As tax season draws near, there are some key messages to think about before even getting started, says Roger Betz, senior district Michigan State University Extension farm business management agent. Most importantly, avoid wide fluctuations in taxable income and think “over time.”
“A relatively uniform income from year to year results in the lowest income tax,” he says. “So, the goal for tax management is to get as much income through the tax system as possible at the lowest cost possible over time. You should try to keep taxable income down, but not get into trouble down the road.”
Betz also offers these five tax planning tips:
1. Don’t buy machinery to reduce taxes. Buy machinery that will make you more money and pay more taxes in the long run. “Too many farmers get caught up in short-term thinking,” Betz says.
2. Try to fill up “lower brackets” each year. For example, fill the top of the 12% bracket ($80,250 taxable income — married filing jointly) without too much jumping into the next bracket of 22%. Betz says this is good management as long as you can stay out of the next higher bracket of 24% in the next two or three years.
“If you jump into the 22% next year and you are at the top of the 12% this year, that is good management,” he says. “You delayed paying tax in the 22% bracket without going into the 24% bracket.”
The brackets are 10%, 12%, 22%, 24%, 32%, 35% and 37%. Taxable income is after the standard deduction of 24,800 MFJ.
3. Schedule F income. In the past, it was almost always wanted to have a positive Schedule F income. But with the newer rules of being able to depreciate the full value of machinery (and many other capital purchases), it is easy to have a low or negative Schedule F, Betz advises.
The trade-in value comes through on 4797 as depreciation recapture and is ordinary income but not subject to self-employment tax.
“You cannot carry a loss on Schedule F forward so any negative value is lost for future self-employment taxable income,” Betz says. “This newer tax law change needs to be considered in your long-term amount of ‘trade-ins’ per year. Too much in one year could cause a large Schedule F loss, but still have significant taxable income from the trade-in value. Properly spreading out this "off-farm" income could have a huge difference in the amount of [self-employment] taxes paid. Also, farmers need positive earned income to enable the deduction of health insurance on the 1040.”
4. Consider Schedule J (Income Tax Averaging). If you have an uncontrollable large income this year and lower bracket incomes in prior years, Betz says to consider moving income from this year and applying it evenly over the three prior tax years. Three years back from 2020 would include 2017.
“That's the year when we had higher tax brackets for basically the same income levels,” Betz says. “Most accountant’s software will not look at the benefit of going back to prior years and amending to income average using Schedule J each year. If you had low income back as far as 2014, you could amend 2017 to push back, then amend 2018 to push back and amend 2019 to push back, and make room to income average in 2020.”
5. Dairy considerations. Dairy farms and other farms with significant Schedule D income have incomes that do not show up as ordinary income, Betz says. The first $80,000 (MFJ) of income is free of federal income tax, and then is at 15% until $496,600 MFJ, and then it goes to 20%. “Farmers who have Schedule D income need to take this into consideration when considering the points above,” he says.
It's a special year
With the Coronavirus Food Assistance Program and CFAP II, many farmers received substantial payments, and they are taxable incomes on Schedule F. “Normal tax management strategies can be applied, including delayed sales and prebuying of inputs within certain limits,” Betz says.
However, the Payment Protection Program loan is not taxable income, and farmers can deduct normal expenses. “This has changed significantly over the past six months,” Betz says.
New or different this year
The section 179 (direct expense) deduction for capital purchases is $1,040,000 in 2020, with the phase out beginning at $2,590,000 of qualified property placed in service.
“Where capital purchases have been made, or can be made, study the depreciation alternatives carefully,” Betz says. “The direct expense deduction of up to $1,040,000 can be taken on current year capital purchases. Its use, however, cannot reduce your taxable income from farming [plus other earned income] below zero.”
Taxable income from farming includes net farm profit, plus gains on the sale of business assets such as breeding livestock.
The Qualified Business Income deduction — a 20% deduction of net profit from a sole proprietorship, partnership or S corporation (pass through of profits to taxpayers) — is available for businesses to go along with the constant 21% tax rate on C corporations. There are limits to this deduction for taxable income, Betz says, but most farms that pass through their profits should qualify.
“LLCs taxed as sole proprietorships, partnerships or S corporations are eligible for the QBI deduction,” he explains. “LLCs taxed as C corporations are not eligible since their tax rate is 21%.”
Estate tax redo?
The election of Joe Biden and a Democratic-controlled Congress will likely put many things back on the table, including possible changes to the estate tax.
“I’ve already had several calls this morning on estate planning and people concerned about the rules changing as they’ve been in flux regards to the estates. That may be the No. 1 issue that farmers are going to be talking about in 2021,” says Dario Arezzo, senior tax consultant for Farm Credit East.
The Tax Cuts and Jobs Act passed several years ago doubled the estate tax exemption to $11.18 million for singles and $22.36 million for married couples from 2018 to 2025. The exemption level is indexed for inflation, and there is a top tax rate of 40%.
