Tax Management: Taking Taxes into Account

Tax management is fundamental to good business management. Most farm managers want to minimize their income taxes while maximizing their after-tax income. To do this, you must understand the tax consequences of each of your business decisions, from planning investments and financing to managing income and expenses. You are constantly making choices that affect the amount of income tax you'll pay and the amount of cash you'll have left to operate your business. You do not have to be a tax expert, but you must be familiar enough to recognize how your decisions will affect your tax liability this year as well as in the future. And you must be able to recognize when to call in a tax consultant for advice.

As the manager of a modern farm business, you cannot afford to consider taxes only at year's end. You have too much capital at stake; and the more successful your business, the greater those stakes are. As your farm business grows, moving you into a higher tax bracket, the tax consequences of your business decisions have an ever greater impact On cash flow and net income.

Choosing an Accounting Method

When you file your first tax return, you choose whether to report on an accrual basis or a cash basis, but once you choose you must continue to use that method. Changing to the other system requires written consent from the Internal Revenue Service. (See Part III, Chapter 1 for an explanation of accrual accounting.)

Although neither method can provide the route to all of your goals, the cash method generally provides more flexibility in managing income. But because both income taxes and Social Security payments may increase year by year, sound management calls fora careful comparison of the costs and benefits under each method. If you believe you will increase your inventory and lower your tax bracket, the cash method will reduce taxes. If your inventory decreases, on the other hand, while your tax rate goes up, the accrual method is more desirable. The following examples illustrate how the two methods work:

Expenses. Suppose you charge $500 worth of feed and take the delivery on December 15, but the feed store does not bill you for it until January 2. Using the cash method, that purchase is deducted in January when the bill is paid. Using the accrual method, the $500 expense is deducted in December, when the cost is incurred or accrued. But because you are required to include your feed on hand in your year-end inventory, the added cost of the $500 purchase (recorded in your accounts payable) is offset by the increase in inventory.

Income. Suppose you raise calves during the year but do not sell any of them. Using the cash method you have earned no income. Using the accrual method you might have earned income if the value of the livestock increased during the year.

Leveling Income

The less your taxable income fluctuates from one year to the next, the less income tax you will pay over a period of years. In the short run, the timing of transactions can play an important role in balancing year-to-year income. If possible, maintain an annual net income at least equal to the year's allowable nonbusiness deductions and personal exemptions; at the same time, try to avoid extremely high taxable income in other tax years.

Reducing fluctuations in your income can help reduce tax rates for several reasons. First, the progressive tax rates cause income in high-income years to be taxed at a higher rate. Second, you cannot take advantage of yearly personal exemptions and deductions if there is not enough income for them to offset in the low-earning years. In 1989, you are allowed a personal exemption of $2,000 for yourself and for each of your dependents. In addition, you can either take a standard deduction $5,200 for joint taxpayers, $3,100 for single taxpayers and $2,600 for married taxpayers filing separate returns or you can itemize if your itemized deductions would exceed those amounts.

Some strategies for evening out your taxable income are:

1. Electing accelerated cost recovery depreciation the year you buy an eligible item.

2. Electing to write off or "expense" up to $10,000 of the cost of eligible newly purchased capital items.

3. Planning expenditures for minor repairs and improvements, small shop tools, and soil and water conservation expenses so they occur in years of high gross income.

4. Moving your annual bills such as property taxes into a year when income is high.

5. Planning sales of grain or other commodities to increase income in low years and decrease income in high years.

Strategies No. 1 through No. 3 can be employed by taxpayers using either cash or accrual accounting methods; strategies No. 4 and No. 5 apply only to cash method taxpayers.

Keeping good records throughout the year is the key to successful tax management. With up-to-date records you can determine your approximate taxable income at any time during the year. These records provide the basis for making sound business decisions.

If a preliminary check of your projected earnings and expenses indicates a high taxable income and you are a cash method taxpayer, you may decide either to delay additional sales until after the end of the year or to increase deductible expenditures before the end of the year. However, use caution before increasing expenses near the end of the year because there is a limit on the amount of prepaid farm expenses that can be deducted in one year. On the other hand, if it appears you will end up with low net income, you could speed up sales to count the earnings in the current year, or defer expenditures until the next year.

