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.

Chapter 3 / Table of Contents / Chapter 5
Tax Code, Regulations and Official Guidance

Chapter Four - Expenses

• Introduction: Farm Business Expenses
• Related Entities
• Capital vs. Reoccurring Costs
• Contract Labor
• Outside Services Informational Sources

Introduction: Farm Business Expenses

IRC § 162 and Treas. Reg. § 1.162-12 provide for the deduction of ordinary and necessary expenses, paid or incurred in connection with the operation and maintenance of a farm. This chapter discusses the various expense items unique to farm returns.

Most farmers use the cash method of accounting to record their expenses. When using the accrual method of accounting, farm business expenses are not deductible until economic performance occurs. Economic performance generally occurs as the property or services are furnished to the farmer and the liability is incurred.

Deposits or Payments
Farmers often write a substantial number of checks during the last few days of the tax year to pay expenses. Large disbursements should always be part of your examination. You must then determine if the disbursement is a payment or a deposit. Whether an expenditure is a payment or a deposit depends on the facts and circumstances of each case.

A deposit to be applied against a future expense is not deductible. Although a check is written, no deduction is allowable until the expense is actually incurred. The following factors, although not all inclusive, are indicative of a deposit rather than a payment.

1. The absence of specific quantity terms.
2. The right to a refund of any unapplied payment credit of the contract. See Lillie v. Commissioner, 45 T.C. 54 (1965), aff’d per curiam, 370 F.2d 562 (9th Cir. 1966).
3. The treatment of the expenditure as a deposit by the seller.
4. The right to substitute other goods or products as specified in the contract.

These factors apply to all farm expenses for which a payment is made prior to delivery.

The issue arises when the seller treats the farmer’s payment as a deposit and does not report the amount paid by the farmer as income. However, the farmer takes the amount paid as an expense. This is a common occurrence in the farming industry for fertilizer, feed, grain, etc. This transaction could have one of three consequences:

1. The disallowance of the expense to the farmer.
2. Income to the seller.
3. A change in accounting method.

Prepaid Expenses
IRC § 464 limits the allowable deduction for prepaid supplies if they exceed 50% of the total deductible farm expenses (excluding prepaid supplies) for the taxable year. If the prepaid farm supplies have actually been used or consumed, the amount is fully deductible. IRC § 464 rules are designed to prevent taxpayers that are not farmers from using a farm to shelter income.

Exceptions: the limit on the deduction for prepaid farm supplies does not apply to a farm-related taxpayer where either of the following apply.

1. The prepaid farm supplies expense is more than 50% of the deductible farm expenses because of a change in business operations caused by extraordinary circumstances. 
2. The total prepaid farm supplies expense for the preceding 3 tax years is less than 50% of the total other deductible farm expenses for those 3 years. 

A taxpayer is a farm-related taxpayer if any of the following tests apply:

1. Main home is on a farm.
2. Principal business is farming.
3. A member of the family meets test (1) or (2).

For this purpose, family includes your brothers and sisters, half-brothers and half-sisters, spouse, parents, grandparents, children, grandchildren, and aunts and uncles and their children. 

Rev. Rul. 79-229, 1979-2 C.B. 210, sets out three tests that must be met in order to deduct the cost of a supply purchased in the current taxable year which will be used in the subsequent taxable year.

1. The expense must be a payment for the purchase of supplies, not a deposit.  The amount is considered a payment if it was made under a binding commitment to accept delivery of a specific quantity at a fixed price, and the farmer is not entitled to a refund or repurchase.
2. The prepayment is not merely for tax avoidance, but has a specific business purpose. Examples of business benefits are:
   
   1. Fixing maximum prices.
   2. Securing an assured feed supply.
   3. Securing preferential treatment in anticipation of shortages.
      
3. The deduction does not result in a material distortion of income. Some factors to consider in determining whether there is a material distortion of income are:
   • The farmer’s customary business practices in conducting the farming operation. 
   • The materiality of the expenditure in relation to the taxpayer’s income for the year.
   • The time of the year the purchase is made.
   • The amount of the expenditure in relation to past purchases.

Inspect check endorsements, flip checks, and check with suppliers to determine the validity of the expense.

Remember Rev. Rul. 79-229 was written before the passive activity rules of IRC § 469 were enacted. Consideration of IRC § 469 could further limit farming expenses. The Passive Activity Loss website on the IRS intranet has a section on farms with common issues, interview questions and many examples and cites to use in determining if there is an issue. Pub. 225 discusses the prepaid farm supplies and livestock feed issue with several examples.