Farm Inventory

If you keep an inventory, you generally must use an accrual method of accounting to determine your gross income. You should keep a complete record of your inventory as part of your farm records. This record should show the actual count or measurement of the inventory. It should also show all factors that enter into its valuation, including quality and weight if they are required.

Items to include in inventory.   Your inventory should include all items held for sale, or for use as feed, seed, etc., whether raised or purchased, that are unsold at the end of the year.

Accounting for inventory.   Generally, if you produce, purchase, or sell merchandise in your business, you must keep an inventory and use the accrual method for purchases and sales of merchandise. However, if you are a qualifying taxpayer or a qualifying small business taxpayer that has an eligible business, you can use the cash method of accounting, even if you produce, purchase, or sell merchandise. If you qualify, you also can choose not to keep an inventory, even if you do not change to the cash method.

You are a qualifying taxpayer only if you meet the gross receipts test for each prior tax year ending after December 16, 1998. To meet the test for a prior tax year, your average annual gross receipts must be $1,000,000 or less for the 3 tax years ending with the prior tax year. A tax shelter cannot be a qualifying taxpayer. See Publication 538 for more information.

You are a qualifying small business taxpayer for your eligible business only if you meet the gross receipts test for each prior tax year ending on or after December 31, 2000, and are not prohibited from using the cash method under section 448 of the Internal Revenue Code. To meet the test for a prior tax year, your average annual gross receipts must be $10,000,000 or less for the 3 tax years ending with the prior tax year. Certain other requirements must be met. See Publication 538 for more information.

The qualifying small business taxpayer exception does not apply to a farming business. However, if you are a qualifying small business taxpayer engaged in a farming business, this exception may apply to your nonfarming businesses, if any.

Hatchery business.   If you are in the hatchery business, and use the accrual method of accounting, you must include in inventory eggs in the process of incubation.

Products held for sale.   All harvested and purchased farm products held for sale or for feed or seed, such as grain, hay, silage, concentrates, cotton, tobacco, etc., must be included in inventory.

Supplies.   You must inventory supplies acquired for sale or that become a physical part of items held for sale. Deduct the cost of supplies in the year used or consumed in operations. Do not include incidental supplies in inventory. Deduct incidental supplies in the year of purchase.

Livestock.   Livestock held primarily for sale must be included in inventory. Livestock held for draft, breeding, or dairy purposes can either be depreciated or included in inventory. See also Unit-livestock-price method, later. If you are in the business of breeding and raising chinchillas, mink, foxes, or other fur-bearing animals, these animals are livestock for inventory purposes.

Growing crops.   You are generally not required to inventory growing crops. However, if the crop has a preproductive period of more than 2 years, you may have to capitalize (or include in inventory) costs associated with the crop. See Uniform Capitalization Rules in chapter 7.

Required to use accrual method.   The following applies if you are required to use an accrual method of accounting.

• The uniform capitalization rules apply to all costs of raising a plant, even if the preproductive period of raising a plant is 2 years or less.
• The costs of animals are subject to the uniform capitalization rules.

Inventory valuation methods.   The following methods, described below, are those generally available for valuing inventory.

1. Cost.
2. Lower of cost or market.
3. Farm-price method.
4. Unit-livestock-price method.

Cost and lower of cost or market methods.   See Publication 538 for information on these valuation methods.

If you value your livestock inventory at cost or the lower of cost or market, you do not need IRS approval to change to the unit-livestock-price method.

Farm-price method.   Under this method, each item, whether raised or purchased, is valued at its market price less the direct cost of disposition. Market price is the current price at the nearest market in the quantities you usually sell. Cost of disposition includes broker's commissions, freight, hauling to market, and other marketing costs. If you use this method, you must use it for your entire inventory, except that livestock can be inventoried under the unit-livestock-price method.

Unit-livestock-price method.   This method recognizes the difficulty of establishing the exact costs of producing and raising each animal. You group or classify livestock according to type and age and use a standard unit price for each animal within a class or group. The unit price you assign should reasonably approximate the normal costs incurred in producing the animals in such classes. Unit prices and classifications are subject to approval by the IRS on examination of your return. You must annually reevaluate your unit livestock prices and adjust the prices upward to reflect increases in the costs of raising livestock. IRS approval is not required for these adjustments. Any other changes in unit prices or classifications do require IRS approval.

