Tax Treatment of Farmers
Farmers include all individuals, partnerships, or corporations cultivating, operating, or managing farms for gain or profit as owners or tenants. However, taxpayers engaged in forestry or timber raising are not farmers.
Farmers, like other taxpayers, are subject to a variety of taxes at all levels of government. At the Federal level, these include income taxes, social security and self-employment taxes, and estate taxes. At the state and local level, the most significant taxes are on property and income. Other taxes such as excise taxes, corporate income taxes, and retail sales taxes are significant for only a small number of farmers.
The Federal income tax is a progressive tax imposed on net income. Taxable income is computed by subtracting allowable adjustments, deductions, and personal exemptions from total income. Numerous provisions of Federal income tax law allow taxpayers to reduce their tax liability if they undertake certain tax-favored activities. Farmers benefit from both general tax provisions available to all taxpayers and from provisions specifically designed for farmers.
A farmer’s gross income includes amounts received in cash plus anything of value received instead of cash. Included are:
- proceeds from the sale of crops, produce, poultry, and livestock;
- fair market value of farm products, other property, or services, received in exchange for farm products or services (i.e., barter income);
- prizes for livestock or products;
- proceeds from sale of natural deposits;
- insurance proceeds to the extent received for the crop destroyed;
- patronage dividends;
- payments for easement or right of way on farm or ranch land;
- proceeds from timber sales;
- CCC loans;
- fee for taking care (pasture) of someone else’s cattle;
- crop shares;
- government aid payments;
- fuel tax credits or refunds; and
- commodity futures (options) gains.
The amount of cash or the value of material or services that a farmer receives from the government under most governmental programs is included in the farmer’s gross income. If government payments are based on improvements, the taxpayer must still include them in income. The full cost of the improvement must be capitalized. But part or all of certain federal or state cost sharing conservation, reclamation, and restoration program payments can be excluded from income.
- Fertilizer and lime received under government programs are included at the value figured in the program.
- Payments under the Dairy Termination Program are taxable as gain or loss on the sale of the dairy cattle as additional amount realized or as ordinary income as replacement for milk production receipts.
- Buyouts of peanut quotas under the Farm Security and Rural Investment Act of 2002.
- Payments from the National Tobacco Settlement Trust to landowners, producers and tobacco quota owners, are compensation for lost revenue due to decreased tobacco demand, and are taxable as ordinary income.
- Payments to terminate tobacco quotas under the Farm Security and Rural Investment Act of 2004.
- Payments to growers under the Fair and Equitable Tobacco Reform Act of 2004.
- Illegal irrigation subsidies, i.e., the excess of the amount required to be paid for any federal irrigation water delivered to the taxpayer during the tax year, over the amount paid for the water.
- First handler payments and inventory protection payments made by the Community Credit Corporation under the Food Security Act of 85 that exceed the cost of the cotton giving rise to the payments, are included in gross income.
- Rents for leasing out upland cotton acreage allotments made under the Agricultural Adjustment Act are ordinary income to the farmer to whom the allocation was made.
- Commodity certificates under government conservation, production flexibility, etc. programs are included in gross income, at their full amount.
- Reimbursements under Disaster Assistance Act are included in gross income, according to the farmer’s accounting method.
Under the capital gain-ordinary loss rule farmers treat net gains on sales, exchanges and involuntary conversions of qualified property used in their trade or business as capital gains, while net losses are ordinary losses.
Generally, a farmer will have a capital gain or loss if s/he sells or exchanges a capital asset. Almost everything a farmer owns and uses for personal purposes or investment is a capital asset.
The following items are examples of capital assets.
- A home owned and occupied by you and your family.
- Household furnishings.
- A car used for pleasure. If car is used both for pleasure and for farm business, it is partly a capital asset and partly a non-capital asset.
- Stocks and bonds.
When a farmer sells, exchanges, or otherwise disposes of his/her property, s/he usually has a gain or a loss. A sale is a transfer of property for money or a mortgage, note, or other promise to pay money. An exchange is a transfer of property for other property or services.
If the amount realized from a sale or exchange of property is more than its adjusted basis, the farmer will have a gain. If the adjusted basis of the property is more than the amount realized, then the farmer will have a loss. The basis of property a farmer buys is usually its cost. The adjusted basis of property is basis plus certain additions and minus certain deductions.
