Tax breaks commonly used by farmers and ranchers also tend to raise red flags with the Internal Revenue Service, increasing the likelihood of an audit.
“In general, tax returns with enormous losses or with a big swing in income from one year to the next get a critical eye from IRS,” said Brent Bright, principal at KCoe Isom, based in Loveland, Colorado. But, sometimes, it’s a mismatch in the details of a return that draw attention.
As farmers prepare to file their 2019 taxes, DTN asked experts to explain seven common red flags that lead to audits.
#1. UNMATCHED INCOME REPORTING
The IRS’s computer system will automatically generate a notice if you don’t report all the income others are reporting on your behalf, Bright said. This includes 1099s from people you’ve done work for (anyone who has paid you $600 or more in the course of trade or business) or K-1 income from your partnerships. Make sure you have all the forms you need before filing your return and include all the pertinent information like the used farm equipment for sale you expended money on.
#2. WORKER DESIGNATION
The IRS knows employers would rather hire independent contractors than employees, allowing them to avoid paying payroll taxes such as Social Security and Medicare, workman’s comp, etc. That’s why it created strict guidelines on how to determine if your worker is an independent contractor or an employee.
If you only, or mostly, hire independent contractors on your farm or ranch, that could be a red flag, said Rod Mauszycki, DTN tax columnist and principal at CliftonLarsonAllen in Minneapolis. It’s also important to make sure you’re compliant with IRS, federal and state labor laws and that you complete the paperwork, whether it’s an I-9 or W-4, correctly. The IRS will not be able to match incorrect Social Security or identification numbers on the 1099s or W-2s you file.
#3. HIGH OFF-FARM OR LOW ON-FARM INCOME WITH HIGH DEDUCTIONS
IRS is hot on the trail for “hobby losses,” said Roger McEowen, Kansas Farm Bureau professor of agricultural law and taxation at Washburn School of Law in Topeka.
“IRS is very suspicious if you have a nice off-farm income and show a loss on a Schedule F,” he said, adding that a prime example would be someone with horses on 20 to 40 acres claiming a loss. If you have had sustained losses for a long period of time, IRS will question whether you operate a legitimate farm business.
The IRS will also question high deductions to see if they are active or passive losses. If you do not “materially participate” in the farm, your losses are considered passive, and your deduction is limited to the extent of your passive income (such as cash rent, dividends and interest). You cannot deduct passive losses against your wage or salary.
Disproportionate charitable deductions are another red flag.
“If you give $25,000 to charity and your farm income is only $50,000, that is suspicious to IRS,” McEowen said, adding the IRS will wonder if you are hiding other income.
#4. SECTION 199A QUALIFIED BUSINESS INCOME
This generous 20% deduction of qualified business income for owners of sole proprietorships, partnerships, S corporations and some trusts and estates — but not C corporations — is in its second year, but regulations are still being formulated. The deduction is limited to 50% of the W-2 wages paid by the business.
In years of a loss, a negative 199A deduction carries forward into future years and reduces or eliminates the current 199A deductions. Also, proper aggregation elections can maximize this deduction, Mauszycki said, adding that because it’s a complicated but lucrative deduction, it’s best to work with an expert tax counsel when claiming this deduction.
#5. CONSERVATION EASEMENTS
This is another hot button for IRS, McEowen said. A taxpayer can donate a qualified real property interest to a qualified organization and receive a charitable contribution deduction. However, the easement has to be for conservation purposes protected in perpetuity (forever).
That is a high standard to meet, as proven by several recent high-profile IRS decisions. For instance, the IRS disallowed a $33.41 million charitable deduction for a conservation easement because the mortgage holders were entitled to insurance proceeds in preference to the land trust.
The IRS also won a court case disallowing a $16 million deduction for a conservation easement because the deed said if a forced court sale occurred, the charity’s payment would be tied to the percentage of the property’s value when the contribution was made, not when the forced sale occurred. The entire deduction was disallowed.
IRS often disputes the valuation of a conservation easement, Bright said. “Be sure to hire a certified, state-licensed land appraiser and keep the appraisal forever.”
#6. S CORPORATION BASIS
The IRS requires S corporations to attach a shareholder basis schedule if the shareholder reports a loss, receives a distribution, sells stock or received a loan repayment for the S corp. Tracking basis will show the IRS if a distribution in excess of basis was paid out, explained Mauszycki. “This would result in additional taxable income.”
#7. CAPITAL ACCOUNTS FOR PARTNERSHIPS
New reporting standards for partnerships go into effect this year, with the IRS requiring partnerships to report capital accounts on a tax basis. This will flag distributions that should be taxable and could increase the odds of an audit.
It’s also important to make sure there’s no intermingling among farm and personal bank accounts and record keeping. If you are audited by the IRS and haven’t carefully separated your farm and personal expenses, the IRS will likely deny many of your farm expenses, resulting in a very expensive tax bill and penalty, which has a reputation for putting farms out of business.
Bright, Mauszycki and McEowen said that all of the potential red flags are also legitimate deductions and classifications. That means farmers shouldn’t be afraid to use them, but they do need to be prepared to defend them with detailed income and expense records.