Many more farmers are using futures contracts to hedge their crops these days than 20 or 30 years ago.  Hedging income and losses are treated as ordinary income or loss as part of the farming operation.  What many farmers do not know is that if they are using futures to speculate in other commodities or crops that these transactions are considered speculation and the income tax treatment is very different.  If a farmer is speculating, then these losses are treated as capital gains and losses.

I will give you an example from when I was in college.  I had a very good friend that was speculating in the commodity market.  During year #1, he enjoyed a very profitable year and lets assume he made $300,000.  All of these gains were short-term and at that time, the top rate was 50%.  Therefore, his tax bill from his speculation that year was $150,000.  During year 2, he lost the $300,000 he made in year 1 and then lost another $300,000.  When he filed his tax return for year 2, he deduction, the net loss of $600,000 on the return, but the capital loss rules limit you to only claiming a net capital loss each year of $3,000.  Therefore, he got a credit of $1,500 for year 2.  Adding the two amounts together resulted in net tax due of $148,500.

If he had all of the transactions in one year, he would have gotten a net refund of $1,500.  As you can see, if your capital gain income occurs earlier than your losses, the tax laws provide a large penalty to taking advantage of any future capital losses.  You can use $3,000 each year or use your capital losses to offset other capital gains.

In your farm operation, make sure to note what is actually hedging and what might be speculation and subject to the rules above.

Moe Russell, of Russell Consulting Group wrote a very good article in the Corn and Soybeans Digest clear back in 2007 on the fact that you do not need to own land to be a farmer.  I personally think in today’s environment, most farmers who already own a bunch of land with no debt are most likely not maximizing their return as a farmer.  They are probably doing a good job of maximizing the return to them as land owners since they are farming it themselves. 

However, as both a landlord and a farmer, you need to review each year what your return has been as both.  Make sure in your management reports that you have allocated cash rent to yourself as landlord that is reflective of what cash rents are bringing in your area.  Make sure that you do not use the highest or lowest, but somewhere in a median range.  Once you allocate this cash rent to your farming operation, how profitable was your farm for the year and what is the trend.  I believe, in many cases, the farmer will find out that it is earning a good cash rent return, but as a farmer, it is generating a loss or very little profit.

If this situation continues for too long, the farmer has two good options:

• Stop farming and either sell the land or cash rent (this would probably be the most difficult for most farmers), or
• Increase the profitability of the farming operation to take advantage of the land that the farmer owns.  This may require renting more acres, sharing equipment with other farmers, etc.

Have you taken the time to do this analysis on your farm.  If not, I think the results may surprise you.

In the recent Holdner Tax Court case, the IRS was able to make an argument that the farming operations carried on by father and son were in fact a partnership and not two separate farming operations that should be reported on their respective schedule F.

In the case, the father and son had operated the farm business together since 1977.  However, during these years, the father and son each reported one half of the income on their schedule F.  However, the father arbitrarily reported most of the farm expenses on his return.  Upon audit, the IRS took the position that the farm operation was in fact a partnership and allocated one-half of the income to each and disallowed all of the farm expenses to both.  In addition, the IRS assessed the 20% accuracy penalty against the dad.

The Tax Court reviewed the case and agreed that the farm operation was in fact a partnership, however, they did allow the deductions to be split 50/50.  The Court did uphold the extra 20% penalty assessed against the dad.

I know that many farmers who farm either with their children or siblings do so in an informal farm partnership and usually report their income and deductions on schedule F.  If this allocation is based upon a formal accounting process, then the IRS is not going to have an issue with the reporting.  However, if the income or deductions are allocated based upon the whim of the individuals involved, then the IRS may come in and both disallow the allocation and assess an extra 20% penalty of the tax owed.

If this applies to your farm operation, make sure you review with your tax advisor that you are handling your allocations correctly.

As I write this post September 2011 wheat futures are trading at slightly more than $7 per bushel.  If I had asked any wheat farmer three months ago would they like to lock in $7 wheat for next year’s crop, I am fairly certain that 100% of them would have said yes.

