1. Strategically Manage Farm Income
Limit your tax burden by stabilizing farm income. Because of the progressiveness of our tax rate structure (higher tax rates for higher incomes), a farm with fluctuating income from year to year pays a higher total tax than a farm with stable income.
There are two basic strategies for smoothing farm income. (1) Income can be shifted from a higher tax year to a lower tax year, and (2) expenses can be shifted from a lower tax year to a higher tax year.
(1) Some commodity sales can be delayed to the next year (grain stored at the farm) as long as the product does not lose value by being stored, and the product’s price is not subject to decline before the end of the year. Income can also be shifted by the use of deferred payment contracts with the buying point. For example, multiple contracts could be used for shifted income from corn and soybeans harvested in 2015. These contracts allow the farmer to maximize their tax situation by allowing the income to be reported in either 2015 or 2016. The income recognition is on a contract by contract basis, so be sure to set up multiple contracts for the most flexibility.
(2) Consider purchasing some of your operating inputs this year to reduce taxable income. This works best for inputs like feed, seed, fertilizer, chemicals, and fuel that can be purchased and delivered to the farm in the current year. Certain prepayments of inputs can also be utilized to minimized current taxable income if the following criteria are met:
• Full payment is made – payment is nonrefundable
• Valid business purpose for advanced purchase
• Prepayment cannot distort income
2. Don’t Waste Deductions
Farmers should consider shifting farm income into years when total income (AGI) is less than the total deductions and exemptions allowed in that year. The following example is for a married farmer filing a joint return and claiming two children as dependents.
As a result of effective tax planning, the couple was able to shift $12,500 into the current year and make use of the deductions and exemptions that otherwise would have been lost. The tax savings from this example will range from $1,500 to over $3,000 depending on the income situation in the following year.
3. Farm Income Averaging
Farmers can also limit the tax burden by taking advantage of the income averaging election for farmers. In a year when income is significantly higher than one or more of the previous three years, this election allows a farmer to spread the higher income equally over the past three years and take advantage of lower tax rates.
You probably have heard a lot about depreciation over the years.
• In general, you can take a larger than normal tax deduction in the same year that you purchase a new piece of equipment. (Via section 179, bonus, or both)
• Buildings also have favorable tax treatment where in some cases the entire cost of construction can be deducted in the first year. The remainder of the cost has to be recovered over 20 years for equipment barns and machine shops. Special purpose structures like silos, grain bins, livestock barns, and chicken houses can be recovered over 10 years.
• Depreciation Myth – Warning: Don’t let the equipment salesman talk you into making a purchase just to save tax dollars. You’re not really saving money if you have to spend $10 to save $3. Only make equipment purchases out of need, and allow a tax professional to help you decide on the timing of that purchase based on your tax strategy as a whole.
5. Pay Your Kids! It Saves Taxes!
The IRS allows the owner/owners (for farms owned jointly by both spouses) of sole proprietor farms to pay their working children wages without withholding payroll taxes as long as the child is under age 18 at the end of the tax year. The wages are fully deductible by the farm which reduces income subject to self-employment tax. The wages also qualify farmers for another tax deduction that will be covered later.
Each child can earn $6,200 without owing any income tax in 2015. That means that for each child you pay, you save about $1,775 per year in income and self-employment taxes. Additionally, the earnings qualify each child for Roth-IRA contributions that can create a nice little retirement fund that is non-taxable at the time it is withdrawn. If a child earned $20,000 before age 18 and contributed the money to a Roth-IRA, the investment would grow to over $800,000 by age 60 assuming average earnings of 8% per year. Historical long-term investment averages are consistently over 10%. The average rate of 10% would grow the Roth-IRA to over $1,000,000. Conclusion – you received good tax savings and you left your children more than 5 times the national average according to U.S. inheritance polls. I’d say that’s a pretty good return on investment.
6. Domestic Production Activities (DPA) Deduction
The other tax deduction that I referred to earlier is one of the most overlooked deductions for farmers – the domestic production activities deduction. You get an extra deduction equal to 9% of net income from domestic farm activities, limited by 50% of W-2 wages you paid during the year.
