Tax planning helps farmers maximize farm earnings
By Scott Castell, Badgerland Financial
Though income tax planning has been around as long as there has been a tax upon income, far too few farmers take advantage of the process. What exactly is tax planning and why is it important? It essentially revolves around the deferral or acceleration of income and expense items depending on the taxpayer’s current and projected tax situation.
The key to sound tax planning involves minimizing the amount of tax paid over time, not just in a single year. While tax planning can take place at various times during the year, it’s important that it’s accomplished no later than mid-December to allow you sufficient time to enact any necessary steps outlined by your tax preparer. Waiting until the year has ended is too late.
Following are examples of tax planning concepts for sole proprietor, cash-basis farmers who want to reduce taxable income—although most, if not all, are applicable to other farm entities.
Use a Certified Public Accountant (CPA) or Enrolled Agent (EA) skilled in the nuances of farm taxation. If you did nothing else but this, you would be taking the first step toward sound tax planning and preparation. Any tax preparer can fill out Schedule F, but is not necessarily knowledgeable in all facets of federal/state farm taxation. At Badgerland Financial, we see this time and again when reviewing tax returns for prospective farming clients.
There are methods a farmer can choose to defer income that would otherwise be included as taxable income, subject to self employment tax. Remember that you are merely delaying the payment of tax, and be mindful of what you think your tax situation will be the following year when deferred income gets recognized. Could it put you into a higher marginal tax bracket? That’s not a good thing unless another deferral could be arranged.
The first method involves deferred payment contracts. These contracts allow you to deliver and sell your milk or crops but defer the receipt of cash and recognition of income until the following year. The deferral of income is on a contract-by-contract basis, and does not violate the constructive receipt doctrine since a written contract has been entered into. Be aware that not all dairy plants, grain elevator operators, and co-ops will write these contracts.
Farmers are also allowed to defer certain crop insurance proceeds. The deferral is limited to actual crop loss and can only be utilized if insurance proceeds were received in the year the loss occurred, and the farm has historically held these covered crops for sale in a subsequent year.
Farm Expense Pre-payment
Unlike other business owners, farmers are allowed to deduct certain pre-paid expenses in the current year even though the use of these items occurs the following year. Some common examples are feed, seed, organic fertilizers or other soil amendments, fuel, and certain supply items. Tax planning with your tax preparer will allow you to see the impact that pre-paying some, or all, of these items has on your tax liability for the current year. There are three caveats that must be met before deductibility is allowed. First, the payment must be made in full. Deposits do not qualify. Second, the payment must serve a legitimate business purpose, such as obtaining a favorable price, rather than just being made for tax avoidance. Lastly, the pre-paid items cannot exceed 50 percent of the total of all other non pre-paid expenses on Schedule F.
Long-term Capital Gains
Long-term capital gains are taxed at separate, and lower, rates than the rates used on taxable income. The highest long-term capital gains rate is 20 percent for a farmer in the 39.6 percent tax bracket. More importantly, the rate is 0 for farmers in the 10 and 15 percent brackets. Livestock used for draft, breeding, dairy, or sporting purposes will qualify for long-term rates if held for the requisite time period; 12 months or longer for all livestock except cattle and horses which must be held for 24 months or longer. This applies to both purchased and raised livestock, but the gains realized on raised livestock will be much higher since there is no basis. I cringe when seeing that qualified livestock was sold before reaching the holding period since this subjects the farmer to the higher ordinary income tax rates. Livestock, just like crops, are commodities subject to price fluctuations. All things being equal, knowing when your livestock have met the holding period and selling accordingly should help you maximize cash flow and minimize tax.
Spouse as Employee
A self-employed farmer is allowed to deduct the cost of his/her family health insurance premiums covering a spouse and children/dependents under the age of 27. The deduction is taken on line 29 of Form 1040, however, so it does not reduce the amount of farming income subject to self employment taxes. Employing your spouse to perform necessary services for the farm and having the medical insurance in their name enables the cost to be deducted as medical expenses on Schedule F, reducing self employment tax. These wages also help the spouse obtain social security retirement benefits. Assuming your farm had income for the year, it could also enable you to qualify for the Domestic Production Activities Deduction (DPAD), which can help further reduce federal tax liability. If you pay your spouse with commodities, the income is still taxable but is not subject to social security and Medicare taxes for the employee-spouse and there is no matching requirement for the farm-employer. Commodity wages are not allowed as qualifying wages for purposes of DPAD and do not entitle the spouse credit toward social security benefits.
This section of the tax code is probably the most widely known among the farming community and common in most tax planning strategies. It allows a farmer to deduct the entire purchase price (only the “boot” portion on even exchanges) of assets in the 3-15 year class lives categories in the year of purchase. For 2014, the maximum deduction (subject to other limitations) was $500,000. On July 21, 2015, the Senate Finance Committee passed a tax extenders bill that included maintaining this $500,000 limit through the 2016 tax year. This still needs to make it through both the House and Senate and be signed by the President, but the outlook looks promising.
A word of caution: Section 179 can be both a solution and a curse. It can significantly reduce both self employment and regular federal income tax in a given year. The flip side is that, depending on the amount of Section 179 deduction taken, there will be less depreciation or none at all on the selected equipment/livestock in future years. In periods of rising commodity prices and increased farm income, this depreciation expense would have been useful. Do not fall into the trap of buying assets to lower your tax liability!
Ask about Section 179 or the other strategies mentioned earlier during a tax planning session with your tax preparer. Tax planning puts you in control of your tax situation and can help eliminate surprises at filing time. Take advantage of it before the year ends—you’ll likely be rewarded.
Scott Castell is Senior Tax Consultant at Badgerland Financial, a member-owned Farm Credit System institution in southern Wisconsin.
From the September | October 2015 Issue