TABLE OF CONTENTS SECTION I FARM PROBLEMS & EXAMPLES. Installment Contracts and Deferred Grain Contracts

Transcription

1 TABLE OF CONTENTS SECTION I FARM PROBLEMS & EXAMPLES Page Installment Contracts and Deferred Grain Contracts Example of Reporting an Installment Sale (Example-Forms) Example of Taxpayer s Home On the Farm (Example-Forms) Example of Taxpayer s Home on the Farm/Machine Shed Converted to Personal Use (Example-Forms) Miscellaneous Leasing Issues Environmental clean-up costs Disaster payments & crop insurance, IRC 451(d) year deferral of weather related sale of other livestock, IRC 451(e) year deferral weather related sale of draft, dairy & breeding livestock, IRC 1033(e) Comparison of 1-year and 4-year deferral rules Employment Taxes on Farm Wages Self-Employment Tax Issues Re: Livestock Confinement Bldg Farm Income Averaging (Example-Forms) CCC loans, tax treatment Ag Law Digest (Vol. 21, No. 9) Implications of Death of a Farmer for CCC Loan Purposes CRP payments Patronage Dividends, tax treatment Wetlands Reserve Program Waterway Improvements on Cash Rental Property Qualified Conservation Contributions Hedging vs. Speculation Transaction Guide for Hedging Transactions Disaster Area Designation Iowa (2015) Prepaid Expense Rules Cash Basis Farmers Grouping Farm Activities Single Economic Units Grouping Election - Rental of Farm Real Estate Social Securities Earnings Test/Benefits Corporate Cash Rent Considerations Spousal Farm Rental Arrangements Considerations

2 TABLE OF CONTENTS SECTION I FARM PROBLEMS & EXAMPLES Page Residence Rental to Farm Corporation Tax Planning for the Young And/Or Low-Income Farmer/Non-farmer Agricultural Commodity Tax Planning: Charitable Gifts Gifts to Family Members Made in Kind Ag Law Digest (Vol. 23, No. 2) Depreciating Farm Drainage Tile Depreciation/Amortization (Residual Soil Fertility)- Letter Employment Agreement Form Spousal Employment - Documentation Payment in Kind Schedule Commodity Transfer Agreement IRS Coordinated Issue Papers Discharge of Indebtedness Income Computation/Taxation Discharge of Indebtedness IRC Other Issues Bankruptcy Split Year Election Chapter 7 or Chapter 11 Only Abandonment Entrapment Theory vs. Deflection Theory Ag Law Digest (Vol. 21, No. 12) Electing to Close the Tax Year in Bankruptcy Ag Law Digest (Vol. 21, No. 2) Traps in Abandonment of Property in Bankruptcy Ag Law Digest (Vol. 23, No. 11) The U.S. Supreme Court Settles (for Now) One of the Chapter 12 Bankruptcy Tax Issues... 97

3 INSTALLMENT CONTRACTS & DEFERRED GRAIN CONTRACTS The installment sale method of reporting deferred payments permits cash method farmers to defer the sale of crops or livestock. IRC 453(1)(2)(A) will permit installment sale reporting where deferred payments are received in a later year. The taxpayer may also elect out of installment sale reporting and report the income in the current year. IRC 453(d)(1). Selling grain at harvest with the check to be received January 2, 2016 does not result in alternative minimum tax in This one aspect of the tax law has been simplified. IRC 56(a)(6) was retroactively repealed by TRA of 1997 for tax years beginning after Installment sale reporting can avoid constructive receipt issues by executing a written contract before the taxpayer has a right to payment and not permitting the contract to be used as collateral for a loan. CRITERIA FOR INSTALLMENT CONTRACT REPORTING 1. Use a written contract that, under local law, binds both the seller and the buyer. 2. Add a provision in the contract that under no circumstances will the seller be entitled to any of the sale proceeds prior to the payment date. 3. Execute the contract before the taxpayer has a right to the money, normally prior to delivery. 4. Specify in the written contract that the taxpayer has no right to transfer or assign the contract rights. 5. Add a prohibition against use of the contract as collateral for any loan. 6. Do not permit the buyer of the commodity to credit the seller/farm producer s account and then charge that account for expenses such as seed, fertilizer, etc. 7. The selling farmer s right to the money is evidenced by a contract not a note. 8. The contract may provide for interest. The Tax Court has held that crop share landlords are entitled to use installment reporting to report the sale and income of their crop share rentals under a price later contract in the year following the year of crop production. See Applegate v. Commissioner 980 F.2d 1125 (7 th Cir. 1992) aff g. 94 T.C. 696 (1990). EXAMPLE 1: Kevin Farmer executes a written contract with his local elevator with the following features - non-assignable, non-transferable, cannot be amended with no possibility of prepayment. The written contract requires Kevin to deliver 5,000 bushels of beans on November 19, 2015, with payment of $9.50 per bushel to be made on January 5, Kevin will be treated as receiving income in 2016 for both regular income tax and alternative minimum tax purposes. EXAMPLE 2: Kevin delivers the 5,000 bushels of beans on November 19, 2015 with payment to be received of $9.50 per bushel. Upon delivery, Kevin decides to defer his payment until January 5, Although Kevin is in constructive receipt of the sale proceeds, he should be able to claim installment reporting and defer the income until 2016 for regular income tax and alternative minimum tax purposes.

4 EXAMPLE 3: Kevin delivers 5,000 bushels of beans according to the terms of a price later contract. He has the right to set the price anytime from July 1, 2015 to June 30, The grain buyer agrees to loan back 80% of market value of the beans upon delivery. As a general rule for regular income tax, Kevin Farmer should only report sale proceeds in the year that he has a right to receive payments, in this example, However, due to the receipt of loan proceeds in 2015, the loan proceeds will likely need to be included as income in NOTE YEAR-END TAX PLANNING: Taxpayers may wish to enter into multiple deferred grain contracts prior to year end using multiple bushel quantities. If the taxpayer s income is too low, the taxpayer may elect out of installment sale reporting on certain contracts and bring their income up to their desired amount. The inclusion amount can be determined at the time the return is prepared. NOTE If a cash method farmer dies at year end with deferred grain installment contracts outstanding, the proceeds from the contracts will be treated as income in respect of a decedent (IRD). That is, there will be no step up in basis for the grain to its fair market value at the date of the decedent s death. If the decedent owns stored grain at death, the grain will receive a step up in basis to its fair market value at the date of the decedent s death. PROBLEM: There are worse problems than not deferring income to a future year. If grain or livestock is delivered with title passing to the buyer, the seller is, with limited exceptions, no more than an unsecured creditor. Sellers of livestock can lose their payment assurances under The Packers and Stockyard Act. Deferred contract sellers of grain do not participate in state indemnity funds or elevator bonding. Therefore, if the buyer (i.e. local elevator, etc.) becomes bankrupt or insolvent between the time of sale (delivery) and the time of payment, the seller may receive only a token payment. Third party guarantees or letters of credit may be arranged through the buyer s Bank as additional security although neither may be a realistic option. An escrow account that serves no benefit to the buyer of the commodity will be treated as a payment in the year it is established and funded.

5 EXAMPLE OF REPORTING AN INSTALLMENT SALE Example 1 The Taxpayer sold a farm on contract, with possession on March 1, The following data is pertinent: Acquired March 1, 1970 Sale Price $675,000 Cost 200,000 Improvements 85,000 Depreciation 110,000 Sale Costs 13,750 Received year of sale 50,000 Assume from a total of $110,000 depreciation, $55,000 is attributable to Sec property and the balance is subject to recapture as Section 1250 straight line depreciation on Line 25 of Schedule D. Sec property may include single purpose agricultural facilities, grain storage facilities and machinery sales and the gain is reported as ordinary income on Form 4797 Part III and Part II. The sale would be reported as set forth on the attached Forms 4797, 6252 and Schedule D. Proof of Reporting: Sale price $ 675,000 Cost $200,000 Improvements $ 85,000 Costs of sale 13, ,750 Less depreciation (110,000) Less adjusted cost basis 188,750 Total realized gain $486,250 Reported per this example: A. Ordinary income (due to Sec recapture in 2015) $ 55,000 B. Downpayment ($50,000 x.63889) 31,944 C. Balance of gain to be reported over remainder of contract $625,000 x = $399,306 $486,250 The gains on Lines B & C are fully subject to Section 1250 straight line depreciation recapture and may be taxed at a maximum marginal rate of 25%.

6

7

8

9 TO GET MORE INVOLVED, ASSUME THE TAXPAYER S HOME WAS ON THE FARM: Example 2 ALLOCATION HOME FARM TOTAL Sale Price $60,000 $615,000 $675,000 Initial cost, allocated $25,000 $175,000 $200,000 at time of purchase Additions and $18,000 $ 85,000 $103,000 improvements Depreciation $110,000 $110,000 Costs of sale based on sale price $ 1,250* $ 12,500* $ 13,750 Received in year of $ 4,500* $ 45,000* $ 50,000 sale * 9% of total Assume from a total of $110,000 depreciation, $25,000 is attributable to Sec property and the balance is subject to recapture as Sec straight line depreciation. Also, assume that the taxpayer has owned and lived in the home as the taxpayer s personal residence at least two of the last five years. Proof of Reporting: Sale price of farm $615,000 Cost $175,000 Improvements 85,000 Costs of sale 12, ,500 Less depreciation (110,000) Less adjusted cost basis 162,500 Total realized gain $452,500 Reported as per this example: A. Ordinary income (due to Sec recapture in 2015) 25,000 B. Down payment $45,500 x ,627 C. Balance of gain to be reported over remainder of contract ($569,500 x.6951) $395,873 $452,500 The gains on lines B & C are all subject to Section 1250 straight line depreciation recapture and may be taxed at a maximum marginal rate of 25%. Gain on the sale of the personal residence need not be reported.

10

11

12

13 TO GET MORE INVOLVED, ASSUME THE TAXPAYER S HOME WAS ON THE FARM AND THAT THE MACHINE SHED FORMERLY USED IN THE FARMING OPERATION WAS CONVERTED TO PERSONAL USE MORE THAN TWO YEARS AGO: Example 3 ALLOCATION HOME/MACHINE FARM TOTAL SHED Sale Price $80,000 $595,000 $675,000 Initial cost, allocated $40,000 $160,000 $200,000 at time of purchase Additions and $18,000 $ 85,000 $103,000 improvements Depreciation $15,000 $ 95,000 $110,000 Costs of sale based $ 1,629* $ 12,121* $ 13,750 on sale price Received in year of $ 5,925* $ 44,075* $ 50,000 sale * 11.85% of total ** 88.15% of total Assume from a total of $95,000 depreciation on the farm, $25,000 is attributable to Sec property and the balance is subject to recapture as Sec straight line depreciation. Also, assume that the taxpayer has owned and lived in the home as the taxpayer s personal residence at least two of the last five years and that the machine shed was converted to personal use prior to May 6, Proof of Reporting: Sale price of farm $595,000 Cost $160,000 Improvements 85,000 Costs of sale 12, ,121 Less depreciation ( 95,000) Less adjusted cost basis 162,121 Total realized gain $432,879 Reported as per this example: A. Ordinary income due to Sec recapture in ,000 B. Down payment ($44,075 x.6855) 30,213 C. Balance of gain to be reported over remainder of contract ($550,925 x.6855) $377,666 $432,879 The gains on lines B & C are all subject to Section 1250 recapture and may be taxed at a maximum marginal rate of 25%. Gain on the sale of the personal residence need not be reported. The authors believe that Revenue Ruling is applicable and has not been modified by the final regulations as issued under I.R.C. Sec. 121.

14

15

16

17 MISCELLANEOUS LEASING ISSUES 1. RENTAL INCOME VS. SELF-EMPLOYMENT INCOME. The IRS argues income from all machinery (personal property) leases, regardless of the lessors involvement in the lease, is subject to self-employment tax. Based on the 1989 case of Carl Stevenson, T.C. Memo , the IRS has added a note to Part I of Schedule E If you are in the business of renting personal property, use Schedule C or C-EZ. The IRS has increased its audit activity regarding this issue. I.R.C. Sec defines self-employment income as "net earnings from self-employment derived by an individual from any trade or business carried on by such individual." Specifically excluded from this definition are "rentals from real estate and from personal property leased with the real estate" unless a share rental is involved with material participation. The IRS appears to conclude that if there is no rental of real estate involved, that the rental income is subject to selfemployment tax. Even though I.R.C. Sec requires the individual to be in a trade or business, the IRS is seemingly ignoring the requirement. A given level of activity by the lessor would seem to be necessary to treat lease income as income from a trade or business. The term "trade or business" is held to mean the same as it does under I.R.C. Sec The Courts, in Sec. 162 cases, have always required a certain level of regular, continuous activity to be held to be a trade or business. See Groetzinger v. Commissioner, 87-1 T.C. Par (1987). If only personal property is leased and no trade or business exists, the income is not subject to selfemployment tax and income should be reported on Form 1040, line 21, and expenses on line 36. See also Michael D. Welch, et. al. v. Commissioner, T. C. Memo , where the Taxpayer s tool rental activity was held to be an active trade or business, was properly reported on Schedule C and was not a rental activity within the meaning of the passive activity rules of I.R.C. Sec It also appears in recent audit activity that if a loss were to occur, the IRS is prepared to argue this is a passive loss and limit deductibility. Rental receipts from an activity that does not constitute a business, should be reported as other income. Related expenses are to be reported on the total deduction line with a notation of PPR (Personal Property Rentals) on the dotted line next to the amount. In order to avoid this issue, wherever possible, it may be best to lease the farm machinery with the farm real estate as these rentals are specifically excluded from net income for selfemployment purposes and should be reported on Schedule E. Incorporating or forming an LLC may also reduce the likelihood that rental income would be subject to self-employment tax. 2. LEASE VS. INSTALLMENT SALE. Due to I.R.C. Sec requiring the recapture of all depreciation deductions taken in the year of sale as ordinary income, the installment sale of farm machinery is prohibitive. Leasing, as opposed to an installment sale agreement, may increase the current deductions to the Lessee. With this in mind, one may well desire to lease the property instead of selling it, so the receipts can be reported over a period of years. If the arrangement is a lease, payments are ordinary income to the lessor and are fully deductible by the lessee. (Lessor's rental proceeds are possibly subject to SE tax as described previously). If the arrangement is treated as a sale, a portion of each payment will be treated as imputed interest. The seller will report the Sec recapture in the year of the sale and interest income each year. The buyer (lessee) will have imputed interest expense under I.R.C. Sec. 483 to report and must depreciate the purchase price. Depending upon the participation of the Buyer

18 (Lessee) and the assets purchased (leased), the Buyer (Lessee) may also take 179 expense and depreciation. The Farmers Tax Guide, Publication 225, provides that the intent or the parties determines whether an agreement is a lease or an installment sale. Publication 225 further provides in absence of other persuasive factors, an agreement will be treated as a sale rather than a lease if any of the following is true: 1. The agreement applies part of each payment toward an equity interest you will receive. 2. The lessee receives title to the property after paying a stated amount of required payments. 3. The lessee must, over a short period of time, pay an amount that represents an unusually large part of the price you would pay to buy the property. 4. The lessee pays rent that is much more than the current fair rental value of the property. 5. The lessee has an option to buy the property at a small price compared to the value of the property at the time the lessee can exercise the option. Determining the value at the time of entering into the original agreement also indicates a sale. 6. The lessee having an option to buy the property at a small price, compared to the total amount paid under the lease. 7. The lease designates some part of the payments as interest, or part of the payments are easy to recognize as interest. Important factors to be considered in determining whether the agreement is a lease or a sale are the parties' intention, the fact that the owner/lessor pays insurance and taxes and if the lease runs over the estimated life of the machinery. An appraisal would also be important. Interest should not be charged if a lease is intended. If an option to purchase should be involved at any time, the option to purchase should be at FAIR MARKET VALUE at the time of purchase. Automatically receiving title at the end of the lease period smacks of a sale and should be avoided. The lease payment should be comparable to what used property would lease for, the problem here being that there are no guidelines for the leasing of used equipment. See Tillman v. Comm., 71 T.C.M (1996) where the "rental agreement" passed title to the Lessee upon execution of the lease, required the Lessee to be responsible for insurance, maintenance and bear the risk of loss was held to be a conditional sales contract. The principle issue is the business reality and economic substance of the transaction. EXAMPLE (1): Able Farmer rents his farm machinery to his daughter, Beth Farmer, under a written lease which requires Beth to pay fair rental value, to repair the machinery, and to provide and pay for insurance on the machinery. Beth may purchase one or more items leased at its fair market value during or upon completion of the lease term. Able Farmer should report the income on Schedule E if the equipment is rented with other land and he is not involved in a trade or business. If land is not rented with the machinery and Able is not involved in a trade or business, the income should be reported on Other Income Line 21 of the Form 1040 and expense on Total Adjustments Line 36 of the Form 1040 and should be identified as P.P.R. Able should report the income on Schedule C if he is involved in a trade or business. It would appear in this set of facts that there is no personal involvement by Able Farmer and that the payments are properly reported on Schedule E or Form 1040, line 21 and line 36, although IRS may argue otherwise. Beth Farmer may take lease payments as an expense on her Schedule F. EXAMPLE (2): Assume Beth Farmer owns a tractor purchased in 2001 at a cost of $22,500. In 2014 she leases a new tractor under a true lease for the sum of $12,500 per year and transfers her tractor to the Lessor for the first payment. Beth Farmer must report the trade-in as a sale, has

19 ordinary income as a result of I.R.C. Sec recapture in the amount of $12,500 and a lease expense on her Schedule F in the amount of $12,500. EXAMPLE (3): Kevin Farmer needs a machine shed for his equipment. Kevin Farmer signs a lease containing the following terms: 1. The $30,000 cost of the machine shed is paid by a leasing company. 2. The lease term is for six years, began in 2009 and is payable as follows: Date payment due Amount of payment Date payment due Amount of payment $7, $6, , , , ,000 Kevin Farmer is responsible for paying all real estate taxes, insurance, utilities, and repairs on the machine shed during the lease period and at the end of the lease period, Kevin Farmer may purchase the building from the leasing company for $1,000. If this purchase option is not exercised, the leasing company reserves the right to remove the building. This lease is merely a financing arrangement, and should be treated as a purchase. Kevin Farmer has all the responsibilities of ownership of the machine shed and the "buyout" amount of $1,000 does not approximate the fair market value of the shed. Kevin Farmer should depreciate the cost of the shed over 20 years and deduct the imputed interest. EXAMPLE (4): Assume Kevin Farmer executes a lease granting the Lessor a right of access to his real estate, pays $4, per year for seven years as rental payments, pays all real estate taxes, insurance and repairs. The lease may be renewed at the end of seven years at fair market value. The building may be purchased at fair market value at the end of the lease or the lease may be terminated. This lease should be treated as a true lease, as the Lessor provided all of the original equity and no bargain purchase was included. 3. LEASING OF A VEHICLE. The question of leasing a vehicle vs. purchasing must be decided on a case by case basis. Although one generally looks at the least cost approach, other tax and non-tax considerations may be involved. The leasing of an automobile or pickup with a gross vehicle weight of less than 6,000 pounds, that is used in a trade or business, may result in the inclusion of an amount in the taxpayer's income. Likewise, this type of vehicle would be subject to MACRS rules and I.R.C. Sec. 280(f) depreciation limits. If a vehicle was purchased, the owner would be entitled to depreciation and interest expense deductions. If a vehicle is leased, the owner is entitled to deduct the business portion of the lease and nonrefundable security deposit subject to the lease value inclusion amounts. If the fair market value of such a vehicle is greater than $16,000 for automobiles and $17,350 for trucks and vans leases beginning in 2015, the inclusion amount must be computed under Rev. Proc The inclusion amount is to be prorated based on the number of days leased during the year and the percentage of business and investment use. The income is reported on the same schedule where the leasing expense is deducted.

