5. Farm Business Expenses
Important Changes
for 2002
Standard mileage rate. The standard mileage rate
for the cost of operating your car, van, pickup, or panel truck in 2002 is 36½ cents a
mile for all business miles driven. See Truck and Car Expenses.
Self-employed health insurance deduction. If you are self-employed,
you can deduct 70% of your health insurance premium as an adjustment to income for 2002.
See Insurance, later.
Introduction
You can generally deduct the current costs of operating your farm. Current costs are
expenses you do not have to capitalize or include in inventory costs. However, your
deduction for the cost of livestock feed and certain other supplies may be limited. If you
have an operating loss, you may not be able to deduct all of it.
Topics
This chapter discusses:
- Deductible expenses
- Capital expenses
- Nondeductible expenses
- Losses from operating a farm
- Net operating losses
- Not-for-profit farming
Useful Items
You may want to see:
Publication
- 463 Travel, Entertainment, Gift, and Car Expenses
- 535 Business Expenses
- 536 Net Operating Losses (NOLs) for Individuals, Estates, and Trusts
- 587 Business Use of Your Home
- 925 Passive Activity and At-Risk Rules
- 936 Home Mortgage Interest Deduction
Form (and Instructions)
- Sch A (Form 1040) Itemized
Deductions
- Sch F (Form 1040) Profit or Loss From Farming
- 1045 Application for Tentative Refund
- 5213 Election To Postpone
Determination as To Whether the Presumption Applies That an
Activity Is Engaged in for Profit
See chapter 21 for information about getting publications and forms.
Deductible Expenses
The ordinary and necessary costs of operating a farm for profit are deductible business
expenses. Part II of Schedule F lists expenses common to farming operations. This chapter
discusses many of these expenses, as well as others not listed on Schedule F.
Reimbursed expenses. If an
expense is reimbursed, either reduce the expense or report the reimbursement as income
when received. See Refund or reimbursement under Income From Other
Sources in chapter 4.
Personal and business expenses. Some expenses you pay during the tax
year may be partly personal and partly business. These may include expenses for gasoline,
oil, fuel, water, rent, electricity, telephone, automobile upkeep, repairs, insurance,
interest, and taxes.
You must allocate these mixed expenses between their business and personal parts. The
personal part of these expenses is not deductible.
Example. You paid $1,500 for electricity during the tax year.
You used one-third of the electricity for personal purposes and two-thirds for farming.
Under these circumstances, you can deduct two-thirds of your electricity expense ($1,000)
as a farm business expense.
Reasonable allocation. It is not always easy to determine
the business and nonbusiness parts of an expense. There is no method of allocation that
applies to all mixed expenses. Any reasonable allocation is acceptable. What is reasonable
depends on the circumstances in each case.
Prepaid Farm Supplies
Prepaid farm supplies are amounts paid during the tax year for the
following items.
- Feed, seed, fertilizer, and similar farm supplies not used or consumed during the year.
However, do not include amounts paid for farm supplies that you would have consumed if not
for a fire, storm, flood, other casualty, disease, or drought.
- Poultry (including egg-laying hens and baby chicks) bought for use (or for both use and
resale) in your farm business. However, include only the amount that would be deductible
in the following year if you had capitalized the cost and deducted it ratably over the
lesser of 12 months or the useful life of the poultry.
- Poultry bought for resale and not resold during the year.
Deduction limit. If you use
the cash method of accounting to report your income and expenses, your deduction for
prepaid farm supplies in the year you pay for them may be limited to 50% of your
other deductible farm expenses for the year (all Schedule F deductions except prepaid farm
supplies). This limit does not apply if you meet one of the exceptions described later.
If the limit applies, you can deduct the excess cost of farm supplies other than
poultry in the year you use or consume the supplies. The excess cost of poultry bought for
use (or for both use and resale) in your farm business is deductible in the year following
the year you pay for it. The excess cost of poultry bought for resale is deductible in the
year you sell or otherwise dispose of that poultry.
