Effects of Federal Tax Policy on Agriculture. By Ron Durst and James Monke.

Food and Rural Economics Division, Economic Research Service, U.S. Department of Agriculture, Agricultural Economic Report No. 800.

Abstract

This report analyzes the effects of the current Federal tax code on farming and

evaluates tax proposals to assist beginning farmers. Investment, management, and

production decisions in agriculture continue to be influenced by Federal tax laws.

Farmers continue to benefit from both Federal income and estate tax policies targeted to agriculture. These provisions exert upward pressure on farmland values

and help support ongoing trends that increase the number of very small and large

farms. However, the influence of the current tax structure with lower marginal tax

rates and a broader income base is less than in earlier decades and may be small

relative to government farm programs. Tax proposals to assist beginning farmers

would likely increase the availability of land for lease or purchase, but would do

little to make land more affordable.

Keywords: Federal tax policy, income tax, social security tax, structure, small

farms, estate and gift tax, capital gains, farm losses 

Disclaimer: Readers should not construe information in this report as advice

given by the U.S. Department of Agriculture but should consult with their own

attorneys or the Internal Revenue Service for tax advice.

Washington, DC 20036-5831 April 2001
Contents

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .iv

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1

Federal Taxes and Farmers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1

Farm Typology and Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2

Federal Income Tax Policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5

Individual Tax Rates and Taxable Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5

The Farm Income Tax Base . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6

The Farm Household Income Tax Base . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12

Capital Gains Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12

Deducting Preproductive Capital Expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .16

Cash Accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .17

Depreciation Allowances and Capital Expensing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .17

Deductions Related to Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .19

Soil and Water Conservation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .19

Livestock Sales Due to Weather-Related Conditions . . . . . . . . . . . . . . . . . . . . . . . . . . . .20

Income Averaging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20

Self-Employed Health Insurance Deduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .21

Net Operating Losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .22

The Passive Loss Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .22

Alternative Minimum Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .24

Earned Income Tax Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .25

Social Security and Other Labor Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .28

Social Security and Self-Employment Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .28

Federal Unemployment Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .30

Federal Estate and Gift Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .31

Special Use Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .31

Installment Payment of Estate Tax for Closely Held Businesses . . . . . . . . . . . . . . . . . . .32

Indexing for Certain Estate and Gift Tax Provisions . . . . . . . . . . . . . . . . . . . . . . . . . . . .33

Deduction for Qualified Family-Owned Businesses . . . . . . . . . . . . . . . . . . . . . . . . . . . .33

Exclusion for Land Subject to Conservation Easement . . . . . . . . . . . . . . . . . . . . . . . . . .33

Implications of Federal Estate and Gift Tax Changes . . . . . . . . . . . . . . . . . . . . . . . . . . .34

 	

			
	
		
Tax Policy Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .36

Tax Burdens . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .36

Capital Investment: Capital/Labor Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .37

Land Prices and Ownership of Capital Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .37

Management Practices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .40

Product Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .41

Farm Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .42

Land Use and Conservation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .43

Proposals for Reform . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .45

Installment Sales Reform . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .45

Tax-Free Rental Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .45

Farm and Ranch Risk Management (FARRM) Accounts . . . . . . . . . . . . . . . . . . . . . . . . .46

Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .48

Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .50

	
	
		 	

		
Summary

Changes to the Federal income tax structure over the last two decades have

resulted in a broader tax base and lower marginal income tax rates with fewer

opportunities to shelter income through exclusions, deductions, and credits.

Despite large increases in the amount of property that can be transferred free of

tax, Federal estate and gift taxes are of continuing concern to the farm community.

Social security and self-employment taxes, however, impose a much greater burden

and play a greater role in investment and management decisions due to sharp

increases in their tax rates and the amount of income subject to such taxes.

In 1998, the U.S. Department of Agriculture’s (USDA) National Commission on

Small Farms recommended that USDA evaluate the effects of the tax code on

farming and of various proposed changes to such Federal policies to aid beginning

farmers. This report is the result of that evaluation.

The authors adopted the farm typology developed by USDA’s Economic Research

Service (ERS) to differentiate several types of small farms – farms with sales

under $250,000, as defined by the Commission. The Internal Revenue Service

(IRS) provided special data tabulations using the ERS typology for the study of the

effects of the Federal income and social security taxes. Estimates of estate tax burdens and effects were based on USDA farm surveys.

The most important Federal taxes for farmers are the income tax, the self-employment tax, and the estate and gift tax. The current tax system provides favorable

treatment to farmers, both through general tax provisions available to all taxpayers

and from provisions specifically targeted to farmers. Large farms with high farm

income and very small farms with high levels of off-farm income benefit most

from many of these provisions. While the Federal income tax has become more

progressive through the expanded earned income tax credit and new higher marginal tax brackets, overall progressivity continues to be reduced by social security

taxes.

Tax policies create financial incentives to engage in tax-favored activities. In farming, tax policies reinforce other factors such as technological change and

economies of size that have contributed to an increasing number of large farms.

Tax benefits generally accrue to those with higher incomes – farm or nonfarm.

Although very small farms do not generate enough farm income to support a family, most small farms benefit from farm losses for tax purposes because these

losses reduce taxes on nonfarm income. 

At the same time, many full-time farmers do not generate enough taxable income –

either farm or nonfarm – to fully utilize available tax benefits. Estate tax rules

encourage farmers to hold land until death and allow most farm estates – except

for the very largest – to be transferred free of tax. Across the farming sector, Federal tax policies affect farmland prices, the cost of capital relative to labor, farm

size and organizational structure, farm management practices, and product supply

and prices.

 	

			
	
		
The most significant effects of current Federal income, estate, and social security

tax policies include the following:

• Exert upward pressure on farmland prices through preferential treatment of capital gains and estate taxes that increase the demand for and reduce the supply of

land on the market.

• Support pre-existing trends in the increasing share of very small and very large

farms.

• Large, profitable farms benefit from tax preferences and deductions.

• Small, lifestyle (hobby) farms use farm losses for tax purposes to offset nonfarm income.

• Help established farmers or nonfarm investors outbid beginning farmers for land.

• Contribute to greater farm output and lower commodity prices resulting from

more intensive use of resources.

• Favor capital investment over labor.

• Encourage environmentally friendly land use because of targeted tax incentives

for conservation and land preservation activities and reduced tax benefits for

harmful practices.

	
	
		 	

		

Introduction

Federal tax policies can have important effects on the

number and size of farms, the organizational structure,

and the amount and relative mix of land, labor, and

capital inputs. The most important Federal taxes for

farmers are the income tax, the self-employment tax,

and the estate and gift tax. In 1996, the most recent

year for which complete data are available, farmers

paid about $19.2 billion in Federal income taxes on

their farm and off-farm income. They also paid $1.8

billion in self-employment taxes. In contrast, Federal

estate and gift taxes were relatively small with taxes on

farm estates estimated at only about $735 million.

While the Federal income tax imposes the largest tax

burden on the broadest group of farmers in the aggregate, the relative importance of the various taxes varies

for the individual farmer with the size and other aspects

of the farm business. 

In January 1998, the U.S. Department of Agriculture’s

(USDA) National Commission on Small Farms – a 30-

member committee appointed by former Secretary of

Agriculture Dan Glickman – released a report addressing the need for action to help small farms survive and

remain competitive. In the report, the Commission

identified tax policy as a contributing factor to the

structure of agriculture and suggested that many tax

policies favor large farms over small farms. As one of

many recommendations in the report, the Commission

requested that the Economic Research Service (ERS)

coordinate a study to review the effects of the tax code

on farming and how the tax code affects entry and exits

from farming (USDA, NCSF Recommendation 5.7, p.

94). To help beginning farmers in particular, the Commission proposed (1) an exemption for the first $10,000

of income to a landlord from leasing farmland or property to a beginning farmer and (2) a revision of the

depreciation recapture rules for a retiring farmer who

sells equipment under an installment sale to a beginning farmer.

This report discusses the most important features of

Federal tax law and how they affect agriculture. It also

assesses the two tax recommendations proposed by the

Commission, as well as another tax proposal regarding

farm savings accounts that Congress has considered as

an option to help farmers manage income variability.

The report builds upon the Department’s last comprehensive overview of the effects of Federal tax policy on

farmers (Davenport, Boehlje, and Martin) that emerged

from a 1979 initiative by former Secretary of Agriculture Bob Bergland to study the structure of agriculture.

Federal Taxes and Farmers

In the 1990’s, the Federal income tax changed dramatically. While top marginal income tax rates increased,

both individual and business taxpayers were provided

several new or expanded tax credits and deductions.

These include child and education tax credits, an

expanded earned income tax credit, reduced capital

gains taxation, and targeted tax relief for farmers, including income averaging and increased deductions for

self-employed health insurance costs. The net effect is

a reduced Federal income tax burden for most farmers.

The self-employment tax paid on earned income from

business activities is comparable to the employees’ and

employers’ share of the social security payroll tax. The

amount of income subject to tax and the tax rates for

the self-employment tax have increased over the past

two decades, increasing the burden of this tax relative

to the income tax. Overall, income taxes exceed selfemployment taxes, but for lower income farmers, the

self-employment tax may be more important.

Although the Federal estate tax represents a very small

share of all Federal taxes paid by farmers and most

farmers or their heirs never pay such taxes, the impact

of Federal estate and gift taxes on the ability to transfer

the family farm to the next generation has been a major

concern of farmers for many years. The number of

	
	
		 	

		

Effects of Federal Tax Policy on Agriculture

Ron Durst and James Monke
farms subject to the Federal estate tax has increased in

recent years, but Federal estate and gift taxes have had

little effect on the ability of small family farms to transfer their farms to the next generation. Nevertheless,

Federal estate tax provisions contained in the Taxpayer

Relief Act of 1997 provide additional reductions in

Federal estate taxes for farmers and other small business owners, making it easier for farmers to transfer

their family farm business across generations. 

Farm Typology and Data

The National Commission on Small Farms established

general criteria to define small farms. The cutoff

between large and small farms was set at $250,000 in

gross sales. The Commission’s intention was to “generally describe the farms that ... should be given priority

consideration by USDA, with special emphasis on

those with the greatest need to improve their net farm

incomes.” The result was a definition that classifies 94

percent of all U.S. farms as small farms.

A broad definition that includes so many farms may be

further refined for policy discussions. Building on the

Commission’s definition, ERS developed a new farm

typology to divide small farms into mutually exclusive,

more homogeneous groups based on family, business,

and occupational characteristics. The four groups are

(1) limited-resource farms, (2) retirement farms, (3)

lifestyle/other farms, and (4) primary occupation farms

(USDA-ERS). The limited-resource group identifies

farmers with low sales, income, and assets, regardless

of their major occupation, and is similar to definitions

used by USDA’s Risk Management Agency and Natural

Resources Conservation Service. Identifying this group

is critical because agencies may need to develop special

programs to serve limited-resource farmers. The other

three groups are based on the major occupation of

farmers who do not operate limited-resource farms –

the occupation at which they spend more than 50 percent of their work time. This farm typology was developed primarily to be applied to the Agricultural

Resource Management Study (ARMS) conducted by

 	

			
	
		

Table 1—Criteria for farm typologies used with IRS and USDA data

USDA Agricultural Resource 

Farm type IRS tax file data Management Study (ARMS)

Family farm A tax return with schedule F Farm proprietorships,

attached; that is, a farm sole partnerships, and family corporations.

proprietor for tax purposes. Produce $1,000 of farm products 

annually.

Small family farm Farm sales < $250,000. Farm sales < $250,000.

• Limited-resource Farm sales < $100,000 and Farm sales < $100,000,

household income < $10,000. farm assets < $150,000, and

household income < $20,000.

• Retirement Social security benefits > $0 and Self-identified as retired,

farm sales < $50,000 – regardless excluding those already identified as 

of age of primary taxpayer – but limited-resource.

excluding returns when only the 

secondary taxpayer is over age 65.

• Primary occupation Either combined farm income Self-identified that farming was

greater than nonfarm income, or principal occupation, excluding 

farm sales > $10,000 and nonfarm those already identified as

income < $50,000. limited-resource.

• Lifestyle/other A residual category for small family farms Self-identified that principal

if not selected as a limited resource, occupation was not farming,

retirement, or primary occupation farm. excluding those already identified as 

limited-resource.

Large family farm Farm sales > $250,000. Farm sales > $250,000.

Note: Household income equals the sum of all income reported on IRS form 1040, including tax-exempt interest, social security, and pension benefits not subject to taxes, but excluding farm losses from schedule F. Combined farm income equals net profit or loss from schedule F, plus capital gains from the sale of business assets, plus farm rental income (crop-share only; cash rents are not listed separately for

taxes). Nonfarm income equals household income minus combined farm income (after adjusting for schedule F losses not included in

household income).
ERS and the National Agricultural Statistics Service,

USDA. The annual ARMS collects financial, production, and marketing information from farmers, including the self-identified primary occupation variable

which is heavily used in the farm typology.

ARMS data provide income statement and balance

sheet information as well as information concerning 

the farm operator and household. However, tax rules

such as cash accounting, capital expensing, and other

deductions and tax credits frequently make farmers’

taxable incomes in any given year dramatically different from the income measured by USDA to estimate

financial performance (General Accounting Office). In

addition, information on taxable income and many

other income tax variables is not available from ARMS

data. 

Limited tax data are available from the Internal Revenue Service (IRS), which compiles an annual stratified

probability sample of individual income tax returns that

contains a large number of variables from many tax

forms. IRS carefully protects the identity of individual

taxpayers in the public use version by not including

identification codes and by blurring other variables by

averaging data with similar returns. In addition to the

public use tax file, which contains separate tax records,

IRS also compiles special tabulations for researchers

who request information on variables that are excluded

from the public use file. Within the entire annual database of about 100,000 observations representing over

118 million taxpayers, a subset of over 6,000 farm

observations includes individual farmers and materially

participating landlords who file schedule F, but

excludes corporate farms and farm partnerships. This

	
	
		 	

		

Table 2—Comparison of the farm typology using ARMS and IRS data, 1996

Small family farms

Primary occupation Large All

Limited- Lifestyle/ Farm sales ($1,000) farmily farm

Item resource Retirement other <$100 $100-$250 farms proprietors

Number

Farmers:

IRS data 218,383 261,926 1,167,321 336,498 151,970 82,865 2,218,964

ARMS data 291,659 261,428 537,181 524,820 192,269 154,307 1,961,664

Percent

Share with sales

under $10,000:

IRS data 51.9 69.8 86.6 2.6 0 0 59.3

ARMS data 87.6 78.6 74.3 42.4 0 0 55.2

Dollars

Average net farm income:

IRS data -730 783 -6,191 5,192 16,914 31,572 -111

ARMS data d d -4,394 d 25,708 93,513 7,906

Average net income to household:

IRS data 1 -97 73,333 69,398 27,744 31,616 94,069 55,040

ARMS data 10,633 40,729 71,673 31,511 59,181 120,703 50,361

Percent

Share of net income to household

from nonfarm source: 2

IRS data 3 98.9 108.9 81.3 46.5 66.4 100.2

ARMS data 127.8 99.7 106.1 104.1 56.6 25.2 84.3

d = data suppressed because the relative standard error for the estimate exceeds 75 percent.

1To be more comparable with ARMS data, includes both taxable and nontaxable sources of income reported on IRS form 1040, and allows

farm losses to reduce net income.

2The percentage of income from nonfarm sources can be more than 100 percent if farm income is negative.

3Not logical to compute because net household income remains negative even though nonfarm income is positive.

Sources: IRS data compiled by USDA-ERS from special tabulations by Internal Revenue Service. ARMS data from USDA-ERS, 

pp. 141-43.
sample can be weighted to represent a population of

about 2.2 million farm sole proprietors.

The IRS data do not allow an exact duplication of the

farm typology designed for USDA data, primarily

because the IRS data lack the self-identified primary

occupation variable. To approximate the categories in

the farm typology, different criteria were developed for

IRS data. These criteria use various combinations of

gross farm sales, household income, nonfarm income,

and social security benefits (table 1). 

With the exception of the lifestyle/other category,

which contains nearly twice as many farms, the number

of farms in each typology category from the IRS data 

is similar to the number from the ARMS data (table 2).

The larger number of lifestyle/other farms reflects the

fact that many households file schedule F for tax purposes but may not be considered farms under the

ARMS requirement of at least $1,000 in sales. Furthermore, 42 percent of farms (220,000 farms) in the

ARMS data with gross sales under $10,000 identified

farming as their primary occupation. Many of these

farms reported farm losses for tax purposes and were

classified as lifestyle/other farms because the IRS data

do not contain the self-identified primary occupation

variable. 

Despite the noted difference between IRS and ARMS

data, both reveal that more than half of farm proprietors

have sales under $10,000. Both databases also suggest

that nonfarm income contributes a majority of income

for farmers as a whole, and that nonfarm income is particularly important for limited-resource, retirement,

lifestyle/other, and primary occupation farmers with

sales under $100,000. However, net farm income

reported for tax purposes is about $8,000 less, on average, than that measured by ARMS. As mentioned

before, tax rules such as cash accounting, capital

expensing, and other farm deductions contribute to a

lower net income for tax purposes for farmers.

 	

			
	
		
Federal Income Tax Policies

The Federal income tax is a progressive tax imposed on

net income. It is collected annually and accounts for a

substantial portion of Federal revenues. The Federal

income tax has the greatest potential impact on investment, management, and production decisions in the

agricultural sector.

The individual income tax is significantly more important than the corporate income tax for understanding

how taxes affect most farmers. Sole proprietorships,

partnerships, and subchapter S corporations are all

taxed at the individual level. The most common form of

farm organization is the sole proprietorship which,

according to the 1997 Census of Agriculture (USDANASS), comprises 86 percent of all farms and 52 percent of total sales (table 3). Income from farm partnerships and subchapter S corporations is passed through

to the individual partners or shareholders for taxation at

the individual shareholder or partner level. Partnerships

comprise 9 percent of farms and 18 percent of sales.

Census data do not separate subchapter S corporations

from other corporations. However, family-held corporations account for about 90 percent of all corporations.

Most of these corporations are subchapter S corporations. These farms represent 2 percent to 3 percent of

all farms and account for about 10 percent of sales.

Therefore, more than 97 percent of all farms and about

80 percent of farm sales are taxed at the individual

level. This chapter primarily focuses on the most significant features of the Federal individual income tax,

and how they affect taxes paid by farmers.

Individual Tax Rates and Taxable Income

Under current law, there are five marginal income tax

brackets on ordinary income: 15, 28, 31, 36, and 39.6

percent. The ordinary income tax rates are progressive,

with higher marginal rates applying to higher amounts

of taxable income.

Taxable income is computed by subtracting allowable

adjustments, deductions, and personal exemptions from

total income. Total income is the sum of wages and

salaries, taxable interest and dividends, capital gains,

net business income, rental income, taxable social security and retirement income, and other miscellaneous

income. Business income from sole proprietorships and

pass-through entities, including farms, is taxed on a net

basis after subtracting allowable business expenses

from gross business revenue. Important statutory

adjustments for farmers include subtractions for half of

the self-employment tax, contributions to tax-deferred

personal retirement plans, and the self-employed health

insurance deduction. The standard deduction or itemized deductions (such as medical and home mortgage

interest expenses, State and local income taxes, property taxes, and charitable contributions) also reduce the

amount of income subject to tax. Personal exemptions

provide an additional allowance against taxable income

for each person in the household. Table 4 summarizes

the taxable income subject to each tax bracket, and the

standard deduction and personal exemption amounts.

Most farmers, like the majority of other taxpayers, are

taxed at the 15-percent marginal tax bracket. However,

most of the tax collected is paid by those in higher tax

brackets. Table 5 illustrates the distribution of marginal

tax brackets and income taxes paid by farm sole proprietors and other taxpayers. In 1995, 53 percent of farm

sole proprietors were in the 15-percent tax bracket, but

they paid only 20 percent of the Federal income taxes

paid by farmers. In contrast, the 5 percent of farmers in

the top three tax brackets paid 54 percent of the taxes

paid by farm sole proprietors. The distributions are 

	
	
		 	

		

Table 3—Most farms are organized as sole proprietorships

Type of organization Number Total sales Net income

Million dollars 

All farms1 1,911,859 196,865 42,557

Sole proprietor 1,643,424 102,666 21,295

Partnership 169,462 35,539 8,706

Corporation2 84,002 56,907 12,212

Other3 14,971 1,753 345

1Units selling $1,000 or more of agricultural products per year.

