I’ve written previously about how electing capital gain treatment can result in tax savings of thousands of dollars for most Christmas tree growers. Many growers interested in electing capital gain treatment often ask me questions such as: “What does it take to convert to the capital gain method?” or “Do I have to wait a certain number of years before I can elect capital gain treatment?” or “Do I need to start keeping my books differently to elect capital gain treatment?” These are great questions that will be answered in this article.
Overview
Generally, the most effective strategy for a Christmas tree grower to reduce his taxes is to elect capital gain treatment under Internal Revenue Code (IRC) § 631 because his qualifying Christmas tree sales will be subject to a lower tax rate and no self-employment taxes.
No wait is necessary for a grower to begin electing capital gain treatment; he can make the change on his next tax return. However, a grower must make a few adjustments to his recordkeeping and operations to support the capital gain election:
1) Recordkeeping
As a reminder, Christmas trees must meet four requirements to qualify for capital gain treatment under IRC § 631: (1) evergreen trees, (2) more than 6 years old, (3) severed at the roots, and (4) sold for ornamental purposes.
If a grower elects capital gain treatment, he must be able to prove that the trees he sold meet the above four requirements. Numbers one and four are easy to meet because most growers sell only evergreen trees and Christmas trees are sold for ornamental purposes. However, a grower must also be able to prove that the trees sold were more than six years old and were cut, rather than sold with the roots.
Certain trees do not qualify for capital gain treatment, such as balled and burlapped trees, potted trees, pre-cut trees purchased from another farm, and non-evergreen trees. A grower’s recordkeeping system must track qualifying sales separately from qualifying sales.
This tracking typically begins with the grower’s point-of-sale (POS) system. Many growers use Square or another credit card processing tool. A grower’s POS should, at a minimum, have different “items” for qualifying and non-qualifying Christmas tree sales. However, even more detail, such as species and height of trees sold, is better because a grower can use this detail to improve Christmas tree operations, in addition to supporting the capital gain election.
The data from the POS must also be input correctly into a grower’s recordkeeping system. I recommend Wave Accounting, but a grower may use any system as long as it accurately captures and reports income and expenses. Qualifying and non-qualifying Christmas tree sales should be separated in the recordkeeping system to make tax reporting and preparation easier.
2) Tree Count
Christmas tree seedlings are generally not deductible the year they are planted. A grower must wait until the tree is sold or otherwise disposed of. The IRS requires a yearly tree count because a grower’s Christmas trees are “inventory” since the grower is in the business of retailing trees to customers.
A yearly inventory count is important to calculate a grower’s Cost of Goods Sold (COGS). COGS includes amounts spent for purchases, labor, and other miscellaneous costs that are allocable to that tax year for planted seedlings. A grower wants the maximum allowable COGS because it results in a larger deduction on the tax return (and lower tax bill).
The inventory of trees on a farm should be counted once per year. The best time would be right after the Christmas season, so the count is as close as possible to the beginning of the year and before taxes are filed. However, other times of the year are permissible as long as the timing is consistent from year to year. Although an inventory count is required for tax purposes, other additional benefits of an inventory count include knowing exactly how many trees are on the farm, as well as the trees’ height and condition.
3) Tax Return
A grower must also report income and expenses differently on his tax return in order to elect capital gain treatment.
First, a grower must report capital gain income separately from ordinary income. This separate reporting is typically accomplished by reporting “stumpage” costs on the grower’s profit and loss tax form (generally Schedule F or C).
For example, all of the grower’s income is reported on Schedule F, the income qualifying for capital gain treatment would be deducted as “stumpage” expense on Schedule F, and the amount of stumpage expense would be reported as the sales price on Form 4797 to calculate capital gain.
Second, a grower must also file Form T. Form T was created for timber owners; however, Christmas trees are considered timber under tax law if they meet the four requirements under IRC § 631 to receive capital gain treatment. If a grower wishes to elect capital gain treatment under IRC § 631(a), which applies to most choose-and-cut growers, he must also check the applicable box on Form T to elect capital gain treatment.
Conclusion
A grower may switch to the capital gain method on his next tax return. However, the capital gain method requires some adjustments, as explained above, to recordkeeping and preparing the tax return. The best methods for recordkeeping, taking a tree count, and preparing the tax return vary greatly based on each farm’s unique situation. A grower should consult with a knowledgeable Christmas tree CPA in order to implement the above steps correctly.
Need help converting to the capital gain method? Contact Andrew today!