Example. During 2002, you bought fertilizer ($4,000), feed
($1,000), and seed ($500) for use on your farm in the following year. Your total prepaid
farm supplies expense for 2002 is $5,500. Your other deductible farm expenses totaled
$10,000 for 2002. Therefore, your deduction for prepaid farm supplies may not exceed
$5,000 (50% of $10,000) for 2002. The excess prepaid farm supplies expense of $500 ($5,500
- $5,000) is deductible in the later tax year you use or consume the supplies.
Exceptions. This limit on the deduction for prepaid farm
supplies expense does not apply if you are a farm-related taxpayer and either of the
following apply.
- Your prepaid farm supplies expense is more than 50% of your other deductible farm
expenses because of a change in business operations caused by unusual circumstances.
- Your total prepaid farm supplies expense for the preceding 3 tax years is less than 50%
of your total other deductible farm expenses for those 3 tax years.
You are a farm-related taxpayer if any of the following tests apply.
- Your main home is on a farm.
- Your principal business is farming.
- A member of your family meets (1) or (2).
For this purpose, your family includes your brothers and sisters, half-brothers and
half-sisters, spouse, parents, grandparents, children, grandchildren, and aunts and uncles
and their children.
 Whether or not
the deduction limit for prepaid farm supplies applies, your expenses for prepaid livestock
feed may be subject to the rules for advance payment of livestock feed, discussed next.
Prepaid Livestock Feed
If you report your income and expenses under the cash method of
accounting, you cannot deduct in the year paid the cost of feed your livestock will
consume in a later year unless you meet all of the following tests.
- The payment is for the purchase of feed rather than a deposit.
- The prepayment has a business purpose and is not merely for tax avoidance.
- Deducting the prepayment does not result in a material distortion of your income.
If you meet all three tests, you can deduct the prepaid feed, subject to the limit on
prepaid farm supplies discussed earlier.
If you fail any of these tests, you can deduct the prepaid feed only in the year it is
consumed.
This rule does
not apply to the purchase of commodity futures contracts.
Payment for the purchase of feed. Whether a payment is for the
purchase of feed or a deposit depends on the facts and circumstances in each case. It is
for the purchase of feed if you can show you made it under a binding commitment to accept
delivery of a specific quantity of feed at a fixed price and you are not entitled, by
contract or business custom, to a refund or repurchase.
The following are some factors that show a payment is a deposit rather than for the
purchase of feed.
- The absence of specific quantity terms.
- The right to a refund of any unapplied payment credit at the end of the contract.
- The seller's treatment of the payment as a deposit.
- The right to substitute other goods or products for those specified in the contract.
A provision permitting substitution of ingredients to vary the particular feed mix to
meet your livestock's current diet requirements will not suggest a deposit. Further, a
price adjustment to reflect market value at the date of delivery is not, by itself, proof
of a deposit.
Business purpose. The prepayment has a business purpose only if you
have a reasonable expectation of receiving some business benefit from prepaying the cost
of livestock feed. The following are some examples of business benefits.
- Fixing maximum prices and securing an assured feed supply.
- Securing preferential treatment in anticipation of a feed shortage.
Other factors considered in determining the existence of a business purpose are whether
the prepayment was a condition imposed by the seller and whether that condition was
meaningful.
No material distortion of income. The following are some factors
considered in determining whether deducting prepaid livestock feed materially distorts
income.
- Your customary business practice in conducting your livestock operations.
- The expense in relation to past purchases.
- The time of year you made the purchase.
- The expense in relation to your income for the year.
Labor Hired
You can deduct reasonable wages paid for regular farm labor,
piecework, contract labor, and other forms of labor hired to perform your farming
operations. You can pay wages in cash or in noncash items such as inventory, capital
assets, or assets used in your business. The cost of boarding farm labor is a deductible
labor cost. Other deductible costs you incur for farm labor include health insurance,
workers' compensation insurance, and other benefits.
If you must withhold social security, Medicare, and income taxes from your employees'
cash wages, you can still deduct the full amount of wages before withholding. See chapter
16 for more information on employment taxes. Also, deduct the employer's share of the
social security and Medicare taxes you must pay on your employees' wages as a farm
business expense on the Taxes line of Schedule F (line 31). See Taxes, later.
