For classification purposes, the IRS considers more than just ground tillers as farmers. The IRS regards orchards, livestock, dairy, poultry, vineyards, ranches, ranges, and even fish as farming. For tax purposes, if the activity is owned by a sole proprietor, farming is considered a small business. However, these activities are reported on Schedule F rather than Schedule C of Form 1040.
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The basic rules governing all small businesses apply with some interesting exceptions.
Here are the basic rules:
- Net profit is subject to self-employment tax, which is calculated on Schedule SE.
- You may deduct all “ordinary and necessary” business expenses.
- Workers you hire are subject to payroll tax withholding and matching unless they pass the test to categorize them as independent contractors.
- Net operating losses can be carried back or forward.
- You may deduct self-employed health insurance on Line 29 of Form 1040.
- You may deduct retirement plan contributions to an IRA, SEP IRA, etc… as an adjustment to income on Form 1040.
- Cost of goods sold: If you purchase livestock for resale, you may take the deduction when you sell the beast (including transportation costs) not when you purchase it.
- The hobby loss rules apply – profit in three of last five years. For breeding, showing, training, and/or racing horses – two of the last seven years.
There are some interesting tax treatment differences between small businesses and farming, and farmers are given some tax breaks not offered to other business owners.
First of all, if a farmer enjoys increased income one year, he can elect income averaging by considering the last three years of low income in order to reduce the current year tax bill. This method will not change a prior year’s tax liability. Basically, the data from prior years is used to determine the current year tax. In the past, income averaging applied to everyone, whether you were a farmer, a self-employed business owner or a wage earner. But this concept was written out of the tax code in the 1986 tax reform--with the exception of farming.
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Secondly, rental income is generally not subject to self-employment tax. However, if you rent some of your land to a farmer and you materially participate in those farming activities – such as a share-cropper arrangement – this form of rental income subject to self-employment tax. If you are paid in crops, the value of those crops is included in income and becomes subject to self-employment tax.
As you are likely aware, land is not depreciable. However, if you are a vineyard owner, you may allocate a certain percentage of your land as “appellation” and deduct amortization based on that value.
Fuel used off-road for farming activities can be subject to federal excise tax refunds or credits. Use IRS Form 4136 to claim a credit and Form 8849 to request a refund. Visit your tax pro or peruse the instructions for these forms to ensure that you qualify.
Some expenses considered “ordinary and necessary” include: clearing brush from an area you wish to farm, removing sentiment from drainage ditches, and expenses for endangered species recovery. You may deduct expenses for soil and water conservation as long as they do not exceed 25% of your income from farming.
Crop insurance proceeds granted to a farmer resulting from crop damage must be included in gross income. You generally include them in the year you receive them.
Some income can be declared in a subsequent year. For example, if you sell more livestock, including poultry, than you normally would in a year because of weather-related conditions, you may be able to postpone until the next year the reporting of the gain from selling the additional animals.
And some income is not taxable. For example, income from certain cost-sharing conservation programs may not be taxable.
For more information about farming, check out Farmers Tax Guide available on the IRS website.
Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, CA and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know.” Follow Bonnie Lee on Twitter at BLTaxpertise and at Facebook.