final copyright 2015 lgutef agricultural issues 9taxworkbook.com/files/2015/09/agriculture.pdf ·...

© 2015 Land Grant University Tax Education Foundation, Inc. 301

AGRICULTURAL ISSUES

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Learning Objectives

After completing this session, participants will be able to perform the following job-related actions:

✔✔ Report gain or loss from sale or loss livestock

✔✔ Prepare Forms 1099-MISC for farmers and accurately report income reported to farmers on Forms 1099-MISC

✔✔ Apply the net investment income tax rules to farmers and retired farmers

✔✔ Help clients make the best use of the basis adjustment on assets that pass through a decedent’s estate

Issue 1: Livestock Transactions � 302Issue 2: Form 1099-MISC � � � � � 315Issue 3: Net Investment

Income Tax � � � � � � � � � � � � � � 317Issue 4: Inherited Property � � � � 319Issue 5: Oil and Gas Payments

and Deductions � � � � � � � � � � 321

Issue 6: Repairs � � � � � � � � � � � � � 328Issue 7: Revoking a

CCC Loan Election � � � � � � � � 335Issue 8: Marketing Gain

on CCC Loans � � � � � � � � � � � � 346

✔✔ Report income and deductions for landowners who receive payments for oil and gas on their property

✔✔ Determine whether amounts paid in the course of a farming business can be deducted or must be capitalized

✔✔ Understand how to elect to report CCC loan amounts as income and how to revoke the election

✔✔ Properly report marketing gain on CCC loans

FINAL COPYRIGHT 2015 LGUTEF

302 ISSUE 1: LIVESTOCK TRANSACTIONS

Immature livestock. Depreciation for livestock begins when the livestock reaches the age of maturity. If you bought immature livestock for drafting purposes, depreciation begins when they can be worked. If you bought immature live-stock for dairy purposes, depreciation begins when they can be milked. If you

Livestock purchased for dairy, breeding, sport, or draft are treated as depreciable assets. The recovery classes of selected livestock placed in service in 2015 are shown in Figure 9.2.

Depreciation begins when the animal is first placed in service for its intended use. IRS Publi-cation 225, Farmer’s Tax Guide (For use in preparing 2014 Returns), states at page 36:

ISSUE 1: LIVESTOCK TRANSACTIONS The acquisition and sale of livestock involves several unique aspects of income tax reporting� This issue addresses when and how the cost of livestock can be deducted, reporting the sale or death of livestock, and special rules available when livestock is involuntarily converted�

Farmers acquire most of their livestock by purchasing or raising it. They hold it for sale to customers, or for dairy, breeding, sport, or draft purposes. Purchased livestock may be considered new or used. All of these factors have an impact on properly reporting the livestock transaction.

Livestock Acquisition

The taxpayer’s reason for acquiring the livestock determines how to handle the transaction. If the taxpayer purchased the animal for resale, the purchase price is not deducted until the taxpayer sells the animal.

Example 9.1 Livestock Purchased for Resale

Ima Hogg purchased 100 feeder pigs in 2014 at a cost of $80 each. She raised them to market hog weight and sold them in 2015 for $130 per head. Ima cannot deduct the $80 purchase cost in 2014. She can deduct the costs she incurred in 2014 for raising the hogs. In 2015 she continues to deduct the costs of raising the hogs until the date of sale. Upon sale Ima reports the $13,000 sale proceeds (100 head × $130 per head) as well as the $8,000 purchase costs (100 head × $80 per head) as shown on Schedule F (Form 1040), Profit or Loss From Farming, in Figure 9.1.

FIGURE 9.1 Sale of Livestock Purchased for Resale


Livestock Acquisition 303

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bought immature livestock for breeding purposes, depreciation begins when they can be bred. Your basis for deprecia-tion is your initial cost for the immature livestock.

Taxpayers could argue that there is no distinction between livestock purchased for dairy purposes and livestock purchased for breeding purposes for two reasons.

1. The process of producing milk begins by breeding the animal that will produce the milk. She is mature at that point, and the pro-duction process has begun.

2. All animals purchased for dairy purposes are purchased to produce offspring as well as to produce milk. Dairy animals are placed in service to produce offspring when they are bred just as nondairy animals are placed in service when they are bred.

Treas. Reg. §§ 1.167(a)-6(b) and 1.471-6(g) do not address the issue of when taxpayers can begin depreciating immature livestock. C.C.A. 2007-25-037 (March 2, 2007) holds that a breeding animal is placed in service on the date that it reaches maturity—the date that it can be bred. It does not say dairy animals are not breeding

animals and does not create a different placed-in-service date for dairy animals.

If additional first-year depreciation (AFYD) is available for the year the livestock is purchased, the livestock qualify if they are new when they are placed in service. If the animals were used for dairy or breeding purposes by another taxpayer prior to the purchase, the animals are considered used and therefore ineligible for AFYD.

Example 9.2 Placed in Service

Phil Farmer purchased 15 heifers in 2014 to add to his dairy herd (at a cost of $22,500). At the time of the purchase, they were not mature enough to be bred. In May 2015 the heifers were mature enough to be bred, and Phil began breeding them. Phil put the $22,500 on his depreciation schedule in 2014 as nondepreciable. In May 2015 he started depreciating these animals over a 5-year MACRS recovery class. Because these heifers (now cows) are considered new, Phil can claim 50% AFYD on them if that provision is extended to assets placed in service in 2015. Farmers are limited to using the 150% declining balance method when computing MACRS depreciation. Phil’s depreciation on these cattle is calculated as shown in Figure 9.3.

FIGURE 9.2 MACRS and MACRS ADS Recovery Periods

Recovery Period (Years)

Livestock Type MACRS ADS

Cattle (dairy or breeding) 5 7

Goats (dairy or breeding) 5 5

Hogs (breeding) 3 3

Breeding and work horses 12 years old or younger 7 10

Breeding and work horses more than 12 years old 3 10

Racehorses (regardless of age) placed in service after December 31, 2008, and before January 1, 2015; racehorses more than 2 years old placed in service before January 1, 2009, or after December 31, 2014; and other horses that are not breeding or work horses and are more than 12 years old 3 12

Any horse not described in the previous three livestock types 7 12

Sheep (breeding) 5 5



FIGURE 9.3 2015 Depreciation for Heifers

Cost $22,500

50% AFYD* (11,250)

Depreciable basis $ 11,250

MACRS cost recovery rate × 15%

Cost recovery $ 1,688

Plus: AFYD 11,250

Total depreciation allowed $12,938

* Assumes that the 50% AFYD provision is extended to assets placed in service in 2015

I�R�C� § 179 and AFYD

The purchase of dairy, breeding, sport, or draft livestock also qualifies for expensing under I�R�C� § 179 in the year placed in service, assuming the purchase meets the other requirements of I�R�C� § 179� When property is eligible for both expens-ing under I�R�C� § 179 and AFYD, the basis of the property is first reduced by the section 179 deduc-tion, and then any remaining basis is subject to AFYD rules� If the taxpayer does not wish to take AFYD on qualifying property, the taxpayer must elect out on a class-by-class basis in a statement attached to the tax return�

Livestock Sales

The taxpayer’s purpose for holding livestock determines where the sale of the livestock is reported. If the taxpayer raised the livestock, or purchased it, with the primary intent to sell it in the ordinary course of business, then the sale is reported on Schedule F (Form 1040). Selling in the ordinary course of business includes animals the taxpayer raises to sell as breeding animals as well as animals raised to sell as slaughter animals. If, however, the taxpayer held the property for dairy, breeding, sport, or draft purposes, the sale is treated as the sale of a business asset and reported on Form 4797, Sales of Business Property.

Properly reporting the sale of dairy, breeding, sport, or draft livestock on Form 4797 requires knowing how long the taxpayer held the animal and whether it was raised or purchased. If the livestock was not held for the required holding period, any gain or loss is ordinary and reported on Form 4797, Part II. If the livestock was held for the required holding period, I.R.C. § 1231 applies. I.R.C. § 1231 provides that all transactions to which the code section applies are first combined. Any resulting net loss is treated as an ordinary loss, fully deductible from income without limitation. However, any net gain is treated as capital gain.

Purchased livestock held the required holding period; held for dairy, breeding, sport, or draft purposes; and sold at a gain is subject to the depreciation recapture provisions of I.R.C. § 1245. Only the economic gains resulting from the taxpayer selling the livestock for more than original cost are included as an I.R.C. § 1231 transaction potentially eligible to be treated as capital gains. Any gain generated as a result of accumulated depreciation is recaptured as ordinary income. The initial entry for these sales is on Form 4797, Part III, where the gain is bifurcated between the ordinary gain due to depreciation recapture and the remaining gain eligible for I.R.C. § 1231 treatment.

Sale of raised livestock held the required holding period and held for dairy, breeding, sport, or draft purposes can result only in a gain because it has no basis. The initial entry for such livestock is on Form 4797, Part I. Purchased livestock held the required holding period; held for dairy, breeding, sport, or draft purposes; and sold at a loss is also entered on Form 4797, Part I.

The required holding period for most livestock is 12 months or more. However, the holding period is 24 months or more for cattle and horses.

Example 9.3 Sale of Dairy Livestock

Figure 9.4 reports the sales price of the livestock Happy Milking sold in 2015, the character of the income, and where it is reported on his income tax return.


Livestock Sales 305

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If Happy Milking was in the business of raising dairy replacements, the $8,500 of heifer sales would have been reported on Schedule F (Form 1040) because the animals were being raised with the intent to sell rather than with the intent to become dairy cows on Happy’s farm. See Figures 9.5 and 9.6 for a partial Schedule

F (Form 1040) and a completed Form 4797. The $48,600 from Form 4797 is transferred to Schedule D (Form 1040), Capital Gains and Losses, and is treated as capital gain. The $15,300 of ordinary income is transferred to page 1 of Form 1040 as fully taxable ordinary income.

FIGURE 9.4 Happy Milking’s Livestock Sales

Livestock Sold Sales Price Character Form Reporting

Calves intended for sale $12,150Ordinary income

subject to SE taxSchedule F (Form

1040), Part I

Raised cows sold at the end of their production cycle

$48,600Section 1231 gain Form 4797, Part I

Purchased cows sold at the end of their production cycle: original cost $15,000, fully depreciated

$ 6,800Section 1245

recaptureForm 4797, Part III*

Heifers culled because they were not productive

$ 8,500 Ordinary income not subject to SE tax

Form 4797, Part II

* All the gain is ordinary. If the selling price exceeded the original cost, that portion of the gain would have been transferred to Form 4797, Part I.

FIGURE 9.5 Sale of Dairy Livestock Held for Sale



FIGURE 9.6 Sale of Dairy Livestock Held for Production of Income


Casualty Gain or Loss 307

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for each cow. Two of the cows were raised (zero basis). The other two cows were purchased at a cost of $2,100 each. One had been expensed under I.R.C. § 179. The other had accumulated depreciation of $1,038 at the time of the casualty ($1,062 remaining basis).

Lucy has a casualty gain on the two raised cows and the cow expensed under I.R.C. § 179. She has a casualty loss on the purchased cow for which insurance proceeds were less than her remaining basis. See Figures 9.7 and 9.8 for a completed Form 4684, Casualties and Thefts, and a completed Form 4797. Note that the initial entry for the gain from the casualty of the purchased cow is on Form 4797, Part III, where the gain due to depreciation (including any section 179 deduction) is recaptured as ordinary income. Only gain eligible for I.R.C. § 1231 treatment is transferred to Form 4684, and in Lucy’s case there is no such gain because the insurance proceeds are less than the cow’s original cost.

Casualty Gain or Loss

Gain or loss from dairy, breeding, sport, or draft livestock due to casualty or theft is treated the same as such conversion of any other property held for use in a trade or business. A loss is the decrease in fair market value (FMV) of the livestock, but no more than the remaining tax basis. In the event of a total loss, the loss is the remaining tax basis. This loss is then reduced by any insurance proceeds or government disaster payments received or expected to be received. If insurance proceeds or government disaster payments exceed the remaining basis, the taxpayer has a casualty gain.

Example 9.4 Dairy Livestock

On February 8, 2015, Lucy Hazzard’s dairy barn roof collapsed under an excessive snow load. Four of her cows were killed in the casualty. Although the FMV of the cows was $1,100 each, the insurance company paid Lucy only $1,000

FIGURE 9.6 Sale of Dairy Livestock Held for Production of Income (Continued)



FIGURE 9.7 Form 4684 for Lucy Hazzard



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FIGURE 9.8 Form 4797 for Lucy Hazzard



as a deduction from self-employment income.

Taxpayers can elect to defer a casualty gain by reinvesting the insurance proceeds in property that is similar or related in use during the replacement period. The replacement period ends 2 years after the end of the tax year in which the casualty occurred.

