Tuesday, November 1, 2016
My post last week on casualty and theft losses generated A LOT of positive feedback and requests for more information about farm losses in general. The tax code does provide some help in dealing with farming losses – especially for taxpayers that are on the cash method (which most farmers are). That’s good news when faced with an economic downturn in the farm economy. It puts year-end tax planning at a premium and is one of the things I am focusing on at the tax schools I am teaching across the country this fall.
It’s also a topic that Andy Biebl of CliftonLarsonAllen’s National Tax Team addressed in a recent farm magazine column. Andy only has limited space for that column. I get to blabber here without limitation. So, let’s take a bit of a deeper look beyond the casualty and theft loss discussion of last week and expand on what Andy has already written on. It’s a big enough issue this fall that it deserves more attention. In addition, I have the feeling that this blog reaches a bit of a different audience than does the farm magazine column. That’s a good thing. It allows the issue to be discussed in front of the widest audience possible.
Farm Income Averaging and Farm Operating Losses
For persons engaged in farming (cultivating of land or the raising or harvesting of any ag or horticultural commodity), the ability to elect to average farm income back three years can be a very important income tax management tool. While farm income averaging is normally utilized to apply lower income tax rates from prior years to the current year taxable income, it can work in reverse when income is low in the current year. When the election is made in that situation, the power of the technique lies in combining an income averaging election with the loss carryback rule.
For example, assume that Joe has a large net Schedule F farming loss for 2016 (unfortunately, many farmers will experience this for 2016). Under the five-year carry back rule that applies to farming losses, Joe can carry that back to his 2011 tax year. If 2011 was a good year for Joe (as it was for many farmers), he was probably in one of the upper income tax brackets that year. A beneficial aspect of the loss carryback rule is that a loss that is carried back to a prior year will offset the income in the highest income tax bracket first, and then the next highest, etc., until it is used up. In our example, if it offsets all of Joe’s income for the carryback year of 2011 before it is used up, the remaining amount simply carries forward to 2012 and any later years. This all points out that a loss from farming isn’t all bad news. It can generate an operating loss that can be carried back and generate a refund in a prior year.
Also, in our example, Joe has the option to decide not to carry back a loss five years. He can carry it back two years instead. Joe can do this by making an election to irrevocably forego the five-year carryback period for a farming loss. I.R.C. §172(i)(3). So, if it would be better from a tax standpoint for Joe to carry a farming loss back two years rather than five, that’s what he should do. It all depends on the level of income in those carryback years and the applicable tax bracket. Also, because two years back (as opposed to five) involves an open tax year, any I.R.C. §179 election that Joe made can be revoked if the loss carry back eliminates the need (from a tax standpoint) for the election. By revoking the I.R.C. §179 election, Joe will get the income tax basis back (to the extent of the election) in the item(s) on which the I.R.C. §179 election was made. That will allow him to claim future depreciation deductions. This is the case, at least, on Joe’s federal return. Some states don’t “couple” with the federal I.R.C. §179 provision.
Note: Yes, you can make or revoke an I.R.C. §179 election on an amended return for an open tax year. Ignore any commentary to the contrary unless it comes from the IRS.
Ok. But, you ask, “where does farm income averaging fit into all of this?” That’s a good question. If we continue with Joe’s situation of a big 2016 loss that he carried back to 2011 (and triggered a refund), there is another piece to the tax puzzle that needs to be inserted here and it has to do with how the income averaging tax is calculated. Under the farm income averaging rules, the Code says that the tax imposed for the year in which income averaging is elected is the sum of the tax for that year on income reduced by the amount of the elected farm income, plus the increase in tax which would have occurred if taxable income for each of the three previous tax years was increased by an amount equal to one-third of elected farm income. I.R.C. §1301(a). That’s a mouthful. In addition, any adjustment to taxable income for a prior year because of the “elected farm income” amount averaged to that tax year is taken into account in applying the income averaging provision for any subsequent taxable year.
So, what does this Code language mean? It means that the income of the past years is adjusted upward for a future year’s computation after income averaging has been used. That means that farm income averaging doesn’t really change the taxable income or tax of any of the three base years. It doesn’t cause the current year’s income to get hauled back and added to the income from a base year. That’s a big deal. The income averaging election simply uses the prior three-year tax base to peg the rate for the year of the election. Any applicable phase-outs or percentage limitations for the base years are not impacted. Treas. Reg. §1.1301-1(d)(1).
So, back to our example with Joe, his tax practitioner might be able to get him a better tax result by amending his 2013 and 2014 tax returns to get more bang out of the income averaging election by not only getting a refund for 2011, but also reducing the applicable tax rate for 2013 and 2014 (for Joe, 2012 is a closed year that is not part of the base years for the income averaging calculation). That makes the bad income year not quite as bad after all. That’s the result that can be obtained with an income averaging election in a down year after a couple of good ones. How do you know whether it makes sense to do all of this? Get your pad and pencil out and run the numbers! Actually, your tax software will do it for you. But, just knowing the mechanics of the combined techniques is the key to being able to “eyeball” when it might be a good idea to plug the numbers into the software for a farm client.
Excess Farm Losses
The 2008 Farm Bill included a provision that limits the deductibility of an “excess farm loss” after 2009 for farmers that don’t operate in the C corporate form that receive any direct or counter-cyclical payment from the USDA, or any payment elected to be received in lieu of a direct or counter-cyclical payment, or any CCC loan. I.R.C. §461(j). CRP payments are not deemed to be a subsidy payment for purposes of this provision. The non-deductible portion of a farming loss is the excess of the aggregate deductions of the farmer for the year attributable to the farming business, or the sum of the aggregate gross income or gain of the farmer for the year attributable to farming, plus a threshold amount defined as the greater of $300,000 (MFJ) or the total of the net farm income for the previous five years. I.R.C. §461(j)(4)(B). There are other detailed rules on this provision, but these are the basics. Also, direct and counter-cyclical payments have now been repealed, so it looks like the only type of subsidy that would count and potentially limit a farmer’s ability to deduct losses would be the receipt of a CCC loan. Loan deficiency payments would appear to not be an “applicable subsidy” for purposes of the provision. Also, for purposes of the rule, losses arising from fire, storm or any other casualty, or because of disease or drought are not subject to the limitation.
Economic conditions in agriculture point toward another bad income year for both crop farmers and livestock producers, in general. This puts a premium on getting good tax advice and engaging in some serious year-end tax planning. The cash method of accounting provides the flexibility and the ability to use a farm income averaging election after the fact can be a powerful tool to manage income, especially when it is combined with the revocation of an I.R.C. §179 election for the open tax years.
Just some things to think about that might help soften the blow and get on your farm client’s Christmas card list!