The ins and outs of prepaid expenses

Austin Duerfeldt, University of Nebraska-Lincoln

There are three tests for 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.

Testing for Availability

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

Test 1: The expenditure must be an actual purchase; it cannot be a mere deposit to buy in the future.

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.

Test 2: The expenditure must be for a business purpose and not merely to avoid taxes.

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.”

Test 3: The expenditure must not result in a material distortion of income.

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:

  1. The relationship between quantity purchased and the projected quantity to be used.
  2. The materiality of the expenditure in relation to total income for the year.
  3. Customary business practices of the taxpayer in buying supplies and the business purpose for paying in advance.
  4. The relationship between the expenditure and past purchases.
  5. The time of year in which the expenditure was made.
  6. How deductions of prepaid expenditures have affected taxes paid by the farmer in previous years.

Rules and Limitations

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

1.  The 50% prepaid expense limit

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.

2. Farm Syndicate Rules

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:

  1. Have ownership interests been offered for sale at any time in an offering required to be registered under federal or state securities regulations?
  2. Were more than 35% of the losses during any period allocated to limited partners or limited entrepreneurs?

Summary

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. If you have questions feel free to email me, Austin Duerfeldt, at [email protected].

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