Economic & Policy Update

Does the IRS Consider My Farming Operation a Hobby Farm?

Tarrah Hardin Contributing Writer

Many producers that have both farm and nonfarm income, may question if the IRS considers their farming activities to be a “business” or a “hobby”. This is a very important distinction to both the farmer and the IRS due to the IRS treatment of business income versus “hobby” income. If a business has a net loss for the year, then that loss can be used (with some limitations) to reduce other income realized by the taxpayer. However, if the IRS considers farming activities to be a “hobby”, then any losses cannot be used to offset income in other areas by the taxpayer. The size of the farming operation is irrelevant in determining if a farming operation is a business or a “hobby”. It is all about the management of the farm. The IRS has nine factors they use to determine the status of the farming operation. Those factors are covered below, as are ways in which a producer can make sure they are not a hobby farm. It is worth noting that if audited, it is the taxpayer/farmer’s responsibility to show proof of meeting the guidelines. 1. Operate your farm in a businesslike manner.

One way to make sure you meet this guideline is to have separate bank accounts for the farm and personal use. A business plan can also demonstrate that you take the farming operations seriously and are interested in its success. 2. Time and effort spent on the operation in hopes to make it profitable. The producer

spending most of their personal time on the farming operation can indicate they are trying to be profitable. The producer may also have employees perform tasks that they cannot do because of time constraints. Both show that the producer is spending an adequate amount of time running their business. 3. Depend on the farm income. The IRS would like to have demonstrated that there is some reliance of the taxpayer on the farming income. There is certainly no issue if there is another source of income outside of the farm.

However, there may be a concern that merely having a significant non-farm income, that the taxpayer is only “farming” as a means to reduce their tax obligations instead of running a business. If the producer continues to need outside income to help support the farming operation, then they need to take a closer look at their financial standing. 4. Your losses are due to circumstances beyond your control or for start-up reasons. As long the producer does not intentionally create losses in their farming, this should not be an issue. Losses can happen at every turn in farming not without anyone’s help, the weather and grain/livestock markets are two great examples. 5. Changing aspects of your operation to improve profitability. Thorough recordkeeping and enterprise analysis will

help producers track income and expenses and monitor profits and losses. As long as the producer has a way to track income and expenses, and make necessary adjustments when losses occur, the producer meets this guideline. 6. You have advisors to help you carry out your farming business. Examples of advisors are a

CPA, financial advisor, UK Farm Management

Specialist, crop scout, or a grain marketer to name a few. Having one or more of these professionals to go to when making decisions about your operation can not only help your operation but also proves you are running your farm like a business. 7. Successfully making a profit in the past in similar activities. This is where farming experience comes into play. If the producer has had a similar operation in the past and tried to make a profit or if they turned a nonprofitable business into a profitable business. 8. In some years, the producer makes a profit and can show the amount. According to the

IRS, a farmer needs to show a profit 3 out of 5 years, even if the profits are not large. Always showing a loss on your Schedule F, can alert the IRS that the operation may be a hobby and not a for-profit business. 9. You can expect future profits in your farming activities. Is there a projected cash flow? Is it positive? If not, can changes be made to help cash flow the year? Profits do not have to be a lot but the business needs to show a profit or at least the intent to be profitable. One key point is that if you keep records, both financial and production, you will already meet most of the requirements. Records are key to being a good producer. Not only can they tell you where you excel but also help if the IRS audits a taxpayer. For additional information, IRS Pub 225 Farmer’s Tax Guide is a great resource.

Estate Transfer under the Proposed American Families Plan

Jerry Pierce Contributing Writer

On May 28th the Biden Administration released a general explanation of its proposed tax changes. This includes an explanation of proposed changes in the American Families Plan that would tax transfers of appreciated property by gift or upon death, tax capital income for high-income earners at ordinary rates, increase the top marginal income tax rate, and apply the 3.8-percent Medicare tax to all trade or business income of high-income taxpayers, including transfer of assets. Transfers of appreciated property by gift or at death will be treated as “realization events” which require recognition of gain. That is, the transfer will be taxed like a sale. The gain is taxable to the one making the gift or to the estate of the one who dies (decedent). The proposal would apply to gifts and deaths beginning in 2022. There would be no adjustment or step-up in basis to fair market value at death when calculating the transfer tax. The purpose is to tax the appreciation or gain in value of assets that have not been taxed before. Gain is calculated by subtracting the adjusted basis from fair market value at the time of gift or death as if the property were sold. Adjusted basis is the original cost plus improvements minus depreciation. See the article Proposed Gift and Estate Tax Changes by Laura Powers in last month’s Economic and Policy Update. The transfer tax is not an estate tax, but a new tax on the unrealized gain at the time of death or gifting. Both transfer tax and estate/gift tax will apply to property passed by death or gifting. Current state and Federal estate taxes continue to apply and would not be changed by the proposal. Basis in assets would continue to be automatically adjusted or “stepped-up” to fair market value at death before estate taxes are calculated. The transfer tax would be deductible on the decedent’s estate tax return.

