Managing Income Taxes Before Year-End
JC Hobbs, Associate Extension Specialist
Department of Agriculture Economics, Oklahoma State University
Introduction
Income tax management is not minimizing total taxes owed, but rather maximizing after-tax net income over the lifetime of the business. Minimizing the near-term tax liability often results in overcapitalizing the business through the purchase of assets or purchasing inputs to create deductions that reduce taxable income to near zero. Additionally, agricultural producers miss an opportunity to build Social Security benefits (especially disability coverage) by not having significant net farm income and paying self-employment taxes. The tax management tools discussed in this article are useful in managing the tax liability before the end of the tax year.
Depreciation
Depreciation is the IRS required method used to recover the cost of purchasing a capital asset (an asset with a useful life exceeding one year). The tax law provides several options to allow businesses to manage the taxable income by allowing the use of 200 percent or 150 percent declining balance, or additional first year (Bonus) depreciation, to quickly depreciate the asset by providing a greater deduction in the first years of the recovery period. In addition, straight line depreciation over the asset’s recovery period, or its alternative longer recovery period, which spreads the depreciation deduction more evenly over the class life of the asset are management options to consider.
Another depreciation-related tool is the Section 179 expensing election. This method allows for the current deduction of all, or at least a large portion of, the asset’s cost in the year of purchase. Section 179 rules state that the amount allowed to be used in any year is limited to the amount of net farm income adjusted for W-2 wages and other farm business income, the annual statutory limit, and lastly, the total investments made during the tax year. The unused or disallowed amount is generally carried forward to be used in future years.
A key point when using depreciation as a tax management tool is to make sure that it makes economic sense to purchase the asset. Frequently, producers will purchase an asset in a high-income year to reduce their tax liability, when the purchase decision should actually be based on business need. It is also important to understand which depreciation tools can be used with farm machinery and equipment, breeding livestock, single purpose buildings, multi-purpose buildings and other assets.
A requirement for an asset to be depreciated in the current year is that it must be both purchased and placed in service (available to be used). The selection of which depreciation tool to use is made when the tax return is being prepared during the tax filing season, which is in the following year. It is important to evaluate the level of current taxable income, as well as the expected future income to determine which method will provide the greatest tax benefit for the current tax year, as well as for future tax years.
There are many options available regarding depreciation. This a useful tool in both high-income and low-income years. Proper planning will result in the optimum amount of deduction to offset taxable income over the long term.
Prepaid Farm Expenses
Expensing prepaid farm inputs under tax law provisions allows a producer to purchase, in the current year, feed, fertilizer, or other supplies that will not be used until the following year. The expenditure must be for a valid business purpose, must be a payment and not just a deposit, and cannot materially distort income. The deduction may be limited to 50 percent of the total deductible farm expenses incurred during the year. For example, if there are $100,000 of expense for the year as an average, and if $55,000 was spent for prepaid items for the subsequent year, then the current year deduction for the prepaid expenses is limited to $50,000 ($100,000 × 50%). Thus, $5,000 ($55,000 - $50,000) will be allowed as a deduction in the following year.
Several exceptions exist that could possibly allow a producer to ignore the prepaid expense limitation. These can be found in IRS Publication 225, Farmer’s Tax Guide. Prepaying expenses is a tool that is useful in high-income years to reduce taxable income.\
Expensing Fertility vs Amortizing the Cost (Code Section 180)
The cost of fertilizer, lime, and other soil amending materials are deductible in the year they are incurred, if the benefit lasts a year or less. If the benefit lasts for more than a year, the expense generally must be capitalized, and a pro-rated deduction is allowed for the value of the material that was utilized in the year. However, farmers can annually elect to deduct the cost of fertilizer in the year the expense is incurred and paid without IRS approval. In a high-income year, electing to deduct fertilizer expenses is an effective tool, while in a low-income year it may be beneficial to capitalize the cost and report the expense over a longer period of time.
