Using this Guide
This guide serves as a roadmap to help farmers through the process of determining whether the federal payroll tax exemption for in-kind payments paid for agricultural labor may be the right choice for them and, if so, what to expect from the process. This guide is broken into two checklists. The first checklist will help farmers determine whether they are even eligible for the exemption by outlining five main factors the IRS evaluates. The second checklist outlines the required records and paperwork that farmers and their workers need to maintain and file with the IRS if they claim the exemption.
As a whole, this guide serves to help farmers determine whether claiming the exemption may be the best option for them. Upon reading this guide, farmers should take time to carefully weigh the high risks of an audit against the potential tax savings or other benefits of using the exemption. If the IRS conducts an audit and disagrees with the applicability of the exemption, the farmer would be required to pay back taxes and penalties.
Questions farmers should ask themselves include:
• How much in-kind wages are being paid out, or how much tax savings will actually result by claiming the exemption?
• What will be the costs in hiring a tax attorney or an accountant to help ensure compliance with the requirements?
• Is keeping up to speed on financial systems, paperwork and record keeping already a struggle?
Whether a farmer should claim the exemption depends on her specific circumstances—including how risk adverse she is.
Part 1 - Overview
Understanding the Issue: Must a farmer pay federal payroll taxes on in-kind wages?
We all know that payroll tax implications arise whenever a farmer pays wages to an employee. What about when a farmer pays workers in forms other than cash, such as meals, lodging, CSA shares, memberships or farm products? These non-cash wages are commonly known as “in-kind” or “commodity” wages. While such forms of compensation don’t come in the form of money or currency per se, and typically don’t run through the banking system, the IRS still wants its piece of the pie. As a general rule, all wages whether cash or in-kind are subject to federal payroll taxes, unless a specific exemption applies.
What’s included in federal payroll taxes?
Federal payroll taxes include social security and Medicare taxes (commonly called FICA taxes), and unemployment tax (commonly called FUTA taxes). The taxes are based on a designated percentage of payroll and the latest percentage is listed in IRS Publication 51. Anyone who has or has had an employee knows that this can add up fast—currently equating to nearly 8.5% of the wages paid. In addition, the employer must withhold income taxes from the employees’ wages. The tax tables in IRS Publication 15 (Employer’s Tax Guide) determine income withholding per paycheck, based on the individual’s payroll, exemptions and payment frequency.
Available Exemptions:
Small farm exemptions apply to farmers who have few employees and/or pay very little in total wages each year
Payroll tax exemptions are part of an array of tax advantages that exist specifically for farmers. Basically, farmers are not obligated to pay federal payroll taxes on wages paid, whether cash or in-kind, until certain thresholds kick in. A farm must begin withholding both FICA taxes (social security and Medicare) and income taxes only when either of the following happens:
(1) The farm pays an employee $150 or more in cash wages (count all wages paid on a time, piecework or other basis) during the year for farm work (the $150 test). The $150 test applies separately to each farm worker that the farm employs. If the farm employs a family of workers, each member is treated separately.
(2) The farm pays cash and non-cash wages of $2,500 or more during the year to all of its employees for farm work (the $2,500 test).
Note that if the $2,500 test for all employees is not met, the $150 test for an employee still applies. In other words, if the farm pays out less than $2,500 to all its employees, the farm still has to pay these FICA taxes and withhold income taxes for each employee that makes $150 or more. The reality is that most farms with employees will have to pay these FICA taxes to some, if not all, employees.
Note that if the $2,500 test for all employees is not met, the $150 test for an employee still applies. In other words, if the farm pays out less than $2,500 to all its employees, the farm still has to pay these FICA taxes and withhold income taxes for each employee that makes $150 or more. The reality is that most farms with employees will have to pay these FICA taxes to some, if not all, employees.
