Prepaid Farm Expenses

Jeffrey E. Tranel
Agricultural and Business Management Economist
Colorado State University Extension

Introduction

Farmers and ranchers often pay for feed, supplies, fertilizer, and other inputs in one year and use those items in the following year. They may do so to pay lower prices, guarantee availability, for planning purposes, and/or other reasons.

The Internal Revenue Code (IRC) allows taxpayers using the cash method of accounting to deduct the costs of such purchases in the year that the purchases are made, rather than the year in which such items are used.  Generally, the deduction for prepaid farm supplies or feed is limited to 50% of other deductible farm expenses (all schedule F deductions except supplies or feed) for the year.  Additionally, farmers and ranchers wanting to deduct the costs of prepaid farm supplies and livestock feed must use the cash method of accounting. 

Farm-Related Taxpayers

A farmer is an individual who is engaged in the business of farming. An individual is in the business of farming if the person “cultivates, operates, or manages a farm for business, either as an owner or tenant” (IRS Publication 225, The Farmer’s Tax Guide). A farm includes livestock, dairy, poultry, fish, fruit, and truck farms. It also includes plantations, ranches, ranges, and orchards. Generally, a farmer has a profit motive when operating a farming business.

A farm-related taxpayer is someone whose:

1. Main home is on the farm,
2. Principal business is farming, or
3. A family member of someone who meets tests 1 and 2. For this purpose, a family member includes the person’s brothers and sisters, half-brothers and half-sisters, spouse, parents, grandparents, children, grandchildren, and aunts and uncles and their children.

Prepaid Farm Supplies and Feed

A farmer or rancher may choose to purchase supplies and/or animal feed in one year and use the inputs in the following year, in order to reduce taxable income in the current year and/or to help ensure business profitability. Prepaid farm supplies are amounts paid during the tax year for seed, fertilizer, and other farm supplies not used or consumed during that year. They also include the costs of purchasing poultry bought for use in the farm business that would be deductible in the following year. The cost of poultry purchased for resale, but not sold during the year, may be deducted as prepaid expenses. Animal feed includes hay, silage, and other harvested forages (not pasture); grains; salt and minerals; and manufactured feeds.

A farmer or rancher reporting income and expenses under the cash method of accounting may deduct (in the year paid) the cost of supplies and livestock feed to be consumed in a future year, if the following tests are met.

1. The expense must be a payment for the purchase of supplies or feed, not a deposit.  It is considered a payment if there is a binding commitment to accept delivery of a specific quantity at a fixed price, and there is no entitlement to a refund or repurchase. Deposits are not considered prepaid farm expenses.
2. The prepayment has a specific business purpose and is not merely to avoid taxes. Examples of business benefits include fixing maximum prices, securing an assured supply, and securing preferential treatment in anticipation of shortages.
3. The deduction does not materially distort income. Some factors to consider in determining whether there is a material distortion of income are (a) the farmer’s customary business practices in conducting the farming operation; (b) the amount of the expense relative to income for the year; (c) the time of the year the purchase is made; and (d) the amount of the expenditure in relation to past purchases.

Whether a payment is for the purchase of supplies or feed, or a deposit, depends on the facts and circumstances in each case.  A supply or feed is considered purchased if it can be shown that the payment was made under a binding commitment to accept delivery of a specific quantity of an item at a fixed price and there is no entitlement, by contract or business custom, to a refund or repurchase. Some factors that show a payment is a deposit rather than for the purchase of a supply or feed.

• The absence of specific quantity terms.
• The right to a refund of any unapplied payment credit at the end of the contract.
• The seller's treatment of the payment as a deposit.
• The right to substitute other goods or products for those specified in the contract. However, provisions to substitute feed ration ingredients to meet an animal's changing diet requirements do not suggest a deposit. Also, a price adjustment to reflect market value at the date of delivery is not, by itself, proof of a deposit.

Limits on Deductions for Prepaid Farm Supplies and Feed

The allowable deduction of prepaid farm supplies and feed may be limited if the expenses exceed fifty percent (50%) of the total deductible farm expenses (excluding prepaid feed or supplies) for the tax year. If the prepaid farm supplies or feed are actually used or consumed during the year they are purchased, the amount is fully deductible.

The limit on the deduction for prepaid farm supplies or feed does not apply to a farm-related taxpayer if (1) the prepaid farm supplies or prepaid feed expense is more than 50% of the deductible farm expenses because of a change in business operations due to extraordinary circumstances or (2) total expenses for prepaid farm supplies or prepaid feed for the three preceding years is less than 50% of all other deductible farm expenses in those three years. This rule does not apply to the purchase of commodity futures contracts.