Installment Sale Contracts for Grain or Livestock
Installment sale contracts for grain and livestock are simply forward contracts used to defer the reporting of income until the following tax year. The disposition occurs in the production year and the payment is received in the subsequent year. To be a qualified installment sale contract, a producer avoids having access to the income until the date specified in the contract (referred to as constructive receipt). Other requirements for a qualified installment sale contract are: the contract should be in place before the commodity is delivered to the buyer, it must be in writing, it cannot be transferrable, and the seller is not entitled to the proceeds before the contract’s expiration date.
Installment sale contracts work well in high income years and can help producers meet a desired level of taxable income. To improve the ability of installment sale contracts to manage taxable income, it is helpful to utilize several smaller contracts, as opposed to one contract for the entire amount of production to be sold using the installment method. In doing so, a producer can elect out of selling all, or part, of the production, and report the sale in the year of production to manage taxable income.
Commodity Credit Corporation (CCC) Loans
Commodity Credit Corporation loans are used to protect cashflow, as commodity prices are highly variable. Producers pledge a part, or all, of their grain as collateral for a loan without the need to sell the crop to generate cashflow. Using a CCC loan, a producer can watch prices to determine the best time to sell the crop or, if prices do not improve, the producer can relinquish the grain to the CCC as loan repayment. Generally, a producer will not report the loan as income, but if desired the producer can elect to treat the loan as a sale and report the loan proceeds as income in the year received. This provides the opportunity to determine the best tax treatment as the tax return is being prepared, and the need to either accelerate paying the tax in the production year or report the crop income in the subsequent year when the crop is actually sold.
Retirement Plan Contributions
In a high-income year, producers should consider making contributions to a retirement plan. This is frequently overlooked, as agricultural producers have the desire to expand the farm operation now versus developing a plan for future retirement from the farm business. There are a variety of retirement plans available for the self-employed agricultural producers, including traditional IRAs, Simplified Employee Pension Plans (SEP or SEP-IRA), and Savings Incentive Match Plan for Employes (SIMPLE and SIMPLE-IRAs), and others. Contribution limits vary but the contributions are currently tax deductible. Timing for making contributions is critical to be able to deduct the contribution against income in the desired year. It is important to meet with a financial advisor to determine the plan that best meets your needs.
Conclusion
Managing the estimated tax liability before the end-of-the year provides an opportunity to work with a tax professional to evaluate the financial status of the business and evaluate various tax management tools available to best manage the estimated income tax burden. Proper tax planning will minimize the long-run tax liability, which can stimulate business growth while also allowing contributions that will generate retirement benefits later.
IRS Publications
To access IRS Publications, go to www.irs.gov and click on “Forms and Publications.” Then click on “Publication number” under “Download forms and publications by.” Type the publication number in the find box to search for the publication. Publications may be viewed online or downloaded by double clicking on the publication.
Additional Topics
This fact sheet was written as part of Rural Tax Education a national effort including Cooperative Extension programs at participating land-grant universities to provide income tax education materials to farmers, ranchers, and other agricultural producers. For a list of universities involved, other fact sheets and additional information related to agricultural income tax please see RuralTax.org.
References
- IRS Publication 225: Farmer’s Tax Guide
- https://www.irs.gov/retirement-plans/retirement-plans-for-self-employed-people
This information is intended for educational purposes only. You are encouraged to seek the advice of your tax or legal advisor, or other authoritative sources, regarding the application of these general tax principles to your individual circumstances. Pursuant to Treasury Department (IRS) Circular 230 Regulations, any federal tax advice contained here is not intended or written to be used, and may not be used, for the purpose of avoiding tax-related penalties or promoting, marketing or recommending to another party any tax-related matters addressed herein.
USDA is an equal opportunity provider, employer, and lender. Rural Tax Education is part of the National Farm Income Tax Extension Committee. The land-grant universities involved in Rural Tax Education are affirmative action/equal opportunity institutions.
This material is based upon work supported by the U.S. Department of Agriculture, under agreement number FSA21CPT0012032. Any opinions, findings, conclusions, or recommendations expressed in this publication are those of the author(s) and do not necessarily reflect the views of the U.S. Department of Agriculture. In addition, any reference to specific brands or types of products or services does not constitute or imply an endorsement by the U.S. Department of Agriculture for those products or services.
Published September 2024