These farmers now have that choice, subject to the basis issues as discussed in a previous post.  I would strongly suggest that all wheat farmers review their budget for next year and see if it makes sense to try to lock in prices near the current level.  Any time that a farmer can at least lock in good prices to cover all of their estimated production costs allows the farmer greater flexibility in marketing their crop and it also pleases the banker.

In a side note, I spent Friday and Saturday driving combines for my cousins down in Walla Walla.  I drove a Case IH 2388 and 1470 for about 18 hours and that was my idea of a vacation.  Yields ranged near 125 bushels for dry land wheat and with the current good prices, I think my cousins might have a good year in farming.  They have some steep hills down in this area and kicking in the 4 wheel drive is always fun for a combine driver.  Using three machines, you can cover a lot of acres in a day, however, this year the fields had a lot more down wheat and the speeds are much lower than normal.  it is fun to see 3 combines, 2 bunk-out wagons and 2 semis all going strong.

Congress back in 2001 dropped the maximum tax rate on dividends received by a taxpayer from 39.6% to 15% (plus any applicable state income taxes).  But under the so-called Sunset Rule, these special low rates expire at the end of 2010.  Beginning in 2011, the top rate is expected to go back to 39.6% and beginning in 2013, the effective top rate will be 43.4% after taking in account the new Medicare surtax of 3.8%.

What this means to a farmer who has a C corporation that is in the top tax bracket both at the corporate level and at the individual level is as follows:

• For 2010, your maximum combined corporate and individual income tax rate will be 44.75%
• For 2011 and 2012, your maximum combined rate will increase to 60.74%
• For 2013 and thereafter, your maximum combined rate will be a whopping 63.21%.  This represents a huge 41% increase since 2010.

A tax planning tip is to review your current retained earnings and see how much you should drop out to you in the form of dividends.  If the corporation needs the working capital, you can always loan it back to it at very cheap interest rates.

I know that many of our readers currently have jobs not related to farming, however, you would like to leave that job and start farming on a full-time basis.   One of the major drawbacks to doing this is the lack of capital.  However, many of you could have a substantial asset that you could tap to create the working capital needed to get started in farming.  This asset is your 401(k) plan.

Here is how it works:

• You will need to create a corporation (generally taxed as a C corporation).
• This corporation will establish a 401(k) plan.
• You will roll over your current 401(k) at the old employer into this new 401(k) plan.
• The new 401(k) plan will then purchase shares in the new corporation and will become an owner of the corporation (this is very similar to an ESOP).
• The money put into the corporation becomes the working capital that the corporation can use to purchase equipment, plant crops, etc.

There is no limit on how much stock the 401(k) can purchase.  This means, that unlike borrowing money from a 401(k) plan which is limited to $50,000 or cashing in the plan and paying taxes and a 10% penalty on the funds received, you are able to maximize the amount of capital you can put into the farm business.

There is a recent article in Bloomberg Businessweek concerning this type of transaction.  The primary topic of the article is that the IRS has noted some abuses in this type of transaction.  Some taxpayers have set up a corporation simply to purchase a motor home, etc.  This will most likely get disallowed on an audit.  However, if you are using the cash to create a farming entity and will be actively farming, there should be no issue with using your 401(k) to fund it.

As in all cases, you need to discuss this with your tax advisor.  Also, the article does refer to a company that has helped do several hundreds of these transactions.

In my post yesterday, I indicated that maximizing your net return per acre was more important than the most yield per acre.  One of our readers wrote a great comment regarding how their operation tries to maximize their yield to achieve the most net revenue per acre.

My post should have stressed that your farm operation should try to maximize your yield up to what I call the point of diminishing returns.  For example, if you can increase your yield by an extra 10 bushels (for corn) by spending $15 on good seed or fertilizer, then your return at $4 corn is $40/$15 or 2.67 to one.  As you do your analysis for your farm, anytime this number is greater than 2, it makes sense to spend the extra money.

If the number is between 1 and 2, then you need to crunch your numbers and get comfortable with your probability of the extra yield happening.  For example, if you think you can make an extra $20 per acre by spending $10, your ratio is 2 to 1, however, if the chance of this happening is 50%, your expected ratio becomes 1 to 1.  At this point, you are simply at the break even point and you are not receiving any extra to cover your overhead related to this extra cost.

