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.

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.

In my last post, I gave an update on the current estate tax law and how it my apply to farmers for 2010.  In that post, I referred to the term “Step Up” and I am using this post just to explain what the term Step Up or Step Down means.

Up until this year, when a person died, the property that passed through to their heirs received a step up or down in cost basis to the fair market value at the time of death.  When the heirs would sell the property, this is the amount they would use for their cost basis.  For example, if a farmer owned land that he paid $100,000 for and it was worth $500,000 when he died, the heirs would be able to use the $500,000 when determining their capital gain when they eventually sold the land.  Conversely, if the fair market value at death was $50,000, then that would be the value they would use.

For the last several decades, this has been rule for inheriting property and then selling it by the heirs.  Starting this year, the IRS requires to Step Down any property, but use cost only on the other property that is worth more than what was paid for it originally.  However, the executor can make an election to step up value of up to $1.3 million or an additional $3 million for a surviving spouse.  In addition, the final income tax return for the person dying will be required to fill out a schedule showing the cost basis of all assets passed on to their heirs.  This cost basis is what the heirs will have to use in computing their capital gains tax when they sell any of these inherited assets.

As you can see, although there might not be any federal estate tax, there will be extra capital gains taxes and a lot more work for the executor and their professional to do.

I am currently in a financial investment conference in Chicago for a couple of days and during one of the sessions, the current estate tax situation was discussed.  There appears to be at least 6 billionaires that have died this year and under the current law, they will owe no federal estate taxes, however, in most cases, they will owe state estate taxes.  Now, this appears to be a good deal, however, there is an income tax cost to not have an estate tax.

This cost relates to there being no step up in basis of the assets that are inherited by the heirs.  They can elect to step up $1.3 million in assets or an extra $3 million going to a surviving spouse.  Lets see how this might affect a farmer with a decent size estate.  Lets assume that a farmer dies with land valued at $10 million and equipment valued at $2 million.  Assume there is no other assets and the basis in these assets is only $1 million.

There will be no federal estate tax due, however, most likely about $1 million of state estate will be due.  Now lets assume the heirs elect to step up the equipment by $1.3 million and then they sell the assets in 2011.  The capital gains rate for the land including state income taxes will be about 30% so, they will owe about $2.7 million of federal and state income taxes.  On the equipment, there will be a gain of $700 thousand and assumption top bracket of about 50% for federal and state taxes will result in total taxes on this gain of about $350 thousand.

Therefore, in total, the estate and heirs have paid estate taxes of $1 million and income taxes of about $3 million for total taxes of $4 million.  Under the law in effect for 2009, there would have been estate taxes of about $4.5 million and no income taxes. 

So you can see that even there is no federal estate tax for this year, a farmer who passes away with certain tax facts can almost pay the same amount in state estate and related income taxes. 

Please make sure to review your situation with your tax advisor.

Also, these laws are most likely to change during this year or next and we will keep you posted.

In my post about large tax increases coming for dividends, there were several replies on our Agweb.com blog site regarding how this affects S corporation dividends and other related issues.

I thought I would use this post to give our farmers a quick update on how income is taxed for C corporations and S corporations.

First, a C corporation simply refers in the part of the Internal Revenue Code dealing with corporate taxation (C).  Almost all farm corporations are C corporations unless they elect to be taxed as an S corporation (to be discussed below).

A C corporation will each year compute it taxable income and then pay an income tax based upon the bottom line.  If the taxable income is less than $50,000 the tax rate is 15%, however, as the income increases over this amount, the tax rates increase substantially and for income between $100,000 and $335,000, the rate is 39% plus whatever the state income tax rate will be.

After this income is computed and the corporate tax paid, the shareholder will be subject to a separate tax when this income is distributed to the shareholder as a dividend.  Right now, this rate is 15%, however, starting next year as discussed in the post, the rate will skyrocket to close to 40% or and starting in 2013, the rate may exceed 40% due to the new Medicare surtax on investment income.

Now, if the farmer would like to stop this so-called double tax, they can elect for the corporation to be taxed as an S corporation (again this is the section in the Internal Revenue Code dealing with these types of corporations, that is why it is called an S corporation).  This election allows the corporation to pay no corporate tax and have all of the income flow through to the shareholders who then pay the tax at their normal tax rates.  This means that when the corporation pays a dividend to the shareholders, there is no additional tax since the tax has already been paid on the income.

Why would a farmer ever want to be a C corporation if there is this double tax?  There are many cases where a farmer would want to be a C corporation.  For example, assume the farm only earns about $75,000 a year.  Under this scenario, the farmer using proper tax planning would most likely not pay any tax at all if they have two or more minor children, whereas, being taxed as an S corporation could result in several thousand dollars of tax (see previous posts on this).

The bottom line is that you need to review your income tax situation both for the current year and for future years and determine which corporation works best for you.

The large health care act passed earlier this year had an up to 35% credit available to farmers who paid for health insurance for their employees.  The credit is based upon the percentage amount of health insurance that a farmer pays times 35%.  As long as you pay at least 50% of the premiums for your employees, then the credit is based upon the amount paid times 35%.