Example 9.5 Casualty Gain Deferred

In the same tax year as the roof collapse, Lucy Hazzard from Example 9.4 bought four cows to replace the ones that were killed. The cows cost $1,500 each. Lucy can elect to defer the gain she

Losses that result from a death caused by a casualty must be netted with other business casualty gains and losses to determine whether they are included in the I.R.C. § 1231 netting process.

■■ If the casualty gains exceed the casualty losses, the net gain is included with other I.R.C. § 1231 gains and netted against I.R.C. § 1231 losses for the year.

■■ If the casualty losses exceed the casualty gains, the net loss is not included in the I.R.C. § 1231 netting process. Instead, it is allowed as an ordinary deduction for pur-poses of the income tax, but it is not allowed

FIGURE 9.8 Form 4797 for Lucy Hazzard (Continued)



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realized on three of the cows. She still deducts the loss realized on the second purchased cow. Lucy reduces the basis of three of the replacement cows by the gain she is not recognizing. She must attach a statement to the return for the year of the casualty providing

1. the details of the casualty, 2. the insurance or other reimbursement

received,

3. the gain realized, 4. the postponed gain,5. a description of the replacement property,6. the adjustment to basis of the replacement

property to reflect the postponed gain, and7. any gain recognized (due to proceeds not

reinvested).

Figure 9.9 provides an example of the election statement for Lucy’s situation.

FIGURE 9.9 Election to Defer Casualty Gain

Election to Postpone Gain under I.R.C. § 1033

On February 8, 2015, taxpayer realized a casualty gain on the death of 3 dairy cows when the barn roof collapsed on them due to an excessive snow load. The taxpayer elects to postpone this casualty gain and has purchased replacement property that is similar or related in use. Insurance proceeds received $3,000

Adjusted tax basis ( 0)

Gain realized $3,000

Gain deferred (3,000)

Gain recognized $( 0)

Cost of replacement property (dairy cows) $4,500

Gain deferred (3,000)

Basis of replacement property $1,500



Weather-Related Provisions for Livestock SalesLivestock producers who are forced to sell animals because of weather-related conditions, such as flood, drought, or other conditions that cause a shortage of water or feed, may be eligible to postpone recognition of income from the proceeds and avoid bunching of income. Two different tax treatments apply only to weather-related sales of livestock in excess of normal business practices. The first applies to draft, breeding, or dairy animals that will be replaced within a 2-year period. The second applies to all livestock and allows a 1-year postponement of reporting the sales proceeds as taxable income.

Replacement The sale or exchange of livestock (other than poultry) held for draft, breeding, or dairy purposes in excess of the number sold as normal business practice is treated as an involuntary conversion if the livestock is sold or exchanged solely on account of drought, flood, or other weather-related conditions [I.R.C. § 1033(e)].

Sport Livestock Ineligible

Note that livestock held for sport does not qualify for this treatment�

If livestock (other than poultry) held for any length of time for draft, breeding, or dairy purposes is sold because of weather-related conditions, the gain realized on the sale does not have to be recognized if the proceeds are used to purchase replacement livestock within 2 years from the end of the tax year in which the sale takes place.

The new livestock purchased must be used for the same purpose as those sold because of weather-related conditions. Breeding stock must be replaced with breeding stock, and dairy cows with dairy cows. The taxpayer must show the weather-related condition caused the sale of more livestock than would normally have been sold. Only the additional animals sold in excess of normal sales can be replaced without recognition of gain. If the taxpayer normally sells one-fifth of the herd each year, only the sales in excess

Replacement Period

If the taxpayer has not reinvested casualty pro-ceeds by the end of the tax year of the casualty but intends to do so within the 2-year replace-ment period, the election statement is modified to remove the calculation of basis of the replace-ment property and to change the statement to reflect the taxpayer’s plans to reinvest� Then, in the year that replacement property is pur-chased, a statement similar to that in Figure 9�9 is attached to the return to show the basis of the replacement property�

If the taxpayer has not reinvested all proceeds received by the end of the replacement period, an amended return must be filed for the year of the casualty to recognize the additional gain�

If the taxpayer dies before buying replace-ment property, the gain must be reported for the year in which the decedent realized the gain (most likely requiring an amended return)� The executor of the estate or the person succeeding to the funds cannot postpone the gain by buying replacement property�

Property Held for SaleAn involuntary conversion (including casualties) of property held for sale, or as a deductible input to the farm operation, generally receives no special tax treatment. Any insurance proceeds or other reimbursements are reported directly on Schedule F (Form 1040). If the taxpayer receives no insurance proceeds and is a cash basis taxpayer, there is generally no deductible loss because these items have zero basis.

Exceptions to Zero Basis Rule

There are two common exceptions to this general statement that property held for sale has zero basis for the cash basis taxpayer� One exception is that growers who are subject to the uniform capi-talization rules under I�R�C� § 263A may have basis in the commodity due to capitalized expenses not yet deducted� A second exception is inventory purchased for resale�



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been no drought, flood, or other weather-related condition. Thus, this election applies only to sales in excess of normal or usual sales [I.R.C. § 451(e)].

To defer income to the next year, taxpayers must meet the following requirements:

1. The taxpayer’s principal business must be farming as defined in I.R.C. § 6420(c)(3).

2. The taxpayer must use the cash method of accounting.

3. The taxpayer must show that the livestock would normally have been sold in the follow-ing year.

4. The weather-related conditions that caused an area to be declared eligible for federal assis-tance must have caused the sale of livestock.

The livestock do not have to be raised or sold in the declared disaster area, they just have to be sold because of the weather-related condition that caused an area to be declared eligible for federal assistance. Also, the sale can take place before or after an area is declared eligible for federal assistance as long as the same weather-related condition caused the sale.

The number of animals that would normally be sold is determined primarily from the taxpayer’s past history. If the taxpayer usually holds all calves until the year after they are born before selling them, but was forced because of weather-related conditions to sell them in the year they were born, the proceeds from this sale may be reported in the year following the year of the sale.

Options for Deferring IncomeThe two weather-related sales of livestock tax provisions have similar but different requirements. Weather-related sales of breeding stock could qualify for either provision. Figure 9.10 compares and contrasts the requirements and tax benefits. Affected taxpayers can determine which provision provides the greatest tax benefit.

of one-fifth will qualify for deferral. There is no requirement that the weather-related conditions cause an area to be declared a disaster area by the federal government. The taxpayer’s basis in the replacement livestock equals the basis in the livestock sold, plus any amount invested in the replacement livestock that exceeds the proceeds from the sale.

The election to defer recognition of gain is made by attaching a statement to the tax return that includes the following information:

1. Evidence of the weather-related condi-tions that forced the sale or exchange of the livestock

2. A computation of the amount of gain realized on the sale or exchange

3. The number and kind of livestock sold or exchanged

4. The number of livestock of each kind that would have been sold or exchanged under usual business practices of the taxpayer

Death of Taxpayer before Replacement

If the taxpayer dies before replacing the involun-tarily converted property, the replacement period expires—it does not carry over to any beneficiary of the estate� In such a case the tax return for the year of the involuntary conversion must be amended to report the gain that was realized� This is the same result that occurs if the taxpayer is still alive but fails to reinvest proceeds during the replacement period�

Deferral of Income for 1 YearCash method farmers can elect to defer for 1 tax year the reporting of income from certain livestock sold on account of drought, flood, or other weather-related conditions. The drought, flood, or other weather-related condition must be of such severity that an area affecting the taxpayer is designated eligible for federal assistance. To qualify for deferral, the taxpayer must show that he or she sold livestock in excess of the number that would ordinarily have been sold had there



gain or loss is not an I.R.C. § 1231 gain or loss. Consequently, the gain or loss is reported on Form 4797, Part II.

Abandonment Loss

I�R�C� § 1231 applies to sales and exchanges of property with results that are dependent on whether the required holding period has been met� Therefore, the death of a purchased cow held for 25 months generates a loss that offsets other I�R�C� § 1231 gains for the year� An argu-ment could be made for treating the death as an abandonment, which would allow an ordinary loss deduction on Form 4797, Part II�

Livestock Deaths Due to DiseaseDeath of livestock because of disease is not a casualty because it is not sudden and unexpected. It is an involuntary conversion, and if the livestock qualifies as I.R.C. § 1231 property, the gain or loss from the death is netted with other I.R.C. § 1231 transactions for the year. If the livestock is I.R.C. § 1231 property, the death of the livestock is reported in Part I of Form 4797 unless there is depreciation recapture to report in Part III of Form 4797. The latter would be the case only if the taxpayer depreciated the animal and received insurance proceeds or other reimbursements as a result of the death.

If draft, breeding, dairy, or sporting livestock has been held for less than 12 months (24 months for cattle and horses) when the animal dies, the

FIGURE 9.10 Comparison of Weather-Related Sale of Livestock Tax Consequences

Alternative Weather-Related Tax Provisions

Postpone Gain by Purchasing Replacement [I.R.C. § 1033(e)]

Defer Income for 1 Year [I.R.C. § 451(e)]

Tax benefit Gain is deferred if replaced within the next 2 years*

Recognition of income is postponed by 1 year

Taxpayer qualifications None Principal trade or business is farming; cash method of accounting

Qualifying livestock Draft, breeding, or dairy livestock All livestock, including poultry

Qualifying sales Sales in excess of normal practice only

Sales in excess of normal practice only

Requirement that area be designated eligible for federal assistance?

No, but designation increases replacement period from 2 to 4 years

Yes

Weather-related condition must have caused the sale?

Yes Yes

Livestock must have been sold in the designated assistance area?

No No

Livestock must be located in the designated assistance area?

No No

Purchase of replacement livestock required?

Yes No

Basis in replacement livestock Reduced by the amount of gain deferred

N/A

Deadline for making the election 2 years after the end of the tax year of sale

Generally, due date of tax return for year of sale, but 4 years after year of sale for sales that qualify for the 4-year replacement period under I�R�C� § 1033(e)(2)

Deadline for replacement Generally 2 years after the end of the tax year of sale*

N/A

* Extended to 4 years if disaster area–related; can be extended further by secretary of Treasury


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Issue 2: Form 1099-MISC 315

on line 1a of Schedule F (Form 1040). There are generally no entries for the sale of livestock raised for sale because these animals have zero basis for the cash basis taxpayer. Insurance proceeds, if any, are included on line 2 of Schedule F (Form 1040).

Income or loss resulting from the death of livestock held for sale in the ordinary course of business is reported on Schedule F (Form 1040). If the taxpayer uses cash accounting, the purchase cost of any livestock purchased for resale that dies is included on line 1b of Schedule F (Form 1040), and the insurance proceeds, if any, are included

ISSUE 2: FORM 1099-MISC Farmers file Forms 1099-MISC for services they purchased in the course of their trade or business and receive Forms 1099-MISC for some of the payments they received�

A taxpayer must issue Form 1099-MISC, Miscellaneous Income, to a vendor when the taxpayer, in the course of a trade or business, pays that vendor over $600 during the year for rent or services. Payments to corporations are generally exempt from Form 1099-MISC reporting. Form 1099-MISC must also be issued to any vendor subject to an IRS backup withholding requirement.

Payments of attorney fees (over $600) paid in the course of a trade or business must be reported in box 7 of Form 1099-MISC even if the law firm is incorporated.

In C.C.A. 2013-49-013 (October 24, 2013), the Treasury indicated that payments to veterinarians were payments for medical and health care services. This requires taxpayers to issue Form 1099-MISC for such services (over $600) in the course of a trade or business even if the veterinarian is incorporated. The amount paid should be reported in box 6 (medical and health care payments) rather than box 7 (nonemployee compensation).

Obtain Form W-9

Annually, business taxpayers should request a signed Form W-9, Request for Taxpayer Identifica-tion Number and Certification, from each vendor, and from each landowner from whom they rent land� This will indicate the correct name, entity type, and identification number to facilitate proper Form 1099-MISC preparation at year-end�

As farms get larger or transition from one generation to the next, there is often a need for additional Form 1099-MISC reporting. Taxpayers sometimes fail to consider this requirement because the payments are all within the family. For example, if the parents own the real estate and rent it to the operating business, that business must issue a Form 1099-MISC for the rent paid (even though this may be on a triple net lease basis and the parents never see any real cash). Another common arrangement is to separate the cropping operation from the livestock operation. Payments by the livestock operation to the cropping operation to purchase feed do not come under Form 1099-MISC reporting requirements. However, if the livestock operation hires the cropping operation to haul away its manure, that payment for custom hire services is subject to Form 1099-MISC reporting.

