Prepaid Farm Supplies

If you are on the cash method of accounting, expenses are generally deductible when paid. However, if you prepay farm supplies, they must be deducted ratably over the period during which they will be used unless you qualify for an exception to this prepayment rule.

Prepaid farm supplies include:

• Feed, seed, fertilizer, and similar farming supplies not consumed during the year (other than what is on hand at the end of the year but would have been consumed had it not been for fire, storm, flood, drought, disease, or other casualty).

• Poultry bought for use in your farm business that would be deductible in the following year if you had capitalized the cost and deducted it ratably over the lesser of 12 months or the useful life of the poultry.

• Poultry bought for resale and not resold during the year.

Prepaid farm expenses are deductible to the extent they do not exceed 50% of other deductible farm expenses in the year (including depreciation and amortization). Any prepaid expenses in excess of this limit are deductible in the following year.

If you are a farm-related taxpayer (your main home is a farm, your principal business is farming, or a member of your family lives on the farm or has farming as his or her principal business), you are not subject to the 50% limit if:

• Your prepaid farm supplies expense is more than 50% of your other deductible farm expenses because of a change in business operations caused by unusual circumstances, or

• Your total prepaid farm supplies expense for the preceding 3 years is less than 50% of your total other deductible farm expenses for those 3 years.

Livestock Feed

Generally, even though you are on the cash basis, feed must be deducted in the year that your livestock consumes it. However, if you meet all of the following 3 tests for the advance payment of feed, you can deduct in the year of payment the cost of feed your livestock will consume in a later year (subject to the prepaid farm supplies limit):

1. The expense is a payment for the purchase of feed and not a deposit. A binding contract for delivery shows this is not a deposit.

2. The prepayment has a business purpose and is not merely a tax avoidance scheme. A business purpose would include securing more favorable payment terms and prices.

3. The deduction of these costs does not result in a material distortion of income. For example, if this is your customary practice, then the deduction will have roughly the same impact on your income each year and will not produce a material distortion.

This limit on deducting the advance payment of feed does not apply to the purchase of commodity futures contracts.

Labor and Related Costs

You can deduct reasonable wages that you pay for regular farm labor, piecework, contract labor, and other forms of labor hired to work your farm. This includes payments to your spouse or child as long as there is a true employer-employee relationship.

You can also deduct related costs including:

• The cost of maintaining houses and their furnishings for tenants or hired help (e.g., heat, light, insurance, depreciation, and repairs).

• Insurance related to the workers (e.g., health insurance and workers' compensation).

• Employer's share of FICA on farm wages.

You must reduce your deduction for wages by any employment tax credits you may be entitled to claim on such wages. These credits are explained in Chapter 7.

Breeding Fees

Cash method farmers may deduct breeding fees as a farm business expense. Accrual method farmers must capitalize such fees and allocate them to the cost basis of the calf, foal, and so on to which they relate.

Fertilizer and Lime

You have a choice of when to deduct the cost of fertilizer and lime used to enrich, neutralize, or enhance farmland.

• You can deduct it in the year you paid or incurred the expense (subject to the prepaid farm supplies rule discussed earlier in this chapter), or

• If the benefit from the material lasts more than one year, you can capitalize the cost and deduct a part of it each year in which the benefit lasts.

After you make your choice, you cannot change your reporting method without IRS consent.

Depreciation

Property used in farming is generally subject to the same depreciation rules as property used in nonfarm businesses. The rules for depreciation are discussed in Chapter 14. However, certain farming property has special recovery periods. Table 20.1 shows the recovery periods for property used in farming.

Instead of depreciating certain farm-related property, you may claim a first-year expensing deduction (see Chapter 14). In addition to equipment and machinery used in farming, this deduction can be taken with respect to single-purpose agricultural or horticultural structures, grain bins, and drainage facilities.

Soil and Water Conservation Expenses

Generally, soil and water conservation expenses must be capitalized. However, you can elect to deduct such expenses within limits. The deduction cannot be more than 25% of gross income from farming. Expenses must be consistent with a plan approved by the Natural Resources Conservation Service (NRCS) of the Department of Agriculture or a comparable state agency. Expenses eligible for this special write-off include:

• Treating or moving earth (e.g., leveling, conditioning, grading, terracing, contour furrowing, and restoration of soil fertility)

• Constructing, controlling, and protecting diversion channels, drainage or irrigation ditches, earthen dams, watercourses, outlets, and ponds

• Eradicating brush

• Planting windbreaks

They also include assessments by conservation districts for any of these expenses (but not more than 10% of your deductible share plus $500 and subject to the total limitation).

