October 20, 2022
Due to weather and rapidly changing market conditions, farm income can vary substantially from year to year. For many producers, 2021 and 2022 have been relatively strong net farm income years. Therefore, tax planning strategies will be relatively important.
First, however, recognize the distinction between average and marginal tax rates. The average tax rate is computed by dividing estimated taxes by taxable income. A taxpayer’s marginal tax rate is the rate of tax on the last dollar of taxable income.
The average tax rate is typically lower than the marginal tax rate because the marginal tax rate applies only to the part of taxable income in the highest applicable tax bracket. In general, tax planning reduces the taxpayer’s marginal tax rate, which will in turn reduce his or her average tax rate.
Tax planning strategies on the farm
High-income taxpayers can take advantage of tax provisions that defer income. Cash-basis taxpayers include income when it is actually or constructively received. You can defer income by deferring the sale of a commodity.
For example, if you harvested in October, you could defer income from part or all of this crop by selling part or all of it in January. Income from the portion of the crop sold in January would be 2023 income.
Another important tax strategy relates to timing of input purchases. Cash-basis taxpayers typically claim deductions when they pay expenses. A cash-basis taxpayer could reduce taxable income by prepaying certain expense items such as feed, seed, fertilizer or fuel. Note, however, that there are restrictions on prepaids, which are outlined in IRS Publication 225, known as The Farmer’s Tax Guide.
Individual retirement accounts and other retirement contributions are another way to defer reporting of income. You can claim a deduction for the contribution when made, and the amounts are not taxed until distributed later, such as upon retirement.
Using accelerated depreciation methods can also mitigate taxes in a high-income year. Accelerated depreciation methods include the Section 179 expense deduction and first-year additional depreciation. The Section 179 expense ceiling for 2022 is $1,080,000.
This means for 2022, you can deduct up to $1,080,000 of the acquisition of qualifying property. The Section 179 expense ceiling is reduced dollar for dollar when Section 179 property placed in service during the tax year exceeds $2,700,000. “Placed in service” means the property is ready and available for its specific use.
For the 2022 tax year, additional first-year depreciation, often referred to as bonus depreciation, is 100%. This means you are allowed to deduct 100% in the year the qualified property is placed in service. In general, new machinery and equipment, fences, grain bins, and single-purpose agricultural structures such as a swine finishing barn are eligible for accelerated depreciation.
The Section 179 expense deduction is particularly useful when a full expense deduction is not needed. Specifically, unlike additional first-year depreciation, the Section 179 deduction can be used to expense any part of a qualifying asset. You don’t have to expense the entire amount.
This is just a brief introduction to key tax planning strategies for a high-income year. More information can be obtained from IRS Publication 225. It’s also important to discuss these issues with your tax accountant.
Langemeier is a Purdue Extension ag economist and associate director of the Purdue Center for Commercial Agriculture.
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