If Mother Nature hands you crop damage via drought, inability to plant, hail, flooding, or fire and you receive crop insurance proceeds, alternatives for the tax reporting of this income are available.
The first option involves reporting the crop insurance proceeds as income in the year payment is received. The second option applies a tax rule that allows a qualified taxpayer to elect to include crop insurance and disaster payments in the year following the year of the crop loss if, under the taxpayer’s business practice, income from the sale of the crop would have been reported in a later year.
Here are some key factors to be aware of:
- The taxpayer must use the cash method of accounting.
- The normal business practice of the taxpayer must be to defer taxability for most of the current-year production to a future year.
- The election to defer is binding on all proceeds from damage to crops representing a single business.
- The taxpayer must include an election statement with the tax return for the year of damage, disclosing relevant facts to support the deferral election.
- An election can be made via an amended return, but once made, the election is irrevocable.
- The portion of the proceeds applicable to the price component of revenue protection insurance cannot be deferred.
- If eligible for deferral, the gross insurance proceeds, before any offset for premium due, are the amount used for deferral.
One of the more challenging tests to substantiate is to prove that were it not for the crop damage, the taxpayer’s “normal business practice” would result in the crop income being reported in a later year. The Internal Revenue Code and the Treasury Regulations do not provide detailed guidance as to how to apply this test. However, there are an IRS Revenue Ruling and a 2008 Tax Court case that provide some guidance. The IRS ruling indicates that an established pattern of deferring more than 50% of current-year production would establish a “normal business practice,” and therefore the taxpayer is eligible to defer the crop insurance income. In the Tax Court case, the Court ruled that an established pattern of deferring 35% of current-year production does not meet the requirement to be able to defer the crop insurance income.
As with many tax provisions, this one is complex, with many gates to get through in order to benefit. Careful understanding of the requirements is needed in order to take advantage of the deferral strategy. If you have questions, or would like to discuss this or other income tax strategies, please contact us.