Most government payments to farmers and small businesses require inclusion as income on your annual federal or state tax return. The continued COVID-19 pandemic, summer 2021 natural disasters including hail and drought, and other governmental funding initiatives will result in some farms and small businesses having significant governmental income payments this year. Since most farmers are cash-basis tax filers, farmers may take advantage of several tax planning strategies to help maximize their after-tax income.
Successful fall tax planning requires that farmers maintain up-to-date farm accounting records to determine what strategies to implement.
Government payments and farm income
Crop insurance payments, crop and livestock disaster payments, Commodity Credit Corporation (CCC) payments, state or county grants or payments funded by the CARES Act, Coronavirus Food Assistance Program (CFAP 1 & 2), and Pandemic Assistance for Producers (PAP) are some of the common governmental programs that require inclusion in gross income on yearly tax returns.
Forms 1099-G and CCC-1099-G are sent to producers at the conclusion of the year and report the governmental payments received. Regular crop insurance proceeds are on a 1099-MISC.
There are some exceptions when it comes to including governmental programs in income.
- Retroactive state and federal laws exclude from gross income select COVID-19 related governmental funds, including forgiven Paycheck Protection Program (PPP) loans and Economic Injury Disaster Loan (EIDL) Advances.
- Expenses purchased with PPP and EIDL advance funds are deductible.
- Unemployment compensation of less than $10,200 was excluded from taxable income in 2020 for single or married filing jointly taxpayers with modified adjusted gross income of $150,000 or less.
- Unemployment is currently taxable in 2021.
Tax planning strategies to maximize after-tax income
Section 179 depreciation
Section 179 depreciation allows you to expense qualified property during the year it is placed in service instead of depreciating property over a series of years as capitalized assets.
- For calendar year 2021, the maximum Section 179 deduction is $1,050,000.
- The investment limit for qualifying property is $2,620,000.
- Qualifying property for Section 179 includes:
- purchased breeding livestock
- single-purpose agricultural structures (hog confinement buildings and nursery high tunnels)
- drainage tile.
- You can take a Section 179 deduction on the qualifying property regardless of whether the asset is new or used.
- You cannot buy the asset from a related party (lineal descendant).
Bonus depreciation (also known as additional first year or special depreciation) is the second method of accelerated depreciation.
- The bonus depreciation allowance is 100% for qualified property acquired and placed in service after September 27, 2017, and before January 1, 2023.
- With bonus depreciation, the assets may be new or used.
- Purchases of qualified used property meet the criteria for the deduction unless purchased from a related party.
Minnesota law - Section 179 and Bonus depreciation
During the 2021 Minnesota legislative session, the State of Minnesota fully adopted the Section 179 provision as modified in federal tax law. This means Minnesota conforms fully to the federal law for 2021 and beyond. The changes to Section 179 at the state level are also retroactive back to 2017 and may require you to amend prior-year tax returns with the State of Minnesota.
Bonus depreciation is not recognized on the Minnesota tax return (it is still subject to the 80% add back) and the amount of bonus depreciation must be spread out over a five-year period.
Deferred contract sales
A farmer can sell grain and livestock in one year, sign a deferred payment contract or an installment contract, and postpone payment and recognition of that income into the following year. But delaying payment increases the chances that the buyer may not pay for the commodity because of financial difficulties.
Because the sale was not reported as income, a cash-basis farmer does not have a deductible loss if the buyer defaults on the deferred payments.
According to the 2009 National Income Tax Workbook:
“A qualified deferred payment contract must avoid terms that result in the farmer having constructive receipt of income. Thus, the agreement should be in place before the grain or other commodity is delivered to the buyer, and it should specify that the seller has no right to any proceeds until the following year. IRC § 483 and § 1274 generally require a buyer to pay interest on an installment sale contract. However, IRC § 483 and §1274 do not apply to installment-sale contracts in two separate situations:
- All payments are due within six months of the contract sale date [IRC §483(c)(1)(A) and 1274(c)(1) (B)].
