
7.
Hogs
8.'
Sheep and goats
9.
Farm bu1ld1ngs
10 yr.
6 yr.
J to ",4 yr.
'&
gra1n b1ns
1 0 yr.
J yr.
5 yr.
25 yr.
Another wlil.y to approach the useful life problem ...nd
,
perhaps the best way to solve the problem is by evidenoe of
how long the individual f~rmer uses this type of item. 15 .
Useful life is of course closely related to the salvage
value of the Iil.sset.
The ~reasury Department in Reg. § 1.167
(a)-l(b) says that useful 11fe and salvage are dependent
pra~tice.
upon the individual farmer's normal
The Treasury
Department usually takes the approach that 1f a farmer uses
a pick-up
3 years and then trades. then that should be the
useful life. or if he uses a tractor 4 years instead of the
,
recommended life of 10 years. then
life to that f .,-rmer.
4
years is the useful
The ; slil.lvage value, will however. be
effected by the useful life used by the taxpa yer.
There are
3 basie methods that a taxpayer may use to
depreciate their assets. : These a re the basic straight line
method ·. declining balance method. and sum of the year-digit
method~
Other methods can be used such a s the unit-of-pro-
duction method, but the
ones.
a~ove
noted
3 methods a re the basiC
A taxpa.yer can always cha'n.ge from one of the acee-
lerated methods of depreCiation to the straight line method
without the IRS approval
~ut
any change to a n accelerated
.method must be approved first Sect. 167 (e)~
Another key tool in re gard to depreoiation is ' that :1A .f a rJ:ler
can use extra first-year depreciation on tangible personal
property under See. 179 of the oode.
As a depreoiation
bonus, the farmer can write-off up to 20% of the oost of
the purchase of th e asset in the ye a r of purchase.
The
remainder of the cost ba.sls is then depreciable in one of
the a bove o.pproved mann ers.
This is an eleotion that the
farmer may t ake and a ppli e s only to tang ible pers on a l property.
Any improvements to the land do not fall within
this election, but farm equipment. machinery. movable
structures that do not beoome
p~ rt
of t he real estate and
dr a ft. breeding, dairy. and sporting livestock do qua lify.
Regs. § 1.179-3.
This additional depreoiation c an be of
great benefit to a taxp",yer if used properly.
The problem
area de a ls with what type of cq uipment becomes a fixture
~ and
1s not elig1blo for this
b~nefit.
The investment cred1t is also a t a x saving t ool that
is now available t'a the f a r mer.
The credit is al lowe d
under Stlot. 38 of · the oode and is further defined i n Sect.
46 and 48.
The oredit is a llowed on t ang ible personal
property as defined und e r Sect. 48 which includes livestook
other than horses.
The oredit is a basic
7% if
the uscful
'11fe of the property aoquired is 7 years or morc.
useful 11fe of the property 1s
1s 1/3 ~f
1s. 2/3 of
'7%.
7%.
If the
3 to 5 y.cn rs. then the oredi t
if the useful 11fe 1s
5
to
7.
then the credit
The useful life for investment credit purposes
does not necessarily have to be the depreci a ble life
13
and this can cause a differenee in some instanees.
The
,i nvestment credit is of 'g*eat benefit to the expanding
farmer or rancher ' or one! who is buying a great deal of
i
nlm equipment.
Recapture of
depreci~tion
and investment credit is
becoming more of a problem that farmers and ranchers face.
The major recapture of depreciation
provisions are Sections
,
1245 and 1250.
Section .1245 deals with the recapture on
personal property and since 1969, the recapture on livestock.
The only real danger in this area that a farmer or
rancher faces is when he buys an entire herd or makes a
relatively large investment in h is herd and holds t hese
an imals only for a short period of time.
of recapture might be significa nt.
makes
Here the impact
"W he r e the t ax pa yer
smOtll initial inve stme nt and operates over a long
.1.
period of time on a c a sh basis, the percentage of annual
.
sales ' prooeeds attributable to an ima ls on which he has
claimed depreciation may be quite small. 1116
make little tax difference to the f a rmer.
is a n accrual basis
more.
bookk ~ eper,
'l 'h15 would
If the farmer
the impact may be somewhat
Only depreoiation taken is 1 9 70 a nd thereafter is
subject to recapture.
