Overview
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 briefly discuss. The first one is one that 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 best utilize the home-sale gain exclusion rule when selling a farm.
More food for thought on the topic of ag law and taxes – it’s the topic of today’s post.
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 that is 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. Such reasons as needing cash to buy more farmland or 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 what the corporate tax liability is. It’s a pure penalty.
Using a 401(k) for Start-Up Capital
One of the drawbacks to starting in farming on a full-time basis is the lack of capital. But you just might have a substantial asset that you could tap to create the necessary working capital.
If you have a 401(k), you might be able to 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 and plant crops and so forth.
There is no limit on how much stock the 401(k) can buy. This means that 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. Some people have set up a corporation simply to buy a motor home for example. If you do that and get audited, you can expect the IRS to disallow the purchase for tax purposes. But 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
Farmers have several reasons to collect ag data about their farming practices. One of those might be to prove damage to crops in court. In one recent case, the management of a lake dam increased the lake level and made farm field tile in the area ineffective to drain 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 was able to 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 what the yield would have been 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 ag tort cases in the future.
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).
Utilizing the Home Sale Exclusion When Selling the Farm
When selling the farm, how much land can be carved out and sold with the farm home to qualify for a special tax break?
For married taxpayers that file jointly up to $500,000 of gain that is attributable to the sale of the taxpayer’s principal residence can be excluded from income. It’s one-half of that amount for a taxpayer that 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 up 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 is dependent on the facts and the outcome depends on the particular situation. But, if the facts support it, including at least some adjacent land with the principal residence can be a significant tax-saving technique. It’s best to fill up that $500,000 amount if your facts allow you to do it.
Conclusion
It’s harvest season, so for those of you in harvest be careful and use common sense. I have been on the road quite a bit recently – from North Dakota to Iowa to western Nebraska. This week my travels take me to Idaho for an all-day tax seminar followed by 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 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.