Taxlink by Andy Biebl

Cash-Accounting Rules

Andy Biebl
By  Andy Biebl , DTN Tax Columnist
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Under the cash method of accounting, income is only taxed when converted to cash. (DTN file photo)

Congress has given some unique privileges in the tax code to farmers. The most important is undoubtedly the ability to use the cash method of accounting. Income is only taxed when converted to cash. All other businesses that deal in goods, rather than services, must use the accrual method. The accrual method requires inventories on hand at year's end to be included in income, as well as accounts receivable from the sale of goods. The justification for the cash method is that farmers face both commodity price volatility as well as production volatility from weather and other growing risks. Taxing those inventories on the accrual method would lead to wild fluctuations in taxable income. However, the cash method is not a lock for all farmers.

THE INVESTOR RISK

The cash method in farming is permissible if the owners are actively involved in farming. But, if an entity such as a partnership or S corporation (but not a C corporation) has more than 35% of its ownership in the hands of investors, the farming entity must use the accrual method under the farming syndicate rules.

EXAMPLE

Bud is a large cattle rancher in need of capital to expand his feedlot facilities. His friend, Dr. Cal, whose veterinarian practice provides services to Bud's cattle operation, offers to invest the $1 million in exchange for a 40% ownership interest. If Bud and Dr. Cal form a partnership to operate the feedlot with 60% owned by Bud and 40% by Dr. Cal, the entity is likely categorized as a farming syndicate in the tax law and must operate under the accrual method of accounting.

EXCEPTIONS TO INVESTOR STATUS

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An individual is not considered an investor under any one of several exceptions:

-- The individual actively participated for a period of not less than five years in the management of the farming activity.

-- The principal residence of the individual is on the farm of the activity.

-- The individual actively participates in the management of any farming business and participates in the further processing of livestock used in the activity.

-- The individual's principal business activity involves active participation in the management of a farming business, in which case any other interest in a farming business is exempt.

-- The interest is held by a member of the family or the spouse of a member of the family of an individual described in one of the four prior exceptions, using a broad multi-generation family definition.

In summary, there is no issue in having a co-owner who is currently or previously actively involved in the farming activity, whose principal business activity is another farming activity or who is a family member of the foregoing. But, if you are seeking capital from other non-farm investors, keep their interest in the activity at 35% or less, or instead, look to a lender rather than an owner/investor.

Tax Columnist Andy Biebl is a CPA and tax partner with the accounting firm of CliftonLarsonAllen, in New Ulm and Minneapolis, Minn.

Read Andy's "Ask the Taxman" column at about.dtnpf.com/tax.

You may email Andy at askandy@dtn.com

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