2Includes family and nonfamily corporations, some of which may be subchapter S corporations.

3Includes cooperatives, estates and trusts, institutional, and other forms of ownership.

Source: USDA-NASS, 1997 Census of Agriculture, table 47.
similar for nonfarm taxpayers as well, with the number

of both farm and nonfarm businesses being skewed

toward the extreme high- and low-tax brackets and the

taxes paid being skewed toward the higher brackets.

Across the farm typology, 70 percent of Federal income

taxes are paid by the 53 percent of farmers in the

lifestyle/other category (table 6). This category also has

the greatest proportion of small family farmers paying

tax rates over the 15-percent bracket (fig. 1).

The Farm Income Tax Base

Numerous provisions of Federal income tax law allow

taxpayers to reduce their tax liability if they undertake

certain tax-favored activities. Many of these activities

are unique to particular industries. Thus, most industries receive some level of preferential tax treatment. In

general, income from farming is taxed more favorably

than income from many other businesses. Federal tax

incentives have encouraged greater investment in the

productive capacity of certain types of farming than

 	

			
	
		

Table 4—Federal income tax brackets, standard 

deduction, and exemption for 2001

Filing status

Item Single Married (joint)

Dollars 

Lower bound of taxable income:

15% tax bracket 0 0

28% tax bracket 27,050 45,200

31% tax bracket 65,550 109,250

36% tax bracket 136,750 166,450

39.6% tax bracket 297,300 297,300

Standard deduction 4,550 7,600

Personal exemption 2,900 2,900

Note: An individual’s taxable income equals the sum of all

income subject to taxation minus the sum of adjustments to

income, the standard deduction or itemized deductions, and the

personal exemption multiplied by the number of allowable exemptions. Amounts are indexed for inflation annually.

Table 5—Most taxpayers are in lower brackets, but those in higher brackets pay most tax

The distribution for farm sole proprietors is skewed slightly toward the extremes 

Farm sole Other nonfarm All other All individual

Item proprietors sole proprietors individuals taxpayers

Number

Taxpayers1 2,244,021 18,859,895 100,114,417 118,218,333

Percent of taxpayers

Not taxable 24.1 23.0 19.5 20.1

15% 53.1 50.2 58.7 57.4

28% 18.2 20.9 18.9 19.1

31% 2.3 3.2 1.9 2.1

36% 1.3 1.7 .6 .8

39.6% 1.0 1.0 .4 .5

All brackets 100.0 100.0 100.0 100.0

Million dollars

Total Federal income tax paid2 17,000 117,240 451,282 585,522

Percent of tax payments

15% 19.8 17.3 24.2 22.6

28% 25.7 29.6 37.7 35.8

31% 9.2 11.8 10.2 10.5

36% 9.2 12.3 7.6 8.6

39.6% 36.1 29.0 20.3 22.5

All brackets 100.0 100.0 100.0 100.0

1Farm sole proprietors file IRS schedule F; other nonfarm sole proprietors file schedule C, but not schedule F; all other individual taxpayers file neither schedule C nor F.

2Total income tax after credits, excluding portions of the earned income credit that are refunded or used to offset other taxes.

Source: USDA-ERS estimates from 1995 IRS Individual Public Use Tax File.
would have been warranted without tax incentives. Tax

preferences also cause some farm investors to alter

management practices to maximize tax benefits, sometimes to the detriment of other economic considerations.

Farmers benefit from both general tax provisions available to all taxpayers and from provisions specifically

designed for farmers. Some of the provisions that are

responsible for this treatment include the current

deductibility of certain capital costs, capital gains treatment of proceeds from the sale of farm assets for which

development costs have been deducted against regular

income, cash accounting, and farm income averaging.

These and other provisions reduce the farm income tax

base.

The favorable tax treatment for farm income is

reflected in the size of farm profits and losses reported

for income tax purposes. These tax preferences are

important reasons why net farm income reported to IRS

is less than that estimated by USDA to measure farm

performance (GAO). Overall, farm sole proprietors

have reported a net taxable loss from farming activities

since 1980 based on IRS form 1040, schedule F.

Aggregate annual net farm losses increased from 1990

to 1995, reversing a recovery that started in 1984 (fig.

2). The proportion of farm sole proprietors reporting a

net farm loss on schedule F also has been increasing,

with around 66 percent of farms reporting losses in

1996, compared with 56 percent in 1989. In 1996, farm

sole proprietors reported over $102 billion in gross

farm business receipts for tax purposes but reported a

net farm operating loss of $7.1 billion. The net loss was

the result of offsetting the $8.9 billion in profits

reported by about one-third of all farm sole proprietors

and $16 billion in losses reported by the remaining

two-thirds (table 7).

	
	
		 	

		

Table 6—Distribution of Federal income taxes and marginal brackets by type of farm, 1996

Small family farms

Primary occupation Large All

Limited- Lifestyle/ Farm sales ($1,000) family farm

Item resource Retirement other <$100 $100-$250 farms proprietors

Number

All farmers 218,383 261,926 1,167,321 336,498 151,970 82,865 2,218,964

Percent

Share across farm types 9.8 11.8 52.6 15.2 6.8 3.7 100.0

Share by bracket within group:

Not taxable 82.9 21.9 10.0 31.2 30.7 21.5 23.7

15% 17.1 45.0 56.1 65.2 58.0 41.8 51.9

28% 0 27.4 26.5 3.3 10.0 23.9 19.2

31% 0 3.0 4.1 .1 1.1 7.5 2.9

36% 0 1.6 1.8 .1 .1 2.9 1.2

39.6% 0 1.1 1.6 .1 0 2.4 1.1

All brackets 100.0 100.0 100.0 100.0 100.0 100.0 100.0

Thousand dollars

Federal income tax paid:1

Total 7,736 2,789,597 13,560,209 865,727 466,087 1,560,277 19,249,632

Percent

Share across farm types 0 14.5 70.4 4.5 2.4 8.1 100.0

Dollars

Average 35 10,650 11,617 2,573 3,067 18,829 8,675

1Total income tax after credits, excluding portions of the earned income credit that are refunded or used to offset other taxes.

Source: Compiled by USDA-ERS from special tabulations by Internal Revenue Service.
 	

			
	
		

0

20

40

60

80

100

Figure 1

Distribution of marginal brackets, 1996

Percent of farms

LimitedresourceRetirement Lifestyle/

other

Farming:

<$100K

Farming: All farms

$100-$250K

Farming:

>$250K

Small farms Large farms

0% 15% 28% Over 28%

Marginal tax rate

Source: USDA-ERS, based on IRS data.

Figure 2

Taxable net farm income on schedule F is lower and less variable than USDA's estimate

Billion (1998 $)

Source: USDA-ERS; tax data are compiled from IRS.

-40

-20

0

20

40

60

80

100

120

1968 73 78 83 88 93 98

USDA net estimate

Taxable net Taxable profits

Taxable losses
Many of these farm losses are reported by smaller

farms in which the operator’s primary source of income

is an off-farm job or other nonfarm source. In fact, 75

percent of farm sole proprietors with farm business

receipts below $25,000 reported a farm loss for tax purposes, and the average loss reported was about $8,100.

These farm losses reduce taxes by offsetting income

from nonfarm sources. These farms averaged over

$59,000 in off-farm income. In contrast, 62 percent of

farms with farm business receipts over $25,000

reported a farm profit, and the average profit was only

about $21,000. Thus, while many commercial-size

farmers pay taxes on their farm income, farm sole proprietors in the aggregate pay little in Federal income

tax on farm income.

By farm typology, a majority of farmers report farm

profits on schedule F in the limited-resource, primary

occupation, and large family farm categories (fig. 3).

However, aggregate net farm income on schedule F was

positive only for primary occupation farmers with gross

farm sales over $50,000 – slightly broader than the two

groups indicated in table 8, which include only primary

occupation small farms with sales over $100,000 and

large family farms (fig. 4).

	
	
		 	

		

Table 7—Farm profits and losses reported for taxes by sole proprietors, 1965-98

Number of Schedule F net income Combined farm net income1

farm sole Farms with loss Farms with loss

Year proprietors Net Number Losses Net Number Losses

1,000 $million 1,000 $million $million 1,000 $million

1965 3,034 3,365 1,035 -1,852 na na na

1966 3,009 4,070 1,012 -1,915 na na na.

1967 3,012 3,353 1,125 -2,208 na na na

1968 3,033 3,127 1,182 -2,408 na na na

1969 3,092 3,578 1,155 -2,559 na na na

1970 3,026 2,789 1,234 -2,903 na na na

1971 2,775 2,188 1,290 -3,282 na na na

1972 2,791 4,106 1,172 -3,226 na na na

1973 2,866 7,228 1,219 -4,066 na na na

1974 2,804 4,996 1,434 -6,411 na na na

1975 2,755 3,563 1,415 -6,560 na na na

1976 2,819 3,456 1,477 -6,891 na na na

1977 2,487 504 1,314 -7,762 na na na

1978 2,705 3,565 1,386 -7,473 na na na

1979 2,605 2,124 1,361 -8,937 na na na

1980 2,608 -1,792 1,485 -11,751 na na na

1981 2,641 -7,812 1,657 -16,340 na na na

1982 2,689 -9,834 1,756 -17,828 na na na

1983 2,710 -9,294 1,742 -17,721 na na na

1984 2,694 -13,096 1,828 -19,434 na na na

1985 2,621 -12,005 1,730 -18,498 na na na

1986 2,533 -6,907 1,548 -15,902 na na na

1987 2,425 -1,421 1,366 -12,119 3,464 1,301 -10,934

1988 2,381 -1,175 1,375 -12,426 4,313 1,295 -11,119

1989 2,378 -210 1,332 -11,738 5,085 1,252 -10,495

1990 2,342 -411 1,325 -11,811 4,766 1,260 -10,792

1991 2,311 -3,070 1,359 -12,614 1,276 1,285 -11,346

1992 2,306 -2,620 1,392 -12,648 2,138 1,299 -11,411

1993 2,293 -3,680 1,373 -13,120 2,985 1,252 -11,353

1994 2,265 -7,335 1,485 -15,718 -853 1,389 -13,951

1995 2,244 -7,857 1,493 -16,032 -1,528 1,388 -14,330

1996 2,219 -7,112 1,461 -16,027 -247 na na

1997 2,161 -6,847 1,439 -16,069 na na na

1998 2,092 -7,934 1,419 -16,743 na na na

na = Not available.

1Schedule F net income plus capital gains from selling business assets and farm rental income.

Source: 1965-86 from Long (p. 2): 1987-98 from USDA-ERS tables compiled from IRS data.
 	

			
	
		

Figure 3

Number of farms with schedule F profits and losses, 1996

Millions of farms

0

.5

1.0

1.5

2.0

2.5

LimitedresourceRetirement Lifestyle/

other

Farming:

<$100K

Farming: All farms

$100-$250K

Farming:

>$250K

Small farms Large farms

With profit

With loss

Source: USDA-ERS, based on IRS data.

Figure 4

Profits and losses on schedule F by farm type, 1996

Billion dollars

LimitedresourceRetirement Livestyle/

other

Farming:

<$100K

Farming: All farms

$100-$250K

Farming:

>$250K

Small farms Large farms

Profits

Net schedule F Losses

Source: USDA-ERS, based on IRS data.

-20

-15

-10

-5

0

5

10

15
	
	
		 	

		

Table 8—Farm income reported for Federal income taxes by farm sole proprietors in 1996

Small family farms

Primary occupation Large All

Limited- Lifestyle/ Farm sales ($1,000) family farm

Item resource Retirement other <$100 $100-$250 farms proprietors

Number

Farmers1 218,383 261,926 1,167,321 336,498 151,970 82,865 2,218,964

Percent

Share across farm types 9.8 11.8 52.6 15.2 6.8 3.7 100.0

$ 1,000

Schedule F income:

Gross receipts2 4,880,938 2,124,520 10,427,201 12,550,843 23,507,928 48,685,150 102,176,580

+ Program payments 242,497 161,492 668,529 764,664 1,415,352 1,619,994 4,872,528

- Purchased livestock3 18,181 -141,618 331,965 158,535 1,087,215 9,257,218 10,711,495

= Gross farm income 5,105,254 2,427,630 10,763,765 13,156,972 23,836,065 41,047,926 96,337,613

Expenses:

Depreciation4 813,318 672,641 4,025,491 2,383,377 3,189,083 3,997,696 15,081,607

Mortgage, interest 438,217 194,809 1,833,096 1,170,983 1,833,607 2,710,899 8,181,611

Total expenses 5,426,513 3,726,907 19,502,838 13,539,736 22,021,309 39,232,296 103,449,598

Profits 338,896 301,989 681,002 1,752,605 2,542,569 3,298,150 8,915,212

Percent

Share with profit 50.6 26.1 19.6 50.8 76.5 76.6 34.2

$1,000

Losses -660,155 -1,601,266 -9,420,075 -2,135,369 -727,813 -1,482,520 -16,027,197

Percent

Share with loss 49.4 73.9 80.4 49.2 23.5 23.4 65.8

$1,000

Net from schedule F -321,259 -1,299,277 -8,739,073 -382,764 1,814,756 1,815,630 -7,111,985

+ Gain on business assets 156,800 1,271,273 1,399,832 1,946,386 727,702 748,670 6,250,661

+ Farm rental income5 5,1086 233,130 112,715 183,420 27,9266 51,904 614,204

= Combined farm inc. -159,352 205,126 -7,226,527 1,747,044 2,570,384 2,616,205 -247,121

Percent

Percent across farm types:

Program payments 5.0 3.3 13.7 15.7 29.0 33.2 100.0

Adjusted gross income 5.3 2.5 11.2 13.7 24.7 42.6 100.0

Depreciation4 5.4 4.5 26.7 15.8 21.1 26.5 100.0

Mortgage, interest 5.4 2.4 22.4 14.3 22.4 33.1 100.0

Total expenses 5.2 3.6 18.9 13.1 21.3 37.9 100.0

Profits 3.8 3.4 7.6 19.7 28.5 37.0 100.0

Losses 4.1 10.0 58.8 13.3 4.5 9.3 100.0

1Includes farm sole proprietors, but excludes farms organized as partnerships or subchapter S corporations.

2Includes gross receipts from crop and livestock sales, taxable CCC loans, crop insurance proceeds, cooperative distributions, and custom

hire. Excludes income from selling farm business assets such as breeding and dairy livestock, which are reported on form 4797, and government agricultural program payments.

3Includes the cost or basis of livestock and other items purchased for resale, such as feeder livestock.

4Includes depreciation and section 179 expensing deduction for farm machinery, equipment, and buildings.

5Includes only crop-share farm rental income. Cash rental income is not reported separately for tax purposes.

6Italics indicate the estimate should be used with caution because the sample contained 10 or fewer returns.

Source: Compiled by USDA-ERS from special tabulations by Internal Revenue Service.
Since net farm profit or loss on schedule F does not

include some farm income reported on other tax forms,

a more complete measure of farm income adds capital

gains from selling business assets (such as culled livestock and land) and farm rental income. For all sole

proprietors, gains from selling business assets add

$6.25 billion, while farm rental income adds an additional $600 million.1 This combined measure of farm

income reveals an aggregate taxable loss of $247 million in 1996, the third consecutive loss in a new trend

since the mid-1980’s (table 7). Combined farm income

for most farm types are made positive by adding these

additional variables to schedule F income, but the

schedule F losses reported by lifestyle/other and limited-resource farms are sufficient to make the aggregate

combined farm income for all farm sole proprietors

negative (table 8).

The Farm Household Income Tax Base

In 1996, farm sole proprietors paid $19 billion in Federal income taxes on their farm and nonfarm incomes.

Most of this amount was paid by farmers whose primary occupation was something other than farming and

was therefore paid mostly on nonfarm income. IRS

data indicate that a majority of farmers’ incomes come

from off-farm sources. This indication is similar to

results from USDA surveys, but the divergence

between farm and nonfarm income for all farm proprietors is greater in the tax data. The only farm types

receiving more than a negligible portion of their

income from farming were primary occupation small

farms and large family farms. Only primary occupation

farms with gross sales between $100,000 and $250,000

received a majority of their income from farming. All

other farm types received a majority of their income

from nonfarm sources (table 9).

Most of the nonfarm income comes from wages and

salaries earned away from the farm by the farm operator or the operator’s spouse. This is especially true for

primary occupation farms and lifestyle/other farms that

receive well over half of their nonfarm income from

wages and salaries. Over 60 percent of primary occupation and lifestyle/other farms earn wage and salary

income (table 10). Another important component is

investment income which includes interest, dividends,

capital gains, and rental property (other than gains from

selling farm business assets or farm rental income).

Large family farms and retirement farms receive relatively more investment income than other types of

farms and are more likely to report such income.

Retirement farms receive nearly as much income from

social security and pensions as from investments. Nonfarm business enterprises contribute a sizeable amount

of income for lifestyle/other farms, and lifestyle/other

farms earn most of the nonfarm business income

reported by all farm proprietors. Despite small amounts

of nonfarm wages and investment income, limitedresource farms report significant losses to nonfarm

businesses and to rental property (table 9). Because of

these losses, limited-resource farms report only a small

amount of net nonfarm income, not enough to offset

their combined farm losses.

In addition to farm business deductions mentioned

throughout this report, other deductions from household income include contributions to retirement

accounts, expenses for self-employed health insurance

and self-employment taxes, the standard or itemized

deductions, and the personal exemption for each member of the household. Although relatively few farmers

use retirement account deductions, such contributions

are relatively more important for primary occupation

farmers because they are less likely to have employersponsored plans at a nonfarm job. 

Most farmers, like most nonfarm taxpayers, claim the

standard deduction rather than itemize. Although about

30 percent of all farmers itemize their nonfarm deductions, only a negligible number of limited-resource

farms itemize, and only about 16 percent of primary

occupation small farms itemize. About 42 percent of

lifestyle/other farm households itemize. The standard or

itemized deduction and personal exemptions combine

to reduce adjusted gross income (AGI) by about onethird, yielding $81 billion of taxable income for farm

sole proprietor households (table 9).

Capital Gains Taxes

Capital gains income is the profit (or loss) realized on

the sale of assets held for investment. It is based on the

difference between the asset’s sale price and the purchase price adjusted for depreciation or improvements

(the basis). Capital gains are generally not recognized

for tax purposes until the taxpayer disposes of an asset.

The income tax system has historically taxed capital

gains at rates that are lower than taxes on ordinary

income.

 	

			
	
		

1Includes only crop share farm rental income. Cash rental income

from farm property is not reported separately from other rental

income for tax purposes.
	
	
		 	

		

Table 9—Total income reported for Federal income taxes by farm sole proprietors, 1996

Small family farms

Primary occupation Large All

Limited- Lifestyle/ Farm sales ($1,000) family farm

Item resource Retirement other <$100 $100-$250 farms proprietors

Number

All farmers 218,383 261,926 1,167,321 336,498 151,970 82,865 2,218,964

$1,000

Household income:1

Wages and salaries 495,716 2,307,041 53,960,415 5,316,390 1,200,441 1,328,595 64,608,598

Interest income (total) 310,292 2,941,629 5,304,360 712,567 224,148 837,997 10,330,993

Dividends 61,993 1,168,483 2,411,889 99,405 102,852 474,910 4,319,531

Nonfarm business net -140,694 491,355 5,011,164 432,494 136,561 178,808 6,109,687

Capital gains, losses 267,425 3,482,182 7,007,586 2,024,307 817,326 1,720,152 15,318,981

Gain on other property -98,957 407,674 704,995 159,487 194,929 183,365 1,551,493

IRA distributed (taxed) 17,215 590,945 547,219 46,605 61,596 42,609 1,306,189

Pension, annuity (total) 83,597 3,702,891 4,867,831 445,856 80,639 141,331 9,322,145

Rent, royalty net income -776,822 2,260,671 9,129,404 336,895 45,147 970,883 11,966,176

Farm profits 338,896 301,989 681,002 1,752,605 2,542,569 3,298,150 8,915,212

Social security (total) 56,574 3,113,574 216,919 77,415 108,306 73,997 3,646,783

Alimony, refund 23,765 40,658 587,352 67,065 17,986 26,780 763,608

Household income 639,000 20,809,092 90,430,136 11,471,091 5,532,500 9,277,577 138,159,396

Schedule F losses -660,155 -1,601,266 -9,420,075 -2,135,369 -727,813 -1,482,520 -16,027,197

Net income to household -21,155 19,207,826 81,010,061 9,335,722 4,804,687 7,795,057 122,132,199

Combined farm income2 -159,352 205,126 -7,226,527 1,747,044 2,570,384 2,616,205 -247,121

Nonfarm income 138,196 19,002,701 88,236,586 7,588,679 2,234,303 5,178,853 122,379,320

Percent

Share of net income from nonfarm3 4 98.9 108.9 81.3 46.5 66.4 100.2

$1,000

Selected adjustments to income:

IRA contributions (deduct) 7,5385 45,029 205,362 56,692 38,665 44,144 397,430

Keogh/SEP contribution 545 19,958 200,240 5,736 50,913 79,894 356,798

Health insurance (self-employed) 18,159 25,773 88,601 53,260 70,743 40,176 296,712

Half of self-employment tax 23,493 51,706 348,738 136,051 179,508 178,067 917,561

Adjusted gross income -1,402,236 15,265,584 75,652,141 7,717,435 3,667,700 5,532,557 106,433,180

Less deductions 1,412,522 2,931,234 13,519,710 2,473,396 1,107,595 1,250,253 22,694,710

Less exemptions 1,039,685 1,221,622 7,893,438 2,413,408 1,253,866 669,197 14,491,217

Taxable income6 44,971 11,678,553 56,548,631 4,711,927 2,591,873 5,800,910 81,376,866

1 Using data reported on form 1040, a broader measure of annual income than reported for taxes since it includes tax-exempt interest,

pensions, annuities, and social security income. Does not include schedule F losses, which are added back to compute net income to

household. Does not include “other income and losses,” which is frequently negative because many farmers carry unused net operating

losses from prior years forward into the tax year.