The amo unt recaptured is the dif-
ference between the adjusted basiS a nd either the fair
,
market value or the recomputed basis, which ever is smaller.
Reg. § 1.1245-1.
,The other major recapture section is 1250 recaptures
only the excess over
stra~ght
line depreciation on real
estate. , The first and obvious thing to note is that if
a farmer uses only straight-line depreciation. then this
reoapture provision will' not apply except in the ease where
the property held for le,s 8 t han a year a nd there. is a gain
on a sale. then any depreciation claimed is converted into
•
ordinary income to the extent of the gain. 17 Sect. 1250
(b) (1).
This in essence ' establishes a 1 year holding
per10d to avoid ordinary income treatment of gains.
Recapture of other farm losses is handled through
sect'ion 1251.
This is handled through the before mentioned
Excess Deductions Acoount.
This ap plies to the
situation where a taxpa yer has farm losses in
~ery
exee~s
limited
of
,$ 2 5.000 in a ny year and who has over $50.000 of nonfarm
adjusted g ross income. 18
Obviously this is a tax considera-
tion of the business man that has a f a rm on t he side a nd
not a problem of the full time f a rmer or rancher.
Section 1252 is a n~w r ecapture provision which converts to ordinary income some or a ll of the ded uctions
claimed for soil and water conserva.tion expe nditures and
__ land-clea.ring expenses to , the extent of the gain re al ized
on the sale or other dispo s ition of the l a nd. 19
This
section provides for the r ecap ture of 100% of these soil
and water conservat1on expend1tures made with respect to
farm land where the land is disposed of within
after it was acquired.
5 years
.If the land is not sold until
,6 to 9 years after it is aoquired, the amount of expenditures recaptured is reduced by 20% a year.
There is
then, of course, no rec~pture if the land is disposed of
10 years or more after it . is aoquired. 20
'. There is also a section that allows for recapture
of the inve stment oredit taken
in prior years.
t
Section
47 of the code provides f?r recapture of the investment
credit taken in earliert~xable years if the property on
whioh the eredit was taken is sold before the close of
.the useful life which was taken into account 1n computing
the credit under section 38.
Since we do at present have
this investment credit availa.ble,
this means that in future
,
years when an item is sold, the recapture of this oredit
must be a factor to be considered.
There are also other: areas of farm and ranoh taxation
that bea r a brief look,
insurance proceeds.
bne such area Aeals with crop
"Und;e r the prOVisions of the • old law'
a cash basis farmer wa s required to report as income in the
ye a r of receipt any proee.eds received from 1nsurance from
crop damage or destructi~n.,,21
,
This of course, caused
many problems for the farmer sinee he often would have to
rep(!)rt two years' 1noome 'in one year.
Now under Seotion 451
of theeede a c a sh b a sis fa rmer wh~se erQPs h a ve be e n
dama ged or destroyed a nd who receives crop insurance pro,
ceeds for his loss, may
,
' e~ect
to defer the reporting of
these proceeds for Federal income tax purposes until the
~ ear
following the ye a r of the d a ma ge or d e struction, if
he normally would have reported the income from the sale
Qf t h e crops in a ye a r a fter t h e rec e ipt of th e insurance,22
This election gives the farmer a little play to keep him
from having one y ear wl~h i a l a rge income and one year with
little income or even a loss,
Another important section de a ls with the cost of
pla nting citrus groves,
Altho ugh t h is d oes not e ffect R
majority of f a rme rs, the 6nes it does eff e ct must adh e re
. to it·, • Section 278 of the code provid e s t ha t t h e expenditures of purc hasing, pla nting, eultlva ting , ma inta ining ,
or .d eveloping · a citrus or! a l mond grove, must be c a pit a lized
if t hey a re incurred within 4 ye a rs a fter the grove is
planted,2J
Th is code h a s , a n exce p tion whic h exe mpts ex-
pe ndltures incurred in repl ll.nting
Il..
