The information found in this article should not be considered tax or legal advice, it is a brief review of options for educational purposes only. Please work with your trusted tax and legal professional to discuss various options that may be well suited to your specific situation.
The 2021 calendar year for many farmers around the country has not failed to hold its fair share of surprises. Although we are seeing increasing input costs in many areas, we have also seen an increase in price to many crops across the agricultural spectrum, and some have continued to receive some federal program payments within the 2021 calendar and tax year. For many farmers this may create a taxable situation, especially for those that had pre-paid inputs in 2020 for their 2021 crop. There are several tax management strategies that can be used to help off-set some of the farm’s 2021 tax liability. However, you must remember a couple of points:
- Tax management is not how to get out of paying taxes, but how to get the most amount of money through the tax system at the least expensive tax rate possible.
- There is no one size fits all and good tax management may require increasing your tax liability in some years.
Prepays, IRC § 461(a); Treas. Reg. § 1.461-1(a)(1)
To purchase inputs for the following year, the farmer must utilize a cash basis accounting and tax structure (not an accrual system). The prepay amount cannot exceed 50% (IRC § 464) of other expenses with some caveats and exceptions, and prepays cannot be used solely as a means to reduce tax liability. First and foremost, it must be done for other beneficial purposes to the farm.
Many farms utilize prepays. Prepays allow a farmer to purchase inputs for the next tax year’s production. Any expenses accrued for this may only be deducted as a cash expense for the tax year in which it was purchased if 1) there is a possibility of a supply issue and this will guarantee that you will have the input required, and/or 2) if purchasing the input in the year prior to use will save the farmer money due to a lower cost of the input(s) today vs. the year it will be used. It is required that the pre-pay has been paid by the farmer and a constructive receipt has been received. There are limits to prepays, so work with your tax professional in determining the right amount for your situation.
Income Averaging (Schedule J), IRC §1301
Income averaging uses IRS Form Schedule J Income Averaging for Farmers and Fisherman. Many farmers are on a cash accounting basis and not an accrual accounting system for accounting and tax purposes. When using the cash accounting method a farmer may see large swings from year to year in revenues and profit. Income averaging allows farmers to spread out these peaks and valleys with some caveats. Income Averaging allows a farmer to take a portion of the taxable income from the current year, split that portion equally, and spread it across the previous three tax years to be taxed at hopefully a lower taxable rate than what it would have been in the present tax year. If there is room left in previous year’s lower tax brackets, this can be very advantageous for a farmer or commercial fisherman.
Retirement Accounts, Health Care Accounts, and Educational Accounts
There are tax free account options that can be used to build your retirement or save for college, or Health Savings Accounts (HSA) for medical expenses. Each comes with its own advantages and disadvantages. This may include taxes owed and penalties incurred if the money is removed prematurely, and/or is not used for its intended purpose. Please speak with a trusted tax or legal professional and include a good financial planner as part of the team in these situations.
Depreciation
Most farmers are very familiar with depreciation, IRC Section 179, and Special Depreciation usually referred to as Bonus Depreciation. Many farmers utilize Sec. 179 or Bonus depreciation to make purchases of equipment, machinery, etc. and subsequently lower their taxable income. This is fine if:
- The purchase was part of the farm’s business plan and not just a way to lower your tax bill, and
- You are using cash to make the purchase, and do not need to take out a loan for the purchase.
In many cases the overuse of these depreciation methods has caused some farmers to get into trouble, either through creating a cash flow issue or through an increased tax liability over time. This is because there may be little “carry-over” depreciation to off-set future income since the entire value of the purchase was depreciated all in one year. Expanding debt just to save money for taxes is not a good idea, especially if it was not already built into your farm’s business plan. The farm’s cash flow may be severely impacted. Even if the farm did not need to take out a loan for the purchase, this can increase the overall tax liability by putting the farm into a higher tax bracket because of the lack of depreciation carry over to offset future income.
Good habits have to be built and continually exercised. Now is the time to make an appointment with your tax professional to discuss some options before the end of the calendar year. These discussions should become a part of the farm’s normal fall/winter year-end rituals. Make sure to provide your tax professional with all of the necessary information, including but not limited to year-to-date (YTD) income, expenses, any capital asset sales and purchases, any known and anticipated income and expenses between the date of the meeting and the end of the year.
Source:
Department of the Treasury, Internal Revenue Service. (2021). 2021 Instructions for Schedule J (2021): https://www.irs.gov/instructions/i1040sj.
Department of the Treasury, Internal Revenue Service. (2021). Publication 225, Farmer’s Tax Guide. https://www.irs.gov/pub/irs-pdf/p225.pdf.
Kantrovich, Adam. “Time to Meet with Your Tax Professional.” Southern Ag Today 1(50.3). December 8, 2021. Permalink