If you use this method, include all raised livestock in inventory, regardless of whether they are held for sale or for draft, breeding, sport, or dairy purposes. This method accounts only for the increase in cost of raising an animal to maturity. It does not provide for any decrease in the animal's market value after it reaches maturity. Also, if you raise cattle, you are not required to inventory hay you grow to feed your herd.

Do not include sold or lost animals in the year-end inventory. If your records do not show which animals were sold or lost, treat the first animals acquired as sold or lost. The animals on hand at the end of the year are considered those most recently acquired.

You must include in inventory all livestock purchased primarily for sale. You can choose either to include in inventory or depreciate livestock purchased for draft, breeding, sport or dairy purposes. However, you must be consistent from year to year, regardless of the practice you have chosen. You cannot change your practice without IRS approval.

You must inventory animals purchased after maturity or capitalize them at their purchase price. If the animals are not mature at purchase, increase the cost at the end of each tax year according to the established unit price. However, in the year of purchase, do not increase the cost of any animal purchased during the last 6 months of the year. This no increase rule does not apply to tax shelters which must make an adjustment for any animal purchased during the year. It also does not apply to taxpayers that must make an adjustment to reasonably reflect the particular period in the year in which animals are purchased, if necessary to avoid significant distortions in income.

Uniform capitalization rules.   A farmer can determine costs required to be allocated under the uniform capitalization rules by using the farm-price or unit-livestock-price inventory method. This applies to any plant or animal, even if the farmer does not hold or treat the plant or animal as inventory property.

Cash Versus Accrual Method

The following examples compare the cash and accrual methods of accounting.

Example 1.   You are a farmer who uses an accrual method of accounting. You keep your books on the calendar tax year basis. You sell grain in December 2002, but you are not paid until January 2003. You must include both the sale proceeds and deduct the costs incurred in producing the grain on your 2002 tax return.

Example 2.   Assume the same facts as in Example 1 except that you use the cash method and there was no constructive receipt of the sale proceeds in 2002. Under this method, you include the sale proceeds in income for 2003, the year you receive payment. You deduct the costs of producing the grain in the year you pay for them.

Special Methods of Accounting

There are special methods of accounting for certain items of income and expense.

Crop method.   If you do not harvest and dispose of your crop in the same tax year that you plant it, you can, with IRS approval, use the crop method of accounting. Under this method, you deduct the entire cost of producing the crop, including the expense of seed or young plants, in the year you realize income from the crop.

You cannot use this method for timber or any commodity subject to the uniform capitalization rules.

Other special methods.   Other special methods of accounting apply to the following items.

• Amortization, see chapter 8.
• Casualties, see chapter 13.
• Condemnations, see chapter 13.
• Depletion, see chapter 8.
• Depreciation, see chapter 8.
• Farm business expenses, see chapter 5.
• Farm income, see chapter 4.
• Installment sales, see chapter 12.
• Soil and water conservation expenses, see chapter 6.
• Thefts, see chapter 13.

Combination Method

You can generally use any combination of cash, accrual, and special methods of accounting if the combination clearly shows your income and expenses and you use it consistently. However, the following restrictions apply.

• If you use the cash method for figuring your income, you must use the cash method for reporting your expenses.
• If you use an accrual method for reporting your expenses, you must use an accrual method for figuring your income.

Change in Accounting Method

Once you have set up your accounting method, you must generally get IRS approval before you can change to another method. A change in your accounting method includes a change in:

• Your overall method, such as from cash to an accrual method, and
• Your treatment of any material item, such as a change in your method of valuing inventory (for example, a change from the farm-price method to the unit-livestock-price method).

To get approval, you must file Form 3115. You may have to pay a fee. For more information, see the Form 3115 instructions.

Farm Income

Important Changes for 2002

Changing your method of accounting for Commodity Credit Corporation (CCC) loans.   Effective for tax years ending on or after December 31, 2001, you can obtain automatic consent to change your method of accounting for loans received from the CCC, from including the loan amount in gross income for the taxable year in which the loan is received to treating the loan amount as a loan. For more information, see Automatic Change Procedures under Change in Accounting Method in Publication 538, Accounting Periods and Methods.