20 ENVIRONMENTAL CLEAN-UP COSTS Priv. Ltr. Rul points out that it is not only painful but expensive to be confronted with environmental clean-up. In that ruling, capitalization was required for the following expenditures: 1. Testing for soil contamination. 2. Testing for groundwater contamination. 3. Excavating and transporting contaminated soil. 4. Legal fees to defend EPA and state agency charges and claims of third parties. 5. Cost of oversight of clean-up activities. 6. Environmental audits. Deduction of costs as current expenses was denied, capitalization of the expenses was required and the expenses were termed incidental, with such costs not adding to the value of the property nor materially prolonging its life. As to legal fees, the same reasoning and result will occur since the fees take on the character of the suit on which the costs were expended. Where there is rehabilitation or restoration that will benefit the property for the remainder of its useful life, the cost must be capitalized. Assessment of the problem, removal of the contamination and replacement of new soil would be a capital item and the legal costs associated therewith would be treated in the same way. Rev. Rul , C.B. 35 addresses the question in a somewhat more favorable light. In this case, the taxpayer bought five acres of land in rural Texas. The land was located near an exit of an Interstate. It was used for grazing and was not contaminated by hazardous waste when purchased. A truck stop was built on the land, and over the years the same became contaminated. The EPA investigated and ordered remedial action consisting of excavation of land at a cost of $45, The Ruling takes the very reasonable position that the expenditure is an expense that is fully deductible as an ordinary and necessary business expense. The expenditure did not result in an improvement that increased the value of the property, and instead, was simply restored to the condition existing prior to the contamination. A manufacturer who replaced underground storage tanks was able to deduct costs incurred in their removal, cleaning and disposal as ordinary business expenses. See Rev. Rul , I.R.B Taxpayer was allowed to currently deduct environmental clean-up costs for contamination occurring during its ownership period, but had to capitalize the environmental clean-up costs for contamination occurring prior to its ownership. Priv. Ltr. Rul For property purchased that was already contaminated, (i.e. property that had housed a dry cleaning business and remedial action including the removal of dry cleaning equipment and replacement of contaminated soil), the expenditures would be a capital expenditure not currently deductible. Priv. Ltr. Rul See also United Dairy Farmers, Inc. v. U.S., 107 F. Supp. 2d 937 (S.D. Ohio 2000) where the Court held a Corporation could not deduct environmental clean up costs.

21 New proposed and temporary IRS regulations issued regarding the capitalization vs. the current deduction of repairs gives further authority for the treatment of previously contaminated properties. FACTS: X purchases a store located on land that, unbeknownst to her, contained underground gasoline storage tanks left by a prior owner. The tanks had leaked, causing soil contamination X was not aware of the contamination at the time of purchase. X incurs costs to remediate the soil RESULT: X is required to capitalize the remediation costs because of the betterment to the land The fact of having acquired the asset with a defect, whether known or unknown, is not relevant to the determination. SOURCE: Reg (a)-3T(h)(4), Example (1). The Court held that environmental remediation costs could be currently deducted if the taxpayer could prove they had caused the contamination during the taxpayer s ownership period. Kerr-McGee Corp. v. U.S U.S. Tax Cases (CCH) Paragraph (Fed. Cls. 2007). The IRS in Rev. Rul , C.B. 509 has determined expenditures incurred to remediate contamination from a manufacturing plant must be capitalized as part of inventory costs under IRC Section 263A. The Ruling also provides that the IRS will not challenge current deductions for remediation costs in any prior taxable year ending on or before February 6, The IRS in Rev. Rul , C.B. 67 has provided additional clarification of issues raised in Rev. Rul , in a variety of manufacturing examples. I.R.C. Sec. 198 provided that qualified clean up costs paid or incurred after August 5, 1997, and paid and incurred before January 1, 2001, would be currently deducted if the taxpayer so elects. This provision has now been extended by the 2010 Tax Relief, Unemployment Insurance Reauthorization and Jobs Creation Act to include expenditures paid or incurred before January 1, Section 198(h) of the Internal Revenue Code states this section shall not apply to expenditures after Deccember 31, These sections apply to hazardous substances referred to as brownfields which include the abatement or control of hazardous substances at a qualified contaminated site. A qualified contaminated site is property that is held for use in a trade or business, for the production of income or as stock in trade or inventory and on which there has been a release of a hazardous substance. The taxpayer must obtain a statement from the states environmental agency as to the release of the hazardous substance. The requirement of the site being located in a targeted area was removed effective December 21, The elimination of the targeted area requirement expands eligible sites to those containing a hazardous substance as certified by a state environmental agency. If the property is later sold, the clean up costs will be treated as being subject to I.R.C. Sec depreciation recapture. Although this election is attractive, the effect will be limited as it

22 must be in connection with the abatement and/or control of hazardous waste on a qualified containment site. The IRS apparently will accept private ruling requests regarding the subject of environmental clean up costs deductibility due to the possible elective deduction under I.R.C. Sec. 198, the possible deduction as ordinary and necessary business expenses under I.R.C. Sec. 162 or as losses under I.R.C. Sec. 165 or the necessity to capitalize these expenses under I.R.C. Section 263. Rev. Proc , C.B The IRS has also provided guidance for taxpayers electing to deduct qualified environmental remediation expenditures under I.R.C. Sec Rev. Proc , C.B The election is made by claiming the costs as a current deduction on the appropriate business schedule being filed and describing them as Section 198 Election. The election must be made on a timely filed return including extensions in the year the expenditures were incurred.

23 DISASTER PAYMENTS & CROP INSURANCE IRC 451(d) GENERAL RULE: Crop loss proceeds from crop insurance and USDA disaster payments are included as income in the year of receipt. However, the cash basis taxpayer may elect to include the proceeds as income in the year following receipt, if the crop loss proceeds are as a result of crop insurance or federal disaster payments received as a result of hail, fire loss, flood, drought or other natural disaster and the income would have normally been reported in the later year under the taxpayer s normal business practice. The provision covers payments made because of damage to crops or the inability to plant crops. IRC 451(d) and Rev. Rul , C.B The exception applies to crop insurance proceeds and disaster payments received under the Agricultural Act of 1949, as amended, and Title II of the Disaster Assistance Act of Agreements with insurance companies that make payments without regard to actual losses do not qualify. IRS Notice 89-55, C.B ELECTION: To defer reporting until the year following receipt, the following information that must be included in a separate, signed election form attached to either an original or amended tax return: 1. Name and address of the taxpayer. 2. A declaration that the taxpayer is making an election under IRC 451(d) & IRC Identify the specific crop or crops destroyed or damaged. 4. A declaration that under normal practice the income that was lost from the crops that were destroyed or damaged would have been included in income for the year following the year of destruction or damage. 5. The cause of the damage and dates the damage occurred. 6. If crop insurance was involved, the amount received from the insurance carriers itemized with respect to each crop and the date received. 7. Name of the insurance carrier. As to disaster payments, it does not appear that there must be a declaration that the area is a disaster area. However, one must still meet the factual test of the disaster, such as drought or flood. NOTE: Rev. Rul provides that where an election was made to defer receipt of taxable income to the year following, such election applied not only to crop insurance receipts but also to disaster payments. Crop insurance proceeds and disaster payments must be combined and reported consistently. The taxpayer cannot pick and choose. The election covers all crops, as well as all crop insurance proceeds. If crop insurance proceeds are received for two crops and the election is made, the proceeds from both are reported in the following year. An election counts for only the tax year that it is made in. An issue arises if the taxpayer receives disaster and/or crop insurance payments for two different crops and the crops are normally marketed in two different years. See, Rev. Rul , C.B. 113, where the taxpayer was required to sell over 50% of all crops in year following harvest to defer all insurance payments. Proceeds from a disaster payment or crop insurance for a crop normally sold at harvest would seem not to be deferrable. NOTE: The Tax Court held in Nelson v. Comm. 130 T.C. 570 (2008) that taxpayers were not eligible to defer federal crop insurance proceeds to the following year, where only 35% of the current crop proceeds were reported in the following year.

24 The Tax Court held that 35% of the crop was less than substantial and not sufficient to support deferral to the following tax year. The Eighth Circuit (Nelson v. Comm., 568 F.3d 662(8 th Cir. 2009), upheld the Tax Court s ruling. The Eighth Circuit used Rev. Rul , C.B.113 as authority that the election to defer was available only to a taxpayer who deferred greater than 50% of income from such crop to the following year. Gross crop insurance proceeds must be deferred. If the farmer has deferred the payment of crop insurance premium to the fall and the insurance carrier reduces the crop insurance proceeds by the premium owed, the gross amount of insurance proceeds without the offset for the insurance premium must be deferred. The crop insurance premium should then be deducted as a current expense. EXAMPLE: Kevin Farmer is entitled to $42,000 crop insurance proceeds, but owes $6,000 of premium and therefore only receives $36,000. Kevin may defer $42,000 of insurance proceeds to the following year and deduct $6,000 crop insurance expense in the current year. The taxpayer may not elect to report payments in the year of loss if the proceeds are received in the year following the year of loss. FSA disaster payments received in the year following the year of loss are not deferrable. CROP REVENUE COVERAGE (CRC) INSURANCE PAYMENTS: CRC insurances are privately developed policies which are broader in scope than the traditional multi peril crop insurance policy. CRC insurance covers any revenue losses whether caused by a casualty (i.e. flood, hail), low prices or low yields. Actual historic production is utilized to set the coverage which ranges from 50% to 85% of production. The commodity base price sets a minimum guarantee, but there is a second price test at harvest which may increase the guarantee. As noted above, the IRS has previously taken the position that crop insurance that provides for payments without regard to actual losses do not qualify for deferral. IRS Notice If a crop insurance payment is based on both crop loss and price loss from a revenue-based insurance policy, only the portion intended to reimburse the farmer for crop loss is deferrable. The portion payable because of a decline in market price is not deferrable and is income in the year the payment is received. Documentation from the insurance carrier may be needed to determine the amount of any loss payment eligible for deferral. Consider the following examples from Roger McEowen s CALT materials Tax and Legal Issues Associated With the 2012 Drought, July 20, 2012 (updated August 6, 2012): EXAMPLE: Al Beback took out an insurance policy (RP) on his corn crop. Under the terms of the policy the approved corn yield was set at 170 bushels/acre, and the base price for corn was set at $4.15/bushel. At harvest, the price of corn was $3.25/bushel. Al s insurance coverage level was set at 75 percent, and his yield was 100 bushels/acre. Al s final revenue guarantee under the policy is 170 bushels x $4.15 x.75 = $529.13/acre. Al s calculated revenue is his actual yield (100 bushels/acre) multiplied by the harvest price ($3.25/bushel) which equals $325/acre. Al s insurance proceeds is the guaranteed amount ($529.13/acre) less the calculated revenue ($325/acre), or $204.12/acre. His physical loss is the 170 bushel/acre approved yield less his actual yield of 100 bushels/acre, or 70 bushels/acre. Multiplied by the harvest price of $3.25/bushel, the result is a physical loss of $227.50/acre. Al s price loss is computed by taking the base price of $4.15/bushel less the harvest price of $3.25/bushel, or $.90/bushel. When multiplied by the approved yield of 170 bushels/acre, the result is $153.00/acre.

25 So, to summarize, Al has the following: Total loss: (1) anticipated income/acre [170 $4.15/ bushel = $705.50/acre] less (2) actual result [100 $3.25/acre = $325.00] for a result of $380.50/acre. Physical loss: 70 bushels/acre x $3.25/bushel harvest price = $227.50/acre Price loss: 170 bushels/acre x $.90/bushel = $ Physical loss as percentage of total loss: $227.50/ =.5979 Insurance payment: $204.12/acre Insurance payment attributable to physical loss (which is deferrable): $ x.5979 = $122.04/acre Portion of insurance payment that is not deferrable: $ $ = $82.08/acre If harvest price exceeds the base price, consider the following example: EXAMPLE: The facts are the same as in the previous example, except that the harvest price of corn was $4.50/bushel. Al s final revenue guarantee under the policy is 170 bushels/acre x $4.15 x.75 = $529.13/acre. Al s calculated revenue is his actual yield (100 bushels/acre) multiplied by the harvest price ($4.50/bushel) which equals $450.00/acre. Al s insurance proceeds are the guaranteed amount ($529.13/acre) less the calculated revenue ($450.00), or $79.13/acre. His yield loss is the 70 bushels/acre which is then multiplied by the harvest price of $4.50/bushel, for a physical loss of $315/acre. Al s price loss is zero because the harvest price exceeded the base price. So, to summarize, Al has the following: Total loss (per acre): $ (physical loss) + $0.00 (price loss) Physical loss as percentage of total loss: $315/315 = 1.00 Insurance payment: $79.13/acre Insurance payment attributable to physical loss (which is deferrable): $79.13 x 1.00 = $79.13/acre Portion of insurance payment that is not deferrable: $ = $0.00 OBSERVATION: Normally, if the price of crop at the time of harvest exceeds the base price, the physical loss will constitute 100 percent of the total loss, and the entire insurance payment will be deferrable. However, if insurance proceeds for physical loss to crops are collected before the harvest price is determined and the harvest price ultimately exceeds the base price, any additional payment attributable to the price difference could be deemed by IRS to be attributable to revenue loss that would not be eligible for deferral. NOTE: For policies not based on physical loss (such as a Group Revenue Protection (GRP) policy, payments received are not deferrable. The same holds true for an Average Crop Revenue Election (ACRE) payment because it is received after the end of the marketing year and in a year after the year the crop at issue is produced. Due to the drop in crop prices during 2013, many farmers may receive revenue loss payments, which will be nondeferrable.

26 WEATHER RELATED SALE OF LIVESTOCK ONE-YEAR DEFERRAL (DISASTER AREA) IRC 451(e) ELECTION: Cash method farmers (principal trade or business is farming) who sell livestock due to weather related sales (i.e. drought, flood, etc.) may elect a one-year deferral for the reporting of gain over and above normal tax year sales. The area of the taxpayer s trade or business must be in or near an area declared to be a disaster area eligible for federal assistance in order for the taxpayer to be eligible for this one-year deferral. Livestock need not have been raised or sold in the actual disaster area; however, sale must have occurred solely on account of the drought or other condition and its impact on water, grazing or other requirements of the animals within the area. IRC (c) and IRS Notice The deferral election applies to all livestock held for sale (raised or feeders), as well as, livestock used for draft, breeding, dairy or sporting purposes, and livestock held for < 2 yrs. (cattle & horses) and other livestock held for < 1 yr. NOTE: Before 1997, only sales of livestock due to drought were eligible for deferral. Sales related to other weather-related conditions (tornadoes, floods, etc.) were added for tax years beginning in 1997 and thereafter. ELECTION FORMAT: A separate election form is to be attached to the return, is to be filed on or before the due date of the return, including extensions, and must contain the following: 1. Declare that you are making an election under IRC 451(e) & IRC Regs Show evidence of the weather related conditions that forced the early sale, including the date (if known) the area was designated as eligible for federal assistance as a disaster area. The sale of livestock may occur before the designation is made. 3. Explanation showing the relationship between the weather related conditions and reason for sale. 4. Document the total number of animals sold in each of the three preceding years. 5. Document the total number of animals that would have been sold under normal conditions. 6. Document total number of animals sold that particular year and the number sold because of the weather related conditions. 7. Compute the amount to be deferred to the following year. TAX PLANNING NOTE - EXTENSION OF DEFERRAL ELECTION PERIOD: For sales of draft, breeding or diary livestock, taxpayers can elect to take advantage of the one (1) year deferral provisions of IRC 451(e) during any of the four (4) years after the close of the first taxable year in which any part of the gain or conversion from livestock sales are realized. IRC 451(e)(3) & 1033(e)(2). This provision is effective for tax returns whose due date (without extensions) is after 12/31/02.

