IRS’s Small Business/Self-Employed Division (SB/SE) has issued an internal memorandum that explains a pilot program for auditing expenses taken on Form 1040, Schedule F, Profit or Loss From Farming.
Background. Form 1040, Schedule F is used to report farm income and expenses. It is always filed together with another tax form, including not just Form 1040 but also Forms 1040NR (U.S. Nonresident Alien Income Tax Return), 1041 (U.S. Income Tax Return for Estates and Trusts) and 1065 (U.S. Return of Partnership Income).
IRS’s pilot program. In its internal memorandum, SB/SE has issued guidance with respect to a pilot program for auditing Schedule F expenses, that is only being worked currently in IRS’s Brookhaven, NY campus. IRS notes that there has been limited coverage of Schedule F in recent years in by IRS’s Correspondence Exam group. IRS notes that there may be compliance issues such as deducting expenses on the wrong form, deducting expenses actually belonging to another taxpayer, or deducting hobby losses.
Among the instructions that the memo provides to auditors are:
… Deposits and supplies. Farmers often write a substantial number of checks during the last few days of the tax year to pay expenses. Large disbursements should always be part of an auditor’s examination. He must then determine if the disbursement is a payment or a deposit. Whether an expenditure is a payment or a deposit depends on the facts and circumstances of each case.
A deposit to be applied against a future expense is not deductible, unless the expense is for future supplies. The following factors, although not all inclusive, are indicative of a deposit as opposed to a payment: a) the absence of specific quantity terms; b) the right to a refund of any unapplied payment credit of the contract; c) the treatment of the expenditure as a deposit by the seller; and d) the right to substitute other goods or products as specified in the contract. These factors apply to all farm expenses for which a payment is made prior to delivery.
Code Sec. 464 limits the allowable deduction for prepaid supplies if they exceed 50% of the total deductible farm expenses for the tax year. If the prepaid farm supplies have actually been used or consumed, the amount is fully deductible.
The expense must be a payment for the purchase of supplies, not a deposit. In order to meet this requirement:
The payment must be made under a binding commitment to accept delivery of a specific quantity at a fixed price, and the farmer must not be entitled to a refund or repurchase.
The prepayment must not merely be for tax avoidance, but must have a specific business purpose. Examples of business benefits are: fixing maximum prices; securing an assured feed supply; and securing preferential treatment in anticipation of shortages.
The deduction must not result in a material distortion of income. Some factors to consider in determining wether there is a material distortion of income are: the farmer’s customary business practices in conducting the farming operation; the materiality of the expenditure in relation to the taxpayer’s income for the year; the time of the year the purchase is made; and the amount of the expenditure in relation to past purchases.
… Schedule F, Line 13, Custom Hire. Farmers may hire individuals or businesses who own equipment that the farmer does not own, such as no-till planters, combines, etc., to perform specific activities on their farms. These amounts are fully deductible as an expense on Line 13 of Schedule F, Custom Hires. Auditors should be attentive that amounts paid for rental or lease of equipment operated by the taxpayer should not be on this line; these should be listed on Line 24A, Rent or lease.
And, wages paid to employees should not be shown on this line. If an auditor does run into employee wages on this line, the memo instructs him to send an email with the employee’s social security number to a specified IRS employee.
… Fuel expenses. In order to determine that all fuel expenses are for conducting business on the farm, the auditor should ask the following questions: a) Do you have a storage tank on the farm? b) And how do you account for personal use from the storage tanks? And, if fuel was purchased from a gas station, the auditor should request an explanation of why that was done to ensure the gas was not for personal use.
References: For farmers’ tax returns, see FTC 2d/FIN ¶ N-1150; United States Tax Reporter ¶ 614.052.
IRS’ Small Business/Self-Employed Division memorandum, “Pilot Program Auditing Schedule F Expenses” (Feb. 27, 2017).