If you were to chart your options related to maximizing your yield compared to your input costs, the return yield to cost would look very similar to the horsepower chart on my BMW motorcycle.  As I add RPM, the horsepower output increases at about a 45 degree angle up to about 8,000 RPM.  At this point, as I add more RPM, the horsepower output slightly increases and then as I get near the redline, the horsepower starts to drop off dramatically.

In your farm operation, try to determine where the extra yield maximizes the return to the bottom line.

Creighton University produces a monthly rural main street economic report based upon  a survey of bankers in an 11 state area which comprises most of the corn belt.  This survey gives a good picture of where the local farm economy is headed.

In the latest report, the highlights are as follows:

• The farmland-price index moved above growth neutral for a third straight month to 59.5 from 58.2 in March.  After beginning a downward slide in the spring 2008, farm and ranch prices have once again begun to grow.  One banker reported that a 143-acre farm in Nebraska brought $8,025 per acre.
• The farm equipment sales index soared from March 41.4 to 57.2 in April.  Bankers are reporting significant improvements in farm and ranch land prices and equipment sales.  They seem to expect these trends to continue in the months ahead.
• One banker indicated the increases in cattle prices is having a large positive impact in the local economy.
• For a second straight month, all bank indicators were healthy.
• However, hiring in the rural area has yet to bounce above growth neutral.

Another interesting note was that about 82% of the bankers surveyed were in support of extending the 45-cent-per-gallon blender credit for ethanol production.  Only 8% were against it.

One of my readers sent me a question about a farming operation that applies to many farm families.  I am going to summarize the question as follows:

Scenario:

160 acre cropland is titled as Kevin XXX and Mary XXX, JTWRS (50%) and The Jane M YYYY Trust (50%).  Kevin and Jane M are brother and sister.  Mary XXX is Kevin’s wife.  Kevin and Mary also have a 240 acre operation of their own.

Is a partnership return REQUIRED to be filed or can Jane M and Kevin XXX each allocate their share of expense/income attributable to the 160 acre operation.

Can you provide me some info?  What’s the penalty for not doing it correctly.

As you can see from the facts, this is a fairly normal situation where property was probably inherited from a mom or dad and it is titled as co-owners in the brother (including wife) and sisters name.  The brother is also farming other property.

Normally, anytime property is owned by more than one party, a partnership of some type is involved.  This usually requires the filing of a partnership income tax return.  Until a few years ago, the penalty for not filing a partnership income tax return was minimal as long as all of the partners reported their share of the income timely.

However, with last year’s new tax laws, the penalty for filing a late partnership income tax return can now be pretty steep.  The penalty is now equal to $195 per partner for each month that the return is late with a maximum of 12 months.  Therefore, under the current case, if a partnership return is required and they never file one, the IRS could assess penalties on three partners for twelve months at $195 per month.  This penalty would equal $7,020 which is substantial.

If the parties want to not to file a partnership return, then can make an election to opt out of the partnership rules.  I will discuss this election in a near future post, but as you can see, the penalty for not making the election can be substantial.

I will have a couple more posts on this subject over the next week or two.

My good friend Scott Heintzelman of The Exuberant Accountant recently posted a summary of the information on the new Health Care act that passed Sunday night and I thought I would post the same summary since this new Act will affect all of us as Americans and as farmers.

Premium Assistance Credit

The act provides for refundable tax credits that eligible taxpayers can use to help cover the cost of health insurance premiums for individuals and families who purchase health insurance through a state health benefit exchange (which each state is required to establish under section 1311 of the act). Under new IRS § 36B, an eligible individual will enroll in a plan offered through an exchange and report his or her income to the exchange. Based on the information provided to the exchange and his or her income, the individual will receive a premium assistance credit. Treasury will pay the premium assistance credit amount directly to the insurance plan in which the individual is enrolled. The individual will then pay to the plan in which he or she is enrolled the dollar difference between the premium tax credit amount and the total premium charged for the plan.