g rove which wa s d nmlrtged
or destroyed by greeze, d'r oug ht, dise a se, pest, or oas ualty,
Th is section ma y also be 'importa nt in re gard to the new
trend of pl ...ntlng peca n g roves,
Th e peca n g rove would se em
to clos e ly pa r a llel the purpos e of this s t a tute so tha t it
s h ould be followed by pec,a n r a ise rs,
Other key provisions of th e tax eode a llow f a rmers to
make certain elections.
The Tre~sury Reg. ~ 1.162-12
I
. allows farmers to elect to currently deduct ~r capitalize
certain pre-production expenses or st a rt up oosts.
Section
175 allows the farmer to elect to expense soil and water
conservation expenditures : subject to the above noted recapture provisions.
Section 180 a llows the farmer to elect
to expense acquisition of ' fertilizer. lime, ma rl, etc. used
to enrlch the soll.
Section 182 allows the farmer to elect
to expense outlays to cle a r land t o make it suitable for
farming.
Section 6420 allows that if gasoline is used on
a farm for farming purposes the farmer does not have to
pay the Section 4081 roa d tax or if he does pay it, he
c~n
get the t a x refunded.
Social Security is a nother f a ctor of
must be considered by the . f a rmer.
t~, xation
tha t
Every self-employed
. farmer must have a Social Security c:l,rd a nd. numoer.
He
pa ys his self-employment tax with his income tax a nd must
compute it on form 1040 SE.
A farmer may have to pay this
se lf-employment tax even though he may owe no inoome t a x.
Share-farmers who may be tre a ted under local l a w as employers or as independent contractors are treated under Social
Security rules as
tenants~24
,
This makes the share-fa rmer
,
self-employed ' and the l a ndowne r is not.
The l a ndowner's
sha re of the crops or livestock proc ee ds is treated as
rental 'income excluded, g e;nerally, . from the self-employment
t a x.
An exception to thi s rule would b e if this wer e deemed
a mat e ri a l
pa rticipa tion
~ontract
in which c a se both the
'parties wo uld be considere d self-employed.
Sooia l Seourity
must · of oourse be with held on a ll employees.
A self-employed
to
lit
pers ~n
ma.y d e duct up to $ 2,500 pa id
retirement pla n for his own b e nefit.
A retir e me nt
plan ma y be established by any self-employed person in the
form of an a nnuity pension or profit-sharing plan. 25
This
is subjeot to strict regulation, however, and must b e handl e d oa refully.
iO% or
. A s .o le ' prC!lprietor or a pa rtner owning a
greater 1nterestin the c a pita l or prof1ts, 1s con-
slde r c d a n "owne r-employe r."
An "owne r- employer" ma y not
pa rtleipat e in a pla n unl e ss it a l s o· include s all of the
full-ti me employees wlth 3 y ears of service.
S~ C
Sect.401(d)(3).
As noted e a rlier in ,t his a rti c le, t he a r ea of f a rm and
r a ncht a xat10n is much t o o br oad t o b e c ove r ed in any d eta il
i,n one a rticle.
Th e gene r a l
o v e r vi e w t hD.t has b e e n provid e d
le a ds up to t he very i mporta nt ar e a of wh:l t type of buslness
form
s h oul~
be used to ope r a te a f a r m or r a nch mo s t e f fe c tively,
for busine ss purposes a s we ll a s for t a x purpos e s.
Th e question
that more a nd more farm e 'r s and r a nchers f a o e eve ry d a y i s
-. whether it would be bene f 1cia l to consider runnlng the1r f a rm
or r a nch a s a
-~ ment
corporat1o~.
,
There s eems to b c a strong move-
towa rd inoorporation, but m(;l.ny of .de e isions ma de to
incorpora te were on a h a pha zard b Hsi s .
