Many Indiana producers have been adversely affected by weather conditions in 2002 and most of the state has been declared a disaster area. However, because of cash accounting methods, these losses may not be reflected in their taxable income until 2003. For example, because of reduced feed supplies some livestock producers have reduced herd size through larger than normal sales of livestock thereby increasing taxable income for 2002. Some crop producers who normally sell their crops in the year following the year of production may receive crop insurance indemnities or government disaster assistance payments this year. In both cases, these producers would be likely to have lower than normal taxable incomes in 2003. Income tax law allows farmers to defer reporting of this income to even out their income and avoid potentially higher taxes. Farm income averaging was enacted after the weather-related provisions and is an alternative which may result in lower taxes for producers in some situations. Good tax management involves consideration of several tax years rather than minimizing this year’s tax bill.

Weather-related Sales of Livestock There are two provisions in tax law which attempt to cushion producers from the consequences of the weather-related sales of livestock. Livestock held for draft, breeding or dairy purposes and sold because of weather-related conditions are provided a two-year reinvestment period under the first provision. The second provision, which applies to all livestock (other than poultry), allows cash basis taxpayers whose primary trade or business is farming a deferral of receipts from sales in excess of normal business practice because of weather-related conditions resulting in a disaster area declaration. Both provisions apply only to those sales which are in excess of normal business practice of the producer.

Sale with Replacement

The gain on the weather-forced sale of livestock held for draft, breeding or dairy (not sporting) purposes does not need to be reported as income if the proceeds will be used to buy replacement livestock within two years after the end of the tax year of the year of sale. Although declaration of a disaster area is not necessary, a producer must be able to show that weather-related conditions forced the sale of more livestock than would normally be sold. For example, a beef producer who normally sells five cows per year may sell 20 cows in 2002 because of limited feed supplies. Gains from the sale of the extra 15 cows would not be reported as income if the producer purchased at least 15 replacement animals before the end of 2004. The new livestock must be used for the same purpose as the livestock which was sold. Beef cows must be replaced with beef cows.

A producer’s tax basis in the replacement livestock equal to the basis in the livestock sold plus any additional amount invested in the replacement livestock that exceeds the proceeds from the sale. For example, a producer sells 20 raised beef cows (with a $0 tax basis) for

$500 each. The gain of $7,500 (15 cows sold in excess of normal business practice X $500) is deferred. If the producer purchased 15 cows in 2004 for $600 each, the tax basis in the replacement animals would be $100 (the $600 cost minus the $500 proceeds from sale).

To make the election under Section 1033(e) to defer recognition of gain, a producer does not report the gain and attaches a statement to the current year’s tax return. The statement shows the following:

1. Evidence of weather-related conditions which forced the sale of the livestock.
2. Computation of the amount of gain realized on the sale.
3. The number and kind of livestock sold.
4. The number and kind of livestock that would have been sold as normal business practice without the weather-related sales.

If a producer spends $7,500 and buys 15 cows before the end of 2004, the basis of the replacement animals will be $0, the same as the raised cows sold. If the producer spends less than $7,500 on the 15 replacement animals, the difference between what was spent and $7,500 must be reported as 2002 income. If less than 15 replacement cows are purchased, the gain from the animals not replaced must be reported as 2002 income regardless of the cost of the replacement animals. When filing an amended 2002 return, the producer will be subject to additional tax and interest on the tax.

Sale without Replacement

Producers who are forced to sell livestock because of weather-related conditions may be eligible for an exception to the rule the livestock-sale proceeds must be reported as income in the year they are received. This exception allows postponement of reporting income for one year. To qualify, an area which affects the livestock must have been declared a disaster area. The animals do not need to have been located in the disaster area and can have been sold before or after the disaster area declaration. However, only the livestock sales in excess of normal business practice qualify for deferral.

A declaration must be attached to the tax return for the year in which the weather-related sale occurred. To make the election the statement should include the following:

1. A declaration that the election is being made under Section 451(e).
2. Evidence of the weather conditions which forced the early sale on the livestock and when the area was declared a disaster area.
3. A statement explaining the relationship between the disaster area and early sale.
4. The total number of animals sold in each of the three preceding years.
5. The number of animals that would have been sold as normal business practice if the weather-related condition had not occurred.
6. Total number of animals sold and the number sold because of the weather-related event during the tax year.
7. Computation of the amount of income (see calculation below) to be deferred for each classification of livestock.

For example, a producer normally farrows and feeds 2,000 pigs per year. However, because of drought which caused the area in which the farm is located to be declared a disaster area, the farmer sells 1,000 pigs as feeder pigs in 2002 rather than feeding them and selling them as market hogs in 2003. Under normal practice, no feeder pigs would be sold, so the proceeds from the sale of the 1,000 head can be deferred ($35 per head X 1,000 feeder pigs = $35,000) can be deferred until 2003.

Crop Insurance and Disaster Assistance Payments

For farmers who use cash accounting, there is an exception to the general rule that payments must be reported in the year in which they are received. This exception applies to crop insurance indemnity payments received when crops cannot be planted (prevented planting) or are damaged or destroyed by a natural disaster such as drought or a flood. This exception does not apply where the insurance indemnity is due to a low price, such as could occur with the Crop Revenue Coverage (CRC) or Revenue Assurance (RA) pro-grams. Government disaster assistance payments are treated the same as insurance indemnity payments.

The exception allows farmers to postpone reporting such payments by one year. To qualify for the exception, a farmer must be able to show that the income from a substantial portion of the crop (generally considered as 50% or more) for which payment has been received would normally have been reported in a year following the receipt of payment.

If a farmer qualifies for this exception, the producer has the option of reporting the income in the year in which it is received. Alternatively, the producer can elect to defer reporting the payment as income until the following year. The election to postpone the reporting of the payment as income when received covers all crops from a farm business. For example, a producer cannot postpone the reporting the payment received for corn unless reporting of the payment for soybeans is also postponed if both payments are received in the same year. However, separate elections can be made for each separate farming business.

To make the election under Section 451(d), a statement is attached to the tax return which includes:

1. The name and address of the producer.
2. A declaration that an election is being made under Section 451(d).
3. Identification of the crop or crops damaged or destroyed.
4. A declaration that under normal business practice the income from the crops that were destroyed or damaged would have been included in gross income in a year following the year of damage or destruction.
5. The cause of destruction or damage of the crops and dates when the destruction or damage occurred.
6. The total amount of payments received, itemized with respect to each crop and each date when payment was received.
7. The names(s) of the insurance companies or federal agencies from which payments were received.

Farm Income Averaging

In contrast to the methods of defer-ring the reporting of income dis-cussed above, farm income averaging uses prior years to generate potential tax savings. Farm income averaging allows farmers to elect part or all of their farm income and have it treated as if it had been earned equally over the three preceding years. The portion of elected farm income is added to the taxable incomes in the base years and is taxed at the tax rates for those years.

If taxable income in 2003 is likely to be low relative to 2002, then the deferral methods discussed above are likely to reduce taxes. However, if taxable income in 2003 is likely to be similar to 2002 or higher, farm income averaging may provide a tax savings alternative. This could occur because of increased off-farm employment or the sale of some farm assets other than land. This is especially true for producers whose taxable incomes in the 1999 to 2001 tax years have been low.

Further Information

For additional information on these tax provisions and details of the elections, see IRS Publication 225, The Farmer’s Tax Guide. This is available on the web at www.irs.gov. under Publication 225 in the search menu.