The Tax Rules Involving Prepaid Farm Expenses

Overview

A common year-end tax strategy for farmers is to pre-pay input expenses by the end of the current tax year.  Pre-paying for next year’s seed, feed, fertilizer and chemicals, for a farmer on the cash method of farming, can reduce a current years’ tax burden.  But, if those deductions could be better utilized in the next tax year, pre-paying may not be the best strategy.   

Also, there have been several prominent cases in recent years involving the pre-paying of farming expenses by farmers on the cash method of accounting.  One avenue of attack has been its attempt to deny the use of pre-paid expenses.  Thus, it’s imperative for a farmer to properly pre-pay expenses to be able to claim the deduction in the year of the pre-payment.  As we get closer to the end of the year, and the timeframe during which many pre-payments occur, it’s a good idea to review the rules and get pre-payment arrangements properly structured so that deductions can be taken in the year of the payment, favorable prices can be received for input supplies and planting can be made more efficient due to having adequate input supplies on hand. 

The pre-paid expense rules.  That’s the topic of today’s post.

Basic Rules

The IRS issued a revenue ruling in 1979 that identified three conditions that must be satisfied for pre-paid expenses for inputs such as fertilizer, seed and chemicals to successfully generate a deduction in the year of pre-payment.  Rev. Rul. 79-229, 1979-2 C.B. 210.  Failure to meet any one of these conditions results in an allowable deduction only when the input is used or consumed.

Binding contract.  The first condition requires the pre-purchase to be an actual purchase evidenced by a binding contract for specific goods (of a minimum quantity) that are deductible items that will be used in the taxpayer’s farming business over the next year.  An absence of specific quantities or a right to a refund of any unapplied credit are indicative of a deposit. Likewise, if the farmer retains the right to substitute other goods or services for those denoted in the purchase contract, a deposit is indicated.  For example, a 1982 case from the Fifth Circuit Court of Appeals involved a Texas farmer who went to the local elevator near year's end, wrote a check for $25,000, and told the elevator operator that he would be back sometime in the following year to pick up $25,000 worth of supplies.  The farmer then deducted those expenses for that tax year and the IRS challenged the deductions.  The farmer lost because the transaction looked like a mere deposit.  Schenk v. Comr., 686 F.2d 315 (5th Cir. 1982).

While the IRS thinks that how the seller of the inputs characterizes the transaction on its books matters, that should be immaterial as to the characterization of the transaction for the farmer’s tax purposes.  That’s particularly the case because of Treas. Reg. §1.451-5(c) which allows the seller to treat the transaction as a deposit without affecting the farmer’s ability to deduct for the amount of the pre-paid expenses.  In addition, the farmer has no control over how an input seller treats the transaction on its books and deductibility should not turn on the seller’s characterization.

So, if a written contract is entered into for specific goods that are otherwise deductible items that will be used in the farming business within the next year, and the payment does not exceed (in total) the price and quantity established in the contract, the first condition is satisfied, and the transaction is a pre-payment rather than a deposit.

Business purpose.  The second IRS condition that is used to determine whether pre-purchased items are deductible is whether the transaction has a business purpose or was entered into solely for tax avoidance purposes.  This is the easiest of the three tests because if a taxpayer is not pre-purchasing to assure the taxpayer a set price, the taxpayer is pre-purchasing to assure supply availability.  Another legitimate business purpose associated with pre-purchasing include avoiding a feed shortage.  Thus, in practically all conceivable transactions, it is fairly easy to think of a business reason for what the taxpayer is doing.  But see, Peterson v. United States, 6 Fed. Appx. 547 (8th Cir. 2001). 