Penalties

For returns filed after December 31, 2015, the penalty for failure to timely file Forms 1099-MISC and payee statements starts at $50 (up from $30) per Form 1099-MISC for the first 30 days; it next increases to $100 (up from $60), and then to $250 (up from $100) after August 1� The maximum penalty imposed may be as high as $1,000,000 (up from $500,000) for the small business tax-payer� Intentional disregard of the rules carries a $500 (up from $250)-per–Form 1099-MISC penalty [Trade Preference and Extension Act of 2015, Pub� L� No� 114-27, § 806(e) (July 29, 2015)]�


316 ISSUE 2: FORM-1099 MISC

1040), but Harold deducted the interest paid on Schedule E (Form 1040), Supplemental Income and Loss, and, therefore, the $952 patronage income should be reported on that form. Harold should include the $952 on Schedule F (Form 1040), line 3a, but not on line 3b for the taxable amount. The $952 refund should be included in rental income on Schedule E (Form 1040).

Example 9.7 Triple Net Lease Reporting

Harold from Example 9.6 rents the farm to his children on a triple net lease: The farm makes the mortgage payments and pays the real estate taxes and liability insurance on the farm in lieu of rent. Harold never receives any actual cash from rental of the farm. The $30,000 total payments, which are reasonable rent for the land, are itemized in Figure 9.11.

FIGURE 9.11 Itemized Triple Net Lease Deemed Payments

Mortgage interest $ 6,500

Mortgage principal 13,500

Property taxes 7,500

Insurance 2,500

Total deemed payments $30,000

Harold’s children issued Harold a Form 1099-MISC for $30,000 of rent.

Harold reports the $30,000 of rent on Schedule E (Form 1040). Harold’s home is still on the farm, so he allocates $1,500 for the real estate taxes and $500 for the insurance to his personal use of his home. He does not allocate any of the mortgage interest to his personal use because he treated prior-year principal payments as paying off the loan proceeds allocated to his personal use. His net rental profit is $16,452, as shown in Figure 9.12.

Crop Sales; 4-H and FFA Sales

The purchase and sale of crops is not subject to Form 1099-MISC reporting because the transac-tion involves materials rather than services� How-ever, farm taxpayers often receive Forms 1099 for crop sales� This can result in inquiries from the IRS as the IRS attempts to match Forms 1099 to the tax return� Taxpayers should contact those issuing Forms 1099 in error to have the situation corrected—or be ready to explain to the IRS why the information on the Form 1099-MISC does not match the return�

Young people often raise animals as part of a 4-H or FFA project and sell them at the local fair� Normally such transactions would not require a Form 1099-MISC because the payment is for a product and not a service� However, where the sales price on animals, such as those named “Best of Show,” greatly exceeds market value, there may be an element of prize money in the pay-ment� Issuing a Form 1099-MISC eliminates any uncertainty�

Reconciling Forms 1099-MISC to Tax Return

Taxpayers who receive Forms 1099-MISC should verify that they have reported this amount of income on their tax return or obtain corrected Forms 1099-MISC in order to avoid matching inquiries from the IRS. In addition, the income should be reported where the IRS expects it to appear. For example, if a farm lending cooperative issues a patronage refund based on interest paid on a farm mortgage loan, the IRS expects to see the refund on Schedule F (Form 1040).

Example 9.6 Form 1099-PATR Matching

Harold Landowner rents land to his son and daughter, who operate the farm. Harold has a mortgage against the farm for a loan he obtained from a farm lending cooperative. In 2015 the cooperative paid a $952 patronage refund based on interest paid on a farm mortgage loan and issued Harold a Form 1099-PATR, Taxable Dis-tributions Received From Cooperatives, for the amount of the refund. The IRS expects to see the $952 patronage refund on Schedule F (Form


Background 317

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ISSUE 3: NET INVESTMENT INCOME TAX Although income from farming and gains from the sale of assets used in farming are not subject to the net investment income tax, income and gains realized by farmers after they retire may be subject to it�

Farmers who actively participate in the farming operation are exempt from the net investment income tax (NIIT) on earnings from the operation and on gains from the sale of business assets used in that operation. Farmers may be subject to the NIIT as the farm operation grows and they add additional entities, or as the role of the owner/operator transitions to being an owner of farm assets who is no longer active in the business. This issue explores some of the tax “landmines” that may be involved.

Background

Individuals who are subject to US income taxes, except for certain nonresident aliens, owe the NIIT if they have any net investment income and also have MAGI that exceeds the thresholds shown in Figure 9.13. These amounts are not scheduled to be adjusted for inflation in future years.

The amount subject to the 3.8% tax is the lesser of the individual’s net investment income or the individual’s excess MAGI.

FIGURE 9.13 MAGI Thresholds for the NIIT

Filing Status Threshold

Married filing jointly $ 250,000

Married filing separately $ 125,000

Single $ 200,000

Head of household (with qualifying person) $ 200,000

Qualifying widow(er) with dependent child $ 250,000

In general, investment income includes, but is not limited to, gross income from inter-est; dividends; net capital gains; rental and roy-alty income; nonqualified annuities; and income from businesses that are involved in trading of financial instruments or commodities as well as from businesses that are passive activities for the taxpayer (within the meaning of I.R.C. § 469). A key point to keep in mind is that if the item is not recognized as income, gain, loss, or a deduction for regular income tax purposes during the cur-rent tax year, then it is not included in calculat-ing the NIIT. Net capital losses are disregarded in calculating investment income and cannot offset other sources of investment income except to the extent of the net capital loss allowed to offset ordi-nary income under I.R.C. § 1211(b).

FIGURE 9.12 Itemized Triple Net Lease PaymentsPatronage income (Example 9�6) $ 952

Rent received 30,000

Mortgage interest (6,500)

Property taxes $7,500

Property allocated to personal use (1,500)

Property tax allocated to business use (6,000)

Insurance $2,500

Insurance allocated to personal use ( 500)

Insurance allocated to business use (2,000)

Net rental profit $16,452


318 ISSUE 3: NET INVESTMENT INCOME TAX

Self-RentalTreas. Reg. § 1.1411-4(g)(6) treats gross rentals as derived in the ordinary course of a trade or business, and therefore excludes them from net investment income if the rental is treated as nonpassive under the I.R.C. § 469 regulations. Under those regulations rental income received from a trade or business in which the taxpayer materially participates is nonpassive. Activities of the taxpayer’s spouse are also attributed to the taxpayer. Any loss continues to be passive. This is the “self-rental rule.” (Note that this recharacterization rule does not apply to income attributable to the rental of property pursuant to a written contract entered into before February 19, 1988.)

Gain or loss from the disposition of self-rental property is also excluded from net investment income.

Material Participation

See pages 498–503 in the 2014 National Income Tax Workbook for a discussion of material par-ticipation rules, especially as they relate to farm taxpayers�

Example 9.9 Father-to-Son Succession Planning II

Hugh Fairweather from Example 9.8 is now 70 and wants to slow down a bit. Ed is not yet financially able to buy out Hugh’s interest in the LLC or the real estate. Hugh does not need the money due to Edwina’s retirement funds—in addition to rent from the farm now that the farm mortgage has been paid off. Under the I.R.C. § 469 passive loss rules, if Hugh’s participation in the farm drops below 500 hours for the year, he may be considered passive and the income will be subject to the NIIT. Also, if he is passive in the farm operation, the rent income that he and Edwina receive from the farm is no longer exempted from the NIIT under the self-rental rules.

As long as their MAGI stays below the NIIT thresholds, they will not owe any NIIT.

Common types of income that are not invest-ment income are wages; unemployment com-pensation; operating income from a nonpassive business; social security benefits; alimony; tax-exempt interest; self-employment (SE) income; Alaska Permanent Fund dividends; and distribu-tions from retirement plans described in I.R.C. §§ 401(a), 403(a), 403(b), 408, 408A, and 457(b).

Farms in Transition

Historically, farms were transferred from one generation to the next, with members of the older generation living on the farm until their health required them to move. This approach allowed a gradual transition of both ownership and management. The NIIT must be considered when implementing such a plan, and current plans must be reviewed for the impact that NIIT may have on them.

Example 9.8 Father-to-Son Succession Planning I

Ed Fairweather has been back on the farm as an employee for 5 years after graduating from the local land grant university. His father, Hugh, is ready to take the next step in sharing ownership and management with Ed. They decided to form a limited liability company (LLC) to handle the cropping operation, but Hugh will continue to own the land with his wife, Edwina, outside the LLC. The LLC will be taxed as a partnership. Ed and Hugh will each own 50% of the LLC, both will be fully involved in the business, and they will split profits equally. Hugh and Edwina will collect rent for the use of their land.

Because Ed and Hugh are active in the business, their profits are subject to SE tax and therefore exempt from the NIIT. The gain from the sale of any farm equipment is also exempt from the NIIT because the assets are used in an active trade or business.

Rental income is generally subject to the NIIT. However, Hugh and Edwina come under the self-rental exception (discussed in the next section) and are not subject to the NIIT on this rental income. If they sell any of this rental prop-erty, the gains from the sale would also be exempt from the NIIT.


9

Issue 4: Inherited Property 319

the NIIT threshold, and both Hugh’s share of the LLC liquidation proceeds and their gain on the sale of rental real estate will be investment income subject to the NIIT.

Managing NIIT in High-Income Years

See pages 92–96 in the 2014 National Income Tax Workbook for further information regarding smoothing AGI and other strategies to manage the NIIT�

Example 9.10 Father-to-Son Succession Planning III

Continuing with the Fairweathers, son Ed real-ized that farming is not as much fun with Dad not around every day. He decided to quit farm-ing and become a tax practitioner in Madison, Wisconsin. Hugh and Edwina will now sell the farm. Ed’s share of the proceeds from liquidating the LLC qualify for the “used in trade or busi-ness” exception to the NIIT to the extent these proceeds represent the sale of business assets. However, Hugh and Edwina, without careful planning, will likely have income in excess of

ISSUE 4: INHERITED PROPERTY Because the income tax basis of most farm assets is adjusted to the value of the asset on the date the owner dies, heirs enjoy a significant income tax benefit on assets they inherit�

Having a proper and thorough appraisal of farm assets at the death of a farm operator is critical for many reasons. This issue addresses the adjustment of basis to the FMV as of the date of death, or the alternate valuation date for the estate, which is 6 months after the date of death. This adjustment is commonly referred to as the step-up in basis. However, in some cases the date-of-death value is lower than remaining tax basis. In those cases the basis must be reduced to date-of-death value. Historically, the instances of step-down in basis for farm assets have been rare.

Alternate Valuation Date

Taxpayers can elect to adjust the basis of assets to their value on the alternate valuation date only if the election reduces both (1) the value of the gross estate, and (2) the sum of (a) the estate tax imposed on the decedent’s estate and (b) the gen-eration-skipping transfer (GST) tax imposed on property included in the decedent’s gross estate� Therefore, if the estate owes no estate tax and no generation-skipping tax, it cannot elect the alter-nate valuation date because the sum of those taxes cannot be reduced�

There are some assets that do not receive a basis adjustment to the date-of-death value even though the assets are included in the estate of the decedent. These assets are referred to as income in respect of a decedent (IRD). They represent income that the deceased taxpayer earned, but had not yet received, at the time of death. This income was not taxed on the final return of the decedent, so it is taxable income on the return of whoever receives the income. In a farm setting the two largest components of IRD are generally accounts receivable for product sold before death and tax-deferred retirement funds (including life insurance annuities).

Inherited assets other than IRD are automatically considered held the required holding period so that any subsequent gain in value is eligible for capital gains treatment.

This step-up in basis can provide significant tax deductions for the continuing farm operation, or reduced gain upon liquidation of those assets.

Example 9.11 Growing Crops

Howie Growing raised soybeans and incurred $87,000 of growing costs for this year’s crop. He had $60,000 of carryover income from last year. When he passed away on July 7, his Schedule F (Form 1040) showed a $27,000 loss before depreciation. His wife, Sarah, took over farming operations upon Howie’s death. At the time of his


320 ISSUE 4: INHERITED PROPERTY

equipment, land, and buildings are also adjusted to the date-of-death value.

Example 9.12 Date-of-Death Basis Adjustment for Equipment

In Example 9.11 pre-death and post-death depreciation were $10,000 and $18,000, respectively. The following illustrates the process that is applied to each depreciable asset on Howie’s depreciation schedule.

Howie purchased a combine in 2014 for $240,000. He claimed $140,000 of section 179 deduction and $10,710 ($100,000 × 10.71%) of MACRS depreciation on his 2014 tax return. Had Howie lived the entire year, his 2015 depreciation would have been $19,130 ($100,000 × 19.13%). Because he died on July 7, his 2015 depreciation prorated to the date of death is $9,853 [$19,130 × (188 days ÷ 365 days)]. His date-of-death basis is $79,437 ($240,000 – $140,000 – $10,710 – $9,853).

At Howie’s death Sarah received the combine. Her basis in the combine is its $200,000 FMV at the date of death. Sarah’s MACRS depreciation deduction is $21,420 using the 10.71% rate for the first year of ownership for 7-year property. Sarah may not expense any of the basis in the combine under I.R.C. § 179 because she did not acquire it by purchase.

