Means Testing is Good Politics, But Economic Sense? 1

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1 Disclaimer: This web page is designed to aid farmers with their marketing and risk management decisions. The risk of loss in trading futures, options, forward contracts, and hedge-to-arrive can be substantial and no warranty is given or implied by the author or any other party. Each farmer must consider whether such marketing strategies are appropriate for his or her situation. This web page does not represent the views of Kansas State University. Means Testing is Good Politics, But Economic Sense? 1 One would doubt that many in Congress really understand the administrative cost for a means test that will likely exceed any savings. The real definition of a big farm is anyone who farms an acre more than I farm. However, Congress continually tries to define a big farm based on payment limits and Adjusted Gross Income (AGI), because it makes good politics. Unlike commodity programs where subsidy checks are sent to farmers, crop insurance only provides a subsidy payment in cash if there is a claim. Otherwise, crop insurance is a production expense and farmers are the ones writing checks. If the proposed means test of a $750,000 ($750K) AGI limit is applied to crop insurance, it will require farmers over the limit to pay a 15 point increase in their share of the crop insurance premium. Most Washington observers expect any means testing for crop insurance will be determined by the Farm Service Agency (FSA) because FSA already has means testing for their programs. One would think the AGI limit would be a simple administrative process. But one only needs to read the 430 pages of FSA handbook on AGI limits, titled Payment Eligibility, Payment Limitation, and Average Adjusted Gross Income to figure out this is more complicated than expected. The good news is that the AGI is effectively net farm income, so the expenses are deducted. If this were gross income, a large number of farmers would be over the limit. Many crop insurance agents are likely to have a few 1 Prepared by G. A. (Art) Barnaby, Jr., Professor, Department of Agricultural Economics, K-State Research and Extension, Kansas State University, Manhattan, KS 66506, June 10, 2013, Phone , barnaby@ksu.edu.

2 farmers that cannot meet the $750K AGI limit and if they drop their coverage, that will impact agencies and their employees. Those big-farm-generated commissions help offset the cost of the paper work, marketing, underwriting, etc., for the small farms that have placed their insurance with the same private agent. It appears some policymakers are starting to understand that only a few farmers would be over the $750K limit, but they account for a very large share of the production. If these big farms drop out of the insurance pool, it would increase rates on the remaining farmers, if these large farmers are producing underwriting gains. The administration is making the opposite argument on the health insurance pool, where they want everyone in the insurance pool to make rates affordable. The Senate Bill would require the Congressional Budget Office (CBO) to conduct a study and report to the Secretary if the AGI limit will increase rates for small farmers or impact the delivery of crop insurance. Many observers expect the analysis will assume everyone is rated correctly and if the big farms are generating gains, it is only because they have not been hit with a weather disaster yet. It will affect an agent because if a large customer drops their coverage or changes to CAT, the income will decline more than the reduction in their expenses. By contrast, the loss of a small farmer will likely reduce cost more than it reduces commission income for an agent, so it will take some interesting assumptions for CBO to report the AGI has no impact crop insurance delivery. The first question: is the $750K AGI limit for crop insurance applied only to farm income or does it include non-farm income? For example, in the FSA Handbook, FSA provides the line number on the tax return that applies to the AGI limit (Table 1). If it is a 1040 return, the AGI would include non-farm income, but that would not be the case on an 1120 return for a farming corporation. As one digs through the FSA handbook on means testing for their programs, one finds it is even difficult to define farm income. If it is only farm income, then what is included in farm income? FSA includes sale of farm equipment, production inputs and services to farmers and ranchers as farm income. For example, if a farmer has a side business providing aerial spraying, that income would be counted as farm income under current FSA rules. Agriculture has had some very good years and as result, there may be some farmers over the $750K limit based on the prior 3 good income years, but suppose the USA enters a year(s) with low farm prices? Farmers will have to pay the higher farmer-paid premiums in their low income years, because they were over the limit in the prior high income years. For 2013, FSA uses years 2011, 2010, and 2009 to calculate the average AGI, because farmers may not have filed their 2012 returns at the start of the crop year. As a result, these farmers would have at least a two-year lag before the lower income average would remove the 15-point farmer-paid premium penalty for crop insurance under the Senate Bill. 2

