The legal and tax issues that farmers and ranchers can potentially face are practically innumerable. Today, I have pulled four more out of the hat to discuss briefly.
The first can occur if you have a C corporation and retain too much of the corporate earnings in the corporation. The next one discusses the possibility of using the funds in a 401(k) as start-up capital for a farming business. Will it work? What might be a trigger for the IRS to examine? Then, I turn my attention to Ag Data. With any technology, there are pros and cons. What might some of those be for Ag Data? Finally, I briefly discuss how to utilize the home-sale gain exclusion rule best when selling a farm.
More food for thought on ag law and taxes – it’s the topic of today’s Firm to Farm blog post by RFD-TV Farm Legal and Tax Expert Roger McEowen with the Washburn School of Law.
Accumulated Earnings Tax
The accumulated earnings tax is a tax you may not have heard about. But, if your farming business is in a C corporation or an S corporation that used to be a C corporation, it’s a tax you should be aware of.
The accumulated earnings tax is a 20 percent penalty imposed when a corporation retains earnings over $250,000 that are beyond the reasonable needs of the business instead of paying dividends. Not paying dividends avoids the shareholder-level tax on dividends.
Whether a purpose exists to avoid the shareholder-level tax is a subjective determination based on the facts and circumstances. Don’t unreasonably accumulate corporate earnings while not paying dividends. Also, don’t use corporate earnings for investments unrelated to the farming business. Corporate loans to a shareholder for personal purposes are a “no-no,” as is the use of corporate funds for a shareholder’s personal benefit.
Make sure you document why you are retaining earnings. Reasons such as needing cash to buy more farmland, insuring against business risks, or buying out a senior member of the family business are fine.
But, again, make sure you record your reasons for the accumulations in your corporate annual meeting minutes and other corporate documents. And remember, if the accumulated earnings tax applies, it’s in addition to the corporate tax liability. It’s a pure penalty.
Using a 401(k) for Farming Start-Up Capital
One of the drawbacks of starting farming on a full-time basis is the lack of capital. However, you might have a substantial asset that you could tap to create the necessary working capital.
If you have a 401(k), you can use the funds to start a farming business. To do this, you will need to create a C corporation to establish a 401(k) plan and then roll over your current 401(k) at the old employer into the new 401 (k) plan. The new plan will then buy shares in the corporation and become an owner. The money put into the corporation will then become the working capital that the corporation can use to buy equipment, plant crops, and so forth.
There is no limit on how much stock the 401(k) can buy. Unlike borrowing money from a 401(k), which is limited to $50,000, or cashing in the plan and paying taxes and a 10 percent penalty on the funds received, you can maximize the amount of capital you put into the farm business.
The IRS has noted some abuses with these transactions. For example, some people have set up a corporation to buy a motor home. If you do that and get audited, you can expect the IRS to disallow the purchase for tax purposes. However, if you use the cash to create a farming entity and will be actively farming, there should be no issue with using your 401(k) to fund it. Actively farming – that’s the key.
Ag Data and Proof of Damages
The case is Houin v. Indiana Department of Natural Resources, 205 N.E.3d 196 (Marshall Co. Cir. Ct. 2021), aff’d. in part and rev’d in part, Indiana Department of Natural Resources v. Houin, 191 N.E.3d 241 (Ind. Ct. App. 2022).
Farmers have several reasons for collecting ag data about their farming practices. One of those might be to prove damage to crops in court. In one recent case, managing a lake dam increased the lake level and made farm field tile ineffective in draining significant rainfalls. The result was that water ponded in the fields and significantly reduced crop yields. But could the farmer prove his damages in terms of lost yield and revenue?
With harvesting data, the court could see exactly where the flooded areas of the fields were and how flooding specifically affected yields. The data showed that flooding, and not soil type, was the reason for the lower yields in the flooded parts of the fields. Drone photos were also used to confirm the yield data. The court could see how the pictures of the fields matched the harvest data. Comparison data from nearby fields that did not drain into the lake watershed was also used to show the yield without the elevated lake level.
The court awarded the farmer almost $500,000 in damages for crop loss and field tile. Ag data helped make the case and will be an important part of many future ag tort cases.
Utilizing Home Sale Exclusions When Selling A Farm
How much land can be carved out and sold with the farm home to qualify for a special tax break when selling the farm?
For married taxpayers who file jointly, up to $500,000 of gain attributable to the sale of the taxpayer’s principal residence can be excluded from income. One-half of that amount is for a taxpayer who files as a single person. But what if the farm sale also involves the residence? How much (if any) of the farmland and outbuildings can be included with the residence to fill that $500,000 amount?
Under current tax regulations, farmland can be treated as part of the principal residence if it is adjacent to land containing the home and is used as part of or along with the home. What is the practical application of those requirements? The IRS rulings and court decisions indicate that the barnyard and areas used in connection with the home can be included as the “residence” portion of the sale. Also, local zoning rules can come into play. For many farm sales, an acre or two can likely be included with the home.
Of course, each situation depends on the facts, and the outcome depends on the situation. But, if the facts support it, including some adjacent land with the principal residence can be a significant tax-saving technique. It’s best to fill out that $500,000 if your facts allow you.
Conclusion
It’s harvest season, so be careful and use common sense for those in harvest. I have been on the road from North Dakota to Iowa to western Nebraska. This week, my travels will take me to Idaho for an all-day tax seminar and a day of Steelhead fishing on the Salmon River. Hopefully, I’ll get some good pictures to share with you. Then it’s on to West Texas for two days of tax lecturing. Then, there will be a couple of events in Kansas before the fall KSU Tax Institutes begin. I have also mixed in a couple of events for high school students – trying to plant seeds in the minds of young people of the need for well-trained rural attorneys. I enjoy their questions and their enthusiasm and energy. A tip of my hat to their teachers – I couldn’t do it.
