September 18, 2014
Year-end Prepaid Expenses
A recently released Tax Court decision provides a reminder
of the importance of maintaining sufficient funds in the
bank when writing year-end checks. We provide a handout
sheet for your cash method farm clients, informing them of
the steps they need to take to ensure that their year-end
prepaid expenses stand up to IRS scrutiny.
Background
The typical cash method farmer or rancher may spend several hundred thousand dollars on year-end
prepaid expenses in order to adjust taxable income to a desired level. Clearly, it is important that our
clients transact those prepaid expenses in a manner that stands up in the event of an IRS examination.
As we all understand, those large checks written in the last few days of the tax year will receive
particular attention from any IRS examiner.
Delivery or Mailing of a Check
Payment by a check becomes deductible when that check is delivered to the payee or when placed in
the mail to that payee [Rev. Rul. 80-335]. If the payee is instructed to hold the check, the expense is
not deductible until the check is cashed [Fischer v. Comm., 14 TC 792, 1950; Blumeyer v. Comm., TC
Memo 1992-647]. Wholly-circular transactions between related parties, where there was no actual
economic outlay, are disallowed [Oren v. Comm., TC Memo 2002-172, aff’d. 357 F.3d 854, CA-8, 2004].
Check Written Against Insufficient Funds and Not Cashed
The Tax Court recently disallowed a corporation’s year-end deduction for officer compensation to its
controlling shareholder of $815,000 [Vanney Associates, Inc. v. Comm., TC Memo 2014-184]. The net
payroll check after withholding was issued for over $460,000 and was written when the balance in the
bank account was less than $390,000. The check was not presented to the bank in the normal course
of business within a few days, but rather was endorsed back over to the corporation and treated as a
shareholder loan on the books. No attempt was made to cash the check. The corporation repaid the
shareholder in the following year. The officer testified that the corporation could have obtained a loan
to cover the check, but he didn’t need the money and he wanted to avoid the expenses of obtaining a
loan.
Tax Planning for Farmers
As we approach tax planning season, it is time to remind our clients of the year-end payment practices
that will withstand IRS scrutiny. In light of the Vanney case, banking relationships may need to be
revised to ensure that overdrafts in the checking account(s) will be honored by the bank. Under
Vanney, it is particularly important that checks issued for related party payments, such as interest,
rent and salaries, be presented promptly for payment and supported by adequate funds in the
account.
With that preliminary guidance, we review the rules regarding prepaid expenses.
The Four Guidelines
We will not repeat all of the steps on the accompanying handout, but use this transmittal to add some
technical background for your reference.
The first three guidelines come from Rev. Rul. 79-229. While this Revenue Ruling specifically discusses
prepaid feed, the IRS uses the three tests in that ruling as applicable to all cash method farm prepaid
expenses.
Observation: From our perspective, the first of these three tests (purchase vs. deposit) is probably the
one of greatest concern. A receipt that reads “Fertilizer — $50,000” is simply not going to cut it. We
need to remind our clients that they must have a detailed invoice, identifying a specific quantity, grade
of goods, unit price, and of course a total expenditure amount. The payment accompanying the
invoice need not be for the entire amount, however.
The third guideline of Rev. Rul. 79-229 (no material distortion of income) has largely been replaced by
Reg. 1.263(a)-4(f), issued January 5, 2004. This regulation allows a cash method taxpayer to prepay
any expenditure that does not produce a benefit extending beyond either 12 months or the end of the
next tax year. All prepaid expenses are subject to this limit, except interest expense, which can never
be treated as a deductible prepaid item [per IRC Sec. 461(g)]. This regulation, with its blanket 12month rule for all expenses other than prepaid interest, results in cash method farmers now being
allowed to prepay rent expense. The rental period must not extend beyond twelve months from the
year-end. Previously, an old Revenue Ruling (Rev. Rul. 55-540) had disallowed deductibility of any
prepaid rent.
The fourth guideline (50% prepaid limit) is by statute [IRC Sec. 464(f)]. As we note in the accompanying
Guidelines handout, in measuring the non-prepaid farm expenses for purposes of making the 50%
calculation, we are entitled to consider not only those expenses incurred to date, but also the farmer’s
depreciation and amortization deductions. Also, it is possible to occasionally violate this 50% test. The
statute allows an exception for a taxpayer whose aggregate prepaid supply items for the past three
years was less than 50% of the aggregate non-prepaid farm expenses for those years. Thus, we are
allowed to violate the 50% statutory limit if, on average, we have not violated it for the past three
years. This exception does require that the taxpayer either live on a farm, have a principal occupation
of farming, or be a member of the family of such a taxpayer.
Borrowed Funds
While payment may be made with borrowed funds, the funds may not be borrowed from the vendor
or payee as part of the same transaction (Hager v. Comm., TC Memo 1982-663, 1982). A purchase by
credit card charge is considered a payment when the charge occurs, not later when the credit card bill
is paid (Rev. Ruls. 78-38 and 78-39).
Conclusion
The guidelines are provided as a tool for your clients, so that expenses will be paid in a way that will
not be upset by the IRS.
Chris Hesse and Andy Biebl