The Tax Cuts and Jobs Act changed some tax rules that may affect you. The IRS put together a fact sheet that sums up the changes. They concern tax rates, accounting methods and capitalization and deductions. For example, for tax years starting after 12/31/17, the tax law no longer requires farmers to account for inventory if they meet the “gross receipts” test. Learn more details here.
Depreciate vs. Inventory
Livestock held primarily for sale by for-profit farmers must be included in inventory. However, livestock held for draft, breeding, or dairy purposes can either be included in inventory or depreciated as the farmer chooses. Both options have advantages and disadvantages, so the decision is ultimately based on whether farmers prefer a current benefit or future benefit.
If farmers choose to depreciate the livestock, they will receive a current depreciation deduction. However, this will decrease the farmer’s basis in the livestock and therefore increase any gain when the livestock is sold.
Also, any future gain on a sale up to the amount of depreciation taken will be taxed at ordinary rates. If, on the other hand, farmers choose to inventory the livestock, they will forego the current depreciation deduction but any future capital gain will be taxed at the lower and more preferable capital gain rates.
Farmers should consider this decision and its impacts carefully, because once a method is chosen, it cannot be changed unless authorized by the Commissioner.
If farmers decide to depreciate their livestock, depreciation will begin when the livestock is mature (i.e., can be worked, milked, or bred). Most farm business assets are depreciated using the Modified Accelerated Cost Recovery System (MACRS) which consists of two depreciation systems: the General Depreciation System (GDS) and the Alternative Depreciation System (ADS).
Generally, GDS must be used unless ADS is required by law or elected. The recovery period for cattle, goats, and sheep under the GDS method is five years, while the recovery period for hogs is three years. These recovery periods remain the same under the ADS method except for cattle, which increases to a seven-year recovery period.
For 3-, 5-, 7-, or 10-year property placed in service before 2018, farmers were required to use the 150% declining balance method over the GDS recovery period (discussed above) unless the election was made to use the straight-line method. For property placed in service after 2017, these types of property are by default depreciated using the 200% declining balance method.
All purchased livestock are considered to be tangible personal property and are therefore eligible for a depreciation deduction under Section 179. Those with a recovery period of 20 years or less are also eligible for a bonus depreciation allowance. For qualified property acquired and placed in service prior to September 28, 2017, there is a bonus depreciation allowance of 40% provided that the original use of the property begins with you. For qualified property acquired and placed in service after September 27, 2017, the bonus depreciation allowance is 100% and the property can be either new or certain used property.
It is important to note that farmers can deduct the costs of raising livestock during the years in which the animals are being raised. If these costs are deducted, the basis of the livestock is zero and, therefore, these costs cannot be depreciated.
If a lower tax rate on a future capital gain is preferred by farmers, they should chose to inventory their livestock. There are two inventory methods available.
The simplest method is called the farm-price method. This method provides for the valuation of inventories at market price less direct cost of disposition.
The other inventory method available is the unit-livestock-price method. To determine the valuation under this method, livestock are classified into groups with respect to age and kind. Then, a price for each class is established, taking into account the normal cost of raising those animals. Farmers using the unit-livestock-price method must reevaluate unit prices each year and adjust either upward or downward to reflect changes in the costs of raising livestock.
Treatment and Calculation of Gain on Sale
Sales of livestock are reported on Form 4797, Sales of Business Property. Calculation of the gain depends on whether the animals were raised by the farmer or purchased.
The gain on sale of livestock raised by the farmer is calculated as the difference between the selling expenses and the gross sales price, assuming the basis is zero because the costs of raising the livestock were deducted during the years in which the animal was being raised.
The gain on sale of livestock purchased by the farmer is calculated by subtracting the adjusted basis and selling expenses from the gross sales price.
Treatment of the gain depends on whether or not the property is qualified under Section 1231. As stated in Section 1231(b)(3), to qualify as property used in trade or business, livestock must be held by the taxpayer for draft, breeding, dairy, or sporting purposes for at least twelve months (twenty-four for cattle and horses). Any livestock that is held primarily for sale to customers in the ordinary course of business does not qualify.
If the Section 1231 holding period is met and the livestock was purchased, any gain is reported on Part III of Form 4797. In other situations where the holding period is met, any gain or loss is reported on Part I. If the Section 1231 holding period is not met, any gain or loss from the sale is reported on Part II of Form 4797, Ordinary Gains and Losses.
There are many different methods available to account for livestock, and it is important that farmers be knowledgeable of their options. The decision of whether to depreciate or inventory their livestock must be made at the beginning of the farming operation and cannot be changed without permission of the Commissioner. These various options make it imperative that farmers utilize the tax planning services a tax professional can provide.
Amanda Hensley serves as a Senior Manager to the Tax Department in the Knoxville office. Amanda joined the firm in November of 2011. She earned both her Bachelor of Science in Business Administration degree in Accounting and Master of Accountancy degree at the University of Tennessee at Knoxville.
The tax professionals at LBMC can help minimize the tax burden and provide crucial information on an ongoing basis to assist in day-to-day operations.
LBMC tax tips are provided as an informational and educational service for clients and friends of the firm. The communication is high-level and should not be considered as legal or tax advice to take any specific action. Individuals should consult with their personal tax or legal advisors before making any tax or legal-related decisions. In addition, the information and data presented are based on sources believed to be reliable, but we do not guarantee their accuracy or completeness. The information is current as of the date indicated and is subject to change without notice.