2 Equals the sum of schedule F, capital gains from the sale of business assets, and farm rental income.

3 Net income to household from nonfarm sources can exceed 100 percent if combined farm income is negative.

4 Not logical to compute because net household income remains negative even though nonfarm income is positive.

5 Italics indicate the estimate should be used with caution because the sample contained 10 or fewer returns.

6 Because taxable income cannot be less than $0, the aggregate amount exceeds adjusted gross income minus deductions and exemptions.

Source: Compiled by USDA-ERS from special tabulations by Internal Revenue Service.
 	

			
	
		

Table 10—Frequency that farmers report sources of income or deductions, 1996

Small family farms

Primary occupation Large All

Limited- Lifestyle/ Farm sales ($1,000) family farm

Item resource Retirement other <$100 $100-$250 farms proprietors

Number

All farmers 218,383 261,926 1,167,321 336,498 151,970 82,865 2,218,964

Percent

Share of farmers with:

Form 1040— 

Wages and salaries 37.1 38.6 86.7 69.5 59.9 62.7 70.8

Interest income (total) 68.5 95.7 81.9 78.9 88.9 91.1 82.6

Dividends 18.4 46.6 34.5 22.2 35.7 46.8 33.0

Nonfarm business net 22.2 17.6 28.7 23.6 22.2 19.1 25.2

Capital gains, losses 33.7 55.0 35.8 36.3 58.6 56.3 40.3

Gain on other property 14.7 14.7 14.9 23.1 34.0 40.9 18.4

IRA distributed (taxed) 3.7 26.4 4.5 2.0 3.5 2.5 6.5

Pension, annuity (total) 12.5 57.8 22.0 13.1 10.0 12.9 22.8

Rent, royalty net income 29.1 51.0 34.9 31.0 36.0 48.6 36.2

Social security (total) 4.8 100.0 1.2 2.8 6.7 6.2 14.0

IRA contributions (deductible) 1.81 6.2 6.8 6.2 11.1 17.3 6.9

Nondeductible 2 na na na na na na 1.4

Keogh, self-employment 

pension contribution 01 1.4 1.8 .41 6.0 10.3 2.0

Self-employment

health insurance 11.7 10.9 7.5 16.5 44.8 43.8 13.6

Half of self-employment tax 40.0 22.4 24.9 50.5 78.1 81.3 35.7

Standard deduction 67.0 69.8 56.7 75.9 71.6 58.5 63.3

Itemized deduction 3.5 28.0 41.6 16.6 16.2 28.2 30.2

Neither deduction 3 29.5 2.2 1.6 7.5 12.2 13.2 6.5

Schedule F—

Program payments 38.4 29.1 20.3 46.9 76.9 83.3 33.4

Depreciation 4 69.6 67.8 74.6 91.3 97.6 98.5 78.3

Mortgage, interest 45.3 25.8 36.1 67.6 91.4 93.4 46.5

Gain on business assets 18.7 25.4 12.3 23.5 40.2 32.3 18.8

Farm rental income 1.2 1 7.5 2.0 2.3 .81 3.4 2.6

Type of tax return—2

Single na na na na na na 16.3

Married filing jointly na na na na na na 80.3

Other na na na na na na 3.4

Tax return prepared by— 2

Taxpayer na na na na na na 15.0

Paid preparer na na na na na na 84.8

Other na na na na na na .2

na=Not available.

I

Italics indicate that estimate should be used with caution because the sample contained 10 or fewer tax returns.

2Data are from 1995 IRS Public Use Tax File (farm typology not available) and have varied little in recent years.

3May not report any deduction if adjusted gross income is negative or if taxpayer can be claimed as a dependent on another return.

4Includes depreciation and section 179 expensing deduction for farm machinery, equipment, and buildings.

Source: Compiled by USDA-ERS from special tabulations by Internal Revenue Service.
Because assets used in the trade or business to produce

other output are eligible for capital gains treatment,

capital gains are an important and frequent component

of income for farmers. According to 1996 IRS tax data,

about 40 percent of all farm sole proprietors reported a

capital gain (table 10). This figure is three times the

frequency for all other taxpayers and twice that for

other small businesses. Data for most of the preceding

decade also indicate similar proportions. By typology,

nearly 60 percent of farms with sales over $250,000

and retirement farms reported capital gains, while about

one-third of smaller sales, primary occupation farms,

limited-resource farms, and lifestyle/other farms

reported capital gains. About two-thirds of all dairy

farmers and about half of other livestock farmers report

some capital gains income each year. Of the $15 billion

in net capital gains reported by farmers in 1996 (table

9), about $6.25 billion or 41 percent was attributed to

assets used in a trade or business (table 8). For primary

occupation small farms, over 90 percent of net capital

gains were from the sale of business assets. For limited-resource and large family farms, about 60 percent

and 44 percent of capital gains, respectively, were from

business assets. Only 36 percent and 20 percent of capital gains were from business assets for retirement and

lifestyle/other farms, respectively. 

Capital gains are also heavily concentrated among the

wealthiest taxpayers, although the distribution is less

concentrated in farming than for all taxpayers. Farmers

in the top 5 percent of the AGI distribution reported

over half of the capital gains reported by farmers, while

the top 5 percent of all taxpayers reported nearly threefourths of the total capital gains. One reason for this

more even distribution is that farmers are more likely to

report capital gains from the sale of business assets,

rather than as a direct result of financial wealth.

Under current law, the maximum individual tax rate on

capital gains is 20 percent for assets held longer than 1

year, and lower rates may be available for assets held

over 5 years. Any capital gain which otherwise would

be taxed at a 15-percent ordinary rate is taxed at a 10-

percent rate. Capital gains on assets held less than 1

year are taxed as ordinary income. A special 25-percent

maximum tax rate applies to gains on certain depreciable business property.

Current law also provides for lower capital gains tax

rates on assets owned for more than 5 years. After

December 31, 2000, gains from selling property owned

for more than 5 years that would be taxed at the 10-

percent rate qualifies for an 8-percent tax rate. Any

gain that otherwise would be taxed at the 20-percent

rate qualifies for an 18-percent tax rate if the asset was

held longer than 5 years and purchased after December

31, 2000. To qualify for the 18-percent rate, taxpayers

may elect to treat existing assets as having been sold

for fair market value on January 1, 2001, and reacquired at that same value.

Historical Background

Beginning with the Revenue Act of 1921, which created a maximum tax rate of 12.5 percent, noncorporate

capital gains have received preferential treatment. This

preferential treatment has been accomplished either by

providing a lower maximum tax rate on capital gains

than on ordinary income or by allowing a portion of the

gain to be excluded. Throughout most of the decade

before the Tax Reform Act of 1986 (TRA86), a 60-percent exclusion applied. Thus, only 40-percent of longterm gains were subject to taxes. Taxpayers in all

brackets benefited from the exclusion, but the exclusion

was more valuable for taxpayers in the higher marginal

brackets. In 1986, the last year of the exclusion, the

maximum effective reduction in tax rates was from the

50-percent ordinary tax bracket to an effective 20-percent tax.

The TRA86 maintained the distinction between capital

gains and ordinary income but eliminated the 60-percent exclusion. Instead, it created a maximum capital

gains tax rate of 28 percent that was equal to the maximum 28-percent ordinary tax rate under the TRA86.

All taxpayers would pay the same rate on capital gains

as ordinary income unless the maximum individual tax

rate increased. When the top individual rate increased

to 31 percent in 1991 (and to 39.6 percent in 1993),

taxpayers in these upper brackets paid a lower rate on

capital gains than on ordinary income. In terms of the

exclusion that existed prior to TRA86, the 28-percent

ceiling on capital gains tax rates created an effective

exclusion of 9.7 percent for taxpayers in the 31-percent

bracket, and 29 percent for taxpayers in the 39.6-percent bracket.2

Preferential capital gains treatment was restored to all

taxpayers following the Taxpayer Relief Act of 1997

	
	
		 	

		

2While lower tax rates on capital gains may be viewed as an effective exclusion, the size of the effective exclusion may be less than

indicated for some taxpayers. Under current law, the entire capital

gain is included in adjusted gross income (AGI) and may therefore

accelerate the phaseout of some deductions or tax credits. When

this occurs, the size of the effective exclusion decreases. Such a

reduction does not occur when part of the gain is directly excluded

from AGI.
(TRA97). The maximum individual tax rate on longterm capital gains became 20 percent (10 percent for

gains that would otherwise be taxed at the 15-percent

ordinary tax bracket). To qualify for the 20-percent and

10-percent rates, the TRA97 required an 18-month

holding period. The Act preserved the maximum 28-

percent rate, however, for assets held between 12 and

18 months. Capital gains on assets held less than 1 year

continued to be taxed as ordinary income. The IRS

Restructuring Act of 1998 simplified the capital gains

rate structure by shortening the holding period requirement from 18 months to 12 months. The 10- and 20-

percent capital gains tax rates create five effective

exclusions for capital gains income – ranging from a

29-percent effective exclusion for taxpayers in the 28-

percent ordinary tax bracket, to a 49-percent effective

exclusion for taxpayers in the 39.6-percent ordinary

bracket (fig. 5).

Capital Gains Treatment of Farm Assets

Assets used in a trade or business (such as farming) are

not capital assets under the tax law, but do receive preferential treatment. Capital assets generally include any

property except business inventory held for sale or

depreciable or real property used in a trade or business.

Property held for personal use is a capital asset, and

gains qualify for capital gains treatment, but losses are

not deductible (except from casualty or theft). Stocks

and bonds are also capital assets qualifying for preferential treatment, and losses may offset both capital

gains and ordinary income depending on individual circumstances.

Although assets used in a trade or business (section

1231 property) are not capital assets, gains from the

sale of such assets are treated as capital gains, and

losses are treated as an offset to ordinary income.

Among the farm assets eligible for such treatment are

farmland and livestock held for draft, dairy, breeding,

or sporting purposes. The holding period requirement is

generally 1 year. Cattle and horses must be held at least

2 years, however, and poultry are not eligible for capital gains treatment.

Depreciable assets used in the trade or business are

treated somewhat differently. Gain from selling depreciable assets generally does not qualify for capital gains

treatment to the extent of recaptured depreciation, since

depreciation reduces taxable income at ordinary tax

rates. For example, gain from selling depreciated

equipment and single-purpose agricultural structures

(section 1245 property) is taxed as ordinary income.

However, under current law, farm buildings and similar

depreciable business real estate (section 1250 property)

receive a 25-percent capital gains tax rate on recaptured

depreciation to the extent of straight-line depreciation

method. Recaptured depreciation in excess of the

straight-line amount is taxed at ordinary tax rates. 

The capital gains treatment for farm business assets is

most beneficial when combined with the ability to

deduct preproductive expenses and to ignore inventories through cash accounting. This combination allows

farmers to deduct development expenditures against

their current income at regular tax rates and to convert

income to capital gains that may be eligible for lower

tax rates which are further deferred until the asset is

sold.

Deducting Preproductive Capital

Expenditures

Another feature of the Federal income tax that applies

specifically to farmers is the ability to deduct the cost

of developing certain farm assets in the tax year when

the costs are incurred or paid. Examples of preproductive development costs include raising dairy, draft,

breeding, or sporting livestock to their age for mature

use, caring for orchards and vineyards before they are

ready to produce crops, and clearing land and building

long-term soil fertility by applying lime, fertilizer, and

other materials. 

 	

			
	
		

Figure 5

Effective exclusion for capital gains income

Percent

Note: Numbers within columns reflect effective exclusions percentage

for capital gains income in each tax bracket.

Source: USDA-ERS.

0

10

20

30

40

50

15

33

29

35

44

49

28 31 36 39.6

Ordinary income tax bracket percentage
Expensing of development costs causes a mismatching

of expenses and income. This mismatching has been

used to generate deductions or losses that can be written off against income from other sources. Farm assets

eligible for deductible development expenses historically have attracted tax-motivated investment, sometimes to the detriment of the affected industry. For

example, concern regarding the impact of tax-motivated

investment on production and price levels prompted citrus and almond growers to seek legislation in 1969

requiring the capitalization of development expenses

incurred within 4 years of planting.

The Tax Reform Act of 1986 placed additional restrictions on deducting preproductive development costs.

Such costs for plants or animals with a development

period of 2 years or longer were required to be capitalized and recovered gradually as depreciation or in lump

sum at time of sale. Farmers were permitted to elect out

of the capitalization requirement if they used the

straight-line depreciation method for all assets placed

in service during the years the election was used. Costs

for land clearing and initial improvements were also

required to be capitalized.

In 1988, Congress repealed the capitalization requirement for livestock out of concern over the burdensome

recordkeeping requirements. Currently, therefore, only

land improvements and costs related to crops with a

development period of 2 years or longer are subject to

the capitalization requirement. 

Cash Accounting

Under the cash method of accounting, expenses are

deducted in the year they are paid and income is recognized in the year it is received. Inventories of both

inputs and products are ignored in determining farm

income. This greatly simplifies the recordkeeping

requirement for farmers. However, it also permits individuals to mismatch income and expenses by deducting

expenses in the current year and recognizing income

that was produced by those expenses in a later year. For

some agricultural enterprises, cash accounting can

allow large deductions during the early years of an

investment and deferred recognition of income by

building inventories of the products produced. This can

cause the accumulation of larger inventories than would

be justified without the tax interaction.

Farmers were originally granted the privilege of using

the cash method of accounting by administrative decision in 1915. Continuation of this right has been justified on the ground that farmers have neither the expertise nor sufficient access to professional assistance to

employ the more complicated bookkeeping systems

necessary for accrual accounting. Based on 1982 IRS

data, approximately 98 percent of farm sole proprietors

used the cash method of accounting. A large number of

farm partnerships and small business corporations also

use the cash method. Because of abuses of the cash

method of accounting, Congress has attempted to limit

its use. In 1976, farm corporations and partnerships

(with a corporation as a partner) with gross receipts

over $1 million were required to use the accrual method

of accounting – but the scope was limited by exceptions

intended to avoid applying the provision to closely held

family corporations. Accounting rules for family farm

corporations also changed under the Tax Reform Act of

1986, which required a permanent switch to accrual

accounting if gross receipts exceeded $25 million anytime after 1985. A family farm corporation is one with

at least 50 percent of stock held by one family.

The Tax Reform Act of 1986 also created additional

restrictions to keep farm sole proprietors from using

cash accounting to distort income. Farmers who use the

cash method of accounting cannot deduct prepaid

expenses for feed, seed, fertilizer, or similar supplies

beyond half of their total farm expenses (excluding the

prepaid amount) until the inputs are actually used. An

amount is a prepaid expense if the supplies are not used

or consumed during the year. Therefore, although farmers can prepay some expenses to manage their tax liability, the deductible amount of prepaid expenses is

limited to half of the total of nonprepaid expenses. An

exception, however, allows a taxpayer whose principal

occupation is farming to exceed this limitation if (1)

the prepayment limitation has been met for the 3 preceding tax years or (2) the excess prepayment is due to

a business operations change caused by extraordinary

circumstances such as fire, storm, casualty, disease,

drought, or government crop diversion program.

Because most farmers are sole proprietors, cash

accounting remains the most common method of

accounting in production agriculture. This provides the

vast majority of farmers some flexibility to prepay

expenses and time income receipts to optimize their

current-year tax burdens. A relatively small number of

very large family farm corporations – mostly raising

livestock, fruit, or vegetables – are required to use the

accrual method of accounting which is the standard

method for most nonfarm businesses with inventories.

	
	
		 	

		
Depreciation Allowances and Capital

Expensing 

Expenditures to purchase assets that will produce

income over a long period of time are capital expenses

and generally must be apportioned over the life that the

asset is expected to produce income. This apportionment, known as depreciation, deducts only a portion of

the cost each year over the life of the asset and helps

match the income generated by an asset to the expense

of purchasing the asset as the value of the asset

decreases over its usable life. Capital expensing is a

faster way of recovering costs by immediately deducting a specified dollar amount in the year an asset is

purchased.

Agriculture is a capital-intensive industry. In addition

to the large investment in land, farming requires substantial investments in buildings, machinery, and equipment. As a result, the system governing the recovery of

these capital costs is particularly important for the agricultural economy – not only for farmers, but also for

machinery manufacturers, builders, and dealers in local

communities.

The capital cost recovery system has a substantial

influence on the amount and composition of farm business investment. It specifies the timing of tax depreciation deductions and the levels of investment tax credits,

if any. It is therefore a primary determinant of the

actual tax burden on income from investment in depreciable farm capital.

Depreciation deductions under the capital cost recovery

system are based on the historical cost of assets, and

thus have fixed nominal values. The real values of

depreciation deductions are reduced by inflation.

Higher rates of inflation reduce the value of future

depreciation deductions and result in higher effective

tax rates and greater disincentives to invest.

Over the years, Congress has made periodic modifications in the capital cost recovery system in an effort to

increase investment incentives and compensate for the

effects of inflation on tax depreciation deductions.

These modifications have included the allowance of

accelerated tax depreciation methods, the introduction

of investment tax credits, and the shortening of writeoff periods.

The Economic Recovery Tax Act of 1981 introduced a

new capital cost recovery system referred to as the 

Accelerated Cost Recovery System (ACRS). Under

ACRS, depreciable assets could be written off at accelerated rates over 3 to 18 years, depending upon asset

type. Most farm assets including many farm structures

used in dairy, poultry, and hog production could be

written off over 5 years, despite significantly longer

economic lives. In addition to the shorter recovery

period, each farmer could immediately deduct up to

$5,000 of investment in depreciable capital each year.

Most capital assets used in farming were also eligible

for a 6-percent or 10-percent investment tax credit.

Qualifying property included machinery, equipment,

livestock purchased for dairy, draft, breeding, or sporting purposes, crop storage facilities, and single-purpose

agricultural structures. The combined effect of the

investment tax credit and ACRS resulted in negative

effective tax rates for investment in most types of farm

machinery, equipment, and some structures3. This provided substantial incentive for increased investment in

farm capital. 

The Tax Reform Act of 1986 modified the ACRS by

lengthening write-off periods and repealing the investment tax credit. However, the option to immediately

deduct up to $5,000 of investment was increased to

$10,000 for businesses that invest less than $200,000

per year. The net effect of these changes is a capital

cost recovery system that is significantly less favorable

than the system that governed investment during 1981-

85. Under current policies, depreciation deductions for

investment in farm property are less favorable than

 	

			
	
		

Table 11—Amount of capital investment that can be

expensed, 1981-2003

Expensing

Tax year amount

Dollars

1981-86 5,000

1987-92 10,000

1993-96 17,000

1997 18,000

1998 18,500

1999 19,000

2000 20,000

2001-02 24,000

2003 and after 25,000

3Negative effective tax rates occur when tax credits and deductions

can offset all the income from the investment plus additional

income from other sources.
deductions for nonfarm property.4 However, the

increase in the amount of investment that can be immediately deducted, which is scheduled to reach $25,000

by 2003, has allowed most small farms to write-off all

of their investment in depreciable capital (table 11). In

fact, based on 1996 investment levels, about 90 percent

of all farmers can expense their capital investment with

about two-thirds of total investment in depreciable farm

equipment eligible to be written off in the year the

equipment is purchased. Larger farms that invest in

excess of $200,000 per year either are not eligible for

the deduction or are allowed to expense a reduced

amount. 

