The Tax Treatment of Farming Net Operating Losses

Overview

In the event that a farmer or rancher is confronted with the situation where expenses exceed income from the business, an operating loss may result.  Losses incurred in the operation of farms and ranches as business enterprises as well as losses resulting from transactions entered into for profit are deductible from gross income.  A net operating loss (NOL) may be claimed as a deduction for individuals and is entered as a negative figure on Form 1040. 

Special rules apply to farm NOLs.  Today’s post examines the proper way to handle a farm NOL and also discusses the changes to NOLs contained in the recently enacted Tax Cuts and Jobs Act (TCJA). 

Farm NOLs – The Basics

Carryback rule.  Until the changes contained in legislation enacted in late 2017, a farm NOL could be carried back five years or, by making in irrevocable election, a farmer could forego the five-year carryback and carry the loss back two years.  Those were the rules in place through 2017.   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.  Whether a loss is carried back two years instead of five depends on the farmer’s level of income in those carryback years and the applicable tax bracket.  

Another beneficial rule can apply when an NOL is carried back to a prior year.  Because two years back (as opposed to five) involves an open tax year, any I.R.C. §179 election that has been 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, the taxpayer 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 the taxpayer to claim future depreciation deductions.  This is the case, at least, on the taxpayer’s federal return.  Some states don’t “couple” with the federal I.R.C. §179 provision.

Taxpayers may elect to forego an NOL carryback in favor of a carryforward (for 20 years).  However, if a taxpayer elects not to carry a net operating loss back to offset income in prior years, the taxpayer will be limited to a carryforward of the NOL. 

The TCJA and The Impact on Farm NOLs

For tax years beginning before 2018, in which an individual taxpayer receives farm subsidies (essentially limited to CCC loans), farming losses were limited to the greater of $300,000 (married filing jointly) or the taxpayer’s total net farm income for the prior five taxable years.

An excess business loss for the taxable year is the excess of aggregate deductions of the taxpayer attributable to trades or businesses of the taxpayer (determined without regard to the limitation of the provision), over the sum of aggregate gross income or gain of the taxpayer plus a threshold amount.  The NOL carried over from other years may not be used in calculating the NOL for the year in question.  In addition, capital losses may not exceed capital gains.  Non-business capital losses may not exceed non-business capital gains, even though there may be an excess of business capital gains over business capital losses.  In addition, no deduction may be claimed for a personal exemption or exemption for dependents, and non-business deductions (either itemized deductions or the zero-bracket amount) may not exceed non-business income. Deductions may be lost for the office in the home, IRA contribution and health insurance costs.

The TCJA made changes to how farmers can treat NOLs.  For tax years beginning after 2017 and before 2026), a farm taxpayer is limited to carrying back up to $500,000 (MFJ) of NOLs. NOLs exceeding the threshold must be carried forward as part of the NOL carryover to the following year.  For tax years beginning before 2018, farm losses and NOLs were unlimited unless the farmer received a loan from the CCC.  In that case, as noted above, farm losses were limited to the greater of $300,000 or net profits over the immediately previous five years with any excess losses carried forward to the next year on Schedule F (or related Form). 

Also, under the TCJA, for tax years beginning after December 31, 2017, NOLs can only offset 80 percent of taxable income (the former rule allowed a 100 percent offset).  In addition, effective for tax years ending after December 31, 2017, NOLs can no longer be carried back five years (for farmers) or two years (for non-farmers). This effective date provision has an immediate impact on any farm corporation that has a fiscal year ending in 2018 insomuch as the corporation will not be allowed to carry back an NOL for five years.  Instead, the NOL can only be carried back two years.  All other corporate taxpayers can only carry an NOL forward.

Instead, under the TCJA, farmer NOLs can only be carried back two years and all others must be carried forward.  NOLs that are carried back can only offset 80 percent of taxable income.   However, NOLs that are carried forward will not expire after 20 years (as they did under prior law).  Similar to the carryback rule, NOLs that are carried forward can only offset

In the case of a partnership or S corporation, the TCJA applies the NOL rules at the partner or shareholder level.  Each partner’s distributive share and each S corporation shareholder’s pro rata share of items of income, gain, deduction, or loss of the partnership or S corporation are taken into account in applying the limitation under the provision for the taxable year of the partner or S corporation shareholder. 

Marital Status Changes

There are additional rules that apply if a taxpayer’s marital status is not the same for all years involved with a NOL carryback/carryforward.  In that case, only the spouse who had the loss can claim the NOL deduction.  On a joint return, the NOL carryback deduction is limited to the income of the spouse with the loss.  Also, the refund for a divorced person claiming a NOL carryback against a joint return with a former spouse cannot be more than the taxpayer’s contribution to taxes paid on the joint return.  The tax Code sets forth a step-by-step procedure to be used in calculating the portion of joint liability allocated to the taxpayer with the NOL carryback.

Change in Filing Status

Special rules also apply in calculating NOL carrybacks/carryforwards for couples who are married to each other throughout the subject NOL years, but who use a mix of MFJ and MFS filing statuses on returns in the carryback or carryforward years.

NOLs and Death

A NOL that has been carried forward is deductible on a decedent’s final income tax return.  It cannot be carried over to a decedent’s estate.  Also, an NOL of a decedent cannot be carried over to subsequent years by a surviving spouse.

Conclusion

Just because the farming business loses money doesn't mean that there isn't a tax benefit that can be taken advantage of to soften the blow.  That's where the NOL rules come into play.