While tax time may be just around the corner, the good news is that you won't be facing a huge onslaught of new changes for 2005 filing, says Neil E. Harl, Iowa State University retired agricultural lawyer and economist.
However, there are still some key items to consider when you start preparing federal and state tax forms for this year, he says.
Some of the more notable areas on the tax radar screen include:
Domestic Production Deduction: This is the big one, says Harl. Born out of the American Jobs Creation Act of 2004, the main focus is the replacement of the Extraterritorial Income (ETI) provisions that had been declared a prohibited export subsidy by the World Trade Organization (WTO) in 2002, he explains.
The Extraterritorial Income Exclusion (ETI) Act of 2000 and its predecessors were originally created to reduce tax payments on income from sales abroad by U.S. exporters to better compete against their foreign counterparts.
In contrast, European companies, for example, paid only taxes on income made in Europe, but not sales abroad, while U.S. firms had been paying taxes on both domestic and foreign sales.
“The bottom line, however, was that in 2002 the WTO became upset over the ETI program, and basically said it was inconsistent with world trade principles,” says Harl. “So the burden was on Congress to do something about it — under pressure from WTO-imposed penalties — which then led to the provision in the American Jobs Creation Act of 2004.”
Essentially, the Act replaced this ETI exclusion with a new tax deduction on income from domestic production activities for all qualifying manufacturers and domestic producers, including farmers — regardless of whether or not they export.
This deduction is important to review with your tax adviser, says Harl, because it affects just about everyone.
The Act allows a 3% deduction for the years 2005 and 2006 on what's called the Qualified Production Activities Income (QPAI), adds Harl. Then the deduction rises to 6% for the years 2007, 2008 and 2009. Afterwards, the deduction plateaus at 9%.
Currently, Harl says the deduction will apply to income derived or calculated from the “domestic production gross receipts” (or gross income from production activities) less the cost of producing that income. Expenses directly or indirectly allocated to those receipts also enter into the calculations.
“Specific guidance on making these final calculations is still lacking, as of press time,” explains Harl. “Better guidelines should be available before tax returns are filed. Again, you'll need to stay in touch with your tax adviser on this.”
Harl also says the overall deduction has some limitations. “For example, the total deduction can't exceed 50% of the W-2 wages of the employer,” he says. “However, it's still not exactly clear how this limit will be handled for farmers who don't have any employees.” A deduction is not available if a producer has a loss for the year.
Another possible sticky point with the deduction will be linked to the meaning of “active conduct of a trade or business,” says Harl. Sole proprietorships, partnerships, limited liability companies, limited liability partnerships and corporations should have no problem qualifying for this deduction, he says.
“The big problem or unknown is how landlords under crop-share leases or livestock-share leases or both are handled,” says Harl. “Historically, these have been considered to be a trade or business if there was active involvement in management under the lease by the landlord.
“However, it's likely that this deduction won't be available to landlords operating under a cash-rent lease. Remember, the Internal Revenue Service (IRS) hasn't provided specifics or guidance on this yet, but if cash-rent landlords become eligible, this would be a major development.”
Again, Harl encourages you to stay in touch with your tax adviser since regulations are expected later this year. Congress might even re-examine or scrutinize these provisions further, considering the fiscal drain on state and federal budgets caused by the major hurricanes this year, as well as the Iraq war.
Also, according to the Washington, D.C-based Center on Budget and Policy Priorities, some 18 states have already elected to opt out of the domestic production deduction provisions for state income tax purposes.
Bankruptcy/Chapter 12: A new tax provision that was buried in the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, which passed last April, is extremely important to farmers who file for Chapter 12 bankruptcy, Harl says.
In addition, the 2005 law made Chapter 12 bankruptcy a permanent part of the Bankruptcy Code. Chapter 12, which was enacted in 1986, was a temporary provision and had been extended several times.
Another provision, also applicable to Chapter 12 of the bankruptcy law, permanently increased the aggregate debt limit eligibility (now based on an inflation adjusted basis) for the individual and spouse up to $3,237,000, adds Harl.
Previously, the limit had been $1.5 million. In short, the new limit allows more people to be eligible for Chapter 12.
But the tax provision is the interesting part, explains Harl. It states that if a debtor gets a discharge in a Chapter 12 proceeding, some taxes are treated as an unsecured claim — those are amounts owed to the government as a result of “sale, transfer, exchange or other disposition of any farm asset used in the debtor's operation,” says Harl.
The key point is that, under prior law, taxes were a priority claim and had to be paid in full. However, in many cases, the debtor did not have sufficient funds to pay the priority tax claims in full, even in deferred payments.
