What will your income tax liability be for 2011? If you are a grain farmer, it may be substantial because of high volume for 2010 crops sold in the high-price period of 2011. If you were adversely affected by weather or a livestock producer, your income may have been lower in 2011 and your tax liability may not be as high.
While you still have a couple days left, Purdue University tax specialist George Patrick says there may be some opportunity to adjust income by delivering and selling grain this year and deferring the income into 2012. In his annual tax guide for farmers Patrick suggests cash basis farmers who have high income in 2011 may want to shift as much as possible into 2012, either with grain sales or increased deductions. With the few days left in 2011, prepaying 2012 expenses could be another option for reducing your tax liability. However, he says they have to be structured properly or there could be some unexpected consequences.
The income deferral must be at an arms-length contract with the buyer, which prevents any opportunity to collect money in the current year. The IRS will rule that you had “constructive receipt” of the money, if you just left the cash at the elevator and did not pick up your check until Jan. 2. To achieve the desired effect, a contract has to be signed by both the producer and the elevator before any grain is delivered; and it should specify that no payment is to be made prior to 2012.
Patrick says doing that with livestock is a bit more complex because the Packers and Stockyards Act requires payment no later than the next business day after delivery. And payment deferral introduces the risk issues raised by the failure of the Eastern Livestock Company. On the other hand, you must determine if the livestock are actually yours or are you just receiving a fee for care and feeding. If the latter is the case, there is no eligibility for an installment sale that defers payment to another year. Patrick says if the animals are yours, both the profit and deductions are reported in the same year. “Report the profit by subtracting the cost of the items purchased for resale in the year of their sale. If the income from the sale is deferred, the deduction for the cost of the items purchased for resale is also deferred.”
If it is breeding stock, an installment sale is allowed, but only if there is a profit. Deducting a loss on the sale of the breeding stock has to occur in the same year of the sale. Patrick says, “If a sale involves the recapture of depreciation on a purchased animal, the installment sale method cannot be used for the gain that is treated as ordinary income. Depreciation recapture must be reported as income in the year of sale.”
For prepaying expenses, there are three requirements that must be met for the IRS to accept such a plan by a cash basis taxpayer.
- The expenditure must be for the supply rather than a deposit.
- The prepayment must be made for a business purpose and not merely for tax avoidance.
- The deduction must not result in a material distortion of income.
Giving a vendor some money, just to get the money off your books is not accepted, and can get you a penalty for an insufficient tax payment and a penalty. That would be the case if:
- If there is an absence of a specific quantity stated in the agreement.
- If there is a right to a refund of any unapplied payment credit at the end of the contract.
- If the seller treats the payment as a deposit, such as a payment of interest.
- If there is a right to substitute goods other than what is specified in the contract.
There also has to be a business purpose for the prepayment, such as guaranteeing delivery or taking advantage of a special price. Additionally, the prepayment cannot materially distort your income. Patrick offers four good examples illustrating what is allowed and not allowed in prepayments.
As 2011 winds down, farmers should examine their potential tax liability and take any possible measures to either defer income into 2012 or prepay expenses for 2012 operations. There are many ways of being successful in using these cash basis tools for reducing tax liability. However, specific rules must be followed or an audit could result in increased taxes and penalties if the tools are found to be misused.