Exclusions Under the Proposal

Property transferred by a decedent to a U.S. spouse or to charity would not be subject to the transfer tax, but it would not receive step-up in basis. The basis of the decedent would be gifted or “carried over” to the one receiving the property. Charitable deductions would not be valued at fair market value but at the decedent’s basis in the property. There is a $1 million per person exclusion from recognition of gains on property transferred by gift or held at death. The exclusion is portable to a surviving spouse. Any portion not used by one spouse can be used by the surviving spouse, making the exclusion effectively up to $2 million per married couple. The current $250,000 per person exclusion for gain on a principal residence still applies to all residences. The exclusion remains portable to the decedent’s surviving spouse, effectively making it $500,000 per couple. Gains on tangible personal property such as household furnishings and personal effects (excluding collectibles) are exempt. Example 1: Farmer and spouse die in 2022. Fair market value of the estate is determined to be $5 million. Basis in assets totals $2 million. Gain is $3 million. Gain on the residence is under $500,000. After subtracting the couple’s $2 million personal exclusion the amount subject to transfer tax is $1 million. Example 2: Same circumstances except that the farmer and spouse gift the property in 2022. The amount subject to transfer tax is the same: $1 million.

Basis for the Person Receiving the Property

The recipient receives a step-up to fair market basis in property received by inheritance. In Example 1 the recipient basis in the property is $5 million. The total basis of property acquired by gift would have two components. The recipient would receive the donor’s basis for the property covered by the $1 million per person exclusion. The amount of property not covered by the personal exclusion would receive a step-up to fair market basis. In other words, the amount of the gift that is taxable to the donor gets the stepped-up in basis for the recipient. The recipient basis in property gifted in Example 2 would be $3 million: fair market value in the amount taxed ($1 million) plus mom and dad’s original basis in the amount not covered by their personal exclusion ($2 million).

Payment of the Tax

The proposal does not provide instructions for tax calculations, but it does give some clues. The following example, based on the examples above, provides a rough estimate of the tax due on the transfer tax based on the information given in the proposal. In both examples above, the taxpayers are assumed to file as married filing jointly because 1) both spouses in Example 1 died in the same year or 2) spouses were assumed to be living at the time of the gift in Example 2. No other income is included in the calculations. Example 3: The first $1 million of the gift would be taxed at capital gains rates, resulting in about $163,170 in Federal tax, plus $38,000 in additional Medicare tax. The remaining $2 million would be subject to ordinary tax rates with the changes in top rate and bracket and the additional Medicare tax. The total tax due on the $3 million would be about $840,595. Payment of the tax for certain family-owned and operated farms and businesses would not be due until the business is sold or ceases to be familyowned and operated. No definition of family has been given. The authors’ original definition of family is those related by lineal descent: from grandparent to parent to children. The proposal provides for a 15-year fixed-rate payment plan for the tax on appreciated assets transferred at death, other than liquid assets. Family-owned and operated farms and businesses electing to defer payment do not qualify. The Internal Revenue Service is authorized to

require security when reasonable. That is, the IRS may take out a lien on the property to secure the tax-deferred or the 15-year tax payment.

Other Provisions that may Affect Estate Transfer

The top marginal individual ordinary income tax rate increases from 37 to 39.6 percent. The income threshold for reaching the top income tax bracket is lowered. For example, the top bracket for married filing jointly would drop from the current $628,300 to $509,300. For those filing as single, the top bracket falls from $523,600 to $452,700. Long-term capital gains and qualified dividends of taxpayers with adjusted gross income of more than $1 million would be taxed at ordinary income tax rates for the amount that exceeds $1 million. Current capital gains rates range from zero to 20 percent. This would include the tax on transfer of assets by death or gift. Effective April 28, 2021. Apply the additional 3.8 percent Medicare tax to all trade or business income of high-income taxpayers with adjusted gross income of $400,000 or more, including transfer of assets. Repeal the deferral of gain from like-kind exchanges (Section 1031) for amounts exceeding $500,000. Applies to exchanges completed in tax years beginning after December 31, 2021.

Effects on Kentucky Farms

Farm data from farms participating in the Kentucky Farm Business Management program were examined to identify balance sheets with basis in assets, especially basis in land. A total of 320 farms in the program were identified. Of those, 160 (50%) appear to have a taxable amount after the exclusion. That is, subtracting adjusted basis from fair market value listed on the balance sheet resulted in a gain greater than the $1 million personal exclusion for the owner or the $2 million exclusion for the owner and spouse. Fair market value averaged $8.4 million. The taxable amount ranged from $14,000 to nearly $28 million. The average amount subject to the transfer tax was about $3.08 million. These are commercial-sized, family-operated Kentucky crop and livestock farms. The average farm operates 2,044 acres. The farmer owns 418 acres (20 percent) and rents the other 1,626. The average Schedule F Income reported was $65,514. The typical Kentucky family farm uses a large portion of rented farmland. The average KFBM farm owns 27% of the land used for production and rents the other 73%. The transfer tax will apply to individual landlords as well. The family farming operation will be adversely affected if it is unable to retain use of this rented land because the transfer tax prompts its sale. Some landlords are family members that are no longer actively involved in the farm. Depending on how broadly family-owned and family-operated are defined the family farm exclusion may not apply to these landowners at their deaths.