Production flexibility contracts eliminated.   The Farm Security and Rural Investment Act of 2002 eliminates additional production flexibility contract payments after May 13, 2002, unless requested by the producer that is a party to the contract. For more information, see Production Flexibility Contract Payments, later.

Farm Security and Rural Investment Act of 2002 creates new payments.   The Farm Security and Rural Investment Act of 2002 created two new types of payments - direct and counter-cyclical payments. These payments are included in taxable income. For more information, see Payments under the Farm Security and Rural Investment Act of 2002, later.

Peanut quota buyout program payments.   For information about the tax treatment of payments to peanut quota holders, see Peanut Quota Buyout Program Payments under Agricultural Program Payments, later.

Introduction

You may receive income from many sources. You must report the income on your tax return, unless it is excluded by law. Where you report the income depends on its source.

This chapter discusses farm income you report on Schedule F (Form 1040). For information on where to report other income, see the instructions for Form 1040.

Accounting method.   The rules discussed in this chapter assume you use the cash method of accounting. Under the cash method, you generally include an item of income in gross income when you receive it. See Cash Method in chapter 3.

If you use an accrual method of accounting, different rules may apply to your situation. See Accrual Method in chapter 3.

Topics

This chapter discusses:

• Schedule F (Form 1040)
• Sales of farm products
• Rents (including crop shares)
• Agricultural program payments
• Income from cooperatives
• Cancellation of debt
• Income from other sources
• Farm income averaging

Useful Items You may want to see:

Publication

• 525   Taxable and Nontaxable Income
• 550   Investment Income and Expenses
• 908   Bankruptcy Tax Guide
• 925   Passive Activity and At-Risk Rules

Form (and Instructions)

• Sch E (Form 1040)   Supplemental
  Income and Loss
• Sch F (Form 1040)   Profit or Loss From Farming
• Sch J (Form 1040)   Farm Income Averaging
• 982   Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment)
• 1099-G   Certain Government Payments
• 1099-PATR   Taxable Distributions
  Received From Cooperatives
• 4797   Sales of Business Property
• 4835   Farm Rental Income and
  Expenses

See chapter 21 for information about getting publications and forms.

Schedule F

Report your farm income on Schedule F (Form 1040). Use this schedule to figure the net profit or loss from regular farming operations.

Income from farming reported on Schedule F (Form 1040) includes amounts you receive from cultivating, operating, or managing a farm for gain or profit, either as owner or tenant. This includes income from operating a stock, dairy, poultry, fish, fruit, or truck farm and income from operating a plantation, ranch, range, or orchard. It also includes income from the sale of crop shares if you materially participate in producing the crop. See Rents (Including Crop Shares), later.

Income reported on Schedule F does not include gains or losses from sales or other dispositions of the following farm assets.

• Land.
• Depreciable farm equipment.
• Buildings and structures.
• Livestock held for draft, breeding, dairy, or sporting purposes.

Gains and losses from most dispositions of farm assets are discussed in chapters 10 and 11. Gains and losses from casualties, thefts, and condemnations are discussed in chapter 13.

Sales of Farm Products

When you sell livestock, produce, grains, or other products you raised on your farm for sale or bought for resale, the entire amount you receive is reported on Schedule F. This includes money and the fair market value of any property or services you receive.

Where to report.   Table 4-1 shows where to report the sale of farm products on your tax return.

Schedule F.   When you sell farm products bought for resale, your profit or loss is the difference between your basis in the item (usually your cost) and any money plus the fair market value of any property you receive for it. See chapter 7 for information on the basis of assets. You generally report these amounts on Schedule F for the year you receive payment.

Example.   In 2001, you bought 20 feeder calves for $6,000 for resale. You sold them in 2002 for $11,000. You report the $11,000 sales price, subtract your $6,000 basis, and report the resulting $5,000 profit in Part 1 of your 2002 Schedule F.

Form 4797.   Sales of livestock held for draft, breeding, dairy, or sporting purposes may result in ordinary or capital gains or losses, depending on the circumstances. In either case, you should always report these sales on Form 4797 instead of Schedule F. See Livestock under Ordinary or Capital Gain or Loss in chapter 10. Animals you do not hold primarily for sale are considered business assets of your farm.

