One of our readers had the following question:

“I am slowing down farming. understand can gift 13000 a year in machinery value each to my son, his wife and his son.  What records and paper work do I need for this? Do I need equipment appraised? Does this allow me to take this equipment off my equipment schedule and not pay any taxes on it? Also my son wants to buy, rent, or lease some of my other depreciated equipment. What is the best way to handle this and paperwork to back it up beings he is my son? Also my son wants to buy,rent, or lease some other depreciated equipment. What is the best way to handle this? . Anything extra because of his relation as far prices?”

A gift of one piece of equipment to one person is fairly easy to do.  You simply transfer the equipment to the person, change the title (if there is title) and the equipment is now in the hands of the new person.  Normally, you do not need to get an appraisal, however, if the equipment is fairly new and the is a combine, tractor, drill, etc. it would make sense to get an equipment appraisal.  If the value exceeds $13,000, you are required to file a gift tax return, however, you can gift up to $1 million during your lifetime (above the annual exclusion of $13,000) tax-free.

Now, when you want to start gifting multiple pieces of equipment to multiple parties, I would suggest that you create a new LLC or S corporation to own this equipment.  The transfer of the equipment to the LLC is normally tax-free and the same with a corporation (unless your liabilities on the equipment exceed your basis, then you will have some taxable gain).

After the transfer is down (and if you are married, I would normally have half in your spouse’s name also), you can then transfer LLC units or stock in the corporation to your children and grandchildren.  Another benefit of this structure, is that the gift is usually discounted by about 35% or so due to a transfer of a minority interest in a LLC versus the direct transfer of equipment.

Once this transfer is done, the LLC will then rent the equipment to your son to use in his farming operation.  If you structure the LLC properly, you should be able to minimize the self-employment tax by having your son be the active manager of the LLC (with say 1% manager ownership interest) and having other other 99% being owned by you, your spouse, son, grandchildren, etc.   These interests are not usually subject to self-employments taxes, if structured properly (this planning is based upon a proposed IRS regulation that was never finalized, so some tax advisors may not be totally comfortable with this type of structure).

I will probably do another couple posts related to this question in the next week or so to update some of the conclusions with more details, but this is an over view of how to handle these types of transactions.

We got a question from a reader today asking if you they are required to report a deduction on their income tax return.  I would normally post a copy of the question here, but the details associated with this question makes that impractical.

In brief, the farmer originally reported $2,000 of interest expense as interest income by mistake and when they got the return back from the CPA and reviewed it, they caught the error and prepared an amended tax return to correct the error.  However, when they got the amended tax return back from the CPA, they expected their gross income to decrease by $4,000 and it only went down by $2,000 since the interest expense was reported on form 4835, farm rental income.  They had net passive losses, so the actual interest expense of $2,000 does not get deducted in the current year, but gets carried forward.

They had an interesting question regarding are you required to report this expense on their return.  Generally, you are required to report all income and expenses associated with your farm operation.  However, you have some lee-way in whether you have to deduct the expense.  In some cases, such as repairs, taxes, interest, etc., you can elect to capitalize these items and either amortize or depreciate over a longer period.  In other cases, you can make an argument that part of the expense is of a personal nature and not deduct that portion.  Also, by capitalizing repairs, this gives you the option to take Section 179 expense of whatever amount you want to maximize your refund.

You are probably asking why would you not want to deduct an expense.  There are several times when you would not want to:

• Lets say you have a couple of kids and your income for this year is not very high.  By capitalizing certain items and depreciating them, you would be able to go from not getting any earned income tax credit to perhaps getting $5,000 or more just by setting these items up on the depreciation schedule.
• You may want to take advantage of the 15% or other low income tax brackets by getting your income up to that level, so your income for the next year would not go over that level.

Here is a quick example of how this works.  Say we have a farmer who has net farm income of $35,000 before deducting a large repair of $35,000.   If they deducted the repair in full, they would owe no tax, however, they would get no refund back either.  If they capitalize the repair and elect to take Section 179 expense of lets say $7,500, they will still not owe any tax, however, they now get an earned income tax credit of $5,000 as a tax refund.

You must be careful to not simply ignore the expense on the return since the IRS, on audit, can report the expense and reduce your tax refund if you were trying to manipulate the earned income tax credit.

We got this question from one of our readers and it would apply to almost any farmer who hires a harvest or planting crew:

“Hi Paul, I was wondering how taxes work on food bought for workers. On our family farm we have a couple part time hired hands who work 200-300 hours a year between planting and harvesting. When working my mother feeds them quite well. Big lunches, dinners, sodas, cookies, deserts, etc. I was wondering if these food purchases are tax deductible? Also, do you know of any good farm tax resources for me to study so I could get a better idea of taxes in relation to farming.”