This article will
,
give some basic
considera~ions
and gUidelines that may be
beneficial in m~king a va~id decision to carryon bUsiness
as a corporation.
There a re four major classifications of corpora tions
having agricultural opera tions: 26
(1)
The basic ineo,rporated farm or ranch business;
(2)
Corporations that combine f a rming or ranc~ing
with the so-called agribusinessaetivities. like
sale of f a rm supplies. or marketing or processing
farm products;
(3)
Corpora tions that combine farming a nd ranching
with unre lated business e s;
(4)
Corporations that combine farming a nd ranching
with agribusiness a nd non- agribusiness activities.
The first of the above listed categories will be of
prime consideration in this artiole.
The difficult deCision
making takes place more iX; this area in most instances
~eeause
; may not at present be generating
the farm or r a nch
, ~
,
a tre mendous amount of income tha t would e a sily c a ll for the
oorporate tax advantage.
all profits of the
In eases in which substantially
busine~s
will be absorbed by salaries
.to be paid to the owners. the separa.te taxable enti ty of
. the corporation is not ordinarily desirable unless there are
other motivating iaetors.~7
GU
,
Any time the corporate form is considered,
dition~ l
basio
. examin:;>. tion.
t~e
tra-
advantages of this form of business need
The first general advantage is that of limited
liabili ty on tho p:..rt of the stockholders . Ilbscnt ·. an · agree- .
ment to the eontrllry.
'rhis is a big advantage over a part-
nership Nherc the partners m&l.Y be held j0intly 0r severally
li a ble for the debts incurred by a partner.
'rhis is a good
advantllge, but is not the ' great Ildvantage tha t most pe o ple
make it out to be especially in the sma ll business
corpor~tion.
Ge ne rally speaking, m0st owners of a small busine ss corporation
a~e required to personally guar ~ ntee th e liabilities of the
corporation at le a st until it has been established and
running on a sound basis for a re a sonable period of time.
Another basic advantage of
:it
oorpora tion is tha t it
permits a business to continue ope r a ting uninterrupted by
the death or disability Qf th e major owner or operator. 28
The units of stock also provide for a very nea t a nd preCise
method · of transferring owne rship of property.
!o1a ny times
·farmers and ranchers go through t he difficult t ask of deeding
their land to others a few acre s eac h year.
Th is 'J3.1{e s a
very bulky abstract and o ften winds up in confusion a s to
where property line s f a ll , between the different owners.
By
the USC of stock, th e f a rm, or ranch is kept in one working
unit with no worry as to partitioning the actual acres.
Values c::>.n be tran~ferred [much more equitably.
Also, if
the farm or ranch is being operated on the corporate basis,
upon . the death of the major owne r, the outstanding debt on
the farm or ranch cannot be
~ ccelerated
du e since the cor-
poration lives on after the owner.
This often keeps the
survi vors from hlOl.ving to re -finance
lit
large sum of money to
cover a l a rge debt outstanding at the major owner's death.
Re-fina ncing of large debts often becomes very expensive in
the ·are·a : of finance charges as well ' 9.S higher interest rates.
The corporate busines$ form a lso provides an easy method
to raise a dditional capital wh e n expansion may be deemed
appropriate.
l~any
times a f a rmer or rancher may Wi sh to
diversify his holdings to add stability t o h is business.
The ' corporate form allows h im t o expa nd in a ll are a s a s well
as allows him to get others t o invest in his new interpr1se
While keeping a large control beca use of the high v a lue of
land that he already owned in th e corporation.
farmers .... re C0ns idered land poer.
Too often
In the corpora te structure,
the c ontributor of this high price land to c a pit91 gives
the f a rmer or
r ~ noher
... l a rge part of the capita l st o ck so
that it can be used to keep eontrol of the corpera tion While
others in fact may h ".ve tC'l put up larger a mounts of cash.
There · are of eourse basic. tax adv::>.ntages to the corporate
form of business.
