Farm Income Averaging

If you are engaged in a farming business, you may be able to average all or some of your farm income by allocating it to the 3 prior years (base years). This may give you a lower tax if your income from farming is high and your taxable income from one or more of the 3 prior years was low. The term farming business is defined in the instructions for Schedule J (Form 1040).

Who can use farm income averaging?   You can use farm income averaging to figure your tax for any year in which you were engaged in a farming business as an individual, a partner in a partnership, or a shareholder in an S corporation. Services performed as an employee are disregarded in determining whether an individual is engaged in a farming business. However, a shareholder of an S corporation engaged in a farming business may treat compensation received from the corporation that is attributable to the farming business as farm income. You do not need to have been engaged in a farming business in any base year.

Corporations, partnerships, S corporations, estates, and trusts cannot use farm income averaging.

Elected Farm Income (EFI)

EFI is the amount of income from your farming business that you choose to have taxed at base year rates. You can designate as EFI any type of income attributable to your farming business. However, your EFI cannot be more than your taxable income, and any EFI from a net capital gain attributable to your farming business cannot be more than your total net capital gain.

Income from your farming business is the sum of any farm income or gain minus any farm deductions or losses allowed as deductions in figuring your taxable income. However, it does not include gain from the sale or other disposition of land.

Gains from the sale or other disposition of farm property.   Gains from the sale or other disposition of farm property other than land can be designated as EFI if you (or your partnership or S corporation) used the property regularly for a substantial period in a farming business. Whether the property has been regularly used for a substantial period depends on all the facts and circumstances.

Liquidation of a farming business.   If you (or your partnership or S corporation) liquidate your farming business, gains on property sold within a reasonable time after operations stop can be designated as EFI. A period of 1 year after stopping operations is a reasonable time. After that, what is a reasonable time depends on the facts and circumstances.

EFI and base year rates.   If your EFI includes both ordinary income and capital gains, you must allocate an equal portion of each type of income to each base year to figure the tax on EFI. For example, you cannot allocate all of the capital gains to a single base year.

How To Figure the Tax

If you average your farm income, you will figure your tax on Schedule J (Form 1040).

Negative taxable income for base year.   If your taxable income for any base year was zero because your deductions were more than your income, you may have negative taxable income for that year to combine with your EFI on Schedule J.

Schedule J for 1999.   Although the Schedule J for 1999 did not allow you to use negative taxable income for a base year, you can file an amended return on Form 1040X to do so. If you did not use Schedule J for 1999 and this change would make using it beneficial, you can amend your return to use it. If you used Schedule J for 1999 and your taxable income for that base year was zero, you can amend your return to refigure your tax.

If you file an amended return to make the changes discussed above, you must generally do so within 3 years from the date you filed your original return or 2 years from the date you paid the tax, whichever is later.

More information.   For more information, see the Schedule J instructions.

Filing status.   You are not prohibited from using farm income averaging solely because your filing status is not the same as your filing status in the base years. For example, if you are married and file jointly, but filed as single in all of the base years, you may still average farm income.

Effect on Other Tax Determinations

You subtract your EFI from your taxable income and add one-third of it to the taxable income of each of the base years to determine the tax rate to use for income averaging. The allocation of your EFI to the base years does not affect other tax determinations. For example, you make the following determinations before subtracting your EFI (or adding it to income in the base years).

• The amount of your self-employment tax.
• Whether, in the aggregate, sales and other dispositions of business property (section 1231 transactions) produce long-term capital gain or ordinary loss.
• The amount of any net operating loss carryover or net capital loss carryover applied and the amount of any carryover to another year.
• The limit on itemized deductions based on your adjusted gross income.
• The amount of any net capital loss or net operating loss in a base year.

Tax on Investment Income of Child Under 14

If your child's investment income is more than $1,500, part of that income may be taxed at your tax rate instead of your child's tax rate.

If you use farm income averaging, figure your child's tax on investment income using your rate after allocating EFI. You cannot use any of your child's investment income as your EFI, even if it is attributable to a farming business. For information on figuring the tax on your child's investment income, see Publication 929, Tax Rules for Children and Dependents.

Alternative Minimum Tax

You cannot use income averaging to determine your alternative minimum tax (AMT). When figuring your AMT, the regular tax you subtract from your tentative minimum tax is the tax you computed using farm income averaging. This may cause you to owe AMT or increase your AMT but, generally, it will not increase your total tax.

Credit for prior year minimum tax.   You may be able to claim a tax credit if you owed AMT in a prior year. See chapter 14.

Schedule J

You can use farm income averaging by filing Schedule J (Form 1040) with your timely filed (including extensions) return for the year. You can also use farm income averaging on a late return, or use, change, or cancel it on an amended return, if the time for filing a claim for refund has not expired for that election year. You generally must file the claim for refund within 3 years from the date you filed your original return or 2 years from the date you paid the tax, whichever is later.

