Publication Date - July 2006

NOTE: This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.

Table of Contents / Chapter 2
Tax Code, Regulations and Official Guidance Search

Chapter One - The Audit Flow

• Purpose of Guide
• The Information Document Request
• The Pre-Audit
• The Initial Interview
• The Audit

The Pre-Audit

The Structural Analysis

One of the most important items in the audit process is the structural analysis. A good structural analysis can lead an examiner to a variety of issues not apparent from visual inspection of the return. It can also lead to the examination of other entities which could prove to be more productive than the initial entity under exam. It is very important to determine during the pre-audit what other entities are involved. This can be started by requesting a listing of related entities before the initial interview. It is important to document if there are no related entities. For most farmers this usually isn’t the case. Just because the farmer owns no direct interest in another farming entity, does not mean there are no related parties. During the interview, question the farmer about family members who farm or who own a farm-related business (i.e., supplier, packer, broker, etc.).

Under IRC §267, Transactions Between Related Parties, the definition of related parties is very broad and can cover a variety of situations. (See Chapter 2, Income). 

The structural analysis needs to include:

1. Ownership percentage in an entity
2. Business transactions including:
   • Services provided or shared
   • Crops sold or marketed
   • Items rented or leased
   • Any lending activity
3. Each entity’s accounting method
4. Each entity’s fiscal year end

The following is an example of what should be included in a structural analysis:

There are two 1065 farm taxpayers A and B. The initial entity was 1065 taxpayer A. There is also an 1120S Processor entity, an 1120 Harvester entity, and two related 1040’s – taxpayers 1 and 2. All are cash basis.

As background:

• Processor processes for all farms mentioned and non-related farms.
• Harvester harvests for related farms and 1040 taxpayer 1’s sole proprietorship. 
• Processor advances money to both 1065 farms, but not to 1040 taxpayer 1.
• 1040 taxpayer 1 rents processing plant to processor
• 1040 taxpayer 2 loans money to harvester
• both 1040’s own directly 50% of each 1065 and 1120S

All of this information will probably not be available during the pre-audit, but as your structural analysis flow-chart is updated, new issues can emerge. K-1 linkage software will hopefully provide more up-front information in assigned cases.

Choice of Entity

There are many reasons why a farmer chooses to operate in a particular type of entity. Many of these reasons are not tax motivated. They include such considerations as water rights, workman’s compensation insurance, government regulations, estate planning, and simplification of accounting systems. However, the form of entity can also have tax implications.

Sole Proprietorships
There are many small farms still being operated as sole proprietorships. This is the simplest method for the farmer. Many farmers want their families to continue farming in future generations. To bring their children into the farming business, many sole proprietorships are at some point in time converted to another entity.

Corporations
Corporations do offer liability protection. However, for large farming operations this usually is not the entity of choice. The accrual accounting methods under IRC § 447 for corporations engaged in farming, can have a substantial tax effect for large farming businesses. Under IRC § 447, S-Corporations are not considered to be corporations and are exempt from the accrual requirements (See Chapter 2, Income). Always remember to include a  corporation’s share of pass-through gross receipts to determine if IRC § 447 applies.

Partnerships and S-Corporations
It may be more advantageous for the large farmer to separate his activity into multiple partnerships and S-Corporations. As long as no C-Corporations are involved, the farmer has full use of the cash method of accounting. Business operations can be divided in a number of ways. They usually are divided by operation, such as ginning, harvesting, processing, marketing, and farming. In some cases, they are also fragmented by ownership. A farmer may have various ownership percentages in many entities that farm. It is also common for a farming entity to join in a partnership with another farming entity to create a new entity that provides a service for each farm. In this way the farmer is able to control all levels of production of his crop, from planting to eventual sale to the consumer.

CAUTION: When examining either of these types of entities, remember the material participation rules of IRC § 469. All partners or shareholders may not be materially participating. Consider the material participation/passive activity issue before IRC §183 Not Engaged in for Profit.