In 1996, farm sole proprietors reported over $15 billion

in depreciation and capital expensing deductions. This

represented about 15 percent of total farm business

expenses reported on farm tax returns for that year. As

would be expected, those farmers who receive most of

their income from farming reported the bulk of these

expenses. Expenses for limited-resource, retirement,

and lifestyle/other farms were significantly smaller on

average. In fact, in 1996 less than 1 percent of limitedresource farmers invested more than the annual expensing limit of $17,500, while nearly half of all large and

nearly two-thirds of very large farms invested more

than the annual expensing limit (fig. 6).

Deductions Related to Land

Land is the primary input in farming. Thus, the tax

policies that affect investment in land are particularly

important for the agricultural economy. Federal income

tax provisions that are most important for farmland

include the deductibility of nominal interest and property tax payments, the capital gains treatment of appreciation in land values, and the deferral of capital gains

until they are realized from sale or other disposition.

Interest and property tax deductions are worth more in

tax reductions for taxpayers in higher tax brackets.

Likewise, preferential capital gains tax rates offer

greater effective tax reductions to those in higher tax

brackets. These provisions have combined to make

farmland, like many other real estate investments, an

attractive tax-favored investment during inflationary

periods.

	
	
		 	

		

4Depreciation deductions were initially determined on the basis of

the 200-percent declining balance method. This was changed to the

150-percent declining balance method in exchange for repealing the

provision requiring the capitalization of livestock development

costs.

Figure 6

Share of farmers with capital investment over the expensing limit by type of farm, 1996

Percent of farms

LimitedresourceRetirement Lifestyle/

other

Primary farmer/ Large Very large

low sales

Farm type

Source: Estimated by ERS-USDA from ARMS data.

0

10

20

30

40

50

60

70

80
Soil and Water Conservation

Since 1954, farmers have been allowed to claim immediate Federal income tax deductions for certain types of

expenditures on soil and water conservation or for the

prevention of erosion of land used in farming. Examples of expenses have included leveling, grading, terracing, custom furrowing, planting windbreaks, and

constructing, controlling, and protecting diversion

channels, drainage ditches, irrigation ditches, earthen

dams, watercourses, outlets, and ponds. The list of

potential eligible expenditures includes all conservation

expenditures that taxpayers would normally add to the

basis of land and deduct for tax purposes when the land

was sold. Deductions are not allowed, however, for

land not used in farming, for draining or filling wetlands, or for preparing land for center-pivot irrigation

systems. Depreciable conservation assets such as pipes,

tiles, pumps, and other nonearthen structures are also

not deductible, except for some assessments by soil and

water conservation districts. Each farmer’s annual conservation deduction is limited to 25 percent of gross

farm income, but excess amounts may be carried over

to future tax years.

Since the Taxpayer Reform Act of 1986, farmers have

been allowed to claim immediate deductions for soil

and water conservation only when the expenses are

consistent with a conservation plan approved by the

USDA Natural Resources Conservation Service

(NRCS) or a comparable State agency. The plan need

not be specific to the individual farm, however. USDA

and some State agencies have developed area-wide

plans that indicate the types of conservation measures

that are considered suitable.

If land is sold within 5 years of immediately deducting

soil and water conservation expenses, any gain on the

sale of land is treated as ordinary income up to the

extent of those soil and water conservation deductions.

If the sale occurs after 5 years but within 10 years, then

only a certain proportion of the gain is treated as ordinary income.

Cost sharing is another method that Federal, State, and

local government programs use to encourage farmers’

soil and water conservation improvements. As an alternative to deducting soil and water conservation

expenses, farmers may be eligible to exclude all or a

portion of the government cost-share payment from

their taxable income. To be eligible, the Secretary of

Agriculture must determine that payments are made

primarily for conservation purposes and IRS must

determine that income does not substantially increase

as a result of the improvement. A substantial increase

in income is defined as the greater of an increase of

$2.50 per acre or a 10-percent increase in the gross

receipts from the affected acreage over the average

gross receipts for the preceding 3 years. Government

payments that are excluded from income are subject to

a 20-year recapture provision which recaptures all of

the exclusion if the property is sold within 10 years.

The recapture percentage is reduced 10 percent per

year for the following 10 years.

Livestock Sales Due to Weather-Related

Conditions

Selling livestock because of weather-related disasters

can create tax timing problems because unusually large

sales may cause marginal income tax rates to increase.

A special rule applicable to involuntary conversions

allows farmers who are forced to sell livestock due to

weather-related conditions (such as drought, floods,

and other weather-related disasters) to defer recognizing that income until the following year. To qualify, the

farmer must show that, under normal business practices, the sale would not have occurred during the current tax year and that weather conditions caused the

area to become eligible for Federal assistance. The

gains realized from selling more breeding or dairy livestock than would normally have been sold can also be

deferred indefinitely by purchasing similar livestock

within 2 years.

Prior to the Taxpayer Relief Act of 1997, the provision

applied only to sales due to drought. The 1997 Act

expanded this special treatment to include floods and

other weather-related conditions. Farmers’ tax savings

from this provision are relatively small overall and are

highly dependent on the location and severity of

weather-related disasters. The small percentage of

farmers who qualify, however, may realize substantial

tax savings in any given year.

Income Averaging

Under a progressive tax rate system, taxpayers whose

annual income fluctuates widely may pay higher total

taxes over a multiyear period than other taxpayers with

similar yet more stable income. This situation creates a

tax inequity because higher marginal tax rates during

years with above-average income raise an individual’s

effective tax rate over time. Income averaging can mitigate this effect by allowing taxpayers to smooth their

 	

			
	
		
tax burdens over time through tax accounting methods

that consider multiyear income. Under current law,

since 1998, farmers are the only taxpayers who are eligible for income averaging. Prior to the Tax Reform

Act of 1986, all taxpayers were eligible for a different

method of income averaging.

Before its repeal in 1986, income averaging was available to both farmers and all other taxpayers who satisfied certain basic requirements. An individual’s income

must have exceeded 140 percent of the average income

in the preceding 3 years. Any excess over $3,000 was

taxed at a lower marginal rate. However, because not

all of the above-average income was eligible for lower

rates, income averaging before 1986 reduced, but did

not eliminate, additional taxes from variable income

streams.

After income averaging was repealed in 1986, the simplified tax structure reduced the additional tax burden

on variable income because the number of tax brackets

dropped from more than a dozen to only three. Since

each tax bracket was much wider, income could vary

more before the taxpayer entered a higher marginal

bracket. Farmers also could still use other income tax

provisions to manage their tax brackets in the absence

of income averaging. Cash accounting could reduce

taxable income through prepaid business expenses or

deferred farm income, and well-timed capital purchases

could reduce taxable income through depreciation

deductions or capital expensing. However, several

developments in the mid-1990’s increased the likelihood that some farmers would pay more tax because of

income variability. The 1993 introduction of additional,

higher tax brackets to the simplified tax structure of the

1986 Act increased the potential for some higher

income taxpayers to reach higher brackets. Some farmers also experienced more income variability following

the decoupling and scheduled phaseout of farm program payments under the 1996 Farm Act.

The Taxpayer Relief Act of 1997 created a new method

of income averaging that is more restrictive by being

available only for farmers and only on farm income.

Under the current law, a farmer can elect to shift a

specified amount of farm income, including gain on the

sale of farm assets except land, to the preceding 3 years

and pay tax at the rate applicable to each year. The current income shifted back is spread equally among the 3

years. If the marginal tax rate was lower during one or

more of the preceding years, a farmer may pay less tax

than without income averaging. The provision does not

allow, however, income from previous years to be

brought forward. Furthermore, as long as some farm

income is available to be shifted, the source of income

variability does not need to be from farm income for

income averaging to be beneficial. 

Compared with tax brackets before the 1986 Tax

Reform Act, today’s flatter tax rate structure and lower

marginal rates require larger changes in income to benefit from income averaging. Restricting income averaging to farm income rather than total household income

also reduces the number of farmers who will benefit

and the potential tax savings. Before the 1986 Act,

about 10 percent of farmers used income averaging and

saved, on average, an estimated $800 each. Data on

farmers’ actual use of the current income averaging

provision is not yet available. However, restricting

income averaging to farm income may reduce the number who will benefit and the tax savings.

Self-Employed Health Insurance Deduction

The self-employed health insurance deduction was created in 1988 and is intended to give small business

owners, including many farmers, tax benefits similar to

employees who receive employer-deductible health

insurance. It is especially important for self-employed

people who must purchase health insurance on their

own. It is easier to use than the alternative of deducting

health insurance premiums with itemized medical

expenses since itemized medical expenses are

deductible only to the extent they exceed 7.5 percent of

AGI – a hurdle that reduces potential deductions and is

difficult for many taxpayers to meet. 

In 2001, farmers and other self-employed taxpayers are

allowed to deduct 60 percent of the cost of providing

health insurance for themselves and their families as

long as they are not eligible for an employer-sponsored

	
	
		 	

		

Table 12—Deductible portion of self-employed

health insurance premiums since inception

Tax year Deduction

Percent

1988-94 25

1995-96 30

1997 40

1998 45

1999-20011 60

20021 70

2003 and after1 100

1Schedule to increase deductibility, part of the Tax and Trade

Extension Relief Act of 1998.
plan. The deduction is allowed as long as the taxpayer’s

earned income from self-employment exceeds the

deduction, thus eliminating the deduction for farmers

with net farm losses. The remainder of their health

insurance premiums may be included with itemized

medical expenses and are deductible if the household is

able to satisfy the itemized medical expenses threshold.

From 1988 until 1994, the self-employed health insurance deduction was limited to 25 percent of premiums

(table 12). Legislation passed in 1995 increased the

deduction to 30 percent. The Small Business Job Protection Act of 1996 increased the deduction to 40 percent for 1997, and established a schedule to gradually

increase the deduction to 80 percent by 2006. Since

then the phase-in schedule has been accelerated twice.

The Taxpayer Relief Act of 1997 advanced the schedule and would have achieved full deductibility by 2007.

Current rates became effective under the Tax and Trade

Extension Relief Act of 1998, which accelerated the

phase-in to full deductibility by 2003.

Only about 14 percent of all farmers use the selfemployed health insurance deduction in any given year.

However, nearly 45 percent of primary occupation

farmers with gross sales over $100,000 annually use

the deduction (table 13). Only about 8 percent of

lifestyle/other farmers use the deduction, primarily

because these households are more likely to receive

health insurance from a nonfarm job or may not qualify

for the deduction given the likelihood of reporting a

farming loss. 

A 60-percent deduction allows a farmer in the 15-percent tax bracket to save 9 percent of the cost of the premium, or $315 in reduced taxes on a $3,500 annual

premium. Increasing the deduction from 60 percent to

100 percent will save an additional 6 percent of the premium. When the self-employed health insurance deduction becomes fully deductible, affected taxpayers will

be able to save a portion of their premiums equal to

their marginal tax bracket, helping make health insurance more affordable and make the tax treatment more

comparable to employer-sponsored plans.

Net Operating Losses

A net operating loss (NOL) occurs when business

expenses exceed gross income. As mentioned previously, each year about two-thirds of all farm sole proprietors report a net farm loss on schedule F. However,

not all of these farms create, nor do all of their losses

represent, a net operating loss. Most losses from schedule F are used to offset nonfarm income in the same tax

year. Only about 10 percent of those losses become net

operating losses, with nearly 100,000 farmers affected.

Under current tax law, net operating losses from farming can be carried back 5 years and forward 20 years.

Carrying back a NOL creates a refund of taxes paid in

previous years, while carrying forward a NOL can

reduce future taxable income. Farmers receive special

treatment for NOL carry-back because other taxpayers

are able to carry back losses only 2 years. The 5-year

carry-back period was enacted in 1998 as part of the

Tax and Trade Relief Extension Act of 1998 – an

 	

			
	
		

Table 13—Use of the self-employed health insurance deduction by farm proprietors, 1996

Small family farms

Primary occupation Large All

Limited- Lifestyle/ Farm sales ($1,000) family farm

Item resource Retirement other <$100 $100-$250 farms proprietors

Number

Farmers using deduction 25,502 28,588 87,840 27,696 24,054 18,846 223,023

Percent

Share of group 11.7 10.9 7.5 16.5 44.8 43.8 13.6

$1,000

Amount deducted 18,159 25,773 88,601 53,260 70,743 40,176 296,712

Dollars

Average deduction 712 902 1,009 959 1,039 1,108 983

Average premium1 2,374 3,005 3,362 3,195 3,464 3,693 3,277

1Premium is computed by dividing the amount deducted by the 30-percent deduction rate allowed in 1996.

Source: Compiled by USDA-ERS from special tabulations by Internal Revenue Service.
attempt to increase cash-flow for farmers temporarily

suffering from losses due to low commodity prices. The

longer carry-back period increases both the likelihood

of a tax refund and the amount of a potential refund if

the NOL is especially large. The NOL rules primarily

benefit farmers with large farm losses who do not

receive much nonfarm income but who have paid taxes

in previous years. Generally, farms with these characteristics include primary occupation small farms and

some limited-resource or retirement farms.

In 1995, about 77,000 farm sole proprietors created an

estimated $1.7 billion of farm NOL’s that could be carried to other tax years. Data are not available to estimate how much of these losses were carried back or

forward, or to classify how the losses created were distributed across the farm typology. Historically, however, the accumulated NOL carry-forward for all farmers is quite large. An estimated 913,000 farmers carried

over $7.8 billion in NOL’s into tax year 1995 (table 14).

The Passive Loss Rules

One of the primary features of farm and other tax shelters that existed in the early 1980’s was the generation

of tax losses and credits that could be used to reduce

taxes on income from other sources. The Tax Reform

Act of 1986 introduced new rules aimed at limiting the

availability of tax shelters throughout the economy.

These new rules placed substantial restrictions on the

ability of individuals, estates, trusts, personal service

corporations, and closely held corporations to use

losses and credits generated from a passive activity to

offset other types of income. Under these rules, such

losses and credits may not be used to offset income or

tax from nonpassive sources such as a trade or business

in which the individual materially participates. Passive

activity losses and credits in excess of passive activity

income are suspended and carried forward indefinitely

to be used to offset future income from the same or

other passive activity.

A passive activity is defined as an activity which

involves the conduct of a trade or business in which the

taxpayer and/or the taxpayer’s spouse does not materially participate. A taxpayer is treated as materially participating in an activity only if the taxpayer is involved

in the operations on a regular, continual, and substantial

basis. Any rental activity is treated as a passive activity,

even if the taxpayer materially participates in the activity. However, a special rule allows up to $25,000 of

losses and credits (deduction equivalents) from rental

real estate activities in which the taxpayer actively participates to be used to offset other types of income. The

active participation requirement is less stringent than

the material participation requirement in that the taxpayer need not be involved in the activity on a regular,

continual, and substantial basis. However, a taxpayer

must participate in the making of management decisions or in arranging for others to provide services. The

$25,000 exemption is phased out by 50 percent of the

amount by which the taxpayer’s adjusted gross income

exceeds $100,000. Thus, taxpayers with adjusted gross

income in excess of $150,000 are not permitted to use

losses in a rental activity to offset income from other

nonpassive sources. 

An examination of Federal income tax return data for

1987 provides some insight into the initial impact of

the passive loss rules. The percentage of individuals

	
	
		 	

		

Table 14—Net operating losses (NOL) reported by farm sole proprietors, 1987-95

NOL carried in1 Total NOL created2 Farm NOL created2

Year Number Amount Number Amount Number Amount

$1,000 $1,000 $1,000

1987 1,069,385 -10,393,240 53,111 -2,669,295 47,783 -1,293,475

1988 877,773 -8,934,429 55,631 -2,375,248 50,840 -1,437,756

1989 900,644 -8,571,596 47,968 -2,261,914 42,722 -1,118,375

1990 864,730 -7,240,840 48,894 -2,008,501 45,012 -1,161,805

1991 901,434 -8,436,830 65,617 -3,272,532 61,551 -1,356,152

1992 809,815 -6,976,746 60,382 -1,950,676 55,234 -1,130,652

1993 887,462 -6,745,299 59,802 -2,556,630 54,454 -1,249,553

1994 872,615 -6,615,389 78,155 -2,716,738 70,333 -1,646,236

1995 913,058 -7,815,663 83,735 -2,691,232 77,490 -1,651,872

1NOL carried forward from previous year for both farm and nonfarm businesses. The estimate may understate the true value by the

amount of other miscellaneous income reported on IRS form 1040, but the bias is expected to be small.

2NOL created as a result of losses in the current year, before carry-back to earlier years.

Source: USDA-ERS estimates based on IRS Individual Public Use Tax Files.
with farm income or loss reporting passive losses was

over 8 percent or more than double the percentage for

all other taxpayers. The average passive loss reported

was also somewhat higher at about $20,000 for a total

of $4.2 billion in passive losses. 

The primary target of the passive loss rules was highincome taxpayers with only limited involvement in the

activity generating the loss. An examination of farmers

reporting passive losses by level of off-farm income

indicates that the passive loss rules had the greatest

impact on this target group. In fact, about half of all

farmers with nonfarm income of $100,000 or more

reported passive losses in 1987. These farmers reported

an average of $64,300 in passive losses for a total of

$2.3 billion. Thus, this relatively small group of farmers accounted for over 55 percent of all passive losses

reported by farmers.

A decade after enactment, the importance of the passive loss rules has declined. For 1995, only about 4 percent of all farmers reported passive losses, with the

average loss of about $12,300 for a total passive loss of

$1.1 billion. This is a small share of the total farm

losses reported by farm sole proprietors, and less than

10 percent of these losses were not allowed to reduce

other income in the current tax year. Clearly, the level

of passive losses has declined substantially since 1987,

with passive losses accounting for only about 6 percent

of farm losses compared with over 30 percent of farm

losses in 1987. This suggests that the passive loss rules

either have discouraged many nonfarm individuals

from making tax-motivated investments in agriculture

or have required them to increase their level of involvement in the farm operation to use these losses to offset

other income. 

Alternative Minimum Tax

In some cases, taxpayers can greatly reduce or even

eliminate income tax liability completely by utilizing

preferential income tax provisions. The alternative minimum tax (AMT) ensures that these individuals pay

some Federal income tax. When the AMT was created

in the 1970’s, very few individuals were affected. However, the exemption amount for the AMT has not been

indexed for inflation while other provisions in the tax

code are indexed. As regular tax deductions increase

relative to the fixed exemption amount for AMT, more

taxpayers begin to owe AMT depending on combinations of base income, tax brackets, and other deductions. The number of taxpayers who pay AMT is projected to increase steadily over the next several years

under the current tax structure. The compliance burden

for affected taxpayers increases greatly because the

AMT requires many separate calculations and tests to

determine eligible deductions under AMT rules.

More farmers are affected by the AMT than other taxpayers. In 1995, less than 1 percent of farm sole proprietors actually paid AMT, although about 11 percent

filed the form used to compute the tax (table 15). By

comparison, a similar share of nonfarm business proprietors paid AMT, but only about 8 percent filed the

form. Of the remaining nonfarm, nonbusiness taxpayers, only about half as many paid AMT in 1995, and

only about 2 percent filed the AMT form. More recent

data indicate that an increasing proportion of farmers

and other taxpayers are subject to the tax. Farm typology data from 1996 indicate that 0.78 percent of all

farmers actually paid AMT, although about 10.1 percent filed the form. Large family farms are most likely

to both file the form and pay the tax (23 percent and 3

percent, respectively), although small primary occupation farms with sales above $100,000 are also much

more likely to be affected than the average farmer

(table 16). Limited-resource farms are virtually unaffected by the AMT because of their low incomes.

Farms in the lifestyle/other category may be affected by

the AMT both because of tax shelter farm activities and

because of other nonfarm tax preferences.

The alternative minimum tax is imposed at rates of 26

percent and 28 percent on alternative minimum taxable

income in excess of a phased-out exemption amount.

