Editor: Michael D. Koppel, CPA/CITP/PFS, MSA, MBA
The severe drought experienced by much of the United States this year, especially in agricultural regions, is expected to produce a record number of crop insurance claims.
Many astute farmers know that under Sec. 451(d), crop insurance proceeds may be deferred in some circumstances to the tax year following that of crop damage or destruction. However, a number of surprising technical parameters surround the deferral. With the possibility of higher 2013 individual income tax rates, if farmers defer their 2012 crop insurance proceeds until 2013, they may pay more taxes over time. Any analysis of this tax planning strategy requires care.
Deferral of Crop Insurance Proceeds
Most farmers use the cash method of accounting to report gross income and deductions from farming operations. Without a special deferral election provided in Sec. 451(d), crop insurance proceeds would be included in gross income in the year received.
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” (Sec. 451(d)).
Proceeds from crop insurance related to crop destruction or damage are treated as a deemed sale of the crop. To elect to include crop insurance and disaster payments in gross income in the year following the year of the crop loss, farmers must use the cash method of accounting and must establish that it is their normal business practice to report more than 50% of income from the sale of the crop in a later year (Rev. Rul. 74-145).
Other Payment Types
In the current agricultural environment, many farmers purchase insurance policies that also include other insurance coverage features, such as revenue protection, revenue protection with harvest price exclusion, yield protection, and group revenue protection.
Payments received under these arrangements are not directly associated with an insured’s actual crop loss. They are instead tied to low crop yields and/or low prices and may not qualify for the crop insurance 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, the farmer can defer only the portion intended as reimbursement for crop loss.
The election—in general: To defer crop insurance proceeds, farmers must make an election on their tax return by attaching a separate, signed statement for the year of damage or destruction (Regs. Sec. 1.451-6(b)(1)). 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).
If the farmer cannot meet the technical requirements for the special election, under cash-basis principles the farmer will still include the insurance proceeds for a current year’s crop in income in the following year if the insurance proceeds are not received until that year.
Normal business practice requirement: To make the election to defer crop insurance proceeds, farmers must establish that under their normal business practice, they would have reported more than 50% of the crop income in the following tax year. There are no safe-harbor guidelines for the definition of “normal business practice.” This means that farmers must establish a history of reporting crop sales proceeds in this manner. If farmers have more than one crop as part of their farming operation, the 50% test must be satisfied with respect to each crop.
Example: During the past 10 years, W, a successful farmer, has had a history of collecting 45% of his corn crop sales proceeds during the year of harvest and receiving 55% in a subsequent year. W has demonstrated that his normal business practice qualifies for the crop insurance proceeds deferral election.
However, if W’s normal business practice history over the past 10 years was to sell between 40% and 65% in the year of harvest and sell the remainder of the crop in each subsequent year, the normal business practice requirement probably is not met.
There is no guidance about how many years establish normal business practice or whether a farmer can aggregate sales percentages over a period of years (where in some years the percentage of the sales proceeds is more than 50% in the following year and in other years it is less than 50%) to meet the 50% requirement.
An “all or nothing” election requirement: The election to defer crop insurance proceeds is “all or nothing.” Farmers may not allocate the proceeds between the two tax years (Rev. Rul. 74-145). They must report all of the crop insurance proceeds in the year of receipt or defer all of them to the following year.
Multiple crops or business units and the “all or nothing” election requirement: This all-or-nothing rule 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 election.
For example, in Rev. Rul. 74-145, a farmer’s single trade or business was raising wheat, barley, and oats. The farmer received insurance proceeds for each of these crops. According to the ruling, the farmer was required to aggregate all crop insurance proceeds either in the year of damage or in the following year. The farmer could not 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 grain farming operations use one set of books and records for all their grain production. Therefore, for such farmers, the all-or-nothing rule requires them to aggregate all grain insurance proceeds when electing to defer the recognition of such proceeds until the following tax year.
However, some farmers may use a completely separate set of books for each of their operations related to corn, soybeans, wheat, cattle, etc. In such cases, farmers may elect 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 a 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 and business tax increases. In tax years beginning after Dec. 31, 2012, single taxpayers with wage income from employment of more than $200,000 or joint taxpayers with wages of more than $250,000 will be subject to the 0.9% Medicare surtax on wages in excess of those amounts. In calendar year 2013, individual income tax rates of 33% and 35% also are currently scheduled to increase to 36% and 39.6%, respectively. Also, the 50% bonus depreciation provision (Sec. 168(k)) expires on Dec. 31, 2012. Given these potential changes, a farmer may face significantly higher income taxes in 2013.
As noted above, the crop insurance election can be made on an amended tax return (Regs. Sec. 1.451-6(b)(1)). Also, the election is binding and is generally not revocable (Regs. Sec. 1.451-6(b)(2)). With the uncertainty of the individual income tax rates and other provisions for 2013, it may make sense to include crop insurance proceeds in income in 2012, pay the income tax, and evaluate the benefit of an election to defer the crop insurance proceeds to 2013 on an amended tax return for 2012.
Another strategy may be to file for an automatic extension of the 2012 Form 1040, U.S. Individual Income Tax Return, to permit the farmer more time to evaluate the benefit of the election. If this strategy is pursued, farmers must follow the estimated tax payment rules. (Farmers typically file their Form 1040 by March 1 to avoid the penalty for underpayment of estimated tax (Sec. 6654(i)(1)(D)).) A required payment is due on Jan. 15, 2013, of either 66.67% of the current-year tax or 100% of the prior-year tax liability.
An extension until Oct. 15, 2013, will allow farmers to evaluate the price and yield of the crop produced in calendar year 2013. If a farmer expects a high crop yield 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 should 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, averaging may provide an overall 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 versus deferring to 2013, when averaging may result in a higher average income tax rate.
Michael Koppel is with Gray, Gray & Gray LLP in Westwood, Mass.
For additional information about these items, contact Mr. Koppel at 781-407-0300 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with CPAmerica International.