The CSP program is a voluntary program that provides financial and technical assistance to promote soil and water conservation. Selected watersheds are protected by paying qualified producers stewardship payments for achieving specified levels of compliance within the standards for soil and water conservation. CSP also may provide cost share payments to producers and landowners for various practices.
County Farm Service Agency offices had distributed copies of the USDA notice to recipients of CSP payments indicating that some of the CSP payments may be excluded from income, under Internal Revenue Code (IRC) Section 126. Some farmers have misinterpreted the notice, thinking that all CSP payments are excluded from income. Unfortunately, this is not the case. The following article will explain the rules for taxation of CSP payments.
Stewardship payments are made to qualifying farmers at Tier I, II and III levels. Larger payments are received for meeting higher Tier levels of compliance with resource management systems. These payments are ordinary income (lines 6a and 6b of Schedule F) and are subject to self-employment earnings. Likewise, any incentive payments are also considered ordinary income. For share-rent landowners, filing Form 4835, lines 3a and 3b are used to report CSP payments, and are subject to ordinary income taxes, but would not be subject to self-employment (SE) tax. However, IRS may argue that share-rent landlords may also be required to use Schedule F to report the CSP stewardship payments so that SE tax may be collected. For example, IRS Notice 2006-108, recently released, addresses the application of the Self-Employment Contributions Act to Conservation Reserve Program (CRP) payments. In this, CRP payments, no matter the situation, are subject to SE tax.
IRC Section 126 excludes cost-share payments from income only if they are for a capital expenditure and meet other requirements. Clearly, stewardship payments are not for capital expenditures thus are not eligible for exclusion under IRC Section 126.
If cost sharing payments are for non-depreciable soil and water conservation improvements, these may be deducted under IRC Section 175. This section allows for deduction of such improvements as for the treatment or movement of earth, construction of drainage ditches or earthen dams, eradication of brush or the planting of windbreaks. The deduction is limited to 25% of gross farm income (line 14 of schedule F), with the excess carried forward to future tax years. Expenses for improvements that can be depreciated cannot be claimed under IRC Section 175. A cash-rent landlord can not use this deduction.
Under IRC Section 126, cost-share payments for depreciable improvements made to farmers and landowners may be eligible for exclusion from income. This exclusion may be useful if the allowable depreciation for the capital improvement is less than the cost-share payment received, such as for a manure storage structure. For the IRC Section 126 exclusion, three conditions must be met: 1) The payment must be for a capital expenditure, 2) The capital expenditure must not substantially increase the annual income for the affected property, and 3) The payment must have been certified by the Secretary of Agriculture for the conservation purpose.
Under Section 126, a mathematical calculation must be made to determine the taxable portion, if any. Begin by determining the value of the Section 126 improvement. In other words, what would a willing buyer pay a willing seller for the improvement. Treasury Regulation 16A126-1 gives an example of $21,000 as a fair market value for an improvement that cost $700,000. The next step is to determine the portion of the cost-share that is excludable from income. To do this, it is the greater present value analysis of either 10% of the average annual income from the affected property for the 3 years immediately prior to the improvement or $2.50 per affected acre. Subtract this figure and the taxpayers contributing cost of the improvement from the value of the improvement to determine the taxable portion. On the Agricultural Program Payments line of Schedule F, 6a is where the entire 1099G amount is to be reported. On line 6b, only the taxable amount is written. As one can see, it may be advisable to seek a qualified income tax practitioner to assist with wading through such calculations. The IRS web site is also a useful resource: www.irs.gov .