Material distortion of income.  The third condition requires that the transaction must not materially distort income.  While pre-purchasing distorts income, the key is whether the distortion is “material.” There is no bright-line test to determine whether income has been materially distorted in any particular case.  The IRS, however, gets most upset when a taxpayer's pattern of pre-purchases bears a suspicious tandem relationship to income.  For example, if a taxpayer's income goes up in one year and the level of pre-purchases also rises, and in a subsequent year, income goes down along with the level of pre-purchases, the IRS could question the transaction.  In addition, the IRS will likely examine the relation of the purchase size to prior purchases and the time of year payment was made.  Thus, it’s important for a farmer to stay consistent with their customary business practices in buying supplies and the business purpose(s) for the pre-payment.  Also, the pre-payment transaction should not provide a tax benefit that extends longer than 12 months.  See Treas. Reg. §1.162-3(c)(1)(iii).     

Some courts have approved deductions for prepaid inputs if the expenditure was made in the course of prudent business practice unless a gross distortion of income resulted.  However, recent cases have found material distortion of income and disallowed the deduction even though a legitimate purpose existed.  In any event, a survey of the decisions indicates that for year-end purchases of the next year's supplies, a taxpayer should try to take delivery or at least enter into a binding, no refund, no substitutes contract.  Likewise, it appears that if a taxpayer stays within the confines of the IRS rulings, the deduction will be allowed.  See, e.g., Comr. v. Van Raden, 650 F.2d 1046 (9th Cir. 1981).   

Limitation

There is an overall limitation on the amount of deduction for pre-paid expenses.  The limit is 50 percent of total deductible farming expenses excluding prepaid expenses.  This is largely drawn right off of Schedule F (including current year depreciation expense).  The taxpayer simply takes into account all of the expenses and is eligible to deduct up to 50 percent on a prepaid basis.  Thus, if a taxpayer has total deductible farming expenses for the year of $80,000, and has prepaid an additional $50,000, the most the taxpayer could deduct would be $40,000 which means the other $10,000 is carried over and deducted the following year. 

Exceptions.  There are two exceptions to the 50 percent test.  One of these exceptions is for a change in business operations caused by extraordinary circumstances.  A farmer is permitted to continue to deduct prepaid expenses even though the prepaid expenses exceed 50 percent of the deductible farming expenses for that year if the failure to meet the 50 percent test was because of a change in business operations directly attributable to extraordinary circumstances. If the reason for a taxpayer's reduced level of inputs was because of something extraordinary such as a major change in federal farm programs, like a 1983-style payment-in-kind program that idled a lot of land, or because of a big casualty loss, or because of a disease outbreak in livestock or something of that nature, that constitutes an extraordinary circumstance and removes the taxpayer from the 50 percent rule.

The second exception permits a “qualified farm-related taxpayer” to meet the 50 percent test over the last three years (computed on an aggregate basis) rather than the last one year.  A “qualified farm-related taxpayer” is a taxpayer whose principal residence is on a farm or whose principal occupation is farming or who is a member of the family of a taxpayer whose principal residence is on a farm or who has a principal occupation of farming.  A corporation carrying on farming operations can qualify as a “farm-related taxpayer.”  See Golden Rod Farms, Inc. v. United States, 115 F.3d 897 (11th Cir. 1997)   

If the aggregate prepaid farm supplies for the three taxable years preceding the taxable year are less than 50 percent, then there is no limitation on deductibility of prepaid expenses.  There is a question, however, concerning how the expenses over the past three years are to be aggregated.  Guidance is needed as to whether carry-over expenses to or from the three-year period are ignored, or whether the 50 percent test applies each year with the excess carried over to the following year.

Conclusion

The ability of a cash method farmer to pre-pay and deduct expenses is a critical tax management tool.  A typical famer’s amount of pre-payments can easily exceed $100,000.  In addition, it should be noted that rent can also be pre-paid (and currently deducted) if it doesn’t extend beyond 12 months.  Treas. Reg. §1.263(a)-4(f)(8), Example 10.  But, for pre-paid rent, the potential application of §467 will need to be considered. 

Make sure to follow the rules and structure pre-payment transactions properly.