Many years ago when I began really studying sound business principles, I was shocked to learn taxes are one of the largest expenses for profitable businesses.
I'm not shocked anymore, but I'm surprised how little time people spend really planning to legally reduce their tax burdens. In the business world, this is called tax planning. It does not actually include rushing out and spending money you don't need to spend on a new tractor at the end of the year. It does actually include working to move as much taxable income from regular income on a Schedule F or a W-2 to the IRS Form 4797 so you can pay capital gains tax, thereby saving significant amounts of money.
It also could include prepaying expenses into the next year if you expect lower income. It may include planning your depreciation schedules so they are most advantageous to your profit flow. It could also include using Schedule 1031 "like kind exchange" to sell one property and buy another to defer capital gains tax.
The all-important key, however, is to make a profit and in fact to make as much profit as possible. This is where managerial accounting, budgeting, gross margin analysis and alternative production ideas come into play. The difficult thing, I believe, is to blend good tax planning into your management plan. Here is an example:
Lately I've been talking with rancher Wally Olson of Claremore about how to do exactly this sort of thing using some of his ideas for the no-depreciation cow-calf operation, with either purchased or raised heifers as the supply stream for these management concepts. I was pondering the difference in tax treatment between purchased and raised breeding stock and so started digging through IRS's Farmer's Tax Guide. Taxes on livestock can be confusing, but generally I found that purchased breeding stock must be held two years before you could potentially claim any amount of capital gains taxation (on Form 4797). Purchased livestock is also depreciable. More on this below.
Raised livestock, on the other hand, does not necessarily need to be held two years as long as they are kept for breeding. Also, they are not tax-depreciable. This seemed quite interesting to me so I asked Olson about his experience with the two things. He immediately said we should talk to his accountant, Walter Lynn of Illinois. I have known Lynn for quite a few years and so Olson set up a conference call and we talked.
I'm going to share with you a summary of what we discussed, but understand this is NOT tax advice for you to accept and use personally. I'm sharing ideas here, not passing along ironclad tax advice. I will have consultations with my own accountant before making any assumptions or plans, and you should too. Got it?
Generally, in our teleconference the other day we came to the loose conclusion that if raising my own heifers -- cheaply and profitably -- is an option, there should be tax advantages over purchasing heifers. Purchased heifers would be depreciated (which of course can offer advantages). The heifers would be either exposed to a bull and then selected based on who got pregnant, or if bought as bred animals they would be calved and then the less-desirable ones sold. Arguably, heifer calves of the favorable early-bred heifer mommas would be kept as raised breeding stock.
One question I had been asking myself is whether, at least from a tax standpoint, I would be better off to keep buying bred cows and/or bred heifers, or to breed my own. There are many pros and cons, but one of the money-management questions I have been pondering is about money turnover. For example I can buy a bred cow or bred heifer, calve her, then sell her fairly soon as either a bred cow, an open cow separate from her calf, or as a pair. Then I would reinvest.
Lynn suggested on purchased stock I would use my purchase price, minus depreciation, to create a taxable basis. If I sold the cow in less than two years for a profit, all the profit between the depreciated basis and the sale price would be ordinary income. In my tax bracket I believe this would be 35% or higher and would include what is commonly known as self-employment tax but in reality is social security taxation. That is a pretty big hit.
If I kept the purchased bred heifer or cow for two years or longer before I sold her, however, it appears I would pay self-employment tax on the difference between the depreciated basis and the original purchase price. Then anything above that would go onto Form 4797 for capital gains treatment, which would be 15% or less. Lynn tells me the new capital gains tax levels are somewhat variable, depending on your tax bracket.
In the third example that's been on my mind, if I kept every heifer every year and turned over my cows quickly, potentially selling them at peak value, all my breeding eligible stock should be taxed at capital gains rate. This should include the heifers I exposed to the bull but which did not get pregnant and therefore sold.
The farmer's tax guide gives this example: "You are in the business of raising registered cattle for sale to others for use as breeding cattle. The business practice is to breed the cattle before sale to establish their fitness as registered breeding cattle. Your use of the young cattle for breeding purposes is ordinary and necessary for selling them as registered breeding cattle. Such use does not demonstrate that you are holding the cattle for breeding purposes. However, those cattle you held as additions or replacements to your own breeding herd to produce calves are considered to be held for breeding purposes, even though they may not actually have produced calves."
This all said to me that the tax advantages from producing my own heifers under a low-cost grazing system could offer the greatest tax advantage, assuming the rest of the system is financially gainful.
This is my early attempts trying to interpret and blend the best of tax accounting and managerial accounting.
Note, too, that setting up a business structure such as a corporation or sub-S corporation will introduce another set of complexities, but perhaps more advantages through ability to separate salary or salaries to yourself from retained earnings, which should involve variable tax liabilities.
Just remember tax law is literally a minefield. You should have the best accounting help to navigate it and to plan your way through it in a manner that helps you keep as much of your wealth as possible in your own pocket.