The Tax Benefits of Deferred Payment Contracts

August 9, 2016 07:25 PM
 
The Tax Benefits of Deferred Payment Contracts

A recent visit with one of my clients, David, illustrates the importance of understanding deferred payment
contracts.  David and his family farm 3,000 acres of corn and soybeans. After catching up, he asked a question that had been weighing on his mind. 

“I have always sold my grain at harvest time,” he began. “Much of it has been contracted during spring to lock in higher prices. When I deliver the grain, I get a check from the elevator. My neighbor usually does the same, but he said his check doesn’t come until after the first of the year. He said he does this for tax planning. Is that correct? How does it work?”

Deferred Payments Defined. David’s neighbor is right. When you deliver grain to the elevator under a contract that calls for payment to be received in the future, you are operating on a deferred payment contract. The contract requires payment to be made within a certain number of days, typically 60 or more.

For farmers who use the cash method of accounting, deferred payment contracts are essentially an installment sale. Under reporting rules for installment sales, a farmer reports income as cash is received. 

Thus, David’s neighbor is able to defer reporting his income from the sale of grain until cash is received after the end of the year. Farm products are one of the few things that can be sold using an installment sale and be reported this way. 

Boost Income. Another great feature of deferred payment contracts is our ability to increase income when a farmer’s tax return is prepared after the end of the calendar year.  

As a taxpayer, you are entitled to certain deductions for your children as well as a standard deduction that has nothing to do with your farm income. 

In addition, about $75,000 of taxable income after these deductions is subject to tax at a very low rate that currently stands at 15% or less. 

By selling some grain on a deferred payment contract, you can elect to bring some of that income back into your tax return. 

“How does that part work?” David asked. “Can I bring into income the exact amount I want?”

Although it would be nice to bring in the exact amount of income, tax rules force farmers to identify the amount of income generated on every single contract. It’s impossible for producers to pick and choose.

For example, suppose David sells 5,000 bushels of corn at $6 each for $30,000 total. If the cash arrives in January, he can elect at tax-filing time to bring that amount into income. Otherwise, he must report the $30,000 in January when he gets the cash. 

Other Considerations. Producers must update their accounting records to reflect they brought income in the form of revenue into their business in the year of the sale, not when they received the cash. Farmers normally update their books by recording this as a receivable and then reversing it out after the end of the year.

If you don’t identify these transactions correctly, you will end up reporting the crop sales twice when you report your income next year at tax time. 

Also keep in mind the importance of having at least a few small contracts throughout the year. Tax professionals usually like to see a couple of contracts that might total $25,000. This allows your professional to optimize your income number.

Suppose David plans to sell $500,000 of corn using deferred payments. He should not sell it on just one contract because it would force him to bring $500,000 into income when he might only need $50,000. Instead, he should have a contract for perhaps $25,000, another for $50,000 and three or four for $100,000. At year-end, he can pick the right combination to achieve his desired income level. 

Be aware: You become a creditor when you sell your grain. Make sure the entity to which you are selling is financially sound. If you have any concerns, sell your crop for cash or deal with another elevator. 

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