27 WEATHER RELATED SALE OF DRAFT, DAIRY & BREEDING LIVESTOCK FOUR-YEAR REINVESTMENT IRC 1033(e) IRC 1033 allows taxpayers who are forced to involuntarily sell livestock to defer gain into replacement property provided qualified replacement property is timely purchased. For example, livestock destroyed by disease may be replaced in a tax deferred manner under IRC 1033(d) (not discussed herein). Livestock held for draft, dairy or breeding purposes sold in excess of normal yearly sales due to drought, flood or other weather related conditions may similarly be replaced under IRC 1033(e). The applicable replacement period is four years after the close of the first taxable year in which any part of the gain on conversion is realized. NOTE: The American Jobs Creation Act of 2004 increased the prior 2-year replacement period to a 4-year period, for tax years with a return due date, excluding extensions, after Sales of draft, dairy or breeding livestock will qualify for involuntary conversion treatment regardless of how long they have been held by the taxpayer. There is no required 12- or 24-month holding period. There is also no requirement that a weather damaged area be declared a drought or disaster area if livestock is replaced within two (2) years. However, if livestock is to be replaced under the 4-year replacement provision authorized in IRC 1033(e)(2), then a disaster/drought declaration must have been made for the area of the taxpayer s trade or business. REPLACEMENT PROPERTY: Replacement livestock must be similar or related in service or use. Thus, dairy cows should be replaced by dairy cows. IRC Regs (e)-1(d). However, breeding cattle may replace buffalo of the same sex. PLR The American Jobs Creation Act of 2004 also expanded IRC 1033 to permit taxpayers to replace livestock with other tangible farm property, if it was not feasible to replace livestock with similar livestock. EXAMPLE: A farmer that sells livestock early in a federally designated drought disaster area and is unable to buy back livestock due to the drought, may reinvest in farm equipment and machinery. However, if replacement property is not like-kind, a 2-year replacement period applies. IRC 1033(e), 1033(f) and 1033(a)(2)(B)(i). If due to soil or other environmental contamination, it is not feasible to reinvest in similar livestock, the taxpayer may invest the proceeds from involuntarily converted livestock into other tangible or real property used for farming purposes. REQUIRED STATEMENT FORMAT (YEAR OF SALE) IRC REGS (e)(1) & (a)(2): 1. Taxpayers must attach a statement to their return for the year in which livestock was sold and provide evidence of existence of the weather related conditions that forced the sale. 2. Compute the gain realized on the sale or exchange. 3. Document the number and kind of livestock sold or exchanged. 4. Document the number of livestock of each kind that would have been sold under the usual business practice in the absence of the weather related conditions.

28 NOTE: The actual election to defer gain can be made at any time within the normal statute of limitations for the period in which the gain was realized, assuming it is before the expiration of the period within which the converted property must be replaced. IRC Regs (a)-2(c)(2). The replacement of the livestock should be reported on the following years tax returns. In the event there is not full reinvestment, the return for the year of the weather related sales must be amended to report additional income in an amount equal to the sum not reinvested. TAX PLANNING NOTE: A taxpayer with raised breeding or dairy animals may prefer to recognize gain as a capital gain in the year of sale, if the income can be reported at the 0% or 15% capital gain rates. This would likely occur with a sole proprietor farmer where regular depreciation or IRC 179 expensing from purchased replacement livestock will offset ordinary SE taxed income in higher tax rate brackets. IRS NOTIFICATION OF EXTENDED DROUGHT LOCATIONS: Due to the intense, prolonged drought in parts of the United States, IRS issued Notice which provides additional time to replace livestock that was initially sold as a result of drought. Notice explains how a taxpayer can determine whether additional time is available. EXAMPLE: The 4-year replacement period scheduled to end on , is extended for one additional year if, for any weekly period included in the 12-month period ending on , severe, extreme or exceptional drought conditions were reported for any location in the county that experienced the drought that forced the sale of the livestock or for any location in a neighboring county. The replacement period may be further extended if the drought conditions persist after To assist taxpayers in determining whether their replacement period has been extended, IRS publishes a yearly list of counties that experienced exceptional, extreme or severe drought for the 12-month period ending each August 31st. This list was complied after consultation with the National Drought Mitigation Center. See Notice for the list of counties for which the replacement period has been extended for the 12-month period ending

29 ONE YEAR (IRC 451(e)) VS. FOUR YEAR (IRC 1033(e)) NOTE: PLR s , and provide that a taxpayer may revoke an election for 1-year deferral under IRC 451(e) and may apply to the District Director for a determination on whether the taxpayer may, in the alternative, defer income under IRC 1033(e) if eligible livestock is replaced within 4 years. A Private Letter Ruling or a Determination Letter will be necessary to request the change. However, this alternative tax reporting/deferral should be possible as all required information would have been filed with the taxpayer s return when the IRC 451(e) election was made; and, there is no requirement to file an IRC 1033(e) election by the due date of the return. NOTE: IRC Regs (a)-2(c)(2) requires an informational statement containing similar information to IRC 451(e) to be included with the return for the tax year or years in which the gain is realized but does not require a per se election. NOTE: It is not possible to first elect under IRC 1033(e), revoke the election, and then make an IRC 451(e) election, as the one-year deferral election needs to be made by the due date of the return, including extensions. ******************************************************** COMPARISON OF ONE-YEAR (IRC 451(e)) / FOUR-YEAR RULES (IRC 1033(e)) Issue Sec. 451(e) - One Yr. Sec. 1033(e) - Four Yr. Period to make election Rule covers Rule allows Due date of return, including extensions (If 1033 livestock four years from due date of return, including extensions) Sales of all livestock in excess of normal business practice Postponement of income to following year Within 4 years of the end of the sale year Sales of draft, breeding and dairy livestock in excess of normal business practice Postpone gain by replacement of livestock Cause of sale Weather related sale Weather related sale, disease Disaster declared Yes No, unless beyond two years, then federal designation is necessary to replace livestock in years 3 and 4 Repurchase required No Yes Carryover basis N/A Basis decreased by gain deferred Replacement period N/A Within 4 years of the end of sale year unless extended by the IRS Qualifying Livestock All livestock Draft, Breeding or Dairy Livestock

30 EMPLOYMENT TAXES ON FARM WAGES Farmers who pay cash wages to an employee of $ or more in a year or exceed a total of $2, of total payroll for the year are subject to social security and medicare taxes on all wages paid. For 2014 farmers must withhold 7.65% of the employee's wages and pay 7.65% as the employer's share. If wages exceed $200, for any one employee, the employer must withhold 0.9% additional medicare tax from the employee s share. Farmers should have each employee sign an I-9 and a W-4 and withhold federal and state income taxes from the wages. Farmers are required to deposit social security and medicare taxes as well as income taxes withheld during the year, unless the tax liability is less than $2, If less than $2, of liability, the taxes may be paid in full with a timely filed quarterly or annual return. Quarterly deposits of state withholding are required if withholding is less than $150 per month. If your state withholding is more than $ , a monthly deposit is required. The minimum threshold for FUTA deposits is $ Farmers are liable for FUTA taxes and SUTA taxes only if they pay wages in excess of $20, in any calendar quarter in the previous two years or employ 10 or more employees a day for at least 20 different weeks during the previous two years. The first $7, of wages are subject to FUTA taxes at a rate of 6.0% less a credit of 5.4% or a rate of.6% for 1/1/13 to 12/31/13. If the farmer pays the employee s share of social security and medicare taxes without deducting it from the employee s wage, this payment amount is treated as additional income to the employee and must be included in Box 1 of the employee s W-2. The payment amount does not increase the employee s social security and medicare wages nor does it get added to total wages for FUTA purposes. Farm wages to a child or spouse of the taxpayer are generally subject to employment taxes including social security and medicare, state and federal income tax withholding and FUTA taxes. Farm wages paid to a child who is under the age of 18 are exempt from social security and medicare taxes. Wages paid to a child who is under the age of 21 for domestic services in the parents home are exempt from social security and medicare taxes. Farm wages or domestic wages paid to a child who is under age 21 are exempt from FUTA tax. Farm wages paid to a spouse are subject to social security and medicare taxes, but are exempt from FUTA tax. Domestic wages paid to a spouse are exempt from social security and medicare tax as well as FUTA tax. In Ross v. Comm., T.C. Summary Opinion , Ms. Ross did consulting and tax preparation and employed her children, ages 8, 11, and 15. The children performed various services including shredding, filing, trash removal, etc. Although Ms. Ross kept time records, no payroll checks were issued and payments were made directly to third parties as directed by her children. The court concluded these wages were not properly deductible. The court discussed general factors that would not support a deduction. Review Dumond v. Comm., T.C. Summary Opinion , (January 31, 2005) where wages to children (ages 10 and 5) were disallowed when received in a lump sum at year end, checks were not cashed until the following year and proceeds went back into the parent s account. Also see Denman v. Comm., 48 T.C. 439 (1967) where only 10% of claimed wages to 10 year old and 7 year old children were allowed. A tax planning opportunity arises for parents to pay their children a wage (must provide a W-2) for work in the home or trade/business to provide the earned income basis upon which to

31 contribute up to $5,500 per year into a Roth IRA. Under the basis recovery rules for Roth IRA distributions, the contributions would be available for distribution for college expenses without income taxation and without incurring the 10% early withdrawal penalty. Also, under current law, the funds held in a Roth IRA account would not be considered a resource for college financial aid purposes. This appears to be a better investment for college-bound children than educational IRAs, if one must choose between the two. However, a Roth IRA contribution will not preclude a contribution to an educational IRA in the same year. The issue also arises whether part-time day laborers are employees or independent contractors. In a farm setting it would seem difficult to find that these laborers are anything other than employees, as the employer is in control of hours, and the laborers do not bring any equipment to the job site. In order to protect the employer in the event of their injury, the employees need to be covered under a workman s compensation insurance policy. In September of 2011, the Service announced a Voluntary Worker Classification Settlement Program. (VCSP) (IRS Announcement, ; IR ). In December of 2012, the VCSP was modified in IRS Announcement ; I.R.B The VCSP permits a taxpayer under IRS audit, other than an employment tax audit, to be eligible to participate. The current eligibility requirements are clarified to provide (a) that a taxpayer who is a member of an affiliated group within the meaning of section 1504(a) is not eligible to participate in the VCSP, if any member of the affiliated group is under employment tax audit, b) that a taxpayer is not eligible to participate if the taxpayer is contesting in court the classification of the class or classes of workers from a previous audit by the IRS or Department of Labor, and c) eliminates the requirement that a taxpayer agree to extend the period of limitations on assessment of employment taxes as part of the VCSP closing agreement with IRS.

32 SELF-EMPLOYMENT TAX ISSUES REGARDING LIVESTOCK CONFINEMENT BUILDINGS If a sole proprietor constructs a confinement building, places their own livestock in the building, provides all management and labor, and pays all expenses, certainly the farmer is materially participating and any net profit will be subject to self-employment tax. The self-employment tax issues become blurred when farm owners construct agricultural production facilities which are subject to a contractual production agreement with a third party tenant/producer. Whether self-employment tax is incurred or not will likely be determined by the extent of involvement the owner retains with regard to the livestock and facilities. In Gill v. Comm. T.C. Memo , the Tax Court determined that self-employment tax liability applied to all payments received by two taxpayers who constructed a poultry facility that was supplied with poultry from a third party. The taxpayers received a monthly payment from the supplier of the poultry flock and were required to perform certain maintenance items, inspections and general flock management responsibilities. The Court held that rental income which was not subject to selfemployment tax, included only payments for use of space and only such services that are required to maintain the property. Further, any exemption from self-employment tax should be narrowly construed. A similar holding resulted where amounts received under a contract to grow sugar beets were subjected to self-employment tax. Schmidt v. Comm., T.C. Memo Under many contractual arrangements regarding livestock confinements, virtually all operating expenses, inventory, and overhead associated with the building are the responsibility of the tenant/producer, rather than the building owner. To avoid having the income being subjected to self-employment tax, the building owner must not participate to a significant degree or bear a substantial risk of loss. One option may be to split the contractual arrangement into two separate agreements. One agreement would be strictly for the rental of the building and a 1099 would be issued showing that this would be rental income exempt from self-employment tax. Given that the capital costs for such buildings are so large, a return on capital shown as rent should not be unreasonable. A second agreement would be entered into providing for herd/flock management. A separate 1099 for nonemployee compensation or a W-2 would be issued for any payments made under this second agreement and said payments would be subject to self-employment tax or FICA tax. If this payment is to a third party and not the owner of the facility, certainly no self-employment tax would be due as the activity of another could not be imputed to the facility owner. However, taxpayers attempting to split payments from shipping companies between lease payments and wages for driving the trucks were found to not actually lease the trucks and all income was to be treated as wage income. Escobar de Paz v. Comm., T.C. Memo , (May 26, 2000). Also see Delno v. Celebrezze, 347 F2.d 159 (9 th Cir. 1965) where the Court held income to be subject to self-employment tax where owner performed services of a substantial nature. In Tax Court Memo Decision, the Court held that rent paid by the taxpayers controlled corporation to the taxpayers, individually, at a rate of $21 per pig run through the building, was held to be subject to self-employment tax. Solvie v. Comm., T.C. Memo , (March 9, 2004). The rent paid on the new building was double the rent paid to the taxpayers on their other buildings and the rent calculation was based on the number of hogs run through the building, not strictly the number of pig spaces. The Solvies wages did not increase even though the number of hogs had increased. With high depreciation and large interest expense payments in early years creating a loss, treatment as a rental activity may not be the best from an income tax perspective. The taxpayer may prefer to offset the loss against self-employment income. QUERY: Can the taxpayer change horses in mid-stream when the building is paid for and depreciation deductions are significantly lower? For example, decrease rent (use a triple net lease) and have tenant furnish labor, management and pay for repairs?

33 FARMERS & FISHERMEN INCOME AVERAGING If you are an individual engaged in a farm business or are a fisherman (brought to us by the American Jobs Creation Act of 2004 [AJCA 04]), you are allowed to elect to average your current farm income over three prior base years to obtain the benefit of applying lower income tax rates from those prior years. Farm income averaging, although originally scheduled to be available to farmers for only 1998, 1999 and 2000, has become a permanent feature of the tax law. A farm business, for income averaging purposes, is defined by a cross-reference to IRC Sec. 263A(e)(4), as the trade or business of farming involving the cultivation of land or the raising or harvesting of any agricultural commodity and includes operating a nursery or sod farm or the raising or harvesting of trees bearing fruit, nuts or other crops or ornamental trees. The instructions for Schedule J provide that a farm business does not include contract harvesting of a commodity. Effective for tax years beginning after 7/22/08, income averaging is available for those catching, taking or harvesting (not processing) fish, mollusks, crustaceans, etc. If a taxpayer farms and fishes, the taxpayer must combine both incomes for averaging purposes. Crewmen who are paid a percentage of the catch may also average income. Taxpayers who have farm income during the tax year as a sole proprietor, a partner in a partnership or a shareholder in an S corporation may use income averaging without regard to whether the individual was engaged in a farming business in any prior year. Prop. Reg. Sec (b). Elected farm income, (EFI) which is averaged over the prior three years, is the amount of taxable income attributable to any farming business which is specifically elected by the taxpayer as subject to income averaging. Any portion of taxable income attributable to farming may be designated as elected farm income for averaging purposes, but may not exceed the taxpayers taxable income. Elected farm income may not exceed taxable income for the taxpayer and net capital gain attributable to a farming business may not exceed total net capital gain for the taxpayer. Elected farm income includes net Schedule F income, gain from the sale or disposition of property (other than land or timber) regularly used by a farmer for a substantial period in a farming business and the taxpayers share of net farm income from a partnership, LLC or Sub S Corporation. Final regulations provide that wages to a Shareholder in a Sub S Corporation engaged in farming and the landlord s share of a crop share lease may be included in elected farm income. It does not matter whether the landlord materially participates in the production of the crop. After 2003 there must be a written lease to prove the crop-share lease. The final regulations specify that elected farm income includes all income and gains less deductions and losses (including loss carryovers and carrybacks and including non-farm losses) attributable to an individual s farming business. The regulations state, however, that income, gain or loss from the sale of development rights, grazing rights and other similar rights are not treated as attributable to a farming business. A significant question has been whether elected farm income for the election year can be negative. IRS Publication 225 for the year 2015 provides in part: If your taxable income for any base year was zero because your deductions were more than income, you may have negative taxable income for that year to combine with your EFI on Schedule J.

