| Publication 225, Farmer's Tax Guide |
2006 Tax Year |
This is archived information that pertains only to the 2006 Tax Year. If you
are looking for information for the current tax year, go to the Tax Prep Help Area.
You must consistently use an accounting method that clearly shows your income and expenses. You must also figure your taxable
income and file an
income tax return for an annual accounting period called a tax year. Only accounting methods are discussed in this chapter.
For information on
accounting periods, see Publication 538, Accounting Periods and Methods, and the instructions for Form 1128, Application To
Adopt, Change, or Retain a
Tax Year.
Topics - This chapter discusses:
Useful Items - You may want to see:
Form (and Instructions)
-
1128
Application To Adopt, Change, or Retain a Tax Year
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3115
Application for Change in Accounting Method
See chapter 17 for information about getting publications and forms.
An accounting method is a set of rules used to determine when and how income and expenses are reported. Your accounting method
includes not only
your overall method of accounting, but also the accounting treatment you use for any material item.
You choose an accounting method for your farm business when you file your first income tax return that includes a Schedule
F. However, you cannot
use the crop method for any tax return, including your first tax return, unless you receive approval from the IRS. The crop
method of accounting is
discussed later under Special Methods of Accounting. How to obtain IRS approval to change an accounting method is discussed later under
Change in Accounting Method.
Kinds of methods.
Generally, you can use any of the following accounting methods.
However, certain farm corporations and partnerships, and all tax shelters, must use an accrual method of accounting. See Accrual method
required, later.
Business and personal items.
You can account for business and personal items using different accounting methods. For example, you can figure your
business income under an
accrual method, even if you use the cash method to figure personal items.
Two or more businesses.
If you operate two or more separate and distinct businesses, you can use a different accounting method for each. No
business is separate and
distinct, however, unless a complete and separate set of books and records is maintained for each business.
Accrual method required.
The following businesses engaged in farming must use an accrual method of accounting.
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A corporation (other than a family corporation) that had gross receipts of more than $1,000,000 for any tax year beginning
after
1975.
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A family corporation that had gross receipts of more than $25,000,000 for any tax year beginning after 1985.
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A partnership with a corporation as a partner.
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A tax shelter.
Note.
Items (1), (2), and (3) do not apply to an S corporation or a business operating a nursery or sod farm, or the raising or
harvesting of trees
(other than fruit and nut trees).
Family corporation.
A family corporation is generally a corporation that meets one of the following ownership requirements.
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Members of the same family own at least 50% of the total combined voting power of all classes of stock entitled to vote and
at least 50% of
the total shares of all other classes of stock of the corporation.
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Members of two families have owned, directly or indirectly, since October 4, 1976, at least 65% of the total combined voting
power of all
classes of voting stock and at least 65% of the total shares of all other classes of the corporation's stock.
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Members of three families have owned, directly or indirectly, since October 4, 1976, at least 50% of the total combined voting
power of all
classes of voting stock and at least 50% of the total shares of all other classes of the corporation's stock.
For more information on family corporations, see Internal Revenue Code section 447.
Tax shelter.
A tax shelter is a partnership, noncorporate enterprise, or S corporation that meets either of the following tests.
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Its principal purpose is the avoidance or evasion of federal income tax.
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It is a farming syndicate. A farming syndicate is an entity that meets either of the following tests.
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Interests in the activity have been offered for sale in an offering required to be registered with a federal or state agency
with the
authority to regulate the offering of securities for sale.
-
More than 35% of the losses during the tax year are allocable to limited partners or limited entrepreneurs.
A “ limited partner” is one whose personal liability for partnership debts is limited to the money or other property the partner contributed
or
is required to contribute to the partnership.
A “ limited entrepreneur” is one who has an interest in an enterprise other than as a limited partner and does not actively participate in the
management of the enterprise.
Most farmers use the cash method because they find it easier to keep cash method records. However, certain farm corporations
and partnerships and
all tax shelters must use an accrual method of accounting. See Accrual method required, earlier.
