Cash method of accounting is under attack. In February 2017, the IRS issued an Action and Decision letter in response to losing Burnett Ranches LTD v. U.S. Under the Internal Revenue Code, a farm or ranch is deemed to be a “farming syndicate” if more than 35% of losses are allocated to limited partners or limited entrepreneurs. Simply put, more than 65% ownership in a farming entity needs to be held by active farmers.
In Burnett, the court ruled that an active ranch manager who held her interest in the farming operation through an intermediary S corporation was still an active farmer. The Court recognized that farmers may use structures that involve S corporations, trusts and limited liability entities for a variety of reasons.
The IRS said it would not follow the ruling in Burnett, and owning a farming entity through an intermediary S corporation could result in the farming entity being deemed a farming syndicate. Although there has been a push to change the IRS position, as of yet there has not been any resolution. Because of its importance, I thought it would be a good idea to review cash and accrual methods of accounting so farmers understand the difference.
Cash method allows you to recognize income when collected and expense when paid. Income and expenses are readily determinable at any point of the year (no uncertainties because of beginning and ending inventory adjustments). Due to the certainty of determining profit/loss, the farmer can participate in tax planning throughout the year.
The accrual method does not follow cash transactions, it follows the economic events of a farm. That is when the crop is raised or grown, the farmer would recognize income regardless of selling the commodity. Likewise, you would not recognize the expense when you buy inputs, you would recognize expenses when you use them.
Therefore, income and expense associated with raising or growing agricultural commodities are recognized in the same year. The benefit is the farmer typically has an accurate reflection of profit/loss. The disadvantage is there is less flexibility for tax planning.
Farmers have a greater ability to use the cash method than other industries. The definition of farming includes livestock, dairy, poultry, fruit plantations, ranches, orchards and land used in farming operations. Farming does not include raised/grown fish or the resale of agricultural products. If there is significant participation in the raising or growing of agricultural products, the business activity can extend into processing. Therefore, it’s possible for processors to meet the farming definition and use the cash method.
Although most farmers can use the cash method, there are some exceptions that require the accrual method. The most common being farming syndicates and C corporations engaged in farming with more than $25 million in gross receipts that are subject to accrual reporting. One thing that is sometimes missed is the requirement to aggregate all gross revenue from controlled groups.
Editor’s Note: Tax Columnist Rod Mauszycki, J.D., MBT, is a tax principal with CLA (CliftonLarsonAllen) in Minneapolis, Minnesota. Send questions to email@example.com