- The total sales price is $3,000 or less [IRC §§1274(c)(3)(C) and 483(d)(2)].
“If the buyer does not make the required deferred payment, the seller’s loss deduction is limited to the basis in the contract, which is generally the commodity’s basis. A farmer’s basis in a raised commodity is usually zero. Therefore, there is no deductible loss.
“The matching principle of accounting requires farmers who sell animals or other items that were purchased for resale to determine the profit or loss by subtracting the cost of the animal or other item from the amount received in the year of sale [Treas. Reg. § 1.61-4(a)].”
Income averaging remains in effect for farmers only. Farmers can elect an amount of their current farm income to divide equally among the previous three years.
- The amount applied to the previous three years is added to the previous year’s taxable income.
- Savings result if the previous year’s income was taxed at a lower tax rate than the current year.
- This election applies to any income that is attributable to a farm business.
- Farm income includes items of income, deduction, gain, and loss attributable to an individual’s farming business. This includes:
- Net Schedule F income.
- An owner’s share of net income from an S corporation, partnership, or limited liability company.
- Wages received by an S corporation shareholder from the S corporation.
- Gain from the sale of assets used in the farming business and reported on Form 4797 and/or Schedule D (Form 1040) but not gain from the sale of land or timber.
Farmers are allowed to use a negative farm income for calculations in the base year. However, this loss carried from the base year to other years in the calculation must be removed from the base year calculation to prevent a double tax benefit.
If you liquidate your farm business, the gain or loss is attributable to your farming business for income averaging only if the property is sold within a reasonable period. One year is considered a reasonable period.
Disaster payments and crop insurance indemnity payments
Any crop insurance proceeds you receive need to be included as income on your tax return. You generally include that income in the year received.
Crop insurance also includes crop disaster payments received from the federal government as the result of destruction or damage to crops or the inability to plant crops because of drought, flood, or any other natural disaster.
Crop and livestock insurance payments include the Noninsured Crop Disaster Assistance Program (NAP) and livestock disaster payments under the ELAP (Emergency Assistance for Livestock, Honeybees and Farm-Raised Fish Program), LIP (Livestock Indemnity Program), and LFP (Livestock Forage Program).
Income received from any of these indemnification programs is reported on Form 1099-G and is taxable to the farmer.
You can postpone reporting crop insurance proceeds as income until the year following the year the damage occurred if you meet all the following conditions:
- You use the cash method of accounting.
- You receive the crop insurance proceeds in the same year the crops are damaged.
- You can show that under normal business practice, you would have included income from the damaged crops in any tax year following the year the damage occurred.
Ambiguities do exist with respect to crop insurance deferrals. Must the taxpayer show that all income from a crop would have been deferred or only a portion? Does the election apply to all payments or only to those for crops that would have been sold in the following year?
IRS Code Section 451 is the principal authority concerning crop insurance. However, Section 451 is silent regarding the questions listed in the prior paragraph. See the drawer below for further information.
One additional piece of authority is Nelson vs. Commissioner. This was a 2009 court case decided in the 8th Circuit Court of Appeals. The court found that all crop insurance was deferrable if a substantial portion of the crop was sold the following year. The court further defined “substantial portion” as greater than 50 percent. Furthermore, the Nelson case says the 50 percent test needs to apply to each crop. The case is unclear about the deferral of individual crops and implies the deferral is an all or none proposition.
In Rev. Ruling 74-145, the IRS referred to the necessity for a substantial part of the crops to have been carried over from the year of production historically; more than 50% was viewed as substantial. Income tax scholars have indicated that under Rev. Ruling 74-145, this is an all or none proposition.
Under the Nelson Court case and Rev. Ruling 74-145, the substantial portion test (over 50% of each crop sold in the following year) may be applied to current year crop sales to determine if a crop insurance deferral is possible.