Under the cash method, include in your gross income all items of income you actually or constructively receive during the
tax year. If you receive
property or services, you must include their fair market value (FMV) in income. See chapter 3 for information on how to report
farm income on your
income tax return.
Constructive receipt.
Income is constructively received when an amount is credited to your account or made available to you without restriction.
You need not have
possession of it. If you authorize someone to be your agent and receive income for you, you are considered to have received
it when your agent
receives it. Income is not constructively received if your control of its receipt is subject to substantial restrictions or
limitations.
Direct payments and counter-cyclical payments.
If you received direct payments or counter-cyclical payments under Subtitle A or C of the Farm Security and Rural
Investment Act of 2002, you will
not be considered to have constructively received a payment merely because you had the option to receive it in the year before
it is required to be
paid.
Delaying receipt of income.
You cannot hold checks or postpone taking possession of similar property from one tax year to another to avoid paying
tax on the income. You must
report the income in the year the property is received or made available to you without restriction.
Example.
Frances Jones, a farmer, was entitled to receive a $10,000 payment on a grain contract in December 2006. She was told in December
that her payment
was available. She requested not to be paid until January 2007. However, she must still include this payment in her 2006 income
because it was made
available to her in 2006.
Debts paid by another person or canceled.
If your debts are paid by another person or are canceled by your creditors, you may have to report part or all of
this debt relief as income. If
you receive income in this way, you constructively receive the income when the debt is canceled or paid. See Cancellation of Debt in
chapter 3.
Installment sale.
If you sell an item under a deferred payment contract that calls for payment the following year, there is no constructive
receipt in the year of
sale. However, see the following example for an exception to this rule.
Example.
You are a farmer who uses the cash method and a calendar tax year. You sell grain in December 2006 under a bona fide arm's-length
contract that
calls for payment in 2007. You include the sale proceeds in your 2007 gross income since that is the year payment is received.
However, if the
contract says that you have the right to the proceeds from the buyer at any time after the grain is delivered, you must include
the sale price in your
2006 income, regardless of when you actually receive payment.
Repayment of income.
If you include an amount in income; and in a later year you have to repay all or part of it, then you can usually
deduct the repayment in the year
in which you make it. If the repayment is more than $3,000, a special rule applies. For details, see Repayments in chapter 11 of
Publication 535, Business Expenses.
Under the cash method, generally you deduct expenses in the tax year in which you actually pay them. This includes business
expenses for which you
contest liability. However, you may not be able to deduct an expense paid in advance or you may be required to capitalize
certain costs, as explained
under Uniform Capitalization Rules in chapter 6. See chapter 4 for information on how to deduct farm business expenses on your income tax
return.
Prepayment.
Generally, you cannot deduct expenses paid in advance. This rule applies to any expense paid far enough in advance
to, in effect, create an asset
with a useful life extending substantially beyond the end of the current tax year.
Example.
On November 1, 2006, you signed and paid $ 3,600 for a 3-year (36-month) insurance contract for equipment. In 2006 you are
allowed to deduct only
$200 (2/36 x $3,600) of the cost of the policy that is attributable to 2006. In 2007, you'll be able to deduct $1,200 (12/36
x $3,600); in 2008 you'll
be able to deduct $1,200 (12/36 x $3,600); and in 2009, you'll be able to deduct the remaining balance of $1,000.
Under an accrual method of accounting, generally you report income in the year earned and deduct or capitalize expenses in
the year incurred. The
purpose of an accrual method of accounting is to correctly match income and expenses.
Generally, you include an amount in income for the tax year in which all events that fix your right to receive the income
have occurred, and you
can determine the amount with reasonable accuracy.
If you use an accrual method of accounting, complete Part III of Schedule F (Form 1040).
Inventory.
If you keep an inventory, generally you must use an accrual method of accounting to determine your gross income. See
Farm Inventory,
later, for more information.