In essence, the Growings deduct the expenses of growing the crop twice due to the step-up in basis. Without the step-up in basis of the crop, their farm profit would have been $85,000 rather than the actual $15,000 ($22,000 – $37,000) com-bined loss. If the appraiser for Howie’s estate had included the crop in the value of the land, rather than breaking out a value for the growing crops, this deduction could have been lost.

Crop or Livestock Share Step-Up

If a landowner materially participates in a crop or livestock share lease, his or her basis in the growing crop or livestock is adjusted to the date-of-death value because the landowner is in the business of farming and produced his or her share of the crop or livestock as of date of death in that trade or business�

If the landowner does not materially partici-pate in the crop or livestock share lease, his or her share of growing crop or livestock is IRD because it is rental income earned but not taxed before death� Therefore, the basis in the landowner’s share of the growing crop or livestock is not adjusted to the date-of-death value�

The bases of fuel in the storage tanks; fertilizer, feed, and other supplies on hand; harvested crops in storage and not yet sold; as well as vehicles,

death, the growing crop was valued at $100,000. Sarah sold the crop for $140,000 net of harvesting costs. Depreciation for the year, adjusted to reflect date-of-death values since July 7, amounted to $28,000 ($10,000 pre-death, $18,000 post-death). The tax return for the Growings reports the amounts shown in Figure 9.14.

FIGURE 9.14 Items Reported on Growings’ 2015 Tax Return

Howie’s Schedule F Sarah’s Schedule F

Crop sales $ 60,000 $ 140,000

Basis of crop 0 (100,000)

Growing costs (87,000) 0

Depreciation (10,000) (18,000)

Net Schedule F (Form 1040) $(37,000) $22,000


Transfers of Mineral Rights 321

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ISSUE 5: OIL AND GAS PAYMENTS AND DEDUCTIONS This issue explores the tax treatment of various payments that a landowner may receive from oil and gas exploration and drilling activity on his or her land�

Landowners receive payments from mining companies for mineral rights, easements, damage to their crops and land, and advance royalty payments. They can offset that income with the depletion allowance as discussed in this issue.

Transfers of Mineral Rights

A landowner often owns both surface and subsurface or mineral rights in a tract of land. The landowner can transfer oil and gas property rights by a lease, a sublease, or a sale. The type of transaction determines the character of the reported income.

Sale of Mineral RightsI.R.C. § 1231 governs the tax consequence of a sale, providing long-term capital gain or ordinary loss treatment for trade or business assets held more than 1 year. There is no cost basis in the mineral rights under I.R.C. § 1011 unless one of the following conditions exists:

■■ The landowner’s basis in the property included a stipulated amount for mineral rights.

■■ The landowner’s basis was the result of an estate tax valuation in which mineral and surface rights were valued separately.

■■ The landowner’s basis can be properly allo-cated between surface and mineral rights because of substantial evidence of value attributable to the minerals at the date of acquisition.

Example 9.13 Sale of Mineral Rights

Roscoe Landowner owned the surface and mineral rights on a parcel of land he purchased 10 years ago for $100,000. The purchase contract allocated $25,000 to the mineral interest. In 2015 he sold all the mineral interest in the property to Diamond Drilling for $40,000 and retained no economic interest in the mineral rights.

Because $25,000 of Roscoe’s original pur-chase price for the property was allocated to the mineral rights, he reports a $15,000 long-term gain ($40,000 – $25,000) on Form 4797, Sales of Business Property. Roscoe’s basis in his remain-ing property is $75,000 ($100,000 – $25,000).

Lease of Mineral RightsThe most common method of conveying an interest in oil or gas property is a lease in which another party (lessee) agrees to develop the mineral interest for the landowner or mineral owner (lessor). The lease generally provides for the following:

1. A lease bonus payable to the lessor upon the execution of the lease

2. A specified primary term of years to begin the drilling operations

3. Delay rental payments for each year in which the lessee has not begun the drilling operations

4. Lease cancellation if the lessee does not pay the delay rental by the due date

5. A basis for dividing the oil and gas pro-duced between the lessor and lessee

6. Continuation of the contract as long as oil or gas is produced from the property

Leases are frequently acquired in blocks. Usually geologists and geophysicists conduct certain preliminary surveys of the surface conditions. If these surveys indicate the area is promising for oil or gas development, oil company agents acquire leases from lessors for the desired area.


322 ISSUE 5: OIL AND GAS PAYMENTS AND DEDUCTIONS

lease bonus. The lease provides for a 5-year primary term and continues so long as oil or gas is produced on the property. Appleseed Exploration bears all the costs of development and operations and will pay Johnny one-eighth of the proceeds from the sale of any production from the property.

Johnny reports the $5,000 bonus payment as ordinary income, subject to depletion, on Sched-ule E (Form 1040), Supplemental Income and Loss.

Delay Rental PaymentsThe lease usually contains a provision requiring the lessee to pay a delay rental payment for each year development is not started after the period allowed by the lease bonus payment (usually 1 year), or else the lessee forfeits the lease. Delay rental payments are ordinary income to the landowner, and no depletion is allowed. Delay rental payments are not advance payments for oil or gas production but are paid for the privilege of deferring development and to hold the lease in effect [Treas. Reg. § 1.612-3(c)(2)].

Example 9.15 Delay Rental Payment

The lease in Example 9.14 also requires Apple-seed Exploration to pay $5-per-acre annual delay rental payments to Johnny Landowner. Apple-seed Exploration did not develop the leased prop-erty within 1 year after the lease commenced. Appleseed Exploration paid Johnny $500 ($5 per acre × 100 acres) the next year to provide Apple-seed Exploration additional time for developing the property. Johnny reports the $500 as ordinary income on Schedule E (Form 1040).

Damage Payments

Payments for damages to the surface of the land during the development of the mineral property may result in taxable income to the lessor.

Payments for damages to crops go to the owner of the crops, which could be the landowner or another person who rents the land from the landowner. The crop damages are ordinary income reported on Schedule F (Form 1040),

Forced Pooling Statutes

Forced or compulsory pooling state laws compel landowners within a spacing unit to pool their interests in the underlying deposit and operate as one unit� An operating interest owner generally files an application with the state to create the spacing unit� As a result, the mineral owners share the royalties from the production in the spacing unit based on their ownership acres as a percent-age of the unit’s production�

The lessor grants the lessee the exclusive right to drill for and produce oil or gas on the designated property. The lessee does not have a specific obligation to develop the property or to pay delay rentals but agrees that the lease will expire if the property is not developed or rentals are not paid. Ordinarily, the lessee can abandon the property without penalty. However, it is customary for the lessee to formally terminate the lease if the lessee decides not to develop the property.

Lease BonusA lease agreement usually requires the lessee to pay cash (a lease bonus) to the lessor upon the execution of the lease. The bonus pays for the rights to explore for oil and gas on the lessor’s property for generally 1 year. Cash bonuses received upon the execution of an oil and gas lease are regarded as advance royalties for income tax purposes [Anderson v. Helvering, 310 U.S. 404 (1940)].

The lease bonus is taxable as ordinary income to the landowner. The payment is eligible for cost depletion [Treas. Reg. § 1.612-3(a)(1)]. Lease bonus payments (and other amounts payable without regard to production) received after August 16, 1986, do not qualify for percentage depletion [I.R.C. § 613A(d)(5)]. If there is no production and the lease expires, the depletion deduction is restored to income (recaptured) in the year the lease terminates. (Computation of depletion is explained later in this chapter.)

Example 9.14 Lease Bonus

Johnny Landowner granted Appleseed Exploration an oil and gas lease on his 100-acre tract of land. Appleseed paid Johnny a $5,000


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Minimum Royalty Provision

A minimum royalty provision requires the lessee to pay a substantially uniform royalty at least annually, either over the life of the lease or for a period of at least 20 years in the absence of min-eral production requiring payment of aggregate royalties in a greater amount [Treas� Reg� § 1�612-3(b)(3)]� The lessor’s receipt of a minimum royalty payment is subject to cost depletion�

Oil and Gas Depletion

An oil- or gas-producing property is a wasting asset, thereby reducing the capital investment. To compensate for this reduction, I.R.C. § 611(a) allows the owner of an economic interest in an oil- or gas-producing property a reasonable deduction for depletion in computing taxable income from the property. Because depletion is figured on a property-by-property basis, the property unit is a significant factor for this calculation.

IntroductionThe allowable depletion deduction for each property is the greater of cost depletion or percentage depletion for that property. To claim a depletion deduction, a taxpayer must have an economic interest in the property and must sell or consume the product.

Economic InterestTo claim a depletion deduction, the taxpayer must possess a legal or equitable ownership interest (economic interest) in the minerals in place and must receive income from the extraction and sale of the minerals. Treas. Reg. § 1.611-1(b)(1) states that a taxpayer has an economic interest if “the taxpayer has acquired by investment any interest in mineral in place or standing timber and secures, by any form of legal relationship, income derived from the extraction of the mineral or severance of the timber, to which he must look for a return of his capital.”

Profit or Loss From Farming, or Form 4835, Farm Rental Income and Expenses, for a crop-sharing arrangement. Damage payments related to the land or to timber property reduce the basis of the property. If the payment exceeds the landowner’s basis in the property, the excess is taxed as I.R.C. § 1231 gain (reported on Form 4797) or as capital gain (reported on Form 8949, Sales and Other Dispositions of Capital Assets).

Example 9.16 Damage Payments

Luke Kool, a cash basis sole proprietor farmer, leased his gas mineral rights on a tract of land to Quality Exploration Company (QEC). Luke received $5,000 for damages to his standing timber that occurred while QEC was preparing the property for drilling. Luke has no taxable gain but reduces his $50,000 basis in the timber by the $5,000 payment.

Luke also received $1,800 for crop damages during the drilling preparation period. He reports the $1,800 as income on his Schedule F (Form 1040) in the year he received the payment.

Advance Royalty Payments

Payments from a lessee to a lessor for a specific number of units of minerals, regardless of whether oil or gas is extracted in the year of the payment, are advance royalty payments. The payment is applied to royalty payments due on future production. The lessor treats these payments as ordinary income.

To the extent the actual production during the period is sufficient to earn these payments, the lessor may claim percentage depletion [Treas. Reg. § 1.613A-3(j)(1)]. The remaining payment is eligible only for cost depletion.

Example 9.17 Advance Royalty Payment

Sal Escarole signed an oil and gas lease with Best Exploration for a 10-year primary term. The lease requires a one-eighth production royalty payment to Sal and $100,000 advance royalties at the beginning of each of the first 3 years. If in the first lease year actual production was sufficient to earn $20,000 of production royalties, Sal can claim percentage depletion on $20,000 and cost depletion on the remaining $80,000.



Production RequirementA depletion deduction is not allowed when the taxpayer extracts the oil or gas; it is allowed when the taxpayer sells the extracted mineral product and reports income [Rev. Rul. 76-533, 1976-2 C.B. 189; and Treas. Reg. § 1.611-2(a)(2)]. Oil or gas that is not sold but is transported from the property is depletable at its representative market or field price (RMFP) when used or consumed by the producer [Rev. Rul. 67-303, 1967-2 C.B. 221; Rev. Rul. 68-665, 1968-2 C.B. 280].

Depletion MethodsTwo methods are compared when computing the depletion deduction for oil and gas property:

1. Cost depletion is a unit-of-production method using the taxpayer’s basis in the mineral property [I.R.C. § 612].

2. Percentage depletion is a specified percentage of the taxpayer’s gross income from the prop-erty, limited to the lesser of 100% of the tax-payer’s taxable income from the property or 65% of the taxpayer’s taxable income from all sources [I.R.C. §§ 613 and 613A].

The method of computing the depletion deduction is not elective. The taxpayer must use the larger of the two amounts for each property.

Definition of the Depletion Property UnitWhen computing the depletion allowance for natural deposits, the term property means each separate interest owned by the taxpayer in each mineral deposit in each separate tract or parcel of land [I.R.C. § 614(a)]. The term interest means an economic interest in a mineral deposit, including working or operating interests, royalties, over-riding royalties, net profits interests, and produc-tion payments that are not treated as loans under I.R.C. § 636 [Treas. Reg. § 1.614-1(a)(2)].

Example 9.18 Separate Interests in a Single Unit

Robert Rancher owns eight parcels of land that are leased under one contract to ABC Explora-tion. Even if each tract of land contains part of the same mineral deposit, Robert owns eight sepa-rate mineral interests, each of which constitutes

a separate property [Treas. Reg. § 1.614-1(a)(5), Example 2].

Cost DepletionCost depletion is the method used to assure the owner of an oil- or gas-producing property a tax deduction at least equal to the investment in the depleting property as the asset is consumed. A taxpayer’s basis for cost depletion is the adjusted basis under I.R.C. § 1011, defined under “Sale of Mineral Rights” at the beginning of this issue.

