Watch Out for Taxation of “Hedges”

We had a reader send an example of a current “hedge” being offered by elevators or cooperatives.  The example is as follows:

·         Cash bean price available of $9.05/bu

·         Producer sells on contract and receives 70% cash payment, or $6.33 per bushel

·         Remaining $2.72 is retained by grain dealer and utilized with what appears to be a put / call option pricing strategy:

1.       Producer’s maximum risk is $2.72 retainage by grain dealer (in other words, $6.33 cash received represents floor price of strategy)

2.       Through a Jul-17 contract, producer has upside pricing potential with the arrangement until that time.  So, if the CBOT bean price went significantly higher, the producer would benefit from that price increase; and if the CBOT bean price went significantly lower, the producer’s payout of the $2.72 retainage would be lowered accordingly, down to $0.  The producer apparently has the ability to close the contract at any current price during the contract.

Most farmers would view this as a hedge since they are locking in a floor price on their beans.  However, it is likely that the IRS would view this as not being a hedge for tax purposes due to the farmer “speculating” on an increase in prices.  Tax hedges only lock in a price to prevent the net crop price from dropping further.  If the farmer sells their beans and then buys the beans back on the “board” with futures or an option, this is not hedging, this is speculation.   Also, the farmer would have a hard time arguing that they have a hedge when cash beans are $9.05 since they may end up with only $6.33.

The tax treatment on this can be harsh if certain price events happens.  For example, if the “hedge” results in a loss and it should have been treated as speculation, it must be reported as a capital loss and if the farmer has no other capital gains, (s)he can only deduct $3,000 per year.  Let’s look at an example:

Spec-U-Late Farms, Inc. enters into a “hedge” of 100,000 beans with their local elevator which puts in a floor of $7 on their beans but with no limit on the upper price when beans are trading at $10 per bushel.  The farmer ends up losing $3 on the “hedge” and instead of deducting the $300,000 on Schedule F, it shows up as a capital loss with a net deduction of $3,000.  Over on Schedule F, the farmer loses the $300,000 deduction.

If you are interested in doing a hedge like this, be very careful to discuss this with your tax advisor before you place the hedge.

 

  • Principal
  • CliftonLarsonAllen
  • Yakima, Washington
  • 509-823-2920

Paul Neiffer is a certified public accountant and business advisor specializing in income taxation, accounting services, and succession planning for farmers and agribusiness processors. Paul is a partner with CliftonLarsonAllen in Yakima, Washington, as well as a regular speaker at national conferences and contributor at agweb.com. Raised on a farm in central Washington, he has been immersed in the ag industry his entire life, including the last 30 years professionally. In fact, Paul drives combine each summer for his cousins and that is what he considers a vacation.

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Comments

Does it matter whether or not the producer is a cash basis taxpayer?

In your example the Producer receives 70% of the contract price up front which he records as income. If the price falls and the Producer receives no more cash how would there even be a loss to report? He never showed that grain (the 30%) as income in the first place did he?

Trent, the key issue is that the IRS can assert that the farmer really reported 100% as income on Schedule F with the remaining 30% as a capital loss on Schedule D. Always, the biggest concern with not getting this correct is the conversion of an ordinary loss to a capital loss which can only offset capital gains or deduct $3,000 per year.

Very Good Articale, but you didn’t finish. As you know the capital loss can be carried over to offset Capital Gains in future years. If no cap gains occur then it will take 90 years! to deduct the remaining loss. What if this occurs in an estate? I don’t think Cap Losses are a pass through item. Yes? No? Thank you. Daryl

If there is a capital loss at the time of death, it is permanently lost.

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