Property for services. If you transfer property to an employee in
payment for services, you can deduct as wages paid the fair market value of the property
on the date of transfer. If the employee pays you anything for the property, deduct as
wages the fair market value of the property minus the payment by the employee for the
property. Treat the wages deducted as an amount received for the property. You may have a
gain or loss to report if the property's adjusted basis on the date of transfer is
different from its fair market value. Any gain or loss has the same character the
exchanged property had in your hands. For more information, see chapter 10.
Child as an employee. You can deduct reasonable wages or other
compensation you pay to your child for doing farm work if a true employer-employee
relationship exists between you and your child. Include these wages in the
child's income. The child may have to file an income tax return. These wages may also be
subject to social security and Medicare taxes if your child is age 18 or older. For more
information, see Family Employees in chapter 16.
The fact that your child spends the wages to buy clothes or other necessities you
normally furnish does not prevent you from deducting your child's wages as a farm expense.
Spouse as an employee. You can deduct reasonable wages or other
compensation you pay to your spouse if a true employer-employee relationship exists
between you and your spouse. Wages you pay to your spouse are subject to social security
and Medicare taxes. For more information, see Family Employees in chapter 16.
Nondeductible Pay
You cannot deduct wages paid for certain household work, construction work, and
maintenance of your home. However, those wages may be subject to the employment taxes
discussed in chapter 16.
Household workers. Do not deduct amounts paid to persons engaged in
household work, except to the extent their services are used in boarding or otherwise
caring for farm laborers.
Construction labor. Do not deduct wages paid to hired help for the
construction of new buildings or other improvements. These wages are part of the cost of
the building or other improvement. You must capitalize them.
Maintaining your home. If your farm employee spends time maintaining
or repairing your home, the wages and employment taxes you pay for that work are
nondeductible personal expenses. For example, assume you have a farm employee for the
entire tax year and the employee spends 5% of the time maintaining your home. The employee
devotes the remaining time to work on your farm. You cannot deduct 5% of the wages and
employment taxes you pay for that employee.
Employment Credits
Reduce your deduction for wages by the amount of any employment
credits you claim. The following are employment credits and their related forms.
- Empowerment zone and renewal community employment credit (Form 8844).
- Indian employment credit (Form 8845).
- Welfare-to-work credit (Form 8861).
- Work opportunity credit (Form 5884).
For more information, see the forms and their instructions.
Repairs and Maintenance
You can deduct most expenses for the repair and maintenance of your
farm property. Common items of repair and maintenance are repainting, replacing
shingles and supports on farm buildings, and minor overhauls of trucks, tractors, and
other farm machinery. However, repairs to, or overhauls of, depreciable property that
substantially prolong the life of the property, increase its value, or adapt it to a
different use are capital expenses. For example, if you repair the barn roof, the cost is
deductible. But if you replace the roof, it is a capital expense. For more information,
see Capital Expenses, later.
Interest
You can deduct as a farm business expense interest paid on farm
mortgages and other obligations you incur in your farm business.
Cash method. If you use the cash method of accounting, you can
generally deduct interest paid during the tax year. You cannot deduct interest paid with
funds received from the original lender through another loan, advance, or other
arrangement similar to a loan. You can, however, deduct the interest when you start making
payments on the new loan.
Prepaid interest. Under the cash method, you generally
cannot deduct any interest paid before the year it is due. Interest paid in advance may be
deducted only in the tax year in which it is due.
Accrual method. If you use an accrual method of accounting, you can
deduct only interest that has accrued during the tax year. However, you cannot deduct
interest owed to a related person who uses the cash method until payment is made and the
interest is includible in the gross income of that person. For more information, see Accrual
Method in chapter 3.
Allocation of interest. If you use the proceeds of a loan for more
than one purpose, you must allocate the interest on that loan to each use. Allocate the
interest to the following categories.
- Trade or business interest.
- Passive activity interest.
- Investment interest.
