Agriculture & Business

Management

Tax Management Opportunities

Caused by the Drought

Presented at the Colorado Farm Show

January 28, 2003

Jeffrey E. Tranel

Agricultural & Business Management Economist

Financial Situation Due to 2002 Drought

Financial Situation Due to 2002 Drought

With no farm profits and no other income,

there is no money for

principal repayment,

family living,

investments,

etc.

Financial Situation Due to 2002 Drought

“My Biggest Tax Problem

Is

Not Paying Enough Taxes!”

Crop Producer:With Losses (No Profits)

Crop ProducersProduced A Crop?

• Higher prices may have offset reduced yields.

• Reduced expenses due to reduced amount of acres.

Crop ProducersReceived Crop Insurance Revenues?

• Revenues may have allowed a profit.– Some income.– Reduced expenses.

Crop ProducersReceived Crop Insurance Revenues?

• Crop insurance revenues may be claimed as taxable income in the year that sales normally occur.– Use cash method of accounting.– Receive proceeds in same tax year that crops are

damaged.– Can show that the income from damaged crops

would have included in the following year.

Crop ProducersHave Carry-Over Sales?

If have “carry over” income and little/no profits, may want to recognize such income to offset current year expenses.– rather than continuing to carry forward income.– rather than pre-paying expenses.

Crop ProducersOther?

• Do not elect accelerated depreciation.

• Use other profits to offset farm losses.

Livestock ProducersFeed Assistance Program

• Such payments must be included in the year of receipt.

Livestock Producers IRS Code Sections 451(e) and 1033(e).

• Requirements of taxpayer.– Qualified farmer.– Uses cash method of accounting.– Sale would not have occurred except for

drought.

Tax Code Section 451(e)

• Primarily for sales of market/feeder animals.

• Allows for deferring recognition of forced sale income to the following year.

• Livestock sold due to drought, flood, or other weather related conditions.

• Area must be designated as eligible for assistance by the federal government.

Tax Code Section 1033(e)

• Allows for the non-recognition of the gain on the sale of breeding livestock.– Horses qualify if used for draft, breeding, or dairy.– Poultry is expressly excluded from livestock.

• Animals sold in excess of normal numbers due to drought (involuntary conversion).

Replacing Property Lost Due to Involuntary Conversion

• Replacement property must be purchased.

• The taxpayer's basis in the property is its cost.

• Replacement property acquired by gift, or tax-free exchange, is not eligible for deferral.– Since the basis of the property is not cost.

Replacing Property Lost Due to Involuntary Conversion

Must be similar or related in service or use.– Functions in the same way.

• Breeding cow and dairy cow do not qualify.

Replacing Property Lost Due to Involuntary Conversion

If reinvestment in similar use property is not feasible because of soil or other environmental contamination,

Livestock may be replaced by other property “used for farming purposes.”

Toxic chemicals are the contaminant.

Brucellosis infected cattle do not qualify (bacterial).

Replacing Property Lost Due to Involuntary Conversion

The converted property must be replaced within a two-year period. – The period ends two years after the close of the

first taxable year in which any part of the gain on the conversion is realized.

– Replacement of the converted property must be completed by the end of the period.

• Merely exerting best efforts to replace property within the period is not adequate.

• Even the fact that replacement property is not available does not stop the running of the replacement period.

Sales in 2002 = Replacement by 31 Dec 2004

Destruction of Diseased Livestock Example: Elk Ranches with Chronic Wasting Disease

Generally, the death or disposition of livestock "by or on account of disease" is an involuntary conversion.

The livestock do not actually have to contract a disease.– Exposure to disease and then sold on

account of this exposure is sufficient. – Cause of death may be lethal injection

given by the State Veterinarian.

1033e Decision Tool(An Excel Template)

1033e Decision Tool(An Excel Template)

1033e Decision Tool(An Excel Template)

1033e Decision Tool(An Excel Template)

Elect to Postpone the Gain?

• In most cases, one is better off postponing the gain.

• Value of Cash and Cattle in 2005 for example ranch (please see 1033e Decision Tool)

– Typical Year $263,538– Drought Ends-Deferred Taxes 148,906– Drought Ends-No Tax Deferment

145,651– Drought Ends-Repl Increase, Deferred Taxes 74,906– Drought Ends-Repl Increase, No Deferment 71,651– Drought Continues-No repl, deferment 114,818– Drought Continues-No repl, no deferment

112,580

Advantages of Postponing the Gain

• Rancher has use of the money• Reduce debt (interest savings)• Invest to generate income.

• Tax return can be amended without penalty (only interest will be assessed).

• Tax liability may be higher in current year.• Abnormally high profits and other income.

Advantages of Paying the Tax

– Less risk of the money not being available.• Family living• Operating expenses

– Greater flexibility in replacing animals.• Type.• Timing.

– Current year tax situation may reduce gains.• Net operating losses (NOL).• Reduced profitability in current year.

What to do with the Money?

Funds need to be available to:– Replace livestock.– Pay taxes (if replacements are not purchased).

• YES– Escrow Account– Debt Reduction with Contingent Liability– Low Risk Investment– Reduce Operating Debt (line of credit)

• NO– Pre-pay term debt– Use for operating expenses– Use for family living

Replacing the Cow Herd

• Should you get back into the cattle business?– Personal and family issues.– Business risks.– Range/pasture recovery.– Financing alternatives.

Personal & Family Issues

• Age.• Health.• Stress.• Personal Goals.

• Family Goals.• Equity Management.• Personalities.

Business Risks

• Production risks.

• Marketing risks.

• Financial risks.

• Legal risks.

• Human risks.

Range & Pasture Recovery

• Current range conditions.

• Grazing management recommendations.

• Re-stocking rates.

• Supplementation.

Typical Partial Budget

Positive Outcomes– Reduced Costs– Increased Returns

– Total Positive

Negative Outcomes– Reduced Returns– Increased Costs

– Total Negative

Positive – Negative = Net Impact

Contact A Tax Professional

• Competent.

• Understands your situation.– Business.– Finances.– Business goals.– Personal goals.– Personality.

jtranel@colostate.eduwww.coopext.colostate.edu/ABM