Normally, meals are deductible to an employer at 50% of the cost of the meals.  However, in this case, where the meals are provided to the employee on the employer’s work site and for the convenience of the employer, the meals are completely 100% deductible by the employer and the employee does not have to pick up any of it as income.

The rationale behind this is that the harvest crew does not have time to run into town to get a meal and it is more productive for the farmer to provide the meals directly on site and get the job done.  Therefore, the tax laws allow the farmer to deduct the meals in full.

We got the following question from one of our readers:

“I’m downsizing and want to sell some of my depreciated equipment. If I sell it out right I will pay full tax the first year on sale price. Can I lease my Equipment to someone for five to ten years to have the income spread over more years.”

This is one of those good news/bad news answers.

First, on equipment sales, you generally taxed on the full gain in the year that you sell the equipment even if you sell it on a contract over a few years.  The only way you could defer this type of gain would be on the portion of gain which greater than the original cost of the equipment.  Generally most used equipment is sold for a price less than what the farmer paid for it, so this would not apply.

The good news is that you can defer this tax by renting the equipment to the new farmer.  You would report the rents as income and deduct any remaining depreciation that you can take on the equipment.

The bad news is that this net income is also subject to self-employment taxes in addition to normal income taxes.  This increases your possible tax rate about 15%.  However, if you are still farming and are already over the maximum wage base of about $107,000, then the extra net tax is only about an extra 2.5%.

Or if you own the equipment in a corporation and lease it out, you would not be subject to any additional self-employment taxes.  Another possibility is to use a LLC to rent out the equipment.

So, in conclusion, you can defer the tax by renting out the equipment, however, it may be at a higher rate.

I just read an article in the most recent issue of BloombergBusinessWeek magazine that had some interesting facts and comments. 

First, for the first 8 months of 2010, farm exports are up by 14% to about $ 70 billion and this is before the recent increase in prices.

Second, it is estimated that China will become the second largest importer of our ag goods with $15 billion in 2011 second only to Canada’s $16.8 and slightly ahead of Mexico at $14.6 billion.

I am not sure if their math is correct since they say Ag is only 1% of our $14.3 trillion dollar economy which would be about $143 billion.  Our corn sales alone would be about $65 billion, so I am not sure if I agree with the math, but they do indicate if you include farm equipment sales, inputs, food processing, etc., the actual impact may be about 10 times higher or over $1 trillion in sales.

Tom Neher, vice president of AgStar Financial says their bank has issued twice as much farm equipment loans as expected in a recent promotion.  “I’ve seen more brand-new combines bought that I’ve seen for a long, long time”, says Neher, who helps manage $2.1 billion in grain-related loans and leases for AgStar.

That is also one of the prime reasons for BHP to try to buy Potash Corp.

In response to our post on when is a deposit income, we had a reader write in the following:

“In regard to today’s blog:　 I have a tenant who , over the years, mails his rent that is due Jan 1 in the previous Dec.　 Obviously he is deducting the rent as a “prepay”.　 I always deposit the check in Jan and count it in that year’s income.　 If one of us is audited, which one of us will get the penalty?”

As usual with tax law, the answer to this question is “It Depends’.  Actually, unless the tenant and the landlord are related parties, neither party will be at risk with regards to an audit.

A cash basis taxpayer can write and mail a check by December 31 and be able to deduct the payment in that year.  If the landlord receives the check in the next year, it is income in that year.  You want to be careful to document this if the check is dated too soon the previous year.  For example a check dated the 29th to the 31st would probably be OK, if it is dated the 25th or sooner, you might have some issues on an audit, but as long as you document when you receive it, you should be fine.

If the tenant and landlord are related parties, then the tenant is not able to deduct the check until the landlord picks up the check as income.  Related parties are usually family members or entities controlled by the same people.  For example, if a corporation which is owned by a farmer, writes a rent check to the farmer for their land rent, the check is not deductible until the farmer reports it as income.

In Friday’s Wall Street Journal, there is a front page article in the Money and Investing Section regarding the worry of various investors about how accurate the USDA has been with the latest US corn crop.  As most farmers know there has been whipsaws in the reports issued this year.

In June, the USDA reported that stockpiles were lower than expected and prices jumped 9%.  In September, the USDA reported a more than expected increase in carry-over by 300 million bushels and then a few weeks later reported the actual 2010 corn crop was going to be substantially lower than expected which resulted in much lower carry-over than the trade expected.  This resulted in a dramatic increase in prices.