Alternative minimum taxable income (AMTI) is the

 	

			
	
		

Table 15—Farm sole proprietors affected by the 

alternative minimum tax (AMT), 1987-96

All Share Share

farm sole filing paying Amount

Year proprietors form 6251 AMT of AMT

Number Percent $1,000

1987 2,424,528 9.5 0.55 167,729

1988 2,381,040 5.6 .46 105,070

1989 2,377,773 5.4 .32 85,782

1990 2,341,679 11.8 .35 90,365

1991 2,310,964 8.9 .45 105,728

1992 2,306,154 11.9 .38 101,493

1993 2,292,963 9.7 .62 128,037

1994 2,264,833 11.4 .63 129,172

1995 2,244,021 11.4 .69 128,074

1996 2,218,964 10.1 .78 180,883

Source: USDA-ERS estimates based on IRS Individual Public

Use Tax Files.
taxpayer’s regular taxable income increased by certain

itemized deductions (or the standard deduction) and

other tax preferences. A relatively high exemption

amount ($45,000 for joint returns) keeps most individuals from owing any AMT, although the exemption is

phased out at high income levels (for joint returns, 25

cents for every $1 that AMTI exceeds $150,000). The

26-percent minimum tax rate applies to taxable income

exceeding the exemption for amounts up to $175,000;

income over this amount is taxed at the 28-percent rate.

Capital gains income, however, is taxed under the AMT

at the same preferential rates as it is under the regular

income tax. If the minimum tax computed exceeds the

tax owed under the regular income tax, the difference is

added to the individual’s tax liability. 

The most important tax preference items for farmers

include accelerated depreciation (for machinery placed

in service before the Tax Reform Act of 1986), passive

farm losses, and installment sales. 

In 1997, Congress took steps to reduce the effect of the

AMT on farmers, small corporations, and other businesses. Many farmers use deferred payment contracts

to deliver farm commodities for sale at a specified

price, usually in autumn, with payment deferred until

the following year. For the majority of farmers using

the cash method of accounting, deferred payment contracts allowed them to delay paying income taxes until

the following tax year when payment was actually

received. However, in a 1996 ruling, IRS interpreted

deferred payment contracts as an installment sale that

must be recognized in the year of sale for AMT purposes. The 1997 law restored farmers’ ability to use

deferred payment contracts to defer regular income

taxes without being subject to the AMT. 

The 1997 law also repealed the AMT for small corporations with 3-year average gross receipts of less than

$7.5 million, beginning with the 1998 tax year. This

allows most farm corporations to avoid the complexities of the AMT.

For depreciable property placed in service in 1999 or

after, AMT depreciation adjustments are simplified

because longer recovery periods are no longer required

compared with regular income taxes. Before this simplification, AMT required depreciation to be computed

both over a longer period of years and at the slower

150-percent declining balance rate (rather than the

faster 200-percent declining balance rate allowed for

nonfarm assets). For farmers, eliminating longer recovery periods means no separate depreciation schedules

for the AMT, because the regular income tax already

required farm property to be depreciated using the 150-

percent declining balance rate. As older equipment is

	
	
		 	

		

Table 16—Farm sole proprietors affected by the alternative minimum tax, 1996

Small family farms

Primary occupation Large All

Limited- Lifestyle/ Farm sales ($1,000) family farm

Item resource Retirement other <$100 $100-$250 farms proprietors

Number

All filing AMT form 5,082 21,469 125,877 27,696 24,054 18,846 223,023

Percent

Share of group 2.3 8.2 10.8 8.2 15.8 22.7 10.1

Number

All paying AMT 1 3,970 9,178 1,124 623 2,309 17,211

Percent

Share of group 0 1.52 .79 .33 .41 2.79 0.78

$1,000

Amount paid 1 25,916 114,380 11,435 2,330 26,685 180,883

Dollars

Average, payers 1 6,528 12,462 10,173 3,740 11,557 10,510

Average, all farms 1 99 98 34 15 322 82

1Data unreliable because of small sample size.

Source: Compiled by USDA-ERS from special tabulations by Internal Revenue Service.
replaced or fully depreciated, this will eventually

reduce the recordkeeping burden and the number of

farms subject to the alternative minimum tax.

The 1997 AMT changes will reduce future AMT burdens for some farmers, but will not likely offset the rising trend in AMT affecting all taxpayers. Also, income

averaging for farmers that was made available by the

1997 Act has begun to create AMT problems for some

farmers because it reduces tax liability for regular tax

purposes but does not affect AMT.

Earned Income Tax Credit

The earned income tax credit (EITC) is a refundable

tax credit available to low-income workers who satisfy

certain income and other eligibility criteria. Workers

with children meeting age, relationship, and residency

requirements can receive a credit of up to 40 percent of

their earned income. Workers between the ages of 25

and 65 who do not have children and are not claimed as

another person’s dependent can receive up to a 7.65-

percent credit.

The EITC was created in 1975 to reduce the burden of

social security taxes on low-income workers, encouraging them to seek employment rather than welfare benefits. The program was expanded in 1990 and 1993 by

increasing the amount of the credit and allowing childless workers to become eligible – making the EITC one

of the largest programs targeted to low-income individuals. As an incentive to work, the EITC increases for

each additional dollar of earnings until a maximum

credit amount is reached. Like most other programs,

the credit is reduced as earnings increase beyond

another income threshold. Most taxpayers receive the

EITC as a lump sum at the end of the year by claiming

it on their Federal income tax return. Since the credit is

 	

			
	
		

Table 17—Earned income credit received by farm households, 1996

Small family farms

Primary occupation Large All

Limited- Lifestyle/ Farm sales ($1,000) family farm

Item resource Retirement other <$100 $100-$250 farms proprietors

$1,000

Amount of credit:

Total1 61,619 5,083 85,310 61,917 42,366 10,353 266,649

Offsets income tax 415 2 0 11,866 4,568 4,535 1,081 22,465

Offsets other taxes 17,328 1,235 2 14,736 20,377 22,716 5,952 82,345

Refundable portion 43,875 3,849 2 58,708 36,972 15,115 3,320 161,838

Percent

Share of credit:

Offsets income tax .7 2 0 13.9 7.4 10.7 10.4 8.4

Offsets other taxes 28.1 24.3 2 17.3 32.9 53.6 57.5 30.9

Refundable portion 71.2 75.7 2 68.8 59.7 35.7 32.1 60.7

Number

All with credit1 48,670 4,020 69,000 43,170 32,900 7,890 205,650

Percent 

Share by group:

Total credit 22.3 1.5 5.9 12.8 21.6 9.5 9.3

Offset of income tax 1.8 2 0 2.7 4.0 8.7 2.7 2.9

Offset of other taxes 16.7 1.4 2 2.3 6.0 15.5 7.8 5.3

Refundable credit 15.2 .9 2 4.0 9.4 8.4 3.9 5.9

Dollars

Average for recipients 1,266 1,264 1,236 1,434 1,288 1,312 1,297

1These figures may understate the current situation because of the disqualified income test enacted in 1996 which eliminated the earned

income credit for many farmers because sales of breeding and dairy livestock were considered part of capital gains from investment activities. An estimated 50,000 farm households were disqualified from receiving nearly $70 million in credits. In 1999, sales of such business

assets were removed from the disqualified income test, restoring the credit to many disqualified farmers.

2Italics indicate that estimate should be used with caution because the sample contained 10 or fewer tax returns.

Source: Compiled by USDA-ERS from special tabulations by Internal Revenue Service.
refundable, any amount in excess of their Federal

income tax or other tax liabilities is refunded to help

offset social security taxes.

Although the EITC is a general tax provision, it is

important to many farm households that qualify

because of low income – frequently limited-resource

farms and primary occupation farms that do not have

nonfarm wage income. In 1995, about 290,000 farmers

– about 13 percent of all farm sole proprietors –

received nearly $350 million from the earned income

credit. These numbers do not reflect, however, the full

phase-in of provisions enacted in 1993. Estimates for

1996 illustrate the differences by farm typology but

understate the total amount of the credit and its recipients relative to current law because of an eligibility test

that disqualified many farmers who routinely sold

breeding and dairy livestock, as discussed below.

Nonetheless, in 1996, nearly 206,000 farmers – or

about 9 percent of all farm sole proprietors – received

over $266 million from the credit (table 17). The average credit was $1,297, with over 60 percent of the total

refunded rather than offsetting taxes. By farm typology,

over 20 percent of limited resource farms and primary

occupation small farms with sales over $100,000

received the credit. About 13 percent of primary occupation farms with sales less than $100,000 received the

credit. For farmers who qualify, the EITC significantly

reduces their effective tax burden and frequently provides additional cash-flow to meet household living

expenses.

Rules for the EITC that are particularly important for

farmers include the treatment of business losses and

how much investment income is received. Eligibility is

phased out if earned income or modified adjusted gross

income exceeds a specified threshold amount. In determining modified adjusted gross income, 75 percent of

business losses – including farming losses – are disregarded. Therefore, farmers cannot easily use losses on

schedule F to reduce other earned income to a level that

qualifies for the EITC. Disregarding 75 percent of business losses falls disproportionately on farmers because

nearly two-thirds of all farmers report a net loss each

year. 

In an effort to better target the credit beginning in 1996

by denying benefits to those with moderate amounts of

accumulated assets, taxpayers who had relatively small

amounts of investment income became ineligible for

the credit regardless of their other income. The investment income limit is $2,200 of interest, dividends, or

net capital gains. IRS initially included the sale of business assets – including culled breeding and dairy livestock – in determining net capital gains. As a result, an

estimated 50,000 farmers were disqualified for as much

as $70 million in annual benefits. The disqualified

income test affected farmers in the Corn Belt, Great

Lakes States, and Northeast regions more than in other

areas and was 10 times more likely to disqualify farmers than nonfarm taxpayers. However, IRS reversed its

position in 1998 (retroactively) by indicating that sales

of breeding and dairy livestock and similar business

assets should not be considered net capital gains for the

investment income test.

	
	
		 	

		
Social Security and Other 

Labor Taxes

The Federal tax system imposes two taxes on wages

paid to farm laborers, a social security tax and an

unemployment insurance tax. The social security (selfemployment) tax is also imposed on a farmer’s net

earnings from self-employment.

Social Security and Self-Employment

Taxes

Social security taxes include two components: the old

age, survivor, and disability (OASDI) portion and the

Medicare hospital insurance (HI) portion. Social security tax burdens have risen dramatically in recent

decades because of increases in both the tax rate and

the amount of income subject to taxation. The most

recent rate increases stem from a decade of legislation,

beginning with the Social Security Amendments Act of

1983 (table 18). 

Unlike Federal income taxes which are progressive, the

social security tax is a flat rate with a maximum taxable amount. In 1980, the total payroll tax on wage

income was 12.26 percent and the maximum amount of

earnings subject to the tax was $25,900. By 1990, the

tax rate had increased to its current level of 15.3 percent (7.65 percent for both the employer and the

employee) and maximum earnings subject to tax were

$50,400. 

Social security taxes increased again in 1991 when a

separate, higher earnings cap was created for the

Medicare hospital insurance (HI) portion of the tax.

Previously, a single earnings cap applied to both the

(HI) portion of the tax and the old age, survivor, and

disability insurance (OASDI) tax. The earnings cap for

the 2.9-percent HI tax (1.45 for both the employer and

the employee) more than doubled from the OASDI cap

and increased from $125,000 in 1991 to $135,000 in

1993. The HI cap was removed completely in 1994,

making all wage and self-employment income subject

to the 2.9-percent tax. While only about 1 percent of

farm sole proprietors had wage or self-employment

income above the cap, the removal of the cap added to

the overall increase in social security tax burdens.

For 2001, a 7.65-percent rate for both the employer and

employee (6.2 percent for OASDI, plus 1.45 percent

for HI) applies to wages through $80,400. Wages above

$80,400 are subject only to the Medicare or hospital

insurance tax rate.

Generally, an employer must withhold social security

and Medicare taxes on all cash wages paid to employees for agriculture labor if their wages for farm work

meet either of two tests. The first test requires that

social security taxes be withheld if an employee

receives $150 or more in wages for the year. Withholding must also occur if a total of $2,500 is paid for all

farm employees during the year. There is a limited

exception for wages paid to a farm worker who

receives less than $150 in annual wages if the farm

worker is employed as a hand-harvest laborer, is paid

on a piece-rate basis, commutes daily from the

worker’s home, and worked in agriculture for less than

13 weeks in the prior year. Compensation paid to agricultural employees in-kind is not subject to social security taxes. This has encouraged some farmers to pay

their employees in farm commodities.

Self-employed farmers must pay 15.3 percent of net

farm profit up to a maximum of $80,400. They pay 2.9

percent on net farm profit above $80,400. Net farm

profit for social security tax purposes does not include

investment income or gains and losses from the sale of

assets used in the farm business. However, since the tax

is imposed on net farm profit, it can include income

generated from assets such as land that are used in the

farm business as well as the return to the farmer’s

labor. Because the share of social security taxes paid by

an employer is not included in an employees’ wage and

salary income, self-employed individuals receive an

income tax deduction for one-half of their self-employment tax and a 7.65-percent exclusion of self-employment income. Thus, the self-employment tax is comparable with social security taxes on wage and salary

income. 

In 1994, the average effective social security tax rate

for all farmers was 10 percent, up from only 7.6 percent in 1987. Effective rates continue to be regressive

and range from nearly 14 percent for farmers with

income less than $10,000 to only 2.6 percent for farmers with income over $200,000. On average, farmers

earning less than $60,000 paid more in social security

taxes than in Federal income taxes. This group, which

represented about 80 percent of all farmers in 1994,

paid an average of $3,400 in social security taxes and

only $1,900 in Federal income taxes. For all farmers,

average Federal income taxes were $7,400, and social

security taxes were $4,600 (Durst and Monke, 1998). 

While the sharp increase in tax rates and the amount of

income subject to tax have increased individual selfemployment tax liabilities, total self-employment taxes

 	

			
	
		
paid by farmers have not increased nearly as fast. In

1996, farmers paid a total of $1.8 billion in selfemployment taxes. The primary reason that total selfemployment taxes have not kept pace with the increase

in tax rates is the drop in the number of farms reporting

a farm profit. IRS data indicate that each year since

1980 farmers in the aggregate have reported negative

net farm income for taxes. The total amount of net farm

losses increased annually from 1990 through 1996,

reversing a recovery in farm income that started in

1984. The proportion of farm sole proprietors reporting

a net farm profit on schedule F has been declining with

only 33 percent of farms reporting profits in 1996,

compared with 44 percent in 1989. The reporting of

	
	
		 	

		

Table 18—Social security tax rates, 1955-2001

Maximum Self-employed Employers and employees

taxable Tax Maximum Tax rates Maximum

Year earnings1 rates tax Each Total tax

Dollars Percent Dollars Percent Dollars

1955 4,200 3.00 126 2.00 4.00 168

1960 4,800 4.50 216 3.00 6.00 288

1970 7,800 6.90 538 4.80 9.60 749

1971 7,800 7.50 585 5.20 10.40 811

1972 9,000 7.50 675 5.20 10.40 936

1973 10,800 8.00 864 5.85 11.70 1,264

1974 13,200 7.90 1,043 5.85 11.70 1,544

1975 14,100 7.90 1,114 5.85 11.70 1,650

1976 15,400 7.90 1,209 5.85 11.70 1,790

1977 16,500 7.90 1,304 5.85 11.70 1,931

1978 17,700 8.10 1,434 6.05 12.10 2,142

1979 22,900 8.10 1,855 6.13 12.26 2,808

1980 25,900 8.10 2,098 6.13 12.26 3,175

1981 29,700 9.30 2,762 6.65 13.30 3,950

1982 32,400 9.35 3,029 6.70 13.40 4,342

1983 35,700 9.35 3,338 6.70 13.40 4,784

1984 37,800 11.302 4,271 7.003 13.70 5,179

1985 39,600 11.802 4,673 7.05 14.10 5,584

1986 42,000 12.302 5,166 7.15 14.30 6,006

1987 43,800 12.302 5,387 7.51 14.30 6,263

1988 45,000 13.022 5,859 7.51 15.02 6,759

1989 48,000 13.022 6,250 7.51 15.02 7,210

1990 51,300 15.304 7,849 7.65 15.30 7,849

1991 53,400 15.30 10,2465 7.65 15.30 10,2465

1992 55,500 15.30 10,6525 7.65 15.30 10,6525

1993 57,600 15.30 11,0575 7.65 15.30 11,0575

1994 60,600 15.30 9,2726 7.65 15.30 9,2726

1995 61,200 15.30 9,364 7.65 15.30 9,364

1996 62,700 15.30 9,593 7.65 15.30 9,593

1997 65,400 15.30 10,006 7.65 15.30 10,006

1998 68,400 15.30 10,465 7.65 15.30 10,465

1999 72,600 15.30 11,108 7.65 15.30 11,108

2000 76,200 15.30 11,659 7.65 15.30 11,659

2001 80,400 15.30 12,301 7.65 15.30 12,301

1Changes in maximum taxable earnings are tied to an index of wages.

2Tax rates shown are effective rates that reflect adjustments for income tax credits.

3Nominal tax rate was 7 percent for both the employer and the employee. A 0.3-percent income tax credit reduced the effective tax rate for

employees to 6.7 percent and the total rate from 14 to 13.7 percent.

4Since1990, self-employed individuals have had a deduction from net earnings equal to half of the self-employment tax rate and an income

tax deduction equal to half of the self-employment tax paid.

5Maximum tax includes the 2.9-percent Medicare tax rate on wages and earnings up to $125,000 in 1991, $130,000 in 1992, and

$135,000 in 1993.

6Since 1994, the earnings ceiling on the Medicare tax rate was removed. Although the maximum tax consequently became unlimited, values in the table reflect the 15.3-percent rate times the regular earnings ceiling.

Sources: Compson and Durst (1992); Publication 17, Internal Revenue Service, various years.
losses for tax purposes varies by type of farm. While

about 80 percent of farms with sales over $100,000

report a profit, only about 25 percent of retirement and

lifestyle/other farms report a profit and pay selfemployment taxes (table 19).

The increases in the social security and self-employment taxes combined with reductions in future retirement benefits (through increases in the age at which

full benefits are available and higher taxes on benefits)

have lowered the expected rate of return on social security tax payments. Thus, farmers and their employees

have an incentive to minimize the taxes they pay. This

has led to tax-driven changes in farm business operations designed to lower social security and self-employment taxes.

Federal Unemployment Taxes

The Federal Unemployment Tax Act (FUTA) is

designed to provide unemployed workers with partial

income during a temporary period of unemployment.

Employer taxes are the primary source of funding for

the unemployment compensation program. Farmers

who pay cash wages of $20,000 or more for agricultural labor in any calendar quarter in the current or preceding calendar year, or employ 10 or more farm workers during 20 different weeks during the current or preceding calendar year, must pay the Federal unemployment tax. The current wage base is $7,000 at a tax rate

of 6.2 percent. Employers may claim a credit for paying State unemployment taxes. The credit is allowable

up to 5.4 percent of the first $7,000 in wages paid to an

employee, reducing the Federal tax to as little as 0.8

percent of the first $7,000 paid to each employee. Selfemployed farmers are not subject to unemployment

insurance coverage. In addition, noncash compensation

for agricultural labor is exempt from the definition of

wages for FUTA purposes.

Most operators of small farms, along with many larger

farms that are highly mechanized and employ little

hired labor, are not affected by the unemployment

insurance tax. However, for those farms that require

substantial amounts of hired labor, the unemployment

insurance tax further increases their hired labor costs. 

 	

			
	
		

Table 19—Self-employment taxes for farm sole proprietors, 1996

Small family farms

Primary occupation Large All

Limited- Lifestyle/ Farm sales ($1,000) family farm

Item resource Retirement other <$100 $100-$250 farms proprietors

Number

Farmers paying tax 87,294 58,802 290,840 169,987 118,670 67,405 792,997

Percent

Share within group 40.0 22.4 24.9 50.5 78.1 81.3 35.7

$1,000

Amount paid 46,985 103,411 697,475 272,102 359,016 356,133 1,835,122

Dollars

Average, payers 538 1,759 2,398 1,601 3,025 5,283 2,314

Average, all farms 215 395 598 809 2,362 4,298 827

Source: Compiled by USDA-ERS from special tabulations by Internal Revenue Service.
Federal Estate and Gift Taxes

The current Federal estate and gift tax system applies a

unified tax rate structure and a cumulative lifetime

credit to gifts and transfers of money and other property at death. Under the system, individuals can transfer

a specified amount ($675,000 in 2001) in cash and

other property without Federal estate or gift tax liability

as a result of the unified lifetime credit. Although every

estate with more than $675,000 in gross assets must file

an estate tax return, the taxable amount is reduced by

deductions for funeral expenses, administrative

expenses, debts, charitable contributions, and transfers

to one’s spouse. As a result, less than half of all estates

required to file a return are actually taxable. Gifts of up

to $10,000 annually to any individual are also exempt

from tax and do not count against the amount exempted

from tax by the unified credit. Transfers in excess of

the exempt amount are taxed at a graduated rate structure that begins at an effective rate of 37 percent, rising

to a maximum rate of 55 percent on taxable estates

above $3 million (table 20).

