Aug 22, 2014
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The Farm CPA

RSS By: Paul Neiffer, Top Producer

Paul is now part of the fourth generation in America that is involved in farming and hopes the next generation will be involved also. Through his blog he provides analysis and insight to farmer tax questions.

More than 100 but Less than 500

Aug 20, 2014

When a farmer or taxpayer owns an S corporation that incurs a loss, the farmer must show that they have materially participated in the companies operations in order to deduct the loss. The slam dunk test is that the owner works for more than 500 hours. If the owner works for less than 100 hours, then it is very difficult to meet any material participation test. If the owner works more than 100 hours but less than 500 hours, then they are in the dreaded "GRAY" zone.

In an US Tax Court case decided today (Charles and Betty Wade), the Tax Court agreed with the taxpayer that he materially participated in the company's operations even though he did not work 500 hours. The company had been very successful in the plastics industry and dad semi-retired to Florida and turned day-to-day operations over to his son. Although semi-retired, he continued to spend at least 100 hours on company business.

With the great recession of 2007-2008, the company started to lose money and he became more and more involved and actually spent substantial time on R & D and developed a new product for the company in 2008 plus made several trips to the company to reassure the workers they still had a job.

During 2008, the company lost over $3 million and the taxpayer carried the loss back and got a refund of about a $1 million. The IRS audited the amended returns and denied the loss claiming the taxpayer was not materially active in the company. The taxpayers claimed that they met one of two tests (1) he worked at least 500 hours in the business; or (2) he participated in the companies’ activities on a regular, continuous, and substantial basis during 2008. As you can see, the 500 hour test is very objective while the second test is extremely subjective. The Tax Court decided to rule on the second test and agreed with the taxpayers. Based on his 237 phone calls with the plant during the year, his development of a new product, etc. the Court agreed he materially participated in the business.

Most cases involving passive/material participation involve the more objective tests. It is nice to see that a subjective test went in the taxpayer's favor. If you are involved with a farm S corporation, partnership or LLC and work in the operation more than 100 hours or less than 500 hours, make sure to document how you meet this test. If you do, you will be able to keep you tax savings.

Mid West Crop Tour 2014

Aug 14, 2014

Pro Farmer conducts a Mid West Crop Tour each year. There are two legs to the tour. The Eastern Leg starts in Columbus, Ohio this Sunday night and on Monday, about 11 routes are conducted from Columbus to Fishers, Indiana. These routes will go over the exact same roads as in previous years, however, the fields scouted will be at random. We usually stop about every 15-20 miles to get a sample and try to get at least one sample in every county. Tuesday, we go from Fishers to Bloomington, Indiana. On Wednesday, we head over to Iowa City, Iowa and then finally head up to Rochester, Minnesota where we finish the tour.

The Western Leg starts in Sioux Falls, South Dakota, goes the first day to Grand Island, Nebraska. The second day scouts the rest of Eastern Nebraska and ends up in Nebraska City, Nebraska. On the third, day we head up to Spencer, Iowa catching all of Western Iowa and on the last day catch Southern Minnesota and meet up with the Eastern Leg at Rochester.

Each night, there is presentation to local farmers on the results of the tour and Pro Farmer will report their estimated yields for each section they cover during that day, etc.

I have participated on the Crop Tour for the last four years and this year will be my fifth tour. This really comprises my summer vacation (I know some of you think that is a sick way of doing a summer vacation, but there are enough of you out there to understand my addiction).

The participation by the scouts on Twitter has gotten greater each year and due to the large anticipated crop this year, I am expecting the Twitter feeds to be at an all time high. If you want to follow my Tweets, my Twitter handle is @FarmCPA and the Hash Tag should be #pftour14. If that is not correct, I will post an update.

I should be posting a recap of each day as it occurs. Sometimes, the evening activities get a little hectic and I might not post until the following morning, but I will keep you updated next week.

Sale of Gifted Grain Can Be Tax Free

Aug 13, 2014

We had a reader ask the following question:

"We want to gift our daughter (she is not a dependent) some grain that is from the 2012 growing season. We plan to have the elevator issue her a contract to show ownership and then she can call them and sell the grain when she is ready. She will sell the grain this tax year. My question is: Because we have already held the grain for over a year, does she qualify to take the income as a capital gain or will she have to take it as ordinary income? "

When a farmer gifts grain to a child or grandchild, the basis in the grain carryovers to the donee. If the grain was harvested in the prior year, then the cost basis is zero. If the grain is donated in the year of harvest, then the farmer must allocate a portion of their expenses to the donated grain. Therefore, most farmers try to make sure to donate previous years grain.

When the donee sells this grain, it will be reported as a capital gain. If time after harvest of the grain and the time of sale is less than a year, it is short-term. If this time is greater than a year, then it is long-term. It does not matter how long the donee/child owns the grain. What is important is the time from harvest until sale.

If the child is a dependent of her/his parents, the kiddie tax rules apply which means we have to pretend that the child's income is added to the parent's income to arrive at the correct tax liability.

In the case of our reader's question, we know that the grain was harvested in 2012. Therefore, the holding period is at least a year plus, so we know this is long-term capital gain when the daughter sells the grain. The reader also indicated that the daughter is not a dependent, therefore, if the gain from the sale of the grain falls with the 15% tax bracket (up to about $36,000 of taxable income for a single taxpayer), then the capital gain will be taxed at a zero rate. This will most likely result in the daughter paying no federal income tax on the gain (unless she has a fair amount of other income). Most likely the worst case is the gain will be taxed at 15%. Additional state income taxes would apply.