Farm Business Expenses

Important Changes for 2002

Standard mileage rate.   The standard mileage rate for the cost of operating your car, van, pickup, or panel truck in 2002 is 36½ cents a mile for all business miles driven. See Truck and Car Expenses.

Self-employed health insurance deduction.   If you are self-employed, you can deduct 70% of your health insurance premium as an adjustment to income for 2002. See Insurance, later.

Introduction

You can generally deduct the current costs of operating your farm. Current costs are expenses you do not have to capitalize or include in inventory costs. However, your deduction for the cost of livestock feed and certain other supplies may be limited. If you have an operating loss, you may not be able to deduct all of it.

Topics

This chapter discusses:

• Deductible expenses
• Capital expenses
• Nondeductible expenses
• Losses from operating a farm
• Net operating losses
• Not-for-profit farming

Useful Items You may want to see:

Publication

• 463   Travel, Entertainment, Gift, and Car Expenses
• 535   Business Expenses
• 536   Net Operating Losses (NOLs) for Individuals, Estates, and Trusts
• 587   Business Use of Your Home
• 925   Passive Activity and At-Risk Rules
• 936   Home Mortgage Interest Deduction

Form (and Instructions)

• Sch A (Form 1040)   Itemized
  Deductions
• Sch F (Form 1040)   Profit or Loss From Farming
• 1045   Application for Tentative Refund
• 5213   Election To Postpone
  Determination as To Whether the Presumption Applies That an
  Activity Is Engaged in for Profit

See chapter 21 for information about getting publications and forms.

Deductible Expenses

The ordinary and necessary costs of operating a farm for profit are deductible business expenses. Part II of Schedule F lists expenses common to farming operations. This chapter discusses many of these expenses, as well as others not listed on Schedule F.

Reimbursed expenses.   If an expense is reimbursed, either reduce the expense or report the reimbursement as income when received. See Refund or reimbursement under Income From Other Sources in chapter 4.

Personal and business expenses.   Some expenses you pay during the tax year may be partly personal and partly business. These may include expenses for gasoline, oil, fuel, water, rent, electricity, telephone, automobile upkeep, repairs, insurance, interest, and taxes.

You must allocate these mixed expenses between their business and personal parts. The personal part of these expenses is not deductible.

Example.   You paid $1,500 for electricity during the tax year. You used one-third of the electricity for personal purposes and two-thirds for farming. Under these circumstances, you can deduct two-thirds of your electricity expense ($1,000) as a farm business expense.

Reasonable allocation.   It is not always easy to determine the business and nonbusiness parts of an expense. There is no method of allocation that applies to all mixed expenses. Any reasonable allocation is acceptable. What is reasonable depends on the circumstances in each case.

Prepaid Farm Supplies

Prepaid farm supplies are amounts paid during the tax year for the following items.

• Feed, seed, fertilizer, and similar farm supplies not used or consumed during the year. However, do not include amounts paid for farm supplies that you would have consumed if not for a fire, storm, flood, other casualty, disease, or drought.
• Poultry (including egg-laying hens and baby chicks) bought for use (or for both use and resale) in your farm business. However, include only the amount that would be deductible in the following year if you had capitalized the cost and deducted it ratably over the lesser of 12 months or the useful life of the poultry.
• Poultry bought for resale and not resold during the year.

Deduction limit.   If you use the cash method of accounting to report your income and expenses, your deduction for prepaid farm supplies in the year you pay for them may be limited to 50% of your other deductible farm expenses for the year (all Schedule F deductions except prepaid farm supplies). This limit does not apply if you meet one of the exceptions described later.

If the limit applies, you can deduct the excess cost of farm supplies other than poultry in the year you use or consume the supplies. The excess cost of poultry bought for use (or for both use and resale) in your farm business is deductible in the year following the year you pay for it. The excess cost of poultry bought for resale is deductible in the year you sell or otherwise dispose of that poultry.

Example.   During 2002, you bought fertilizer ($4,000), feed ($1,000), and seed ($500) for use on your farm in the following year. Your total prepaid farm supplies expense for 2002 is $5,500. Your other deductible farm expenses totaled $10,000 for 2002. Therefore, your deduction for prepaid farm supplies may not exceed $5,000 (50% of $10,000) for 2002. The excess prepaid farm supplies expense of $500 ($5,500 - $5,000) is deductible in the later tax year you use or consume the supplies.

Exceptions.   This limit on the deduction for prepaid farm supplies expense does not apply if you are a farm-related taxpayer and either of the following apply.

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

You are a farm-related taxpayer if any of the following tests apply.

1. Your main home is on a farm.
2. Your principal business is farming.
3. A member of your family meets (1) or (2).

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

Whether or not the deduction limit for prepaid farm supplies applies, your expenses for prepaid livestock feed may be subject to the rules for advance payment of livestock feed, discussed next.

Prepaid Livestock Feed

If you report your income and expenses under the cash method of accounting, you cannot deduct in the year paid the cost of feed your livestock will consume in a later year unless you meet all of the following tests.

