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Blog

Jul 10, 2017

IRS Takes a Look at Farmers' Prepayment Process

Of all of industries in the United States, farmers and ranchers probably have the widest array of tax planning opportunities.  One of the most used techniques for a cash basis farmer is prepaying some of next year’s expenses.  And, as happens, the IRS has now rolled out a pilot program for auditing expenses reported on Schedule F.  So, we’d like to take this opportunity to refresh your memory on some of the rules.

A deposit on next year’s input costs is not deductible.  You can’t just send a $50,000 check to the feed yard to apply against next year’s feed bill and take a deduction on this year’s tax return.  Here are some of the things that would indicate your payment is a deposit:

  • You didn’t specify the quantity and price of the item you’re paying for.
  • You’re entitled to a refund of any unapplied payment credit.
  • The seller reports the expenditure as a deposit on their books.
  • You have the right to substitute other products for the item specified in the contract.

In order for a prepaid expense to be currently deductible, you need to at a minimum comply with the following rules:

Business Purpose. You must have some purpose other than tax avoidance for making the expenditure.  For example, if you think fertilizer prices are going to rise you might want to lock in a price and prepay the bill.

Binding Commitment.  You must enter into a binding commitment with the vendor to accept delivery of a specific quantity at a fixed price and not be entitled to a refund or repurchase.

Distortion of Income.  The prepayments can’t result in a material distortion of income.  This concept is hard to define, but here are some of the factors that are looked at.

  • The amount of time it takes to consume the commodity. For example, if you prepaid the next two years’ worth of feed you’ve probably distorted the current year income. Twelve months is the rule of thumb.
  • The size of the expenditure in relation to the current year income.
  • The amount of the expenditure in relation to the past purchases made for the same expense, and the time of year the expenditure was made.
  • Whether the taxes paid by a taxpayer who consistently prepays over a period of years are reasonably comparable to the taxes that would have been paid had the taxpayer not consistently paid in advance.

Here are a few frequently asked questions we receive concerning prepayments that will emphasize a few more points we need to make:

What if your business plan changes?  What if you prepaid corn seed and decide not to plant corn? Most likely, the prepayment would stand up.  If you sold the corn seed in the subsequent year, you would report the income.

What if I used all but a small amount of the seed I prepaid? The fact that you do not consume all of the item(s) you prepaid does not necessarily jeopardize the deductibility of the expense in the year paid, but the amount of unused seed should be minimal.

Can I prepay interest on my bank notes?  No.  You can pay the interest you’ve incurred to date but you can’t prepay next year’s interest and take the deduction this year.

Can I prepay rent? This was once taboo, but you are able to prepay rent that does not extend beyond twelve months of the year end.

In summary, you’ve probably gotten the gist of what we’re saying in this article.  Be sure you’ve dotted your i’s and crossed your t’s with regard to prepayments, and always call your tax advisor if you have any questions at all!!  We are also happy to address any concerns you may have.  Contact us today at 866.307.2727.