Tuesday, March 7, 2017
The IRS recently issued interim guidance on a pilot program for Schedule F expenses for small business/self-employed taxpayer examinations. The program is to start on April 1, 2017 and run for one year. The focus will be on “hobby” farmers, and the program will be conducted through the IRS Brookhaven campus in Holtsville, NY. While the pilot will only consist of 50 tax returns from tax year 2015 being examined, it could be an indication that the IRS is looking to increase the audit rate of returns with a Schedule F. In addition, without knowing how the returns will be selected for examination, it may be more likely to impact the relatively smaller farming operations.
Focus of the Pilot Program
The interim guidance points out that the IRS believes that compliance issues may exist with respect to the deduction of expenses on the wrong form, or expenses that actually belonged to another taxpayer, or that should be subject to the hobby loss rules of I.R.C. §183. Indeed, the IRS notes that a filter for the project will be designed to identify those taxpayers who have W-2s with large income and who also file a Schedule F “and may not have time to farm.” IRS also says the filtering for expenses will be via the same process that it uses when it examines Schedule C, and notes that deductions that relate to the taxpayer’s W-2 employment, Schedule A or a corporate return should not appear on Schedule F. In addition, the guidance informs IRS personnel that the examined returns could have start-up costs or be a hobby activity which would lead to non-deductible losses.
The interim guidance directs the IRS examiners to consult IRS Pub. 225 (Farmers’ Tax Guide) and directs its examiners to look for a taxpayer with a primary residence on a farm where the principal business is farming. The interim guidance also directs examiners to look for deductions that “appear to be excessive for the income reported.” The implication is that such expenses won’t be deemed to be ordinary and necessary business expenses. How that might impact the practice of pre-paying farm expenses remains to be seen. One of the tests for pre-paying and deducting farming expenses is that the pre-payment must not materially distort income. Is the IRS implying in the interim guidance that it views a high level of pre-paid expenses when income is relatively low to be a material distortion of income? Perhaps that’s reading too much into the guidance and giving the IRS too much credit. The guidance does instruct that deposits are not deductible pre-payments, although it does state that a deposit is deductible if it is for future supplies. That is a strange statement. A pre-payment that constitutes a deposit is not deductible in accordance with Rev. Rul. 79-229, which the guidance doesn’t mention.
The IRS also instructs its examiners to separate deductible business expenses from capital expenses and personal expenses. On the capital expense issue, there is no mention of the $2,500 safe harbor (per invoice or per item) which allows a current deduction. The guidance also instructs examiners to pick through gas, oil, fuel, repairs, etc., to determine the “business and non-business parts” of the expense. Again, no mention is made of the safe harbor.
The interim guidance indicates that custom hire expense is deductible on line 13 of Schedule F. It also notes that fuel expense is deductible if it is used for conducting business on the farm. On that issue, the IRS believes that having an on-farm storage tank and accounting for personal use of fuel is important, and that fuel bought from a gas station needs further explanation to ensure it was not used for personal purposes.
As for mortgage interest, the interim guidance notes that it is deductible if it relates to real property that is used in the taxpayer’s farming business. The guidance also states that repair and maintenance expenses on the taxpayer’s personal residence are not deductible, without mentioning the situation that is common in agriculture – an office in the home for which related repairs and maintenance would be deductible.
The interim guidance does get into an explanation of the pre-paid expense rules and this time states that the pre-payment cannot be a deposit and states that the taxpayer must be able to document the reason for the prepayment.
The interim guidance would appear to be targeted toward taxpayers that either farm or crop share some acres where the income ends up on Schedule F, but where other non-farm sources of income predominate (e.g., W-2 income, income from leases for hunting, bed and breakfast, conservation reserve program payments, organic farming, etc.). In those situations, it is likely that the Schedule F expenses will exceed the Schedule F income. That’s particularly the case when depreciation is claimed on items associated with the “farm” - a small tractor, all-terrain vehicle, pickup truck, etc. That’s the typical hobby loss scenario that IRS is apparently looking for.
Keep in mind that the IRS is only going to examine 50 returns in their pilot project, and those returns will relate to the 2015 tax year. The IRS should focus its attention on those returns with small losses, but it’s not known whether that will be the IRS approach. Also, where is the IRS going to come up with the funds to audit, even if the pilot program indicates a widespread problem? Those funds aren’t available, and aren’t likely to be forthcoming in the near future.
In any event, it’s helpful to know what the IRS is up to.