34 The final regulations provide all allowable deductions including any NOL, are used to determine taxable income even if the result is negative. However, any negative amount that provided a benefit in another taxable year must be added back to the base year taxable amount. Therefore, NOL carried to other years and providing a benefit may not be used. [Reg (d)(2)] The regulations provide a safe harbor for the disposition of property after the cessation of farming. They state if a gain or loss (from the disposition of property) is realized after cessation of a farming business, such gain or loss is treated as attributable to a farming business if the property is sold within a reasonable time after cessation of the farming business. A sale or other disposition within one year of cessation of a farming business is presumed to be within a reasonable time. Whether a sale or other disposition that occurs more than one year after cessation of the farming business is within a reasonable time depends on all the facts and circumstances. [Reg (e)(1)(ii)(B)]. The regulations make it clear that income averaging affects only federal income tax, and has no application to employment taxes (FICA, FUTA, SECA or income tax withholding). Previously, the regulations stated that income averaging does not apply for purposes of figuring alternative minimum tax. However, Section 314(a) of the AJCA-04 provides that in calculating alternative minimum tax, regular tax liability will be determined without regard to farm income averaging. Therefore, taxpayers using income averaging will receive the full benefit of said lower tax rates. Income tax is to be determined by allocating elected farm income to the base years only after all other adjustments and determinations have been made. The regulations allow taxpayers with both ordinary income and capital gain income that are eligible for income averaging to select how much of the elected farm income is made up of capital gain or ordinary income. [Reg (e)(2)(i)]. If the elected farm income includes both ordinary income and capital gain income, the regulations provide such income must be allocated in equal portions among the tax brackets of the three prior years. Capital gains that are included in the tax bracket of a prior year do not offset capital losses from that year. They are taxed at the lesser of the capital gains rate or the ordinary income tax rates for the prior year. [Reg (d)(1)]. Net capital losses first offset net capital gains, both farm and nonfarm, before reducing ordinary income. [Reg (e)(ii), Ex. 3,4]. The rule that capital losses can only offset up to $3,000 or ordinary income per year still applies for purposes of elected farm income calculations, also. [Reg. Sec (e)(ii) Ex. 5]. Thus a taxpayer can elect to carryback only ordinary income or any combination after making these adjustments. The final regulations permit a taxpayer to make changes or revoke the election on an amended return if the statute has not expired. EXAMPLE 1: Kevin and Jane are married with no dependent children, and use the standard deduction. Kevin s Schedule F income for the year is $130,000 and their taxable income is $113,600. In the past, Kevin and Jane have been reporting taxable income in the 10%/15% bracket. Assume taxable incomes for tax years 2012, 2013 and 2014 are $16,000, $17,000 and $18,000 respectively. Each of 2012, 2013 and 2014 would need approximately $58,000 of additional taxable income to reach the top of the 10%/15% tax bracket. Kevin and Jane could elect to average all of their current farm income or gains, up to their 2015 taxable income, and keep the elected farm income in the 15% bracket. We will assume for this example that only $96,600 is averaged with approximately $38,700 being removed from the 25% bracket. This would reduce their current tax liability by approximately $38,700 of income x 10% or approximately $3,870. See Example 1 on Schedule J following, which shows actual savings totaling $3, [$19, regular tax less $16,070 Schedule J tax].

35 EXAMPLE 2: Assume Kevin and Jane had the following income for the three base years and 2015: 2012 ($50,000) (includes $30,000 NOL) 2014 $ 1, , $150,000 Also assume electable farm income for 2015 is $93,000. Kevin and Jane must eliminate the NOL from the base year 2012, therefore, base year income becomes ($20,000). Base years plus elected farm income 2012 ($20,000) + 31,000 = 11, $15, ,000 = 46, , ,000 = 32,500 Tax computations are as follows: Base year Share of Income after Income tax Income tax Add l. tax Base Income elected share of elected with farm without farm due to Year as adjusted farm income farm income income avg. income avg. EFI 2012 ($20,000) $31,000 $11,000 x 10% $1, $ 0 $1, ,000 31,000 46,000 x 10/15% $6, $1,500 4, ,500 31,000 32,500 x 10/15% $3, , Taxable Less elected Income farm income Taxable Income ,000 (93,000) 57,000 x 10/15% 7, INCOME TAX WITH INCOME AVERAGING $17, INCOME TAX WITHOUT INCOME AVERAGING 10% $ 1,845 15% 8, % 18, ,000 $29, INCOME TAX SAVINGS $29, $17, = $12,035 EXAMPLE 3: Kevin and Jane are eligible for income averaging, elect to apply Schedule J to $45,000 of income in 2013, to $60,000 of income in 2014 and $66,000 for the year Their base income for averaging must reflect the additions which occur from their prior income averaging. For example: Base Income $10,000 $10,000 $10,000 $45,000 $60,000 $66,000 EFI 13 15,000 15,000 15,000-45,000 25,000 25,000 25,000 0 EFI 14 20,000 20,000 20,000-60,000 45,000 45,000 20,000 0 EFI 15 22,000 22,000 22,000-66,000 67,000 42,000 22,000 0

36 SCHEDULE J (Form 1040) Department of the Treasury Internal Revenue Service (99) Income Averaging for Farmers and Fishermen Attach to Form 1040 or Form 1040NR. Information about Schedule J and its separate instructions is at DRAFT AS OF May 21, 2015 DO NOT FILE OMB No Attachment Sequence No. 20 Name(s) shown on return Social security number (SSN) EXAMPLE 1 1 Enter the taxable income from your 2015 Form 1040, line 43, or Form 1040NR, line ,600 2a Enter your elected farm income (see instructions). Do not enter more than the amount on line 1 2a Capital gain included on line 2a: b Excess, if any, of net long-term capital gain over net short-term capital loss b c Unrecaptured section 1250 gain c 3 Subtract line 2a from line Figure the tax on the amount on line 3 using the 2015 tax rates (see instructions) } 5 If you used Schedule J to figure your tax for: 2014, enter the amount from your 2014 Schedule J, line but not 2014, enter the amount from your 2013 Schedule J, line but not 2013 or 2014, enter the amount from your ,000 Schedule J, line 3. Otherwise, enter the taxable income from your 2012 Form 1040, line 43; Form 1040A, line 27; Form 1040EZ, line 6; Form 1040NR, line 41; or Form 1040NR-EZ, line 14. If zero or less, see instructions. 96,600 17,000 1,700 6 Divide the amount on line 2a by ,200 7 Combine lines 5 and 6. If zero or less, enter ,200 8 Figure the tax on the amount on line 7 using the 2012 tax rates (see instructions) } 9 If you used Schedule J to figure your tax for: 2014, enter the amount from your 2014 Schedule J, line but not 2014, enter the amount from your 2013 Schedule J, line ,000 Otherwise, enter the taxable income from your 2013 Form 1040, line 43; Form 1040A, line 27; Form 1040EZ, line 6; Form 1040NR, line 41; or Form 1040NR-EZ, line 14. If zero or less, see instructions. 6, Enter the amount from line , Combine lines 9 and 10. If less than zero, enter as a negative amount 11 49, Figure the tax on the amount on line 11 using the 2013 tax rates (see instructions) , If you used Schedule J to figure your tax for 2014, enter the amount from your 2014 Schedule J, line 3. Otherwise, enter the taxable income from your 2014 Form 1040, line 43; Form 1040A, line 27; Form 1040EZ, line 6; Form 1040NR, line 41; or Form 1040NR-EZ, line 14. If zero or less, see instructions , Enter the amount from line , Combine lines 13 and 14. If less than zero, enter as a negative amount 15 50, Figure the tax on the amount on line 15 using the 2014 tax rates (see instructions) , Add lines 4, 8, 12, and For Paperwork Reduction Act Notice, see your tax return instructions. Cat. No Y Schedule J (Form 1040) ,170 Schedule J (Form 1040) 2015 Page 2 18 Amount from line , If you used Schedule J to figure your tax for: 2014, enter the amount from your 2014 Schedule J, line but not 2014, enter the amount from your 2013 Schedule J, line but not 2013 or 2014, enter the amount from your ,600 Schedule J, line 4. Otherwise, enter the tax from your 2012 Form 1040, line 44;* Form 1040A, line 28;* Form 1040EZ, line 10; Form 1040NR, line 42;* or Form 1040NR-EZ, line ,700 DRAFT AS OF May 21, } 2015 DO NOT FILE 20 If you used Schedule J to figure your tax for: 2014, enter the amount from your 2014 Schedule J, line but not 2014, enter the amount from your 2013 Schedule J, line 4. Otherwise, enter the tax from your 2013 Form 1040, line 44;* Form 1040A, line 28;* Form 1040EZ, line 10; Form 1040NR, line 42;* or Form 1040NR-EZ, line If you used Schedule J to figure your tax for 2014, enter the amount from your 2014 Schedule J, line 4. Otherwise, enter the tax from your 2014 Form 1040, line 44;* Form 1040A, line 28;* Form 1040EZ, line 10; Form 1040NR, line 42;* or Form 1040NR-EZ, line } 1,800 *Only include tax reported on this line that is imposed by section 1 of the Internal Revenue Code (see instructions). Do not include alternative minimum tax from Form 1040A. 22 Add lines 19 through , Tax. Subtract line 22 from line 18. Also include this amount on Form 1040, line 44; or Form 1040NR, line ,070 Caution: Your tax may be less if you figure it using the 2015 Tax Table, Tax Computation Worksheet, Qualified Dividends and Capital Gain Tax Worksheet, or Schedule D Tax Worksheet. Attach Schedule J only if you are using it to figure your tax. Schedule J (Form 1040) 2015

37 SCHEDULE J (Form 1040) Department of the Treasury Internal Revenue Service (99) Income Averaging for Farmers and Fishermen Attach to Form 1040 or Form 1040NR. Information about Schedule J and its separate instructions is at DRAFT AS OF May 21, 2015 DO NOT FILE OMB No Attachment Sequence No. 20 Name(s) shown on return Social security number (SSN) EXAMPLE 2 1 Enter the taxable income from your 2015 Form 1040, line 43, or Form 1040NR, line ,000 2a Enter your elected farm income (see instructions). Do not enter more than the amount on line 1 2a Capital gain included on line 2a: b Excess, if any, of net long-term capital gain over net short-term capital loss b c Unrecaptured section 1250 gain c 3 Subtract line 2a from line Figure the tax on the amount on line 3 using the 2015 tax rates (see instructions) } 5 If you used Schedule J to figure your tax for: 2014, enter the amount from your 2014 Schedule J, line but not 2014, enter the amount from your 2013 Schedule J, line but not 2013 or 2014, enter the amount from your ,000 Schedule J, line 3. Otherwise, enter the taxable income from your 2012 Form 1040, line 43; Form 1040A, line 27; Form 1040EZ, line 6; Form 1040NR, line 41; or Form 1040NR-EZ, line 14. If zero or less, see instructions. 93,000 57,000 7, Divide the amount on line 2a by ,000 7 Combine lines 5 and 6. If zero or less, enter ,000 8 Figure the tax on the amount on line 7 using the 2012 tax rates (see instructions) } 9 If you used Schedule J to figure your tax for: 2014, enter the amount from your 2014 Schedule J, line but not 2014, enter the amount from your 2013 Schedule J, line ,000 Otherwise, enter the taxable income from your 2013 Form 1040, line 43; Form 1040A, line 27; Form 1040EZ, line 6; Form 1040NR, line 41; or Form 1040NR-EZ, line 14. If zero or less, see instructions. 1, Enter the amount from line , Combine lines 9 and 10. If less than zero, enter as a negative amount 11 46, Figure the tax on the amount on line 11 using the 2013 tax rates (see instructions) , If you used Schedule J to figure your tax for 2014, enter the amount from your 2014 Schedule J, line 3. Otherwise, enter the taxable income from your 2014 Form 1040, line 43; Form 1040A, line 27; Form 1040EZ, line 6; Form 1040NR, line 41; or Form 1040NR-EZ, line 14. If zero or less, see instructions , Enter the amount from line , Combine lines 13 and 14. If less than zero, enter as a negative amount 15 32, Figure the tax on the amount on line 15 using the 2014 tax rates (see instructions) , Add lines 4, 8, 12, and , For Paperwork Reduction Act Notice, see your tax return instructions. Cat. No Y Schedule J (Form 1040) 2015 Schedule J (Form 1040) 2015 Page 2 18 Amount from line , If you used Schedule J to figure your tax for: 2014, enter the amount from your 2014 Schedule J, line but not 2014, enter the amount from your 2013 Schedule J, line but not 2013 or 2014, enter the amount from your Schedule J, line 4. Otherwise, enter the tax from your 2012 Form 1040, line 44;* Form 1040A, line 28;* Form 1040EZ, line 10; Form 1040NR, line 42;* or Form 1040NR-EZ, line ,500 DRAFT AS OF May 21, } 2015 DO NOT FILE 20 If you used Schedule J to figure your tax for: 2014, enter the amount from your 2014 Schedule J, line but not 2014, enter the amount from your 2013 Schedule J, line 4. Otherwise, enter the tax from your 2013 Form 1040, line 44;* Form 1040A, line 28;* Form 1040EZ, line 10; Form 1040NR, line 42;* or Form 1040NR-EZ, line If you used Schedule J to figure your tax for 2014, enter the amount from your 2014 Schedule J, line 4. Otherwise, enter the tax from your 2014 Form 1040, line 44;* Form 1040A, line 28;* Form 1040EZ, line 10; Form 1040NR, line 42;* or Form 1040NR-EZ, line } 150 *Only include tax reported on this line that is imposed by section 1 of the Internal Revenue Code (see instructions). Do not include alternative minimum tax from Form 1040A. 22 Add lines 19 through , Tax. Subtract line 22 from line 18. Also include this amount on Form 1040, line 44; or Form 1040NR, line , Caution: Your tax may be less if you figure it using the 2015 Tax Table, Tax Computation Worksheet, Qualified Dividends and Capital Gain Tax Worksheet, or Schedule D Tax Worksheet. Attach Schedule J only if you are using it to figure your tax. Schedule J (Form 1040) 2015

38 EXAMPLE OF INCOME TAX TREATMENT OF CCC LOANS Consider the following example: Assume CCC loan received October 15, 2015 $10,000 Price of corn when resold 45,000 Activity I.R.C. Sec. 77 Election Made Loan Reported as Income Upon receipt of loan Report Income in 2015 of $10, Paid cash in the amount of Basis remains the same in corn $10,000 to redeem corn from CCC Corn sold in 2016 after Income of $45,000-$10,000 or redeeming corn $35,000. I.R.C. Sec. 77 Election Made Loan Not Reported as Income No entry (loan) Basis remains the same in corn Income of $35,000 TOTAL INCOME $45,000 $35,000 Due to the current grain prices and low county posted rates, no taxable gain on redemption of grain will occur. If there is a taxable gain on redemption of the grain due to the loan reduction, this will be reported on CCC 1099-G and will need to be reported on Schedule F line 6(a) and on 6(b). Other commentators may have a different opinion on handling these loans and repayments. An argument can be made that when an election has been made under I.R.C. Sec. 77 to report the loan as income, and loan is repaid, the basis of the commodity is reduced and no gain on the repayment of the loan would be recognized. See Rev. Rul , C.B. 41 and I.R.C. Sec. 1016(a)(8). When the commodity is sold the gain would be recognized by having a lower cost basis in the commodity. This difference of opinion does not change the total amount of income to be reported, but may result in a timing difference as to when it will be reported. Please review the instructions and examples as set forth in Publication 225, Farmer s Tax Guide. These instructions and examples clearly set forth authority to defer recognition of the market gain until the commodity is sold, when you have made an I.R.C. Sec. 77 election. The authors believe, however, that this reduction in the loan amount is a planned payment of the marketing assistance loan program and should be recognized at the time the loan is repaid. The sealing of the commodity and redeeming the loan for less than face value are two distinct transactions. WHEN REPORTING THE LOAN AS INCOME (ELECTION UNDER I.R.C. SEC. 77), THE FOLLOWING APPLY: 1. When the loan is received you have, in effect, sold the grain. Taxwise, it is the same as if grain was sold to the elevator. 2. If the grain is redeemed and the loan repaid, you are in effect using a planned program payment to reduce the amount of the loan and the difference should be recognized as income. 3. If the grain is redeemed and the loan is repaid, the cost basis of the grain would remain the same.