Effect of Change in Plans

After purchasing supplies or feed for the following year, a producer’s plans may change. The producer may decide not to produce the crop or raise the livestock for which the items were purchased. For example:

• Drought forced the sale of livestock, so the feed was not needed.
• Weather or market conditions caused the producer to plant a crop for which the supply was not needed, or the quantity of supply was significantly less than needed for the alternative crop.

One potential consequence of the change in plans is that the IRS may deny the producer’s deduction of prepaid farm supplies or feed. This denial is not likely if the amount of the payment is reasonably determined in good faith at the time of the payment.

Another consequence arises if the prepaid supplies or feed are sold in the year such items would have normally been used or sold. In such cases, the income from the sale of those items would be considered taxable income. Since the cost of the prepaid supplies was deducted in the preceding year, there would be no off-setting expense, i.e., the supplies or feed would have a zero basis (see Example 2 above).

There may be times when a farmer purchases prepaid feed or supplies in one year, has a change in production plans, and sells the prepaid items back to the seller in the following year. If the prepaid supplies are returned to the seller for a credit, the taxpayer must be careful to avoid the original transaction being considered a deposit rather than a purchase. The taxpayer should document the negotiations, in order to prove that the value of the supply was exactly equal to the original purchase price. In such cases, it is the farmer or rancher who faces the risk of a change in price. However, if the negotiated sales price is different than the purchase price, the farmer must show that he or she faced the risk of a price change.

Conclusion

Farmers and ranchers, using the cash method of accounting, may deduct the costs of prepaid supplies and prepaid feed in the year of purchase rather than the year of use or consumption. Such purchases must be for business purposes – to fix maximum prices, secure sufficient supplies, etc. – and may not distort income from one year to the next. Further, prepayments must be for a specific quantity at a fixed price, rather than as a deposit. There are various tests that must be met and limitations to the deductibility of prepaid expenses.

Generally, the deduction for prepaid farm supplies and prepaid livestock feed is limited to 50% of other deductible farm expenses (all schedule F deductions except supplies) for the year. Qualified (tax-related) farmers and ranchers are not subject to the “50% limitation” if they meet certain conditions.

Farmers and ranchers have unique business, financial, and tax liability circumstances. They should consult with their tax preparers before deducting expenses of prepaid farm supplies and feed.

IRS Publications

IRS Publication 225 (Farmer’s Tax Guide) can serve as a good reference for producers wanting more information about prepaid supplies and feed.

To access IRS forms and publications, go to www.irs.gov and click on “Forms and Publications”.  Then click on “Publication number” under “Download forms and publications by” and type the publication number in the find box to search for the publication.  Publications may be viewed online or downloaded by double clicking on the publication.

Numerous parts of the Internal Revenue Code and Revenue Rulings were referenced when writing this fact sheet. They include: Rev. Rul. 82-208, 1982-2 C.B. 58; Rev. Rul. 79-229, 1979-2 C.B. 210; IRC § 464; IRC § 469; and Grynberg v.  Commissioner, 83 T.C. 255 (1984).

Additional Topics

This fact sheet was written as part of Rural Tax Education, a national effort including Cooperative Extension programs at participating land-grant universities to provide income tax education materials to farmers, ranchers, and other agricultural producers.  For a list of universities involved, other fact sheets and additional information related to agricultural income tax please see RuralTax.org.

 

This information is intended for educational purposes only. You are encouraged to seek the advice of your tax or legal advisor, or other authoritative sources, regarding the application of these general tax principles to your individual circumstances. Pursuant to Treasury Department (IRS) Circular 230 Regulations, any federal tax advice contained here is not intended or written to be used, and may not be used, for the purpose of avoiding tax-related penalties or promoting, marketing or recommending to another party any tax-related matters addressed herein.

USDA is an equal opportunity provider, employer, and lender. Rural Tax Education is part of the National Farm Income Tax Extension Committee.  The land-grant universities involved in Rural Tax Education are affirmative action/equal opportunity institutions.

This material is based upon work supported by the U.S. Department of Agriculture, under agreement number FSA21CPT0012032. Any opinions, findings, conclusions, or recommendations expressed in this publication are those of the author(s) and do not necessarily reflect the views of the U.S. Department of Agriculture. In addition, any reference to specific brands or types of products or services does not constitute or imply an endorsement by the U.S. Department of Agriculture for those products or services.

Published September 2023

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