Farm Management - Managing Income Taxes

Types of Income Taxes

• Ordinary Income Tax

  • Applies to net farm profit plus other taxable income

  • Deductions include personal deductions, exemptions, and half of self-employment tax

  • Calculated as:
    \text{Taxable Income} = \text{Net Farm Profit} + \text{Other Income} - \text{Personal Deductions} - \text{Exemptions} - \frac{1}{2} \times \text{Self-Employment Tax}

  • Taxable income is multiplied by the ordinary income tax rate

• Capital Gains Tax

  • Tax on income from the sale of certain assets (capital gains)

  • Reported separately from ordinary income

  • Lower tax rate applied

  • Calculation:
    \text{Tax Due} = (\text{Capital Gains} - \text{Original Tax Basis}) \times \text{Capital Gains Tax Rate}

• Self-Employment Tax

  • Tax on income from self-employment activities

  • Includes Social Security and Medicare taxes

  • Calculation:
    \text{Self-Employment Tax} = \text{Net Farm Profit} \times \text{Self-Employment Tax Rate}

Objectives of Tax Management

• Maximize Long-Run After-Tax Profit

  • Continuous evaluation of decisions impact on taxes

  • Avoid payment of taxes not legally due

  • Postpone tax payments when possible

The Tax Year

• Most farmers use calendar year for tax accounting

• Option to use a fiscal year with IRS permission

• Filing schedules vary:

  • Returns due by March 1 if using the calendar year, or April 15 with estimated payment by January 15

Tax Accounting Methods

• Cash Method

  • Taxes applied when income received, expenses deducted when paid

  • No inventories included in taxable income

  • Advantages: Simplicity, flexibility, tax deferral from growing inventory

• Accrual Method

  • Income taxed when earned, deduct expenses when incurred

  • Includes inventories in taxable income

  • Advantages: Better income measurement, reduces income fluctuations, lowers taxes in declining inventories

Tax Record Requirements

• Complete and accurate records essential for tax management

• Records needed: receipts/expenses, depreciation schedules, capital item records

• Computerized accounting systems recommended

The Tax System and Tax Rates

• Federal taxes based on marginal rates which change annually

• Taxable income includes farm income and all other sources minus deductions

• Self-employment tax contributions for Social Security and Medicare

Personal Exemptions and Standard Deductions

• Standard Deductions:

  • 2015: $6,300 single, $12,600 married

  • 2018 & 2019: $12,000 single, $24,000 married filing jointly

• Personal exemptions eliminated in 2018 and 2019

Self-Employment Tax

• Subject to different brackets annually

• Additional 0.9% tax for high earnings

Capital Gains

• Gains from sales of qualified assets taxed at lower rates than ordinary income

• Important for cash-basis farmers dealing with livestock

Tax Management Strategies

• Form of Business Organization

• Income Leveling: Stabilizing taxable income

• Income Averaging: Averaging past tax returns for current taxable income

• Deferring Taxes: Flexibility in timing income and expenses

• Net Operating Loss (NOL): Offsetting income for up to 20 years

• Tax-Free Exchanges: Trading property to avoid capital gains taxes

Depreciation in Tax Management

• Non-cash, tax-deductible expense

• Calculated with the Modified Accelerated Cost Recovery System (MACRS)

• Allows for various recovery periods:

  • 3-year for breeding hogs

  • 5-year for vehicles, cattle

  • 7-year for machinery

  • 15-year for structures, 20-year for general purpose buildings

Summary

• Seek to maximize long-run after-tax income

• Use various tax management strategies to reduce tax liabilities and improve profit.