1. The payment is for the purchase of feed rather than a deposit.
2. The prepayment has a business purpose and is not merely for tax avoidance.
3. Deducting the prepayment does not result in a material distortion of your income.

If you meet all three tests, you can deduct the prepaid feed, subject to the limit on prepaid farm supplies discussed earlier.

If you fail any of these tests, you can deduct the prepaid feed only in the year it is consumed.

This rule does not apply to the purchase of commodity futures contracts.

Payment for the purchase of feed.   Whether a payment is for the purchase of feed or a deposit depends on the facts and circumstances in each case. It is for the purchase of feed if you can show you made it under a binding commitment to accept delivery of a specific quantity of feed at a fixed price and you are not entitled, by contract or business custom, to a refund or repurchase.

The following are some factors that show a payment is a deposit rather than for the purchase of feed.

• The absence of specific quantity terms.
• The right to a refund of any unapplied payment credit at the end of the contract.
• The seller's treatment of the payment as a deposit.
• The right to substitute other goods or products for those specified in the contract.

A provision permitting substitution of ingredients to vary the particular feed mix to meet your livestock's current diet requirements will not suggest a deposit. Further, a price adjustment to reflect market value at the date of delivery is not, by itself, proof of a deposit.

Business purpose.   The prepayment has a business purpose only if you have a reasonable expectation of receiving some business benefit from prepaying the cost of livestock feed. The following are some examples of business benefits.

• Fixing maximum prices and securing an assured feed supply.
• Securing preferential treatment in anticipation of a feed shortage.

Other factors considered in determining the existence of a business purpose are whether the prepayment was a condition imposed by the seller and whether that condition was meaningful.

No material distortion of income.   The following are some factors considered in determining whether deducting prepaid livestock feed materially distorts income.

• Your customary business practice in conducting your livestock operations.
• The expense in relation to past purchases.
• The time of year you made the purchase.
• The expense in relation to your income for the year.

Labor Hired

You can deduct reasonable wages paid for regular farm labor, piecework, contract labor, and other forms of labor hired to perform your farming operations. You can pay wages in cash or in noncash items such as inventory, capital assets, or assets used in your business. The cost of boarding farm labor is a deductible labor cost. Other deductible costs you incur for farm labor include health insurance, workers' compensation insurance, and other benefits.

If you must withhold social security, Medicare, and income taxes from your employees' cash wages, you can still deduct the full amount of wages before withholding. See chapter 16 for more information on employment taxes. Also, deduct the employer's share of the social security and Medicare taxes you must pay on your employees' wages as a farm business expense on the Taxes line of Schedule F (line 31). See Taxes, later.

Property for services.   If you transfer property to an employee in payment for services, you can deduct as wages paid the fair market value of the property on the date of transfer. If the employee pays you anything for the property, deduct as wages the fair market value of the property minus the payment by the employee for the property. Treat the wages deducted as an amount received for the property. You may have a gain or loss to report if the property's adjusted basis on the date of transfer is different from its fair market value. Any gain or loss has the same character the exchanged property had in your hands. For more information, see chapter 10.

Child as an employee.   You can deduct reasonable wages or other compensation you pay to your child for doing farm work if a true employer-employee relationship exists between you and your child. Include these wages in the child's income. The child may have to file an income tax return. These wages may also be subject to social security and Medicare taxes if your child is age 18 or older. For more information, see Family Employees in chapter 16.

The fact that your child spends the wages to buy clothes or other necessities you normally furnish does not prevent you from deducting your child's wages as a farm expense.

Spouse as an employee.   You can deduct reasonable wages or other compensation you pay to your spouse if a true employer-employee relationship exists between you and your spouse. Wages you pay to your spouse are subject to social security and Medicare taxes. For more information, see Family Employees in chapter 16.

Nondeductible Pay

You cannot deduct wages paid for certain household work, construction work, and maintenance of your home. However, those wages may be subject to the employment taxes discussed in chapter 16.

Household workers.   Do not deduct amounts paid to persons engaged in household work, except to the extent their services are used in boarding or otherwise caring for farm laborers.

Construction labor.   Do not deduct wages paid to hired help for the construction of new buildings or other improvements. These wages are part of the cost of the building or other improvement. You must capitalize them.

Maintaining your home.   If your farm employee spends time maintaining or repairing your home, the wages and employment taxes you pay for that work are nondeductible personal expenses. For example, assume you have a farm employee for the entire tax year and the employee spends 5% of the time maintaining your home. The employee devotes the remaining time to work on your farm. You cannot deduct 5% of the wages and employment taxes you pay for that employee.

Employment Credits

Reduce your deduction for wages by the amount of any employment credits you claim. The following are employment credits and their related forms.

• Empowerment zone and renewal community employment credit (Form 8844).
• Indian employment credit (Form 8845).
• Welfare-to-work credit (Form 8861).
• Work opportunity credit (Form 5884).

For more information, see the forms and their instructions.

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