With filing dates for income tax approaching, it's a good time to ponder how to simplify the tax filing process you are using if you are a farmer or small business owner. Neil Harl, emeritus professor of economics and ag law at Iowa State University and a well-known tax and estate planning expert, says more farmers should be taking advantage of the "small partnership tax exception" when filing their federal tax return.
This law has been on the books for a number of years. "Congress in 1982 provided one of the few genuine simplification steps that can be taken when filing federal income tax returns," says Harl, who although retired from ISU is still a member of the Iowa State Bar Association. He remains busy putting on tax seminars across the U.S. for lawyers, accountants, tax preparers and others.
More farmers need to be using this simpler approach
"More farmers and small business people need to be taking advantage of this exception, which has been allowed by IRS for quite a while, since 1982," says Harl. "It's a very simple way to file your taxes, much simpler and cheaper than filing a complicated partnership tax return. I estimate 90% of our farm partnerships in Iowa and the Midwest are eligible for the small partnership exception."
How did this exception come about? In the 1970s and early 1980s, Congress was worried about tax sheltering. The concern included tax sheltering provisions that affected agriculture, but it wasn't limited to agriculture. There were a lot of high profile projects being built or proposed. The U.S. Department of Treasury set up a commission to look into this situation, and Dr. Neil Harl was appointed to serve on that commission.
It was a small group, he says, seven or eight people as advisers who served on the commission. "Officials at the U.S. Treasury wanted us to make recommendations as to how to deal with tax sheltering in agriculture. They thought the reason so many investors were taking advantage of tax shelters in agriculture was because of cash accounting. They told us upfront that they thought our commission should recommend the U.S. tax laws not allow cash accounting to be used in agriculture. Our commission didn't agree with their view."
How the "small partnership exception" came about
"Our commission," says Harl, "responded to the U.S. Treasury officials, telling them we believed it's more complicated than just using cash accounting methods." The commission made some recommendations and most were enacted during the next few years.
The U.S. Treasury and the Internal Revenue Service were also concerned about partnerships. Most tax sheltering was taking place as partnerships, in particular, limited partnerships. Throughout the decade of the 1970s there was emphasis in tax writing committees of Congress to do something about partnerships being used to shelter income from taxes.
The mood in Washington, and the message Congress was sending to IRS, was "you've got to tighten up on tax laws affecting partnerships." A group of senators and representatives from the Midwest responded. "They told us," says Harl, "that if our commission recommended that the proposed tougher rules be enacted, that would make life quite difficult for small family farmers and for people who own a small business. Thus, we knew we needed to recommend and support an exception to the complicated rules for partnerships."
Rules for business partnerships are complicated
Out of that discussion eventually came some legislation in 1982. This legislation was passed, enacted and has been law now for quite a while. "In the 1982 Tax Act, Congress created a special exception for small partnerships. It passed that year," he says.
This "small partnerships exception" has been in Section 6231(a)(1)(B) of the IRS Code for a number of years now. "It provides a simple way to report income," explains Harl. "If you are eligible, you simply pass the income, losses and credits straight through without filing a partnership tax return. You go through to schedule F if you're a farmer, schedule C if you're a small business, schedule E if you are retired.
The law says you're not even deemed to be a partnership if you meet the "exception" requirements. What are the requirements?
"You must have 10 or fewer members in your business entity and all members have to be individuals. Husband and wife, however, are counted as one. Estates of individuals or C corporations could be a member as well. But you couldn't have a pass-through entity as a member."
How does this work? Any penalties or pitfalls?
Harl explains a pass-through entity: "A pass-through entity is like a limited liability company, or LLC, or LLP or a trust. Those could not be members of a small partnership exception. I think 90% of the farm partnerships in Iowa and Midwest are eligible for the IRS small partnership exception. The penalty is stiff, as you may know if you're familiar with partnerships. The penalty applies if you fail to file a timely or complete Form 1065, the federal income tax return for partnerships."
That penalty is $195 a month, per partner, for up to 12 months, says Harl. You can get a bill from IRS for $1,500 or $2,000 or more for the penalty. But the penalty wouldn't apply if you're in a small partnership and use the small partnership exception. This is a very simple way to file your income tax, and it bypasses a penalty issue, except in the case where you don't pay the tax. That's the only time you'd have to worry about a penalty when using the small partnership exception.
A simple way to handle income for many farmers
The "small partnership exception" is a simple way to handle income for a farming operation or small business that would otherwise be in a partnership situation. "It's often said our U.S. tax laws aren't simple," notes Harl. "But this is one instance where a tax law is simple. It's been on the books for many years now, and some people use it. In fact, my wife and I use it on our farm in southern Iowa, a small partnership situation like we've explained here."
Harl encourages everyone involved in a farming or small business partnership to take a look at this. Would it be helpful? It's certainly simpler and you sidestep the penalty issue. "We think it certainly deserves a look and is something to ask your accountant or your tax adviser about," he says.
Check with your tax adviser or tax practitioner
Attending Harl's seminars, lawyers and CPAs say this small partnership exception should be used by more farmers. "Even many of the people attending my seminars; lawyers, accountants and others aren't aware of it or don't fully understand it until I explain it. Many of their clients can use it. We want to spread the word about the small partnership exception. It's strange to find something simple in our tax system. This exception is something that's often being overlooked."
What's Hart's advice for farmers who may think they are eligible? Take a look at your tax situation and if you have questions check with your tax adviser or tax practitioner.
Double-check with that person to make sure you're eligible for the small partnership exception. Remember: you must have 10 or fewer members in your entity and it can't be a pass-through entity. But they can be a C corporation as a member. "Best thing is to check with your tax adviser to be sure you are eligible," says Hart.
EDITOR'S NOTE: For more information, read the article authored by Neil Harl on page 64 in January 2015 Wallaces Farmer magazine. It is titled "This year simplify your tax filing." You can access the magazine online at www.wallacesfarmer.com. Scroll to the bottom of the page and click on Magazines Online.