The ke'y question is at what point does it
"
become advantage GUS from an income t :;\ x standpoint to be
taxed as a corporation. , Nany
write~s
have attempted to
develCllp "rule,S of thumb" l i 'n this ",rea and many of them have
been wrong.
A common mistake in anaylsis of the breaking
point is to lookllt the marginal tax rate rather than the
effective tax rate.
A correct analysis would seem to be
that if you normally file ,your t a x return
9 ,S
a married couple
fi11ng jointly. in order for it to be advantageous for you
to be taxed as a corporation your tax ab le incom~ would need
to be $60.000 or more.
This could mean that a married couple
could have an extremely l a rge gross income . but after all
deductions Gould have l e ss thu n ~6 0,ooo on which to be taxed
and in which case it would cost them tax dollars to be taxed
as a corpora tion.
A sta rtling compa rison shows that if you
are a single t axpayer, you ne ed only to h a v e $12,000 or more
of taxable income for it to b e advantageo us to be taxed a s
a
cor~oration.
This gr e at difference of amount of t a x ab l e
income shows again t he disadvantage that single taxPQyers
- face under present l aws.
,Th is breaking point, a n a lysis a lso
applies to the subchapter ' S corpor9tion e lection to be t a xed
as a p:ilrtnership.
The subchapter S corporation is di scus se d
in more detail below. Another pure t ax considera tion, espeal",lly
in the breaking point
analysi~
,
,
is that of franchise tax.
The
franchise tax is paid for the privilege of doing bUSiness in
a , st"te as a corporation.
Here in Texas, the franchise tax
is paid on the amount of capital in the
~orporation.
In
~a- small corporation wi th ~api tal of only ~250. 000 to ;~ 500. 000,
the fran~hise tax can run from $500.00 " to over $1,000.00 per
,
year.
.
Although this is not a large am ount of money, it should
be considered in - the decislon of whether to be taxed as a
corporation.
Another factor mentioned earlier in this article
is that of valuation of land for property tax purposes.
corpor ~ tef Q rm
A
may ha ve its land v a lued for r ea l estate
development pUrposes rather th a n just for agricultural purposes.
This means that prope rty t a xes could easily double
or triple upon incorpora ti o n if the l a nd is located mear "city with real estate development potential.
Other pure t a x benefits of incorporation th a t ma.y be
considered ' a re: 29
(1 )
Qua.lified pension and profit-sharing plan ~§ 401-404.
(2)
StookoptlonpLan~9 421-425.
0)
Group term life : insuraneo
(4)
Medical insuran~e and exp~nse benefits §§ 104-125.
(5)
Wage oontinuation benefits § 105 (d).
(6)
Employer death benefits § 101 (b).
g 79.
i
:
There are of course ' ba sic d isa.d vant age s to operating
as a corporation, the bigge st being one of complexity and
record kee.ping.
The I.R.S. m:ltY quickly pi e roe a Sham
oor~
porilltion and not allow i t t a x b e nefits if the business fs
nmt truly run as a corporat1on.
Th1s calls for
holders meet1ng w1th the m1nutes being kept.
~nnual
stock-
This also adds
some small a mount of expense to the operation of the business.
Also there is the orig1na l expense of incorporation which may
easily run from $500 to
~ 600
to several thouslI.nd dollars
dependent upon hmw comple x t h e corporation is made to be.
Ther e 1s a lso double t a xa tion on div1dends.
The type of business · form that ha s recently beoome
popula r for farmers and
pmrat1on.
r ~nchers
1s the subchapter S eor-
I.R.S. Sect10ns 1371 to 1377.
This is a s mall
bus1ness form where the stockh olders ca n ha ve corporate
·status, but elect to be taxed as a
p a rtnership~ .
Under this
eleet10n the corpora tion w111 pa y no tax on eorporate c .. rnings,
but each
st ~. ekholder
w111 report the income of the corpQt"a-
tien actually distributed as well as his prorn ta share of the
corporation's undistributed income.