- Portfolio interest.
- Personal interest.
You generally allocate interest on a loan the same way you allocate the loan proceeds.
You allocate loan proceeds by tracing disbursements to specific uses.
 The easiest way
to trace disbursements to specific uses is to keep the proceeds of a particular loan
separate from any other funds.
Secured loan. The allocation of loan proceeds and the
related interest is generally not affected by the use of property that secures the loan.
Example. You secure a loan with property used in your farming
business. You use the loan proceeds to buy a car for personal use. You must allocate
interest expense on the loan to personal use (purchase of the car) even though the loan is
secured by farm business property.
If the property
that secures the loan is your home, you generally do not allocate the loan proceeds or the
related interest. The interest is usually deductible as qualified home mortgage interest,
regardless of how the loan proceeds are used. For more information, see Publication 936.
Allocation period. The period for which a loan is allocated
to a particular use begins on the date the proceeds are used and ends on the earlier of
the following dates.
- The date the loan is repaid.
- The date the loan is reallocated to another use.
More information. For more information on interest, see chapter 5 in
Publication 535.
Breeding Fees
You can deduct breeding fees as a farm business expense.
However, if you use an accrual method of accounting, you must capitalize breeding fees and
allocate them to the cost basis of the calf, foal, etc. For more information on who must
use an accrual method of accounting, see Accrual method required under Accounting
Methods in chapter 3.
Fertilizer and Lime
You can deduct in the year paid or incurred the cost of fertilizer,
lime, and other materials applied to farm land to enrich, neutralize, or condition
it. You can also deduct the cost of applying these materials in the year you pay or incur
it. However, see Prepaid Farm Supplies, earlier, for a rule that may limit your
deduction for these materials.
If the benefits of the fertilizer, lime, or other materials last substantially more
than one year, you generally must capitalize their cost and deduct a part each year the
benefits last. However, you can choose to deduct these expenses in the year paid or
incurred. If you make this choice, it can only be changed with IRS approval.
Farm land is land used for producing crops, fruits, or other agricultural products or
for sustaining livestock. It does not include land you have never used previously for
producing crops or sustaining livestock. You cannot deduct initial land preparation costs.
(See Capital Expenses, later.)
Include government payments you receive for lime or fertilizer in income. See Fertilizer
and Lime under Agricultural Program Payments in chapter 4.
Taxes
You can deduct as a farm business expense the real estate and
personal property taxes on farm business assets, such as farm equipment, animals,
farm land, and farm buildings. You also can deduct the social security and Medicare taxes
you pay to match the amount withheld from the wages of farm employees and any federal
unemployment tax you pay. For information on employment taxes, see chapter 16.
Allocation of taxes. The taxes on the part of your farm you use as
your home (including the furnishings and surrounding land not used for farming) are
nonbusiness taxes. You may be able to deduct these nonbusiness taxes as itemized
deductions on Schedule A (Form 1040). To determine the nonbusiness part, allocate the
taxes between the farm assets and nonbusiness assets. The allocation can be done from the
assessed valuations. If your tax statement does not show the assessed valuations, you can
usually get them from the tax assessor.
State and local general sales taxes. State and local general sales taxes on nondepreciable farm business expense
items are deductible as part of the cost of those items. Include state and local
general sales taxes imposed on the purchase of assets for use in your farm business as
part of the cost you depreciate. Also treat the taxes as part of your cost if they are
imposed on the seller and passed on to you.
State and federal income taxes. Individuals cannot deduct state and federal income taxes as farm business
expenses. Individuals can deduct state income tax only as an itemized deduction on
Schedule A (Form 1040). You cannot deduct federal income tax.
Highway use tax. You can
deduct the federal use tax on highway motor vehicles paid on a truck or truck tractor used
in your farm business. For information on the tax itself, including information on
vehicles subject to the tax, see the instructions for Form 2290, Heavy Highway Vehicle
Use Tax Return.
Self-employment tax deduction. You can deduct one-half of your
self-employment tax in figuring your adjusted gross income on Form 1040. For more
information, see chapter 15.
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