This new provision addresses a major problem faced by many family farmers filing under Chapter 12. That problem occurred when assets were sold to make the operation economically viable but then triggered a gain that had to be paid as a priority claim.
The new provision would allow those tax bills to be treated as unsecured claims and consequently could be discharged.
Harl recommends consulting with your tax adviser to see if additional guidance is published on how inventory sales (for example, grain and livestock as well as other products produced in the debtor's operation) are considered “used in the debtor's operation.”
If they're not used in the operation, those items would not be eligible to be treated as unsecured claims under the new rules and would also not be eligible for discharge. Some of those points remain unclear and need further interpretation and rules from the IRS, he says.
Involuntary Conversions/Casualty Losses: With the severe hurricane and storm damage in the Gulf Coast this year, terms like “involuntary conversions” and “casualty losses” have quickly and painfully become all too familiar in the tax planning vocabulary.
An involuntary conversion occurs when your property is destroyed (for example, by storm, flood, fire or wind), stolen, condemned or disposed of under the threat of condemnation and you receive other property or money in payment, such as insurance or a condemnation award.
Gain or loss from an involuntary conversion of your property is usually recognized for tax purposes, unless the property is your main home or the property is reinvested in eligible property. Unless you reinvest in time, you report the gain or claim the loss (if it is deductible) on your tax return for the year you realize it, according to the IRS.
Involuntarily converted or destroyed property previously used in a trade or business or held for the production of income can be reported as a loss, adds Harl.
You can't deduct a loss from an involuntary conversion of property you held for personal use unless the loss resulted from a casualty or theft, according to the IRS.
However, depending on the type of property you receive, you may not have to report a gain on an involuntary conversion. You do not report the gain if you receive or reinvest in property that is “similar or related in service or use” to the converted property.
Your basis for the new property is the same as your basis for the converted property. This means that the gain is deferred until a taxable sale or exchange occurs.
If you lost buildings or other real property to condemnation, the proceeds can be reinvested in “like-kind” property (which allows more latitude than the “similar or related in service or use” test), explains Harl. And you have three years rather than two to reinvest.
He also recommends discussing with your tax adviser about the details in “like-kind” property that may help you reduce tax liabilities. For real estate, property meets the test if reinvested in other real estate.
Also, if a presidential-declared disaster has been officially designated in your area, Harl says there are certain tax provisions to consider when reinvesting proceeds from insurance on the residence and its contents.
For example, there's no gain from proceeds received on unscheduled personal property (such as clothing and household goods). Proceeds from “scheduled property” — such as photographic equipment or guns — are included in insurance proceeds on the residence and can be reinvested without gain. That period for reinvestment is longer.
The “Casualty Loss Provision” is one that covers many conditions, such as losses due to: fire, floods, storms, freezing, mistaken use of herbicides, earthquakes and wind.
The provision allows claiming a “casualty loss” only on your tax return; it does not involve any reinvestment requirements.
Essentially, you are claiming a deduction or loss for the lesser of the difference in fair market value before and after the loss and the income tax investment or basis in the property, says Harl.
“The deduction can't exceed the income tax basis in the property,” he adds. “So if something has been depreciated out, it has no basis. Consequently, you wouldn't have a deduction. The most you can deduct is the basis.”
Other areas to keep watch on or review with your tax adviser:
Like-Kind Exchange: Under Section 1031 of the IRS Code, a real property owner can sell property and then reinvest the proceeds in ownership of like-kind property and defer the capital gains taxes. To qualify as a 1031 like-kind exchange, property exchanges must be done in accordance with the rules which include some critically important time requirements for identifying the replacement property and closing on the replacement property.
How long you must live in the principal residence to avoid gain on the sale and the types of property involved in the like-kind exchanges, as well as any tax exclusions, are just a few items to discuss with your tax adviser.
Expense Method Depreciation: For 2005, the Expense Method Depreciation amount is $105,000 (up from $102,000 in 2004). For 2006, the preliminary estimate is $108,000. However, the amount for 2006 is not official yet, as of press time, according to Harl.
Harl also recommends discussing with your tax adviser the eligibility rules and definitions concerning sport utility vehicles (SUVs) — some are limited to a maximum of $25,000 of expense method depreciation. The definition is broad enough to include pickup trucks, according to Harl, but exceptions apply, including an exception if a pickup has a 6 ft. or larger box.
Alternative Minimum Tax (AMT): In 2004, the AMT was eliminated on income averaging and that will continue in 2005. So, income averaging is more useful to farmers, especially in cases where it's advantageous to spread out farm income over several years.
For more information, you can access the Farmer's Tax Guide, Publication 225, IRS, on line at: http://www.irs.gov/publications/p225/. The 2004 version is available on line now (also in pdf form), and the 2005 version will be available soon.