One of our readers sent us the following question:
"If I prepay inputs for 2011, do I have to deduct them in 2010? Also, if I just need some of the expense this year can I deduct part of it? Thank you!"
A farmer that uses the cash method of accounting (which is substantially all of the farmers) may prepay direct farming costs that will be consumed over the next twelve months. A livestock farmer or dairy may prepay their feed needs for this 12 month period. A row-crop farmer may purchase their 12 month needs of seed, sprays, fertilizer, diesel and gas, etc. There must be an appropriate business reason for this purchase such as locking in a lower price, or making sure you have an adequate supply for the upcoming crop year.
A prepayment of farm expense must involve an actual purchase of the product and not simply a deposit. The IRS considers a deposit if the following conditions are met:
- The right to substitute other goods or products for the items specified in the contract (you may in certain circumstances be able to substitute other products or goods, but you can not have the right to do this),
- The absence of specific quantity terms and conditions,
- The right to refund any unused credit at the termination of the contract, and
- The seller's treatment of the expenditure as a deposit (however, we believe that this should not be a condition of a deposit since the farmer has not control over how the seller of the product will classify the transaction on their books).
A simple way of looking at the transaction is whether title to the input item has passed from the seller to the farmer. If the title and the rights associated with the input passes to the farmer, then the item is considered a qualified prepaid farm expense. If the title does not pass, it is a deposit.
Assuming you do not have a deposit, a farmer can elect to prepay as much of their upcoming needs as they see fit. For example, if a corn farmer knows their fertilizer needs for the 2011 crop year will be $200,000, the farmer can purchase up to $200,000 of specific fertilizer by December 31, 2010 and deduct it on the 2010 tax return. The farmer can buy as much as they want to in 2010, but is limited to deducting $200,000 in 2010 for the 2011 crop.
Now for the specific question regarding whether you have to deduct the prepayments. The general rule for cash basis farmers is that all cash expense are deducted when paid. However, if the farmer can document that part of these prepayments were in fact, either a (1) deposit or (2) inputs for the 2012 crop, these payments would be considered non-deductible in 2010, but rather in deductible in 2011.
This allows a farmer some flexibility, but it does not let a farmer simply pick and choose how much they want to deduct.
Remember, prepayments of farm inputs for the upcoming year are deductible, a deposit is not.