Endangered species recovery expenditures are included with soil and water conservation expenditures and land erosion expenditures to be currently deductible. Endangered species recovery expenditures are costs incurred for the purpose of achieving site-specific management actions recommended in recovery plans approved pursuant to the Endangered Species Act of 1973.

Reforestation Expenses

You can deduct up to $5,000 annually ($10,000, if married filing jointly) in qualified reforestation expenses. Amounts in excess of this dollar limit can be amortized over 84 months. For further details, see Chapter 14.

Miscellaneous Expenses

Ordinary and necessary business expenses common to all businesses (e.g., advertising costs or attorney's fees) are deductible. Other expenses specific to farming activities that may be deducted as ordinary and necessary expenses include:

• Chemicals

• Fuels and oil

• Freight and trucking

• Ginning

• Insect sprays and dusts

• Litter and bedding

• Livestock fees

• Storage and warehousing

• Tying materials and containers

• Veterinary fees and medicine

Passive Activity Rules

Losses from an activity in which you do not materially participate and any rental activity cannot exceed your income from passive activities. Thus, if you own the farm but do not work it yourself, you may not be able to deduct your losses.

At-Risk Rules

These rules, which limit your deduction for losses to your economic investment, apply to farming activities in the same way in which they apply to nonfarming activities.

Hobby Loss Rules

If you are not engaged in the farming activity with a realistic profit motive, then your losses are not deductible. They do not carry over to another year; they are gone forever. There is considerable litigation each year involving gentlemen farmers, and their success in deducting losses depends on demonstrating a profit motive. For details, see Chapter 26.

Farming Losses

Farming losses cannot be used as a tax shelter. Farming losses by those receiving certain subsidies are limited in how much can be used to offset nonfarm income on Schedule F. The limit is the greater of $300,000 ($150,000 for married persons filing separately) or the net farm income received over the past 5 years.

Losses limited by this rule are not lost forever; they can be carried forward and used in future years to the extent allowed by this rule.

The limit applies to farmers (other than those operating as C corporations) who receive any direct or countercyclical payments under Title I of the Food, Conservation, and Energy Act of 2008, or Commodity Credit loans. For partnerships and S corporations, the limit applies at the partner or shareholder level, based on the year in which the entity's tax year ends.

Net Operating Losses

Farmers are subject to special rules for net operating loss (NOL) carrybacks. Instead of the usual 2-year carryback applicable to most other businesses, farmers can use a 5-year carryback for farming losses. However, there is a 3-year carryback for the part of the NOL attributable to a federal disaster.

You can choose to forgo the carryback and simply carry forward the loss for up to 20 years. There is no special carryforward period for farmers. For farms operated through a partnership or S corporation, the losses pass through to the owners who claim the NOLs on their individual returns.

Net operating losses—figuring them and claiming quick refunds—are discussed in greater detail in Chapter 4.

Credits for Farming Activities

In addition to credits available to nonfarm businesses, certain credits may be unique (or more relevant) to farmers. These include the following.

Claiming a Credit or Refund

You can claim the aforementioned credits for fuel-related excise taxes on your income tax return. The credits are claimed on Form 4136. Alternatively, you can claim a refund of the excise taxes you already paid. The claim for refund can be made for any quarter of your tax year for which you can claim $750 or more.

If for any quarter the excise tax paid on all fuels used for qualifying purposes is less than $750, you carry the amount over to the next quarter of your tax year to determine if you can claim at least $750 for that quarter. If you cannot claim at least $750 at the end of the fourth quarter of your tax year, you must claim a credit on your income tax return.

You can use Form 8849 to file a claim for refund. If you file Form 720, you can use the Schedule C portion of Form 720 for your claims, rather than Form 8849.

You must file a quarterly claim by the last day of the first quarter following the end of the last quarter included in the claim. If you do not file a timely refund claim for the fourth quarter of your tax year, you will have to claim a credit for that amount on your income tax return.

If you claimed taxes as an expense deduction that reduced your income, you must now include any credit or refund of excise taxes on fuels.

Who Claims a Credit or Refund?

If fertilizer or pesticides are applied to your farm aerially or otherwise, the applicator is treated as having used the fuel. For kerosene used in aviation, the registered ultimate vendor is the claimant.

Exemption from Excise Tax on Fuels

As a farmer, you can buy diesel fuel and kerosene excise tax free (and so are not eligible to claim any credit with respect to these fuels). To obtain tax exemption, you must provide the vendor with a signed certificate and keep a copy of it with your other business records. A Sample Exemption Certificate (Table 20.2) is reproduced on page 470.

For more information about these special tax credits, see IRS Publication 510, Excise Taxes (Including Fuel Tax Credits and Refunds).