One of the bigger deductions that farmers qualify for is the Domestic Production Activities Deduction (DPAD). In brief, the farmer is allowed to deduct 9% of their net farm income (in some cases this may be very limited if all of the farm products are sold through a cooperative). This 9% deduction has a limit based upon 50% of W2 wages.
However, the definition of W2 wages is not simply looking at the W2s provided to your employees during the year and taking 50% of that number as the limit. These wages cannot include wages paid to your children under age 18 (if a sole proprietor farmer) and commodity wages. However, wages paid in cash to spouses and children over age 17 are allowed as part of these wages. For many of our farmers who are self-employed and have little cash wages, this DPAD is usually very minimal. If the COOP distributes this deduction through to the farmer, they are allowed to deduct this amount even if they have no wages.
Let's run some examples:
Example 1 - Farmer Fred is a sole proprietor who nets $400,000 on the farm. He is entitled to a DPAD deduction based upon the lower of 9% of the $400,000 or 50% of his qualified W2 wages. He paid his spouse cash wages of $10,000 and had no other wages during the year. His net DPAD deduction is $5,000 ($10,000 * 50%).
Example 2 - Same as # 1, but Fred paid other non-related employees $100,000 of wages during the year. His DPAD deduction is $36,000 (9% of $400,000) since the 50% W2 limit was calculated at $55,000 ($100,000 + $10,000)/2.
Example 3 - Same as #2, except $50,000 of the wages paid to his employees were paid in grain. In this case, his total W2 wages that are qualified are ($50,000 + $10,000)/2 or $30,000. In this case, the overall DPAD deduction allowed is $30,000.
As you can see, this calculation can get very complicated very quickly. If you are generating a large amount of farm income as sole proprietor, it may make sense to pay some wages to your spouse and incur the related payroll taxes. Although it will generate about 12-13% of net payroll taxes (based on the after-tax effect of deducting the employer share), the allowed DPAD deduction may offset some of this extra cost plus you may be building up extra social security benefits for the spouse.
We find that this deduction can be both missed or miscalculated on many farmer returns and with proper planning can help reduce your tax bill. Again, as always, discuss this with your tax advisor.