Subtract Allowable Depletion Deduction

Allowable depletion deductions (whether fig-ured as cost or percentage depletion) reduce the taxpayer’s remaining basis for cost depletion computations�

Reserves of Oil and GasTo calculate cost depletion, taxpayers must estimate their reserves of oil and gas, which is the number of units (for example, barrels of oil or thousands of cubic feet of natural gas) that are expected to be recovered in the future. Estimates “must be made according to the method current in the industry and in the light of the most accurate and reliable information obtainable” [Treas. Reg. § 1.611-2(c)(1)].

Rev. Proc. 2004-19, 2004-10 I.R.B. 563, provides an elective safe harbor for oil and gas property owners to use in determining recoverable reserves for computing cost depletion for tax years ending after March 7, 2004. The total recoverable units under this election are equal to 105% of the property’s proved reserves (both developed and undeveloped). Industry definitions of proved reserves (developed and undeveloped) refer to minerals that are reasonably known or on good evidence believed to be recoverable under existing economic and operating conditions [17 C.F.R. § 210.4-10].

Cost Depletion CalculationWhen computing cost depletion, the taxpayer must first compute a unit cost by dividing the taxpayer’s adjusted depletable basis by the


Oil and Gas Depletion 325

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number of remaining recoverable barrels of oil or thousands of cubic feet (MCF) of gas. The unit cost is then multiplied by the number of units (barrels or MCF) sold during the tax period to compute the cost depletion deduction, as shown in Figure 9.15.

The “reserves” used in the cost depletion computations for any tax period are the reserves at the end of that tax period plus the units produced during that tax period [Treas. Reg. § 1.611- 2(a)(3)].

FIGURE 9.15 Cost Depletion Calculation

Cost depletion =Adjusted basis

× Units soldReserves

Example 9.19 Cost Depletion (Royalty Interest)

Slate Rock’s adjusted basis in his one-eighth royalty interest is $22,000. During the first year of the lease, the producer sold 5,000 barrels of oil. The estimated reserves at the end of the year were 35,000 barrels. Slate’s cost depletion amount is $2,750, as calculated in Figure 9.16. Although he receives only a one-eighth share, his cost depletion calculation considers the entire quantity that was depleted and the entire reserves.

FIGURE 9.16 Slate Rock’s Cost Depletion

Cost depletion

=$22,000

× 5,000 = $2,75035,000 + 5,000

Cost depletion can also be based on dollar amounts. This calculation is used for bonus payments that are not based on production.

The taxpayer’s adjusted depletable basis is divided by the total remaining gross income expected to be received from the beginning of the tax period until the resource is totally depleted. This calculation results in a unit cost expressed as dollars of cost per expected dollar receipts. The resulting fraction is then multiplied by reportable gross income for the tax period to compute the allowable cost depletion [Treas. Reg. § 1.612-3(a)].

Cost depletion, if it is greater than the allowable percentage depletion, must be used in lieu of percentage depletion.

Percentage DepletionPercentage depletion, based on income, is allowable even if the taxpayer has a zero basis for cost depletion. The percentage depletion deduction is computed as a percentage of gross income from the property, limited to the taxable income from the property. For this reason the definitions of gross income from the property and taxable income from the property are very important.

The cumulative percentage depletion for all of the taxpayer’s properties is limited to his or her taxable income from all sources.

The typical percentage depletion rate is 15% of the gross income for oil and gas (see the exception for certain domestic gas wells discussed later in this section).

Gross Income from the PropertyTreas. Reg. § 1.613-3 defines gross income from oil and gas well property as the amount for which the taxpayer sells the oil or gas in the immediate vicinity of the well. For the landowner/lessor, gross income will normally be the royalty payment.

The lessor’s gross income from the property does not include a lease bonus or advance royalty that was payable without regard to production [I.R.C. § 613A(d)(5)]. In addition, delay rental payments and most land damage payments are not considered gross income for purposes of the depletion calculation.

Taxable Income from the PropertyTaxable income from the property means gross income from the property less all allowable deductions (except any deduction for depletion or domestic production activities) attributable to the mining processes, including mining transportation. The non-operator landowner does not typically incur any mining expenses, and therefore taxable income is the same as gross income.

Taxable Income from All SourcesA taxpayer’s percentage depletion deduction for all properties may not exceed 65% of his or her adjusted taxable income from all sources for the year [I.R.C. § 613A(d)]. The adjustments eliminate



for that property. If percentage depletion is greater, and any of it is disallowed because of the 65%-of-taxable-income limitation, the disallowed portion is carried forward and added to the depletion allowance for the following year, before income limitations (including the 65%-of-taxable-income limitation) are applied for that year [Treas. Reg. § 1.613A-4(a)(2)]. The disallowed percentage depletion amount is allocated to the properties from which the oil or gas was produced in proportion to the percentage depletion otherwise allowable to each property.

A taxpayer who claims a percentage depletion deduction must attach a statement to the tax return providing all data necessary to determine gross income from the property and taxable income from the property [Treas. Reg. § 1.613-6].

Example 9.20 Sufficient Taxable Income (Royalty Interest)

Slate Rock from Example 9.19 received a check for his royalty interest. His one-eighth share of the gross income was $55,000. The amount was reduced by a 6% production tax ($55,000 × 6% = $3,300) paid to the state, giving him a net check amount of $51,700 ($55,000 − $3,300). His adjusted taxable income from all sources is $120,000.

Slate is eligible for the percentage depletion deduction. Slate’s tentative percentage depletion amount is $8,250 (15% × $55,000 gross income). His 65%-of-adjusted-taxable-income limit is $78,000 (65% × $120,000 adjusted taxable income).

Therefore, his depletion deduction is not limited by either of the income limits because

1. his taxable income from the property is $51,700, and

2. his entire $78,000 limit based on adjusted tax-able income from all sources is allocated to this property because he has no other oil and gas properties.

Because his percentage depletion is greater than his $2,750 cost depletion, Slate must use the $8,250 percentage depletion on his tax return. He reduces his depletable cost basis to $13,750 ($22,000 original basis – $8,250 depletion deduction).

■■ net operating loss carrybacks;■■ capital loss carrybacks;■■ the percentage depletion itself; and■■ in the case of a trust, any distributions to its beneficiaries.

The taxable income limit is allocated among the taxpayer’s properties in proportion to the percentage depletion that would have been allowed without the taxable income limit [I.R.C. § 613A(d)(1)].

Exception for Certain Domestic Gas WellsA 22% percentage depletion rate is allowed for (1) regulated natural gas and (2) natural gas sold under a fixed contract. Natural gas from geopressured brine is eligible for a 10% percentage depletion rate.

The term regulated natural gas means domestic natural gas produced and sold by the producer before July 1, 1976. Natural gas sold under a fixed contract refers to domestic natural gas sold by the producer under a contract in effect on February 1, 1975. In both instances the price cannot have been adjusted to reflect any increase in the seller’s tax liability resulting from the repeal of percentage depletion for gas. Price increases after February 1, 1975, are presumed to take increases in tax liabilities into account unless the taxpayer presents clear and convincing evidence that they did not [I.R.C. § 613A(b)(3)(B)].

The term qualified natural gas from geopressured brine refers to natural gas determined in accordance with section 503 of the Natural Gas Policy Act of 1978, Pub. L. No. 65-21. The gas must be produced from a well where drilling began after September 30, 1978, and before January 1, 1984 [I.R.C. § 613A(b)].

Greater of Cost or Percentage DepletionThe allowable percentage depletion for each property is compared to the cost depletion for each property to determine the greater of cost depletion or percentage depletion. The larger of the two is the allowable deduction under Treas. Reg. § 1.611-1(a). The determination is made on a property-by-property basis.

If cost depletion for a property is greater, there is no carryover of unused percentage depletion


Pipeline Right-of-Way Easements 327

9

the holder’s interest. The title to the property remains with the landowner, who is responsible for property taxes on the land covered by the ROW easement.

The common perpetual ROW contract requires that pipelines be buried below “plough depth” and recognizes the landowner’s interest in conducting agricultural activities on the surface of land burdened with pipeline easements. Easement grants often expressly prohibit certain obstruction activities by the landowner within a certain distance from the easement, such as planting trees, building fences, installing asphalt paving, and similar activities.

Taxation of Proceeds Granting a perpetual easement can result in I.R.C. § 1231 gain, reported on Form 4797, Part I, and a reduction in basis in the land affected by the easement. The general rule is set out in Treas. Reg. § 1.61-6(a) as follows:

When a part of a larger property is sold, the cost or other basis of the entire property shall be equitably apportioned among the several parts, and the gain realized or loss sustained on the part of the entire property sold is the difference between the selling price and the cost or other basis allocated to such part. The sale of each part is treated as a separate transaction and gain or loss shall be com-puted separately on each part. Thus, gain or loss shall be determined at the time of sale of each part and not deferred until the entire property has been disposed of.

When an easement is sold, there are two issues for allocating basis:

1. The allocation of basis between the portion of the property that is subject to the easement and the rest of the property

2. The allocation of basis between the rights cre-ated by the easement and the rest of the rights in the property retained by the landowner

Property AffectedTaxpayers have argued unsuccessfully that the entire basis in property from which an easement is acquired should be compared with the sale price of the easement. For example, in Iske v. Commissioner, T.C. Memo. 1980-61, aff’d

Oil and Gas Taxation

See pages 568–595 in the 2013 National Income Tax Workbook for further information regard-ing oil and gas issues, especially as they relate to operators and interests owned by entities�

Pipeline Right-of-Way Easements

Transportation pipelines move products (oil, gas, and refined products) between cities, countries, and even continents. Millions of miles of oil and gas transportation pipelines crisscross the United States.

When a pipeline is built, it is routed along a right of way (ROW) across a tract of land. A pipeline ROW easement for this purpose involves a perpetual or permanent easement granting the pipeline transmission company the right to lay, construct, operate, maintain, inspect (including aerial reconnaissance), remove, alter, abandon in place, replace, relocate, and reconstruct a pipeline on the property.

In addition to the enumerated perpetual ROW easement, the landowner may grant the pipeline transmission company a temporary easement during the construction of the pipeline. The temporary easement payment is ordinary income to the landowner and is reported as rental income on Schedule E (Form 1040).

Crop Damage ProceedsROW easement contracts often include payments for damage to crops during construction of the pipeline. Pipeline construction damage proceeds are ordinary income in the year of receipt, and the crop owner reports the proceeds as other income on line 10 of Schedule F (Form 1040) [Rev. Rul. 73-161, 1973-1 C.B. 366]. Damage proceeds the crop owner receives for crop damage in years subsequent to pipeline construction completion are also reported as ordinary income.

Perpetual Easement IssuesEasements do not give the holder a right to possess the land on which they are imposed, but they do give the holder the use of the land consistent with



De Minimis Safe Harbor

Treas. Reg. § 1.263(a)-1(f)(1) provides a de minimis safe harbor that permits a current-year deduction for the acquisition or production of units of tangible property that have an economic useful life that does not exceed 12 months or that cost less than a specified amount. Although the taxpayer’s accounting procedures can set any dollar limit for expensing, the per item tax deduction is limited to $500 for taxpayers without an applicable financial statement (AFS) and $5,000 for taxpayers with an AFS.

An AFS (in descending priority) is defined as

1. a financial statement required to be filed with the Securities and Exchange Commission (SEC);

ISSUE 6: REPAIRS This issue explains whether amounts paid in the course of a farm trade or business must be capitalized or can be deducted�

Determining whether an expenditure is currently deductible or whether it must be capitalized and depreciated requires a careful examination and thorough understanding of all the particular facts and circumstances related to the nature of the taxpayer’s industry and its business operations. T.D. 9636, 2013-43 I.R.B. 331, promulgated new regulations that clarify the treatment of amounts paid in the course of a trade or business and provide some safe harbors and elections to simplify the application of those rules.

Repair Regulations

See the “Repair Regulations” chapter in this book for a more detailed explanation of the repair regulations�

(unpublished opinion) 636 F.2d 1225 (8th Cir. 1980), the taxpayer argued that his entire basis in two parcels of land should be compared with the amount he received for an easement across the property. The court agreed with the IRS and held that only the basis allocable to the immediate acreage covered by the easement may be used.

Easements Related to Wind Energy Installations

See pages 410–413 in the 2010 National Income Tax Workbook for an in-depth discussion of ease-ments related to wind turbines�

Right Created by Easement vs. Rights RetainedWhere a taxpayer owns all rights to a property, and did not make an allocation of any of the rights at the time of acquisition, the entire basis of the affected property may be used in calculating gain or loss on the sale of the easement.

Example 9.21 Basis Allocation to ROW

A pipeline transmission company purchased a 50-foot-wide permanent ROW easement along the southern boundary of Guy Gardner’s farm for the construction and maintenance of a pipeline. The amount paid for the easement can be offset by only the basis allocable to the 50-foot-wide strip affected by the easement, and Guy must report any excess amount as I.R.C. § 1231 gain [Rev. Rul. 73-161, 1973-1 C.B. 366].

