Ask the Taxman by Andy Biebl

DTN Tax Columnist Andy Biebl is a CPA and principal with the accounting firm of CliftonLarsonAllen LLP in New Ulm and Minneapolis, Minn., and a national authority on agricultural taxation. To pose questions for upcoming columns, email AskAndy@dtn.com.

QUESTION:

What do you do when the IRS says you aren't a business? We have a grain operation that has a 40-year history, and are going through an IRS exam and now to Appeals. We installed a $150,000 solar system on the farm site using federal, state, and utility subsidies. The IRS says that we built it for personal use and cannot claim depreciation. We sell about 70% of the electricity to the power company, the rest goes into our farming operation, and only about $65 per month would be for our household. This IRS position seems crazy. Do you agree?

ANSWER:

Based on the facts you described, the IRS position appears to be totally unwarranted. The IRS is apparently attempting to disallow depreciation on the solar system on the premise that it is a personal use asset, but that does not square with the facts. And one asset alone -- using solar to produce electricity -- does not create a Section 183 hobby loss position for an established grain farming business. It's hard to say whether this is pure incompetence or bad behavior on the part of the IRS, but we have seen too much of both lately. My best advice is simply to persevere; if not solved at Appeals, the courts usually get it right.

Frequently when I get a question about an IRS assertion of non-business status in farming, it is around the hobby issue of a sideline ranching activity, or more commonly, a horse activity. Full-time farmers rarely face a hobby loss issue. But individuals with a substantial income from another source who undertake a sideline farming activity and use cash method accounting deferrals to create a negative, need to recognize that Section 183 can allow the IRS to eliminate the loss. This is a subjective area of the law. The regulations provide a series of nine factors to ascertain whether the activity is conducted in a business-like manner with a reasonable expectation of profit.

The IRS computers are getting much better at finding loss activities that are inside higher income returns. If you have a farming, ranching, or horse operation that is less than your full-time business and it is producing a tax loss, you should be discussing with your tax adviser about the risks of a Section 183 hobby loss attack.

QUESTION:

In a recent column discussing strategies for the new 3.8% tax, you stated that there is a special exemption for farm self-rentals for those who own real estate and lease it back to the business in which they materially participate. I am curious as to the definition of business organization. Does it make a difference if it is a C or S corporation? And how about an LLC taxed as a partnership?

ANSWER:

The self-rental exemption is very broad. It simply requires that the taxpayer own real estate that is leased to a business activity in which that individual materially participates. Normally, material participation requires at least 500 hours per year. But the type of business entity is not the issue: It can be a C corporation, S corporation, partnership or even leasing to a spouse-owned proprietorship.

I have had several questions on this point of self-rentals, including some from CPAs, so let's get technical for a moment and summarize the rules as laid out in IRS Final Regulation 1.1411-4(g)(6).

1. A self-rental, in which real estate is leased to a business activity in which the taxpayer has ownership and materially participates, is exempt from the 3.8% tax. The business activity can be a closely-held C corporation, S corporation, partnership, or a spouse's proprietorship. This self-rental status requires no special election, and it only applies to net rental income, not a rental loss (i.e. the rental income is re-characterized as non-passive and also is not subject to the 3.8% tax; a rental loss would be a suspended passive loss).

2. The same regulation also provides an exemption to the 3.8% tax for a rental activity that has been grouped under Reg. 1.469-4(d) with a business that uses the real estate. This grouping requires a tax return election (with that election in writing since 2011 tax returns), and is only available if the real estate is leased to an S corporation, partnership, or spouse's proprietorship; it is specifically not available for real estate used by a C corporation. For most taxpayers, this grouping election is unnecessary, as the self-rental exception solves the 3.8% tax. But if there is a risk that the rental activity may run in the red and produce a suspended passive loss, the grouping election can solve that risk as well.

There is one more key point about negating the 3.8% tax on net rental income, whether accomplished by the self-rental definition or a grouping position: Any gains on sale of the real estate are also exempt from the 3.8%. For most taxpayers, that is the greater risk. Net rental income is only exposed to the 3.8% tax if the taxpayer's Form 1040 adjusted gross income exceeds $200,000 single or $250,000 joint. But when a land sale occurs, that threshold is blown by and the 3.8% tax can present a significant cost if the property is not in self-rental or grouped rental status.

QUESTION:

In a recent article, the question concerned depreciation and the farmer indicated he was facing a high income year because he was selling his cow/calf herd. Wouldn't the income from the sale of his herd be treated separately as capital gain?

ANSWER:

Yes. If the animals sold were raised and held for breeding use rather than resale, there would be capital gain. But any purchased breeding stock that had been depreciated, as well as any raised animals held for resale, would produce ordinary income. So, the probability is that the sale proceeds would have been part capital gain and part ordinary income.

But there's also another aspect to the capital gain equation. In a high-income year (i.e. over $400,000 single or $450,000 joint of total income), there is now a third-tier capital gain rate of 20%. Most states do not have preferential capital gain rates, so state income taxes can easily add another 5% to 10%, and now the capital gain privilege, while helpful, is not a total solution.

(MZT/ES/BAS)

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