However, there is a cap on how much premium that you can use.  This cap is based upon the average premium for small group markets for each state.  The IRS just published revenue ruling 2010-13 that outlines what this cap amount is for each state.   The cap is based either on employee-only coverage or family coverage.  I will give you an example of how this cap might work for you as a farmer:

Suppose you have two employees.  One is single and one is married with kids.  Assume that you pay 80% of the medical insurance for each employee.  Also, assume you are a farmer in Iowa.

Lets calculate the maximum amount of the credit by assumimg that the cost of this premium is $500 per month for the employee and $950 per month for the family.  The credit that you could take is 80% of the premium times 35% for the year.  This would equal $500*12*.8*.35 or $1,680 for the single employee and $950*12*.8*.35  or $3,192 for the family employee or a total credit of $4,872.

Now, we need to determine how much of this credit is allowed by comparing it to the small group market tables from the IRS.  For the single employee, the maximum credit allowed for Iowa for a year is $4,652.  Since the farmer only paid 80% of the premium, this would equal a total allowed amount of $3,721.60 times 35% equals $1,302.56 maximum credit allowed for a single employee.  For the family employee, the state of Iowa maximum annual amount is $10,503 times 80% times 35% equals $2,940.84.  These two amounts added to together results in a maximum credit allowed of $4,243.40. 

Our original calculation resulted in a credit of $4,872.  The IRS only allows $4,243.40 based upon the small group market tables, so the actual credit you would use on your tax return is the $4,243.40.

A quick way of determining whether you need to worry about this is to look at your premium on a monthly basis and compare it to the table amount (after dividing by 12 to make a monthly comparison).  If your premium is less than the table amount, you can ignore it on the tax return, however, if your premium is greater than the table amount, you will need to limit your credit based on this calculation.

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.

My post from yesterday resulted in several comments and questions that I would like to respond to.

One comment is that code section 4975 deals with prohibited transactions regarding you and your pension plan or IRA.  There are severe penalties for not obeying the rules regarding these transactions.  However, if you obey the rules, the penalties do not apply to you.  I sometimes find that other tax advisers are not comfortable with these rules and would rather not have to deal with these types of transactions, however, if you follow the rules and use a company that is extremely familiar with the rules, you should be in compliance.

The majority of these rules do not allow you to sell or rent land, equipment, etc. between your pension plan or IRA and yourself.  However, in my post yesterday, the transaction described involved the purchase of the employer’s stock directly from the employer to the pension plan.  This is one of the transactions allowed by the code as long as you follow the rules.

Another question was whether you can use an IRA to do this.  The general answer is no, however, in most cases, once you set up your 401(k) or other pension plan with your new corporation, you can roll over your IRA to the pension plan and then have it purchase the stock.  This will allow you to use the IRA in an indirect way.  Certain types of IRA rollovers may not work, so like in call cases with my posts regarding tax laws, talk this over with your qualified tax advisor. 

Another question asked if you could purchase farm land using this method.  The answer is yes, no and maybe.  For it to be yes, the corporation would need to purchase the land if you are going to farm it.  If you are simply purchasing the farmland to rent out to a non-related third party, you can use the IRA or pension plan to purchase the land directly.  However, if you fund any of the purchase with debt, there are several rules that come into play.  You can not personally guarantee the debt.  In most cases, it would need to be seller financing for the deal to work.  If you personally are going to farm the land, then you can not have the IRA or pension plan own the land and rent it to you.

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.

Scott Heintzelman of The Exuberant Accountant has a very good post on the new rules coming for 1099 reporting for all businesses starting in 2012.  In one of my previous posts, I had indicated that these rules were coming, but Scott does a very good job of highlighting the changes.

One thing that needs to be stressed on these rules that most of us probably have ignored is that if we do not comply properly with the rules, two bad things can happen.

First, if you do not report the transaction to the IRS, they can assess a penalty of $50 per form 1099 not reported up to a current maximum of $100,000.  Under the current rules, if you missed one or two 1099s that should have been reported, the total penalty might be less than $500.  Under the new rules, if you are required to issue form 1099 to all businesses that you purchase goods and services from, the penalty could add up very fast.  For example, if you deal with 100 vendors that you paid more than $600 to during 2012 and do not report any of these transactions on form 1099, then your potential penalty is at least $10,000.

Second and perhaps more important is that if you do not provide your federal identification number to your customers, they may be required to perform backup withholding on payments to be transmitted to you.  This backup withholding is usually 20% of the total sale.  Therefore, if you sold grain for $250,000 to your local elevator and backup withholding applies, the elevator would only give you a check for $200,000 and send $50,000 to the IRS.  You would be able to get this $50,000 back when you file your return, but that means you have to wait until the following year to get your money.

Under current rules, backup withholding does not apply to  the sale of farm products, but it is my opinion that with the new rules, backup withholding will probably apply on the sale of any product including farm products.  Therefore, it will be very important to provide your EIN to any customer you sell products to.

I would strongly suggest that you review your current accounting system and Trprocedures to make sure that you are ready for 2012.  As the scientist Carl Sagen would say, the IRS is about to get Billions and Billions of form 1099 starting in 2012.