3 Effective AGI Limit Varies by State. In non-community property states like Kansas, a married couple filing a joint return requires a CPA or lawyer to certify what each person s income would have been if they had filed a separate return, assuming the AGI line on their tax return is over $750K. So if they had filled separate returns and wife and husband don t show equal returns, then they will hit the limit with less than $1.5 million of AGI. For example, assume the adjusted gross is $1 million and separate returns shows the husband s AGI at $249K and wife s AGI at $751K, then they hit the limit at $1 million, rather than $1.5 million. However, in this example, if the wife s AGI exceeds the limit and the husband AGI is under $750K he would still be able to collect benefits base on his share of the farm income, but his wife could not collect benefits. Farmers with joint returns over the $750K limit must request FSA make the income split and provide the analysis from a CPA or lawyer. The Kansas FSA accepts the amounts provided by a CPA or Lawyer, if a joint return is split because the farmer is over $750K AGI without any additional analysis. In a community property state, FSA splints the return 50-50, so a couple filing jointly would effectively have a limit of $1.5 million. As result, the effective limit for means testing varies by state based on community property rules. Under a partnership, if one of the partners is over AGI limit in the FSA program, they will split each producer s share and those under the AGI limit will receive FSA benefits. But how would that work under crop insurance? The partnership pays a premium that would have to be split based on share and the number of partners over the limit. This means part of the partnership s premium would be paid at the current rate and part of the premium would require the partnership to pay a 15 point increase in the farmer s share of the premium. Tax experts are reporting that farmers can use 179 expense and other accelerated depreciation methods that would keep the AGI below $750K, and reduce the number of farmers that would be over the limit. For 2013, the 179 limit is $500,000 that has limit on capital purchases equal to $2 million. The 2013 bonus depreciation is equal to 50%. Section 179 deduction is available for most new and used capital equipment, and also includes certain software. Bonus depreciation can be taken on new equipment only (no used equipment, no software). When applying these provisions, Section 179 is generally taken first, followed by bonus depreciation, unless the business has no taxable profit in the given tax year. Farmers might also build grain storage, especially temporary storage and use tax depreciation methods to reduce their AGI. The storage would then allow farmers move sales across tax years to keep their AGI below the limit. One should be aware that the tax code is continuously changing and may increase or decrease the available tax tools to limit the reported AGI. However, as a general statement, farmers have been able to manage their AGI as a method to limit their income tax payments. 3

4 Likely USDA will need to audit farmers to make sure they are not over the AGI limit for crop insurance. If a farmer is audited, there will likely be a delay so the audit maybe for a prior year or perhaps several prior years. So If USDA determines after the fact that a farmer was over the $750K AGI limit and should have paid the additional 15 point of premium, will the Approved Insurance Provider (AIP) be responsible for recovering the under-paid premium from a prior year(s)? What if that year was also a claim year? Because she was over the AGI limit and did not pay the insurance premium penalty was she not eligible for crop insurance, and the claim check is now fraudulent. So is the farmer required to refund the entire claim paid or just pay the additional premium for the prior year(s) that should have been charged? Under FSA rules, if a farmer signs up for a 15-year Conservation Reserve Program (CRP) contract and is under the AGI limit at the start of the contract, then she will continue to be paid even if she is over the AGI limit in later years. Crop insurance is a continuous contract. If no one cancels the crop insurance contract, it rolls the policy over into a new contract. Therefore, since it too is a continuous contract, the question would be raised, if the farmer is under the AGI limit when he initiates the contract, will the crop insurance contract still roll over based on the same terms, even if he is over the AGI limit in later years? Unlike payment limits, the AGI is a hard limit with few if any ways to avoid the limit. The use of section 179 expense is one of those methods to limit AGI, but tax codes change. If the AGI limit were lowered to $250K, it would create a lot of administrative costs because it would catch a much larger number of farmers. USDA would need to hire more employees to handle the paper work if a $250K AGI limit were adopted as some in Congress have advocated. This analysis assumes the definition for AGI will be the same for crop insurance as it is for FSA. If for some reason the income limit were defined as gross income, then there would be a large number of farmers over a $750,000 gross income limit. 4

5 Table 1. FSA Tax Form Line Numbers for AGI Participation Limits. 5