An aggressive position involves allocation of the entire property’s basis to the ROW easement proceeds in a situation when it is impossible to determine the basis of the easement property, and restrictions of the easement substantially affect the entire property.

Entire Basis Applied to ROW Proceeds

If the entire property basis is applied against ROW easement grant proceeds, the taxpayer should file Form 8275, Disclosure Statement, if the “reason-able basis” or “substantial authority” standards can be met�


De Minimis Safe Harbor 329

9

or less are expensed. Management will periodically review these levels and make any modifications as necessary.

In 2015 Derry paid $350 for a power washer to clean his dairy parlor. He expects the power washer to last about 3 years. If Derry elects the de minimis safe harbor for deducting expenses by attaching a statement to his original income tax return for 2015, he can deduct the $350 he paid for the power washer on that return. Derry could revise his accounting procedure to allow him to expense purchases of up to the $500 allowed by the de minimis safe harbor. He chose the $400 level to avoid generating losses in his farm business.

Question 1.Prior to 2014 Derry deducted the cost of fixed assets if the cost was $200 or less or if the useful life was 1 year or less. He changed his accounting procedure in 2014 to take advantage of the de minimis rule in the final regulations issued in 2013 [T.D. 9636, 2013-43 I.R.B. 331]. Does that change require Derry to file Form 3115, Application for Change in Accounting Method?

Answer 1.No. The preamble to the final regulations states that a change in accounting procedures is a taxable-year election and is not, by itself, a change in accounting method. Therefore, the taxpayer is not required to file Form 3115 [T.D. 9636, 2013-43 I.R.B. 331, § IV, I]. This position was restated by the IRS in Rev. Proc. 2015-20.

Question 2.Derry paid $400 each for 10 heifer calves that he plans to raise and place in his dairy herd when they are ready to be bred. He paid $450 each for another 7 heifer calves. Can he deduct the cost of the calves?

Answer 2.Under I.R.C. § 162 Derry must deduct the cost of the 10 calves that cost $400 each because the cost of each is within his $400-or-less accounting procedure. He must capitalize the cost of the 7 calves that cost $450 each and recover that cost under the depreciation rules, including I.R.C. § 179 and the additional first-year depreciation (AFYD) rules (to the extent they are available for 2015).

2. a certified audited financial statement that is accompanied by the report of an indepen-dent CPA and that is used for credit purposes; reporting to shareholders, partners, or similar persons; or any other substantial nontax pur-pose; or

3. a financial statement (other than a tax return) required to be provided to a federal or state government or an agency other than the SEC or the IRS.

When a taxpayer properly applies the de minimis safe harbor, the amount paid is not treated as a capital expenditure or as a material and supply. Instead the amount is deducted under Treas. Reg. § 1.162-1, provided it otherwise constitutes an ordinary and necessary business expense.

Taxpayers may not selectively choose items to expense under the de minimis safe harbor. If the taxpayer elects the safe harbor, expenditures for all units of property that meet the safe harbor requirements must be deducted in the year the expenses are paid by a cash basis taxpayer or incurred by an accrual basis taxpayer. Any subsequent gain on disposition of the property is ordinary income [Treas. Reg. § 1.263(a)- 1(f)(3)(iii)].

Example 9.22 Accounting Procedure

In 2014 Derry Jersey adopted the following accounting procedure for his dairy farm business. He does not have an AFS.

The company considers a fixed asset to be a tangible asset purchased for use in the day-to-day operations of the company from which an economic benefit will be derived over a period greater than 1 year. Fixed assets include items such as build-ings, leasehold improvements, livestock, equipment, office furniture, fixtures, computers, and other related technology equipment.

At the time a fixed asset is acquired, its cost is capitalized unless it has a value of $400 or less (including transactional and other costs related to the acquisition), in which case the cost is expensed in the period the asset is acquired.

Additionally, amounts paid for prop-erty with an estimated useful life of 12 months or less and with a value of $800


330 ISSUE 6: REPAIRS

Question 1.Does the answer change if the Beginning Farmer Program capitalizes the $100,000 cost of the heifers when it converts Richard’s cash basis statement to accrual basis?

Answer 1.Possibly. The regulations do not address this situation, but the reason they treat a statement submitted to a government agency (other than the IRS or the SEC) as an AFS is that the taxpayer cannot use one set of books to apply for a government program and then use another set of books to report taxable income. If the Beginning Farmer Program does not rely on the financial statements that Richard submitted, the IRS could possibly invoke its authority under the anti-abuse provision in Treas. Reg. § 1.263(a)-3(f)(6) to adjust Richard’s deductions so that they conform to the accrual basis income and expenses used by the Beginning Farmer Program.

Question 2.Deducting $75,000 (50 heifers × $1,500) on his 2015 tax return reduces Richard’s taxable income below the amount he would like to report. Can Richard choose to capitalize the cost of 20 heifers and deduct the cost of the remaining 30 on his income tax return?

Answer 2.No. If Richard elects the de minimis safe harbor, he must apply his accounting procedure to all of his purchases to report them on his income tax return.

Question 3.To show more income, Richard would like to capitalize the cost of 20 heifers on the financial statement he submits to his bank when he applies for a loan. Does that affect his safe harbor for deducting amounts paid on his income tax return?

Answer 3.Treas. Reg. § 1.263(a)-3(f)(i)(C) requires only that the taxpayer treat the amount paid as an expense on its AFS—in this case, the financial statement Richard submitted to the Beginning Farmer Pro-gram. However, the anti-abuse rule in Treas. Reg. § 1.263(a)-3(f)(6) requires the IRS to make appro-priate adjustments if the taxpayer manipulates transactions with the intent to achieve a tax ben-efit. The IRS could use that authority to deny the $100,000 deduction on Richard’s 2015 income tax return because he did not use the accounting

Question 3.Derry does not have an AFS, and instead of the $400-or-less accounting procedure, he adopted a $600-or-less accounting procedure. In 2015 he paid $550 for an air compressor for his dairy business. Can he deduct $500 of the cost under I.R.C. § 162 and the remaining $50 under I.R.C. § 179?

Answer 3.None of the $550 cost of the compressor quali-fies for the $500 de minimis safe harbor. Unless Derry can show that deducting the cost of the compressor under I.R.C. § 162 will not distort his income, he must capitalize the entire $550 cost and recover that cost under the depreciation rules, including I.R.C. § 179 and the AFYD rules (to the extent they are available for 2015).

Example 9.23 Applicable Financial Statement

A state Beginning Farmer Program requires Richard A. Maize to file a financial statement each year to qualify for the program. The financial statement is not audited. Richard has a written accounting procedure under which he deducts amounts paid that are $3,000 or less. In 2015 Richard paid $1,500 each for 50 dairy heifers.

Because Richard is required to file a financial statement with a state government agency, he has an AFS that qualifies him for the $5,000 limit on the de minimis safe harbor for deducting expenses under an accounting procedure. Therefore, if he elects to use the safe harbor, he must deduct the cost of all 50 heifers on his 2015 income tax return.

AFS to a Government Agency

The regulations do not specify how much finan-cial information farmers must provide to meet the AFS standard� It is something less than what is required on a certified statement� Is an income statement sufficient? Or must complete financial statements, including a balance sheet, cash flow, and similar statements be provided? What is clear is that the AFS must clearly reflect the business’s income� For example, if heifers are expensed for tax purposes, they must be reflected as expensed on the AFS�


Improvements to Property 331

9

procedure in his books and records when report-ing his income and expenses to his bank.

Improvements to Property

Treas. Reg. § 1.263(a)-3 provides the rules for distinguishing between repairs and capital improvements. It integrates the basic rules and concepts developed over the years through court cases and IRS guidance, but bright-line tests are absent. Thus facts and circumstances continue to play an important role in determining whether expenditures are deductible as repair costs or result in capital improvements.

Treas. Reg. § 1.263(a)-3(d) states that an amount paid after the taxpayer places a unit of property in service is paid for an improvement if the amount paid

1. results in a betterment to the unit of property,2. restores the unit of property, or3. adapts the unit of property to a new or

different use.

Example 9.24 Combine

In 2015 Goldy Durham paid $10,000 to overhaul the engine in her combine. She paid $150,000 for the combine in 2009 and deducted the full purchase price under I.R.C. § 179. The FMV of the combine in 2015 is $70,000.

Question 1.Is Goldy required to capitalize the $10,000 she paid for the engine overhaul, or can she deduct it on her 2015 income tax return as an I.R.C. § 162 business expense?

Answer 1.Because the engine and the combine are functionally interdependent, the combine is a single unit of property for purposes of the repair regulations. The overhaul is not an improvement of the combine because it

1. is not a betterment of the combine,2. is not a restoration of the combine, and3. does not adapt the combine to a new or dif-

ferent use.

Therefore, Goldy can deduct the $10,000 payment on her 2015 income tax return as a business expense.

Routine Maintenance Safe Harbor

If the $10,000 Goldy paid qualifies for the rou-tine maintenance safe harbor, she could deduct it even if the overhaul was a betterment, resto-ration, or adaptation� For an explanation of the routine maintenance safe harbor, see the “Repair Regulations” chapter in this book�

Question 2.If Goldy adopted an accounting procedure for 2015 that requires deducting amounts paid that were $500 or less, can she still deduct the $10,000 cost of the overhaul?

Answer 2.Yes. Goldy’s accounting policy allows her to deduct amounts paid whether or not they are improvements to property. It does not prevent her from deducting an amount paid that is not an improvement.

Question 3.If Goldy capitalized the $9,000 cost of a similar overhaul of her tractor engine in 2014, is she required to capitalize the $10,000 cost of overhauling her combine engine in 2015?

Answer 3.No. Facts and circumstances determine whether the cost of rebuilding an engine is an improvement that must be capitalized or a repair. Goldy’s conclusion that the $9,000 she paid in 2014 to overhaul her tractor engine was a capital expenditure did not establish a method of accounting that requires her to treat her $10,000 payment to overhaul her combine engine in 2015 as a capital expenditure.

Question 4.Does this application of the regulations that apply to tax years beginning on or after January 1, 2014, require Goldy to file Form 3115?



Example 9.25 Replacement Tractor Tires

When Goldy purchased her tractor in 2011, she depreciated the entire cost of the tractor, including the tires, over 7 years using the 150% declining balance method for farm equipment. In 2015 Goldy paid $12,000 to replace all of the tires on her tractor. Can Goldy deduct the cost of the tires on her 2015 income tax return, or is she required to capitalize that cost?

Because Goldy’s tractor is property other than a building, the initial units of property for the tractor are determined under the general rule in Treas. Reg. § 1.263(a)-3(e)(3)(i) and are com-prised of all the components that are function-ally interdependent. Under this rule Goldy must treat the tractor, including its tires, as a single unit of property because the tractor and the tires are functionally interdependent (that is, the placing the tires in service is dependent on placing the tractor in service) [Treas. Reg. § 1.263(a)-3(e)(6), Example 16]. Because the replacement tires do not improve the tractor (they do not adapt the tractor to a new or different use, are not a bet-terment, and are not a restoration), Goldy must deduct the cost of the tires as a business expense under I.R.C. § 162 on her 2015 income tax return.

Prior Guidance

Cases decided and revenue rulings and proce-dures issued before the repair regulations were finalized in T�D� 9636, 2013-43 I�R�B� 331, could be interpreted to require tires to be treated as a sep-arate unit of property that must be depreciated [W.H. Tompkins Co. v. Commissioner, 47 B�T�A� 292 (1942); Zelco, Inc. v. Commissioner, 331 F�2d 418, 421 (1st Cir� 1964); Interstate Truck Service, Inc. v. Commissioner, T�C� Memo� 1958-219; Rev� Rul� 59-249, 1959-2 C�B� 55; Rev� Rul� 68-134, 1968-1 C�B� 63; and Rev� Proc� 2002-27, 2002-1 C�B� 802]� Even if that interpretation in prior cases and rul-ings is correct, it apparently has been superseded by the final regulations as previously cited�

Answer 4.No. Because facts and circumstances determine whether the cost of rebuilding an engine is a repair or an improvement that must be capitalized, the conclusion that an amount paid is or is not a repair does not establish a method of accounting.

Amended Return

If Goldy concludes that she erroneously capital-ized the $9,000 cost of overhauling her tractor engine in 2014, she can amend her 2014 return to claim that amount as a deduction instead of a capitalized payment�

Question 5.Goldy paid $25,000 for a corn header for her combine in 2010. In 2015 she paid $10,000 to rebuild the corn header so that it will harvest 20-inch rows of corn rather than 30-inch rows. Can Goldy deduct the cost of rebuilding the header?