The amount realized from a sale or exchange is the total of all money received plus the fair market value of all property or services received. The amount realized also includes liabilities assumed by the buyer and any liabilities to which the property transferred is subject, such as real estate taxes or a mortgage.
The gain or loss realized from a sale or exchange of property is usually a recognized gain or loss for tax purposes. A recognized gain is a gain that must be included in gross income and reported on the income tax return. A recognized loss is a loss deducted from gross income. For example, if recognized gain from the sale of a tractor is $5,300, the farmer includes that amount in gross income. However, the farmer’s gain or loss realized from the exchange of property may not be recognized for tax purposes. Also, a loss from the disposition of property held for personal use is not deductible.
Certain exchanges of property are not taxable and thus, any gain from the exchange is not recognized, and any loss cannot be deducted. A farmer’s gain or loss will not be recognized until s/he sells or otherwise dispose of the property.
The exchange of property for the same kind of property is the most common type of nontaxable exchange.
If one receives property in a like-kind exchange, the basis of the property will be the same as the basis of the property given up. If, in addition to giving up like-kind property, one pays money in a like-kind exchange, s/he still has no recognized gain or loss. The basis of the property received is the basis of the property given up, increased by the money paid.
For example: A farmer traded an old tractor with an adjusted basis of $1,500 for a new one. The new tractor costs $30,000. He was allowed $8,000 for the old tractor and paid $22,000 cash. He has no recognized gain or loss on the transaction regardless of the adjusted basis of his old tractor and the basis of the new tractor is $23,500, the adjusted basis of the old tractor plus the cash paid. If he had sold the old tractor to a third party for $8,000 and bought a new one, he would have a recognized gain or loss on the sale of his old tractor equal to the difference between the amount realized and the adjusted basis of the old tractor. In this case, the taxable gain would be $6,500 ($8,000 – $1,500).
Whether a farmer reports a capital gain or loss depends on how long s/he owns the asset before sale or exchange. The time s/he owns an asset before disposing of it is the holding period. If a farmer hold a capital asset one year or less, the gain or loss resulting from its disposition is short term. If s/he hold a capital asset longer than one year, the gain or loss resulting from its disposition is long term.
If the total of capital gains is more than the total of capital losses, the difference is taxable. However, part of gain (but not more than net capital gain) may be taxed at a lower rate than the rate of tax on ordinary income. The tax rates that apply to a net capital gain are generally lower than the tax rates that apply to other income. These lower rates are called the maximum capital gains rates.
If the total of capital losses is more than the total of capital gains, the difference is deductible. But there are limits on how much loss one can deduct and when it can be deducted.
A farmer who operates a farm for profit is entitled to deduct from gross income necessary expenses, all amounts actually expended in the carrying on of the business of farming. The farmer’s accounting method generally controls the proper time for deducting the business expense.
A farmers’ business expenses include:
- rent paid for farm;
- taxes and tax preparation fees;
- marketing quota penalties paid for marketing crops in excess of marketing quotas, unless deducted from the amount paid by the buyer to the farmer (who includes only the net amount received in income);
- egg-laying hens, and plants, chicks, etc., bought for resale;
- car and truck expenses;
- maintaining houses and furnishings for tenants and hired help, including costs for heat, light, insurance, repairs, and depreciation;
- interest on farm mortgages and other obligations incurred to carry on farm business;
- educational expenses to maintain and improve farming skills;
- ordinary tools of short life (one year or less) or small cost, such as hand tools, shovels and rakes; and
- premiums on fire, storm, crop, theft, liability, and other insurance on farm business assets.
The taxpayer may deduct the actual cost of operating a truck or car in his/her farm business, but only for the business use. Deductible expenses include costs for gasoline, oil, repairs, license tags, insurance and depreciation (subject to certain limits).
Farmers may deduct as business expenses the real estate and personal property taxes on farm business assets, e.g., farm equipment, animals, farmland, and farm buildings. Taxes on any part of the farm used as the taxpayer’s residence (including furnishings) aren’t deductible as business expenses.
State and federal income taxes aren’t deductible as farm business expenses. But a state tax can be deducted as an itemized deduction.
State or local general sales taxes imposed:
- on non-depreciable farm business expense items are deductible as part of the cost of those items; and
- on the purchase of assets for use in the taxpayer’s farm business (including amounts imposed on the seller which are passed through to the taxpayer-buyer) are included as part of the cost the taxpayer depreciates.