A different threshold applies for federal unemployment taxes, or FUTA taxes. The farmer must begin paying federal unemployment tax when either of the following happens:
(1) The farmer pays wages of $20,000 or more to workers during any calendar quarter of the previous two years, or,
(2) the farmer employed 10 or more workers for any part of a day (even if not at the same time during the day) during any 20 or more weeks last year or the previous year. In other words, if the farmer paid less than $20,000 to all workers in every calendar quarter (January–March, April–June, July–September, and October–December) in the past two years, and if she had less than 10 employees in every given period of 20 weeks (not necessarily in 20 consecutive weeks) over the past two years, she is exempt from paying unemployment taxes. Farmers will have to maintain an ongoing tally to determine whether this exemption applies and when their unemployment tax obligations may begin to kick in.
For farmers who fall within these thresholds, they can stop here! They’re exempt from paying federal payroll taxes regardless of whether the wage paid is cash or in-kind. If farmers choose to claim either or both of these exemptions, they must keep records including pay stubs and timesheets in case of an audit.
Farmers who exceed either or both of these thresholds will generally be subject to FICA and/or FUTA, unless they pay their workers in-kind wages and meet a set of factors.
What about family members?
Generally, the wages you pay to family members who are farm employees are subject to federal payroll taxes. However, certain exemptions may apply to wages paid to children, spouses, and parents. Be sure to consult with a tax attorney or an accountant for more details.
In-Kind wages exemption applies to farmers who pay in-kind wages for agricultural labor if certain factors are met
Some farmers have heard the “good news” that if they pay in-kind or commodity wages for agricultural labor they are exempt from having to pay federal payroll taxes. Is this true? The answer is, it depends. The IRS recognizes such an exemption for payroll taxes when non-cash wages are paid for agricultural labor. The purpose of this guide is to help farmers better understand this federal payroll tax exemption and to determine whether claiming the exemption is the best approach for them.
The “bad news” is that this federal payroll tax exemption can be challenging to comply with and greatly raises the likelihood of an audit. The exemption is full of nuanced rules and limitations, which have for the most part evolved as a result of farmers’ historical and excessive abuse of the exemption. Since the exemption was adopted in the 1970s, farmers have been coming up with schemes to seemingly comply with it as a way to avoid paying payroll taxes. For example, let’s say Farmer Joe reports to the IRS that he paid his worker Jane in livestock, and as such, he deserves an exemption on federal payroll taxes. The IRS investigates and discovers this scenario: Joe “paid” Jane for her work by transferring ownership to the livestock on paper (the livestock didn’t actually move to Jane’s farm). Immediately thereafter, Joe sells Jane’s stock together with his own, which Jane and Joe had planned to do all along. As a result, Jane essentially receives cash wages tax free. For all intents and purposes, this scenario is equivalent to paying Jane a cash wage and the IRS might demand its piece of the pie, plus a penalty!
The widespread nature of these scenarios led to an IRS crack down. They eventually commissioned a task force in the 1990s to develop recommended guidelines as to when, exactly, such scenarios are a tax avoidance scheme and when they are legitimately in accordance with the tax code. These guidelines have since been integrated into the IRS’ Farmers Audit Technique Guide (ATG) that IRS auditors use when assessing a farmer’s compliance with the exemption. Even still, a bright red flag is raised by IRS auditors whenever farmers take advantage of the exemption. It is a near certainty that farmers who rely on the exemption will face an IRS audit. Considering the time and expense necessary to comply with an audit, farmers must ask themselves, is it really worth it?
Yet another downfall for sustainable-minded, diversified farms is that the exemption and the compliance guidelines were developed for the commodity farm—hence the name “commodity wages.” It can be challenging to apply the exemption to unique and more discrete contexts outside the commodities market—such as workers getting paid through CSA shares as well as room and board.
For all of these reasons, farmers who choose to take advantage of the exemption should tread cautiously. They need to carefully consider whether claiming the exemption is the best approach for them in the long run. They must acknowledge that they are assuming some risks and uncertainties in facing an audit and potentially back taxes and penalties. If they do decide to rely on the exemption as a way to avoid payroll taxes, they must have robust recordkeeping systems in place that will make an audit as smooth as possible.
