In the last Tax Talks, “Tax Strategies for 2022: Understanding Your Tax Liability,” we began to understand the importance of record keeping and tax planning early in the year. In today’s blog, we’ll continue to build upon that foundation and understand what adjustments you can make to your tax liability.
Most farmers report their income and expenses on a cash basis, rather than accrual, which gives them a bit more flexibility when tax planning. For example, if you get a $10,000 load of feed delivered on 12/30/22 and you normally pay the bill 5 days later to get the cash discount on 1/4/23 then that $10,000 feed expense goes into 2023. However, if you write the check on 12/31/22 then it’s a 2022 expense. The same scenario holds true for income, if you send a cull cow to the auction on 12/30/22 but don’t get the check for her until January of 2023, then that income is reported in 2023.
Cash basis means income or expense is recognized on the date the cash is received or paid regardless of the date the item/product was sold or purchased. A word of caution, if your milk check is in your mailbox on December 30 and for tax planning reasons you decide not to deposit it until January 1, the IRS has a rule called constructive receipt, meaning if the cash is available to you on December 30 and you choose not to physically retrieve or deposit it until January 1, then it is still reported in the prior year when it was made available to you.
If you’ve determined through tax planning that you owe more in taxes than desired, here are some options that you have as a cash basis taxpayer to reduce the tax liability.
- Pay up any open/outstanding accounts that may have accumulated in past years due to cash flow constraints. This could be old feed bills, equipment repair bills, fertilizer, fuel, seed, etc. These open accounts usually have high interest rates associated with them so the quicker they’re paid up, the better.
- Review your operation for any deferred maintenance items on equipment and buildings. Getting production assets repaired will usually lead to longer life and more efficient operations. Be aware the repairs need to be completed and paid for prior to year-end to be deductible.
- Look at prepaying some farm expenses such as feed, fertilizer, seed, fuel, etc. prior to year-end. Farmers are usually able to secure significant discounts and lock in favorable prices by doing this which reduces operating costs. Given the current input prices and supply issues, however, proceed with caution here. Also, the IRS imposes a limit on prepaying expenses. Prepaid expenses cannot exceed 50% of all other Schedule F expenses with prepaid expenses excluded.
- Purchase equipment to replace items that are prone to high maintenance costs due to wear and tear or have become inefficient/obsolete due to age. Large purchases such as tractors or planters may be a challenge due to supply chain issues, so don’t wait until December to start looking. Per the IRS, to be eligible for current year depreciation the equipment must be on the farm and available for use. Be aware if you have a trade-in involved with the purchase, that will usually generate additional taxable income as you must treat the trade-in as if you sold the item for the trade-in value. Also be sure to get a copy of the invoice to your accountant along with the finance contract (if financed through a third party) so your accountant can document the trade-in and pick up the additional finance fees. For 2022 you can use the Section 179 deduction to direct expense up to $1,080,000 of equipment, single purpose livestock buildings, and land improvements, such as tiling, as long as total capital purchases of all these items is under $2,700,000 for the year.
- The Special Depreciation Allowance (SDA) is still available for 2022. You can use this method to direct expense 100% of capital purchases if you go over the $2,700,000 purchase threshold for using Section 179 or to direct expense items that Section 179 can’t be used on such as general-purpose machine sheds or a farm shop.
- Defer farm income out of 2022 by not selling cash crops, equipment, or livestock until 2023. Some milk coops will also let you defer some of your 2022 milk checks to 2023 but contact them early on as they may need time to process this request.
- A great way to manage tax liability while also preparing for retirement is to make contributions to a traditional deductible IRA. For 2022 individuals can contribute up to $6,000 to an IRA. If you’re over age 50 you can contribute an additional $1,000. You have until the due date of the return in April of 2023 to make the contribution.
Be aware of the debt considerations when making tax planning decisions. What works well in one year may set you up for a disaster in a following year. For example, if you borrow $40,000 on your line of credit in December 2022 to pre-pay your 2023 fertilizer, you’ll get the extra $40,000 of expense in 2022, but then you’re going to have to pay back the $40,000 in 2023 with no deduction. The same is true on equipment purchases. If you finance a tractor purchase for $50,000 over five years in 2022 and direct expense the whole $50,000 using Section 179 depreciation, you’re going to have principal payments on the tractor for the next five years with no offsetting depreciation expense. Thus, tax planning decisions should be made carefully with future impacts in mind.
The last tool in the toolbox for tax planning is using Schedule J, Farm Income Averaging. This schedule was put in place especially for farmers due to the extreme volatility in commodity prices they receive which can cause large swings in farm income. This is exactly what dairy and crop farmers are dealing with in 2022. Schedule J allows farmers to take farm income from the current year and average it over the previous three years. This allows farmers who may be in a 22% – 37% tax bracket in 2022 and carry it back to 2019, 2020, and 2021 where it may be taxed at only 10% or 12%. This is a powerful tool and can generate tax savings of $20,000 - $30,000 or more depending on the circumstances.
Bear in mind, the overall goal of tax planning is not to eliminate taxes but to understand what is generating the tax liability and adjust accordingly. Any successful business is going to pay some taxes at some point, the goal should be to minimize and manage the expense, no different than any other business expense. To do this you need an accurate and timely set of farm records and a tax advisor who is familiar with all tax benefits and tools available to a farming business.
Today's Tax Talk was contributed by Edward Maxwell, Tax Consultant, Farm Credit East
Farm Credit East is ready to talk tax planning for your business. Now may be a good time to get your recordkeeping in order and reach out to your relationship manager to see what can be done to manage the impact of 2022’s high input prices on your operation.