09 Jun FARM EXPENSES ARE RIPE FOR AUDIT
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
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:
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.
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.
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.
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.
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.