Under an accrual method of accounting, you generally deduct or capitalize a business expense when both of the following apply.
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The all-events test has been met. This test is met when:
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All events have occurred that fix the fact of liability, and
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The liability can be determined with reasonable accuracy.
-
Economic performance has occurred.
Economic performance.
Generally, you cannot deduct or capitalize a business expense until economic performance occurs. If your expense is
for property or services
provided to you, or for your use of property, economic performance occurs as the property or services are provided or as the
property is used.
If your expense is for property or services you provide to others, economic performance occurs as you provide the
property or services.
An exception to the economic performance rule allows certain recurring items to be treated as incurred during a tax
year even though economic
performance has not occurred. For more information, see Economic Performance in Publication 538.
Example.
Jane, who is a farmer, uses a calendar tax year and an accrual method of accounting. She enters into a contract with Waterworks,
Inc. in 2006. The
contract states that Jane must pay Waterworks, Inc. $200,000 in December 2006. It further stipulates that Waterworks will
install a complete
irrigation system, including a new well, by January 1, 2007. She pays Waterworks $200,000 in December 2006. Installation begins
in May 2007, and they
complete the irrigation system in December 2007.
Economic performance for Jane's liability in the contract occurs as the property and services are provided. Jane incurs the
$200,000 cost in 2007.
Special rule for related persons.
Business expenses and interest owed to a related person who uses the cash method of accounting are not deductible
until you make the payment and
the corresponding amount is includible in the related person's gross income. Determine the relationship for this rule as of
the end of the tax year
for which the expense or interest would otherwise be deductible. For more information, see Internal Revenue Code section 267.
If you are required to keep an inventory (see below), 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 applicable.
Accounting for inventory.
Generally, if you produce, purchase, or sell merchandise in your business, you are required to 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.
A qualifying taxpayer is a taxpayer that for each prior tax year ending after December 16, 1998, has average annual
gross receipts of $1 million or
less for the 3-tax-year period ending with that prior tax year. A tax shelter cannot be a qualifying taxpayer. See Publication
538 for more
information.
A qualifying small business taxpayer is a taxpayer that: (a) for each prior tax year ending after December 31, 2000, has average annual
gross receipts of $10 million or less for the 3-tax-year period ending with that prior tax year; and (b) whose principal business activity
is not an ineligible activity. 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.
Supplies acquired for sale or that become a physical part of items held for sale must be included in inventory. Deduct
the cost of supplies in the
year used or consumed in operations. Do not include incidental supplies in inventory as these are deductible 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.
Generally, growing crops are not required to be included in inventory. 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 6.
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.
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.
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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.
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. However, if you value your livestock inventory using the farm-price method, then you must obtain permission from the
IRS 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 or downward
to reflect increases or
decreases 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
method you have chosen.
You cannot change your method without obtaining approval from the IRS.
You must include in 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 2006, but
you are not paid until January 2007. You must both include the sale proceeds and deduct the costs incurred in producing the
grain on your 2006 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
2006. Under this method, you include the sale proceeds in income for 2007, the year you receive payment. 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. See Regulations section 1.162-12 for details on deductible expenses of farmers.
Other special methods.
Other special methods of accounting apply to the following items.
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Amortization, see chapter 7.
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Casualties, see chapter 11.
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Condemnations, see chapter 11.
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Depletion, see chapter 7.
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Depreciation, see chapter 7.
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Farm business expenses, see chapter 4.
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Farm income, see chapter 3.
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Installment sales, see chapter 10.
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Soil and water conservation expenses, see chapter 5.
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Thefts, see chapter 11.
Generally, you can 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 the accrual method for reporting your expenses, you must use the accrual method for figuring your income.
Change in Accounting Method
Once you have set up your accounting method, generally you must receive approval from the IRS 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 obtain approval, you must file
Form 3115. You may also have to pay a fee. For more information, see the Form 3115 instructions.
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