Extension Responds: Drought
Income Tax Consequences of Purchasing Fertilizer in the Fall
By Philip E. Harris, Department of Agricultural and Applied Economics,
University of Wisconsin-Madison/Extension,
August 21,2003
Introduction
Volatile prices for fertilizer may cause some producers to buy their fertilizer this fall rather than waiting until next spring. The income tax consequence of the purchase is one factor to consider when making that decision.
When is the Deduction Most Beneficial?
Producers should consider whether the deduction for the cost of the fertilizer would be more beneficial on their 2003 income tax return or their 2004 income tax return. Generally, the earlier a deduction can be claimed the better since it will postpone income tax liability. Purchasing fertilizer in the fall of 2003 reduces the income taxes that must be paid by the end of February 2004. By contrast, purchasing fertilizer in the spring of 2004 reduces income taxes that don't have to be paid until the end of February 2005.
Producers should be careful not to reduce 2003 income too far below their normal income because that can increase total income tax liability. In general, keeping taxable income as level as possible from one year to the next minimizes income taxes because the marginal income tax rate increases as income rises. The extra taxes paid on income in the high brackets are not fully offset by lower taxes in the low-income years. Keeping farm income above about $4,000 per year also helps to maximize Social Security benefits. If fertilizer for the 2004 crop is purchased in 2003, that cost will be deducted on the 2003 income tax return rather than the 2004 return. The deduction in 2003 could cause 2003 taxable income to be lower than normal and 2004 taxable income to be higher than normal.
Example 1. John and Mary Farmer normally have about $50,000 of taxable income on their joint return. In 2003, they purchased $15,000 of fertilizer that they normally would have purchased the following spring. That reduces their taxable income for 2003 to $35,000. If they revert to buying their fertilizer in the spring for their 2005 crop, their 2004 taxable income could be $15,000 higher than normal.
Many other factors can affect taxable income each year, and taxpayers can control some of those factors to offset the effect of the fall purchase of fertilizer. For example, crop sales could be accelerated into 2003 to increase 2003 taxable income. Payment of other expenses could be delayed until 2004 to offset the increased fertilizer costs in 2003. Depreciable assets purchased in 2003 could be depreciated at a lower rate.
Income averaging rules allow farmers to tax part or all of their farm income at marginal income tax rates from the three previous years. This is another way to level income for income tax purposes, but it is not very precise because it requires the taxpayer to pay tax on one-third of the elected farm income at the marginal tax rate of each of the three previous years.
Example 2. Assume John and Mary have $65,000 of taxable income in 2004 as a result of purchasing their fertilizer in the fall of 2003. If they elect income averaging on $15,000 of that income, only $5,000 will be taxed at their 2003 marginal income tax rate. The other $10,000 will be taxed at their 2001 and 2002 marginal tax rates.
In summary, producers should keep an eye on the income tax consequences of shifting the fertilizer purchase from the spring to the previous fall and minimize the effect of that shift by using other income tax planning strategies.
Will the Cost of Fertilizer be Allowed as a Deduction in 2003?
Producers who have concluded that the fall purchase of fertilizer will give them a tax advantage need to make sure that they will be allowed to claim the expense as a deduction on their 2003 income tax return. There are two rules that limit the deduction of pre-paid farm expenses — expenses that are paid before the year the item that is purchased is actually used in the farm production. Both of the rules are aimed at taxpayers who have high non-farm income and are trying to use a farm business as a way to shelter that income. Consequently, neither rule affects many full-time producers.
50 percent Limit. One of the rules limits the deduction of pre-paid expenses to 50 percent of the other deductible farm expenses for the year. However, this rule does not apply to taxpayers who have a connection to a farm and who don't regularly pre-pay more than 50 percent of their expenses. A taxpayer has a connection to a farm if his or her principal occupation is farming, his or her principal residence is on a farm, or he or she is a family member of a taxpayer who meets one of those two requirements. Taxpayers are treated as not regularly prepaying more than 50 percent of their expenses if their aggregate pre-paid farm expenses for the three previous years are less than 50 percent of their aggregate non-pre-paid expenses for those years, or unless extraordinary circumstances caused the excess prepaid expenses in the current year. The rule also does not apply to taxpayers who use accrual accounting. This rule does not affect many full time farmers because they meet the requirements for exemption from the rule.
Example 3. John and Mary live on their farm and regularly pay $205,000 in farm expenses each year. About $5,000 of those expenses are pre-paid. John and Mary are not subject to the 50 percent limit on pre-paid expenses because they meet the farm connection requirement and they don't regularly prepay more than 50 percent of their expenses.
General Test. The second rule that limits deduction of prepaid expenses is a more general test set out in Rev. Rul. 79-229. Under this test, three requirements must be met to deduct a pre-paid expense.
• The expenditure must be a payment for the purchase of a supply rather than a deposit. The supply that is purchased must be identified, and the producer must have ownership of the supply even if it is not delivered. If the producer just deposits money at the local farm supply and can apply it to any farm input, the deduction is not allowed until the supply is identified.
• The prepayment must be made for a business purpose and not merely for tax avoidance. This requirement is not difficult to meet for full-time producers. Avoiding a price increase, applying fertilizer in the fall to get an early start for the next year, and buying in bulk to reduce cost are examples of legitimate business purposes.
• The deduction of the expenditure must not materially distort income. The IRS seldom applies this rule to deny a deduction unless the taxpayer has distorted farm income to shelter non-farm income that would be taxed in a high bracket.
Example 4. John and Mary purchased fertilizer rather than merely made a deposit that could be applied to any farm supply. Their business purpose for the purchase is to protect themselves from a price increase. The $15,000 of added expense does not materially distort their taxable income.
Summary
Producers should consider the income tax consequences of purchasing fertilizer in the fall rather than in the spring. Most producers will be allowed to deduct the cost in the year of the purchase. That earlier deduction is generally to their benefit because it postpones tax liability. However, producers should make sure the early purchase does increase their tax liability by pushing income into higher brackets in the following year.