39 4. If the grain is resold, deduct the cost basis of the reacquired grain when resold. If the grain is used as livestock feed, deduct the cost basis as the grain is fed. (Query or as a prepaid feed expense?) WHEN REPORTING A LOAN AS A LOAN (NO ELECTION UNDER I.R.C. SEC. 77), THE FOLLOWING APPLY: 1. When the loan is received it is simply a loan, and should not be reported as income any more than a bank loan would be. 2. The taxpayer does not deduct anything when paying off the loan principal. The treatment is no different than when paying off a bank loan. However, the taxpayer will report as income the portion of the program payment used to reduce the loan amount, upon redemption. 3. When grain is sold or fed, there is no basis to deduct. Instead, report the proceeds from the sale of grain or the sale proceeds of the livestock as income. The election to treat the loan as income is made on the return by simply reporting loan proceeds as income. The I.R.C. Sec. 77 Election must be made on a timely filed return and not on an amended return. (Rev. Rul ). This election may be made at any time, but will cover all commodities for the tax year. Treas. Reg. Sec Where one obtains a loan and pays the loan off within the same year, there is nothing to indicate an election to treat loan proceeds as income. See Thompson v. Comm., 322 F 2 d. 122 (5th Cir. 1963). However, see Isaak v. Comm., 400 F 2 d. 869 (9 th Cir. 1968), where the Court held that income needs to be reported in an amount equal to the loan amount, even if the loan is repaid during the same tax year. Where one has not made an election to treat loan proceeds as income, such person is free at any time and without prior approval to make such an election. See Rev. Rul for tax years prior to Once the election was made, it had to be followed in all subsequent years until a change was authorized by IRS pursuant to an application to change accounting method. If the taxpayer elected to report the loan as income under IRC Sec. 77, the practice had to continue unless a change of accounting was approved by the Service. The taxpayer had to file Form 3115 within the first 180 days of the tax year in which the change would have become effective. In January of 2003, the IRS issued a new Revenue Procedure for tax years after 12/31/01, (Rev. Proc , IRB ) which permits the taxpayer... to change it s method of accounting for loans received from the Commodity Credit Corporation from including the loan amount in gross income for the taxable year in which the loan is received to treating the loan amount as a loan. Farmers may automatically change back to the loan method by filing Form 3115 for the year of the change. A copy of Form 3115 should be attached to the taxpayer s tax return and a copy should be separately sent to the Internal Revenue Service, Associate Chief Counsel (domestic) Attention: ITA-Automatic Ruling Branch, P.O. Box 7604, Benjamin Franklin Station, Washington,.D.C See Section D of Tax Manual for Form Further guidance has been provided in Rev. Proc , C.B. 587, which preserves this procedure and leaves the statutory authority for this procedure the same. Upon the death of a farmer, who had previously made an I.R.C. Sec. 77 Election, it may be advantageous for the personal representative to file Form 3115, if carryover basis rules allow a step up in basis to the fair market value for the commodities. A possible issue may arise as to whether a pre-death CCC loan would be treated as IRD. IRS Notice provides that taxable market gain incurred when CCC loans are repaid after January 1, 2007, will need to be reported on CCC 1099-G, regardless of whether the loan was repaid with cash or CCC certificates.

40

41 CRP PAYMENTS There were a variety of situations and not always a clear answer as to how the income from CRP payments should be reported and whether it is subject to self-employment tax. A 1996 Tax Court case, Ray v. Comm., T.C. Memo , 72 T.C.M. 780, held CRP payments to be subject to selfemployment tax when received by a materially participating landowner and the payments had a "direct nexus" with the farming operation. Further, Ltr. Rul , May 1, 1996, found that CRP payments received by taxpayers that leased all of their remaining cropland to a Subchapter "S" corporation to be subject to self-employment tax. In Wuebker v. Comm., 110 T.C. No. 431, (June 23, 1998), the Tax Court concluded the CRP payments were rental income from real estate and were exempt from self-employment tax under IRC Sec. 1402(a)(1). The facts of this case were that Wuebker, a materially participating farmer, had placed 214 acres of land in a 10 year CRP contract in 1991 and received approximately $18,000 of CRP payments in 1992 and The taxpayer reported these as rents on Schedule E. The Tax Court found that the federal legislation authorizing the Conservation Reserve Program described these payments as rental income. The Court further found that Wuebker had done little in 1992 and 1993 to service or keep up the CRP ground. The Tax court appears to distinguish the Wuebker Case from the Ray Case by pointing out that the issue of equating the CRP payments to rent never arose in the Ray Case. The Tax Court further points out that a finding of these payments to be the equivalent of rental income makes the direct nexus issue of Ray a moot point. Upon appeal, the Sixth Circuit in a split decision reversed the Tax Court, finding that CRP income received by a farmer is subject to self-employment tax. Wuebker V. Comm., USTC 50254, CA-6, 3/3/2000. The Sixth Circuit found a direct nexus to the farming activity and disregarded all rental terminology. CAUTION: The Iowa Department of Revenue is only permitting a capital gain exclusion on CRP farm real estate sales when payments were reported for self employment tax purposes. It appears that some early refund claims were processed, but the IRS Service Centers then denied the refund claims. The denials stated The IRS is not following the Wuebker decision. CRP payments are subject to self-employment tax. In 2003 Chief Counsel s Ruling CCA Ltr. Rul was released. This Ruling involved two different situations. The first involves an active farmer who had bid land into the Conservation Reserve Program and the Ruling, not unexpectedly, states the payments should be included on Schedule F. The second situation is of more concern in that a non-farmer acquired land that had previously been accepted into the Conservation Reserve Program. The Ruling provides that these payments may not be reported on Form 4835 and should be reported on Schedule F. This Ruling seems to be contradictory to prior Ltr. Rul and even to the Ray Case, but gives you an indication as to the IRS s future position regarding these questions. In IRS Notice , IRB No , the Service announced a proposed Revenue Ruling that requires all CRP payments to be treated as earned income and subject to self-employment tax. Comments were requested from the Service through March 19, No final Revenue Ruling has been issued. The IRS appears to be using Notice as authority in some recent audits in the Midwest, particularly out of the Bismarck, North Dakota Office.

42 The Tax Court in Morehouse v. Comm., 140 T.C. No. 15 (2013) held that an investor in land, who had never farmed, needed to report the CRP income as subject to self-employment tax. The Tax Court found the taxpayer s participation in the CRP constituted a trade or business and relied upon the Wuebker Sixth Circuit Case. The Court further concluded that CRP payments were not rentals from real estate. The Morehouse Case was appealed to the U.S. Eighth Circuit Court of Appeals. On October 10, 2014, the U.S. Eighth Circuit Court of Appeals reversed the Tax Court and held that CRP payments are not subject to self-employment tax and are to be treated as rentals from real estate. Morehouse v. Comm., 114 AFTR 2d Your tax clients are able to follow the Morehouse Eighth Circuit decision, however, the IRS has issued a non-acquiescence. In Section 15301(a) of the 2008 Farm Bill, CRP payments received after December 31, 2007 are specifically excluded from self-employment tax for individuals that are receiving social security retirement, survivor or disability payments. The mere receipt of these benefits exempt the CRP payments from self-employment tax, not whether the taxpayer materially participates or files a schedule F or whether the taxpayer has reached full retirement age. See Form SE where the Schedule F assumes inclusion, and then the CRP inclusion amounts are removed from self-employment tax reporting by subtracting them out on line 1(b). Following are various situations that may arise and include possible answers: 1. Beth Renter has always rented her property on a cash rent basis prior to putting her land into the CRP and consequently, does not materially participate in the farming of her property. ANSWER: After the Eighth Circuit s Morehouse decision, reporting the income on Form 4835/Schedule E is appropriate. If Beth is collecting social security retirement or survivor or disability payments, the CRP payments would not be subject to self-employment tax. 2. Melissa Renter rents her property on a crop share lease, actively participates, but does not materially participate and did not pay self-employment tax on the lease income prior to putting the land into the CRP. ANSWER: The answer should be the same as in No. 1 above. 3. Kevin Farmer actively farms and pays self-employment tax on all farm income. ANSWER: Reporting the income on Schedule F and paying self-employment tax would have been the obvious answer prior to the Wuebker Tax Court Case and after the Morehouse Case. 4. Assume Kevin Farmer rents the property on a crop-share basis but materially participates and pays self-employment tax. ANSWERS: The treatment should be the same as for the active farmer in No. 3. Report the income on Schedule F and pay self-employment tax.

43 PATRONAGE DIVIDENDS Patronage dividends can be either qualified or non-qualified. 1. Qualified patronage dividends are those where (1) at least 20% of the total dividend is paid in cash, and (2) the dividend is redeemable in cash within 90 days of issue OR the distributee has consented to report it as income. 2. Non-qualified patronage dividends do not result in taxable income to the patron. However, when the taxpayer actually receives a dividend check, it is taxable income. A non-qualified patronage dividend is the equivalent of a person being on a cash basis; it is taxable when received. Patronage dividends can be paid on: 1. Current business expense items. Examples include dividends paid by reason of the purchase of fuel, fertilizer, chemicals, farm supplies or any other currently deductible expense items. The gross amount of the dividend is reported per the 1099-PATR. The income is reported on Schedule F if the taxpayer is an active farmer or on Form 4835 if the taxpayer is a non-materially participating farmer. If the patronage dividend has been reported and thereafter there is an allocation of loss, the loss is claimed as an expense deduction on Schedule F or Form 4835 as appropriate. 2. Capital items. Examples include the purchase of any capital item that will be placed on the depreciation schedule. Do not include in income patronage dividends from buying capital assets or depreciable property used in your business. Instead, reduce the basis of these assets by the dividends. The loss rebate is an adjustment to the cost of such item and should not be reported on either Schedule F or Form Reduction in basis is made on January 1 of the year of the dividend. It is the equivalent of reporting less depreciation over a period of time. If there is no basis left to reduce, then such rebate is included in gross income. Example: If a tractor has been sold and there was ordinary income as a result of the sale (depreciation recapture), such rebate would be ordinary income on Form 4797 and not on Schedule F or Form Personal items. A patron does not include a patronage dividend to the extent it is due to purchases of personal, living or family items. If the patronage dividend is as a result of being a member of a grocery store cooperative or a store selling personal clothing, the dividend is not taxable income since the cost of the item was not tax deductible. Patronage dividends are reported as follows: The gross amount of a patronage dividend is shown on line 3a, while the taxable amount is shown on line 3b on the Schedule F, or on lines 2a and 2b of Form TAX CONSEQUENCES WHEN COOP STOCK IS GIFTED: 1. If the stock was issued as a qualified patronage dividend, the basis is equal to the face value of the allocation, less the cash received. 2. If the stock was issued as a non-qualified patronage dividend, none of the allocation is included in income, and hence a zero basis results.

44 3. Upon sale or redemption the amount received, less basis, is income. WHAT HAPPENS IN THE EVENT OF DEATH? 1. A qualified patronage dividend receives a step up in basis equal to the fair market value at time of death. Remember, a qualified patronage dividend already has a basis of the taxable allocation less the cash received, but if the value is either higher or lower at date of death, it is adjusted to that value. 2. A non-qualified patronage dividend is equivalent to income in respect of decedent and does not receive a step up in basis. Funds received after death are income. Even though it is IRD, the value of the dividend must be shown for Federal Estate and Iowa Inheritance tax purposes. WHAT HAPPENS IN THE EVENT OF BANKRUPTCY? 1. If a qualified patronage dividend is involved, there is a taxable loss measured by the amount received in bankruptcy, less the basis. 2. If a non-qualified patronage dividend is involved, since nothing had been reported for income tax purposes and no basis exists, there are no income tax consequences.

45 THE WETLANDS RESERVE PROGRAM Iowa was among the states authorized to implement this program. Payment can be made lump sum or over 10 years. Some questions immediately arise: 1. When the easement is granted to set aside the property for use as wetlands, what part of the basis of the property can be deducted? The granting of an easement means ownership of the land is retained by the farm owner. Use is severely restricted so ownership may be virtually useless, except for hunting. Taxes continue to accrue and the owner has exposure from a liability point of view. With the practical use of the land forever given up, Rev. Rul appears to allow one to exhaust basis. In this ruling, the taxpayers were allowed to reduce their basis to zero. 2. Is the amount received a capital gain item? The answer to this question seems to be yes. The portion of the payment for the easement which exceeds basis in the property is treated as long-term capital gain. Report the transaction on Form Additionally, both the ten year ownership requirement and ten year material participation requirements must be met in order to qualify for the Iowa capital gains deduction. 3. Does it qualify as an involuntary taking and hence not taxable with the ability to replace? Again, it is a voluntary program. Accordingly, it is not an involuntary taking. 4. Are expenses in connection with a farm that is in the CRP deductible as soil and water conservation expenses? The answer to this question seems to be yes if one is in the business of farming. The 2008 Farm Act provides that a taxpayer engaged in the business of farming will be allowed to treat expenditures paid or incurred by the taxpayer during the tax year for the purpose of soil or water conservation in respect of land used for farming, or the prevention of erosion of land used in farming, or for endangered species recovery as expenses not chargeable to capital account. There are rather severe and continuing restrictions. There are limited use restrictions with respect to the land, such as a single cutting of hay, reforestation, and limited pasturing. Any cost to conserve the property should qualify as deductible soil and water conservation expenses. 5. If the property is sold, is there recapture of the deduction of such expenses? If such expenses are deducted, recapture of these IRC 1252 expenses is applicable upon sale. If the property is sold within five years of the expenses, there is 100% recapture. After 5 years the recapture amount decreases by 20% for each year that elapses after the initial five years. 6. Is there a deduction for reforestation? A taxpayer (other than a trust) may elect to expense up to $10,000 ($5,000 MFS) of qualified reforestation expenditures each tax year for each qualified timber property. A taxpayer may elect to amortize over 84 months amounts for which a current deduction is not elected. IRC 194. The expense election may be made by estates. Both trusts and estates may make the amortization election. Election guidance is provided in Notice The basis of the property can be deducted as an offset against the Wetlands Reserve Program receipts. It appears that the use need not be prorata or on a per acre basis. However, the deduction is limited to the taxpayer s basis. Once the basis is exhausted, all receipts in excess of basis are income.

46 CASH RENTAL PROPERTY AND WATERWAY IMPROVEMENTS (IRC 126) Assume a cash rental property is improved with waterways with the following factual situation: 240 acres cash rented for $100 per acre = $24, Waterway constructed at a cost of 18, Increase in the value of the farm 10, SCS cost sharing received 9, A. Can the cost of the waterways be expensed if the farm is cash rented? The answer is no. The land is not considered as being used in the business of farming. The return is not dependent upon production and the income is passive. The cost must be capitalized. Since it is an earthen structure, it is not depreciable. B. Can the cost of the waterways be expensed as a soil or water conservation expense if the farm is crop shared? The answer is yes. The return is entirely dependent upon production and hence the cost can be expensed. The expense is limited to 25% of the gross income from farming, in this example $24, x 25% = $6, C. Reverting back to the cash rental situation, can the SCS payment of $9, be excluded from income under the provisions of Section 126 of the Code? There are three tests to be met: 1. The payment must not be for a currently deductible expense. This test is met. 2. The project must be one made primarily for conserving soil and water resources, improving forests for providing habitat for wildlife. Since SCS approved, this test is met. 3. The project cannot substantially increase the annual income of the property. Such increase is considered substantial if it exceeds the greater of: a. 10% of the annual gross income of the affected property before the improvement or b. $2.50 multiplied by the number of acres. In (a) above, $24, x 10% = $2, is greater than (b) which would be $2.50 x 240 = $ As a result, the exclusion will be allowed if this project does not result in an increase in annual rent of more than $2, There is a further limitation the same being: a. That the fair market value of 10% of the annual gross income or

47 b. $2.50 per acre multiplied by the number of acres plus the owner s unreimbursed costs must be more than the increase in fair market value because of the improvements. value. The value of improvements to the farm resulted in $10, increase in fair market To determine the excludable portion of the FSA payment of $9,000.00, one proceeds as follows: The excludable portion is defined as the present fair market value of the greater of: A. $24, x 10% or $2, or B. $2.50 x 240 acres or This results in $2, being the greater and to determine the present FMV one divides $2, by an assumed FMV factor (e.g..08%) with a result that the present FMV is $30, To determine if the $9, payment can be excluded: Test 4(A): 1. Value added by improvement $ 10, Excludable present FMV of $2, Which is $2, divided by.08, or (30,000.00) 3. Less taxpayer s net cost of $18,000.00) Total, less FSA payment of (9,000.00) ( 9,000.00) Hence, since 1 less 2 & 3 is minus $(29,000.00) Taxpayer meets this test Finally to see if the value added by the improvement is less than the $2.50/acre x 240 acres or $ divided by.08, one proceeds: If no income, then value added by the improvement: This is Test 4(B) 1. Value added by improvement $10, Less $2.50/acre x 240 acres = $ = ( 7,500.00) 3. Less costs out of pocket of $18, Less FSA payment of $9, = ( 9,000.00) Hence excludable ( 6,500.00) Since less than zero, taxpayer meets this test. CONCLUSION: As a result, the $9, FSA payment can be excluded from taxable income. The FSA payment is reported on Schedule F as received but is not shown as taxable. The net result is that

48 the taxpayer has expended $18, and has received from FSA $9,000.00, without income tax consequences and hence, this leaves just $9, to be depreciated. RECAPTURE: In event the property is sold within 19 years there will be recapture of the excluded cost showing payments multiplied by the percentage: 10 years 100% Recapture Less than 15 50% Less than 11 90% 16 40% 12 80% 17 30% 13 70% 18 20% 14 60% 19 10% More than 19-0-

49 QUALIFIED CONSERVATION CONTRIBUTIONS 1. A qualified conservation contribution is a contribution A.) of a qualified real property interest B.) to a qualified organization C.) exclusively for conservation purposes IRC Sec. 170(h)(1) 2. A qualified real property interest is any one of the following interests in real property: A.) the entire interest of a donor other than a qualified mineral interest; B.) a remainder interest; C.) a restriction (granted in perpetuity) on the use which may be made of real property; for example, a permanent conservation easement which is the most common form of a qualified conservation contribution. IRC Sec. 170(h)(2) 3. A deduction for a permanent conservation easement is allowed for the difference between the fair market value of the property before the easement and the fair market value of the property after the easement. 4. As of the date of this publication, taxpayers making a qualified conservation attribution will be able to deduct up to 30% of the taxpayer s contribution base (i.e. AGI). Excess contributions are carried over up to 5 years. IRC Sec. 170(b)(1)(E). 5. If Congress extends the pre-january 1, 2015 code provision, a qualified farmer or rancher, (i.e. a taxpayer whose gross income from farming is greater than one-half of the taxpayer s gross income) a qualified conservation contribution shall be deductible up to 100% of the taxpayer s contribution base (i.e. AGI). IRC Sec. 170(b)(1)E(iv). Excess contributions are carried over up to 15 years. IRC Sec. 170(b)(1)E. Corporations which are not publicly traded also qualify for this limit and carryover. IRC Sec. 170(b)(2). For taxpayers other than qualified farmers or ranchers, a qualified conservation contribution shall be deductible up to 50% of the taxpayer s contribution base (i.e. AGI). Excess contributions are carried over up to 15 years. IRS Sec. 170(b)(1)(E). 6. Taxpayers must comply with substantiation requirements set out in the Internal Revenue Code in order to receive the charitable contribution deduction. See Elizabeth Bruzewicz and Howard Prossnitz v. U.S., No.1:07-cv-04074, United States District Court for the Northern District of Illinois (Mar. 25, 2009). Also see DiDonato, et ux v. Commissioner, TC Memo (June 29, 2011), where the Taxpayer was denied a charitable deduction for a conservation easement for failing to meet substantiation requirements of IRC Sec. 170(f)(8). 7. In Wachter v. Comm., 142 TC No. 7 (March 11, 2014) the Court held that even though under North Dakota law, easements were limited to 99 years, the conservation easement was only deductible, if perpetual.