Deferring Taxes

Current tax regulations offer opportunities to defer payment of taxes, a strategy particularly useful for taxpayers whose income does not fluctuate widely. Deferring taxes leaves you more money to cover immediate expenses, builds your net worth, and provides money to expand your business.

There are two ways farmers can defer taxes. One way is to pay the current year's taxes on the following March 1, rather than paying estimated taxes on a quarterly basis throughout the year. The other way involves shifting income into a future year by trading assets.

Rather than selling one asset for a greater amount than its tax basis and buying another asset fora similar use, you can defer the taxes that would be due, as long as the "like-kind" exchange requirements are met. Suppose you are trading in an old tractor and buying a new combine. The adjusted tax basis of the tractor (the value on which you will be taxed) is added to the additional cash you paid for the combine, raising the combine's tax basis accordingly. Any gain you realize on the tractor and therefore any taxes you owe on that gain is deferred. Like-kind exchanges are especially important in real estate transactions. Many farmers who sell land and replace it with other property are shocked to learn that they could avoid income taxes on capital gains by arranging a like-kind trade instead of an outright sale.

Organizing the Business

The way your business is organized sole proprietorship, partnership,or corporation affects both how you file your taxes and how much you pay. As a sole proprietor, for example, you report your business income on your individual income tax return. The income of a partnership is reported on a partnership return, but the partners pay their share of income tax on their individual returns. A corporation reports income on a corporation return and also pays tax on the income. If the shareholders elect to be taxed as a small business corporation (an S corporation), however, the income is not taxed to the corporation, but is reported on the shareholders' individual returns. (See Part II, Chapter 11 on business structures.)

Corporate and Individual Taxes. Tax rates differ for corporations and individuals. Currently the Federal tax rates for individuals range from 15 percent to 33 percent. Corporate tax rates range from 15 percent to 34 percent. Corporate owners face the potential of double taxation they are required to pay individual taxes on any dividends they receive after the corporate taxes are paid.

Social Security Taxes. Another added tax burden small businesses incur is the Social Security tax. Since Social Security taxes range from 13.2 percent to 15.1 percent, essentially the same as the lowest income tax bracket, Social Security tax management is a concern. Farmers can influence the amount they pay to Social Security by how they structure their business. Sole proprietors, partners, and S corporation shareholders are treated as self-employed taxpayers. In 1989, these taxpayers paid a 13.02 percent rate on the first $48,000 of Schedule F earnings. In contrast, shareholders who work for the corporation are treated as corporate employees and tax is paid on their salaries. The employee's and employer's combined Social Security tax rate is 15.02 percent for salaries up to $48,000.

Self-employed farmers using cash accounting also can influence their Social Security earnings by producing certain goods that are exempt from Social Security taxes. Examples include breeding livestock and timber. Capital gains on land, buildings, and equipment are also exempt. Income from leasing a farm is not subject to Social Security taxes unless the landowner materially participates in the farm business.

Farmers need to carefully evaluate the extent to which they want to build Social Security benefits. Retired farmers reporting farm income, for example, continue to pay self-employment taxes, which can subject them to reduced retirement benefits. These farmers should consider their retirement goals and the Social Security consequences of their business arrangements.

The Big Picture

Remember, the object of tax management is not simply to minimize taxes. If you transact business solely to reduce taxes, you may actually lower your net income. Frequently, there is no conflict between a wise tax decision and a good business decision, but when you must make a choice, choose the strategy that leads to a larger net income. In other words, income taxes should be treated like any other cost of operating a farm. The objective of income tax planning is to maximize after-tax income. To do that effectively, keep taxes in mind as you conduct your daily business.

Philip E. Harris, Associate Professor of Agricultural Economics and Law, University of Wisconsin, Madison, WI, and; W. A. Tinsley, Professor of Agricultural Economics and Rural Sociology, Clemson University, Clemson, SC.