If you're going to accumulate wealth, you're going to have to pay some taxes along the way," says Glenn Kennedy. "Your best bet is not to try to eliminate taxes, but aim to minimize them over the long haul."
Kennedy is a CPA and a partner with McGladrey & Pullen, LLP, Rocky Mount, NC. He has had plenty of experience working with farmers to save income and self-employment (Social Security) taxes.
His first rule is to realize that everybody's situation can be unique when it comes to income tax planning. He shared a number of good tax-planning ideas, but obviously not all of them will work for everybody, every year. They should, however, spark your ambition to do some tax planning.
Kennedy suggests you always run tax plans by your tax advisors. Better yet, sit down with a tax professional and do a good year-end tax plan.
Begin by tallying up your income and expenses for the year, to date, to get an idea of where your taxable income is likely to be at year end. Use last year's tax return to guide you in what has to be reported as income and what deductions you can subtract.
"I also like to do a comparison to the prior year or years," says Kennedy. "It lets you know if you're ahead or behind the same time last year and provides a good clue as to how this year might end in terms of taxable income."
Despite often being abused and over-used, Kennedy sees the cash basis accounting for taxes that is used by self-employed farmers, partnerships and S-corporations as one of the best, tax-planning tools available.
"The big thing is you can buy cattle feed and other farm supplies right up until the end of your tax year (December 31 for most farmers) and deduct it for that tax year," says Kennedy.
Say you pre-figure your tax in the last days of the year and see that your federal taxable income is going to be $71,200 on the joint return you will file with your spouse for 1997. (Remember, the figures are different for other filing statuses.)
The first $41,200 of that will be taxed at 15%. The next $30,000 will be taxed at 28%. The federal income tax rate jumps right from 15% to 28% - there's nothing in between. Your total federal income tax bill would be $14,580.
But if you are a cash basis taxpayer, you could buy $30,000 of feed or other farm/ranch supplies ahead - supplies you will use in 1998 - and keep your taxable income down to $41,200 and your federal income tax tab at $6,180 ($41,200 X 15%), using a joint tax return. You wouldn't pay any tax at the 28% rate; only at the lowest 15% rate.
Another cash-basis tax planning tool is to delay sales, says Kennedy. That's fine for a crop farmer who sells some of his grain. He can hold off some sales until the next tax year and reduce his income.
But that grain doesn't compile additional production costs the longer it is held. Cattle do. And, they're likely to get fatter, too. You might hold cattle for a few days, maybe even a week, to push the income into the next year. But make sure good management prevails over tax planning.
The income tax strategy of holding off sales and buying deductible items ahead of time can create a vicious cycle.
"Once you're caught up in it you have to keep doing it year after year," says Kennedy. "However, if you're in the cattle business long enough, you'll have a year when things don't go so well. In those lean income years, don't forget to play catch up," he explains, by not delaying sales or not buying ahead.
"The trouble is, in those low income years, it's mentally hard to work up to the top of that 15% tax bracket ($41,200 taxable income in 1997 if you file a married, filing jointly tax return) because then you have to pay more than $6,000 of income tax plus a pretty big amount of Social Security tax," says Kennedy. "That's hard to do when you've been through a low income year.
"I want to stress, however, that a successful operation that's going to average about $40,000 annual taxable income ought to be pushing up to the top of that 15% tax bracket every year," he adds. "If you don't, someday you will pay tax at a 28% rate on taxable income that could have been taxed at 15%."
Add about 15% for the Social Security tax and maybe some state income tax and you can be pushing toward 50% tax on the taxable dollars that fall into the 28% bracket.
Never Lose Free Deductions In 1997, the standard deduction for a married couple filing a joint federal income tax return is $6,900. Each personal exemption is $2,650. If you don't have enough income to use those, they're lost forever. There is no way to carry them over to next year.
Consider a couple with two dependent children. Four personal exemptions is $10,600. Add the $6,900 standard deduction and you can have $17,500 of income before you will pay a cent of federal income tax. You sure don't want less income than that because anything less is at least a 15% lost opportunity.
For example, if your income is only $7,500, you would lose $10,000 of deductions forever, worth at least $1,500.
Even if you plan to do most of your own income tax planning, consider asking your tax preparer to give you an update on depreciation. Tell him/her what you've bought and sold during this year and ask them to calculate the new depreciation figure for 1997.