Answer 5.The combine and the corn header are not interdependent because the combine is designed to operate with other headers such as a small grain header. Therefore, the header is a separate unit of property and not a component of the combine. Because rebuilding the header adapts it to greater capacity (20-inch rows rather than 30-inch rows), the rebuilding cost is a betterment, which must be capitalized and depreciated over a new 7-year recovery period.

Question 6.If Goldy replaced just the snapping rollers on the corn header, can she deduct the $5,000 she paid to buy and install them?

Answer 6.Yes. Replacing the snapping rollers does not improve the header because it

1. is not a betterment of the combine,2. is not a restoration of the combine, and3. does not adapt the combine to a new or dif-

ferent use.

Therefore, Goldy can deduct the $5,000 pay-ment on her 2015 income tax return as a business expense.


Improvements to Property 333

9

Farm Truck Tires

Tires on over-the-road trucks and trailers that have a recovery period different than the truck on which they are mounted are treated differ-ently� See the “Repair Regulations” chapter in this book�

Example 9.26 Restored Tractor

Bob Bovine found a neglected and inoperable 1951 Farmall M tractor in the back corner of his father’s machine shed. Bob decided to restore the tractor for use in mowing and other light work in his farming business. The restoration cost included $2,500 for new tires.

Bob must capitalize the $2,500 cost of the new tires because the cost was incurred in restor-ing the tractor. The cost of new tires is eligible for expensing under I.R.C. § 179 and AFYD.

Example 9.27 Barn Roof

In 2015 the only amount Cherry Picker spent on her barn was $3,500 to replace the cupolas because they had rusted and were leaking. The new cupolas are comparable to the original cupolas. Cherry paid $200,000 to build the barn in 1990 and has fully depreciated that cost. Her average annual gross receipts for 2012 through 2014 were $300,000.

Cherry is a qualifying taxpayer for purposes of the safe harbor for small taxpayers [Treas. Reg. § 1.263(a)-3(h)] because her average annual gross receipts for the prior 3 years is less than or equal to $10,000,000. Her barn is an eligible building because its unadjusted basis is $1,000,000 or less. The $3,500 she spent on the building does not exceed the lesser of (1) $4,000 (2% of the $200,000 unadjusted basis of the barn), or (2) $10,000.

Therefore, Cherry can elect to deduct the $3,500 cost of the cupolas under the safe harbor for small taxpayers.

Question 1.What if, in addition to replacing the cupolas in 2015, Cherry paid $5,000 to paint the barn and expects to have to paint the barn every 8 years?

Answer 1.Because the $8,500 she spent on the barn in 2015 exceeds $4,000, neither of the two expenses qualifies for the safe harbor for small taxpayers. The amounts she paid can be deducted as an expense in 2015 only if they do not improve the barn.

Because the roof (including the cupolas) performs a discrete and critical function in the building structure, the roof comprises a major component of the building structure. Although the replacement cupolas may aid in the function of the building structure, they do not by themselves comprise a significant portion of the roof. In addition, the replacement cupolas do not comprise a substantial structural part of the building structure.

Because Cherry replaced only the cupolas, she is not required to capitalize the amount she paid to replace them. Instead Cherry can deduct the cost as a repair [Treas. Reg. § 1.263-3(k)(7), Example 15].

Painting the barn does not improve it because the painting

1. is not a betterment of the barn,2. is not a restoration of the barn, and3. does not adapt the barn to a new or different

use.

Therefore, Cherry can deduct the $5,000 cost of painting the barn on her 2015 income tax return.

Question 2.Is the answer different if Cherry disposed of the original cupolas, elected to treat the disposal of these components as a partial disposition of the building, and deducted the adjusted basis of the components as a loss on the disposition?

Answer 2.Yes, it is. Amounts paid for replacement of the cupolas constitute a restoration of the building structure when Cherry properly deducted a loss for that component. The regulations require Cherry to capitalize and depreciate the amounts she paid for the replacement cupolas as an improvement to the building unit of property. However, Cherry is not required to capitalize the amounts she paid to remove the original cupolas as part of the cost of the improvement, regardless of their relation to the improvement [Treas. Reg. § 1.263(a)-3(g)(2)(ii), Example 4].



taxpayer is any taxpayer with average annual gross receipts of $10,000,000 or less that is not prohibited from using cash accounting under I.R.C. § 448. The only farming business that is prohibited from using cash accounting under I.R.C. § 448 is a tax shelter. A tax shelter is any of the following:a. An enterprise other than a C corporation

for which interests have been offered for sale in an offering required to be registered with any federal or state agency

b. A partnership or other entity (other than a corporation that is not an S corporation) if more than 35% of the losses of such entity during the tax year are allocable to limited partners or limited entrepreneurs

c. Any entity if a significant purpose of the entity is the avoidance of federal income tax

Limitations on Deducting Prepaid ExpensesTwo sets of rules limit deductions of expenses that are paid in the year before an input is needed in a cash basis farming business.

Prepaid Expense Rules under I.R.C. § 464 I.R.C. § 464 limits the deduction of prepaid farm expenses for certain taxpayers to 50% of their deductible farming expenses. In addition to farm syndicates, I.R.C. § 464 applies to any taxpayer who

1. does not use an accrual method of accounting,2. has excess prepaid farm supplies for the tax

year, and3. is not a qualified farm-related taxpayer.

Therefore, qualified farm-related taxpayers are not subject to the I.R.C. § 464 limitations regardless of the amount of expenses they prepay.

Prepaid Expenses and Deposits under Rev. Rul. 79-229Rev. 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 tax year that will be used in the subsequent tax year.

1. The expenditure must be a payment for the purchase of a supply rather than a deposit.

Question 3.If Cherry replaced the entire roof, does she have to capitalize the cost?

Answer 3.Yes. She must capitalize the cost of replacing the entire roof as a restoration because the entire roof is a substantial structural part of the building.

If Cherry made the partial disposition elec-tion, she can claim a current-year loss equal to the unadjusted basis of the entire old roof. The election does not negatively impact her tax treat-ment of the new roof because the cost of replac-ing the roof must be capitalized whether or not she makes the partial disposition election.

Prepaid Expenses

The final regulations promulgated in T.D. 9636, 2013-43 I.R.B. 331, apparently do not change the rules for deducting prepaid farm expenses.

Prior RulesGenerally, taxpayers who produce, purchase, or sell merchandise in their business must keep an inventory [Treas. Reg. § 1.471-1] and use the accrual method of accounting [Treas. Reg. § 1.446-1(c)(2-1(c)(2)()(i)] for purchases and sales of merchandise. However, the following excep-tions allow taxpayers to not keep an inventory and to use the cash method of accounting even if they produce, purchase, or sell merchandise.

1. Treas. Reg. § 1.471-6(a) excepts farmers from the general rule that taxpayers must keep an inventory. Therefore, the Treas. Reg. § 1.446-1(c)(2)(i) rule requiring accrual accounting does not apply to farmers.

2. Rev. Proc. 2001-10, 2001-C.B. 272, allows taxpayers (other than tax shelters) with aver-age annual gross receipts of $1,000,000 or less to not keep an inventory and to use cash accounting.

3. Rev. Proc. 2002-28, 2002-1 C.B. 815, allows qualifying small business taxpayers to not keep an inventory and to use cash account-ing if they do not have a prohibited principal business activity. (Farming is not a prohibited principal activity.) A qualifying small business


9

Issue 7: Revoking a CCC Loan Election 335

2. The prepayment must be made for a business purpose and not merely for tax avoidance.

3. The deduction of such costs in the tax year of prepayment must not result in a material distortion of income.

Effect of Repair RegulationsThe repair regulations generally codify prior law and provide new safe harbors and elections. Treas. Reg. § 1.162-3(b) says, “Nothing in this section [on material and supplies] changes the treatment of any amount that is specifically provided for under any provision of the Internal Revenue Code or regulations other than section 162(a) or section 212 and the regulations under those sections.” IRS Publication 225, Farmer’s Tax Guide (For use in preparing 2014 Returns), explains the prepaid expense rules in the same way prior editions of that publication explained the rules before the new regulations were issued. Therefore, the new regulations apparently do not change the rules for deducting prepaid farm expenses.

Example 9.28 Qualified Farm-Related Taxpayer

Dusty Furrow is a qualified farm-related tax-payer. In 2015 he had $180,000 of deductible farm expenses as defined in I.R.C. § 464(d)(3)(C). To be ready for an expanded operation, he also purchased $100,000 of farm supplies for use in 2016.

None of the amounts paid is subject to limita-tion under I.R.C. § 464.

Uniform Capitalization Rules

The rules regarding materials and supplies do not change the treatment of any amount that is subject to I.R.C. § 263A [Treas. Reg. § 1.162-3(b)]. Therefore, the new Treasury regulations do not change how farmers apply the uniform capitalization rules.

Example 9.29 Preproduction Expenses

Betty Chardonnay, a calendar-year taxpayer, invested $120,000 to establish 10 acres of grapes during the period that began with planting the seedlings in 2011 and ended when the vines became commercially productive on August 15, 2015. The $120,000 includes $10,000 for the acquisition and initial planting of seedlings and $110,000 for the costs of cultivating, maintaining, spraying, fertilizing, and other horticultural prac-tices, as well as the tax depreciation, repairs, farm overhead, real estate taxes, and interest expense on debt directly attributable to the vines [I.R.C. § 263A(f); Treas. Reg. § 1.263A-4(b)(1)(i)]. Betty must capitalize the $120,000.

Betty can begin depreciating the $120,000 capitalized cost using the straight-line method over the vines’ 10-year MACRS recovery period and the half-year convention on her 2015 fed-eral income tax return. The costs she incurs after August 15, 2015, are deducted as ordi-nary farming expenses [Treas. Reg. § 1.263A- 4(b)(2)(i)(C)(2)].

ISSUE 7: REVOKING A CCC LOAN ELECTION Farmers can elect to report CCC loans as income by simply reporting the income on their tax return� The election applies to subsequent CCC loans until the election is revoked by filing Form 3115�

Producers continue to use Commodity Credit Corporation (CCC) loans and loan deficiency payments (LDPs) to increase the amount they receive for their crops and to affect the timing of their income. As discussed later, CCC loans are not included in income unless producers elect under I.R.C. § 77 to include the loan as income. That election cannot be revoked

without the commissioner’s consent. Rev. Proc. 2002-9, 2002-3 I.R.B. 327, added revocation of the section 77 election to the list of changes in accounting methods that has the commissioner’s automatic consent. This issue discusses the effect of the election and then explains and illustrates the procedure for revoking the election.


336 ISSUE 7: REVOKING A CCC LOAN ELECTION

Market Price Is above the Loan RateIf market prices rise above the loan rate, producers will choose to repay the loan, with interest, and then sell the commodity for more than the loan amount. If the section 77 election was made, the producer has a basis in the commodity equal to the amount of the loan. That basis is subtracted from the sale price to determine the gain or loss on sale.

The income tax consequences of the sale depend on whether the taxpayer made the section 77 election.

If the producer has not made the section 77 election, the CCC loan is treated the same as any other loan—it is not income when the loan is received, and none of the amount is reported on Schedule F (Form 1040).

Example 9.31 No Section 77 Election

If Marshall from Example 9.30 did not make the section 77 election to treat CCC loans as income, the $150,000 loan is treated the same as any other loan—it is not income in the year it is received. Because he did not sell the corn in 2015, there is no income from the corn to report on his 2015 tax return.

Effect of the Election

This issue begins with an explanation of the election and an illustration of the effect of the election on the timing of reporting the gain from the commodity the taxpayer pledged as collateral for the CCC loan.

CCC Nonrecourse Marketing Assistance LoanInstead of selling a commodity, producers can use the commodity as collateral for a nonrecourse loan from the CCC. This option puts cash in the producer’s pocket at the time of harvest and lets the producer wait to see if market prices improve. The loan rate varies by county.

The loan must be reported as income when received by producers who have made the section 77 election in the current year or any previous year.

Example 9.30 Section 77 Election

Marshall Artz pledged 75,000 bushels of his 2015 corn harvest as collateral for a $150,000 CCC loan at the rate of $2.00 per bushel. If Marshall has made the section 77 election to treat CCC loans as income in 2014 or any previous year (and has not revoked that election, as discussed later in this issue), he must either revoke the election for 2015 or report the $150,000 as income on line 5a of his 2015 Schedule F (Form 1040) as shown in Figure 9.17.

FIGURE 9.17 Schedule F (Form 1040): Section 77 Election


Effect of the Election 337

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Example 9.32 Section 77 Election and Sale

If Marshall from Example 9.30 made the section 77 election, repaid the loan (including $1,200 of interest), and sold the corn for $262,000 in 2015, he must report the income and expenses as shown on the Schedule F (Form 1040) in Figure 9.18.