• Example: Your gross farm income is $500,000. Your farm expenses are $400,000, of which you paid $65,000 in W-2 wages. Your DPA deduction would be $9,000 ($500,000 – $400,000 * .09). If your W-2 wages were less than $18,000, your DPA deduction would be limited to 50% of whatever your W-2 wages were.
7. Tax Estimates
Don’t pay the IRS unnecessary penalties and interest.
• For farmers that have other sources of household income, you need to know how much of your total income will be from farming because that will determine if you are given special treatment for paying estimated taxes.
• If 2/3 (66.67%) of your total income for the year is from farming, you get to wait until January 15th of the following year to make your estimated tax payment. Or you can have your tax return complete and pay the full tax bill by March 1st.
o Example: A taxpayer, who is a farmer, had $100,000 taxable income in 2014 (including $50,000 wage income earned by the taxpayer’s spouse). The taxpayer expects to have $150,000 taxable income in 2015 which includes $55,000 wage income earned by the taxpayer’s spouse. The taxpayer is required to make quarterly tax estimates because the farm income is only 63% of the total household income. If the taxpayer’s household income had been $165,000, of which $110,000 was from farming, then the special rule would apply and quarterly tax estimates would not be required.
8. Conservation Expenses vs. Farm Land Preparation
Be careful with your treatment of expenses related to clearing land for farming.
• Expenses related to the treatment, protection, or movement of earth such as leveling, grading, terracing, diversion and drainage ditches, earth dams, ponds, brush removal, and planting windbreaks are all generally deductible as long as they are consistent with a federally approved NRCS Conservation Plan for your specific farm, county, or state. (There is a 25% of gross income limit on conservation expenses)
• When you clear a tract of timber land for farm use, the cost associated with preparing the ground for farming cannot be deducted as a current expense according to the IRS. The costs must be added to your basis in the land and can only be recovered when you sell the land.
9. Estate Planning
Don’t put off planning for the future of your estate and the tax effects that will result from the transfer. Things that you need to know:
• You can give $14,000 per year to as many people as you want without triggering a tax on either party, and without reducing your lifetime taxable estate exemption of $5,430,000 per person.
Example: If the value of your estate including cash, investments, land, personal property, and life insurance proceeds benefitting anyone other than your spouse is over this exemption amount, then you need to be giving away $14,000/year to each one of your heirs. (You also have the added benefit of being able to see how your heirs use the money while you are still living)
• Make sure to file an estate tax return upon the death of the first spouse so that the surviving spouse can make use of the deceased spouse’s unused lifetime exemption amount. This way, the surviving spouse can protect up to $10,860,000 of the total estate from taxation.
• If you expect to have a taxable estate, make plans to be liquid enough to cover the tax bill. In many cases, landowners are wealthy from a net worth perspective, but they have historically reinvested earnings into their land, resulting in a relatively small amount of liquid investments. This often leads to the heirs of the estate being forced to sell part of the land just to pay the taxes.
Fuel Tax Credit
This tax credit is available at the federal and state level. It allows farmers that have purchased fuel (gasoline and green, un-dyed diesel fuel) that included road use taxes, but the fuel was used on the farm, to receive a credit against taxes owed. These credits allow for a refund in some cases. The IRS requires a set of books that differentiate between the purchase of untaxed diesel fuel and other fuels where road use taxes are charged in the event that they want to review the credit being claimed. This is another good reason to start using QuickBooks or a similar accounting software in 2015.
Important points to consider:
• Fuel purchases that will not be eligible for the credit include all red, dyed diesel fuel and any gasoline or green, un-dyed diesel fuel that is used on the road.
• Fuel used in a vehicle for both personal and farm use is eligible for the fuel used on the farm only.
• Gasoline used in an ATV, automobile, or any piece of equipment on a farm is eligible for the credit.
Required record retention:
• The total number of gallons bought and used during the tax year (maintain this easily in QuickBooks – check memo)
• The dates of the purchases (maintain this easily in QuickBooks – check memo)
• The names and addresses of suppliers and amounts bought from each during the tax year (maintain this easily in QuickBooks – vendor information)
• The nontaxable use for which you used the fuel (you’ll have to keep a log)
• The number of gallons used for each nontaxable use (you’ll have to keep a log)