Farmers typically pay for seed, fertilizer, and other inputs in one year and use the items in the subsequent year. There are many reasons to do so, such as: obtaining a lower purchase price, guarantee the availability of the particular item, and of course for tax planning purposes. Typically larger farmers can spend tens of thousands of dollars on year-end prepaid expenses in order to adjust taxable income to a desired level; therefore, it is extremely important that farmers adhere to the IRS rules regarding prepaid expenses.
The IRS allows farm-related taxpayers to deduct costs of farm supplies in the year the purchase is made versus the year in which such purchases are used; however, the prepaid purchases of farm supplies are limited generally to 50% of other deductible farm expenses (all deductions except supplies) for the year.
A “Farm related taxpayer” is someone who meets any of the following tests: (1) The main home is on the farm, (2) The principal business is farming or (3 ) a member of your family meets (1) or (2). For this definition, your family includes the taxpayer’s brother and sisters, spouse, parents, grandparents, children, grandchildren, aunts, uncles and their children.
Farm related taxpayers wanting to deduct the costs of prepaid farm supplies must use the cash method of accounting. Prepaid farm supplies are amounts the farmer pays during the year for feed, seed, fertilizer and similar farm supplies not used or consumed during the year. Other deductible farm expenses are all the other amounts allowable (such as deductions for wages, amortization and depreciation, interest expense and property taxes) other than the prepaid farm supplies. Costs that must be capitalized are not included in the 50% test. Prepaid farm expenses that exceed 50% of the other deductible expenses may only be deducted as the purchased items are consumed (typically the following year).
Example: In 2015, you bought seed ($5,000) and fertilizer ($8,000) for use on the farm in the following year. The total prepaid farm supply expense for 2015 is $13,000. Your other deductible expenses totaled $24,000 for 2015. Therefore, the deduction for prepaid farm supplies may not exceed $12,000 (50% of the $24,000) for 2015. The excess paid for farm supplies of $1,000 ($13,000 to $12,000) is deductible in 2016 when you use or consume the supplies.
Additional criteria/guidelines for deducting prepaid supplies should also be considered as explained in IRS Revenue Ruling 79-229:
- Actual purchase vs. deposit. The expenditure must be an actual purchase and not just a deposit to buy in the future. This guideline is one for the most concern, if audited. If your invoice just states “Seed – $25,000,” you more than likely have a problem substantiating a prepaid expense. The invoice must clearly specify a definite quantity, quality and price for the items purchased. In addition, there should be no right to refund or repurchase noted on the invoice.
- Business purpose. The expenditure must have a business purpose other than tax avoidance. As we discussed before, farmers usually prepay in order to secure adequate quantities, obtain discounts and hedge the expectation of rising prices. All of these reasons provide a business purpose for prepaying.
- No income distortion The expenditure must not result in a material distortion of income; that is, the farmer’s prepaid purchases cannot extend beyond 12 months or the end of the next tax year.
Exceptions to the 50% rule do exist. For a farm related taxpayer, the 50% test is waived and prepaid farm expenses may be ducted in full if:
- the farmer has prepaid farm expenses in excess of 50% of the other farm expenses because of a change in business operations directly attributable to extraordinary circumstances, such as drought or changes in government crop diversion programs; or
- the farmer has an aggregate prepaid farm expenses for the preceding three tax years that are less than 50% of the aggregate other deductible expenses for those three tax years. This exception is a significant privilege and might be used when either markets or weather causes significant fluctuations in potential taxable income for a particular year.
In conclusion, farmers should be aware of the unique definitions and guidelines related to prepayment of farm expenses in order to navigate the IRS requirements and properly plan for taxes.
Brian E. Ravencraft, CPA, CGMA is a Principal with Holbrook & Manter, CPAs. Brian has been with Holbrook & Manter since 1995, primarily focusing on the areas of Tax Consulting and Management Advisory Services within several firm service areas, focusing on agri-business and closely held businesses and their owners. Holbrook & Manter is a professional services firm founded in 1919 and we are unique in that we offer the resources of a large firm without compromising the focused and responsive personal attention that each client deserves. You can reach Brian through www.HolbrookManter.com or at BRavencraft@HolbrookManter.com.