This is one more reason why it is a great idea to gift grain to your children. It reduces your income and self-employment taxes and in many cases if the grain is held long enough, the gain will be tax-free to the child and taxed at favorable capital gains rates (even if the kiddie tax applies).

Three Years is the Normal Statute of Limitations, But Not Always

Aug 12, 2014

I get a phone call or email many times during the year asking how long a taxpayer needs to keep documents. The answer is "it depends" as is usually the answer for all tax questions. The IRS generally has three years from the due date of your tax return to assess additional tax. Therefore, if you filed your 2013 tax return without an extension, the IRS has until April 15, 2017. With an extension, the date would be October 15, 2017.

Now, in the case of fraud (assuming the IRS can prove fraud), the IRS has six years to assess additional tax. Now, if you invest in a partnership that is subject to certain rules that were put into place many years ago, this 3 or 6 year period can be dramatically longer as was shown in an US Tax Court case released today.

In the McElroy case, the taxpayers had invested $37,500 each year during 1996, 1997 and 1998 in partnerships. The partnerships took the money from the partners, acquired cemetery sites, held them for a year and then donated them to qualified cemeteries to pass through a charitable donation. For example, in 1999, the partnership acquired sites with a value of about $95,000. Without waiting a year, the partnership then donated the sites and then passed-through to the partners a charitable donation of $1,864,850 or about 20:1. As you can probably guess this was sham and the operator of the partnerships suddenly found himself in hot water and finally ended up serving some type in the Federal Pen.

The taxpayer had invested $37,500 each year expecting net tax benefits of at least $50,000 a year. He filed his returns and the normal 3 year statute passed fairly quickly. The partnerships were subject to rules passed back in 1982 that required a tax matters person (TMP) to be appointed. That person was Mr. Johnson who agreed with the IRS to extend the statute of limitations through 2008 as the TMP for the partnership. After being sent to jail, the TMP was transferred to Mr. McElroy who continued as the TMP until he declared bankruptcy in 2010.

The partnership audits were finally settled in 2013 (at least 15 years after the first individual return was filed) and the IRS then assessed additional taxes on Mr. McElroy. He claimed that the statute of limitations had expired clear back in 2002. However, one of the nasty features about these types of partnerships is that any item that is ultimately resolved at the partnership level is then passed through to the partner (assuming the IRS assesses the liability within a year of the final assessment). That happened in this case and the Tax Court agreed with the IRS that Mr. McElroy owed the additional tax assessment even though it happened more than 15 years after the deduction.

When investing in any partnership where you are a limited partner or member, the fine print will usually spell out the possibility of this happening, although most people never read or understand those sections. Therefore, this can happen to you. If you invest in a partnership that promises substantial tax benefits; don't breathe a sigh of relief when the normal three-year statute of limitations passes since you may be required to pay your tax savings plus interest plus penalties more than 15 years down the road.

How Does Section 179 Work?

Aug 11, 2014

A reader sent us the following question:

"I am wondering how many dollars worth of used machinery I can purchase and use for 2014 income deduction. I do not understand Section 179."

I get this question fairly often especially regarding how much Section 179 farmers can use for 2014. The current law is that a farmer can deduct up to $25,000 of equipment purchases incurred in 2014, however, if the farmer purchases more than $225,000, then they will not be able to take any Section 179 at all (it is phased-out dollar-for-dollar above $200,000).

As mentioned in previous posts, we believe that Congress as part of their lame-duck session after the Mid-Term elections and before December 31, 2014 will enact legislation to increase Section 179. Now whether this is back to the old $500,000 level (the amounts for 2010-2013) or a number lower (or perhaps higher), nobody knows right now. Two years ago, Congress did increase it back to $500,000 in December, and both the Senate and the House have proposed making it $500,000 or even a $1 million, but none of those proposals have made it to law and Congress is officially on vacation until September and even when they get back, no tax laws will be passed before the election.

Now for how Section 179 works:

  • This is a special upfront deduction that is allowed on the purchase of any farm asset with a life of 15 years or less (about everything other than farm buildings);
  • It is based on your year beginning in (so November 30, 2014 year-end corporations still have a $500,000 deduction limit since their year began in 2013);
  • After the deduction is taken, if the equipment is new, then 50% bonus depreciation will be taken (assuming that comes back into play);
  • After any bonus depreciation is taken, then the remaining amount is subject to normal depreciation rules.

Let's go through an example:

Farmer Anderson purchases a new tractor for $350,000 in 2014. Under current law, he could no take Section 179 on the tractor or any bonus depreciation. If the 2014 law was the same as 2013, he could take Section 179 expense on the whole tractor or any portion thereof. Let's assume he takes Section 179 of $100,000. This reduces his cost basis to $250,000. 50% bonus depreciation would be $125,000 bringing this cost basis for depreciation down to $125,000. This is depreciated over 7 years with an assumption of a half-year depreciation in year one on a 150% declining balance method (faster than straight-line). This results in a depreciation deduction of about $13,400. Therefore, under the old 2013 law, Farmer Anderson could deduction a total of $238,400 (he could also deduct the full amount). Under current law, he can only take depreciation of about $37,500.

If the tractor had been used, then no bonus depreciation would be allowed.

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