Ag Accounting: The Ins and Outs of Prepaid Expenses

 

 

We have all witnessed the prepaid December scramble: a farmer running all over town writing checks because a tax preparer just advised that an additional $40,000 in expenses would be beneficial. One stop will be to the chemical company, another stop to the machinery dealer, and then maybe, if more is necessary, there will be a stop at the oil company to contract some fuel. While this is all well and good, we sometimes forget that there are some rules to the prepaid expense game. Here are the things you need to keep in mind before writing that check.

 

 

There are three tests for prepaid expenses. The first of these tests is easy but gets abused none the less.

 

What this means is you cannot just write a check to the machinery dealer. This test is to determine whether the transaction is a purchase or a deposit. To be an actual purchase, it needs to include several details.

 

First, it needs to outline the specific quantity of items purchased. I can have prepaid expenses from the chemical company for 30 tons of lime at $X.XX price. I cannot, however, have a prepaid expense of $X.XX to the chemical company that is applied to my account for use later. The best practice here is to secure an invoice that clearly states a definitive quantity, quality, and price for the item purchased. There should also be no right to refund the payment nor substitute for other goods or services.

 

The establishment of a prepaid expenditure as a legitimate business purpose in agriculture is straightforward. Here are some examples to keep in mind. If you are prepaying anhydrous so you have the required quantity at the time of application, it fits this test. If you are purchasing seed corn in late fall to take advantage of discounts, that fits this test. If you are contracting fuel due to the expectation of rising costs, that also fits this test. The main point is that when asked about why you purchased this prepaid expense, you have a justified business purpose that drove the decision, not just wanting “to avoid paying taxes.”

 

This test is the most difficult for the purchase to pass as a legitimate prepaid expense. There are six key factors to look at with your tax preparer when working through this test:

 

In addition to the testing process, there are two rules/limits to keep in mind.

 

 

Under this limit, if your prepaid expenses equal 50% or more of your deductible non-prepaid expenses for the taxable year, the prepaid expenses are only deductible as the purchased items are consumed. In a simplified example, if you had $100,000 in deductible non-prepaid expenses in 2018, you could only deduct $50,000 in prepaid expenses. Any prepaid expenses over $50,000 would need to be expensed in a later tax year when these goods are used or consumed. There are some exceptions to this limit that you can find in IRS Publication 225.

 

 

These rules were developed to manage investors in limited partnership tax shelters. There are two primary points to review if you are wondering if the IRS considers you a syndicate:

 

Prepaid expenses can be a helpful tool for farming and ranching operations.  Hopefully, this article cleared up some gray areas that may have otherwise been a conversation starter during an audit.