The USDA’s reporting problems will probably be a topic of conversation when agency officials gather for their annual data user’s meeting in Chicago on Monday.  I would like to be an invisible participant in that meeting!

The USDA indicated they had a hard time estimating the average weight of the corn kernel, which led to the USDA reducing their estimate twice since indicating a record crop in August.

Some analysts cut the USDA some slack by stating this year’s crop was a unique set of circumstances related to weather and unlikely to see again  (however, that is what they always seem to say about 100 year floods that happen every 10 years or so).

As we stated in a previous post, volatile times are here and USDA reports may make it even more volatile.

Another nugget of information that I got out of the speech by Dr. Boehlje of Purdue University on Wednesday is that accordingto their studies at the school, the volatility associated with agriculture has gone up by 400% in the last few years. 

This means that the price swings in ag commodities is now 4 times greater than it used to be.   I can still remember when I used to trade ag commodities on the futures exchange (many years ago) that a price move in corn of 3 to 5 cents was a huge move.  Now, 10 to 20 cents is almost the norm.

Dr. Boehlje also indicated that the volatility is not just in the sales price, but also the price that farmers pay for inputs such as fertilizer, seed and diesel.  Just in the last two years, we have seen fertilizer prices zoom up to about $1,000 per ton, back down to about $300 per ton and probably now around $700 per ton.

How does all of this volatility affect our farmers.  Dr. Boehlje indicates that great farmers view these times as a great opportunity to expand their operation and make it more efficient.  It requires them to take maximum advantage of marketing skills, financial reporting, and banking relationships.  It allows them to lock in great prices and also lock in their input costs.  Even if input costs go up by 50% or more, the increase in prices allow them to lock in a contribution margin larger than they can get now.  However, this requires them to know what their actual cost of operations are down to the bushel and acre level and they have a great relationship with their bankers.

The key question is where do you fall in this spectrum?  Do you view this volatility as an opportunity or does is worry you.  I hope you are in the former’s viewpoint.

Dr. Michael Boehlje, a farm economics professor at Purdue University spoke at out opening day of the National Ag conference of the American Institute of Certified Public Accountants (I know that is a mouthful).  He gave a 4 plus hour presentation on the agricultural economy both currently and insights into the future.

One of the insights that he had was that current interest rates are at almost an all-time low.  The normal yield curve currently has a dip in rates between the three to seven year maturity before it steepens out to the normal curve.  He indicated that this presents a great current opportunity to lock in great rates in that three to seven year period.

He also indicated that it is much tougher to lock in low rates as compared to about a year ago due to the futures markets already pricing in higher rates beginning next year.  For example, he presented a chart showing the projected 3 month LIBOR rate (which a lot of banks use to set interest rates).  That rate is currently about .2%, however, the futures market is projecting this rate would be as follows:

• 2011 – 1% or so
• 2012 – 2% or so
• 2013 – 3% or so
• 2014 – 4% or so
• Beyond 2015 it trends up to about 5%

This means that banks are not willing to lock in rates beyond a three to five period at a rate much lower than the expected LIBOR rate plus their normal spread of 200 to 300 basis points.

I will be at the annual American Institute of Certified Public Accountants Ag Convention in Denver today till Friday.  I hope to come away some ideas for our farmers.

We had a reader ask the following question:

“Can you hold checks that have been sent to us for grain sold in 2010 until 2011?”

The technical answer to this is that these checks will be considered income for 2010 even if they are not deposited until 2011.  Even if a farmer is on the cash basis of accounting, any constructive receipt of funds is considered to be income in the year available to farmers.  Constructive Receipt is defined as any income, although not actually in the farmer’s possession, which is:

1. It is credited to the farmer’s account,
2. Set apart for the farmer,
3. Made available so the farmer can draw upon it at any time, or
4. The farmer can draw upon if it notice of intent to withdraw is given.

In this case, the farmer has constructive receipt of the income since they can deposit into the bank at any time.

In my state of Washington, we have several thousand farmers who have their fruit processed at the local packing house.  Each variety of fruit is received, packed and then sold.  After this process is complete, the packing house will then close out the “pool” and allocate the income and expense to each of the growers in the pool.  Once the process is completed and the posting of the net income is made to the grower’s account, this net income becomes income to the farmer even though they have not received any cash.  This is due to the fact that the pool closing has been (1) credited to the farmer, (2) set apart on the grower’s account statement, and (3) the farmer can draw upon the funds at any time with a notice to the packing warehouse.

A farmer can defer grain income into future years by entering into a contract, but I will leave that for a future post.

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