Estate and gift tax receipts have historically accounted

for a relatively small share of total annual Federal revenues. The receipts from the Federal estate and gift tax

for fiscal year 1999 are estimated at $25.9 billion, less

than 2 percent of total Federal revenues. While the

aggregate importance of estate and gift taxes is small

relative to other Federal government revenue sources,

the potential impact of these taxes on an individual or

group of individuals, such as farmers and other small

business owners, can be substantial. 

The impact of Federal estate and gift taxes on the farm

sector was an important issue during the late 1970’s.

During that period, the appreciation in land values, the

increase in farm size, and the rising investment in farm

machinery and equipment increased estate values and

taxes substantially. Congressional concern that

increased estate and gift taxes might cause the break-up

of some family farms and other small businesses

resulted in the enactment of two special provisions in

the Tax Reform Act of 1976. These provisions are the

special use valuation of farmland and the installment

payment of estate taxes. Concern for the effects of the

Federal estate tax on farmers and other small businesses was also the primary impetus for the changes

enacted as part of the Taxpayer Relief Act of 1997,

which included a new deduction for qualified familyowned business interests.

Special Use Value

The value of property for estate tax purposes is generally the fair market value at the date of death. However,

if certain conditions are satisfied, real property included

in the estate which is devoted to farming or other

closely held business use may be valued at the property’s value as a farm or other closely held business

rather than its fair market value. To be considered qual-

	
	
		 	

		

Table 20—Federal estate and gift tax rate schedule, 2001

Of amount

Taxable estate Tax liability is1 Plus over

Dollars Dollars Percent Dollars

10,000 and under 0 18 0

10,001- 20,000 1,800 20 10,000

20,001- 40,000 3,800 22 20,000

40,001- 60,000 8,200 24 40,000

60,001- 80,000 13,000 26 60,000

80,001- 100,000 18,200 28 80,000

100,001- 150,000 23,800 30 100,000

150,001- 250,000 38,800 32 150,000

250,001- 500,000 70,800 34 250,000

500,001- 750,000 155,800 37 500,000

750,001- 1,000,000 248,300 39 750,000

1,000,001- 1,250,000 345,800 41 1,000,000

1,250,001- 1,500,000 448,300 43 1,250,000

1,500,001- 2,000,000 555,800 45 1,500,000

2,000,001- 2,500,000 780,800 49 2,000,000

2,500,001- 3,000,000 1,025,800 53 2,500,000

3,000,001 and over 1,290,800 55 3,000,000

1Before credits and phase-out of graduated rates for estates with taxable amount in excess of $10,000,000.

Source: Internal Revenue Code Section 2001.
ified property, the property must be transferred to a

qualified heir,5 must have been used as a farm for 5

years during the 8-year period ending with the decedent’s death, the decedent or a member of the decedent’s family must have participated in the farm business, the value of the qualified real property must equal

at least 25 percent of the estate, and the combined

value of the real and other business property must be at

least 50 percent of the gross estate. 

The method used to value farmland for use value purposes is to divide the 5-year average annual gross cash

or share rental for comparable land in the area, minus

State and local real estate taxes, by an average of the

annual effective interest rate for all new Federal Land

Bank (FLB) loans for the year of death. For most

farms, the use valuation law can reduce the value of the

real property portion of qualifying estates by 40 percent

to 70 percent, with the largest reductions occurring for

farmland which has residential or commercial development potential. All or a portion of the estate tax benefits obtained under the special use valuation provision

are recaptured if the property is sold to a nonfamily

member or if the property ceases to be used for farming

or other closely held business purpose within 10 years

of the decedent’s death.

The Tax Reform Act of 1981 increased the maximum

reduction in value under special use value from

$500,000 to $750,000 for estates of those dying in

1983 or later. In the absence of other changes, this

change would have increased the incentive to invest in

farmland for estate tax purposes. However, the Economic Recovery Tax Act of 1981 made other substantial changes in estate and gift tax provisions. These

included reductions in marginal estate and gift tax

rates, an increase in the annual gift tax exclusion, an

increase in the unified credit and the allowance of an

unlimited marital deduction. The net effect of these

provisions was to substantially increase the amount of

property that could be transferred tax free. The cumulative effect of these changes reduced the incentive for

many estates to qualify for special use value. Nevertheless, for those estates in need of additional tax saving

techniques, the special use value provision continues to

offer significant tax benefits. Even with reduced Federal estate tax rates, the maximum estate tax savings

available under special use value is $440,000. In addition, the liberalization of the qualification requirements

for special use value lowered the barriers which might

otherwise have discouraged some investors from seeking special use value benefits. Thus, the special use

value provision may have an unintended impact on the

farm sector. The potential estate tax savings may have

encouraged additional purchases while the recapture

provisions discouraged sales. The net effect has been

reduced availability but increased demand for farmland. 

Installment Payment of Estate Tax for

Closely Held Businesses

A second special provision for farmers and other small

business owners is aimed at the liquidity problem that

these businesses can face as a result of having a large

portion of the estate in land and other relatively illiquid

business assets. Federal estate and gift taxes generally

must be paid within 9 months of the date of death.

However, when at least 35 percent of an estate’s value

is a farm or closely held business, estate taxes may be

paid over an additional 14-year period. Prior to 1998,

the interest rate on taxes due on the first $1 million in

value of qualifying assets was 4 percent. For amounts

above $1 million, the rate was the normal rate applicable to underpayments of tax. Interest paid on deferred

estate taxes was deductible for either estate or income

tax purposes. 

Beginning in 1998, the interest rate on the first $1 million in taxable value (above amounts exempted by the

unified credit) of the farm or other closely held business was reduced to 2 percent. The interest rate on

amounts above $1 million in taxable value was reduced

to 45 percent of the rate applicable to underpayments

of tax. However, the interest is not deductible for either

estate or income tax purposes. These changes to the

installment payment provision reduced both the interest

expense and the administrative burden associated with

installment payments. The amount of estate tax eligible

for the 2-percent interest rate will increase from

$153,000 to $435,000 by 2006. As a result, a $2-million estate qualifying for the installment payment provision would have the present value of its tax cut in

half compared with an estate required to pay Federal

estate taxes in full within 9 months of death.6 This

change combined with the increase in the amount of

property that can be transferred tax free should greatly

reduce the liquidity problem that some farm heirs

might otherwise experience as a result of Federal estate

taxes. 

 	

			
	
		

5 A qualified heir means a member of the decedent’s family,

including an ancester, spouse, lineal descendants, and parents and

their descendants. 6Assumes a 2-percent interest rate and an 8-percent discount rate.
Indexing for Certain Estate and Gift Tax

Provisions

The value of various estate tax provisions has not been

changed for several years. As a result, the real value

has declined significantly. Beginning in 1999, the

$10,000 annual exclusion for gifts, the $750,000 cap on

the reduction in value under special use valuation, and

the $1-million ceiling on the value of a closely held

business eligible for the special low interest rate under

the installment payment provision were indexed for

inflation. While indexing will not restore the loss in

value, it will maintain the real value at current levels in

the future. 

Deduction for Qualified Family-Owned

Businesses

Beginning in 1998, a new deduction for the first

$675,000 of qualified family-owned business interests

was enacted. The deduction is in addition to any benefits from special use valuation and the unified credit.

However, the total amount excludable from this provision and the unified credit is limited to $1.3 million.

Thus, as the amount shielded from tax by the unified

credit increases, the additional exempt amount for

farms and closely held businesses declines to $300,000

by 2006 and thereafter (table 21).

A qualified family-owned business interest is any stake

in a business with its principal place of business in the

United States in which one family owns at least 50 percent of the business, two families own at least 70 percent, or three families own at least 90 percent, as long

as the decedent’s family owns at least 30 percent. To be

eligible for the deduction, such interests must represent

more than 50 percent of a decedent’s estate, the decedent or a member of the family must have owned and

materially participated in the business for at least 5 of

the 8 years before death, and each qualified heir or a

member of the heir’s family must materially participate

in the business for at least 5 of each 8-year period ending within 10 years after the decedent’s death. The benefits from the deduction are recaptured if the qualified

heir fails to meet the material participation requirements, the qualified heir disposes of the business interest other than to a family member or through a qualified conservation contribution, the principal place of

business is moved outside the United States, or the heir

loses U.S. citizenship.

The new exclusion for farms and other family-owned

businesses combined with the increased unified credit

is expected to reduce the number of taxable farm

estates by nearly 50 percent. The total taxes paid are

expected to drop by about one-third. This new deduction along with the other changes to the Federal estate

tax provisions should reduce, if not eliminate, the need

to sell farm assets to pay Federal estate taxes. Nevertheless, the targeting provisions associated with the

new deduction are extremely complex and contain a

number of pitfalls for the uninformed. Qualifying for

the new deduction will require careful planning, further

increasing the administrative burden and expense associated with the estate tax. 

Exclusion for Land Subject to

Conservation Easement

Since 1981, a deduction has been allowed for Federal

income, estate, and gift tax purposes for a contribution

of a qualified real property interest to a charity or other

qualifying organization exclusively for conservation

purposes. A qualifying real property interest includes a

perpetual restriction or easement on the use of real

property. A conservation purpose is defined as (1) the

preservation of land for the general public’s outdoor

recreation or education, (2) the preservation of a natural

habitat, (3) the preservation of open space for the scenic enjoyment of the general public or in furtherance of

a governmental conservation policy, and (4) the preservation of historically important land or certified historic

structures. 

	
	
		 	

		

Table 21—Potential Federal estate tax exemption 

amount from unified credit and family-owned 

business deduction

Unified Family 

credit business Total 

exclusion deduction exclusion

Year amount amount amount1

Dollars

1987-97 600,000 0 600,000

1998 625,000 675,000 1,300,000

1999 650,000 675,000 1,300,000

2000-01 675,000 675,000 1,300,000

2002-03 700,000 675,000 1,300,000

2004 850,000 675,000 1,300,000

2005 950,000 675,000 1,300,000

2006 1,000,000 675,000 1,300,000

1Total amount exempted by unified credit and family business

deduction cannot exceed $1,300,000.

Source: Compiled by USDA-ERS from information contained in

Internal Revenue Code Sections 2010 and 2057.
Beginning in 1998, in addition to the reduction in value

for the conservation easement, an exclusion is provided

for up to 40 percent of the value of land in an estate

that is subject to a qualified conservation easement and

located within 25 miles of a metro area, a national park

or wilderness area, or within 10 miles of an urban

national forest. The decedent or a member of the decedent’s family must have owned the land for at least 3

years prior to the date of death and the donation must

have been made by the decedent or his or her family.

The exclusion is based on the value of the property

after the conservation easement is placed, and does not

include any retained development rights to use the land

for any commercial purpose except those supportive of

farming. If the value of the conservation easement is

less than 30 percent of the value of the land for purposes of the exclusion, the exclusion percentage is

reduced 2 percentage points for each percentage point

below 30 percent. The maximum exclusion is limited to

$400,000 in 2001 but increases to $500,000 in 2002

and thereafter. 

Granting a qualified conservation easement is not

treated as a disposition that would trigger the recapture

of special use valuation benefits, and the existence of a

qualified conservation easement does not affect eligibility for special use valuation. Thus, the exclusion can be

used in combination with the special use valuation provision. 

The exclusion provides an additional incentive to

donate a conservation easement within the designated

areas. However, given the increased unified credit, the

availability of special use valuation, and the new

deduction for family-owned business interests, the

number of landowners who are subject to the Federal

estate tax and who would benefit from the additional

exclusion may be relatively small. Geographic targeting

of conservation easements will also limit the pool of

potential donors. Nevertheless, those farmers willing to

forgo potential future development gains can transfer

an additional $500,000 in farmland to their heirs without affecting the operation of the farm business. 

Implications of Federal Estate and Gift 

Tax Changes

The amount of property that can be transferred tax free

has increased substantially since 1980. The Economic

Recovery Tax Act of 1981 increased the unified credit

each year from 1982 through 1987, from an effective

exemption amount of $225,000 in 1982 to $600,000 in

1987. The exemption amount remained the same until

the 1997 Act which increased it to $1,000,000 by 2006

(table 21).

The combination of the new family business deduction

and special use value will substantially reduce the number of farm estates subject to the Federal estate tax.

Those that are eligible for these provisions but remain

taxable are primarily farming occupation with high

sales, large or very large farms (fig. 7). The majority 

of other farms that remain taxable are not eligible for

special use valuation or the family business deduction

due to the share of nonfarm assets in the estate. For

lifestyle/other and retirement farms, average nonfarm

net worth exceeds average farm net worth. For

lifestyle/other farms, this may reflect the relative

importance of the farm and nonfarm activities. For

retirement farms, it may reflect the disposition of farm

assets in anticipation of or during retirement. 

Based on simulations using 1998 farm-level survey

data, about 4 percent of all farm estates would owe

Federal estate and gift taxes, slightly higher than the 

2 percent of all estates. Of the 31,161 estimated farm

estates for the 1998 year, only 5,394 had assets in

excess of $625,000 and would be required to file an

estate tax return (fig. 8). After deductions, special use

value and the family business deduction, only 1,219 

of the estates would be taxable. The average tax due

was estimated at $600,000 on an average net worth 

of $2,800,000 for an average tax rate of 21 percent.

The special use valuation and the family business

deduction reduced both the number of taxable estates

and total Federal estate taxes for all farm estates by

about half. 

The changes enacted in 1997 reduced the number of

farm estates that will be subject to tax but increased the

favored treatment of farm and other business assets

over other assets for estate tax purposes. Thus, the family-owned business deduction combined with other targeted provisions will encourage older farmers to retain

ownership of land, livestock, machinery, and other farm

assets until death. This will increase the amount of

farm property transferred to heirs but may reduce

opportunities for others to enter farming. 

 	

			
	
		
	
	
		 	

		

Figure 7

Share of farm estates that owe Federal estate taxes by farm typology, 1998

Percent of farms

LimitedresourceRetirement Lifestyle/

other

Primary farmer/ Large Very large

low sales

Primary farmer/

high sales

Farm type

Source: Estimated by ERS-USDA from ARMS data.

0

5

10

15

20

Figure 8

Share of farm estates with returns and taxes, 1998

Source: Estimates by USDA-ERS from ARMS data.

Returns with taxes

 4%

Returns/no taxes

 11%

No returns

 85%
Tax Policy Implications

Individuals frequently change their behavior in

response to economic incentives. Tax policies provide a

variety of economic incentives that encourage certain

activities or investments by providing more favorable

tax treatment relative to other activities or investments.

To the extent that tax policy and not market forces is

the primary determinant of how economic resources are

allocated, economic efficiency may not be optimal

from the broader resource allocation perspective. In

addition, tax incentives can have impacts that are unintended or counter to other government policy goals.

The tax provisions outlined throughout the preceding

chapters create incentives for farmers and nonfarm

investors in farm assets to behave in certain ways and

to create certain observable results that follow. Implications of Federal tax policies of significance to farmers

are particularly notable in tax burdens, land prices and

the ownership of capital assets, the cost of capital relative to labor, the size and organizational structure of

farms, management and husbandry practices, and product supplies and prices.

Tax Burdens

The various special farm tax provisions affect both

farmers’ effective tax rates and their tax burdens relative to all other taxpayers. Research examining the

effects of Federal tax policies on farmers’ tax burdens

prior to the 1980’s concluded that special agricultural

tax preferences reduced the tax burden on farm income

(Davenport, Boehlje, and Martin). Individuals with substantial farm income enjoyed a substantially lower tax

burden than individuals with no farm income. Furthermore, the gap between farm and nonfarm tax burdens

widened with increasing levels of income. However,

that research compared tax burdens of farmers with all

other taxpayers and not with other business owners.

Therefore, whether farm tax provisions provided more

favorable treatment to farmers than other business owners who also benefit from targeted tax provisions is

unclear. This research also found that the Federal

income tax was less progressive than suggested by the

marginal tax rate structure. For those farmers whose

primary source of income was from farming, Federal

income tax rates were found to be relatively flat suggesting that larger, higher income farmers were able to

utilize investment incentives, capital gains, and other

tax provisions to offset higher marginal income tax

rates (Sisson). 

The tax structure has changed substantially since this

research was conducted. Tax law changes in the early

1980’s reduced marginal tax rates and provided significant investment incentives, while legislation in the mid1980’s reduced marginal income tax rates and eliminated much of the preferential treatment that agriculture received, particularly for investors who utilized

farm investments as a tax shelter. Nevertheless, while

the average effective Federal income tax rate increased

from 14 percent in 1987 to just over 15 percent in

1990, tax rates were slightly less progressive (Compson and Durst, 1992).7 The differences in tax rates for

farm and nonfarm taxpayers were also reduced by the

elimination of income averaging, the capital gains

exclusion, the investment tax credit, and other important farm tax provisions. 

Two new tax brackets for high-income taxpayers were

added in 1993, increasing the maximum marginal tax

rate from 31 to 39.6 percent. This reversed the trend of

lower marginal tax rates that began in 1981. For lowincome households, the earned income tax credit was

expanded in 1990 and 1993 by increasing the benefit

levels and simplifying eligibility rules. Thus, while the

overall tax rate increased from 15 percent to 16 percent

between 1990 and 1994, an analysis of IRS data confirms that average effective tax rates became more progressive – increasing for high-income taxpayers

because of the new tax brackets and decreasing for

low-income farmers due to the expansion of the earned

income tax credit (Durst and Monke, 1998).

Since 1997, farmers have benefited from a variety of

new tax provisions including income averaging, an

increased self-employed health insurance deduction,

expanded capital expensing and reduced tax rates for

capital gains. These provisions are likely to reduce the

progressivity while more general tax provisions such as

the new education and child tax credits should primarily benefit lower and middle income farmers. Thus,

while these changes are expected to reduce the average

effective tax burden of farmers by as much as 2 percentage points, the effect on progressivity and on farm

tax burdens relative to other taxpayers is unclear.

 	

			
	
		

7The average effective tax rate equals the amount of tax paid after

all tax credits divided by an expanded measure of income which

includes adjusted gross income plus statutory deductions, taxexempt interest, and other variables.
Capital Investment: Capital/Labor Ratios

Agriculture is a capital-intensive industry. Throughout

much of the 1970’s and early 1980’s, farming became

increasingly capital intensive. Accompanying this

increased use of capital has been a sharp, long-term

decline in the use of labor. The number of farm workers has declined steadily over the last three decades.

The result has been a sharp increase in capital/labor

ratios in agriculture. Tax policy is one of a number of

factors that may have played a role in this trend. Tax

policies have historically provided incentives for investment in depreciable capital, while taxes have been

imposed on the utilization of labor.

Prior to the Tax Reform Act of 1986 and the Social

Security Reform Act of 1983, Federal tax provisions

provided a number of incentives for farmers to substitute capital for labor. Accelerated depreciation and the

investment tax credit greatly reduced the cost of capital

while labor costs continued to rise due to increases in

social security and other labor taxes. The Tax Reform

Act of 1986 represented a significant shift in tax policy

incentives for investment in depreciable capital. The

investment tax credit was eliminated, while depreciation periods for most farm assets were lengthened. The

result was a significant increase in the after-tax cost of

capital. At the same time, labor taxes continued to

increase primarily as a result of increases in social

security taxes. The net effect of the changes is unclear.

While the changes to the cost of capital were of a

greater magnitude, little or no empirical evidence exists

regarding current tax incentives to substitute capital for

labor. Regardless, incentives for capital investment are

clearly less than existed in the late 1970’s and early

1980’s. 

A number of studies have examined the effect of tax

policy on optimal equipment replacement decisions.