Family Limited Partnerships
Family Limited Partnerships (FLP) are typically an estate planning tool. The use of FLPs is becoming more common in many different areas. Farming is only one industry utilizing the FLP. FLPs transfer assets from an older generation to a younger generation. This can be done by creating a partnership to which a farmer transfers assets, such as land. The farmer then gifts limited partnership interests to his children while he maintains a general interest. Usually the general interest is a small percentage while the limited interests are quite large. It is important to note the farmer is gifting an interest in the partnership, not an interest in the partnership’s assets. If this is all done correctly, the farmer is able to avoid substantial gift taxes by discounting the value of the limited partnership interest. The discounting can easily be from 20% - 50% of the value of the assets.

Example

Farmer A and his wife form a partnership contributing land with a FMV of $1,000,000. The value of the limited partnership interests is discounted to $500,000. They then each gift limited partnership interests as follows:

$11,000 each to four children and their spouses (2x11X8) equals $176,000

$11,000 each to a trust with their 10 grandchildren as beneficiaries (2x11x10) equals $220,000

Total tax free gift  of $ 396,000 ($176,000 + $220,000 = $396,000)

If they had given the land and not the limited partnership interest, the taxable gift would have been $302,000 for each spouse ($1,000,000 - $396,000 divided by 2). But since they chose to use a FLP, the taxable gift is $52,000 for each spouse ($500,000 - 396,000 divided by 2).

Note: that the annual exclusion amount per donee for gift taxes changed in the 2002 tax year to $11,000.

This can be a substantial savings in both gift tax and in the use of the unified credit, see  IRC § 2505, Unified Credit Against Gift Tax. If the discount appears to be excessive or questionable, consult with an estate tax attorney. There are numerous factors that need to be considered when reviewing a FLP. These are outlined in IRC § 704(e), Partner’s Distributive Share, and explained in detail in Tax Management Portfolio 722-2nd, Family Limited Partnerships.

Trusts
Many large farming businesses use trusts as part of their operations. This is usually done for estate planning purposes. The auditing of trust returns is within the scope of the general program revenue agent and should always be considered when reviewing a multi-entity farm.  Auditing a farming trust is essentially the same as auditing any other farming entity.  The only real differences are in the areas of distributions and  report writing. The area of distributions can be complex and if distributions are an issue, further research on the part of the agent will be required. 

Items to consider when reviewing a trust return are:

1. What kind of trust return are you reviewing?
   1. Complex Trust - These are taxed at a higher rate than individuals. If this is a complex trust, is income correctly being taxed at this level or is the trust diverting income to an entity with a lower tax rate?
   2. Simple Trust - If this is a simple trust, it  passes income to trust beneficiaries, but cannot pass-through operating losses.
   3. Grantor Trust - Usually a return is not required to be filed for a grantor trust. It is an estate planning tool commonly referred to as a living trust.
2. If trusts are for the benefit of minor children, are their parents including distributions made to the children as income for relief of support obligations? (IRC § 677, Income for Benefit of Grantor.)
3. Is the trust really a trust?

These are just a sample of the questions that can arise in the area of trust audits. If you open a trust return for examination, there are many sources of usefulinformation:

• Federal Income Taxation of Estates and Trusts  published by Warren, Gorham & Lamont is an excellent source for trust information. Various trust topics are also detailed in some of the Tax Management publications.

• Tax Management Portfolio 700-2nd, Choice of Entity details the rules regarding taxing trusts as associations. This portfolio also covers many different aspects regarding choices of entities.

Limited Liability Partnerships (LLP) and Limited Liability Company (LLC)
LLPs and LLCs are fairly new types of entities. There is some case law available. The purpose of LLPs and LLCs is to shield the owners from liability while avoiding the double taxation of using a corporation. LLPs and LLCs are more advantageous than S-Corporations. They have limited liability in pass-through form and partnership advantages such as: the inclusion of all entities’ liabilities in basis, ease of contributions, and distributions of property. In farming entities, what often happens is, an LLP or LLC is formed for the operation of the farming business only, not for the holding of the assets. The assets are frequently being held by other entities. This may shield the owners from any lawsuits pertaining to the business.