Farm Commons strongly recommends that any farmer choosing to take advantage of the exemption seek the help of an attorney or accountant along the way. The time with the attorney or accountant can be far more efficient and cost-effective if the farmer first becomes familiar with the issues and factors involved. Building farmers’ knowledge and awareness of these issues is the fundamental purpose of this guide.
Another Option for Lodging: Deduction from Gross Wages
Many farms may choose not to use the commodity wage exception because of the risk of an audit. However, there is another option to reduce the payroll tax burden on in-kind wages if those wages are in the form of lodging. If it’s practically necessary for the farm to provide lodging to employees, the value may be excluded from gross wages under 26 U.S.C. 119 for federal tax purposes. A lower gross income reduces the worker’s and the farm’s payroll tax burden. This is an exception from the rule because, generally speaking, the IRS requires that fringe benefits such as lodging be added to cash wages when calculating an individual’s gross income. That means that a farm providing lodging needs to contribute payroll taxes on the full value of wages and lodging given to the employee. However, keep in mind that lodging is not a deductible business expense. Farm Commons recommends that farmers who are interested in this option work with an accountant to weigh the options. As you can see, it gets complicated fast!
Part 2: Checklist: Determining whether the federal payroll tax exemption for in-kind wages for agricultural labor is applicable
The first step is to determine whether the exemption is even available for a farmer based on the specific circumstances of the in-kind payment arrangement. Farmers must consider the following five factors to determine whether they can claim the exemption or if they must pay payroll taxes on in-kind wages paid to their employees.
The in-kind products or services paid must be compensation for agricultural labor
Farmers can claim the exemption only if the in-kind payments are paid to workers who are engaged in “agricultural labor.” What is “agricultural labor”? The Internal Revenue Code provides a specific definition, which basically includes all services performed on a farm in connection with the farm operation. It extends to packaging, processing, storage, and delivery of agricultural commodities as long as more than half of those commodities are produced on the farm where the labor is performed. However, agricultural labor does not extend to commercial canning or freezing. It also does not extend to labor performed after delivery to a terminal market for distribution.
This definition can be better understood through examples. Let’s say Farmer Joe runs a CSA farm and hires four workers—Alex, Brenda, Carry, and Diane—who each agree to work on the farm in exchange for a CSA share. Farmer Joe’s CSA farm works in collaboration with two other local farms. The majority of the products that are packed into the CSA boxes are from the other two farms. Farmer Joe also sells some of his farm products at two local farmers’ markets.
• Alex’s role is limited to field work. She spends all of her time weeding, planting, and harvesting.
• Brenda spends her time in the packing shed where she sorts the products from all three farms and packs the CSA boxes.
• Carry helps out with some value-added products that are included in the CSA shares, including jams, salsas, and fermented veggies.
• Diane spends some time working out in the field. However, most of her time is spent managing the farmers’ market sales, including packing the truck and attending the two markets each week.
Based on these facts, Alex is the only worker performing agricultural labor as defined. Therefore, Farmer Joe may claim the federal payroll exemption for the the in-kind wages paid to Alex, but he may not do so for those paid to Brenda, Carry, and Diane. As for Brenda, the majority of the products she’s sorting and packing are from the the other two farms, so she falls outside of the definition. As for Carry, she’s engaged in activities involving commercial canning, which is explicitly excluded from the definition. As for Diane, her activities are spent off the farm, selling products post-delivery at the farmers’ market. As the definition is written, it includes delivery but no sales, including direct-to-consumer sales.
Let’s change the facts a bit. If Farmer Joe’s CSA was limited to his own farm products, then Brenda’s work in the packing shed would also be considered agricultural labor. That’s because sorting and packing are included in the definition so long as more than half of the products are produced on the farm where the labor is performed. Note too that if a worker performs some tasks that are not deemed agricultural labor, it will rule out the payroll tax exemption entirely. For example, if Alex worked one day at the farmers’ market or did some canning, she too would fall out of the definition of agricultural labor and Farmer Joe would not be able to claim the federal payroll exemption for the in-kind wages he pays her.