50 8. Iowa Law A. There is a charitable conservation tax credit for real property conveyed as an unconditional charitable donation in perpetuity to a qualified organization exclusively for conservation purposes. The tax credit is fifty percent of the fair market value of a qualified real property interest located in Iowa. The maximum amount of the credit is $100,000. The amount of the contribution for which the tax credit is claimed is not deductible as an itemized deduction. I.C.A (W). B. The terms conservation purpose, qualified organization and qualified real property interest have the same meaning as under Section 170(h) of the Internal Revenue Code, except that a conveyance of land for open space for the purpose of fulfilling density requirements to obtain subdivision or building permits is not considered a conveyance for a conservation purpose. C. Any tax credit in excess of the tax liability is nonrefundable. The excess may be carried forward for up to twenty years. An individual may claim a proportionate share of the pass through tax credit from a partnership, limited liability company, S corporation, estate, or trust. The share of the individual shall be based on the individual s pro rata share of earnings of the partnership, limited liability company, S corporation, estate or trust. D. The tax credit is retroactive to January 1, 2008, for tax years beginning on or after that date. Section V, Code of Iowa.

51 HEDGING VS. SPECULATION HEDGING: Commodity future contracts are used by farmers to hedge against the risk of price fluctuations to farm inventory, and to lock in market positions. Gain or loss on these contracts represents ordinary income or loss, normally reported on Sch F upon the closing of the transaction. Alternatively, a farmer can make an election to mark-to-market all hedging transactions during the year and report this gain or loss on Sch F. IRC Reg (e)(1)(ii). NOTE: If the price of your commodity (i.e. hogs, cattle, corn or soybeans) goes up in value, a short (sale) position in the market should go down. One should balance or offset the other. The net result will be that the hedge maintains your position. Hedging transactions which are clearly identified as such before the close of the day upon which they are entered into are removed from capital asset status. IRC 1221(a)(7). A transaction that is not properly identified as a hedge or that fails to meet the definition of a hedging transaction is considered a speculative transaction involving a capital asset. IRC Reg (g)(2) and IRC 1256(e)(1). Failure to properly identify a transaction as a hedging transaction can result in elimination of the ordinary income or loss status of the transaction. SPECULATION: Farmers might also speculatively enter into a commodity future contract with the intention of making a profit on the transaction itself. This is speculation and speculative contracts are reported under marked to market rules which treat such contracts as sold at market value on the last business day of the tax year, whether they are closed by year-end or not. IRC 1256(a)(1). Speculative contracts are reported on Form The capital gain or loss is treated, by statute, as 40% short-term and 60% long-term. These amounts are transferred from Form 6781 to Schedule D and matched against other short-term and long-term gains and losses. NOTE: A farmer who harvests corn, sells it, and buys futures in the market place believing the sale is the better course of action as compared to storing the commodity. ****************************************************************************************************** HEDGING - IDENTIFICATION AND RECORDKEEPING: 1. Same day rule. Under IRC 1221(a)(7), a taxpayer that enters into a hedging transaction, including recycling an existing hedging transaction, must clearly identify it as a hedging transaction before the close of the day on which the transaction was entered into. a. Acceptable identification methods include placing hedging transactions in a separate account that has been identified as containing only hedges; or b. Making notations or other identifying marks within books and records, such as notations on trading tickets, purchase orders, or confirmations. IRC Reg (f)(4)(iv) day rule. In addition, the taxpayer must identify the item or risk being hedged in a substantially contemporaneous manner. The regulations require that the taxpayer must identify the item being hedged and the type of risk being hedged not more than 35 days after entering into the hedging transaction. IRC Reg (f)(2). FAILURE TO MEET SAME DAY IDENTIFICATION RULE: 1. If the transaction was identified as a hedge and is actually speculative, any gain is ordinary but loss is capital. IRC Reg (g)(1)(i). 2. If the transaction was inadvertently identified as a hedge and is actually speculative, gain or loss is capital. IRC Reg (g)(1)(ii).

52 3. If the transaction was not identified as a hedge, gain or loss is capital, even if it would otherwise have been a hedge unless the taxpayer can establish there was an inadvertent error. IRC Reg (g)(2)(i) and (ii). 4. Under an anti-abuse rule, if the taxpayer purposely does not make an identification (i.e. wants capital gain treatment on a gain), the gain is ordinary. IRC Reg (g)(iii). ADDITIONAL CRITERIA FOR HEDGING STATUS: 1. The futures or option contact must be in commodities which are purchased or raised by the farmer, and be within the farmer s range of production. 2. The futures or option contract must be opposite the farmer s physical position in farm commodities on hand or to be acquired, so as to constitute a price hedge [IRS Publ. 225, Chapter 8]. a. If the farmer grows a crop or raises livestock, the purchase of a put or going short futures will qualify as a hedge. b. If the farmer raises livestock and needs to purchase grain, the purchase of a call or going long futures will qualify as a hedge. 3. A taxpayer can enter into additional hedging transactions to counteract all or any part of the risk from a previous hedging transaction. IRC Reg (d)(3). 4. A taxpayer may hedge all or any portion of a risk for all or any part of the period during which it is exposed to the risk including crops that may not yet be planted for multiple years. IRC Reg (d)(7)(i). 5. Hedging must be performed by the entity that owns the inventory. Another entity, even if under identical ownership cannot hedge a commodity for the other entity. In Welter v. Comm r, TC Memo (Oct. 29, 2003), a farmer engaged in commodities transactions through personal brokerage accounts. His farming operation, however, was conducted by S corporations that utilized land that the farmer leased to them. The farmer claimed hedge treatment on his commodity trading activity and the IRS disagreed. The commodity trading activity was related to the business activity of the corporations. The farmer was personally engaged in the transactions, and the business activities of the corporations could not be attributed to the farmer. ADDITIONAL EXAMPLES: The taxpayer planted 200 acres of soybeans and expected a yield of 50 bu/acre or 10,000 bushels. He buys put options before the crop is planted or while the crop is growing for 10,000 bushels of soybeans on the Board (October contract). Assume he loses $1,500 on the hedge and sells the soybeans for $55,000. Where does he report these items? ANSWER: Schedule F reporting: Sale of soybeans $55,000 Other expense loss on hedge $ 1,500 Assume the same taxpayer, after selling the soybeans, bought 10,000 bushels on the Board, he purchases call options (the right to sell) 10,000 bushels of soybeans. This is speculation. Futures contract cost $55,000 On Dec 30 of the same year, he sold contract for $70,000 ANSWER: The gain is $15,000 reportable on Form $6,000 of the gain is short term capital gain and $9,000 of the gain is long term capital gain. ******************************************************************************************************

53 SPECULATION LOSS CARRYBACKS: Taxpayers can make an election for a 3-year carryback of net IRC 1256 speculation losses to offset any net 1256 gains in those years. IRC 1212(c)(1). SPECULATION - C CORPORATIONS: Since C corporations do not have favorable capital loss treatment, and to ensure the availability of IRC 1256 loss carry backs, care must be taken to make sure that all speculative transactions are done personally or in a pass-through entity. CASH METHOD HEDGING: Report box 9 of $3,300 profit (Schedule F, line 8). MARKED TO MARKET SPECULATION: Report box 12 of $(6,000) loss (Form 6781). NOTE: When farmers enter into hedging transactions that remain open at year-end, they will receive a Form 1099-B reflecting the year-end status of the contracts. Normally, year-end unrealized gains or losses on open regulated futures contracts (i.e. IRC 1256 speculation contracts) are recognized and reported on Form However, hedging transactions are exempt from the IRC 1256 rules. IRC 1256(e). Thus, farmers who enter into hedging transactions generally report gains and losses on Schedule F only when realized. TAX PLANNING: To avoid IRS matching problems, each unrealized gain or loss shown on a Form 1099-B should be reported on Form 6781; but a net hedging gain or loss reversal should also be entered with a description explaining the adjustment. These adjustments should reflect that the reporting of any gain or loss from realized hedging transactions will be reported on Schedule F. The net result of the adjustments on Form 6781 will be to leave the correct speculation gain or loss reported on Form 6781, at line 5.

54 TRANSACTION GUIDE FOR HEDGING TRANSACTIONS Transactions 1. Short sale of commodity contract by producer of commodity (a) Just before planting the crop (b) While crop is growing (c) After crop is sold 2. Purchase of commodity contract (long position) by producer of commodity (a) Just before planting the crop (b) While crop is growing (c) After crop is sold (store-on-the-board-transaction) 3. Purchase of put option (right to sell) by producer of commodity (a) Just before planting the crop (b) While crop is growing (c) After crop is sold 4. Purchase of call option (right to buy) by producer of commodity (a) Just before planting the crop (b) While crop is growing (c) After crop is sold Classification Hedging Hedging Speculation Speculation Speculation Speculation Hedging Hedging Speculation Speculation Speculation Speculation 5. Short sale of commodity contract by user of commodity Speculation 6. Purchase of commodity contract (long position) by user of commodity Hedging 7. Purchase of put option (right to sell) by user of commodity Speculation 8. Purchase of call option (right to buy) by user of commodity Hedging 9. Reversing transaction (commodity market position) to reduce risk in the business 10. Multiple commodity transactions during the growing season-all part of a program that reduces risk Hedging Hedging 11. Partial risk reduction Hedging 12. Hedging price support payments Hedging

55 FEDERAL DISASTER AREA DESIGNATION IOWA EFFECTIVE DATE NATURE OF DISASTER AFFECTED IOWA COUNTIES June 20-25, 2015 DR-4234 Severe storms, tornadoes, straight-line winds and flooding -- taxpayers may deduct losses attributable to these disasters on their 2015 federal income tax returns, or on an amended return for Allamakee, Appanoose, Butler, Clayton, Dallas, Davis, Des Moines, Guthrie, Howard, Jefferson, Lee, Lucas, Marion, Mitchell, Monroe, Warren, Wayne, Winneshiek, and Wright SOURCE: Federal Emergency Management Agency s (FEMA) website -- [

56 PREPAID EXPENSE RULES -- CASH BASIS FARMERS Many farm tax clients typically spend thousands of dollars on year-end prepaid expenses. Thus, it is important to educate those clients about what is required for such a transaction to stand up under audit. The following are four guidelines to be used in determining the viability of these transactions: 1. ACTUAL PURCHASE NOT DEPOSIT. The payment must be for an actual purchase of specific goods, and the invoice for such payment should clearly state a specific quantity, quality, and unit price for those goods. The payment cannot be a deposit, and there should be no right to a refund or sale back at a later date. 2. LEGITIMATE BUSINESS REASON. Farmers must provide a legitimate business reason for prepaying expenses (e.g. early purchase for a better discount, expectation that the cost of goods to be purchased will rise, concerns regarding ability to purchase adequate quantities at later dates, etc.). 3. NO MATERIAL DISTORTION OF INCOME. Cases and rulings have consistently held that prepayments which do not provide benefits extending beyond the next 12 months do not result in a material distortion of income. Rev. Rul Thus, supplies purchased for use in the next crop year (fertilizer, chemicals, seed, fuel, feed, etc.) should pass this test, as long as they will be used within the next 12 months. IRC Regs (a)-4(f) % LIMITATION. The IRS limits the prepaid expenses eligible for deduction to 50% of non-prepaid expenses (including interest expense and depreciation). IRC 464(f) outlines the limitation in greater detail if a farmer comes close to the limit; however, these instances are generally rare. NOTE: A farmer who satisfied the 50% test for the three preceding taxable years (calculated on an aggregate basis average of last 3 yrs.) is exempt from this rule for the current tax year. There are other things to remember when dealing with prepaid expenses: Documentation. The biggest problem is usually documentation of the purchase. Remind your farm clients to get an invoice that includes quantity, quality and price per unit, as well as, total price. Payment. Another concern deals with how payment is made: Charging a purchase on a credit card is acceptable and is considered payment at the time of charge, even though payment of the credit card bill will occur later. A payment by check is considered made once the check is mailed or delivered to the payee, regardless of when that check is cashed by the payee. CAUTION: The farmer should NEVER direct the payee to hold the check for a period of time after receipt, nor should the farmer postdate the check. Payment by check when a bank account is overdrawn is only permissible when sufficient funds can be made available for credit when the check is cashed (e.g. through a bank line of credit). If the funds are not available for the payee at the time the check is presented to the bank, the prepayment is not a legitimate expense in that calendar year for tax purposes.

57 Payment may be made from borrowed funds, whether a bank line of credit or a loan from a lending institution, BUT the funds CANNOT be borrowed from the vendor or payee in the transaction. Payment by promissory note, even when secured by collateral (e.g. letter of credit, etc.) does not produce a deduction. Prepaid Interest. Finally, deductions for prepaid interest are statutorily prohibited. Such payments must be amortized over the period to which they relate. IRC 461(g). Prepaid Rent. Cash method taxpayers are allowed to deduct rent prepayments as long as the prepayment does not extend beyond 12 months. IRC Regs 1.263(a)-4(f)(8), Example 10. Accrual method taxpayers may not take advantage of this prepaid rent rule because of the economic performance rules of IRC Regs These rules provide that payment for the use of property (i.e. rent) may only be deducted ratably over the period of time to which an accrual taxpayer is entitled to use the property.

58 GROUPING FARM ACTIVITIES - SINGLE ECONOMIC UNIT (Grain Storage Facility/Grain Marketing/Hog Production Investments/Farm Rental Property) In the past few years, farmers have been given the opportunity to invest in entities (generally LLCs or "S" corporations) that provide grain farmers with access to grain storage or grain marketing (ethanol plant) facilities and hog producers with access to hog production facilities (breeder stock or feeder pigs). Generally, the farmer's investment in these entities is passive in nature making any pass-through losses currently non-deductible due to a lack of ownership in other passive investments which generate pass-through income. The Internal Revenue Code permits grouping of multiple activities if the activities constitute an "appropriate economic unit" for measuring income, gain or loss for passive activity loss purposes. Taxpayers may use any reasonable effort to make the grouping determination, although the following factors under IRC Reg (c)(2) are given the greatest weight: (a) Similarities and differences in types of business, (b) Extent of common ownership, (c) Extent of common control, (d) Geographical location, and (e) Interdependence between the activities. Purchasing or selling goods between the activities, Having products or services that are normally provided together, Having the same customers, Having the same employees, and Being accounted for with a single set of books and records. A rental activity cannot be combined with a business activity unless either is insubstantial in relation to the other or each owner of the business activity has the same proportionate ownership interest in the rental activity. IRC Reg (d)(1). NOTE HUSBAND/WIFE OWNERSHIP: The regulations do not define the term "insubstantial". Courts have accepted grouping elections when the gross receipts of a rental business are insubstantial (less than 10%) when compared to a business activity. NOTE: The ownership interests of a husband and wife filing a joint return are treated as one for purposes of the proportionate ownership test. IRC Reg IT(j)(1).