Eligibility for the premium assistance credit is based on the individuals income for the tax year ending two years prior to the enrollment period. The premium assistance credit is available for individuals (single or joint filers) with household incomes between 100% and 400% of the federal poverty level (for the family size involved) who do not received health insurance through an employer or a spouse’s employer. The credit amount is determined by the Secretary of Health and Human Services, based on the percentage of income the cost of premiums represents, rising from 2% of income for those at 100% of federal poverty level for the family size involved to 9.5% of income for those at 400% of federal poverty level for the family size involved.

The premium assistance credit will be available for years ending after Dec. 31, 2013.

Small Business Tax Credit

The act provides tax credits for small businesses and individuals designed to increase levels of health insurance coverage, as part of the IRC § 38 general business credit. Small businesses defined as businesses with 25 or fewer employees and average annual wages of less than $40,000 would be eligible for a credit of up to 50% of nonelective contributions the business makes on behalf of their employees for insurance premiums (new IRC § 45R). Tax-exempt organizations would get a 35% credit against payroll taxes.

Employers with 10 or fewer employees and average wages of less than $20,000 would get 100% of the credit; it would be phased out, up to the 25-employee limit. The $20,000 average annual wages figure will be indexed for inflation after 2013. Five-percent owners under the section 416 top-heavy plan rules and 2% S corporation shareholders are not included in the definition of employee, but leased employees are counted.

This credit is available for tax years beginning after Dec. 31, 2009.

Excise Tax on Uninsured Individuals

The act creates new IRC § 5000A, which requires U.S. citizens and legal residents to maintain minimum amounts of health insurance coverage. Minimum essential coverage includes various government-sponsored programs, eligible employer-sponsored plans, plans in the individual market, grandfathered group health plans and other coverage as recognized by the Secretary of Health and Human Services in coordination with the Secretary of the Treasury. This requirement would not apply to individuals who are incarcerated, not legally present in the United States or maintain religious exemptions.

Individuals who fail to maintain minimum essential coverage will be subject to a penalty equal to $750. The fee for an uninsured individual under age 18 is one-half of the adult fee. The total household penalty may not exceed 300% of the per-adult penalty.

The penalty amount will be phased in over the years 2014-2016 and will be indexed for inflation after 2016. However, liens and seizures are not authorized to enforce this penalty, and noncompliance will not be subject to criminal penalties.

This provision is effective for tax years beginning after Dec. 31, 2013. The reconciliation bill if enacted would change the amount of the penalty.

Tax-Exempt Health Insurers

The act provides for a program administered by the Department of Health and Human Services that will foster the creation of qualified nonprofit health insurance issuers to offer health insurance. Insurers receiving federal grants or loans under the program would be exempt from federal tax (under IRC § 501(a)) for periods when the insurer complies with the terms of the program.

Reporting Requirements

The act requires insurers (including employers who self-insure) that provide minimum essential coverage to any individual during a calendar year to report certain health insurance coverage information to both the covered individual and to the IRS (new IRC § 6055).

The information required to be reported includes: (1) the name, address, and taxpayer identification number of the primary insured, and the name and taxpayer identification number of each other individual obtaining coverage under the policy; (2) the dates during which the individual was covered under the policy during the calendar year; (3) whether the coverage is a qualified health plan offered through an exchange; (4) the amount of any premium tax credit or cost-sharing reduction received by the individual with respect to such coverage; and (5) such other information as the Secretary may require.

This requirement is effective for calendar years beginning after 2013.

Medical Care Itemized Deduction Threshold

The threshold for the itemized deduction for unreimbursed medical expenses is increased from 7.5% of AGI to 10% of AGI for regular income tax purposes. This is effective for tax years beginning after Dec. 31, 2012, except that for 2013, 2014, 2015 and 2016, if either the taxpayer or the taxpayer’s spouse turns 65 before the end of the tax year, the increased threshold does not apply and the threshold remains at 7.5% of AGI.

Cafeteria Plans

The act makes premiums for coverage under a qualified health plan offered through an exchange a qualified benefit under a cafeteria plan. This provision applies only to cafeteria plans established by a small employer that elects to make all its full-time employees eligible for one or more qualified plans offered in the small group market through an exchange.

This provision is effective for tax years beginning after Dec. 31, 2013.

