The severe drought experienced by much of the United States this year, especially in the country’s agricultural producing section, will mean a record number of crop insurance claims.
Many astute farmers understand that crop insurance proceeds may be deferred for one tax year. However, there are a number of surprising technical parameters that surround the ability of farmers to defer their crop insurance proceeds.
With the uncertainty regarding the 2013 individual income tax rates, any analysis of this tax planning strategy requires a more careful analysis.
Deferral of crop insurance proceeds. Most farmers use the cash method of accounting to report their gross income and deductions from their farming operation. Without a special deferral election provided in the Internal Revenue Code, the crop insurance proceeds would be aggregated with the gross income. If farmers deferred their 2012 crop insurance proceeds until 2013, they may find that this results in more taxes over time.
This election applies to payments made because of damage to crops or the inability to plant crops. Also, the election applies to federal payments received for drought, flood or “any other natural disaster.”
Proceeds from crop insurance related to destruction or damage to crops are treated as if the receipt from insurance proceeds is a “deemed” sale of the crop. Farmers using the cash method of accounting may elect to include crop insurance and disaster payments in gross income in the year following the year of the crop loss. Farmers must establish that it is their normal business practice to report income from the sale of crops in the later year.
Deferral of crop insurance proceeds when other payment types are triggered. Under our current agricultural environment, many farmers purchase insurance policies that also include other insurance coverage features. These might include revenue protection, revenue protection with harvest price exclusion, yield protection and group revenue protection.
Payments received under these types of arrangements are not directly associated with an insured’s actual loss. They are instead tied to low crop yields and/or low prices and may not qualify for the crop deferral election.
As noted above, for crop insurance proceeds to be deferrable, payment under an insurance policy must result from damage to crops or the inability to plant crops. Crop insurance proceeds received for other than damage or destruction of crops are not eligible for deferral.
If a crop insurance payment is based on both crop loss and price loss from a revenue-based crop insurance policy, only the portion intended to reimburse the farmer for crop loss is deferrable.
- The election – in general. To defer the crop insurance proceeds, farmers must make an election on their tax return. The election is made by attaching a separate signed statement to the return for the year of damage or destruction.
Farmers are also permitted to make the election on an amended tax return (assuming that they initially included the insurance proceeds in the year of actual receipt).This election applies to all crop insurance proceeds received during a particular calendar year. However, see the discussion below regarding this “all or nothing” requirement.
Finally, if the technical requirements for the special election cannot be met, deferral can still be achieved if the insurance proceeds for a current year’s crop are not received until the following year.
- Normal business practice requirement. Farmers who plan to make the election to defer crop insurance proceeds must establish that their normal business practice is to report more than 50 percent of their current crop income in the subsequent tax year. There are no “safe-harbor” guidelines for the definition of normal business practice.
The income tax regulations and court decisions require that farmers establish, with respect to the crop on which crop insurance proceeds are received, that more than 50 percent of such proceeds would normally be collected in the subsequent year. This means that farmers must establish a history of reporting more than 50 percent of the crop sales in the subsequent year. If farmers have more than one crop as part of their farming operation, the 50 percent test must be satisfied with respect to each crop.
During the past 10 years, William Smith, a successful farmer, has a history of collecting 45 percent of his corn crop proceeds during the year of harvest and deferring 55 percent to a subsequent year. Smith has demonstrated that his normal business practice would qualify for the crop insurance proceeds deferral election.
However, if Smith’s normal business practice history over the past 10 years was to sell between 40 percent and 65 percent in the year of harvest and sell the remainder of the crop in the subsequent year, it is likely that the normal business practice requirement may not be met. If the aggregate percentage for the 10 years is more than 50 percent, he may qualify.
There is no guidance as to the number of years that should be included in the computation of what comprises the “normal business practice” requirement. Alternatively, there is no guidance if a farmer simply aggregates crop sale activity to determine that more than 50 percent was collected in the subsequent year.
