Capital Sourcing Rules Require Independent Economic Participation

Key Takeaways:
  • FSA applies strict rules to the sourcing of capital that producers use to apply for USDA payment programs.
  • “Tainted” capital — even if inadvertent — can result in steep penalties.
  • USDA payment programs require independent economic participation on the part of the producer.

 

Applying for payment programs administered by the USDA through the Farm Service Agency (FSA) is a complex process, applicants should work with a team of advisors with knowledge and expertise in FSA programs to ensure they are complying with all the rules.

One of the most important rules governs “tainted capital,” and a violation of this rule could result in significant financial penalties, even if it is unintentional.

Use of “tainted capital” to satisfy the requirement that an applicant contribute a portion of their own capital to qualify for agricultural payment programs can result in a year-end FSA review — similar to an audit. If the review finds that the applicant used tainted capital, they may be required to pay back all the program funds they received, as well as be subject to future reviews.

What is ‘Tainted’ Capital?

The USDA applies capital source rules to a wide variety of programs that are open to actively engaged farmers, delineating the types of capital that can and can’t be used to support an application for USDA program payments. The programs covered by capital source rules include:

  • Commodity and price support programs
  • Direct and guaranteed farm loans
  • Microloans
  • Disaster assistance programs
  • Conservation programs

These are programs that require strict financial integrity to control risk exposure and ensure statutory compliance. Capital that cannot be used is known as “tainted” capital, an informal, not official, term.

The most significant example of tainted capital, for most farmers, is land. The USDA does not allow land to be used as collateral when applying for most loans.

Capital Sourcing Rules

The capital sourcing rules that govern USDA payment programs are set out by law, not by agency regulations. A core principle guiding the law is that payment program eligibility requires real, independent economic participation by the applicant. In other words, participants can’t establish eligibility by using artificial financing structures. The capital risk must belong to the participant.

Additionally, funding provided by the person or entity that is applying must be independently contributed and — in the case of partnership entities — all partners should be at risk commensurate to their ownership percentage.

The funding cannot include:

  • Value of labor or management
  • Shared or recycled funds from another member
  • Program payments or non-arm’s-length transfers

A core rule is that the capital must reflect real financial risk and independence. In the case of a partnership, this applies to all partners individually. This means that the capital must come from a fund separate and distinct from that of any other person or entity with an interest in the farming operation.

This is a key concept, as it is the legal basis for evaluating whether capital is “qualifying.”

While it is not a term defined by the law, “tainted capital” is mentioned in the FSA 6-PL Handbook and refers to capital that appears to meet contribution requirements on paper, but lacks true independence or risk, usually because it is derived from another entity or participant in the same operation.

The FSA considers capital to be non-qualifying (tainted) when:

  • It is circular or pass-through funding, such as loaned or gifted funding, or funds that are routed from one partnership member to another.
  • The funds are from shared or commingled accounts.
  • The funds come from loans for which another partner guarantees repayment or the borrower has no meaningful financial risk.
  • Capital contributions that occur just to qualify for payment eligibility and are not tied to real operational financing needs.

Applicant Must Have AEF Qualification

Under the “left hand/right hand” concept of farm management, an applicant for USDA payment programs must qualify as “actively engaged in farming” (AEF) by contributing capital, equipment or land, and personal labor or management, and the contributions must be commensurate with the claimed share of profit and risk.

Under this protocol, capital is deemed as tainted if it does not count toward an applicant’s contribution to the farm operation, or if the person is determined not qualified for the AEF designation.

FSA Enforcement Practices

  • FSA will evaluate the source of funds to determine if the capital is real or artificial.
  • FSA will evaluate the level of risk the applicant assumes.
  • FSA will examine independent bank records, loan documentation and evidence of liability and repayment.
  • FSA may trace the money used by an applicant to fulfill the capital requirement back to its origin.

If a capital sourcing violation is discovered, even if it is inadvertent, the producer may be subject to reviews of their payment program history. If further violations are discovered, the producer could potentially have to repay all payment funds that were received, in addition to penalties. The enforcement mechanisms are real and they are significant.

Questions?

To qualify for USDA payment programs that are administered by FSA, producers must provide capital that is independently sourced, contained in separate bank accounts, belongs only to the producer and represents real financial risk, and is not derived from other partners.

In other words, eligibility for USDA payment programs requires independent economic participation on the part of the producer. Working with a team of advisors who specialize in the ag industry — including an accountant, your banker and possibly an attorney — is advisable to ensure that you don’t inadvertently run afoul of USDA rules and regulations.

If you would like to discuss your eligibility for USDA payment programs and review your contribution for possible tainted capital, contact an Adams Brown agriculture advisor.