Additional Hospital Insurance Tax on High-Income Taxpayers

Under the act, the employee portion of the hospital insurance tax part of FICA, currently amounting to 1.45% of covered wages, is increased by 0.9% on wages that exceed a threshold amount. The additional tax is imposed on the combined wages of both the taxpayer and the taxpayer’s spouse, in the case of a joint return. The threshold amount is $250,000 in the case of a joint return or surviving spouse, $125,000 in the case of a married individual filing a separate return, and $200,000 in any other case.

For self-employed taxpayers, the same additional hospital insurance tax applies to the hospital insurance portion of SECA tax on self-employment income in excess of the threshold amount.

The provision applies to remuneration received and tax years beginning after Dec. 31, 2012.

Employer Responsibility

Under new IRC § 4980H, an applicable large employer that does not offer coverage for all its full-time employees, offers minimum essential coverage that is unaffordable, or offers minimum essential coverage that consists of a plan under which the plan’s share of the total allowed cost of benefits is less than 60%, is required to pay a penalty if any full-time employee is certified to the employer as having purchased health insurance through a state exchange with respect to which a tax credit or cost-sharing reduction is allowed or paid to the employee.

An employer is an applicable large employer with respect to any calendar year if it employed an average of at least 50 full-time employees during the preceding calendar year.

An applicable large employer who fails to offer its full-time employees and their dependents the opportunity to enroll in minimum essential coverage under an employer-sponsored plan for any month is subject to a penalty if at least one of its full-time employees is certified to the employer as having enrolled in health insurance coverage purchased through a state exchange with respect to which a premium tax credit or cost-sharing reduction is allowed or paid to such employee or employees. The penalty for any month is an excise tax equal to the number of full-time employees over a 30-employee threshold during the applicable month (regardless of how many employees are receiving a premium tax credit or cost-sharing reduction) multiplied by one-twelfth of $2,000.

An applicable large employer who offers, for any month, its full-time employees and their dependents the opportunity to enroll in minimum essential coverage under an employer-sponsored plan is subject to a penalty if any full-time employee is certified to the employer as having enrolled in health insurance coverage purchased through a state exchange with respect to which a premium tax credit or cost-sharing reduction is allowed or paid to such employee or employees.

This provision is effective for months beginning after Dec. 31, 2013.

Fees on Health Plans

Under new section 4375, a fee is imposed on each specified health insurance policy. The fee is equal to two dollars (one dollar in the case of policy years ending during fiscal year 2013) multiplied by the average number of lives covered under the policy. The issuer of the policy is liable for payment of the fee.

For any policy year beginning after September 30, 2014, the dollar amount is equal to the sum of: (1) the dollar amount for policy years ending in the preceding fiscal year, plus (2) an amount equal to the product of (A) the dollar amount for policy years ending in the preceding fiscal year, multiplied by (B) the percentage increase in the projected per capita amount of National Health Expenditures, as most recently published by the Secretary before the beginning of the fiscal year.

The issuer of the policy is liable for payment of the fee.

In the case of an applicable self-insured health plan, new IRC § 4376 imposes a fee equal to two dollars (one dollar in the case of policy years ending during fiscal year 2013) multiplied by the average number of lives covered under the plan. For any policy year beginning after September 30, 2014, the dollar amount is equal to the sum of: (1) the dollar amount for policy years ending in the preceding fiscal year, plus (2) an amount equal to the product of (A) the dollar amount for policy years ending in the preceding fiscal year, multiplied by (B) the percentage increase in the projected per capita amount of National Health Expenditures, as most recently published by the Secretary before the beginning of the fiscal year. The plan sponsor is liable for payment of the fee.

The fee is effective with respect to policies and plans for portions of policy or plan years beginning on or after Oct. 1, 2012.

Excise Tax on High-Cost Employer Plans

New IRC § 4980I imposes an excise tax on insurers if the aggregate value of employer-sponsored health insurance coverage for an employee (including, for purposes of the provision, any former employee, surviving spouse and any other primary insured individual) exceeds a threshold amount. The tax is equal to 40% of the aggregate value that exceeds the threshold amount. For 2018, the threshold amount is $10,200 for individual coverage and $27,500 for family coverage, multiplied by the health cost adjustment percentage (as defined in the act) and increased by the age and gender adjusted excess premium amount (as defined in the act).

