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More and more farmers are looking to futures markets to reduce risk. There are two techniques farmers can use: hedging and speculation. Hedging is what most people think about when they market their crop. Tax law defines hedging as a transaction in the normal course of business to minimize risk of price changes with respect to inventory or supplies. It's basically buying or selling a contract on an exchange in the normal course of business as a temporary substitute for a future cash transaction. Speculation is where you buy or sell commodities for a profit that is not a normal part of your operation.

Unfortunately, there is a blurry line between hedging and speculation that is often crossed. Many times, a farmer believes he or she is hedging but is, in fact, speculating. To be a hedge, the transition entered into must be in the commodity the farmer is raising and within the normal range of production. The contract must be opposite to the farmer's physical position in the commodity on hand or to be acquired to be a price hedge.

However, there are many transactions that would not qualify for hedging. For example, selling a crop at harvest and buying it back on the board would rarely be considered a hedge. Marketing commodities you don't grow is not a hedge. If a farmer purchases a call option as part of a hedging strategy, it no longer qualifies as a hedge. Also, there are issues with common control entities entering into hedge transactions.

Let's talk about the tax differences between the two. Hedging is easy. Hedge gain or loss is ordinary income or loss on the farm schedule in the year the hedge is closed. If it's speculation, you must mark to market on the last day of the year (all contracts, not just closed contracts). It is reported on Form 6781, which allocates capital gains and losses to 40% short-term and 60% long-term. If there is a gain, speculation provides a better tax result. But for losses, the capital loss can't offset your farming income (active business income) and might be suspended. For C corporations, there is not a separate capital gains rate, so speculation is rarely advantageous.

As you can see, the line between hedging and speculation is a blurry one, which many farmers cross. If it produces income, speculation provides better tax treatment. But, when it produces a loss, hedging always wins.

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DTN Tax Columnist Rod Mauszycki, J.D., MBT, is a tax principal with CLA (CliftonLarsonAllen) in Minneapolis, Minnesota. Read Rod's "Ask the Taxman" column at https://www.dtnpf.com/…. You may email Rod at taxman@dtn.com.

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