Many successful farmers have ownership interests in various entities. They may have:
- a corporation that handles the farming;
- a partnership that owns land rented to the corporation;
- an interest in an ethanol plant to which they deliver corn;
- an interest in a hog confinement facility to which they sell feed; and
- other entities that might or might not be in the farming business.
Until the mid-1980s, it really did not matter how much time or effort farmers put into these various ownership interests. However, since Congress passed the passive activity rules in 1986, we now must pay attention to MAP: Material, Active, Passive.
Under the rules, if you materially participate in an activity (such as a farm S corporation) and the entity generates a loss, you are allowed to deduct the loss in full on your tax return. However, if you are passive in the farm operation (for instance, if you’re the father in a father-and-son S corporation and you are semi-retired), the loss is limited strictly to offsetting other passive income that you might have.
Under the rules, there are three classes of participation in an activity.
Material: This type of involvement is almost always good because the loss is fully deductible, assuming there is enough basis in the entity.
Active: Normally, active participation is associated with real estate rental. Under the rules, if you own more than 10% of a rental house in town and actively participate in the rental process, you can deduct up to $25,000 of net rental losses. However, if your other income is greater than $150,000, you cannot deduct any of the net loss.
Passive: If you spend just a few hours on an activity, a loss can be deducted only against other passive income or deducted in full when the activity is sold. Almost all rentals are considered passive.
Any losses not allowed are not lost, but simply carried forward to offset passive income in the future or to be fully deducted when the activity is sold.
Some farmers try to get around the rules by creating a passive income generator. For example, they will have the farm operating entity pay rent to them or to an entity they control. They assume this rental income is considered passive, but the Internal Revenue Service (IRS) has ruled that any rents paid to the farmer (if the farmer materially participates in the farm operating entity) is considered nonpassive income or a passive loss. It’s sort of like "heads, they win; tails, you lose."
In our example, if the farm operating entity shows income of $250,000 and the land ownership entity shows a loss of $75,000 after depreciation and interest, the farmer is required to pay tax on the full $250,000 and can deduct the loss only in the future.
Grouping Is Good. There is a way that farmers can change their bad passive status to a good material status. They can elect to group passive activities, such as an ethanol plant or hog confinement investment, as one material activity with the farm operation. By grouping, a passive loss that cannot be immediately deducted is changed into a material loss that can be.
For example, if your farm generates a net income of $250,000, a hog confinement investment shows a loss of $50,000 and an ethanol investment has a $75,000 loss, without the election you are taxed on the $250,000 farm income. With the election, the net income is reduced to $125,000, for a savings of about $44,000 in the highest federal tax bracket.
The IRS recently ruled that if you have not informed it of a grouping election, you need to do it now. Doing so can prevent the IRS from reclassifying activities to your detriment.
This column cannot begin to cover all of the passive activity rules, but if any of these situations apply to you, take special care to discuss them with your tax adviser when preparing your 2010 return.