The provision is effective for tax years beginning after Dec. 31, 2017.

Tax on HSA Distributions

The additional tax on distributions from a health savings account (HSA) or an Archer medical savings account (MSA) that are not used for qualified medical expenses is increased to 20% of the disbursed amount, effective for disbursements made during tax years starting after Dec. 31, 2010.

Tax on Indoor Tanning Services

The act imposes a 10% tax on amounts paid for indoor tanning services (new IRC § 5000B). Like a sales tax, the tax will be collected from the person tanning when payment for the tanning services is made. The provision applies to services performed on or after July 1, 2010.

Flexible Spending Account

The act mandates that the maximum amount available for reimbursement of incurred medical expenses of an employee, the employee’s dependents, and any other eligible beneficiaries with respect to the employee, under a health flexible spending account for a plan year (or other 12-month coverage period) must not exceed $2,500. The provision is effective for tax years beginning after Dec. 31, 2012.

SIMPLE Cafeteria Plans for Small Business

The act establishes a SIMPLE cafeteria plan for small businesses. Under the provision, an eligible small employer is provided with a safe harbor from the nondiscrimination requirements for cafeteria plans as well as from the nondiscrimination requirements for specified qualified benefits offered under a cafeteria plan, including group term life insurance, benefits under a self insured medical expense reimbursement plan, and benefits under a dependent care assistance program. Under the safe harbor, a cafeteria plan and the specified qualified benefits are treated as meeting the specified nondiscrimination rules if the cafeteria plan satisfies minimum eligibility and participation requirements and minimum contribution requirements.

The provision is effective for tax years beginning after Dec. 31, 2010.

Expansion of Adoption Credit, Adoption Assistance Programs

For 2010, the maximum adoption credit is increased to $13,170 per eligible child (a $1,000 increase). This increase applies to both non-special needs adoptions and special needs adoptions. Also, the adoption credit is made refundable. The new dollar limit and phase-out of the adoption credit are adjusted for inflation in tax years beginning after Dec. 31, 2010. Also, the scheduled sunset of EGTRRA provisions relating to the adoption credit is delayed for one year (i.e., the sunset becomes effective for tax years beginning after Dec. 31, 2011).

For adoption assistance programs, the maximum exclusion is increased to $13,170 per eligible child (a $1,000 increase). The new dollar limit and income limitations of the employer-provided adoption assistance exclusion are adjusted for inflation in tax years beginning after Dec. 31, 2010. The EGTRRA sunset of provisions relating to adoption assistance programs is also delayed for one year (i.e., the sunset becomes effective for tax years beginning after Dec. 31, 2011).

Charitable Hospitals

The act establishes new requirements applicable to section 501(c)(3) hospitals, regarding conducting a community health needs assessment, adopting a written financial assistance policy, limitations on charges, and collection activities.

Information Reporting

The act requires employers to disclose on each employee’s annual Form W-2 the value of the employee’s health insurance coverage sponsored by the employer, effective for tax years beginning after Dec. 31, 2010.

The act requires businesses to file an information return (e.g., a Form 1099) for all payments aggregating $600 or more in a calendar year to a single payee, including corporations (other than a payee that is a tax-exempt corporation). The provision is effective for payments made after Dec. 31, 2011.

Return Information Disclosure

The act allows the IRS, upon written request of the Secretary of Health and Human Services, to disclose certain taxpayer return information if the taxpayers income is relevant in determining the amount of the tax credit or cost-sharing reduction, or eligibility for participation in the specified state health subsidy programs.

Upon written request from the Commissioner of Social Security, the IRS may disclose the certain limited return information of a taxpayer whose Medicare Part D premium subsidy, according to the records of the Secretary, may be subject to adjustment.

The act contains a provision to extend the general exclusion for reimbursements for medical care expenses under an employer-provided accident or health plan to any child of an mployee who has not attained age 27 as of the end of the tax year and codifying the economic substance doctrine.