Generally, farmers can establish their practice of reporting crop income in the following taxable year by referencing their prior year’s sale records. For a payment to constitute insurance for the destruction of or damage to crops, the insured must suffer actual physical loss. Agreements with the insurance companies that provide for payments without regard to actual losses by the insured, such as payments if county average yield is less than a specified amount, are not payments for the destruction of or damage to crops. Such payments do not qualify for deferral under IRS code section 451(f). Payments made for a decline in the price of the commodity, rather than a physical loss, do not qualify for deferral.
An indemnity payment from a Revenue Protection (RP) policy is based on price as well as quantity and quality of the commodity produced. Only the payment for destruction or damage (yield loss) is eligible for deferral. A farmer who receives compensation from an RP policy must determine the portion of the payment that is due to crop destruction or damage rather than due to a reduced market price.
An RP policy guarantees a minimum amount of revenue per acre for the insured farmer. The policy provides a formula for computing the deemed revenue the insured received from the crop that was produced. Considered is the price of the commodity at the time of harvest, the quantity the insured farmer harvested, and the quality of the commodity harvested. This deemed revenue is compared with the guaranteed minimum revenue. The excess of the guaranteed minimum over the deemed revenue received is the amount paid to the insured farmer.
An insurance payment received from a prevented planting policy does qualify for crop insurance deferral (assuming the taxpayer meets all other requirements for deferral). This provision is addressed specifically in IRS code section 451(f).
If you use the cash method of accounting to report your income and expenses, your deduction for prepaid farm expenses in the year you pay for them is limited to 50 percent of the other deductible farm expenses for the year (all Schedule F deductions minus prepaid farm expenses). This limit does not apply if you meet all the exceptions described below.
Many cash-basis tax filers use prepaid expenses at year-end to balance income with expenses. This practice also allows farm producers to guarantee delivery and lock-in prices on crop inputs for the following year.
The 2020 Farmers Tax Guide from the IRS says prepayments must meet the following conditions:
- Must be for an actual purchase and not a deposit.
- The prepayment has a business purpose and is not merely for tax avoidance.
- The prepayment does not result in a material distortion of income.
There are a couple of exceptions. The limit on the deduction for prepaid farm expenses does not apply if you are a farmer and either of the following applies:
- Your prepaid farm expense is more than 50 percent of your other deductible farm expenses because of a change in the business operations caused by unusual circumstances.
- Your total prepaid farm expense for the preceding three tax years is less than 50 percent of your total other deductible farm expenses for those three years.
The maximum pre‑paid amount is calculated each year based upon the final figures on Schedule F.
Fall-applied fertilizer and lime are treated differently if applied before the new year. If you purchase fertilizer and lime late in 2021 and apply it before January 1, 2022, the fertilizer and lime expense is not considered a prepayment for tax purposes and thus is not subject to the 50 percent rule.
Prepay example: During 2021, Bert bought crop chemicals ($40,000), feed ($10,000) and seed ($50,000) for use on his farm in the following year. His total pre-paid farm expenses for 2021 are $100,000.
His other deductible farm expenses totaled $180,000 (total schedule F expense minus pre-paid expenses, including depreciation) for 2021.
Therefore, Bert’s deduction for prepaid farm supplies cannot be more than $90,000 (50 percent of $180,000) for 2021. The excess pre-paid farm expense of $10,000 ($100,000 minus $90,000) is deductible in 2022 when he uses or consumes the supplies.
This article is educational in nature and is not legal, financial or tax advice.
IRS website. www.irs.gov
- Eligible Paycheck Protection Program expenses now deductible
- 2020 Unemployment Compensation Exclusion FAQs — Topic A: Eligibility
2009 National Income Tax Workbook, Land Grant University Tax Education Foundation, Inc., pp. 380-381.
2020 Publication 225. The Farmers Tax Guide. pp. 19-20. www.irs.gov