TAXES AND DROUGHT
By Gary DiGiuseppe
When you're deciding how to use the tax code to compensate for the worst drought in memory, among the important things to remember is your best approach may be to take no special steps at all.
"Just because your neighbor's doing it isn't any sign that you need to do it, because everybody's situation is different," says William Schawe, CPA with Seidel, Schroeder & Company in Brenham. "Right now we're in a period of low tax rates. Our tax brackets right now are probably at the lowest they've ever been and seeing the way the economy is right now, the general consensus is that the tax brackets are going to go up into the future. So you might be postponing some gain that would cost you more taxes down the road when you sell the replacement cattle."
A late August survey of members by the Texas and Southwestern Cattle Raisers Association (TSCRA) showed the situation has caused many producers to liquidate stock. Of 874 members who responded, 84 percent said they had reduced their herd size from the 3-year average. The average reduction was 38 percent, and the average reduction of the cow and bred heifer herd was 34 percent. Thirteen percent said they intend to increase the number of breeding females in their herd in 2012, so those producers may be able to roll returns from liquidated stock forward under 1 of 2 provisions of the federal tax code.
One provision is under section 451 in the IRS code, the "general rule for taxable year of inclusion," which may allow producers to postpone gains for a year on raised livestock. To qualify, farming or ranching must be your principal business, you must use the cash method of accounting, and the area in which the cattle were raised must be designated for federal assistance. A sale before an area has become eligible for federal assistance may still qualify, as long as a drought caused the area subsequently to become eligible.
Also, the sale must be shown not to be a normal business practice. Schawe notes, "There's a 3-year lookback period where you go back over the prior 3 years and determine your average number of, say, breeding cattle sold. Only the excess sales over the prior 3 years are what you can defer the gain on." The IRS says "all facts and circumstances" will be used to determine your usual business practices; in addition, you must make the postponement election separately for each class of livestock.
But Schawe says producers don't use section 451 to defer income as often as they use section 1033 pertaining to involuntary conversion, which includes circumstances when ranchers are forced to sell their breeding stock due to weather related conditions.
Schawe explains, "The gain from the sale of your excess breeding stock can be picked up in future years if you intend to replace. The normal replacement period when it comes to cattle is 2 years. That's the general rule. However, if you're in an area that qualifies for federal assistance, the period on purchasing replacement livestock can be extended up to 4 years."
Or even longer, under what the IRS calls a "persistent drought condition." Schawe says the agency publishes an annual list of drought counties, based on conditions during the 12 months ending in August. He says, "Even the 4-year replacement period can be extended until the end of the year after your county is considered drought-free. If you show up on that list for 6 years, you don't have to buy your replacement cattle back for 6 years. So there are some pretty liberal rules when it comes to replacement period, if you elect to postpone your sales and you intend to buy back."
Both of these options are elections and have to be written up in an attachment to the return. The attachment should include a statement that the taxpayer is making an election under the appropriate section of the tax code, evidence of drought conditions, a statement explaining the relationship of the drought area to the early sale or exchange of the livestock, and the number of animals the filer has sold in the number of years appropriate to the exemption being sought.
In the case of section 1033, the replacements have to be for the same purpose as the animals that were liquidated. You can't sell off beef cows and use the section to apply the cost of acquiring dairy cows.
Incidentally, the producer who seeks a deferral option under section 451 can amend the return later to request the section 1033 option if he buys replacement livestock, or if he changes his mind and does not buy replacements, he can switch from 1033 to 451. However, he may have to file a letter seeking the change.
Under the involuntary conversion rule, Schawe says the producer has a carryover basis. "Let's say for example that you've got some cows out there that you had previously bought," he says. "They are fully depreciated, so that on the cattle that you buy back you have to spend the total dollars back to avoid paying any tax on any gains, but then naturally when you buy back the replacement cattle you still have a zero basis because on your previous sales your cattle were fully depreciated."
But Schawe emphasizes the importance of discussing your personal situation with a tax consultant before deciding which deferral to take, if any.
"Let's say, for example, the cattle that you're selling are raised cattle where you have a zero basis," he says. "Right now if you're in a 15 percent bracket or less, you might be able to pay zero tax on it. It's a possibility you could sell $40,000 to $50,000 worth of cattle that are not subject to depreciation or capture, and the sale of these cattle are capital gains income, and you might be able to walk away without having to pay any tax on your income."
In addition, a great many producers are trying to hang on with minimal liquidation, and given the high cost of feed, they may be better off just taking the returns on any excess sold stock in 2011.
And, adds Schawe, if "you're sitting there at the end of the year with a tax return with a negative figure because your farm expenses to maintain your herd have wiped out all of your income to where you've had to dip into your savings to pay the bills, you could create a net operating loss."
This would be expenses measured against all income both on and off the farm, including returns from sources like oil and gas leases, interest, dividends and pensions.
He says, "If you've paid income tax in the prior 5 years, you can do what we call a net operating loss carryback and receive a refund from taxes that you have previously paid. You start with the fifth year, and if your loss isn't absorbed you go to the fourth, and so on."
The carryback period for most business operating losses is just 2 years, but farmers get 5. In addition, if you know you'll have positive income in the future you can carry losses forward up to 5 years.
Schawe says it appears a lot of ranchers who plan to stay in the business are dipping into savings and cashing social security checks to keep their animals fed.
"If people use these elections and benefits that the government gives you to replace, you might be paying $2,000 for a cow that isn't worth $1,000 [in 2012]," he says. "I would anticipate probably 75 percent of them are probably just going to pick up the income because they've already spent the funds to try to hang on this long already. It would have to be a pretty large operation, I would think. Somebody has to sell 150 to 200 head before they would probably consider these deferments, because there's no need of going through the hassle to defer the sales on 10 to 15 cows."
There is also an income deferral option under section 451 for crops that were destroyed and for which crop insurance payments will be made. Federal assistance like disaster payments and crop insurance reimbursements are taxable; however, payments under livestock assistance programs wouldn't be made until 2012. Most income is taxable in the year in which payment is received. At the time of this writing, several disaster loss measures in the 2008 Farm Bill were about to expire. Unless they've been extended by Congress, producers would have had to apply to USDA's Farm Service Agency for compensation to cover forage or animal losses due to the elements, and to have obtained documentation for those losses, by Sept. 30, 2011.
There are other unusual deductions beyond the high feed cost that could make it more advantageous for producers to absorb liquidation income in 2011.
"There's a lot of ‘dozer work going on right now to clean out stock tanks, so that when it does start raining, the tanks won't have 4 feet of mud in them," observes Schawe. Although producers could write off the full cost of stock tank repairs and maintenance in the first year, many are also taking the opportunity to make them deeper and wider.
"That would possibly qualify as a land improvement, which they could depreciate over a 15-year period," says Schawe, but he warns producers to check with the IRS.
"Sometimes the Internal Revenue, depending on the various agents that you run into, says that earthen dams aren't depreciable because there's no determinable useful life," he says. "However, I think a lot of that would remain to be decided, whether it's by a court of law or by common sense, because tank dams do erode when there are heavy rains, and they do deteriorate."