FARM EXPENSES ARE RIPE FOR AUDIT

Every year, individual taxpayers choose between completing the 1040A, 1040EZ, and the so-called “long form” 1040 tax return. The long form allows growers to lower their tax liabilities by adjusting gross income while also claiming numerous itemized deductions on the Schedule F. While filling out this particular schedule can provide growers with greater tax benefits, it can also expose them to greater risks if they do not maintain adequate records. This year, the IRS announced a pilot program to begin auditing Schedule F expenses.

This article introduces some of the common Schedule F expenses that growers can expect to have audited, including the following: prepaid supplies, fuel expenses, property repairs and maintenance, mortgage interest deductions, and custom hires. As long as taxpayers maintain adequate records concerning the business purpose for such payments, however, they should not hesitate to take full advantage of the benefits afforded to them by the tax laws.

Risk of Audit

 
In February 2017, the IRS released a memorandum instructing auditors to verify the accuracy of certain growers’ tax returns through a pilot program that scrutinizes Schedule F expenses. This pilot program will likely segue into an established audit practice by the agency, which means it is time for agricultural taxpayers to take note of the risk of audit now in order to prepare and maintain adequate records for later.

Schedule F is used to report farm income and expenses. When it comes to reporting expenses, even honest growers can inadvertently contribute to the agency’s ongoing taxpayer-compliance issues. Some common examples of reporting errors include: inadvertently deducting expenses on the wrong form, deducting expenses that belong to another taxpayer, or mischaracterizing hobby losses. Making any of these mistakes can result in tax deficiencies, including interest on the tax due, and in some cases even penalties. To prevent that from happening, take note of the following farm expenses that are now ripe for audit:

Prepaid Supplies

 
Farmers must plan ahead in accordance with their expected crop cycles. For that reason, growers are particularly inclined to prepay for certain supplies in the tax year prior to their next growing season. Taxpayers may deduct these expenses as long as the following conditions are met: (1) the payment is not a deposit; (2) the payment is for a legitimate business purpose; and (3) the deduction does not result in a material distortion of income. These rules are designed to prevent income tax avoidance. Likewise, the allowable deduction for prepaid supplies cannot exceed 50% of the total deductible farm expenses for the tax year, unless the prepaid farm supplies have actually been used or consumed in the year of payment.

The limit on the allowable deduction for prepaid farm supplies does not apply to a grower-taxpayer, however, where either of the following apply: (1) the expense is more than 50% of the deductible farm expenses because of a change in business operations caused by extraordinary circumstances; or (2) the total prepaid farm supplies expense for the preceding 3 tax years is less than 50% of the total other deductible farm expenses for those 3 years. Accordingly, best practice is to document the initial reason for purchasing prepaid supplies, as well as the dates of their use or consumption.

Fuel

 
Fuel expenses on the farm may include gas, diesel, or oil. Auditors will now ask where the fuel was purchased, whether the farm has a storage tank, and for an explanation of how the grower keeps track of any non-deductible personal use of such fuel. Accordingly, taxpayers should keep careful records of their fuel consumption to ensure it is not re-characterized by the IRS as a non-farm expense.

The purchase of fuel may be re-characterized as non-farm expense if it is used during non-business activities, or activities that are otherwise not specifically engaged in for profit. Expenses incurred for such activities are often disallowed as “hobby losses.” The hobby loss rule should be of particular concern for startups and newbies who have realized a loss several years in a row. Grower-taxpayers bear the burden of proving that they engaged in the activity with an actual and honest objective of realizing a profit, or with the honest belief that the business will at some point in the future become profitable. Thus, it is a good idea to keep a record of your profit expectations along with the books and records to back them up.

Real Property

 

Repairs and maintenance are fully deductible if they do not add to a farm building’s value or “appreciably prolong its life,” but rather keep the structure in an ordinarily efficient operating condition. Moreover, the real property must be farm-related and not used as a personal residence. Likewise, a taxpayer may only deduct the mortgage interest on real property that is used for farming on the Schedule F. If the mortgage loan combines both farm property and personal property, then the taxpayer should keep records that show the amount of interest applied to each in order to prevent the farm mortgage interest deduction from being disallowed.

Tangible Property

 
Just as with real property, it is important to distinguish the repairs and maintenance expenses for farm equipment and other assets from “improvements.” The latter refers to the cost investments in tangible property that materially increase the value of the property or appreciably prolong the property’s useful life, such as the replacement of a major component.

Unsurprisingly, taxpayers and the IRS often disagree about whether the cost to replace a particular item is an improvement or a deductible expense. If the IRS takes the position that a repair is actually an improvement, the expense must be deducted over time instead of “written off,” or immediately expensed upfront. Notably, for tangible property, the GOP Blueprint for tax reform advocates a full and immediate deduction for the cost of investment. This would allow all businesses to benefit from a full and immediate write-off of their investments in tangible property. Keep an eye out for this tax reform as Congress enacts new legislation under a Republican administration.

Custom Hires

 

Growers may also deduct the expenses paid to individuals or businesses with proprietary equipment to perform certain farming activities. An employee’s wages, however, are never a custom hire expense. The auditor is instructed to e-mail the employee’s social security number and pertinent details to a specified IRS employee if wages are being improperly deducted. As a result, it behooves both parties to maintain written contracts to protect the service provider’s worker classification, in addition to safeguarding the receipts or bank statements that document the grower’s payment for services.

Conclusion

 
Despite all these warnings, growers should not be reluctant to aggressively deduct genuine business expenses on the Form 1040, Schedule F. Taxpayers are simply being asked to provide documentation that shows they qualify for these expenses, which tends to be a fairly easy undertaking in the digital age of information.  The best practice is to work with certified legal, accounting, and tax professionals to ensure the costs being deducted do not appear excessive for the income being reported. Tax policy is ultimately looking to ensure that the business expenses being deducted are reasonable, ordinary, and necessary under the circumstances.
For additional guidance, taxpayers can read the IRS’ Farmers Audit Technique Guide, available on the agency’s website. Reading the guide can help taxpayers minimize the risk of audit, or at least survive the inevitable. As long as taxpayers maintain adequate records of their payments and related circumstances, the IRS will permit them to take full advantage of the tax laws. Just remember the burden of proof is always on the taxpayer to prove entitlement to these deductions. Thus, it is incumbent upon grower-taxpayers to keep all of their records up to date and organized for a minimum of three years after filing.
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