In the October 2004 issue of the Ag Manager, discussion of the tax management process started by emphasizing the need for up-to-date farm records prior to the end of the year. With up-to-date records as of the end of September or October, the manager can then make estimates of income and expenses for the remainder of the year and make comparisons of the projected 2004 net farm income to the net income of previous years. The over-all goal of income tax management is not to minimize tax liability, but to avoid large swings in net income from one year to the next, e.g., being in the 35% tax bracket one year, showing a net operating loss the second year and then bouncing back into the 15% bracket the third year. Large swings in taxable income means more income tax will be paid over time due to the progressive tax rates, but less total tax will be paid if net income is leveled out over time.
When the estimate of the 2004 net farm income has been compared with the net income of previous years, one of three tax management strategies can be decided upon. One strategy is to increase net income by reducing planned expenses and/or generating more income, a second strategy is to decrease net income by increasing planned expenses and/or reducing income while a third strategy is to do nothing and continue as planned for the remainder of the year.
To increase taxable income consider increasing grain and livestock sales, but make sure any increased sales are in line with any marketing plans. Collect any money that might be owed. To reduce expenses delay purchases of inputs until after January 1, postpone capital purchases that are not absolutely necessary and use slower depreciation methods for assets placed in service during 2004.
If 2004 has been a good year and net income is projected to be up significantly, consider postponing grain and livestock sales, but again make sure these are sound marketing decisions. Use qualified deferred payment contracts so grain can be delivered and the payment postponed until after January 1. Pre-pay expenses for 2005, but make sure prepayments are for specific products, quantities and prices so the payments are not considered to be deposits. Pay interest on outstanding loans up-to-date by the end of the year. Additional capital purchases may be advisable, but don’t buy depreciable assets just because more depreciation is needed. Use accelerated depreciation methods and/or the section 179 expensing election for assets placed in service during 2004.
Regardless of the tax management strategy chosen, the manager should estimate the income and self-employment tax that will be due March 1 (or April 15) and begin making plans on where the money will come from to pay that liability. There are not many surprises worse than having the tax return completed two days before the deadline and not knowing where the money will come from to pay the taxes.
For 2004 the standard deduction is $9,700 for taxpayers that are married filing jointly (MFJ) and $4,850 for single filers. The 2004 personal exemption is $3,100 for each exemption. A younger couple with two children will have to have taxable income of $22,100 before income tax is due, an older couple with no children will have to have $15,900 before any income tax is due while the single filer would need taxable income of $7,950 before income tax is due. Although no income tax is due for these example taxpayers, if those taxable income amounts are all from farming, their respective SE tax liabilities would be $3,123, $2,247 and $1,123. SE tax is due on all net profits once those profits exceed $400. It is estimated that 70-75% of the over-all tax bill for the average self employed person is for SE tax, the remainder being income tax liability.
For MFJ taxpayers, the first $14,300 of taxable income is taxed at 10%, the next $43,800 is taxed at 15% and the next $59,150 is taxed at 25%. For single taxpayers, the first $7,150 of taxable income is taxed at 10%, the next $21,900 at 15% and the next $41,300 at 25%.
However, year-end tax management is not without its dilemmas. Having cash (or interest free credit) available to use for buying next year’s inputs always make tax management easier, but don’t tie up all available cash purchasing inputs and not have any cash available to pay the tax bill. Interest paid on borrowed money to purchase inputs is deductible while interest on money borrowed to pay income taxes is not deductible. And always make sure the interest paid is less than the taxes saved, otherwise it may not be such a good deal. If there is extra cash available at year’s end another consideration (or dilemma) is to make additional payments on outstanding loans starting with the shortest term and/or highest cost loans first. Although this strategy won’t cut your tax bill since the extra principal payment(s) is not deductible, it will make your operation more financially sound.
The overall goal of tax management is to avoid large swings in net income, not to minimize tax liability. Records and estimates are critical to determining and implementing the appropriate tax management strategy by December 31. Finally, it is important to estimate the tax liability so cash will be available by the due date of the tax return. Seek the help of a tax professional if necessary to complete this process. The goal of this process is to make well-informed tax management decisions