Sect. 1372 (b).
stockholder also takes his sha re of any corporate
Each
loss ~ whieh
becomes a n~t operating loss to him just as it wo~ld be to a
I
partnership or sale proprietorship.
Seot. 1374.
The stock-
holder a lso r e ports his share of long-term capital ga ins.
I
The Subchapter S election can only be made in limited
situations usually in the : small closely held corporation.
There can be only one class of steck in the corporation and
no more than ten stockholders.
All stockholders must be
individuals or estates; no: trust mlil.y hold Subchapter S stock.
The corporation must be a domestie corporation and none of the
stoekholders
C):;l.!'l
be nonresIdent aliens.
"Ordinarily, each
,
tcmant in oommon or jOint tenant is deemed a stockholder, but
stock held a s community property or by a husband and wife in
jOint tonanoy, tenancy by ,the interity : or · ,;enaJ:l.0Y in oommon
is held by one stockholde~.1130
Seot. 1371 (0).
Also a
oorporation is not eligible for subchapter S if more than
80% of its gross receipts comes from s~urees outside the
United States or if more than 20% of its gross receipts comes
from royalties, rents, dividends, interest, annuities, and
sales a nd exchanges of stock or sec urities.
Sect. 1371, 1372.
There is also no limit on s ize or c s p ita liz a tion.
The subchapter S corporation provides mos t of the above
mentioned liI.dvantagtlls of corpora te form a s well a s gi ving the
small business a t ax bre ak .
~terest
One major reason for t hc in-
in the f a rming a nd ranching industry looking to the
subCha pter S corporation is tha t it minimizes the effects of
the "Fa mily Farm Cy cle."
"The duration of m:ilny f a rm businesses
elosel~ pa rallels the life of the hQu~ehold."31
The sub-
chapter S eorporation provides a pla nned and orderly tr 8 nsfer
af the f;arm ar ranch busine.ss over a period of time as a
.
'~ going .
-
I
uni t" to the younger shareholders and permi ts a gradual
movement of
owner-employe~s
and their capital into and out of
20
the farm busine ss in keeping with their own personal life
cycle.
The main dis a dvant a ges to the Subchapter S corporation
a re:
(1 )
Ad ded expe nses a'.,nd complexity of record keeping.
(2 )
Limitation on t h e number and ch a racter of the
stoc k holders.
~1371( a ).
(3)
Re quir e me nt of one cla ss of stock. ~ 1371 ( a )(4).
(4)
Da n ge r of loss of t a x-fr e e char a cter of d istr1buti~ns
becaus e of d ea t h , tra nsf e r of interest,
or t e r mina tion of e lecti on. ~ 1375 (d).
(5)
Probl ems of qua lifi oa t1 on whe r e the "pa s s ive
inve stme nt i n c ome " (such a s r oya lti es a nd rel'lt)
is a si gn1fic Ol.nt it em in corpora t e inc o me . S 1377(e) (5).
This l :i1st dis a dva n t lAg e d ea ling with "pa ssive i n v es t ment
i n come " b ears a much clos e r l ook as it c ould ea sily ca u s e
probl ems for a f a r me r.
The subc hap t e r S e l e cti on will t e r-
mina te in a ny t a xa ble year in wh ich mor e t h a n ? O% o f t he
e l e cting c or por a tion's g ro s s r e c e ipts a r e ne rived f r om " passive
inve:st me nt inco me ." 32
Th e bi g g es t 1=e diat e d a n ge r for a
f a r me r may b e wher e he opera
, t e s only p a rt o f h 1l!! l a n d and r e nts
out t he rest to somc othe r f a r me r.
If t he f a r mer t ake s a
c a s h pa yme nt per a ere the~ it clearly , f a lls i nto t h e e a t e ;
.g ori e s o f rent.
A more c omplex
problem r e volves a round the
,
This ~s usually )rds . on gr ... in and 4th3
farming on sharos.
on co tton.
This is a very: common practice for renting land
in T exas and may well b e ~ e emed just a rental agr e ement whieh
would be pa. ss i ve income fair Subehapter S purposes.
way to a void t h is problem may b e t h r o ugh the
oipation concept."