Bottom line: Farmers who want to take advantage of the payroll tax exemption for in-kind wages paid for agricultural labor need to be sure that they assign these workers only tasks that fall within the definition of agricultural labor. Packing and sorting the majority of other farms’ products, producing value-added products such as canned and frozen products, and selling at the farmers’ market are not considered agricultural labor as defined for purposes of this federal payroll exemption.
Special Note: The remaining four factors assume that whatever is paid in-kind is destined for the commodities market. Remember, this exemption was designed for the commodity farmer. This is generally not the case for most in-kind payment arrangements on small, diversified farms—such as worker share arrangements for CSA members. It certainly was not intended for interns working in exchange for room and board. Nevertheless, farmers who pay their workers in farm products, including CSA shares, will be judged according to these factors when determining payroll tax obligations.
If the in-kind wage is a farm product: the employee must take ownership and control over the products, including bearing the costs of ownership
While it’s okay for an employee to ultimately sell the products she receives as wages, it must be done separately from the farm business to ensure the in-kind payment is legitimate and not a scheme to avoid payroll taxes. The IRS requires that the product is in fact transferred to the employee and that the employee has a level of control over it. The IRS will consider all the facts and circumstances of the transfer to determine whether this factor is met. For example, is there proper documentation of the transfer? Employment contracts, assembly sheets, sales tickets, storage/warehouse receipts should all indicate that the products were officially transferred to the employee. If the farmer has a loan out or other security on certain products—for example, livestock—the farmer needs to be sure that the security has been released so that full title is transferred to the employee.
In addition, the IRS will look at whether the employee bears the costs of ownership of the products. For example, is the employee responsible for paying maintenance costs such as storage and handling after she receives the products, even if the products remain at the farmer’s facility?
Bottom line: Farmers must maintain records establishing the transfer of title of all products paid to an employee as in-kind wages. The employee must bear the risk of ownership once the transfer has occurred. For example, if the products are still stored at the farmer’s facility, the employee should pay storage and maintenance fees as applicable.
If the in-kind wage is a farm product: the employee must assume the risk of loss that comes with accepting the in-kind wage
Risk of loss means the potential that a crop will rot or lose value. This factor comes into play when employees receive a percentage of production or yield of farm products. The employee must assume the risk that yield will be below expectations or that quality may be deficient. If the employee is insulated from risk of gain or loss on the farm product, the IRS may find the product wasn’t actually transferred to the employee. The IRS will presume shared risk as long as the employer doesn’t guarantee replacement or minimum units of production. Keep in mind that this is what distinguishes being paid in cash as opposed to product or services. Cash does not (generally, over the short term) lose value. Agreeing to accept the risk of loss in one’s wages helps the IRS decide that the wage is not simply a tax avoidance scheme.
Bottom line: Farmers should see that the employee receiving in-kind payments understands and acknowledges a risk in the in-kind payment arrangement. In particular, CSA farmers might make clear in their worker share agreements that the risk of production is shared with all members, including worker shares. This may present a challenge for CSA farms that sell excess product at farmers’ markets or into wholesale markets after allocating a set volume to the CSA. The IRS may see this as a guaranteed minimum for the in-kind payment to the worker share. If the worker share bears some risk—for example, if there’s a complete crop failure—the farmer may be able to meet this factor so long as this shared risk is clearly incorporated.
If the in-kind wage is a farm product: the employee must hold on to the in-kind products paid for a period of time and not sell or convert them to cash right away
The IRS will assess whether the in-kind payment was intended to be equivalent to cash. Again, the IRS is looking for schemes by farmers to avoid payroll taxes. The following provides an example of such a scheme to better understand what not to do.
Let’s say Farmer Jill reports that she transferred two pigs to her worker as in-kind wages. In actuality, Farmer Jill had already sold these two pigs plus four more at the market. Farmer Jill and the employee together load all six pigs on the same trailer and take them down to the market. They divvy up the cash they receive from the buyer on the spot. In the eyes of the IRS, this is an immediate cash conversion. It appears that the farmer and the employee worked in concert so that the farmer could avoid payroll taxes even though the employee walks away with cash.