59 EXAMPLE - Grain Storage Facility: Lloyd is a sole proprietor grain farmer with inadequate grain storage for his crops. His local Coop is selling memberships in a new LLC that will own and manage a large grain storage facility located at the local elevator. An investment in the LLC will guarantee Lloyd adequate storage for his crops at what Lloyd believes to be a lower out-of-pocket cost than building his own grain storage facility. Accordingly, he invests in the LLC. The Coop's management contract with the LLC is structured such that the LLC will have no income or expense from operating the grain storage facility. LLC members will receive their prorata share of depreciation deductions from the grain storage investment as the only pass-through item on yearly Schedule K-1s from the LLC. Thus, Schedule K-1s will always reflect a pass-through loss that will not be currently deductible to Lloyd as he has no passive income to offset this loss. Although Lloyd does not materially participate in the grain storage LLC, he is allowed to make an election to aggregate (as a single activity) his grain farming proprietorship with his investment in the grain storage LLC since he requires adequate grain storage for his crops. Because Lloyd materially participates in his grain farming operation, he is also deemed to materially participate in the grain facility LLC. Accordingly, any losses reported on the LLC Schedule K-1 will be fully deductible as business losses on Lloyd's Form What if Lloyd did not make a grouping election for these activities until he had accumulated several years of carryover suspended passive losses with regard to his investment in the grain storage LLC? The grouping election converts the prior passive activity to a business activity. Thus, prior carryover suspended losses will be allowed to the extent of profits from Lloyd s farming activities on current and subsequent tax returns. IRC 469(f)(1). NOTE: The above grouping election does not result in income or loss being grouped for self-employment tax purposes. An election to group a grain storage LLC with a sole proprietorship farming operation is included in this Manual at Section D Election and Computation Forms. Also included are election forms for grouping rental real estate, hog breeding operations and an interest in a grain ethanol facility. GROUPING OF RENTAL LAND HOLDINGS: Farmers may want to consider grouping multiple farmland rental activities to allow passive losses from one property to offset income recharacterized as nonpassive income from other properties. This grouping consideration arises because net income from a rental activity may not be considered passive if less than 30% of the unadjusted basis of the property is depreciable. IRC Reg T(f)(3). Thus, this rule converts what appears to be passive rental income into nonpassive income. The rule only applies if net income occurs from the rental activity. If the rental of the land produces a loss, the loss retains its passive character. TAX PLANNING: An aggregation election may be helpful in the case of a farmer or retired farmer who has some land rentals that produce passive losses and others that produce nonpassive income. Normally, there is no advantage to aggregating rental properties because rentals generally are considered passive. However, where land rental is involved, farmland generally will produce nonpassive income as denoted above. If other parcels of farmland produce a loss (due to substantial depreciation, interest, or real estate taxes), the loss is separately

60 considered passive; and, therefore, may not be deductible. By making an aggregation election, the taxpayer can combine all land rentals into a single activity, allowing loss properties to net against income properties, with the aggregation occurring before application of the 30% depreciable basis test. EXAMPLE: Joe owns four separate farms, all of which are cash rented to various tenants. While in the aggregate the four parcels yield net rental income, two produce rental income and two produce rental losses. If Joe, does not make an aggregation election, the two properties with net income will be treated as producing nonpassive income, as each of these properties has less than 30% of its basis in depreciable property. The two properties yielding a loss will be treated as producing passive activity losses (PALs). These PALs would not be deductible on Joe s 2015 return. By making an aggregation election, Joe can treat all farm tracts as a single activity, which means that the losses from the two parcels can offset the income from the other two parcels. NOTE: A closely-held C corporation cannot be grouped with a rental activity for purposes of treating the rental activity as an active business. IRC Reg (d)(5)(ii). ********************************************* REQUIRED DISCLOSURES OF PASSIVE ACTIVITY LOSS (PAL) GROUPINGS Rev. Proc requires taxpayers to include disclosure statements for PAL groupings on their returns, effective for tax years beginning on or after January 25, Thus, for calendar-year taxpayers the new disclosure rules were effective beginning with their 2011 return. No new disclosures were required for groups that existed before January 25, 2010, unless changes to groupings were made. However, some commentators and the author s of this manual believe it is beneficial and desirable to file grouping elections with each year s tax return to document consistency with regard to the grouping election and return preparation. Disclosure statements will be required for new activity groupings, additions to prior groupings or regroupings as set for below: NEW ACTIVITY GROUPINGS: A written disclosure statement must be filed with the original return for the first year in which two or more activities are grouped together into a single activity. The statement must list the names, addresses, and employer identification numbers (if applicable) for the activities that are grouped. The statement must also declare that the activities that are now being grouped together constitute an appropriate economic unit for measuring gain or loss under IRC 469. Rev. Proc (Section 4.02). ADDITIONS TO EXISTING GROUPINGS: For a tax year in which a new activity is added to an existing grouping, the taxpayer must file a written disclosure statement with the original return for that year. The statement must list the name, address, and employer identification number (if applicable) for the new activity and list the same information for the activity or activities within the existing grouping to which the new activity is being added. The statement must also declare that the activities that are now being grouped together constitute an appropriate economic unit for measuring gain or loss under IRC

61 469. Rev. Proc (Section 4.04). REGROUPINGS: If pursuant to IRC Reg (e)(2) it is determined that the existing grouping of activities is clearly inappropriate or that a material change in the facts and circumstances has occurred that makes the existing grouping clearly inappropriate, the taxpayer must regroup the activities into one or more appropriate economic units. The taxpayer must file a written disclosure statement with the original return for the tax year in which the regrouping occurs. The statement must list the name, address, and employer identification number (if applicable) for the activities that are being regrouped and an explanation of why the original grouping was deemed to be clearly inappropriate. Finally, if the regrouping results in two or more activities being grouped into a single activity, the statement must declare that the now-combined activities constitute an appropriate economic unit for measuring gain or loss under IRC 469. Rev. Proc (Section 4.04). NOTE: Not making the election in one year in which the taxpayer is eligible does not preclude making the election in a later year. IRC (g)(1). FAILURE TO MAKE REQUIRED DISCLOSURES: Failure to make the required PAL grouping disclosure results in each activity being treated as a separate activity for PAL purposes. However, if a taxpayer who failed to make a grouping disclosures has (1) filed all affected returns in a manner consistent with the desired grouping of activities, and (2) makes the required grouping disclosure with the returns for the year in which the failure to disclose was first discovered, the IRS will deem the grouping election to have been timely made. If the IRS first discovers the failure to make a grouping disclosure, the taxpayer must show reasonable cause for the failure to disclose to avoid disallowance of the grouping. Rev. Proc (Section 4.07) FRESH START REGROUPING PRIVILEGE RESULTING FROM 3.8% MEDICARE CONTRIBUTION TAX (NIIT): A material change in facts and circumstances includes becoming subject to the 3.8% NIIT. Accordingly, a taxpayer may regroup activities for the first tax year that begins after 2013 in which the taxpayer: (1) Has net investment income; and (2) Meets the income threshold requirements for the NIIT. NOTE: A taxpayer may regroup activities only once, and a regrouping will apply to the tax year for which the regrouping is done and all subsequent years IRC Reg (b)(3)(iv). NOTE AMENDED RETURNS: If a taxpayer had properly made a regrouping election and it was later determined that adjustments required an amended tax return that either reduced gross income below the threshold level or eliminated investment income, then the taxpayer is required to undo the regrouping election and is bound by this until both tests apply in the future. Conversely, if a taxpayer had not made a regrouping election because their income was under the threshold level, but additional income was determined after filing the original return, the taxpayer is allowed to make a regrouping election at that time. IRC Reg (b)(3)(iv)(C). When an examination of a taxpayer s records results in a redetermination of income, then the taxpayer is subject to the same provisions. NOTE REGROUPING MAY PREVENT NIIT: The NIIT regrouping privilege is particularly important for taxpayers who have reported passive business income in prior tax years and would now face NIIT on that passive business income. If that

62 passive business income activity can be grouped with other business activities so as to achieve either material participation (typically more than 500 hours) or significant participation (over 100 hours) NIIT can be eliminated. TO GROUP OR NOT TO GROUP: Benefits of Grouping: When several activities are grouped together, losses from one or more activities within the grouping can offset income from one or more other activities within the grouping. When several activities are grouped together, it s often easier to meet the material participation standard for the combined activity. If the material participation standard is met for a tax year, the combined activity is exempt from the PAL rules. Detriments to Grouping: IRC 469 Complete Disposition Rule Suspended Losses. IRC Reg (g). If the activity to be grouped has suspended losses and is likely to be sold in the near future or will discontinue business, grouping may lockup suspended losses. Under the complete disposition rule, disposition of the activity with the suspended losses will not free-up the losses for deduction purposes until after substantially all of a taxpayer s interest in the grouped activities have been disposed of. (NOTE: Credits attributable to these activities will generally also be frozen.) When Not to Group: If the activity to be grouped generates passive income. Grouping would make the income non-passive. The activity to be grouped generates passive losses, but the taxpayer has other sources of passive income to be used to offset. NOTE EFFECT OF GROUPING ELECTION: Once made, a grouping election applies to all future years. The election is irrevocable unless the grouping was clearly inappropriate or a material change in facts and circumstances has occurred that makes the original grouping inappropriate. In these instances a regrouping will be permitted, if appropriate, or the affected activities will be treated separately. IRC Reg (g)(2). *********************************************

63 Attachment to Form 1040 Schedules E NAME(S): SSN/TIN: ELECTION TO GROUP ACTIVITIES PURSUANT TO INTERNAL REVENUE CODE REG (c) (Rental of Farm Real Estate) The taxpayer hereby elects to group the following farm rental activities together so that the grouped activities are treated as a single activity for the tax year ended, and all years thereafter. The taxpayer represents that the grouped activities constitute an appropriate economic unit for the measurement of gain or loss for the purposes of IRC 469. Accordingly, the taxpayer hereby elects to group the following farm rental activities together so that the grouped activities are treated as a single activity under IRC 469(c)(7)(A) for the current tax year and all years thereafter. The following activities are to be grouped together and treated as one activity: ACTIVITY DESCRIPTION Name: Address: TIN (if applicable): Name: Address: TIN (if applicable): (Revised 11/15)

64 SOCIAL SECURITY EARNINGS TEST The Senior Citizens Freedom to Work Act signed into law on April 7, 2000, eliminated (retroactive to ) the retirement earnings test in and after the month in which a person attains full retirement age for social security benefits. For , full retirement age for persons born in = age 66 years. Taxpayers reaching full retirement age during a calendar year are subject to an earnings limit for the months prior to attainment of the full retirement age. For example, for taxpayers turning age 66 during 2015 and 2016, there is a monthly earnings limit of $3,490 ($41, months) for the months before they attain full retirement age. Excess earnings for this period result in a $1 reduction in benefits for each $3 of excess earnings received before attaining the age of 66 years. NOTE: For taxpayers age 62 through the start of the calendar year in which they attain full retirement age, benefits are reduced by $1 for every $2 of earnings over the annual limit of $15,720 for 2015 and Preparers will need to watch for additional taxable social security benefits for those age 62-70, particularly where social security benefits were not previously received. Taxpayers may now draw full social security benefits without restriction, leading in many cases to 50% or 85% taxability of these benefits received. Further, be aware that full retirement age will gradually increase between 2021 and In 2027, the full retirement age will be age 67. *************************************************************** SOCIAL SECURITY BENEFITS (Age 62 vs Full Retirement) Year of Birth Retirement Age To Collect Full Benefits years, 2 months years, 4 months years, 6 months years, 8 months years, 10 months years, 0 months years, 2 months years, 4 months years, 6 months years, 8 months years, 10 months 1960 & later years, 0 months Retirement Age for Full Social Security Benefits * (PERSONS BORN ON JANUARY 1 OF ANY YEAR SHOULD REFER TO THE PREVIOUS YEAR.)

65 EXAMPLE: John currently farms an 80-acre tract of land while working primarily as a W-2 employee (PIK wages) for a large area farmer. John will turn age 62 in July, 2016 and has asked you to advise him whether he should consider taking social security now or wait until he attains full retirement (age 66). He has provided you with his yearly social security earnings record which indicates he will receive the following estimated benefits: Age 66 $1,288/mo. Age 62 (25% Discount) $ 966/mo. Difference $ 322/mo. COMPUTATION Age 62 monthly benefit $ 966 Months until full retirement x 48 Total benefits paid before full retirement $46,368 Benefit difference 322 No. of months to recoup benefit of early 144 mos. retirement proceeds after full retirement age yrs. Age Age must live to for benefits to equalize Age 78 OTHER CONSIDERATIONS/COMMENTS Payment-in-kind (PIK) wages: PIK wages will count toward the earnings limitation test (e.g and 2016 = $15,720). The earnings limitation test includes all earnings regardless of whether or not the earnings are subject to social security (FICA/Med) taxation. Fringe benefits/health insurance: Employer-provided health insurance benefits are not taxed as wages under the Internal Revenue Code. As such, they are not considered to be earnings (earned income) for purposes of the annual earnings limitation test. (IRC 3121(a)(2)(B), POMS Section RS and RS ) SSA: Program Operations Manual System. FSA payment inclusion for earnings limitation test: Generally, FSA payments are not included as earnings when calculating each calendar year's earnings limitation. (POMS Section RS ) SSA: Program Operations Manual System. This statement is true except in the initial year of application for social security benefits. In the initial year, all FSA program payments are counted along with other earned income and earnings for purposes of the annual earnings limitation test. Possible problem - cash rented farm real estate: In the above fact pattern, your client should be aware that a social security benefits eligibility problem could occur if his employer is cash renting farm ground owned by the client. If this is the case and your client performs planting, harvesting, and/or other duties on this ground as a part of his employment, the cash rental paid by the Employer/Landlord will likely be considered as additional earnings (deemed material participation) even though your client is receiving wages for the work

66 involved. This situation would result in a doubling up of income (wages plus cash rental) for purposes of the age earnings limitation test. Obviously, one easy way to avoid this situation would be to have the client work on ground other than that owned by the client when performing agricultural employment duties for the Employer/Landlord. ANNUAL SOCIAL SECURITY BENEFIT STATEMENTS Prior to 2011, an annual statement was mailed each year to every taxpayer age 25 or older approximately two to three months prior to their birthday. In March 2011, the SSA announced that it was suspending the mailing of these statements in order to conserve funds. In early 2012, the SSA resumed sending the annual statements to people age 60 and older. The SSA has now made the annual statements available online at WEBSITE/ADDITIONAL INFORMATION Social Security Administration [ The Social Security Administration provides three on-line retirement benefits calculators at These calculators estimate retirement benefit amounts, as well as, disability and survivor benefits. However, none of these calculations are linked to the user s social security earnings record, but instead use the earnings amounts which are entered into the calculator to make projections. There is a benefit estimation program (Retirement Estimator) available at which uses social security earnings records and projected future earnings to estimate the individual s retirement benefit. NOTE: If a taxpayer delays taking social security benefits at full retirement age, they receive additional benefits for each year of postponement until they reach age 70. The rate of increase is set forth in the following table. Year of Birth Yearly Rate of Increase Monthly Rate of Increase % 13/24 of 1% % 7/12 of 1% % 5/8 of 1% 1943 or later 8.0% 2/3 of 1%

67 Estimating your Social Security retirement benefit For workers born in 1953 (people born in 1953 become age 62 in 2015 and are eligible for a benefit) This worksheet shows how to estimate the Social Security monthly retirement benefit you would be eligible for at age 62 if you were born in It also allows you to estimate what you would receive at age 66, your full retirement age, excluding any cost-of-living adjustments for which you may be eligible. If you continue working past age 62, your additional earnings could increase your benefit. People born after 1953 can use this worksheet, but their benefit may be higher because of additional earnings and benefit increases. If you were born before 1953, visit and search for Retirement Age Calculator. Step 1: Enter your earnings in Column B, but not more than the amount shown in Column A. If you have no earnings, enter 0. Step 2: Multiply the amounts in Column B by the index factors in Column C, and enter the results in Column D. This gives you your indexed earnings, or the estimated value of your earnings in current dollars. Step 3: Choose from Column D the 35 years with the highest amounts. Add these amounts. $ Step 4: Divide the result from Step 3 by 420 (the number of months in 35 years). Round down to the next lowest dollar. This will give you your average indexed monthly earnings. $ Year A. Maximum earnings B. Actual earnings C. Index factor 1954 $3, $4, $4, $4, $4, $4, $4, $4, $4, $4, $4, $4, $6, $6, $7, $7, $7, $7, $9, $10, $13, $14, $15, $16, $17, $22, $25, $29, $32, $35, $37, Printed on recycled paper D. Indexed earnings Step 5: a. Multiply the first $826 in Step 4 by 90%. $ b. Multiply the amount in Step 4 over $826 and less than or equal to $4,980 by 32%. $ c. Multiply the amount in Step 4 over $4,980 by 15%. $ Step 6: Add a, b and c from Step 5. Round down to the next lowest dollar. This is your estimated monthly retirement benefit at age 66, your full retirement age. $ Step 7: Multiply the amount in Step 6 by 75%. This is your estimated monthly retirement benefit if you retire at age 62. $ Year A. Maximum earnings B. Actual earnings C. Index factor 1985 $39, $42, $43, $45, $48, $51, $53, $55, $57, $60, $61, $62, $65, $68, $72, $76, $80, $84, $87, $87, $90, $94, $97, $102, $106, $106, $106, $110, $113, $117, D. Indexed earnings Social Security Administration SSA Publication No ICN Unit of Issue - HD (one hundred) January 2015 (Recycle prior editions)