Reasonable amounts paid for regular farm labor, piecework, contract, or other labor hired to perform farming operations are deductible. This includes wages paid in cash and other property. Deductible labor includes the actual cost of boarding hired farm labor and the costs of their health and workers’ compensation insurance.
Farmers who pay wages in cash include in their deductible labor costs the amount of social security, medicare and income tax withheld from those wages, as well as the portion of the social security and medicare taxes the farmer (as the employer) must pay.
A farmer can deduct wages paid to his/her spouse if a true employer-employee relationship exists between them. Similarly, reasonable wages paid by a parent to his/her child for farm work rendered as a bona fide employee are deductible, even if the child uses the wages for part of his/her own support.
Most expenses for the repair and maintenance of farm property (including repainting, replacing shingles and supports on farm buildings, and minor overhauls of trucks, tractors, and other farm machinery) are deductible as business expenses. If the repair is a major overhaul of depreciable property that substantially prolongs its useful life, increases its value, or adapts it to a different use, the expenses must be capitalized.
For example, the roof of a taxpayer’s barn is damaged. S/he can deduct the costs of repairing the roof. But if s/he has it replaced instead, the costs of the new roof must be capitalized.
If a farmer’s expenses are for items that are only partly used for business, a reasonable allocation must be made, based on the circumstances, between the business and personal portions. Only the business portion is a deductible business expense.
For example: a farmer paid $ 1,500 for electricity for the tax year. The electricity was on-third for personal use and two-third for farming use. The farmer can deduct $ 1,000 (2/3 of $ 1,500) as a business expense.
A farmer’s basic local home telephone service (including taxes) is a nondeductible personal expense even if s/he has an office in his/her home. But charges on that line for farming business long-distance calls and the cost of a second line used exclusively for the farming business are deductible.
A farmer is allowed a business expense deduction for the cost of preparing that part of his/her tax return, or in resolving asserted tax deficiencies that relate to his/her farm business. No deduction is allowed for expenses incurred in raising produce or livestock consumed by the farmer and his/her family.
A depletion deduction is available to a farmer as an owner and operator only if s/he has an economic interest in mineral deposits or standing timber.
Individuals engaged in a farming business may elect to use income averaging to compute their tax for a tax year. An electing individual’s tax for the year will equal the sum of:
- a tax computed on taxable income reduced by elected farm income, plus
- the increase in tax imposed would result if taxable income for the three previous tax years (base years) were increased by an amount equal to one-third of the elected farm income.
An individual engaged in a farming business can make a farm income averaging election to compute his/her current year (election year) income tax liability by averaging, over the prior three-year period (base years), all or a portion of the individual’s current year electible farm income.
Making the income averaging election may result in a lower tax if the farmer’s current year income from farming is high and his/her taxable income for one or more of the three earlier years was low. It may be to a farmer’s advantage to include less than the full amount of his/her income from farming in his/her elected farm income, depending on the farmer’s tax bracket for the current and the three earlier tax years.
Determining the tax liability for the election involves computation of the tax that would be imposed, if:
- taxable income for the election year were reduced by EFI, and
- taxable income for each of the base years were increased by one-third of EFI.
The reduction and increases required for this computation don’t affect the actual taxable income for either the election year or the base years. So, for each of those years, the actual taxable income is determined without regard to any hypothetical reduction or increase required for computing the tax for the election year.
To compute the amount, all allowable deductions (including the full amount of any net operating loss carryover) are taken into account in determining the taxable income for the base year even if the deductions exceed gross income and the result is negative. But if the result is negative, any amount that may provide a benefit in another tax year is added back in determining base year taxable income.
An individual doesn’t have to have been engaged in a farming business in any of the base years in order to make a farm or fishing income averaging election.
A farmer does not have to pay the estimated tax if s/he files his/her return and pays the tax on or before March first of the following year. If s/he doesn’t file his/her return and pay the tax on or before March first, s/he need only make one estimated tax payment for the year, which is due on or before January fifteen of the following tax year. A farmer or fisherman may avoid penalty by paying hundred percent of the previous year’s tax. The underpayment penalty is based on the difference between the amount of estimated tax s/he paid by the due date and two third of the actual tax for the year.