Table 4-1. Where To Report Sales of Farm Products

Item Sold	Schedule F	Form 4797
Farm products raised for sale	X
Farm products bought for resale	X
Farm products not held primarily for sale, such as livestock held for draft, breeding, dairy, or sporting purposes (bought or raised)		X

Sale by agent.   If your agent sells your farm products, you must include the net proceeds from the sale in gross income for the year the agent receives payment. This applies even if your agent pays you in a later year. You have constructive receipt of the income when your agent receives payment. For a discussion on constructive receipt of income, see Cash Method under Accounting Methods in chapter 3.

Sales Caused by Weather-Related Conditions

If you sell more livestock, including poultry, than you normally would in a year because of a drought, flood, or other weather-related condition, you may be able to postpone reporting the gain from selling the additional animals until the next year. You must meet all the following conditions to qualify.

• Your principal trade or business is farming.
• You use the cash method of accounting.
• You can show that, under your usual business practices, you would not have sold the additional animals this year except for the weather-related condition.
• The weather-related condition caused an area to be designated as eligible for assistance by the federal government.

Sales made before an area became eligible for federal assistance qualify if the weather-related condition that caused the sale also caused the area to be designated as eligible for federal assistance. The designation can be made by the President, the Department of Agriculture (or any of its agencies), or by other federal departments or agencies.

A weather-related sale of livestock (other than poultry) held for draft, breeding, or dairy purposes may be an involuntary conversion. If you plan to replace the livestock, see Other Involuntary Conversions in chapter 13 for more information.

Usual business practice.   You must determine the number of animals you would have sold had you followed your usual business practice in the absence of the weather-related condition. Do this by considering all the facts and circumstances, but do not take into account your sales in any earlier year for which you postponed the gain. If you have not yet established a usual business practice, rely on the usual business practices of similarly situated farmers in your general region.

Connection with affected area.   The livestock does not have to be raised or sold in an area affected by a weather-related condition for the postponement to apply. However, the sale must occur solely because of a weather-related condition that affected the water, grazing, or other requirements of the livestock. This requirement generally will not be met if the costs of food, water, or other requirements of the livestock affected by the weather-related condition are not substantial in relation to the total costs of holding the livestock.

Classes of livestock.   You must figure the amount to be postponed separately for each generic class of animals - for example, hogs, sheep, and cattle. Do not separate animals into classes based on age, sex, or breed.

Amount to be postponed.   Follow these steps to figure the amount to be postponed for each class of animals.

1. Divide the total income realized from the sale of all livestock in the class during the tax year by the total number of such livestock sold. For this purpose, do not treat any postponed gain from the previous year as income received from the sale of livestock.
2. Multiply the result in (1) by the excess number of such livestock sold solely because of weather-related conditions.

Example.   You are a calendar year taxpayer and you normally sell 100 head of beef cattle a year. As a result of drought, you sold 135 head during 2002. You realized $35,100 from the sale. On August 9, 2002, as a result of drought, the affected area was declared a disaster area eligible for federal assistance. The income you can postpone until 2003 is $9,100 [($35,100 ÷ 135) × 35].

How to postpone gain.   To postpone gain, attach a statement to your tax return for the year of the sale. The statement must include your name and address and give the following information for each class of livestock for which you are postponing gain.

• A statement that you are postponing gain under section 451(e) of the Internal Revenue Code.
• Evidence of the weather-related conditions that forced the early sale or exchange of the livestock and the date, if known, on which an area was designated as eligible for assistance by the federal government because of weather-related conditions.
• A statement explaining the relationship of the area affected by the weather-related condition to your early sale or exchange of the livestock.
• The number of animals sold in each of the 3 preceding years.
• The number of animals you would have sold in the tax year had you followed your normal business practice in the absence of weather-related conditions.
• The total number of animals sold and the number sold because of weather-related conditions during the tax year.
• A computation, as described earlier, of the income to be postponed for each class of livestock.

You must file the statement and the return by the due date of the return, including extensions. If you timely filed your return for the year without postponing gain, you can still postpone gain by filing an amended return within 6 months of the due date of the return (excluding extensions). Attach the statement to the amended return and write Filed pursuant to section 301.9100-2 at the top of the amended return. File the amended return at the same address you filed the original return. Once you have filed the statement, you can cancel your postponement of gain only with the approval of the IRS.

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