Tax Implications of Using Risk Management Strategies
Most of our nation's agricultural producers have experienced significant volatility both in the prices they receive for the commodities they produce and in the prices they pay for inputs. In response to increased price volatility, a growing number of producers have included risk management strategies in their farm management planning in order to reduce exposure to potential losses from price changes. Although most economists agree that the use of risk management tools has advantages, it is important for producers to be aware of tax implications before implementing them.
First, the Internal Revenue Service (IRS) treats hedging activity differently than it treats speculative activity. According to the Oklahoma Cooperative Extension Service1, the IRS defines a hedging activity as "a transaction that any taxpayer enters into in the normal course of the taxpayer's trade or business." It must be used for:
- controlling price changes or instabilities in currencies for property the individual holds; and
- controlling price changes in borrowed or planned to be borrowed property, interest rates or currency fluctuations.
With this in mind, a farmer who enters into a futures contract to protect against commodity price volatility is considered to be engaging in a hedging activity. Therefore, reportable funds should be treated as ordinary income (or loss) and reported on Schedule F (Form 1040), "Profit or Loss from Farming." In addition, the IRS specifies that, in order to qualify as a hedge and not as a speculative transaction, a farmer/rancher must complete both of the following identification procedures:
- written documentation detailing the transaction as a hedging activity on the same day the transaction occurred; and
- the taxpayer must identify the risk being hedged within 35 days after establishing the position.
In contrast to the definition of a hedge, the IRS states that if a farmer/rancher enters into a contract with the intention of profiting from this transaction, then it is defined as a speculative transaction, requiring it to be reported on Schedule D (Form 1040), "Capital Gains or Losses."
To differentiate a hedging transaction from a speculative transaction, it is important to consider whether or not the intention of the transaction is to reduce the exposure of loss associated with unexpected changes in commodity prices. For example, if a producer owns 67 head of feeder cattle and plans to market them during April, then he/she could take a short position by selling one April feeder cattle contract. This position will protect against downward price movement in the feeder cattle futures market and will return money if prices move downward. Thus, the transaction reduces price risk for an operation.
However, if a producer who does not own hogs believes the April contract for lean hogs is priced too high and sells (short position) one contract with the intention of profiting from a downward price movement, then he would be engaging in a speculative transaction, according to IRS rules.
To help properly guide hedging or speculative transactions and the related tax implications, Figure 1 shows a guide from the 2009 Oklahoma State Farm and Business Tax Institute (p. 378). Before action is taken, each strategy needs to be scrutinized to determine if the purpose of the action is for risk management or speculative purposes. Feel free to contact me with questions or concerns you may have regarding the IRS rules associated with hedging or speculative activities for your farm.
1 Oklahoma Cooperative Extension Service. Agricultural Issues. In P.E. Harris, L.E. Curry, and N.S. Collum (editors) 2009 National Income Tax Workbook. Land Grant University Tax Education Foundation, Inc., 2009. Found at: www.taxworkbook.com [accessed: Jan. 18, 2009] : 377.