FIGURE 9.18 Schedule F (Form 1040): Section 77 Election and Sale

Conflicting Authority

In Thompson v. Commissioner, 322 F�2d 122 (5th Cir� 1963), the court held that a taxpayer who had made the section 77 election did not have to report a loan as income because it was repaid in the same year the loan was received� In Isaak v. Commissioner, 400 F�2d 869 (9th Cir� 1968), the court held that such a taxpayer does have to report the loan as income� The IRS is likely to fol-low the Isaak case and require Marshall to report the loan as income, as shown in Example 9�32� In Rev� Rul� 80-19, 1980-1 C�B� 185, the facts were not on point—the taxpayer elected to report the CCC loan he received in 1976 as income and repaid the loan in 1977� However, the IRS cited the Isaak case to support its statement that “therefore, if an election is made under section 77 of the Code, the crop is treated as being sold when it is pledged as collateral for the loan and it is treated as being repurchased when it is redeemed by repayment of the loan�”

Example 9.33 No Section 77 Election, Loan Repaid

If Marshall from Example 9.30 did not make the section 77 election, repaid the loan (including $1,200 of interest), and sold the corn for $262,000 in 2015, he must report the income and expenses as shown on the 2015 Schedule F (Form 1040) in Figure 9.19.



If the producer made the section 77 election, the difference between the loan rate and the PCP is reported on line 4a but not on line 4b of Schedule F (Form 1040), because the loan has already been reported on line 5a and the basis of the commodity was reduced by the difference between the loan rate and the PCP. The producer has a basis in the commodity equal to the PCP.

Example 9.34 Section 77 Election, Commodity Redeemed

If Marshall from Example 9.30 made the section 77 election on his $150,000 loan, redeemed the commodity by paying $135,000 to the CCC when the PCP was $1.80 per bushel, and sold the corn for $142,500, he will receive a Form CCC-1099-G for $15,000 from the CCC, and he must report income as shown on the Schedule F (Form 1040) in Figure 9.20.

Market Prices Do Not Rise above the Loan RateIf market prices do not rise above the loan rate, producers will choose to redeem the commodity by paying the posted county price (PCP) to the CCC. By making that payment, the producer is no longer obligated on the loan and can keep the difference between the loan rate and the PCP.

If the section 77 election was not made, the producer has no basis in the commodity. Therefore, the full sale price must be reported as income in the year of the sale.

Sale in Following Year

If the commodity is not sold until 2016, the pro-ducer does not have to report the sale until 2016 and will simply have the commodity on hand at the end of the year with a basis equal to the loan amount (if the section 77 election has been made) or zero (if the section 77 election has not been made)�

FIGURE 9.19 Schedule F (Form 1040): No Section 77 Election, Loan Repaid


Effect of the Election 339

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Example 9.35 No Section 77 Election, Commodity Redeemed

If Marshall from Example 9.30 did not make the section 77 election, redeemed the commodity by paying $135,000 to the CCC when the PCP was $1.80 per bushel, and sold the corn for $142,500, he will receive a Form CCC-1099-G for $15,000 ($150,000 – $135,000) from the CCC, and he must report the following on Schedule F (Form 1040), as shown in Figure 9.21.

A producer who redeems the commodity by paying the PCP will receive a Form CCC-1099-G from the CCC for the difference between the loan rate and the PCP. The producer must report that amount on line 4a of the producer’s 2015 Schedule F (Form 1040). If the producer has not made the section 77 election, the producer reports the difference between the loan rate and the PCP on line 4b of Schedule F (Form 1040), because the loan has not been reported on line 5a. The producer has a zero basis in the commodity.

FIGURE 9.20 Schedule F (Form 1040): Section 77 Election, Commodity Redeemed

FIGURE 9.21 Schedule F (Form 1040): No Section 77 Election, Commodity Redeemed



Cutoff basisRev. Proc. 2011-14 states that this change in method of accounting is made on a cutoff basis, which means that there are no adjustments to income. Income that was reported from loans in years before the election was revoked cannot be removed from income as a result of the revocation.

Example 9.37 Cutoff Basis

If Marshall from Example 9.30 revoked his sec-tion 77 election beginning in 2015, he cannot adjust his income to remove the loans he has reported as income in previous years.

Changing the Election

As noted earlier, Rev. Proc. 2011-14, 2011-4 I.R.B. 330, gives farmers automatic consent to revoke an election to report CCC loans as income. However, to take advantage of the automatic consent, producers must file Form 3115, Application for Change in Accounting Method. Because this change has automatic consent, Form 3115 is filed with the return for the year of the change, and there is no user fee.

the loan and paid the PCP rate on the date they claimed the LDP.

The LDP allows producers to reap the benefit of the CCC program even if they forward-contract their crop or sell the crop shortly after harvest. These producers must collect the LDP between the date of harvest and the date of title transfer.

Example 9.36 Loan Deficiency Payment

Instead of taking a CCC loan, Marshall from Example 9.30 claimed his LDP when the loan rate was $2.00 per bushel and the PCP was $1.80 per bushel. He received a $15,000 LDP from the CCC and a Form CCC-1099-G reporting that $15,000. Marshall sold his corn for $142,500. Marshall must report the income on his 2015 Schedule F (Form 1040) as shown in Figure 9.22.

Total Income Is the Same

Although the reporting procedure differs, the amount received for the crop and the total tax-able income are exactly the same in Examples 9�34 and 9�35� When income is reported depends on specific situations�

Loan Deficiency PaymentInstead of taking a CCC loan and paying it off at the PCP, producers can simply claim a loan deficiency payment (LDP) for the commodity they have produced. That payment is equal to the difference between the loan rate and the PCP on the date the LDP is claimed. Consequently, producers get the same result as if they had taken

FIGURE 9.22 Schedule F (Form 1040): Loan Deficiency Payment


Changing the Election 341

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When and Where to FileAttach the original Form 3115 to the taxpayer’s timely filed (including extensions) federal income tax return for the year of change. File a signed Ogden office copy of the Form 3115 no earlier than the first day of the year of change and no later than the date the original is filed with the federal income tax return for the year of change.

Send the Ogden office copy of Form 3115 to: Internal Revenue Service, 1973 Rulon White Blvd., Mail Stop 4917, Ogden, Utah 84201-1000.

Example 9.38 Revoking Election

Marshall from Example 9.30 could revoke his section 77 election beginning in 2015 by filing Form 3115 in duplicate. He files the original with his timely filed (including extensions) income tax return for 2015 and sends an Ogden office copy to the Ogden, Utah, address listed previously. Figures 9.23 and 9.24 show Marshall’s Form 3115 and the statement attached to it.

Scope LimitationsSection 4 of Rev. Proc. 2011-14 generally makes the automatic consent inapplicable if the taxpayer

1. is under examination by the IRS or has an income issue before an appeals office or a fed-eral court and the method of accounting to be changed is an issue under consideration by the appeals office or the federal court,

2. is affected by an IRS examination or an appeal before an appeals office or a federal court as a member of a consolidated group or an entity,

3. has made the same change in method of accounting or applied for a change in the same method of accounting within the last 5 years, or

4. would be required to take the entire adjust-ment resulting from the change in method of accounting into account in the year of the change because it is the final year of the tax-payer’s business.

However, section 2.01(2) of the Appendix to Rev. Proc. 2011-14 makes those scope limitations inapplicable to changing the taxpayer’s method of reporting CCC loans.



FIGURE 9.23 Form 3115 for Marshall Artz



9

FIGURE 9.23 Form 3115 for Marshall Artz (Continued)



FIGURE 9.23 Form 3115 for Marshall Artz (Continued)



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FIGURE 9.24 Attachment for Form 3115 for Marshall Artz

Marshall ArtzSS# 001-77-1040Statement for Form 3115, Part II, lines 14, 15, and 16; and Part IV, line 25Revoking Section 77 ElectionTax Year 2015

Part II

■■ Line 14a: The item being changed is the treatment of the proceeds from Commodity Credit Corporation (CCC) loans. The treatment under I.R.C. § 77 is changed from treating the proceeds as income to treating the proceeds as a loan.

■■ Line 14b: The present method of accounting is treating the CCC loans as income.■■ Line 14c: The proposed method of accounting is treating the CCC loans as loans. ■■ Line 14d: The taxpayer’s overall method of accounting is the cash method.■■ Line 15a: The business consists of growing corn in a farming business. It is operated as a sole proprietorship.

■■ Line 15b: The applicant has no other trades or businesses.■■ Line 16a: Rev. Proc. 2011-14, 2011-4 I.R.B. 330, gives farmers automatic consent to revoke an election to report CCC loans as income.

■■ Line 16b: I.R.C. § 77(a); Rev. Proc. 2011-14, 2011-4 I.R.B. 330.■■ Line 16c: No contrary authority exists.

Part IV

■■ Line 25: Section 2.01 in the Appendix of Rev. Proc. 2011-14, 2011-4 I.R.B. 330, states, “This change is made on a cut-off basis and applies only to loans received from the Commodity Credit Corporation on or after the beginning of the year of change. Accordingly, a § 481(a) adjustment is neither permitted nor required.”


346 ISSUE 8: MARKETING GAIN ON CCC LOANS

Notice 2007-63, 2007-33 I.R.B. 353, states

A taxpayer that has made an election under I.R.C. § 77 accounts for market gain for the year in which a CCC loan is repaid by making an adjustment to the basis of the commodity that secures the loan. The taxpayer’s basis in the com-modity before the repayment of the loan is equal to the amount of the loan previ-ously reported as income. That basis is reduced by the amount of any market gain associated with the repayment of the loan. An individual taxpayer that has made a I.R.C. § 77 election should report the market gain as an Agricultural Pro-gram Payment on line 6a of Schedule F, but not as a taxable amount on line 6b, for the year in which the loan is repaid.

The position taken in Notice 2007-63, the MSSP publication Farming—Specific Income Issues and Farm Cooperatives, and in Publication 225 appears to be consistent with I.R.C. § 1016(a)(8) and Treas. Reg. § 1.1016-5(e). They require a reduction in the basis of the commodity to the extent of any deficiency on the CCC loan with respect to which the taxpayer has been relieved from liability.

Example 9.39 Marketing Loan Gain

Kitty Litter received a $100,000 CCC loan for her 2014 corn crop in November 2014 and reported the $100,000 loan as income on her 2014 income tax return under I.R.C. § 77(a). In February 2015 the posted county price was below the loan rate, so she paid off the loan for $92,500. In May 2015 Kitty sold the corn for $103,000.

ISSUE 8: MARKETING GAIN ON CCC LOANS Farmers sometimes realize gain from paying CCC loans at less than the amount of the loan� How and when that gain is reported depends on how the farmer reported the CCC loan when it was received�

Producers can elect to report CCC loans as income in the year the loan is received [I.R.C. § 77(a)]. The amount included in income is added to the basis of the commodity that secures the loan [I.R.C. § 1016(a)(8)].

Producers are allowed to satisfy their obligation to repay the loan by paying an amount equal to a specified price multiplied by the quantity of the commodity that secures the loan. For cotton and rice the specified price is the adjusted world price (AWP). For wheat, feed grains, and oil seed, it is a rate set by the secretary of agriculture called the posted county price (PCP). Producers will choose this option only if the AWP or the PCP is below the loan rate for the commodity. The difference between the loan received and the loan payment is called marketing loan gain.

Loans Reported as Loans

A taxpayer that reports the CCC loan as a loan rather than as income must report the marketing loan gain as income in the year the loan is paid on lines 4a and 4b of Schedule F (Form 1040)�

The income tax issue is how and when to report the increase in wealth that is realized when a CCC loan that has been reported as income is satisfied with a payment that is less than the loan received.

The Market Segment Specialization Program (MSSP) publication Farming—Specific Income Issues and Farm Cooperatives states at page 5-2 that “a farmer who included the loan amount in income does not recognize the Market Gain. Instead, the farmer reduces the basis of the grain.”Publication 225, Farmer’s Tax Guide, has clearly covered this issue for several years and has consistently taken the position that a producer who reported the CCC loan as income does not report market gain but instead reduces his or her basis in the commodity. For example, see pages 9 and 10 of Publication 225, supra.


9

Issue 8: Marketing Gain on CCC Loans 347

FIGURE 9.25 Schedule F (Form 1040): Marketing Loan Gain

Following the guidance of Notice 2007-63, IRS Publication 225, and the MSSP publication Farming—Specific Income Issues and Farm Cooperatives, Kitty reduces her basis in the corn from $100,000 to $92,500 when she repays the loan in 2015. She reports the sale of the corn on her 2015 Schedule F (Form 1040), as shown in Figure 9.25, by including the $103,000 sale price on line 1a and her $92,500 basis on line 1b, which adds $10,500 to the income she reports on line 1c. Kitty will receive a Form 1099-G showing a marketing loan gain of $7,500. Kitty reports the $7,500 on line 4a but does not include it as a taxable amount on line 4b.


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