After relatively low audit activity for Schedule F filers in recent years, it’s likely that some farmers may be receiving audit notices soon. The IRS’s Small Business/Self-Employed Division recently released a memo announcing a “Pilot Program Auditing Schedule F Expenses” (February 27, 2017). This memo outlines scrutiny surrounding expenses taken on Form 1040, Schedule F, Profit or Loss From Farming.
The memo noted that auditors will be looking for compliance issues such as using the wrong form to deduct expenses, erroneously deducting expenses that belong to another taxpayer, or deducting hobby losses.
Schedule F filers who are tapped for audit may find the following items scrutinized:
Deposits and supplies – Large disbursements, whether expenditures are actually a payment or a deposit. To be considered a deductible purchase of supplies, the following requirements must be met:
- Must be made under a binding commitment to accept delivery of a specific quantity at a fixed price, and there must be no entitlement to a refund or repurchase.
- Prepayment must not be merely for tax avoidance, but must have a specific business purpose such as locking in a price or ensuring availability.
- Deductions must not result in a material distortion of income. Things that may be considered: customary business practices of the farmer, materiality of the expenditure in relation to income for the year, the time of year the purchase is made, and the amount of the expenditure in relation to past purchases.
Schedule F, Line 13, Custom Hire – Hiring individuals or businesses that own equipment not owned by the taxpayer, such as no-till planters, combines, etc., to perform specific activities on their farms. While these amounts are fully deductible as an expense, auditors are being instructed to be attentive that amounts paid for rental or lease of equipment operated by the taxpayer should not be claimed on this line, but rather Line 24A, Rent or Lease. In addition, wages paid to employees should not be included on this line.
Fuel Expenses – Auditors will be looking to determine that all fuel expenses claimed were for conducting business on the farm and not for personal use.
As you file your 2016 returns and plan for 2017, it’s good to keep these items in mind. For additional insights, see our recent TaxThink blog post An IRS audit isn’t the end of the world.