EAST LANSING, Mich. — One of the only certain things in farming is that the income tax deadline will come every year. Between federal and state income taxes and self-employment tax, prospects of a large tax bill can feel overwhelming. Year-end tax planning can address this concern and is an essential tool for farm financial management.
We tend to think that tax planning is only necessary in good years. However, a better tax planning strategy is to maintain consistent taxable income across years. This minimizes taxes owed over a longer span of years. Thus, farmers can benefit from tax planning in moderate and poor years too.
Tax planning when net farm income is high
Most tax planning occurs in years where income is high to avoid a large tax liability. In general, there are three major strategies for tax management when net farm income is high: deferring income, prepaying expenses and taking accelerated depreciation.
Deferring income commonly refers to carrying over crops or livestock for sale to the next year. Remember that income is recognized when funds are available to your farm, not when the check is cashed. A deferred sale is also effective as long as a contract states that payment will occur in the next year. In addition, some insurance claims can be deferred.
Prepaying expenses not only increases cash expenses in this year but may also allow discounts on next year’s inputs. Remember that expenses can only be recognized when payment is extended to a vendor. Purchases made on account are not deductible.
Taking accelerated depreciation refers to using section 179 and bonus depreciation methods. These depreciation options allow many asset purchases to be depreciated entirely or in large part for the current tax year. In high income years, farmers often want to heavily rely on accelerated depreciation to reduce taxable income. However, while accelerated depreciation can significantly increase current year expenses, relying too heavily on it can leave you with a large tax liability on top of debt payments in future years.
Tax planning when net farm income is low
Tax planning can also be advantageous in low income years. Planning helps to maintain a stable taxable income over time and avoid tax losses that have limited long-term benefit. Taxable income can be boosted by increasing farm income and/or decreasing expenses, as well as taking advantage of nonfarm tax provisions.
The most common way to increase income is to sell farm products that may otherwise have been carried over to next year. Recognizing all insurance claim payments instead of deferring them may provide an opportunity to manage income as well.
Deferring common bills, such as insurance premiums, rent or interest until after the first of next year can reduce the current year expenses. Since expenses are only recognized when a vendor is paid, you might also choose to buy inputs on vendor account. Reducing prepaid expenses is another option, although you need to consider how this offsets purchases that take advantage of available discounts.
Although it does not impact self-employment income, a low income year may also be an opportunity to convert traditional IRA funds to a Roth IRA. If negative or extremely low self-employment income is unavoidable, you or your spouse may still want to pay enough to gain credits for social security.
Tax planning when net farm income is moderate
Maintaining a level taxable income is often a wise long term tax management strategy. Your tax preparer can help you plan a target net farm income to maintain consistent total tax liability. You can also use a combination of available options to reach that target.
The primary tools in year-end tax planning are income timing, increasing or decreasing expenses and managing depreciation. Crop and livestock sales may be most effective to manage an increase or decrease of income. Managing expenses should first be done with cash options. Prepaying expenses during a production year can allow you to reach a target balance of income and expenses. Accelerated depreciation can provide flexibility, allowing assets to be purchased when they are most advantageous to your overall financial condition.
Even after year end, a few tools exist to further refine your tax liability. Contributions to personal IRAs and health savings accounts (HSAs) are not due until the April tax deadline. Depreciation decisions can also be made when preparing the tax return. In addition, farm income averaging is a tool that your tax preparer can use to reduce federal income tax.
Although year-end tax planning takes some effort, it is an important tool to reduce your long-term tax liability. Work with your tax preparer to develop a plan that is right for your farm. More information about farm income taxes can be found at the IRS website. Additional tax planning information is available from the MSU TelFarm Center. You can also contact your Michigan State University Extension Farm Business Management Educator with questions.
— Corey Clark, Michigan State University Extension