What Are Prepaid Expenses and How Can They Be Deducted?

As the year winds down and you have your farm operation’s taxes ready to be filed, don’t be surprised if your tax preparer suggests that you spend an additional sum of money on expenses. These are called “prepaid expenses” and are prepaid farm supply amounts paid during the tax year for seed, fertilizer or other farm supplies not used or consumed that year.

According to its website, the Internal Revenue Service (IRS) limits the allowable deduction for prepaid supplies if they exceed 50% of the total deductible farm expenses (excluding prepaid supplies) for the taxable year. If the prepaid farm supplies have actually been used or consumed, the amount is fully deductible.

However, prepaid expenses can be difficult to understand and even get approved. The IRS has put into the following criteria for deducting prepaid supplies and can be further explained in IRS Revenue Ruling 79-229:

1. Actual purchase vs. deposit
   The expenditure must be a payment for the purchase of supplies, not a deposit. The amount is considered a payment if it was made under a binding commitment to accept delivery of a specific quantity at a fixed price, and the farmer is not entitled to a refund or repurchase.
2. The prepayment is not merely for tax avoidance, but has a specific business purpose. Examples of business benefits are:
   1. Fixing maximum prices
   2. Securing an assured feed supply
   3. Securing preferential treatment in anticipation of shortages
3. The deduction does not result in a material distortion of income. Some factors to consider in determining whether there is a material distortion of income are:
   1. The farmer’s customary business practices in conducting the farming operation.
   2. The materiality of the expenditure in relation to the taxpayer’s income for the year.
   3. The time of the year the purchase is made.
   4. The amount of the expenditure in relation to past purchases. Inspect check endorsements, flip checks, and check with suppliers to determine the validity of the expense.

Farm managers need to understand the rules and regulations set in place by the IRS when it comes to meeting requirements for prepaid expenses, and a tax and accounting provider specializing in agriculture can help.

Whether you are a full-time farmer or you enjoy farming part-time, Compeer Financial has the tax expertise you need. Visit compeer.com to see if our services are right or for you.

Tax and accounting services are subject to regional availability. For information about service availability in your area, please contact your local Compeer Financial representative.