Many producers’ initial reaction to tax planning is often simply tax avoidance. A common approach is, “I don’t want to pay any tax at all” or “I want to pay less than last year.” However, tax professionals often point out that the focus of tax planning shouldn’t be solely paying the minimal tax. It should be about paying the right amount of tax that maximizes tax benefits and minimizes tax over the long term.
So, what’s the “right amount?”
The answer: it depends. Good tax planning focuses on both the current year and long-term goals. There may be years when paying no tax is the best plan. But it is important to be aware of the potential implications of simply prepaying to defer tax liability. A reduction in available funds to prepay could dangerously deplete working capital and cause a higher-than-usual tax bill at a very inopportune time.
It’s also important to consider the consequences of taking on additional debt to finance tax deductions. Taking on more debt to finance equipment and deducting the assets being purchased could increase cash flow requirements and result in loan payments having to be paid off with after-tax money. This could increase tax in future years.
Adjusting for the “right amount”
Inevitably, businesses will need to report taxable income for personal or non-deductible withdrawals, to accumulate cash savings, and to permanently pay off debt from acquiring non-depreciable assets (land, personal residences, etc.).
That being said, agricultural producers and small businesses still have incredible flexibility to adjust their tax due from one year to the next. Some producers have flexibility when they sell their products and set payment terms. They can reduce income by investing in new equipment, building inventory, or prepaying for future expenses, among other options. This flexibility gives producers a great opportunity for tax planning rather than simply waiting until the following February or March to be surprised by a tax bill.
A proactive tax planning approach
During tax planning visits, I like to spend time with my clients discussing how they can build working capital, accumulate savings and pay down debt with “after-tax” money. In addition to the usual conversations, I like to discuss tax planning tools such as tax deferral techniques, maximizing tax brackets, using farm income averaging, creating long-term capital gain income and minimizing self-employment income, just to name a few options for producers. The discussion should focus on maximizing income and reducing the effective tax rate rather than simply reducing the total tax dollars.
As the end of 2019 nears, I challenge producers to take a multi-year approach and ask their tax advisors to help them develop a long-term tax strategy that will work for the continued success of their business.