68 CORPORATE CASH RENT CONSIDERATIONS ISSUE: Does the cash rental of farm real estate to an entity in which the taxpayer materially participates result in the net rental income reported by the landlords on their individual income tax returns (Schedule E) being subjected to self-employment social security taxation? IRC 1402(a)(1) PROBLEM (IRC Reg (a)-4(b)(1)) Generally, rentals from real estate, whether cash rent or crop share, are excluded from the definition of self-employment income. IRC 1402(a)(1). There is an exception, however, if three criteria are met: (1) The rental income is derived from the rental of land under an arrangement between the owner and lessee which provides that the lessee shall produce agricultural commodities on the land. (2) The arrangement calls for the material participation of the owner in the management or production of the agricultural commodities, and (3) There is actual material participation by the owner. The IRS has taken the position that a combination of involvement as lessor and as employee or partner equates to material participation for rentals from land, and results in self-employment taxation. This should not be the case with mere rental of buildings under a literal reading of the Code and Regs. absent significant involvement in management of the building. CASE HISTORY/FACT PATTERNS The IRS initially ( ) was successful in arguing that any land rental income reported on Schedule E was subject to self-employment taxation if the landlord(s) was also an employee or partner in the leasing entity, whether salaries were paid by the leasing entity under employment contracts, or rental payments were fixed or variable. The concept was that these types of rental activities met the arrangement language of IRC Reg (a)-4(b)(1). SEE: Mizell v. Comm'r., T.C. Memo (Pine Bluff, AR) Ltr. Rul (May 1, 1996) -- (Casper, WY case) FSA (4/30/99) Bot v. Comm., TC Memo (8/3/99) Hennen v. Comm., TC Memo (9/16/99) McNamara v. Comm., TC Memo (10/4/99) It was not until the 8 th reversed McNamara, Bot and Hennen in late 2000 (McNamara, et al. v. Comm., 236 F.3d 410 (8 th Circuit 2000) (12/29/00), that the outcome of these cases began to change. 8 TH CIRCUIT HOLDING: In reversing the Tax Court, the Eighth Circuit found the following: (1) Lessor-lessee relationship should stand on their own apart from employer-employee relationships. (2) IRC 1402(a)(1) requires material participation by the landlord in the rental arrangement itself in order to subject the arrangement to self-employment tax. The Court stated:

69 The mere existence of an arrangement requiring and resulting in material participation in agricultural production does not automatically transform rents received by the landowner into selfemployment income. It is only where the payment of those rents comprise part of such an arrangement that such rents can be said to derive from the arrangement. (3) Rents that are consistent with market rates very strongly suggest that the rental arrangement stands on its own as an independent transaction and cannot be said to be part of an arrangement for participation in agricultural production. The McNamara, Bot and Hennen cases were remanded to the Tax Court to provide an opportunity for the IRS to show a connection between the rents and the production (labor) arrangement. In mid-july, 2002, the Tax Court in a brief opinion, conceded that the rentals in all three cases were fair market rentals. Hennen v. Comm r, T.C. Docket No (July 10, 2002). IRS Non-acquiesce in McNamara, Hennen and Bot: In 2003, the IRS announced that it will not acquiesce in the McNamara, et al. decisions. In other circuits, it will "assert that it is correct to look to the overall scheme of farming operations in determining whether rentals were derived under an arrangement calling for material participation in farm production." AOD CC Subsequent cases followed the 8 th Circuit analysis: (A) Johnson v. Comm., T.C. Memo (3/9/04): Involved a Minnesota married couple who were 50/50 shareholders in a farming corporation to which they leased farmland and other personal property. During the three (3) years in question ( ) there were no written lease agreements or employment agreements between the corporation and the Johnsons. HOLDING: Rent amount represented a fair market rent and that there was no nexus between the rent paid and the couple s material participation. As such, the rents were not subject to self-employment tax. The corporation s obligation to make rental payments is separate and distinct from the taxpayers material participation in the corporation s farming operation. (B) Solvie v. Comm., T.C. Memo (Mar. 9, 2004): Involved the rental of a newly built 800-head capacity hog barn by a family farming corporation from a married couple who were the sole shareholders (50/50) of the farm corporation. The couple also leased farmland, buildings and some personal property to the corporation. When the new hog barn was built, the couple increased the overall rental they were receiving from the corporation by $21 per hog per rotation of hogs passing through the building. HOLDING: The Tax Court found a nexus between the hog barn and the couple s material participation in the farming operation. Had the couple not performed services for the corporation, there would have been no rental on the hog barn. The rental amount exceeded a fair market rental; thus, it was includible in farm rental income and subject to self-employment tax. ****************************************************** FARM RENTAL PROCEDURES AFTER McNAMARA, SOLVIE AND JOHNSON (AVOIDING SELF- EMPLOYMENT TAX ON RENTS: Rents other than reasonable fair market rentals will likely be subject to self-employment tax. Rents dependent on the taxpayer s material participation (e.g., tied to production) are also likely to be subject to self-employment tax.

70 Clients should enter into written leases specifying reasonable rentals to document the landlord/tenant relationship. The lease should indicate that no participation in the farming operation is required by the landlord to facilitate the lease arrangement. While these provisions should pass muster, it may be better to simply indicate that no personal participation is required by the lessor in the raising or production of commodities under the lease. If clients wish to take further action to distance themselves from the fact patterns set forth above, the following additional planning strategies may be considered. (1) Transfer land ownership to spouse and discontinue the spouse's involvement in the corporation as either an officer or director. The spouse would then rent the land they own to the production entity utilizing a cash rent or non-material participation crop-share lease. No attribution rules exist to treat spousal ownership of land in this type of setting as land ownership by the non-land owning spouse. COMMENT: This approach may not be acceptable to many spouses due to estate planning and other general ownership concerns. See the discussion below for a list of planning points that should be considered when entering into spousal farm rental arrangements. (2) Convey the land to another entity (e.g. FLP or LLC) (other than a grantor trust) with the land-owning entity then entering into a lease with the production entity. For example, if a family limited partnership were utilized, the spouse not involved with the production entity could act as the sole general partner. One of the duties of the general partner would be to enter into appropriate cash rent or non-material participation crop-share lease with the production entity. An employment agreement could be utilized so that the general partner spouse would receive a salary (guaranteed payment) for negotiating lease arrangements among other duties. Any salary (guaranteed payment) would be subject to social security taxation. Although a successful outcome (in terms of avoiding self-employment tax) is not assured, it is believed that income from self-employment would not be imputed to the entity owners. ********************************************* SPOUSAL FARM RENTAL ARRANGEMENTS -- CONSIDERATIONS The following planning points should be considered when constructing an agreement to make rental payments to a spouse. OWNERSHIP INTEREST: The spouse must own an interest in the land rented to the farm operator. A more desirable fact pattern exists if the farm operator has no equity interest in the property, but joint ownership may not be fatal, based on LR and other authorities. WRITTEN LEASE AGREEMENT: A formal written lease agreement should be executed. REASONABLE RENT: The rental rate must be reasonable in amount, with payment made at least annually. SPOUSAL MORTGAGE: If the spouse is the sole owner of the property,

71 any real estate mortgage should be in the name of the spouse considered the landlord. However, the farm operator could be a loan guarantor. SEPARATE FUNDS: The "landlord" spouse should deposit the rental income in a separate account. It should not be commingled with funds used to finance the farming operations or other joint ventures. The "landlord" spouse should pay the landlord's taxes and interest from separate funds using the separate account. FORM 1099 FILINGS: The farm operator should file Form 1099 for all rent payments to the "landlord" spouse. ADDITIONAL: The spouse should avoid material participation in the farm business to avoid self-employment tax. The "landlord" spouse cannot avoid material participation in the farming business for purposes of the passive activity rules since participation by a spouse is treated as participation by the taxpayer. IRC Reg T(f)(3). See also: Fransen v. U.S., No (5 th Cir. 10/1/99). Income derived from property rented by a taxpayer for use in a trade or business in which he or she materially participates (self-rental property) is not treated as passive activity income. Furthermore, such situations of material participation (especially if a wage is paid) coupled with rental income could be recharacterized as a partnership. Thus, the payments could be deemed subject to self-employment tax. *********************************************

72 RESIDENCE RENTAL BY INDIVIDUAL (EMPLOYEE) TO FARM CORPORATION: IRC 280A(c)(6) provides that no business deduction shall be allowed for any portion of a home rented to the taxpayer s employer. In IRS Technical Assistance (ITA) , the IRS concluded that: (1) An individual who rents a portion of a dwelling unit to his or her employer and uses that dwelling unit in performing services as an employee of that employer may deduct home mortgage interest, real property taxes, and personal casualty losses to the extent permitted under IRC 163, 164, and 165(c)(3) & (h); and (2) The individual may not deduct otherwise allowable trade or business expenses under IRC 162, business casualty losses under IRC 165(c)(1), or depreciation under IRC 167, to the extent those expenses and losses are attributable to the use by the employee of the dwelling unit in performing services for the employer. In 1998, the Tax Court arrived at the same result in Roy v. Comm., T.C. Memo (3/31/98). Roy involved an individual who was both an employee and shareholder in a Subchapter S" family farming corporation. The corporation paid the individual $1,000/month for the use of the taxpayer's 5-acre residential building site, which was located at the corporate farm business location. The 5- acre building site was used for various purposes other than as a residence. Mr. Roy attempted to claim offsetting expenses on Sch. E against this rental income. The IRS disallowed the deductions under IRC 28OA(c)(6). The issue of whether the value of lodging was excludable from the shareholder's income on the grounds the employee was required to live on the premises was not raised. OUTCOME: The language of IRC 28OA(c)(6) will prevent individuals who rent their residence to their corporation, while employed by the corporation, from claiming any offsetting expenses against the rental income on Sch. E (other than mortgage interest and taxes). PARTIAL SOLUTION: Adjust the terms of the lease to have the corporation pay the operating expenses involved with the residence (e.g. utilities, insurance, minor repairs, etc.) C CORPORATION POSSIBLE SOLUTION: Consider transferring the residential tract to the corporation and authorize the employee to reside there, if can satisfy the requisites of IRC 119 (for convenience of employer, etc.). NOTE: The corporation will not be eligible for IRC 121 personal residence exclusion of gain on sale.

73 TAX PLANNING FOR THE YOUNG AND/OR LOW-INCOME FARMER/NON-FARMER (OPTIONAL METHOD FOR COMPUTING SELF-EMPLOYMENT EARNINGS) (SOCIAL SECURITY BENEFIT COVERAGE) FACTS: Your client is a young, single farmer whose yearly Schedule F has historically shown little or no net farm income. He/she is seeking your recommendations regarding optimization of farm income reporting for income and social security tax purposes. RECOMMENDATION: Optimize usage of earned income credit vs. net operating loss. For years in which low net income or a net operating loss occurs, elect the optional self-employment tax method. This option is intended to benefit lowincome sole proprietors and partners by permitting them to report more than actual net earnings from farming or business operations as self-employment income in order to receive greater credit towards social security benefits. A. Earned Income Credit: For 2015, single individuals without children can claim earned income credit at the following rates: Year Credit rate Maximum credit Earnings level maximum credit No Qualifying Children Phase-out begins at: Phase-out rate Credit phased out at: % $503 $6,580 $8, % $14,820 For 2015, earned income (farm, W-2, etc.) may be optimized for a low-income individual at $6,580 to maximize the earned income credit. At this level for 2015, SE tax would be $1,007; of which earned income credit would pay $503 (difference = $504). There should be no regular income tax due to the standard deduction and personal exemptions. B. Social Security Benefit Coverage: As a general rule, for 2015, approximately 90% of the social security dollars paid into the system on earned incomes between $-0- and $9,912 are projected to be returned to the taxpayer at retirement. This payback percentage drops dramatically above $9,912 of average inflationadjusted earnings to only 32% of the earnings between $9,912 and $59,760, with the percentage further reduced to 15% above $59,760. To qualify for social security benefits, one must have enough quarters of earnings coverage to be "insured". To qualify for retirement benefits, one must be "fully insured" (age 31 or older = 40 quarters of earnings coverage) or currently insured (20 quarters of coverage in the 10 years immediately before death or disability). For 2015 this rate is $1,220/qtr. - $4,880/yr. Up to four quarters of coverage can be earned per year. Disability considerations are also important. One needs a minimum of 6 quarters for initial disability eligibility. Generally, after age 21, a young individual will need to average 2 quarters of earnings coverage per year to maintain disability coverage. Maximizing use of the earned income credit to pay higher social security taxes and taking full advantage of the optional SE tax election are extremely important for these purposes. C. Net Operating Loss and Election of Optional SE Tax: If positive net farm income cannot be obtained and a net operating loss will result, a self-employed individual should elect the optional method for computing self-employment taxes if there is not significant other earned income subject to social security tax (W-2, etc.). Prior to 2008, if a self-employed individual had no other earned income and presuming all other requirements were met (e.g. gross farm income limits, etc.), the individual was treated as having net earnings for self-

74 employment tax purposes of $1,600. D AND AFTER IRC 1402(a) & (l): The pre-2008 optional method for computing self-employment earnings had never been indexed for inflation and had not seen change for many years. Since maximum earnings under the old SE optional method could not exceed $1,600 per year, concerns arose regarding how selfemployed low income individuals could accumulate sufficient quarters of earnings coverage to be fully insured or even currently insured for purposes of receiving social security benefits. As discussed above, for 2015, an individual is required to have $1,220 of earnings to generate one quarter of coverage toward social security eligibility. Without a change in tax law, at $1,600 maximum earnings per year under the current SE optional method, only one quarter of coverage might be earned per year by a low income self-employed individual. The 2008 Farm Bill increased the dollar thresholds for the farm and nonfarm optional methods for computing net earnings from self-employment, and made these thresholds subject to annual indexing. The dollar threshold amounts have been increased to allow electing taxpayers to secure four credits of Social Security benefit coverage each taxable year in 2008 and thereafter. For 2008, $4,200 of earnings was necessary to secure four quarters of Social Security benefit coverage ($1,050/qtr.). Thus, the maximum income dollar threshold for the farm optional and nonfarm optional methods was $4,200. For 2014, the amount was $4,800 ($1,200/qtr.). For 2015, the amount is $4,880 ($1,220/qtr.). EXAMPLE FARMERS: For 2015, a self-employed farmer can elect to report as net earnings from self-employment two-thirds of his gross income from farming as long as that gross income is not more than $7,320 (150% of $1,220 x 4). If gross income from farming exceeded $7,320 but actual net earnings from such operations were less than $5,284, the individual could report $4,880 as his net earnings from self-employment. NOTE: $4,880 x 15.3% = $747 SE Tax. SE 15.3% = $747 x ½ = $374 SE Tax deduction. Sam (age 26) is a young, single farmer (with no children) whose 2015 Sch. F reports gross income of $50,000 and net income of $1,020. Sam has no other income to report for If Sam does not elect the SE optional method, his 2015 federal return will report SE tax of $144. This tax will be offset by earned income credit of $71; net tax due = $73. However, Sam will not have reported sufficient earnings for even one quarter of social security benefit eligibility. If Sam does elect the SE optional method, he will pay SE tax on $4,880 x 15.3% = $747. This tax will be offset by earned income credit of $373; net tax due = $374. Under the SE optional method, Sam will have reported sufficient earnings for four quarters of social security benefit eligibility (retirement and disability) at a cost of $374. NOTE: There is no limit on the number of years that a qualified individual can use the farm-optional method. NON-FARM RULES: Similarly for 2015, if a self-employed individual (sole proprietor or partner) had gross non-farm income of not more than $7,320 (150% of the sum of the minimum earnings required for a quarter of coverage under the SSA for each quarter of the tax year ($1,220 x 4 = $4,880 for 2015)), he could report two-thirds of his gross nonfarm income as net earnings from self-employment. If the individual s gross nonfarm income exceeded $7,320, but actual net earnings were less than $5,284, he could report the sum of the minimum earnings required for a quarter of coverage under the SSA for each quarter of the tax year as his net earnings from self-employment.

75 NOTE: For 2015, a self-employed individual (sole proprietor or partner) not engaged in farming could use the nonfarm optional method of computing net earnings from self-employment if: (1) The individual s net earnings from nonfarm self-employment were less than $5,284; (2) The net earnings from nonfarm self-employment were less than % of the individual s total gross income from nonfarm self-employment ($7,320 x = $5,284); (3) The individual was self-employed on a regular basis (i.e., actual net earnings from self-employment have been $400 or more in at least two of the three tax years preceding use of the optional method); and (4) The nonfarm optional method has not previously been used for more than four years (i.e. there is a five-year lifetime limit). ***************************************************** NOTE: An election to use the optional method of computing net earnings from self-employment can be made or revoked on an amended return filed within the 3- year statute of limitations. NOTE EARNED INCOME CREDIT OPTIMIZATION: The effect of electing the optional self-employment tax method may be more profound if the taxpayer has off-farm earned income. Tax planning may allow for optimization of the earned income credit (EIC). YEAR-END TAX PLANNING SUGGESTIONS FOR FARMERS: (1) Income acceleration possibilities -- additional grain/livestock sales, sealed grain (if election to report as income); etc. (2) Income deceleration possibilities -- deferral of grain/livestock sales, sealed grain (if election to report as loan); etc. (3) Expense acceleration possibilities -- prepayment of expenses; 179 election to expense; additional first-year depreciation election, etc. (4) Expense deceleration possibilities -- postpone expenses; slow down depreciation (SL or longer life); capitalize repair costs; capitalize fertilization costs (IRC 180 yearly election to expense). NOTE: Effect on state taxation. (e.g. single individual in Iowa - exempt from taxation if net income is less than $9,000). ***************************************************** (Revised 11/15)