People Skills: Appropriate Feedback

Steve Isaacs Contributing Writer

Farmers manage crops and cattle, machinery and marketing, land and labor. That last one may be the most difficult. People are the most important resource in a farm business. Nothing productive happens unless people are doing something with the crops, cattle, machinery, marketing, and land. However, managing people is often the least developed of the skills necessary to run a successful farm business. Giving appropriate feedback to employees or family members is important. Most folks want to know how they’re doing. Students want to know grades, really. Athletes want to know the score. And employees want to know if they are doing it right. If you think praising people when they do something right and criticizing them when they do something wrong is all there is to knowing how to provide feedback, then don’t be surprised that things aren’t going well in the people part of the business. Dr. Bob Milligan with Dairy Strategies suggests that there’s more than Positive and Negative feedback. Another category is Redirective. Let’s look at all three.

POSITIVE

Hopefully, things go right most of the time. So, the majority of the feedback to employees should be easy, right? If so, why isn’t there more of it? Too many managers probably feel that if things are going well, don’t mess with it. Further, it’s not easy. Giving compliments and praise does not come easy for many managers. Why, I dunno. Genuine gratitude and praise for work well done are among the most valuable rewards a manager can provide. Management guru Ken Blanchard says, “Find people doing the right thing and acknowledge it.” Here’s an acronym to help fuel the Positive feedback engine, STAG. Positive feedback to employees should be Specific, Timely, Appropriate, and Genuine. Attaboys are nice, but for what? Say what it is that they’ve done well…”Glad you saw that calf wasn’t acting right.” Don’t wait till tomorrow, or certainly not till the next performance review. Say it while you’re treating the calf. Make the feedback appropriate…she saved the calf, not the farm, but the calf is important. And be genuine. People can tell patronizing from genuine…every time.

REDIRECTIVE or NEGATIVE

Sadly, things don’t always go well…stuff happens. Managers tend to react negatively when “stuff happens” and the appropriate response and feedback can make the difference in improved performance in the future. Here’s where the distinction between Redirective and Negative feedback is important. When things go wrong there’s a tendency for employees to blame the situation or circumstances for the problem while there’s a tendency for managers to blame the person. This “attribution theory” is simply an attempt to link the cause of behavior to the “situation” or to the “person.” This is important. If the bad outcome is truly a result of the situation, and the manager blames the employee, the employee will

justifiably think they are being treated unfairly. However, if the bad outcome truly results from the actions and behavior of the person, then the feedback needs to be directed toward changing the behavior. In other words, something other than Negative feedback is needed if the problem is a result of the situation. This is Redirective feedback. Redirective feedback is focused on correcting the situation, not disciplining the employee. Fix what caused the problem. On the other hand, if the behavior of the employee is what caused the problem, try to change the behavior. The employee must understand that their behavior (not the situation) is what caused the problem. This is where Negative feedback is appropriate. If Negative feedback is used, be absolutely certain that is was the behavior, not the situation, that caused the problem, and that the employee understands that the behavior must change. An example. A worn, but well-maintained roller chain on a piece of equipment that breaks probably did so because of wear…the situation. Use Redirective feedback to evaluate the maintenance and replacement procedures to anticipate and prevent future problems. However, if maintenance and lubrication of the chain was the responsibility of the employee, and they acknowledge that they had not lubricated the machine in the last fifty hours of use, and the broken chain is dry as a bone, then Negative feedback is the appropriate response. The employee’s behavior must change, and consequences should be severe enough to ensure change happens. If there is any uncertainty about “situation” versus “person,” then use Redirective feedback. If it was the situation then the employee does not feel treated unfairly and the result is the same… improved performance. If it was the person, then hopefully they will figure it out and can change their behavior, and the result is the same… improved performance. Redirective feedback can bridge the chasm between Positive and Negative feedback. If an employee does something right or wrong, then Positive or Negative would suffice. When the situation created the problem and circumstances can be improved without blaming the employee for something that really wasn’t their fault, then employees don’t feel they were treated unfairly. They can be part of the solution. Knowing what type of feedback to provide and when to give it is a key to improving performance and morale. Problems are more likely to occur and less likely to be remedied by using the wrong feedback. This graphic helps illustrate the Positive/ Redirective/Negative feedback concept. Please note that it is not to scale. Hopefully, the blue box will be the dominant state of most businesses. However, when “stuff happens,” it helps to know how to respond appropriately. Graphic courtesy of Dr. R.A. Milligan, Senior Consultant, Dairy Strategies, LLC.

The Agricultural Economics Department publishes the Economic and Policy Update towards the end of each month. Each issue features articles written by extension personnel within the department and other experts across the country. Topics will vary greatly but regularly include marketing, management, policy, natural resources, and rural development issues. If you would like to recieve this newsletter by email, please contact Kenny Burdine at kburdine@uky.edu. You can also view current and past issues online at

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Co-editors: Kenny Burdine, Alison Davis, and Greg Halich