Cash method farm proprietors might find numerous situations where giving farm commodities to shift income to the donee is advantageous.
- Moving income to minor children of the farmer-taxpayer to take advantage of their low tax rates;
- Assistance with college costs for children of the taxpayer; or
- Support for parents of the taxpayer.
A. Tax Consequences to Donor/Farmer
There is no income recognition by a donor upon a gift of inventory.
While the assignment of income doctrine prevents a transfer of income or other secured earnings from one taxpayer to another, the courts, and subsequently the IRS, have ruled that a gift of raised farm commodities represents a transfer of an asset rather than an assignment of income.
The nonrecognition to the donor is only advantageous to the cash method farmer.
An accrual method farmer will have tax basis in raised commodities which often approaches market value, so that little income shifting is accomplished.
The cash method operator, conversely, has zero basis in raised inventory.
In addition to the income tax advantage to the donor, the donor also sidesteps the self-employment tax on the commodities which are given to another; excludable gross income is not considered in determining self-employment income.
It is generally preferable to give commodities raised in a prior year. Opening inventory must be reduced for any cost or undeducted expense relating to the inventory which is given to another.
Costs deducted on prior returns will apparently not be disturbed, so that the farmer reporting on a calendar year basis would be allowed to deduct the costs of raising the crop in full if the gift of the raised commodity is not made until the following January.
The IRS, in Publication 225, takes the same position, holding that costs which apply to gifts of agricultural products may not be deducted as a farm business expense in the year of the gift or any later year.
Form 709, U.S. Gift Tax Return, is required if the value of the gift exceeds the $10,000 annual exclusion per donee.
The key to preventing the assignment of income problem is to recognize that two distinct steps must be taken:
- The donor makes a gift of unsold cash-basis inventory using a prior year crop or commodity.
- The title transfer must be documented, such as through an elevator storage ticket.
- The donee independently accomplishes a sale of the commodity, recognizing income because of the zero basis in the commodity.
B. Tax Consequences to Donee
The donor’s basis carries over to the donee. On raised commodities given in the year after harvest, the donee would succeed to the zero basis of the donor.
Assuming the transfer is a gift (rather than compensation for services), the income would be classified as unearned income in the hands of the donee, and thus not subject to self-employment tax. If the donee has materially participated in the production of the crop, the IRS could assert either of the following:
- The transfer was not a gift but was compensation which is taxable in the year of the transfer even if not sold; or
- The arrangement between the donor and donee is that of a partnership subject to self-employment tax on the reclassified income.
We watch for the possibility of the kiddie tax for children under age 14 where unearned income exceeds $1,400. Up to the $1,400 threshold, income is taxed as follows:
- First $700 of unearned income is tax-free; and
- Unearned income of a child from $700 to $1,400 is taxed at the child’s rate.
C. Capital Gain Status.
While the raised farm commodity was inventory in the hands of the farmer-donor, the donee will typically not be in the business of farming so as to have inventory status with respect to the commodity.
Section 1221 defines a capital asset as all property, except for specific items such as inventory, items held for resale, and Section 1231 productive assets used in the trade or business. Several cases have held that capital gain recognition occurs if the taxpayer is not actively conducting a trade or business, even though the asset may have been inventory when formerly in the hands of a related party.
Stockholders were allowed capital gin treatment upon the sale of inventory received from a liquidated corporation.
Capital gain was recognized by the executors of a proprietor’s fur business.
A unique court case involved conversion of farm commodities from inventory to capital asset status by the same taxpayer.
The taxpayer originally sealed a crop and recognized income when the CCC loan amount was approximately equal to current market. The loan was then repaid, but the crop was held for approximately three more years before ultimate sale at a substantially higher price. The court approved long-term capital gain treatment on the difference between the sale price and the tax basis in the crop.
Capital gain designation is important because of the preferential rate available for capital gains. Further, capital gains can be offset by unused capital loss carryovers.