If you buy at least $18,000 worth of machinery and equipment in 1997 - but less than $200,000 worth - you can deduct the first $18,000 as a current deduction, Kennedy reminds. Then you can take regular depreciation on the rest.
If you buy more than $200,000 worth, you'll lose the chance to currently deduct that amount at the rate of $1 for each $1 you go over $200,000. At $218,000, you can't currently deduct anything, says Kennedy.
You don't really lose any tax benefit that way. You just get to deduct it as regular depreciation over the years rather than all at once.
So, if you're counting on that extra deduction, be sure to watch the $200,000 limit, Kennedy warns.
Another depreciation quirk is to watch the timing of your depreciable purchases. If you buy most of those assets on or before September 30, you can use what is called a half-year convention, Kennedy explains.
But if you buy 40% or more from October 1 to December 31, you have to use a mid-quarter convention. The difference could be thousands of dollars worth of depreciation deduction.
"You can also depreciate livestock buildings pretty fast - at an accelerated rate over 10 years," Kennedy says. "However, that could be too fast for the best long-term income tax results."
For example, you could be hard pressed to have taxable income up to the top of the 15% tax bracket in the early years of a building's life. Therefore, the deduction may be worth only 15% in tax savings.
By the time the building is depreciated out, you may have a hard time keeping your taxable income out of the 28% tax rate, he explains.
While you're growing in your operation, you may be wise to elect an alternative depreciation method to allow for slower depreciation.
Another Possibility A "C" corporation - where the corporation becomes a separate taxpayer - is another possibility to consider when it becomes nearly impossible to stay in the 15% federal income tax bracket.
This corporation can deduct some things that you, as a sole proprietor or partnership, can't deduct. Some things that can be considered are all health insurance premiums and all medical expenses not covered by insurance, some meals for employees (including you) and some utilities and other expenses for the farm residence.
The other benefit is that the first $50,000 of corporation federal taxable income is taxed at 15%. That lets you have up to $91,200 taxed at 15% rather than just $41,200 on a joint return. But plan that out. There can also be tax on the corporation's after-tax profit when you later draw it out.
If any of that fits your situation, at least study the idea of a "C" corporation.
Cut Social Security Tax Adjustments you can make in your earned income will also affect your Social Security tax, Kennedy reminds producers.
Understand that, while income such as rent and interest is not subject to the Social Security tax, all net income from your self- employed business is subject to the tax. You can't reduce the taxable amount for the Social Security tax with things like standard or itemized deductions and personal exemptions.
"Young people often say they wish they didn't have to pay any Social Security tax because they don't believe Social Security will be around when they get to retirement age," says Kennedy. "But, I suggest make every effort to pay at least the minimum each year until they are fully covered for disability benefits and for widow/widower and children benefits in case they become disabled or die."
For well-covered farmers, those who have already paid at least a fair amount of Social Security tax for a lot of years, Kennedy's advice takes on a different tone. "Look for ways to pay less Social Security tax," he suggests. "One of the best ways is to incorporate either as an "S" or a "C" corporation.
"With either one, you, as an employee, can draw a reasonable salary," Kennedy continues. "That is going to be subject to the Social Security tax. But then you can take distributions from an S corporation as dividends or additional distributed profits for the rest of your income. Since that is considered unearned income, it is not subject to the Social Security tax.
"With either a C or S corporation, you would incorporate the business and continue to own land and buildings as an individual," he explains. "Again, you can draw a reasonable salary and get the rest of your income by renting the land and buildings to the corporation. So far, rent is considered unearned income that is not subject to the Social Security tax."
Of course, study this carefully with your tax advisors. It's a major decision.
Think Good Management First It's great to save income taxes, but never let tax savings take the upper hand over good farm management.
"In the past, farmers have bought machinery and equipment just for tax deductions," says Kennedy. "Often, it was primarily for the depreciation and investment credit to cut their taxes.
"One farmer even had two combines and was only using one because that's all he needed," Kennedy explains. "That didn't make sense. He would have been better off paying more tax and investing the money."
The same thing can be true when you buy things like feed needs in advance or try to reduce income by holding back sale of cattle that are ready for market.
If feed price drops after you have bought a big supply for next year to get the deduction this year, the extra cost can easily be more than the tax savings. Even with price discounts for buying ahead, if you have to borrow the money, that cost may be more than the discount and tax savings.
"Always balance tax savings with good farm management," Kennedy says. l