- An “all or nothing” election requirement. The election to defer crop insurance proceeds is an “all or nothing” election. Farmers may not allocate the proceeds between two tax years. They report all of the crop insurance proceeds in the year of receipt or defer 100 percent of the crop insurance proceeds to the following year.
- Multiple crops or business units and the “all or nothing” election requirement. This “all or nothing” aspect of the election to defer crop insurance proceeds applies to each single trade or business of the farmer. All crops that are covered by a single trade or business of the farmer must be reported using the same reporting election.
For example, in a Revenue Ruling published by the Internal Revenue Service, the farmer’s single trade or business was comprised of raising wheat, barley and oats. Insurance proceeds were received for each of these crops.
According to the ruling, the farmer is required to aggregate all crop insurance proceeds either in the year of damage or in the following year. The farmer is not allowed to defer the wheat insurance proceeds to the next year and report the barley and oats proceeds in the current year.
A single trade or business is one using a single set of books and records. Most farming operations comprise one set of books and records that accounts for all their grain production. Therefore, the “all or nothing” rule will require the aggregation of all crop insurance proceeds when making the election to defer the receipt of such proceeds until the tax year.
However, some farmers may use a completely separate set of books for their corn, soybeans, wheat, cattle, etc., operations. In these rare cases of separate trades or businesses under one entity, the farmer may make an election to defer crop insurance proceeds on the basis of each trade or business. The tests are applied to each entity in which the farmer operates. Thus, for the farmer with multiple farming entities, an election made for one entity has no effect on another entity.
Income tax rate uncertainty. The ability to defer crop insurance proceeds is an important planning tool for many farmers. However, for calendar year 2012, this strategy should be reconsidered in light of possible individual tax rate increases.
Single taxpayers with income of $200,000 or joint taxpayers with income of $250,000 will be subject to the 0.9 percent Medicare surtax on earned income. In calendar year 2013, there is the strong possibility that the individual income tax rates may exceed the top 33 percent to 35 percent ordinary tax rates. Also, the 50 percent bonus depreciation provision expires after Dec. 31, 2012. Given these potential tax system changes, a farmer may face significantly higher income tax in calendar year 2013.
As noted above, the crop insurance election can be made on an amended tax return. Also, any election to defer crop insurance proceeds is a binding election on the farmer and is generally not revocable. With the uncertainty of the individual income tax rates for calendar year 2013, it may make sense to include the crop insurance proceeds in 2012, pay the income tax and evaluate the benefit of an election to defer the crop insurance proceeds on an amended tax return in calendar year 2013.
Farmers typically file their Form 1040 tax return on March 1. Another strategy may be to file for an automatic extension of the 2012 Form 1040 tax return to permit the farmer more time to evaluate the benefit of the election. If this strategy is pursued, farmers must follow the liberalized estimated tax payment rules. A required payment is due on Jan. 15, 2013, of either (i) 66.67 percent of the current-year tax or (ii) 100 percent of the prior-year tax liability.
An extension until Oct. 15, 2013, will allow farmers the opportunity to evaluate the price and yield of the crop produced in calendar year 2013. If a farmer expects high crop yields and adequate yield/price protection in calendar year 2013, it may make sense to include the crop insurance proceeds in calendar year 2012 rather than in calendar year 2013. In addition, by Oct. 15, 2013, there may be more certainty regarding tax rates for 2013.
Finally, farmers should consider the decision to defer any crop insurance proceeds in light of the farm income averaging tax provision. When a farmer experiences negative or low taxable income in the three prior base years, the farm income averaging provision may permit the reporting of a higher level of farm or ranch income at a lower marginal tax rate.
In this case, it would be appropriate to include crop insurance proceeds on the farmer’s income tax return for calendar year 2012 vs. deferring to 2013 when averaging may result in a higher averaged income tax rate.
Michael R Miranda, CPA QKA
Williams & Company CPA PC
Sioux Falls, South Dakota