Watch Out for Timing of Hedging Loss
I hesitate to write this post since I know that most of our farmers who hedge (including their tax advisors) may be technically reporting their hedging loss in the wrong year. In most cases this will not be true, but there are cases where it may happen and if an IRS auditor who knows hedge accounting picks your tax return to do an audit, you may end up with the wrong result. NOTE – The following applies to farms with more than $5 million in average cash receipts. If you are under this level, the following may apply or may not.
Under tax accounting for hedging, the hedge gain or loss is not recognized until the futures or options transaction is closed AND the underlying product being hedged is sold or purchased (in the case of feed). Most farmers and their tax advisors simply record the gain or loss when the hedge transaction is closed out. If both the hedge transaction and underlying product sale occurs in the same year, no-harm, no-foul. However, if a hedge loss is incurred right at year-end and the underlying product is sold after year-end, most farmers will inaccurately report taxable income for each year.
Example: Farmer Benson grows corn. She hedges 100,000 bushels of corn in storage on October 1, 2014. She closes out the hedge on December 29, 2014 for a $100,000 loss. On January 15, 2015, she sells her corn for $450,000. Most farmers (including their tax advisors) would report the $100,000 hedge loss in 2014, when technically the loss should be reported in 2015 when the corn is sold.
If the hedge transaction had resulted in a $100,000 gain, then technically the gain would be deferred from 2014 until 2015. In this case, the farmer would have the benefit of deferral until 2015. Remember that the tax laws allow for hedge gains or losses to be deferred until the “hedge” is closed out. The hedge is related to the product being sold not the futures contract. Therefore, all closed hedge gains and losses are technically accumulated and reported for tax purposes when the item being hedged is finally sold or purchased.
Over time, these transactions all wash out and the net gain or loss will be exactly the same, however, the timing of these transactions can cost or save farmers income taxes on an annual basis. The income tax treatment of hedges has many pitfalls and this is just one pitfall that may arise.
(Note: Some commentators may disagree with this analysis, but I know personally this is how IRS agents with hedging knowledge will generally treat these transactions).
Paul Neiffer, CPA
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 principal with CliftonLarsonAllen in Walla Walla, 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. Paul and his wife purchase an 180 acre ranch in 2016 and enjoy keeping it full of animals.
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