The only
~ ma teri a lparti-
" Mat e ri a l partioipation leases ha ve been
held sUffieient to a void cla ssific at ion of crop proc eeds and
soil b ank payments mad e iri li e u of t hem as personal holding
[
compa ny inc ome and as
of subchapt e r S."))
pas~ive
investment ino ome for purposes
Reg. § 1.1)72-4(b)(5)(vi).
A material
particlp ... tion situation is where the l and owne r ac tua ll y has
a say in how the l and is f a r med , crops rot a t ed , etc.
This
concept is b y no means a settled a r ea a nd should be a VOi d e d
if possible.
I
Another danger in r ea lti on to t h is "pass ive income" ide a
is where a f a r me r is una ble
, t o ma ke a li ke k ind exeh:i1.nge on
property so ends up selling one pieoe of prope rty t o buy
anot he r piece of l and .
I~
t he oorporation we r e t o carry t he
n ote en the old prope rty it would r eoe ive a r e l a tively l :o>,rge
amount of . inte rest income
' ~lh ic h
c o uld eas il y pr ovide a pro-
blem espeo i a lly i n t he early years of t he n ew business .
One
way to a void this proble m would be to trans f e r the old farm
out of t h is corpora tien prior to sa, l e and ha ve th e individual
c a rry the note.
Then the proce eds fro m t he no t e could be
pla ced b a ck into the
corpor~tion
c~pital
a s a contribution to
iI.nd would not be deemed income.
Th e suboha pter S corpora tion a s a wh ole provides gre a t
pote ntial to a farming or r a nching ope ration if the
t a xp~yers
a r e a wa re of a ll t h e proble ms a nd avoid the pit-fa lls.
It
provid e s a very neat a nd effici e nt manner ta> run the business
a s we ll a s tra nsf e r t h e b0sine ss.
It provides a broad b a se
th a t ma y be used for expa nsion a nd dive rsifioation.
Also at
the prope r bre a king point i the corpora tion c a n elect out of
subc h Rpt ~ r
S and there can b e substa nti a l t a x
a d va nt ~ ge.
It
is a lso importa nt to not e ; tha t t he sha r eh older's share of the
income from a Subcha pter S cor por a ti on is n o t d e rive d from
--P:--traue or busine ss e a rri ed on by t hc s t o e lcho l rie r and th e refore is Ro t "net e a rning s fr on s e l f - empl oyme n t"
so will n o t
reduo e Soci a l Se curity bene fit s a f t e r r e tir e ~ e nt .
§
102).)4
This a rticle is me a nt t o onl y po int o ut t he f ac tor s tha t
shou:).d b e t a ken .int o a cc o unt i n f:;; r mi ng a n d r a nc h ing t axa ti o n
Rnd inc orp o r a ti on.
Ea c h
v a ri a bl e s " n d t1 u s t b e
n o t ed he rein.
s it u ~ ti on
e x a ;~ i n e d
h a s a d if f e r e nt s e t
~f
i n the li gh t o f t "1e poin ts
I f on e truly und erstands the prob l e ms di sc ussed
.a bove a n intellige nt deeision ean be ma de when one of t he
a bove situa tions arise.
FOOTNOTES
1. John C. O'Byrne. F"" r m Inc ome TEI, x Ma nu a l, 4th Ed ••
Allen Smith Company, Indianapolis Indiana . 1 9 70.
2. Ha rvis Bra nscomb; Jr., "The Cash 11ethod as Applies
In Ag rieulture--A Reexamination"" 'r he Ta x La wy e r, VillI. 25,
(1 9 71), pp. 125-140.
3.
Id. ,
4.
Willi a m C. Griffith Rnd Cha rles I. Joy, "What The
Act Do e s To The Fa rmer:
Farm Parity Or Cla ss Discrimination?",.
The Ta x La wy e r. Vol. 23, (1969), pp. 495-510.
5.
Id.
