ecently, the Internal Revenue Service has challenged a producer's reporting of amounts received under a ledger marketing contract. The Service is taking the position that the producer must report all amounts received under a ledger contract as income in the year received, even amounts which must be repaid upon termination of the contract. This producer, and others, have elected to report these additional payments as a loan rather than income.

In general, a ledger contract sets a trigger price for sales of market hogs and if the actual market price is less than the trigger, the producer receives the trigger price with the difference accounted for in a deficiency account (ledger). If the market price is more than the trigger price, either the difference or a percentage of the market price is applied to the deficiency account, if there is one, or deposited into a reserve account. The balance of the market price is paid to the producer.

At the termination of the contract, most contracts require the producer to repay any balance in the deficiency account (negative ledger balance). On the other hand, if there is a balance in the reserve account (positive ledger balance), the packer is required to pay the producer that amount. In addition, some contracts require the producer to pay interest on the negative balance and require the packer to pay interest to the producer on the positive balance.

The question is whether the producer must report all of the payments for market hogs as income when received, even though the portion recorded in the deficiency account must be repaid either from subsequent payments when hog prices exceed the trigger price or upon termination of the contract.

In some cases, including one case currently under review by the IRS, the producer has been treating the amounts as a loan. The IRS is rejecting this approach arguing that the ledger balance is not a loan because it "lacks the indicia of bona fide indebtedness." The IRS takes the position that the negative ledger amounts are income when received because (1) there is no fixed maturity date and the taxpayer is not required to make periodic payments on the loan. The IRS does not consider reductions from sales of hogs to be payments on the loan; (2) there is no loan document, only the ledger contract. The IRS argues that a true loan document provides an interest rate, term of the note, and a schedule for repayment; (3) the ledger contract allows the producer, at the end of the contract, to request to either pay the balance or continue delivering hogs until the balance is paid. The IRS has also referred to a case involving advance commissions to insurance agents, even though in that case the court ruled that the advances were loans, not income. In that case the tax court established a 3 part test for factors of a loan: (1) the payments were structured as a loan and required payment of interest; (2) the agent was personally liable for amounts owed under the contract; and (3) the company demanded and received repayment if the commissions earned were not enough to repay the amounts owed.

There are counter arguments to the IRS's position, including a regulation that states a loan transaction is characterized according to its economic substance, rather than the terms used to describe it. That appears to be a critical factor relative to ledger contracts as, in substance, they arguably qualify as a loan even though there may not be a formal loan document. Other critical factors which have been argued to the IRS is that the packer treats the transaction as a loan on its books and requires repayment. In many cases, packers have taken legal action to recover amounts owed by producers under ledger contracts.

Some tax analysts have stated that treating payments in excess of market price under ledger contracts as loans is difficult, if not impossible, when the contract does not characterize the amounts as loans. Other tax analysts have taken the position that the determination must be made on the individual facts of each contract, looking at the underlying substance of the transaction to determine if payments are a debt (treated as a loan) or if the payments are unrestricted cash payments (treated as income).

At least one case currently under review with the IRS will likely go forward on appeal. Until there is a change in the IRS's position or a court decision giving clear guidance on this issue, producers who have treated ledger account balances as loans should discuss this position once again with their tax return preparer. Producers may want to consider working with their packer to modify their ledger contracts to more clearly meet the IRS requirements for a loan. At the very least, producers should be aware of the issues the IRS is raising and be prepared to defend their position if audited.