Exercise caution when working with deferred payment contracts

Most farming operations use the cash accounting method, meaning income and expenses are recorded when they are actually received or paid. Because of this, farm managers often meet with their tax professionals near year-end to develop a strategy for managing sales and expenses in a way that produces the desired taxable income outcome.

One tool available to cash-basis farmers is the deferred payment contract. A deferred payment contract is different from a standard delivery contract.

For example, a producer may contract corn for delivery to a local ethanol plant in November. At the time the delivery contract is signed, the price, quantity, and delivery date are all agreed upon and documented in the contract.

When November arrives, and the corn is ready to be delivered, the producer may wish—after meeting with their tax professional—to defer the income from this sale into the following tax year. This deferral can be accomplished by using a deferred payment contract.

Requirements for a deferred payment contract

To be valid, a deferred payment contract must meet the following conditions:

• The contract must be executed before the grain or commodity is delivered to the buyer.
• The contract must be in writing.
• The contract must not be transferable or assignable.
• The contract must clearly state that the seller is not entitled to receive any proceeds until a specific date in the following tax year.

Under a deferred payment contract, the farmer relinquishes ownership of the commodity at delivery and, per the contract terms, cannot receive any portion of the sale proceeds until the specified payment date. If the farmer receives any funds related to the contract before that date, the contract becomes invalid, and the entire amount becomes taxable in the original year of sale.

According to the 2024 Agricultural Tax Issues textbook published by the Land Grant University Tax Education Foundation, installment contracts can be particularly useful for helping farmers meet a taxable income target. I.R.C. § 453(b)(1) defines an installment sale as “a disposition of property where at least one payment is to be received after the close of the taxable year in which the disposition occurs.” Grain and livestock forward contracts are often used to defer income into a subsequent tax year, with disposition (delivery) occurring in the production year and payment in the following tax year. Cash-basis farmers are eligible to use installment sale reporting because the commodity is not required to be inventoried (Treas. Reg. §15A.453-1(b)(4)).

Risk considerations

It is important to understand that farmers using deferred payment contracts are considered unsecured creditors. If the buyer becomes financially insolvent before payment is made, the farmer will be low on the priority list during bankruptcy proceedings. In addition, deferred payment contracts are typically not covered by state grain indemnity funds, including Minnesota’s.

Installment sale rules

Deferred payment contracts are governed by the IRS installment sale rules. Under these rules, a producer may elect out of installment reporting by reporting the deferred payment sale in the year of the original sale. This election must be made on a contract-by-contract basis; it cannot be applied partially within a single contract.

Example

Suppose a farmer wants to defer $100,000 of corn sales (25,000 bushels at $4 per bushel). If the farmer enters into a single deferred payment contract covering the entire 25,000 bushels, flexibility is limited. During tax preparation, the farmer may discover it would be beneficial to recognize an additional $25,000 of income in the current year.

With only one contract, the farmer has just two options:

1. Defer the entire $100,000 into the following tax year, or
2. Elect out of installment reporting and recognize the full $100,000 in the year of sale.

Creating multiple smaller contracts

A more flexible approach is to create multiple smaller deferred payment contracts. Instead of one contract for 25,000 bushels, the farmer could establish five separate contracts of 5,000 bushels each. This allows the farmer to selectively opt out of installment reporting on individual contracts, providing greater control over taxable income while maintaining the benefits of deferral.