D. Holding Period of Donee.
In general, the holding period of an asset in the hands of a donee refers to the holding period of the donor.
The IRS has raised the argument (not decided by Tax Court) that long-term treatment is achieved only when the asset has been held in investment status for the necessary holding period by the donee.
The holding period can become a critical issue in light of the favorable capital gain rates after the Taxpayer Relief Act of 1997.
E. Use of Proceeds by Donee
Reversion of sales proceeds to the donor or retention of unfettered command over the funds will cause taxation back to the donor.
- In an early case, the Tax Court held that income was taxable to the parent, despite a purported transfer of farm property to children. Funds were not segregated to the children, but rather were retained by the parent.
- A parent was held to be taxable on sales from a citrus grove owned by his four children. As the sales proceeds were often retained by the parent and not reported by the children on their respective tax returns, and the parent retained control over the proceeds from the fruit sales.
- A farmer was taxed on crops given to children where the sale proceeds were immediately borrowed back from the children by the parents.
- A farmer who made a gift of soybeans to his wife was determined to remain taxable on the income for self-employment tax purposes. The proceeds from the gift were deposited in a joint account where the husband maintained control.
The farmer in the above situation failed for additional reasons beyond the use of proceeds issue. The IRS ruled that the gift of soybeans to the spouse had no economic substance or independent significance beyond tax avoidance. Also, warehouse receipts were used to transfer title to the soybeans, and the IRS suggested that these were negotiable instruments representing a prior conversion or sale of the soybeans by the farmer. This multi-pronged attack suggests that spousal gifts of zero-basis grain will encounter strong IRS resistance.
In a second opinion regarding the validity of gifts of grain from a self-employed farmer to his spouse, the IRS National Office similarly ruled that the gift lacked economic substance. The IRS held that the gift was a tax avoidance transaction, with no evidence that the donee had actual title to and control of the grain. Again, the proceeds from the sale were deposited in a joint account.
To accomplish a valid gift, all of the following elements must occur:
- An intention on the part of competent donor to make a gift;
- Irrevocable delivery by the donor of the property in such a manner so as to vest full title and control in the hands of the donee;
- Acceptance of the gift by the donee; and
- No valuable consideration given back to the donor in exchange for the transfer.
F. Dependency Exemption of Child
Assuming that the cash proceeds from the sale of donated commodities are properly segregated in the hands of a child/donee, the specific use of the proceeds for support items could have an adverse impact on the parents’ dependency deduction for the child. In general, proceeds in the hands of the child should not be used to provide items of support so as to fail the 50% parental support test. But where parental AGI is high so as to cause Section 151(d) phase-out of personal exemptions, it may be an advantage to move the dependency exemption from the parental return to the child’s return.
The requirement of control by the donee after the date of gift raises the question of self-employment income if the gift is in the form of raised livestock.
A donee who assumes the care and feeding of animals after the date of gift would presumably face the risk of Section 1402 material participation and the self-employed social security tax. Several cases have allowed a shift of income to children on gifts of cattle, determined by the degree of control the children displayed over cattle and sales proceeds. Physical segregation of cattle at time of the gift is helpful although not determinative.
Also helpful is a reimbursement from donees of any post-gift maintenance expenses for the animals.
G. Share Rent Landlord Issues
While raised commodities retain inventory status in the hands of an active farmer, to share rent landlord raised commodities are the equivalent of accrued rental income.
Raised commodities which are received as rents in a nonmaterial participation lease or passive lease arrangement are considered the equivalent of rental income to the landlord, such that a gift or transfer causes full taxation to the donor under the assignment of income doctrine.
Cash-method farm proprietors and partners who intend to make a gift of raised commodities should be given the following pointers:
- Time the gift early in the year prior to harvest to establish evidence that prior year crop was given;
- Document the gift as a separate transaction preceding the sale of the crop by the donee;
- Donee must retain full use and control of the sales proceeds; and
- Beware of inventory loans, CCC loans, or other liens against the crop which is the subject to the gift.
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