One of the early studies found that the investment tax

credit had only a minor impact on the farm machinery

replacement decision (Chisholm). However, later studies found that the investment tax credit significantly

reduced the replacement age of farm machinery and

that this reduction resulted in the substitution of capital

for labor. The effect was found to be greater for higher

income taxpayers (Kay and Rister). A later study found

similar results for both accelerated depreciation and the

investment tax credit (Bates, Rayner, and Custance). 

Studies conducted following the Tax Reform Act of

1986 are consistent with these earlier studies. The optimal replacement age for farm assets was shown to be

inversely related to the amount of the investment tax

credit and the present value of depreciation allowances.

Therefore, these studies concluded that the abolition of

the investment tax credit and reductions in the present

values of tax depreciation allowances would increase

optimal replacement ages and reduce optimal replacement rates (Smith). However, little or no work has been

done regarding the effect of social security and other

labor taxes on the cost and use of labor in agriculture.

These taxes increase the cost of using labor directly

and indirectly through the increased costs associated

with the recordkeeping requirements necessary to comply with the taxes. Of the payroll taxes, social security

is clearly the most significant. The contribution rate

and amount of wages subject to the tax have increased

dramatically in recent years. Unemployment insurance,

on the other hand, is imposed at a much lower rate and

on a smaller segment of the farm labor force. Nevertheless, the combined effect of these and related State

taxes such as workers’ compensation insurance is to

increase the cost of farm labor. 

In summary, tax incentives for capital investment in the

early 1980’s clearly encouraged the use of capital in

agriculture, while payroll and other labor taxes discouraged the use of farm labor. However, this tax-induced

substitution of capital for labor may have been relatively minor compared with other nontax factors. Tax

policy merely strengthened an existing trend caused

primarily by other factors such as technology developments. Therefore, while the overall reduction of investment incentives should result in reduced capital investment relative to prior laws, this clearly does not suggest

a reversal of the trend to substitute capital for labor. 

Land Prices and Ownership of 

Capital Assets

Farmland is a key asset because the supply of land

available is relatively more limited than other farm

assets. Low land prices facilitate entry into farming

while high land prices make entry difficult. If a

prospective farmer is unable to buy land or to arrange a

rental agreement with a landlord, there is no way to

enter land-based farming. Farmland historically has

been a good tax investment during inflationary periods

and has, therefore, been attractive to both farm and

nonfarm investors. Its value as an inflationary hedge

comes both from the deductibility of nominal interest

payments on loans and the appreciation of land values

on a tax-deferred basis. 

	
	
		 	

		
Capital gains taxes are levied on nominal returns. Taxing both real and inflationary gains makes the effective

tax rate on the real return (the capital gains tax divided

by the real capital gain) nearly always greater than the

marginal tax rate. If the real rate of return is low relative to inflation, then most of the nominal capital gain

is due to inflation and the effective tax rate on the real

return could exceed 100 percent.8 Longer holding periods help reduce the effective tax rate by compounding

the real rate of return, but effective tax rates often

remain high relative to the marginal tax rate. Although

inflation also increases effective tax rates on interest

and dividends, the effect on capital gains is often perceived to be greater because of the magnitude of capital

sales and the proportion of the sale price that gains represent after long holding periods.

Effective tax rates always exceed the taxpayer’s marginal bracket in an inflationary environment unless part

of the nominal gain is excluded from taxation. If part of

the gain is excluded, then the effective rate may drop

below the taxpayer’s marginal rate under certain combinations of holding periods and real rates of return.

Since lowering capital gains tax rates below ordinary

tax rates is effectively similar to providing an exclusion, current law helps to reduce the effect of taxing

inflationary gains. For example, using a hypothetical

30-year holding period with 2-percent annual real capital appreciation, 4-percent inflation, and tax law from

1996, an individual in the 28-percent ordinary tax

bracket faced effective capital gains tax rates on real

returns of 52 percent. Under current law with the 20-

percent capital gains tax rate (an effective exclusion of

29 percent), the effective tax rate in the scenario drops

to 37 percent. Under pre-1986 tax law with the 60-percent exclusion, the scenario would result in a 21-percent effective tax rate on the real return.

Tax timing issues also benefit the investor who borrows. Deductible interest expenses reduce tax liability

during the current year, while capital gains taxes are

deferred until the asset is sold. Deferring capital gains

taxes slightly increases the implicit after-tax rate of

return. This increases with longer holding periods and

can be especially important for those who intend to

hold assets indefinitely.

Before the current policy of a maximum tax rate on

capital gains, deferring capital gains until an asset was

sold could create problems at the time of sale because

unusually large gains may have pushed the taxpayer

into a higher marginal tax bracket. In such cases, the

potential for higher taxes may have been reduced somewhat by making land sales on the installment method

or by selling the land in smaller parcels over time. 

Farm Tax Shelter Opportunities

Lower capital gains tax rates increase incentives to

invest in assets that generate capital gains and to alter

management practices to maximize such income. In

farming, this increases farm investment especially in

livestock and farmland. Preferential capital gains treatment may accelerate the growth in the number of large,

investor-owned farms and make obtaining or controlling the means of production (primarily farmland and

production facilities) more difficult for some smaller

family farms. However, tax shelter opportunities are

more constrained now than they were before the Tax

Reform Act of 1986.

The use and abuse of tax provisions available in farming before the Tax Reform Act of 1986 is well documented (Long; Davenport, Boehlje, and Martin).

Before the 1986 Act, both farm and nonfarm investors

were encouraged to invest more in favored activities.

Several provisions enacted in recent years, including

those contained in the Tax Reform Act of 1986, restrict

such investments. These include limits on the ability to

use the cash method of accounting, limits on the current deductibility of development costs, restrictions on

prepaid expenses, and passive loss rules that limit the

ability of some individuals to deduct losses. While

these changes and lower marginal tax rates have

reduced both the incentive and the opportunity to make

tax-shelter investments in farming, they have not eliminated all such opportunities.

Tax laws encourage financing land and other assets

with debt, particularly in an inflationary environment.

Since nominal interest expenses for businesses are fully

deductible for tax purposes, the value of the tax deduction equals the nominal interest multiplied by the tax

rate. For borrowers with fixed nominal interest rate

contracts, an increase in inflation reduces the effective

real cost of borrowing. The real cost of borrowing is

also reduced by the nominal tax benefit. Therefore, if

inflation increases while a borrower holds a fixed interest rate loan, the real after-tax cost of borrowing on a

fixed-rate loan will decrease and could even become

negative after combining the effects of inflation and

taxes. The reduction in borrowing costs is greater for

 	

			
	
		

8For example, after a 1-year period with 3-percent inflation and a

4-percent nominal capital gain, a 25-percent capital gains tax yields

a 100-percent effective tax on the real return.
individuals in higher marginal tax brackets.9 These

relationships increase the incentive to finance investments with debt, particularly for assets that generally

appreciate in value during inflationary periods, and for

those in higher income tax brackets.

Inflation also creates the expectation that asset values

will grow over time. Economic returns become divided

between current cash returns and deferred capital gains

returns. When current returns are low relative to asset

values and interest expenses, loan payments on debtfinanced assets can exceed the cash-flow from those

assets. The negative cash-flow can provide a tax shelter

if the owner has other income to shield from taxes. The

net effect can tend to restrict land purchases to those

with sufficient outside resources to meet the negative

cash-flow requirements. This creates barriers to entry

and increases both the concentration of land ownership

and the reliance on rented land.

Because the net tax benefits are greatest for highbracket taxpayers who leverage their ownership with

debt, they can bid substantially more for land. Highbracket taxpayers are frequently able to outbid lower

bracket taxpayers when appreciation rates are high

compared with annual cash returns. Furthermore, highbracket taxpayers prefer capital gain income to ordinary income and are willing to accept low cash returns

as long as the asset appreciates in value. Thus, the

established farmers or nonfarm investors may be able

to outbid beginning farmers in the real estate market. In

contrast, the beginning farmer is normally more concerned with cash-flow than appreciation. Thus, beginning farmers have difficulty competing for real estate

and obtaining ownership of farmland. The beginning

farmer may, however, have the opportunity to rent

farmland from owners who acquire real estate more for

its appreciation than its cash-flow generating capacity.

Lock-in effect

Because increases in the value of property are not taxed

until assets are sold and gains are realized, potential tax

liabilities increase as gains accumulate and give taxpayers a growing incentive to hold onto assets rather than

selling and reallocating funds. This incentive to continue to hold property – the lock-in effect – is compounded by estate planning. At death, unrealized capital gains that occurred during life are fully exempted

from the income tax. When ownership is transferred to

the heirs, the basis for determining gain upon the sale

of the asset is stepped-up to the fair market value when

the decedent died. The prospect of gaining tax exemption through death is an incentive not to sell the asset.

From the resource allocation perspective, the lock-in

effect encourages owners to continue to hold assets that

may even earn below-average risk-adjusted returns,

because they believe that tax deferral with a substandard return is better than realizing gains and paying

taxes in order to reallocate funds. Either way, the lockin effect reduces the land available for purchase but

increases land for rent.

In farming, land is the most common asset affected by

the lock-in effect. A reduced supply of land available

for sale increases the price of land in the face of

unchanging demand. A person expecting to hold the

land until death as an investment for heirs would be

able to bid even higher than a buyer who at some point

expects to realize the appreciation and pay tax on it.

That economic rents accrue to asset owners is important for the distribution of returns from farming. The

average capital gain on farmland purchased in 1966 and

held for 30 years represents about 80 percent of the

value of the land. 

Preferential capital gains taxes decrease, but do not

eliminate, the lock-in effect. Farmers and farm assets

may be less responsive to preferential tax rates because

capital assets that are part of an ongoing farm business

may be difficult to sell without disrupting production.

Farm businesses are also not very mobile, reflected in

part by the low turnover of farmland; only about 3 percent is traded at market prices each year (Rogers and

Wunderlich). Sellers of farm assets also face much

higher transaction costs compared with owners of corporate stock or more liquid assets. Furthermore, about

40 percent of farmland is owned by individuals age 65

or older who are consequently better able (and increasingly motivated) to avoid capital gains taxes completely

by holding their land until they die. Estate tax provisions that require continued business and asset ownership, such as special use valuation and the new family

business deduction, also discourage current owners

from selling business assets. Owners with equity can

easily access unrealized gains without incurring a tax

liability by borrowing against the property.

The magnitude of the lock-in effect may be measured

by computing the additional rate of return that a new

investment would need to earn over the existing rate of

return to compensate for realizing capital gains taxes

	
	
		 	

		

9For example, after a 1-year period with 3-percent inflation and a

4-percent nominal capital gain, a 25-percent capital gains tax yields

a 100-percent effective tax on the real return.
today if a locked-in asset were sold (Minarik). The premium required on the new asset to make the switch

increases the longer that an existing asset has been

owned, the shorter the funds are expected to be reinvested, the higher the income tax rate or the asset’s

growth rate, and the more likely the existing asset is to

become part of an estate. Under current law, and

assuming the owner’s life expectancy is about 10 years,

the proceeds of average U.S. farmland owned for 25

years would need to earn a 2-percent bonus return to

compensate for realizing capital gains taxes if it were

sold and reinvested (fig. 9). If the reinvested asset was

not expected to become part of an estate, the extra

return needed is smaller and the difference is less

noticeable as the future holding period exceeds 15-20

years. For many investors, such additional returns may

be difficult to achieve in the same asset risk class,

although specific parcels of land or corporate stocks

may offer opportunities. Consequently, many long-term

landowners will continue to hold land rather than sell,

even with current preferential capital gains treatment.

Management Practices

Total returns can be characterized as coming from two

sources – the agricultural product and the tax system

(Davenport, Boehlje, and Martin, p. 28). Maximizing

these returns requires different management skills and

sometimes introduces conflicting factors into the decision making process. The return from the agricultural

product depends on prices, yields, weather, technology,

interest rates, and the husbandry of the farming entrepreneur. The return from the tax system depends on

careful tax planning and the tax rate of the farmer.

Farmers who are not able to increase their total return

by managing their taxes must survive on the return

from farm products alone, and they can find themselves

at a competitive disadvantage to farmers who are able

to earn high returns from both sources.

 	

			
	
		

0%

1%

2%

3%

4%

5%

Figure 9

Hold until death; capital gain not taxed

Expect to sell before death

Expected years until sale or death

The extra return needed to offset the lock-in effect is greater if the asset can be passed through an

estate, but declines the longer the new asset will be owned

Extra return to offset lock-in

 Note: Figure assumes a 20-percent capital gains tax rate and that the existing asset has been owned 25 years, yielding an annual 6-percent 

capital gain and 10.5-percent total return (generally representative of average U.S. farmland).

 Source: Simulation by the authors.

0 5 10 15 20 25
Due to numerous tax incentives, farm management

practices that maximize before-tax returns may not

maximize after-tax returns. The optimal management

practice to maximize after-tax returns may differ from

standard management practices that are not biased by

tax preferences. Economic efficiency suffers when optimal plant and animal husbandry practices are altered to

maximize after-tax returns.

In the early 1880’s, an often-cited example of the influence of tax incentives on farm management practices

was the farrow-to-finish hog industry. Under normal

production practices, a breeding sow would be used for

several farrowing cycles before being culled because,

after the first litter, sows usually produce larger litters

and provide better care for their offspring. In such an

operation, perhaps about 20-25 percent of gilts (young

females) would be kept for breeding as older sows are

culled, while the balance would be sold as soon as they

were ready for market. Sales of breeding sows would

be a fairly small percentage of total sales. However,

because tax law allows breeding sows held longer than

1 year to be eligible for long-term capital gains treatment, a strong incentive existed to increase the proportion of sales eligible for preferential tax treatment by

breeding all gilts at least once. While hogs raised to

market weight are younger than 1 year, a one-litter sow

is usually just over 1 year old and thus eligible for capital gains treatment. The practice of breeding gilts for

only one litter, despite their inferior farrowing and

mothering qualities, was adopted for the sole purpose

of reporting more sales as capital gains rather than as

ordinary income. An optimal husbandry practice is

weakened by economic incentives from tax law.

In addition to the lower income tax rates available for

sales of breeding livestock, another incentive exists to

increase the proportion of animals that are used in the

trade or business rather than being held for sale. Sales

of animals used in the trade or business (for example,

breeding livestock) are not included with regular farm

business earnings and are therefore not subject to the

self-employment tax. Thus, as self-employment tax

rates have increased over the past two decades, the

incentive has grown to retain livestock for breeding

purposes and to cull others sooner.

In the early 1980’s, favorable capital cost recovery policies (such as depreciation, expensing, and investment

tax credits) stimulated investment in single-purpose

agricultural buildings for dairy, poultry, and hogs and

encouraged faster replacement of depreciating equipment or the acquisition of larger equipment. For the

most part, these incentives were reduced by the Tax

Reform Act of 1986 which eliminated the investment

tax credit and lengthened depreciation periods for both

machinery and single-purpose structures. 

Reductions in marginal tax rates and a reduced differential between the tax rate on ordinary business income

and capital gains income has reduced the incentive to

adopt such practices. Incentives to invest in depreciable

property near the end of a tax year to qualify for a full

year’s tax benefit have also been reduced. Nonetheless,

capital expensing allowances may still encourage farmers to purchase or replace depreciable equipment based

not only on the need for productive infrastructure but

also for tax reasons.

Product Prices

Tax policies that encourage commodity production but

that do not change consumer demand tend to increase

supply and reduce prices in the long run. Since most

agricultural products have inelastic demand, the result

is lower total farm revenue for the affected commodity

than if the tax policy had not affected production and

prices. Consumers, however, may benefit from greater

supplies and lower prices.

General equilibrium models comparing the effects of

taxes across agriculture and other sectors of the economy reveal increased resource use in agriculture and

greater farm output. Eliminating tax differences would

raise the model’s household price for food by 2 percent

to 4 percent as farm output decreased, particularly

shifting away from livestock and feed grains into

oilseeds and other crops (Hertel and Tsigas, 1988).

Favorable tax treatment throughout the late 1970’s and

early 1980’s stimulated investment in the agricultural

sector and resulted in increased production of many

commodities – especially livestock and perennial crops

that benefited from rules concerning the cost of developing capital assets. The investment tax credit and

accelerated depreciation deductions encouraged farmers

to buy machinery and equipment and to build new farm

structures. Single-purpose agricultural structures used

in dairy, poultry, and hog operations were popular. The

additional investment expanded production capacity,

brought more acreage into production, and enhanced

productivity – all increasing production and putting

downward pressure on prices.

The Tax Reform Act of 1986 reduced these incentives

to expand production. Repeal of the investment tax

	
	
		 	

		
credit and a return to slower depreciation schedules for

farm machinery reduced the pace of investment. Efforts

to eliminate deductions for expenses to drain or fill

wetlands and to reduce incentives for center-pivot irrigation systems have slowed the conversion of marginal

land into cropland.

However, the ability to immediately expense a limited

amount of depreciable business property, rather than

depreciate it over a specified number of years, still provides some tax benefits that promote investment and

increase output, although at a much reduced rate. The

return to preferential capital gains tax rates in the Taxpayer Relief Act of 1997 has increased incentives to

invest in capital assets such as breeding and dairy livestock and farmland and may tend to support higher production levels that could continue to put downward

pressure on prices.

Farm Structure

Federal tax policy can have important implications for

various structural aspects of farming. These include the

number and size of farms, the value and incentive to

buy and sell assets, especially farmland, and the legal

form in which the business is operated. 

The Number and Size of Farms

Throughout the late 1970’s and early 1980’s, the number of very small noncommercial farms (1-49 acres)

and the number of large commercial farms (500 acres

or more) increased while the number of farms in the

50- to 499-acre size class decreased. Information from

the 1987 Census of Agriculture regarding farm size distribution suggested a continuation of this trend.

Between 1982 and 1987, the total number of farms

declined with much of the decline concentrated in the

middle of the farm size distribution. This trend has continued in the 1990’s. From 1992 to 1997 the number of

farms with between 50 and 499 acres declined by over

15,000 farms, while the number of farms smaller than

50 acres increased by over 10,500 farms. As a result,

both small noncommercial farms and very large commercial farms continue to increase as a proportion of

all farms. Factors cited for this change in the number of

large farms include technology and the desire to

achieve income levels and standards of living equal to

those of individuals in the nonfarm sector. Personal

preferences for a rural or farm lifestyle, while relying

on off-farm income to support the household, contribute to the growth in the number of small farms. Tax

policies also have supported this change in farm size

distribution. 

Federal tax policies applicable to farming tend to reinforce those factors contributing to an increase in the

number of very small and large farms. These tax provisions provide the greatest benefits to those farmers with

relatively high levels of farm or off-farm income. Generally, very small farms do not generate enough farm

income to support a farmer and the family. These farmers frequently rely on off-farm sources of income for

their support. Thus, part-time or noncommercial farms

have other income that can be offset by farm losses for

tax purposes. Similarly, large farm operations often

generate sufficient levels of farm income to fully benefit from the various farm tax preferences. Many farmers

devoting full-time to the farming operation, however,

do not generate enough taxable income – either farm or

nonfarm – to fully utilize the available tax benefits.

Incentive to Incorporate 

A corporation is a separate taxable entity for Federal

income tax purposes. While many of the rules regarding the computation of net farm income are the same

for corporations and individuals, various aspects of the

corporate form of business have encouraged the incorporation of farm businesses. Those aspects of the corporate income tax which have encouraged family farms

to incorporate include lower and less progressive tax

rates for retained earnings, the availability of business

deductions for various fringe benefits not generally

available to sole proprietorships or farm partnerships,

and the ease of transferring the farm business and other

estate planning reasons.

Between 1974 and 1997, the number of corporate farms

increased from 28,442 to 84,002. This growth was

almost entirely attributable to an increase in the number

of family and other closely held farming corporations.

In fact, only about 2 percent of all farm corporations

were other than family held with 10 or more shareholders. Thus, this increase reflects a shift in the form in

which family farms conducted business rather than an

increase in the presence of widely held corporations in

farming. A substantial portion of the growth in family

farm corporations can be attributed to Federal tax policies.

In 1975 and again in 1978, tax rates for corporations

were reduced. As a result, corporate rates were lower

and less progressive than individual rates. This provided substantial incentive to incorporate the farm business.

