Farmers, avoid these tax preparing mistakes this year
Every year tax reporting gets a bit more complicated.
The first income tax return in 1913 had only one page of instructions. Now, federal tax laws and regulations require more than 10 million words. Who knows all of it? Nobody. Who has to deal with it? Almost everyone.
In 1913 only 3% of the population had to pay federal income tax; rates started at 1% and peaked at 7%. Tax reporting decisions were certainly simpler. When rules are easy for everyone to understand, they are easy to follow and comply with. When they get onerously burdensome, they become harder to understand and to follow. Over the course of reviewing thousands of tax returns, I have seen many different kinds of errors and noncompliance. Following are some of the errors and problems I’ve seen with farm reporting.
During my career, I have noticed that a six-figure loss tends to get the attention of the Internal Revenue Service (IRS). Nine out of 10 full audits that I have seen have been returns with $100,000-plus losses on Schedule C (a small business), Schedule E (a rental property), or Schedule F (a farm). One time, I saw a taxpayer get a full IRS audit due to showing a $135,000 loss on a new cattle operation. What was the problem? The previous tax preparer didn’t know the rules on depreciating cattle.
Dairy cows and breeding cattle can be depreciated. Cattle that are just held for resale are not depreciated. Depreciable cattle can be written off over five years or even one year using bonus depreciation or the Section 179 deduction. In the case I just mentioned, the new rancher bought a herd of breeder cattle, but his tax preparer wrote all of them off in the year of purchase as a regular expense, like supplies. This was disallowed during the IRS audit because the cows should have been set up as assets and depreciated, rather than just being written off as a regular expense.
The problem of writing off capital purchases as regular expenses is common. When you look at books prepared by many amateur accountants, you will find trucks, tractors, and all sorts of assets posted to expense accounts labeled “truck expense” or “tractor expense.” They don’t belong there. They should be posted to asset accounts, and the corresponding annual depreciation expense should be posted to an account called accumulated depreciation. A tractor and its accumulated depreciation sit on your balance sheet from the day you buy it until the day you sell it. Then a gain or loss on the equipment sale is recognized based on the sale proceeds.
There are accounting records far worse than ones with wrongly posted assets. We have seen clients walk in with virtually no records. Apparently, they have it all memorized. Need to know how much they spent on fertilizer? Just ask; they’ll give you a number. Heaven forbid they get audited, because when you provide the IRS with no records, the agency provides you with no deductions.
This issue of missing records is a big problem when someone is given a farm or inherited one long ago and then sells the farm. People walk in and say, “Here is the closing statement for the farm I sold for $500,000.” Then we ask, “OK, how much did you pay for it?” Deer in the headlights…. Frequently, we hear, “I have no idea; it was 30 years ago.” Or we hear that their parents bought it 50 years ago, and they inherited it.
Under current tax laws, you get stepped-up basis, using date of death values for inherited property. However, this requires that someone had the foresight to get an appraisal as of the date of death. Normally, when the taxpayer has no idea about the basis for a farm sale, the tax preparer is going to guess at a conservative number or just call it $0 basis, which means maximum taxation. Keep those real estate purchase records forever, and be sure to obtain and retain appraisals for inherited property.
Continuing with the missing record theme, we see many small-business owners (including farmers) with no records for their use of personal vehicles. When you claim that you drove your partially personal-use Chevy Tahoe 7,000 miles for farm purposes, you are supposed to have contemporaneously created mileage records of dates, destinations, distances, and purposes for the mileage. Then you get to claim 56¢ per mile as a tax deduction (for 2021). Millions of taxpayers likely claim business miles on their returns with virtually no mileage records in hand. If the IRS asks to see your mileage records, no record is going to mean no deduction. Cell phone mileage apps or old-fashioned paper can help you keep mileage records. Do what you will, but I sleep better when all the backup is in hand.
Active vs. Passive Farming
One piece of backup you probably get annually is a 1099-G from the USDA. It reports various ag program payments received, including CRP rents. Schedule F and Form 4835 have separate lines for ag program payments, and those lines are the right place to report the payments. Sometimes we see farm income statements not delineating the difference between crop sale proceeds and ag program payments; it’s just shown as one bucket of “farm revenue.” The IRS computers are looking for program payments, so report those numbers in the place the computers are seeking them. The same goes for 1099-PATRs, which report co-op distributions.
Finally, you need to understand the difference between active and passive farm activity and how that affects reporting. On an individual Form 1040, farm activity is reported either on a Schedule F or a Form 4835. A Schedule F is where active farmers report, and Form 4835 is for inactive farm landlords.
What makes someone an active farmer vs. passive? This can be a gray area. Clearly, someone working full-time as a farmer and netting $100,000 each year is active, and someone getting cash rent and never setting foot on the farm is passive. Unfortunately, there are myriad situations in between and many people reporting on the wrong form.
Why does it matter?
An active farmer reporting on Schedule F can take an infinite amount of losses against other income, which could be a spouse’s salary, a part-time job, or stock dividends. Losses on Form 4835 are passive, which are limited to between $0 and $25,000, depending on the income level. So, if you have an executive making $250,000 in salary and renting out 10 acres of hay on a 50-acre farm (with a personal-use hunting cabin), that tax filer cannot take losses from the passive activity. However, if it’s incorrectly reported on a Schedule F, that will happen.
The other big difference is that net income on Schedule F is subject to self-employment tax, and net income on Form 4835 is not. Active farmers who errantly report on a Form 4835 skip paying self-employment taxes (Social Security and Medicare) on the income, which the IRS frowns upon.
Bottom line, you need to see a tax preparer who understands the subtleties of farm income reporting.