September 28, 2022
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 Dec. 30 and you normally pay the bill five days later to get the cash discount on Jan. 4, then that $10,000 feed expense goes into the next year. However, if you write the check on Dec. 31, then it’s a current-year expense.
The same scenario holds true for income. For example, if you send a cull cow to auction Dec. 30, but don’t get the check for her until January, then that income is reported in the next year.
Cash basis means that the income or expense is recognized on the date the cash is received or paid, regardless of the date the item or product was sold or purchased.
One exception to the cash-basis rule is cashing your milk check. If your milk check is in your mailbox on Dec. 30, and for tax planning reasons you decide not to deposit it until Jan. 1, the IRS has a rule called constructive receipt — meaning if the cash is available to you on Dec. 30 and you choose not to physically retrieve or deposit it until Jan. 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 any open or 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 that the repairs need to be completed and paid for before year-end to be deductible.
Prepay some farm expenses like feed, fertilizer, seed, fuel, etc., before 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, you should proceed with caution. 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 or 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 that 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 its 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 is still available for 2022. You can use this method to direct-expense 100% of capital purchases if you go over the $2.7 million purchase threshold for using Section 179, or to direct-expense items that Section 179 can’t be used on like general-purpose machine sheds or a farm shop.
You can defer farm income out of 2022 by not selling cash crops, equipment or livestock until 2023. Some milk co-ops 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 older than age 50, you can contribute an additional $1,000. You have until the due date of the return in April 2023 to make the contribution.
Be aware of the debt considerations when making tax planning decisions. What works well one year may set you up for disaster the following year. For example, if you borrow $40,000 on your line of credit in December 2022 to prepay 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 for equipment purchases. If you finance a tractor 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.
One last tool
The last tool in the toolbox for tax planning is using Schedule J, Farm Income Averaging. For farmers, this schedule can help deal with extreme volatility in commodity prices that 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 out over the previous three years. So if you are in the 22% to 37% tax bracket in 2022 and carry it back to 2019, 2020 and 2021, it may be taxed at only 10% or 12%. This is a great tool that can generate tax savings of $20,000 to $30,000 or more depending on the circumstances.
Remember that 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.
To do this you need an accurate and timely set of farm records, and a tax adviser who is familiar with all tax benefits and tools available to a farming business.
Maxwell is a tax consultant for Farm Credit East. This article originally ran in the organization’s Today’s Harvest blog.
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