We had a reader ask the following question as a follow up to our post of gifts:

“Please touch on one more aspect of gifting. Gifting grain and the tax owed by the recipient. Thanks, I enjoy your emails.”

Cash method farmers have had many situations where the gifts of farm commodities to family members could be advantageous:

• Moving income to minor children in a lower tax bracket,
• Helping with college costs for children of the taxpayer,
• Supporting parents of the farmers.

With the expansion of the kiddie tax in 2008 to dependents up to age 23 attending college, this reduced the advantage of making gifts of farm commodities to relatives, but not completely.  The farmer still removes this income from their schedule F and if self-employed, neither the farmer or child will pay self-employment taxes on the gift.

One thing to remember is to gift farm commodities that were raised in the prior year since there will be no reduction in operating costs related to the commodity gifted (if gifted in the year of production, you have to reduce your operating costs by amount attributable to the gift).

If the family member is not a dependent under age 24 (if going to college), the income tax effect to them is very straight forward.  The basis in the commodity carries over, most likely zero (unless gifted in the year of production).  The grain is considered a capital asset in the hands of the donee and if sold in less than a year, it is subject to ordinary income tax rates.  If held more than a year, it is subject to favorable capital gains rates.  In the case of parents that the farmer is supporting, they may only have social security income and could easily earn another $10-20,000 of gifted farm commodity income and pay no tax, or if held for more than a year, they could easily double or triple that amount in certain situations for 2011 and 2012.

For dependent children, it is likely that the kiddie tax will apply and the child will pay income taxes on the sale of the grain based upon the farmer’s tax rate.  Therefore, there is minimal income tax savings, but there can be substantial self employment tax savings.

One last reminder is that you must make sure to document the gift properly and the person receiving the commodity must have actual control and ownership before selling the commodity and you should review this with your tax advisor to make sure it is done properly.

One of the great options open to farmers is to pay their employees in-kind wages.  In-kind wages are the payments of the crops that a farmer grows.  For example, a farmer could pay their employees either cash wages of $10,000 or 1,000 bushels of soybeans worth $10,000.  The reason that a farmer would want to do this is that in-kind wages are not subject to self-employment taxes.  On $50,000 of these types of wages, the savings to the farmer and employee would total about $7,500.

Generally, we suggest using these types of wages where the farmer has a C corporation set up to do the farming operation and it will pay some of the farmer’s wages in-kind.  The structure of these wages is very important since if the IRS determines these are a cash equivalent, then the wages are subject to payroll taxes.

Wages paid in-kind are crops that are transferred from the employer and put into the name of the employee.  The employee then has the risk and reward due to the fluctuations in the value of the crop.  For example, the employer may transfer 1,000 bushels of beans to the employee at $10 per bushel or a total in-kind wage of $10,000.  This amount is reported to the IRS on the employee’s W-2.  After receiving the 1,000 bushel of beans, the employee will determine when and if they want to sell the beans.  If the beans go up in value by 50 cents a bushel, the employee will report a short-term capital gain of $500 (if held more than a year, then it is long-term).  Conversely, if the beans drop in value by 50 cents, they will report a short-term capital loss of $500.

The highlights of what is required to qualify is as follows:

• Did your employees perform agricultural related work?
• Did you pay the employees in commodities raised and harvested on your farm?
• Did you pay them a partial cash wage?
• Did you have an employment contract with the following:
  • Was it written
  • Was the employee’s duties defined as Agricultural labor
  • Did it state the employee would be paid a commodity wage
  • Did it state the type of commodity
  • Did it state the quantity of the commodity
  • Was it signed by both the employer and employee
  • Was it notorized on the date of the agreement
• Did the employer remove the lein, if any, on the commodity paid to the employee?
• Was the grain in open storage and not a warehouse receipt?
• Was the grain readily marketable and not contracted for sale?
• Did the employer notify the warehouse to transfer the commodity to the employee?
• Do you have bill of sale for the transfer
• Will the employee be responsible for the following:
  • Assuming the risk of loss due to price fluctuations, damage, death, etc.
  • Assuming the costs of owning and maintaining the commodity
  • Holding the commodity long enough to prove ownership and control
  • Marketing the commodities themselves

Again, these wages normally work best between a corporation owned by the farmer and the farmer as employee.  You still should make sure to pay enough cash wages to provide four full quarters of credit for social security purposes.

This is a complicated part of farm employment and make sure to review this with appropirate legal and tax advisors to enjoy the benefit.

I have been reading several articles lately on the possible estate tax law changes that will be coming.  The Bush changes from about 8 years ago will be changed and soon.

Most agree that the estate exemption will most likely be around $3.5 to $5 million and indexed for inflation.  Also, the gift tax exemption will also go back to being the same as the estate tax exemption.  There are also signs that they will allow any unused exemption for the spouse who died to be carried over to the surving spouse.

For example, under the current law, if one spouse dies first and has nothing in their name, their estate tax exemption expires worthless.  Under the proposed changes, if a spouse dies with assets of $2,000,000 and the estate exemption is $3.5 million, then $1.5 million would carry over to the surviving spouse.

A great change for farmers is an increase in the special use allowance up to about $3,5 million.  This allows many more family farms to pass tax free to their heirs and keep it in farming.  The special use valuation is a method that reduces the value of farm property to what it would be worth as farm use only.  Many farmers are close to cities and their land is worth substantially more as development property than farm property.  This special use allows the estate to value it as farmland only.  There are many restrictions on this, but for those who it applies to, it can save substantial taxes and keep the land in the family as farmland.

As these changes wind their way through Congress, I will keep you updated.

The US Court of Federal Claims issued a decision in 2008 indicating proceeds from selling life insurance stock companies that had de-mutualized were in fact tax free.  There have been serveral large life insurance companies such as Metropolitan, Principal, Prudential, etc. that have de-mutualized over the last several years.

The IRS had argued that when these stocks were sold that 100% of the proceeds were subject to capital gains taxes.  The Court ruled that the sales were not taxable, but simply a return of capital.

For more details, including a copy of the decision, please visit the site set up by Chuck Ulrich, a CPA who has battled with the IRS on this matter for many years.

If the sales occurred in the 2005 or later, you can still file an amended tax return to get your refund.  You need to be warned that the IRS has appealed this decision, but for right now, this is the new law on this situation.

Please make sure to check this with your tax advisor, you may be entitled to a very large refund plus interset.

Uncle Sam offers a tax advantage to farmers and fishermen that no other taxpayers receive. When your income is very high compared to previous years, the tax laws allow you to assume that you were able to average all of your farm income over a four year period.

This can save you several thousand dollars of tax. For example, if you had zero income for 2005, 2006, 2007 and then had $300,000 of farm income in 2008, with out this income averaging, your tax bill for 2008 would be about $72,000. By income averaging, your tax bill for 2008 would fall to $42,000, or a savings of about $30,000.

You need to make sure that your tax preparer is aware of this in any year where your income is much higher than the last three years.