To avoid such schemes, the IRS requires that the employee hold the products for a period of time prior to selling them. The longer the employee holds the products the more likely this factor will be met. It’s recommended that the employee hold them for at least two weeks. In addition, the products can’t be subject to a deferred contract for a future sale. For example, neither the farmer nor the employee can enter a contract with a buyer to purchase the pigs in two weeks as a way to meet this factor.
Bottom line: The farmer must transfer ownership of the products to the employee before the products are sold. The employee should hold the products she receives for two weeks or more before selling them (if the employee intends to sell the product at all).
If the in-kind wage is a farm product: the employee must market the product herself upon resale, without the assistance of the farmer
If the employee decides to sell the products she receives, she must not work in concert with the farmer. The IRS will again see this as a scheme where the farmer and the employee have arranged to work together to convert the products to cash as a way to avoid payroll taxes. Ideally, the employee should conduct the marketing and negotiations on her own. However, this may not be possible in a small rural area, where there’s a single or just a handful of markets or buyers. If she seeks the help of the farmer, she should compensate the farmer for such marketing services as a separate transaction. The employee should not sell the product back to the farmer, as this will most certainly be treated as a sham.
Bottom line: If the employee decides to sell the products she receives as wages, the farmer and employee must not act together to arrange for the sale. If she seeks the help of the farmer, she should compensate the farmer for marketing services through a separate arrangement.
Part 3: Checklist: Records and paperwork that farmers and employees must maintain to comply with the exemption
If a farmer qualifies for the “commodity wage” payroll tax exemption (based on the Checklist in Part 2), the second step is to understand what needs to be done to comply with the federal payroll tax exemption for noncash agricultural wages—including paperwork and recordkeeping. The following outlines the procedures both farmers and workers must follow if they choose to take advantage of the exemption.
The farmer and employee must have a clear, written agreement in place establishing the employer-employee relationship
The exemption applies only if there is an employer-employee relationship. The IRS therefore requires documentation of this relationship. The best way to document this is through a formal employment contract. However, farmers must be aware that having a formal employment agreement in place brings legal risks and implications. Once an employment agreement is in place, farmers are obligated to act in good faith and in accordance with the terms of the contract. If a farmer breaches a term of the contract, he could face an expensive and drawn out lawsuit. If he does so in bad faith, for example he intentionally breaches a provision to harm the employee, the farmer faces additional claims. Also, an employment contract can inadvertently affect the farmer’s ability to release employees at will. Farmers should seek guidance when drafting employment contracts.
Another option to meet this factor would be for the farmer to prepare a job description and compensation plan for each employee who receives in-kind payments. The farmer should then have all employees sign an acknowledgement statement saying that: (1) they have read, understand, and agree to the job description and compensation plan and (2) they acknowledge this arrangement has no effect on their at-will employment status. While this approach does not create a formal employment agreement per se, it establishes the employer-employee relationship.
Nevertheless, farmers should realize that in certain circumstances courts could convert this signed statement into an employment agreement. If this happens, the farmer would be bound by the terms of the job description and compensation plan as if it was a formal employment contract. The safest route around this is to treat your employees well and honor the agreements you make, whether in a formal contract or not.
Either way, the employment agreement or compensation plan and acknowledgment statement should be in writing, signed by both the farmer employer and the employee. It should state the specifics of the products or services being offered as in-kind wages. It should also clearly describe the employee’s duties, which must fall within the definition of agricultural labor as outlined in Part 1. Finally, the written agreement or statement should clearly inform the employee that the in-kind payments excluded from FICA will also have the effect of lowering her total contribution to the social security program, which in turn, may limit eligibility for social security benefits. This will help show that the employee entered the arrangement willingly while knowing the implications on her end.
Bottom line: If farmers want to take advantage of the exemption, they need to have documentation in place establishing an employer-employee arrangement with all employees receiving in-kind payments. The best approach in the eyes of the IRS is to have a formal employment agreement in place. This agreement can specify that the arrangement is “at will”—meaning that the farmer could fire the employee at any time for any reason. Another option would be for farmers to prepare a job description and in-kind compensation plan for each employee and have all employees sign a statement acknowledging that they are at-will employees and that they have read and agree to the in-kind compensation plan.
