Hedging, when done properly, is designed to minimize price risk for commodity producers. But while economic risk might be minimized, IRS risk can increase.
The tax law defines a hedge as a transaction in the normal course of business to minimize the risk of price change with respect to inventory or supplies. This requires a producer to have a hedging position that's opposite the physical position on the farm and within normal production ranges. For example, if a producer in the middle of the summer growing season is concerned about a potential decline in the corn price, his physical long position can be hedged with a short position in December corn. If the corn price does in fact decline by year-end, the actual crop will be sold for less, but there will be an offsetting gain when the hedging position is closed.
For tax purposes, hedging transactions are reported as ordinary income or loss on the farm schedule in the year in which the hedge is closed (positions open over year-end aren't reported). In general, producers who are hedging their production do so with short positions on the board. But one hedge can be partially countered with a later hedge in the opposite direction. And a long position on the board also can be a hedge if it's price-protecting a future input, such as bean meal for a hog producer.
The danger here is the tax law definition of hedging (price protection) is much narrower than many modern practices that involve futures positions. For example, the practice of going long on the board as a less expensive way of carrying crop may make great business sense, but the tax law will characterize it as speculation. Also, hedging via a substitute commodity is a problem; the futures contract must be the same commodity as held by the producer.
The tax law defines everything that fails the hedging definition as speculation. These receive capital gain or loss treatment rather than ordinary status. If the net is a gain, the law deems 60% to qualify for favorable long-term capital gain rates. But on the loss side, there is a limit of $3,000 of deductibility against ordinary income. Excess capital losses carry to other years, but subject to the same limits. Finally, speculative contracts must be "marked-to-market" each Dec. 31, with any accrued profit or loss on the contract recognized for tax purposes as if closed out on Dec. 31.
Beyond the narrow definition of what is a hedge, the tax rules effectively require hedging transactions to be segregated into one account. Further, within 35 days of each hedging transaction, there must be additional notations that identify the risk being hedged and the linkage to the farming business. Finally, recognize that merely characterizing an account as hedging is insufficient. The IRS will scrutinize the specific trades and recharacterize those that don't fit the price protection definition. If that affects contracts with losses, a fully deducted ordinary loss will be converted to a meager $3,000 capital loss.
Editor's Note: Andy Biebl is a CPA and principal with the firm of CliftonLarsonAllen LLP in Minneapolis and New Ulm, Minn., and a national authority on ag taxation. He writes a monthly column for our sister magazine, The Progressive Farmer.
Andy Biebl can be reached at AskAndy@dtn.com
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