6. ' Hugh B. 11uir, "Tax Adva ntage in Fa rming Before a nd
Aft e r the Ta x Re f or m Act of 1969: How MUQh Reform?" Ta x
Counsele r's QUa rterly, Vol. 15, (1971). pp. 1-59.
---
T(u
7.
Id. ,
8.
See note 4 supra.
9.
See note 6 supra.
, 10. Roland L. Hjorth. "Fa r m Losses a n d Rela ted Provisions",
La w Re view. Vol. 25. (1969), pp. , 581-610.
Id.
11.
12. ' See note 4 supra ,.
13. ' See note 10
supr ~ .
14.
See note 1 supra.
15.
See note 1 supra.
16.
S e e note 10 supra .
17.
See note 1 supra.
18.
See note 10 supra.
19.
See nGlte 6 supra .
20.
~
See note 4 supra.
21- Egils H.· Krolls .. "Ta x R~form Act of 1969 al'ld the
Fa r me r" , 'ra.xes i 'rhe Ta x Mae;G. zlne , Vol. 48, (1970) , pp. 329-334.
,
22.
See note 4 supra.
23.
See note 4 supra.
24.
See note 1 supra .
25.
See n ote 1 supra.
26. Na tlonal Plannlng Assoel a t16n, The Effects of
Fede r a l Income Ta xes on th e Structure of A rl culture ,
Plannlng Pamphlet
131, 197 2.
27 .
Ira . A. C0hen, Fa r m al'lrl R~mch L,-,.w , Practlclng La w
Real Esta te Law a nd Practlce, New York Clty, 1969.
28 .
See note 26 supra.
29.
Se e note 27 supra.
30.
See note 1 supra .
Instltut~,
31. Nei l E. Ha rl, " Publl c Pollcy Aspects of Fa rm
Incorpora tion", Bus iness La wyers , Vol. 20, (1964), pp. 933-951.
32. Stanl e y W. Rosenkran z, "Subchapt e r S--An Illusory
Pr omls e ?", Tax Counse l or' s Qua rt e rly , Vol. 16, (1972), pp.
267-336.
.
33.
See note 2
34.
See note 1 supra.
~upra.
BIBLIOGRAPHY
1.
Bransoomb, Jr., Harvis, "The Cash Nethod as Applies
In Agriculture-~A Reexamination", The Tax Lawyer,
Vd. 25, (1971).
2.
Cohen, Ira A., Fa r m a nd Ra nch Law, Practicing Law
Institute, Re a l Estate Law and Practioe, New
York City, 1969~
3.
Grifflth, Wllliam C. and Joy, Charles I., "What The
Aot Does To The :Farmer: Fa rm Parity Or Class
Desoriminatiorl ?", The Tax La wyer, Vol. 23, (1969).
4.
Harl, Neil E., "Public Poliey Aspects of Farm Incorporatiol1",
Busine ss Lawyers, Vol. 20, (1964).
5.
Hjorth, Roland L., "Farm Loss e s and Related Provisions",
Tax L:a1~ Revlew, Vol. 25, (1969).
6.
Krolls, Eglls H., "Tax Reform Act of 1969 a nd the
Farmer", Taxes, The Ta.x f1ap:a zine, V,,1. :.48, (1970).
7. ·· Nuir, Hugh B., "Tax Adva ntaga in Fa rming Before "'.nd
After the Tax Reform Aot of 1969: How Muoh Reform?",
Tax Counselor's QUa rt e rly, Vol. 15, (1971).
8.
National Planning Associa ti on, The Effocts of Federal
Income Taxe s on the Structure of A rioulture,
Planning Pa.mphlet
131, 1972,
9.
o 'Byrne ,
10.
John C., Fa rm Income Ta x Nanua.l, 4th Ed.,
Allen Smith Company, Irldianapolis Indiana, 1970.
RC)senkranz, Sta.nley W., "Subohapter S--An Illusory Pr"miso?",
Tax Counselor's Quarterly, Vol. 16, (1972).