Ask the Taxman by Andy Biebl

Can I Salvage Taxes on an Off-Farm Investment?

Andy Biebl
By  Andy Biebl , DTN Tax Columnist
Check the facts before assuming that profit from a non-farm investment can offset your farm loss. (DTN file photo)

QUESTION:

I have been a partner in a development company for about 12 years. I invested a substantial amount to assist my daughter and son-in-law. I put up the bulk of the money and have guaranteed the debt, although more recently other partners were added as personal guarantors.

I have not attended partnership meetings, but assume I am considered an active partner because my name was on all of the debt and there are many questions that came my way about business decisions.

The economy hit the skids about the time we formed the partnership, and for most years the Schedule K-1 allocations were insignificant. There really was not any profit until 2015. This year the company made a large sale, and my share of the profit is in excess of $300,000. The partnership accountant said I am a passive partner and that will cause a larger income tax burden. The Schedule K-1 shows me as a Limited Partner, and my accountant, who is not a CPA, said this means I am passive. I would like to use Section 179 to claim first-year depreciation on new farm equipment, and reduce my Schedule F negative number to offset some of this partnership profit. But my accountant said with the K-1 designated as a Limited Partner, my Section 179 deduction will be somehow limited. My farm equipment is in need of upgrade, this would be a good time to do so, especially if I can use a Schedule F loss against this large partnership income. Will this work?

ANSWER:

There is a lot built into your question, and a number of myths to slay. In the interest of order, let's separate the issues.

1. Passive partner incurring more tax.

Passive status primarily relates to the loss limitation rules under Sec. 469. Investors who do not materially participate in a business activity face restrictions on the use of losses from that activity. But your development business has generated income. When your accountant says more tax, I'm guessing he or she is thinking of the Sec. 1411 net investment income tax, from the Affordable Care Act, that imposes a 3.8% hit on business interests that are passive. So yes, you will face nearly a 4% higher tax than if you were active in the development partnership. The definition of active for this test would require that you attain 500 hours per year of material participation in the business. This is probably not occurring, based on your recitation of the facts.

The fact that you have guaranteed debt has no direct bearing on your active or passive status. The test for active status relates to your annual "material participation," with the general test requiring 500 hours per year of involvement. There is a look-back test that may benefit you. If you did not attain 500 hours this year, but did so in any 5 out of the 10 most recent years, you are considered a material participant this year.

2. Section 179 deduction and limited partner status.

Your primary question relates to the active business income limit under Section 179. The Section 179 deduction is limited to the taxpayer's total business net income, considering only those business activities that are "actively conducted" by the taxpayer (a different test than the "material participation" definition above). The guidance on this definition is at Reg. 1.179-2(c)(6), and you and your accountant should carefully review this language to determine how it aligns with your involvement in the development partnership.

The regulation states that this is a "facts and circumstances" situation. To be actively conducting, the taxpayer must "meaningfully participate in the management or operations of the trade or business." There is also an example in the regulations that provides guidance. In that example, an individual owner has a business manager, but the owner approves the budget, hires the employees, acquires the necessary supplies, writes checks to pay all bills, etc., and accordingly is considered to meaningfully participate. But the example goes on to define a second business activity in which a different employee manages the second business without the owner doing the key management activities. The second business is considered passive. My general sense from your description is that you are on the passive side for this test. As a result, if your farm schedule broke even before depreciation, you could not claim any Sec. 179 deduction so as to create a loss to offset the development partnership's $300,000 of net income. You could only do so if the partnership was an active business in terms of your conduct of management activities.

3. 50% bonus and prepaids.

But don't despair; there are other alternatives outside of the Section 179 deduction. The upcoming extender bill is likely to also renew the 50% first-year bonus deduction on new equipment. Thus, if you were to acquire several items of new machinery, you could claim an immediate 50% first-year deduction, assuming the machinery was new (not used) and was acquired and available for service by Dec. 31.

You can also use traditional cash method techniques for your farming operation to create a loss. Assuming you operate on the cash method, grain sales or inventory sales can be deferred for payment into 2016, and expenses accelerated on a prepaid basis into 2015. You may need a short-term operating line from a friendly banker to pull this off, but most ag lenders are accustomed to these working capital loans, assuming there is adequate inventory deferrals that can be collateralized.

4. Detailed Tax Projection.

A key bit of advice here is to have your accountant prepare a detailed tax projection that includes the gain from the partnership's pass-through income to you. You stated that "the company made a large sale" and that your share of the profit is in excess of $300,000. Depending on the activity of the partnership, this might be ordinary income or capital gain. That's a key distinction, leading to far different tax results. But that aside, you need to determine exactly how much of a farm loss makes sense, considering the tax rates that will apply to the pass-through income from the partnership. As noted earlier, you will incur the 3.8% net investment income tax. But this only applies to joint returns over $250,000 of income, so even a modest farm loss might pull you beneath that threshold. A detailed tax projection can identify the amount of farm loss that you should be targeting, using multiple "what if" scenarios to test the true tax cost of different income levels.

5. Self-employment tax.

Another issue to address with your tax adviser is the application of the self-employed Social Security tax (SE tax) to your partnership income. This may apply if the income is ordinary business income, such as from real estate development; it should not apply if the income is capital gain such as from the sale of a rental property.

The SE tax determination is made not on your hours of involvement, but rather your status with respect to the partnership as a manager or non-manager, and as a General or Limited Partner. You indicate that the K-1 states you are a Limited Partner. That's helpful in avoiding the SE tax. But further, you should be a partner who lacks management authority under the terms of the partnership agreement to avoid SE tax. This is a very complicated question. The best guidance is within a complex set of proposed regulations from the IRS issued in 1997 under Sec. 1402. Again, that should get a careful analysis by a tax professional who reviews the partnership agreement. The SE tax on $300,000 of net income would be over $20,000, although if your farm business is also a self-employment activity, a loss could help with this tax, in addition to reducing income tax.

Editor's Note: Andy Biebl is a CPA and tax principal with the firm of CliftonLarsonAllen LLP in Minneapolis with more than 40 years of experience in ag taxation, including 30 years as a trainer for the American Institute of CPAs and other technical seminars. He writes a monthly column for our sister magazine, The Progressive Farmer. To pose questions for future tax columns, e-mail AskAndy@dtn.com.

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(MZT/CZ)