Watch Out for Taxation of "Hedges"

Published on: 18:21PM Oct 25, 2016

~~We had a reader send an example of a current "hedge" being offered by elevators or cooperatives.  The example is as follows:

·         Cash bean price available of $9.05/bu

·         Producer sells on contract and receives 70% cash payment, or $6.33 per bushel

·         Remaining $2.72 is retained by grain dealer and utilized with what appears to be a put / call option pricing strategy:

1.       Producer’s maximum risk is $2.72 retainage by grain dealer (in other words, $6.33 cash received represents floor price of strategy)

2.       Through a Jul-17 contract, producer has upside pricing potential with the arrangement until that time.  So, if the CBOT bean price went significantly higher, the producer would benefit from that price increase; and if the CBOT bean price went significantly lower, the producer’s payout of the $2.72 retainage would be lowered accordingly, down to $0.  The producer apparently has the ability to close the contract at any current price during the contract.

Most farmers would view this as a hedge since they are locking in a floor price on their beans.  However, it is likely that the IRS would view this as not being a hedge for tax purposes due to the farmer "speculating" on an increase in prices.  Tax hedges only lock in a price to prevent the net crop price from dropping further.  If the farmer sells their beans and then buys the beans back on the "board" with futures or an option, this is not hedging, this is speculation.   Also, the farmer would have a hard time arguing that they have a hedge when cash beans are $9.05 since they may end up with only $6.33.

The tax treatment on this can be harsh if certain price events happens.  For example, if the "hedge" results in a loss and it should have been treated as speculation, it must be reported as a capital loss and if the farmer has no other capital gains, (s)he can only deduct $3,000 per year.  Let's look at an example:

Spec-U-Late Farms, Inc. enters into a "hedge" of 100,000 beans with their local elevator which puts in a floor of $7 on their beans but with no limit on the upper price when beans are trading at $10 per bushel.  The farmer ends up losing $3 on the "hedge" and instead of deducting the $300,000 on Schedule F, it shows up as a capital loss with a net deduction of $3,000.  Over on Schedule F, the farmer loses the $300,000 deduction.

If you are interested in doing a hedge like this, be very careful to discuss this with your tax advisor before you place the hedge.