Look at the following areas of the returns for potential issues:

1. If assets are being kept out of the LLPs and LLCs to shield them from creditors, are the assets being rented from related parties at fair market value?
2. The liability section of the balance sheet is also a significant area of interest.  The members are able to claim their share of most entity liabilities in basis, but there are numerous additional rules regarding who is liable for which liability. The at risk rules of IRC § 465 also apply to losses from LLPs and LLCs.
3. How it was formed is an important issue to address. Was it previously a corporation or a partnership? This could trigger taxable events such as distributions, corporate liquidations, etc.

Most code sections under Subchapter K apply to LLPs and LLCs. There are also private letter rulings regarding many aspects of LLPs and LLCs. Tax Management Portfolio 725-2nd, Limited Liability Companies, is an excellent source of information regarding the tax treatment of these new entities.

The Crop Map

Always request a complete crop map for the year under audit. Have the farmer include: acres of each crop planted and/or vacant, which parcels are owned and which are rented, location of one parcel compared to another, and the year planted for trees and vines. This can be a valuable tool in many areas of the exam.

The crop map can be used to determine the farm area to tour. Touring row crop parcels miles away from the farm shop can be a waste of valuable time. Vacant land owned by a farmer who has trees and vines could warrant a physical inspection.  Remember, the crop map is for the year of audit and the actual tour is at least one crop year later. In row crop farming, the tour and the map won’t coincide due to crop rotation.

The crop map can be a useful audit tool. You can:

1. Compare the map with industry averages
2. Compare the crop map with lease agreements. Verify income and expenses are properly allocated.
3. Map out distances between parcels. How far away is one parcel from another? Some parcels are located in other counties. How does the farmer transport equipment from one location to another? Should there be highway use tax returns or are some parcels being harvested by other parties?
4. For trees and vines, review the map for the year planted to see if IRC § 263A, Uniform Capitalization of Costs--UNICAP should be considered (See Chapter 4, Expenses). Always take the year planted under consideration when estimating income using industry averages. New plantings take years to come into full production and should always be considered.

Using Industry Averages

Industry averages can be tools in estimating both income and expenses. They can be used to either expand or limit the scope of your audit.

Income Averages

For income averages, contact your local county department of agriculture for production in your area. In many states, these county crop production reports are published yearly and include all crops produced in the county. They can also include highlights of that specific crop year. Here you can learn about major storm or insect damage to a particular crop and timetables for each crop from planting to harvesting.  The information you will be focusing on is the production per acre and the value per unit. By using the crop map provided by the farmer you can compute the estimated income by multiplying acres planted on the map, times production per acre, times value per unit and comparing this to the income for that particular crop reported on the farmer’s trial balance.

Example

If you were auditing a farmer for 20XX who grew broccoli on 150 acres:
150 acres x 5.18 tons/acre (County average yield) = 777 tons

777 tons x 511 dollars/ton (County average payment) = $397,047

If the farmer is reporting a reasonable amount compared to the average, you can limit your audit scope accordingly. If not, then further audit work needs to be performed.

Using income averages needs to be done with caution. If the farmer’s income is far below the industry average, ask the farmer specific questions regarding that particular crop during the initial interview. The farmer may have had unusually low yield or price. Most farmers can tell you exactly why a yield or a price is low for a given year.

Expense Averages

In many states, sample production costs are available for a wide variety of crops.  These can be prepared by a university agricultural extension. Similar estimates can sometimes be obtained by contacting county farm advisors. As with income, these are only guides and should be used with appropriate interview questions. The sample cost analysis worksheets available can be very detailed. They can include costs to establish permanent plantings and costs to produce a crop. For example, information is available for California from the University of California Cooperative Extension. The worksheets can break down the costs of operating a particular type of farm. Sample costs are not always available for each crop year, but they can be adjusted to reflect current costs per hour for labor, price per item for capital purchases, etc. 

These averages can be used for determining if expenses are reasonable and the amounts of costs to capitalize under IRC § 263A, UNICAP. If only a portion of the taxpayer’s acreage is subject to these rules, see Chapter 4, Expenses. For example, if the farmer has 100 acres of new vines and also has 500 acres of existing vines, you can use these estimates to allocate costs between the new acreage (capital costs) and the existing acreage (current expenses).