The farmer must have records showing the actual transfer of the in-kind products and services to the employee
If the IRS conducts an audit, the farmer will need to provide documents that the farm products or services offered as wages were in fact transferred to the employee or performed for the employee’s benefit. As for the transfer of farm products, the IRS will look to sales records, weight tickets, veterinary inspection certifications, receipts for storage and feed costs, breeding certificates, and formal registrations of title as applicable. As for the transfer of services, such as lodging and meals, the IRS will look to documentation like lease agreements and meal logs that indicate that the employee actually received the lodging and meals.
Bottom line: Farmers must have records in place clearly indicating that the in-kind products have officially been transferred to the employee or that the in-kind services have been performed. The farmer should have the employee sign a receipt as proof that the transfer in fact took place. However, the IRS will likely ask for other documentation as well. The farmer should retain all documents available to support the transfer in case of an audit.
The farmer must have records identifying the specific in-kind products that were transferred to the employee
This factor comes generally into play for commodities or farm products that are stored at a public warehouse or grain elevator. It can also include livestock. The point is that whenever the farmer makes an in-kind payment, it must be clear exactly which specific products belong to the employee. For example, if products are stored at a facility, that facility should provide a separate accounting for the employee’s products. For livestock, some kind of physical identification such as ear tags needs to be in place and tracked.
Bottom line: Farmers must have records in place indicating exactly which products have been transferred to the employee as an in-kind payment.
The farmer must have records establishing the fair market value of the in-kind products and services paid as wages at the time such wages are paid
The IRS requires that the value of the in-kind products and services reported be based on the fair market value of those products at the time they are paid or transferred to the employee. The farmer will therefore need to have systems in place to demonstrate this value. For example, let’s say that Farmer Joe pays his CSA work share employees once a week with a CSA share box. How much is this box? This is an easy example, as it likely does not fluctuate from week to week and is based on the prorated amount of the annual CSA membership fee. However, the farmer will still need to provide documentation to the IRS of this value in case of an audit. If the farmer pays in commodities or livestock, he will have to provide documentation of the going market rate of the particular commodities at the time of transfer.
Bottom line: Be sure to maintain adequate records to demonstrate the fair market value of the in-kind products and services at the time these wages are paid. For more on the proper valuation of in-kind wages, see Farm Commons’ resource Farmers’ Guide to Meeting Federal Minimum Wage Requirements through In-Kind Wages.
The farmer and employee must properly report the in-kind wages on their federal tax filings
The following outlines the basic tax filing and reporting procedures that the farmer and employee must follow when the exemption is being claimed:
• The farmer must include the fair market value of the in-kind products and services as wages on the employee’s W-2. The value is determined at the time of the transfer and must be documented.
• The farmer can deduct the fair market value of the in-kind product and services paid on their Schedule F as wages. The farmer must also show the value of the product and services paid as commodity sales on their Schedule F.
• The employee must report the fair market value of the in-kind products and services at the time paid as income on his or her tax return.
• If the employee eventually sells the in-kind products or services, the employee must record the sale as a short-term capital gain or loss on Schedule D in the year she sells the commodity. This gain or loss will be calculated based on the fair market value of the in-kind products or services when paid and the actual sales price.
Bottom line: Make sure the wages are properly valued for the purposes of IRS reporting (which may be different than for determining minimum wage compliance), and that both parties are properly reporting the exchange in their tax returns.
Conclusion
The federal payroll exemption for in-kind wages for agricultural labor comes with a near certainty of an audit. It is highly recommended that farmers seek the assistance of an attorney or a tax accountant who is familiar with the commodity wages exemption to ensure that they are in full compliance when preparing and filing their tax documents. The consequences of noncompliance come with a significant price tag, including back taxes and penalties. Farmers must also realize that this resource is limited to the commodity wage exemption only, which applies to federal FICA and FUTA tax. Other state and federal tax laws apply and may or may not offer a similar exemption.