Tax Planning for Unique Situations
We recently interviewed Dave Fleming, accounting officer with Horizon Farm Credit. Farm taxes have many nuances, especially in a year like 2020, and Dave discusses tax planning strategies for farmers.
Let’s begin by talking about the basics of tax planning. What’s the goal of tax planning, and why is tax planning especially critical in 2020 for farmers?
The ultimate goal of good long-term tax planning is to even out the peaks and valleys of income. Oftentimes people think of tax planning as a way to get income down, and that certainly is true sometimes, but there are times when it may be beneficial to bring income up. Tax planning is a two-way street.
One of the main reasons to bring income up is to avoid a Net Operating Loss (NOL). Several tax attributes are lost whenever the taxpayer experiences an NOL. The other reason is to take advantage of tax credits. People love a sale and if you think about using tax credits to pay taxes that's kind of like paying your taxes on sale so to speak. There are many credits that are either use it or lose it, meaning if you don't use them this year, you have lost them forever. Finally, if a taxpayer has marketplace insurance, there often are large advanced premium tax credits. To qualify for these you don't want your income too low or you have to repay them back. Also if it's too high you repay them back. You want to strike an even balance.
To the second part of your question, why in 2020? Well, it's been a year like no other. Who would have thought back in January that we'd have churches and theaters closed for weeks even into months? We had milk sales rationed at the retail level while at the producer level on the farm some farmers were being forced to dump milk. The agriculture industry saw much larger government payments than in the past. Some commodities are up in price; some are down in price. A few weeks ago my coworker Kenny Nearhoof did a great job on a podcast explaining some of the COVID assistance programs.
The net result is some farmers have substantially higher incomes and there are other farmers that have extremely low incomes.
In the case of a farm that would benefit from a tax perspective to increasing income, what tax planning strategies have you seen effectively used?
I’ve used about five or six different strategies with customers over the years.
Where it is feasible, one way is to step up income. Obviously a dairy farmer can't make the cows produce more milk to substantially change his income. However, if you think about grain farmers where they have an opportunity to market grain either this year or next year, you can move up sales.
For example, let's say a farm loses $100,000 this year and makes $120,000 of profit next year. What's the two-year profit? It's $20,000. So, what's the tax this year? It's zero. That sounds pretty good so far. But what's the tax next year? It's over $21,000 for self-employment Pennsylvania and state and local income tax. That is enough to get almost anyone’s attention! Plus, I'm ignoring the federal income tax factor in this because I'm assuming that the NOL from this year's large loss and the standard deduction will offset the majority of that. You can simply just ride out the current interest rate you have. It's not going to cost you anything to do that. I know you're going to be stuck there, but it's one of the options you have.
Now, let’s consider moving sales up to sell an extra $100,000 of product this year. The income this year is still zero and the taxes are zero. Next year, his income will be to be $20,000 because he had the extra sales this year. His total tax bill will be in the range of about $3,600. Therefore, we're looking at saving about $18,000 by good tax planning.
Now, some people will say, "Well, I expect the price of the commodity to go up next year." I checked corn prices from one of the major buyers in western Pennsylvania and they were offering $4.49 per bushel last Friday. However, good tax planning though to another $0.81 per bushel on those 22,000 bushels that would have to be sold to generate an extra $100,000 income. So, tax planning is worth about $0.81 per bushel in this case, and the offer on July corn next year is only about $0.09 more than what it was last Friday. So you have a surefire win when using good tax planning.
Other strategies to use include delaying prepaying, or if you have expenses that are due in December wait until January 2 to pay them. People worry about losing a discount on pre-payments for seed corn, but usually the tax savings is much greater than what the discount on seed corn is.
You can also capitalize larger repairs and then depreciate them over five or seven years. You can slow down depreciation by using straight line depreciation.
Another alternative is to take Section 179 on capital purchases if there's no other earned income. It will be disallowed, and it will carry forward to next year. You have to be careful on this one though because next year you can't decide how much Section 179 you're going to take. It's going to take an amount equal to the earned income on the tax return.
Also, if you have crop insurance you can delay crop insurance payments on 2020 losses until 2021 for federal tax purposes. Keep in mind that Pennsylvania doesn't allow this for state taxes.
Let’s look at the opposite side. For a farm that would benefit from a tax perspective in bringing income down, what do you recommend?
First pay any open accounts. That will save on taxes. Also, the interest charges on those open accounts is oftentimes the highest interest that the farmer pays, so there’s a two-fold benefit.
Secondly, prepay expenses. Especially consider prepaying things like feed on a livestock farm because you're going to use that feed right away in January, and you start getting those prepayment dollars back. Prepaying spring crop inputs is also good. As I mentioned previously, you can sometimes get some discounts on things like seed and lock in favorable prices on fertilizer.
You can use bonus depreciation and or Section 179 on qualifying capital purchases to bring income down. You can also defer crop insurance payments. In some cases, an IRA can be used to bring down federal tax.
Is there anything else you’d like to share with our listeners about taxes and tax planning?
We have been living most of our lives in a period of falling taxes. Ever since 1980 we've seen falling taxes rates starting with the Kemp Roth tax bill. In fact, even if you go back a little further, President Kennedy had some tax cuts in the 1960s. Our tax rates are at extremely low levels.
As my coworker Kenny Nearhoof pointed out in his podcast, $100,000 of income in 1980 was equivalent to $316,000 in 2020. However, in 1980 you had a 59% marginal tax rate. In 2020 we have a 24% tax rate. That is huge. Maybe it's time to pay some taxes before tax rates go back up.