Another feature associated with the corporate form of

organization is the ease with which annual gifts of farm

 	

			
	
		
property can be made since ownership is represented

by certificates of stock. Estate and gift tax laws permit

an individual to transfer $10,000 each to an unlimited

number of individuals free of tax each year. This allows

a married couple to make gifts of $20,000 per recipient

per year free of tax. However, the transfer of the actual

farm assets can cause problems due to the difficulty in

partitioning the farm business. By incorporating, the

transfer of the farm business can be accomplished by

transferring shares of stock in the corporation. This

avoids partitioning farm assets and allows the farmer to

transfer a substantial amount of farm property to the

next generation without losing control of the farm operation while still reserving the entire tax-exempt amount

that will be allowed by the unified credit at death.

Finally, the corporate form of business organization

permits a number of fringe benefits to be provided to

the shareholder-employee at a lower after-tax cost. The

cost of many fringe benefits, including health insurance, meals, and lodging on business premises and pension and profit sharing plans, are fully deductible to the

corporation and often not included in the taxable

income of the shareholder-employee. 

Beginning in 1986, the incentive to incorporate was

reduced somewhat by expanding the fringe benefits

available to noncorporate businesses, by limiting those

available to corporations, by reducing marginal income

tax rates for individuals, and by strengthening the double taxation of corporate assets at the time such assets

are distributed from the corporation. Despite these

changes, tax savings can continue to be realized since

income retained in the corporation is not subject to

social security (self-employment) taxes. Nevertheless,

these changes may have prompted some corporations to

shift from a regular C corporation to a subchapter S

corporation in which income is passed through to the

shareholders and no corporate-level tax applies.

The organizational structure under which the farm business is conducted would seem to be of little significance; especially if most corporations, partnerships, or

other forms of organization are closely held family

operations. However, the shift to the corporate form of

organization during the 1970’s may have allowed these

farms to expand more rapidly as a result of the reduced

taxes on earnings retained in the corporation. It also

may have facilitated the transfer of the farm business to

the next generation resulting in the continuation of the

farm business.

Land Use and Conservation

Despite tax provisions designed to encourage investments in conservation, Federal tax policies throughout

the 1970’s and early 1980’s had a negative effect on

resource conservation. Several features of the tax code

promoted farming practices that exploited both soil and

water resources. These features included capital gains

treatment for land used in farming, the investment tax

credit and accelerated depreciation, and provisions governing the deductibility of land clearing and soil and

water conservation expenditures. 

Throughout the 1970’s and early 1980’s, the immediate

deductibility of land clearing and development expenditures, combined with favorable capital gains treatment,

provided a major incentive to expand farming operations onto highly erodible rangelands and wetlands.

Speculative investors received substantial tax benefits

from the purchase of fragile rangeland, timberland, or

wetland and its conversion to cropland. The costs of

conversion and preparation were immediately

deductible against ordinary income. Upon sale, these

sodbusters and swampbusters were able to exclude 60

percent of the large increase in the land’s market value.

In the case of wetlands, research evaluating a largescale conversion in the Pocosin region of North Carolina suggested that such a conversion produced tax

savings worth as much as $600 per acre (Heimlich).

This represented an estimated one-third of the conversion expenses. In the case of rangeland, the capital

gains exemption was cited as the primary stimulus for

conversion of Montana rangeland to dryland wheat production. Tax benefits were also cited as a major factor

in the conversion of large areas of fragile sandy rangeland in the Nebraska Sandhills to irrigated cropland.

Capital gains in combination with other available tax

benefits were found to have subsidized the conversion

of this rangeland to irrigated cropland by as much as

$180 per acre (Laylock).

Even the deduction for soil and water conservation

expenses has had a questionable impact on soil and

water conservation efforts. Farmers claimed nearly

$103 million in conservation deductions for the 1982

tax year. Despite the obvious positive effect of most of

the expenditures eligible for this deduction, many conservation expenses that qualified were of questionable

value with regard to erosion control and water conserving measures. The conservation provision allowed

deductions for wetland drainage, the leveling of land to

facilitate irrigation installation, and other destructive

	
	
		 	

		
practices on highly erodible land and wetland. Furthermore, the provision contained no explicit targeting

mechanism. Utilization of the deduction was related

more to income and farm size rather than the actual

need for the conservation expenditures. As a result,

researchers examining the effect of the proposed repeal

of the soil and water conservation deduction suggested

that its repeal might not have a significant adverse

impact on soil erosion control practices on U.S. farmland (Anderson and Bills).

Several features of the Tax Reform Act of 1986 had a

favorable impact on natural resource conservation.

Many of the provisions that encouraged the conversion

of rangeland and wetlands to cropland were eliminated

or reduced. The remaining provisions were more effectively targeted. 

Specifically, the repeal of the deduction for land-clearing expenses and the capital gains exclusion eliminated

a major incentive to convert marginal land to cropland.

In addition, the characterization of gains from the sale

of highly erodible land and wetland converted to cropland as ordinary income rather than capital gain has

been an important deterrent to sodbusting and swampbusting since preferential capital gains taxation was

restored. The repeal of the investment tax credit and the

lengthening of recovery periods for irrigation equipment also greatly reduced the subsidy for the capital

equipment necessary for the irrigation of fragile rangeland. 

In addition to modifying those provisions which had a

negative impact on soil conservation efforts, the 1986

Act also improved the effectiveness of the deduction

for soil and water conservation expenditures through

improved targeting. The deduction can no longer be

used to deduct expenses associated with the draining

and filling of wetlands or for preparing land for centerpivot irrigation systems. Furthermore, only expenditures for practices taken in connection with plans

approved by USDA’s NRCS or a comparable State

agency can be deducted under the soil and water conservation provision. Finally, more recently, the increase

of tax incentives for the donation of a conservation

easement should further efforts to slow the conversion

of farmland to commercial or residential development

uses.

 	

			
	
		
Proposals for Reform

The National Commission on Small Farms recommended a review of two tax reform proposals in A Time

to Act to help “retiring farmers to assist new farmers in

getting started” in farming (p. 95, Recommendation

5.7). The first proposal addresses the tax treatment of

an installment sale, while the second involves the taxation of rental income from a beginning farmer. A third

proposal being considered by Congress is designed to

aid farmers in managing risk through farm savings

accounts. 

Installment Sales Reform

Installment sales of farmland and other farm property

can provide benefits to both the buyer and the seller.

Buyers have an alternative source of financing other

than a bank or other traditional lender while the seller

can realize more from the sale due to reduced tax liability. Under the current installment sale rules, taxable

gain on the sale is generally recognized on a pro rata

basis as the payments are received. However, there is

an exception for depreciation recapture. Depreciation

recapture must be fully recognized in the year of the

sale even if it exceeds the amount of the payment actually received. This can cause problems for sales of an

ongoing farm business with significant amounts of farm

machinery and equipment or single-purpose or other

farm structures. In such instances, the seller will likely

require that the first-year payment be large enough to

cover the tax liability associated with the depreciation

recapture. Since depreciation recapture is taxed as ordinary income, this could be quite large and may make it

difficult for a beginning farmer to purchase a farm business that has farm machinery, livestock, or farm buildings in addition to farmland on an installment basis. In

some instances, the recapture amount may be so large

that there may be little incentive to sell the farm on an

installment basis and instead require that the purchaser

find another source of funding for the purchase. Again,

this can place the beginning farmer, who may have

more difficulty in securing financing, at a disadvantage. 

Allowing depreciation recapture to be recognized in the

same manner as other gain in the case of an installment

sale to a beginning farmer would increase the incentive

for the owner to sell farm land and other farm business

assets on an installment basis and should reduce the

amount of money required as an initial payment. Thus,

beginning farmers should be able to negotiate more

favorable payment terms than under existing installment sales rules. However, the reduction in the downpayment amount is likely to be less than the first-year

tax savings. Although the additional downpayment

amount goes to the Internal Revenue Service (IRS) and

not the seller, reducing the amount of the downpayment

increases the risk assumed by the seller should the

beginning farmer default and the seller be forced to

repossess and resell the property. Because sellers are

likely to view an installment sale to a beginning farmer

as riskier than a sale to an established farmer, there

may be resistance to lowering the downpayment

amount. Thus, the reduction in the downpayment

amount is likely to be less than the tax savings in the

year of sale.

One of the reasons for making an installment sale is to

spread the gain over several years and avoid the higher

tax rates that can be applicable in the case of a sale for

a lump-sum payment. The reintroduction of income

averaging for farmers may reduce the need to spread

payments over a period of years because farm income

can be spread over the 3 prior years. While averaging

does not apply to land, gain from the sale of other farm

business assets or other farm income is eligible for

income averaging and could reduce the benefits from

an installment sale.

Recent estate tax changes may also affect the willingness of retiring farmers to sell farm property under a

land contract to a beginning farmer. The new familyowned business deduction currently allows as much as

$675,000 in business assets to be transferred free of tax

in addition to the amount exempted by the unified

credit. Because the new provision requires that the

trade or business be more than 50 percent of the estate

to qualify, older farmers are encouraged to remain fully

invested in land and other business assets. Land sales

on contract are discouraged since a land contract is not

likely to be considered a business asset. Thus, modifying the installment sales rules may remove one obstacle

to sales to beginning farmers. However, given the other

obstacles, the change may not substantially increase the

number of retiring farmers willing to sell land to a

beginning farmer through a land contract. 

Tax-Free Rental Income

Beginning farmers are frequently at a disadvantage in

bidding for land available to rent. They may be in

direct competition with established farmers who not

only may be in a financial position to outbid them but

also may be perceived as more creditworthy and reliable. 

	
	
		 	

		
One of the proposals designed to make rental land

available to beginning farmers is to exempt the first

$10,000 of income to a landlord who leases farmland

or other property to a beginning farmer. Farm landlords, many of whom are retired, would clearly benefit

from tax-free rental income, with the level of benefit

depending upon the landlord’s tax rate. 

Exempting rental income from beginning farmers

should provide beginning farmers greater access to

farmland through rental arrangements. However, there

may be little financial assistance provided to beginning

farmers. Research has shown that similar subsidies

accrue to the asset owner rather than the operator

(Schertz and Johnston, 1998a,b). Thus, while the same

before-tax rent from a beginning farmer would provide

a higher after-tax return to the landlord, there may be

little pressure to reduce the rent amount charged to the

beginning farmer. Thus, the landlord could capture

much of the financial benefit associated with the tax

incentive. The amount of benefit, if any, captured by

the beginning farmer would depend upon the local

farmland rental market. Thus, the primary benefit to

the beginning farmer would likely be the increased

availability of farmland for rent due to the tax savings

available to the landlord.

Nebraska enacted a similar policy in 1999 that provides

a State income tax credit to landlords who rent property

to beginning farmers (Fredrick). To qualify, a beginning

farmer must have net worth under $100,000 and provide most of the physical labor and management in the

farm. The tax credit that the landlord receives is 5 percent of the gross rental income. While it is too early to

evaluate the success of the Nebraska program, future

analysis could indicate whether beginning farmers

receive part of the benefit in the form of lower rents or

whether the landlord captures most of the benefit. 

Farm and Ranch Risk Management

(FARRM) Accounts

A program of tax-deferred savings accounts for farmers

is among the alternatives under consideration by Congress to help farm operators manage their year-to-year

income variability. Unlike the income-averaging provision included in the Taxpayer Relief Act of 1997 allowing farmers to spread above-average income to prior

tax years and avoid a higher tax bracket, tax-deferred

savings accounts would build a cash reserve that is

available for future use. By depositing income into

Farm and Ranch Risk Management (FARRM) accounts

during years of high net income, farmers could build a

fund to draw on during years with low income. Farmers

who are able to build new savings through these

accounts could be better able to smooth their household

consumption over time and self-insure some of their

income risk. 

Proposals for tax-deferred farm risk management

accounts originally surfaced after passage of the 1996

Farm Act, as a mechanism to encourage farmers to save

a portion of the 7-year transition payments. In 1998, as

Congress sought to expand the farm safety net and ease

stress from low commodity prices and regional disasters, it considered FARRM accounts but did not enact

them. In 1999 and 2000, FARRM accounts were again

included as one part of several proposed tax reduction

packages that were not enacted.

As proposed, farmers could take a Federal income tax

deduction for a FARRM deposit of no more than 20

percent of eligible farm income. Eligible farm income

is defined as taxable net farm income from schedule F

of IRS form 1040, plus net capital gains from the sale

of farm assets including livestock but not land.

Deposits would be made into interest-bearing accounts

and earnings would be distributed and taxable annually.

Withdrawals from principal would be at the farmer’s

discretion and taxable in the year withdrawn. Deposits

could stay in the account for up to 5 years, with new

amounts added on a first-in, first-out basis. Deposits

not withdrawn after 5 years would incur a 10-percent

penalty. FARRM funds would also have to be withdrawn if the participant stops farming. Deposits and

withdrawals would not affect self-employment taxes.

FARRM account eligibility would be limited to individual taxpayers – sole proprietors, partners in farm partnerships, and shareholders in subchapter S corporations –

who report positive eligible farm income. The program

could be relatively easy to administer by using existing

tax forms and reporting requirements similar to IRA’s.

Based on 1994 IRS data, an estimated 916,000 farmers

would be eligible to contribute as much as $2.8 billion

to FARRM accounts each year. Farm sole proprietors

account for over two-thirds of eligible participants and

three-fourths of potential contributions. Partners in

farm partnerships make up about one-fourth of eligible

participants and one-sixth of potential contributions.

Although farm sole proprietors make up the largest

share of potentially eligible individuals, over two-thirds

of all farm sole proprietors either report a farm loss or

have no Federal income tax liability and therefore

 	

			
	
		
could neither participate nor benefit from participation.

About half of the remaining sole proprietors who are

eligible would be limited to contributing less than

$1,000 in any given year. Thus, each year only about

one of every six sole proprietors could contribute more

than $1,000. Actual participation rates and amounts

could be significantly less than the number and amount

eligible.

While an estimated 27 percent of all sole proprietors

would be eligible for FARRM deposits in any given

year and the average potential contribution for those

who are eligible would be $3,500, there would be considerable variation among the farm types. Large family

farms with sales over $250,000 are the most likely to

be eligible, at 69 percent. Their average potential contribution is $10,800, more than twice that of the next

closest group. For these large farms, and even many

primary-occupation small farms, FARRM accounts

could offer the ability to build a sizeable and useful

self-insurance safety net over several years.

At the other extreme, however, limited-resource farms

are the least likely to be eligible. Because of low

income, most of these farms do not owe income tax

and would have no incentive to participate. For the 10

percent who are eligible, their average potential deposit

is only $760. With such small amounts, FARRM

accounts would be of little value to limited-resource

farms.

FARRM accounts will also be of relatively little benefit

to other groups of small farms, such as retirement and

lifestyle farms. Although lifestyle farms make up the

largest group by the number of farms, only 20 percent

would be eligible because most lifestyle farms report

taxable farm losses. On the other hand, many lifestyle

farms may not need an additional risk management tool

because their primary occupation and source of income

is away from the farm.

The amount of money that would actually be deposited

into FARRM accounts and a minimum balance that

would be necessary to provide sufficient risk protection

– for either farm operations or household living

expenses – are difficult to estimate. But with over 80

percent of all farmers limited to contributions of less

than $1,000 in any given year, and with participation

rates certain to be less than 100 percent, most farmers

are not likely to accumulate significant reserves. Some

producers with low contribution limits may be able to

deposit larger amounts in years when farm income is

higher. But the 5-year window for building reserves

and the generally low level of taxable net farm income

combine to reduce the likelihood that most farmers

would be able to build balances adequate to self-insure

risk exposure.

Without targeting (specifying other income criteria for

those who are eligible to participate) most of the benefits would go to relatively few farmers, and some

would go to individuals who do not rely on farming for

their livelihood (Monke and Durst, 1999). To meet

goals of program efficiency (benefits offsetting costs)

and risk management, FARRM accounts must create

new savings rather than shift assets or replace existing

risk management practices (Monke). The primary benefits would be farmers’ increased financial stability and

the potential need for lower emergency aid payments. 

To enhance farmers’ risk management capabilities, new

savings must come from reduced household consumption or from funds that would have been invested in the

business, rather than from shifting existing savings,

diverting future new savings, or borrowing. Available

data indicate that most potentially eligible farmers have

ample resources to shift funds into FARRM accounts

instead of creating new savings. 

In summary, tax-deferred risk management accounts

have the potential to encourage farmers to provide their

own safety net by saving money from high-income

years to withdraw during low-income years. Taxpayers

could benefit if farmers’ additional financial diversification and liquidity reduce the need for income support

programs or ad hoc disaster relief. Nonetheless, there

are several potential limitations to the program’s effectiveness. These include (1) low levels of taxable farm

income that preclude most farmers from building

meaningful balances, particularly those most in need of

risk management tools such as limited-resource and

beginning farmers; (2) concentration of benefits among

operators with large farms and relatively high nonfarm

income; and (3) funding of FARRM accounts with

existing liquid assets instead of new savings. Given

these limitations and differences within and across farm

types, FARRM accounts may improve short-term cashflow for those who participate but are not likely to significantly reduce the demand for emergency relief from

the Federal government.

	
	
		 	

		
Conclusions

The Federal tax structure that existed at the beginning

of the 1980’s is very different from the current Federal

tax policies. Then, the Federal income tax system contained numerous exclusions, deductions, and credits

with relatively high marginal income tax rates. Social

security and self-employment taxes were still relatively

low. Federal estate and gift taxes on the other hand

were of major concern due to the sharp increase in the

value of farm estates and the limited number of exclusions and credits available to shield farm estates from

taxes. 

Research evaluating the impact of these policies on the

agricultural sector reached a number of conclusions.

The most significant conclusions included the following:

• Individuals with substantial farm income had significantly lower Federal income tax burdens compared

with all other taxpayers.

• Federal income, estate, and gift tax policies exerted

upward pressure on farmland values.

• Federal income, estate, and gift tax policies helped

concentrate farmland ownership with high-income

farmers and nonfarmers, reducing opportunities for

beginning farmers.

• Federal income tax policies stimulated capital investment and encouraged the substitution of capital for

labor.

• Federal income tax policies encouraged farmers to

alter management practices to maximize after-tax

returns.

• Federal income tax policies contributed to increased

supplies and lower prices for some farm commodities,

especially livestock and orchards and vineyards.

• Federal income, estate, and gift tax policies supported

growth trends in the number of very small and very

large farms.

• Federal income tax policies encouraged the conversion of highly erodible and wetlands into cropland. 

Tax legislation enacted during the decades of the

1980’s and 1990’s have resulted in a significant shift in

Federal tax policies. Despite increases in marginal

income tax rates and targeted tax relief in recent years,

the Federal income tax system contains a broader base

and lower marginal income tax rates with fewer opportunities to shelter income through exclusions, deductions, and credits compared with the system that existed

two decades ago. Federal estate and gift taxes are of

continuing concern, despite large increases in the

amount of property that can be transferred free of tax.

Social security and self-employment taxes impose a

much greater burden and play a greater role in investment and management decisions due to sharp increases

in tax rates and the amount of income subject to such

taxes.

Although the implications of this new structure are less

clear and research regarding the impact of these policies is somewhat limited, a number of implications of

such policies for the agricultural sector have been

established:

• The Federal income tax system has become more progressive as a result of an expanded earned income tax

credit, increased marginal tax rates, and other

changes, while overall progressivity continues to be

reduced by Federal payroll taxes, primarily social

security and self-employment taxes.

• Federal income and payroll tax policies continue to

favor capital investment over labor especially for

those able to currently expense a large portion of their

capital investment, but the availability of investments

with negative effective tax rates is limited. 

• Federal tax policies affecting land use, conservation,

and preservation are environmentally friendlier due to

reduced tax benefits for certain harmful practices and

targeted incentives in support of farmland conservation and preservation efforts.

• Federal income, estate, and gift tax policies that provide favorable treatment to farmland relative to other

assets continue to reduce the supply and increase the

demand for farmland, exerting upward pressure on

values.

• Federal tax policies continue to result in increased

resource use in agriculture contributing to greater

farm output and lower prices. 

• Federal income, estate, and gift tax policies continue

to support trends in an increase in the number of very

small and very large farms.

 	

			
	
		
• Proposals to increase opportunities for beginning

farmers should increase the availability of land but

are not expected to have a significant effect on affordability. 

• Proposals to create FARRM accounts may allow

many primary occupation small farms and large farms

to build a sizeable and useful self-insurance safety net

over several years but are unlikely to provide a meaningful safety net for most farmers because they would

not be eligible to contribute or could contribute only

small amounts to such accounts.

	
	
		 	

		
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