From 2012 to 2017, the exemption ranged from $5.12 million to $5.49 million. But some proposals by lawmakers, he says, have called for dropping the exemption to $3.5 million per person.
“That’s a pretty big drastic decline, and so I’m going to say that as of right now, that will be the hot issue for 2021, is farmers moving and really looking at their estate plans because of the moving thresholds,” Arezzo says.
Other discounts providing farmers tax advantages will likely be back on the table, he says, including eliminating or modifying discounts for valuating assets.
"There were a lot of rules that got put on pause from an administrative estate standpoint that could really make estate planning even worse because some of the tools that estate planners use could come into play and make it a lot harder to take advantage of some of these discounts and valuation tools should that happen,” Arezzo says.
One important tax resource is The Farmer’s Tax Guide for use in preparing 2020 federal income tax returns. This resource is available now online.
This free guide, Internal Revenue Service publication 225, dated Oct. 15, 2020, provides a review of what’s new for 2020 and 2021 and important reminders. The IRS has created a page for information about recent developments affecting Publication 225 at IRS.gov/Pub225.
The Farmer’s Tax Guide explains how the federal tax laws apply to farming and can be used as a guide to figure taxes and complete the farm tax return. Forms and publications can be downloaded at irs.gov/forms/pubs.
Tax planning tips
Experts at GreenStone Farm Credit Services off the following tax planning tips:
Have your records in order. Having an accurate set of financial records is critical for a tax preparer to work with — preferably not a shoebox of receipts. A computer program or a worksheet that reconciles back to your bank and debt statements is best. This is generally the first step in good financial planning and a piece that should not be ignored. If this is not something you want to do, it may be best to hire a bookkeeper or accountant to assist you.
Get off autopilot. It is not uncommon to see businesses make financial decisions that they shouldn’t have made because books are not up to date. Examples include buying the same amount of prepaids as last year or making a capital expenditure because you had to last year, only to find out that neither were necessary because you were in a different position than a year ago.
Nothing is irrelevant. Make sure you tell your tax preparer about all equipment purchases. For instance, if equipment is dealer- or manufacturer-financed, it may not show up in your bank accounts if no payment was made in the tax year. That can be a sizeable capital expenditure your tax accountant won’t know about unless you tell them.
Meet with your tax accountant early. Meet to discuss your current financial situation and what tax bracket you will likely be in. Allow enough time to bring in additional income if facing a net operating loss, or to make additional purchases if your income is too high.
Going into your tax planning sessions well-prepared, and with the mindset that nothing is irrelevant, will help position you well for tax time.
Changes to PPP
The first round of the Paycheck Protection Program, passed as a result of the Coronavirus Aid, Relief and Economic Security Act, paid out $8.18 billion in loans to farming, forestry and hunting businesses, according to a December article by Farm Progress policy editor Jacqui Fatka. Dairy and miscellaneous crops got the most money.
A recent update to the program confirms what many farmers were likely wondering: PPP funds are now tax deductible regardless of when the loan is forgiven. So if you got a loan of $100,000 last year and haven’t gotten it forgiven, haven’t applied to get it forgiven, or you anticipate getting it forgiven soon, you can deduct it from your 2020 tax return.
An additional $284 billion in PPP funds are available through March 13. The sign-up period started Monday for applicants who didn’t get money from the first round. “Second draw” applications have started with community financial institutions, and soon all participating lenders will be able to process PPP loans, although the IRS hasn’t specified when this will open.
Be aware of changes
Arezzo says many agribusinesses and farmers might be hard-pressed to get more money through PPP the second time around.
That’s because if you want to apply for a second loan — up to $2 million — you must show at least a 25% reduction in gross receipts between comparable quarters of 2019 and 2020. Payments from the Coronavirus Food Assistance Program raised income for many farmers last year, Arezzo says, and that could reduce the number of farmers getting PPP help the second time around.
“I think for a lot of farmers, they might not be able to cross that threshold given the amount of CFAP infusion that was had,” he says.
But if you are eligible for a second PPP loan, or if you’re applying for your first loan, there are more things you can use the money for, including for the purchase of personal protective equipment, facility modifications and even property damage from public disturbances.
The PPP application also has been streamlined if you make less $150,000, making it simpler for smaller farms that want to apply for a loan.
The loan calculation for sole proprietors and farms without employees is also changing.
“What this bill did, it said that basically if you're a farmer and you had at least $100,000 of gross income, you can use the gross instead of the net, so if you're a farmer who got a PPP loan based on the lower profit reported in your taxes, you can go back and get more PPP,” Arezzo says.
If you got an Employee Retention Credit from the IRS, you can also get a PPP loan although you must use it for wages not paid using PPP.
And if you got an Economic Injury Disaster Loan, you’ll no longer have your PPP loan amount reduced.
"So there's a lot of changes all around, and that could cause some challenges to farmers right now filing their year-end 2020 payroll reports," Arezzo says.