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4-step process for tax planning

JJ Gouin/Getty Images Corn kernels and farm tax form
NEVER TOO EARLY: The official tax season is still months away, but now’s the time to get prepared.
Tax season is several months away, but it’s good to start planning now.

This year is shaping up to be a strange year for dairy producers.

Despite the unprecedented high prices for inputs such as feed, fertilizer and fuel, most dairy farmers will still be looking at a much higher taxable income because of strong milk prices that have persisted throughout the year. This makes tax planning crucial for farmers to avoid substantial liability when they have their 2022 taxes prepared.

Keep in mind, there’s nothing wrong with paying income taxes. In most cases, it’s a positive sign that you’re making money. But like any other business expense, you need to understand what’s driving the amount you owe, and how you can manage to minimize the “tax bite.” 

Keep good records 

You need to have a good record-keeping system to accurately detail your farm income and expenses. If you wait until the dark, cold months of January and February to do your books for the year when there isn’t much else going on, you’re not going to have the opportunity to accurately tax plan. 

Keeping books current throughout the year also helps ensure transactions are categorized correctly while they’re still fresh in your mind, instead of having to guess what they were months later.

Also, don’t rely on the premise that since there’s no money left in the farm’s checking account at the end of the year that you must not have a tax problem. Family living expenses such as groceries, personal home expenses, college tuition and more are not tax deductible.

Only interest paid on loans can be deducted as a business expense, not principal payments, so if you’ve used the extra income generated throughout the year to pay down debt, you could still have a tax issue even with no money left in your account.

Start planning now

For most of our clients, we like to get together in early to mid-November to tax plan. At this point, most of the major expenses for crop harvesting are done, and we only have to estimate the last two months of income and expenses.

This time frame can vary depending on the client and how involved the year-end plan will be. 

Certain tax strategies such as deferring milk income or major asset purchases may need to be implemented earlier to get the transaction completed by the end of the year.

It’s a process

Tax planning is usually a four-step process:

  1. determining what your current taxable income is to date
  2. projecting income and expenses through the end of the year
  3. calculating the tax liability on that income
  4. figuring out what adjustments you can make to your tax liability based on that outcome

For example, if you meet with your farm financial adviser in November and you determine that your Schedule F farm profit for 2022 will be $95,000, and raised cow sales will generate another $20,000 and you’ve got a $15,000 gain on a piece of equipment that was traded, that represents a taxable income of $130,000.

If you are filing a married-filing-jointly return and you had no other outside income to add, your federal tax liability would be about $20,440 on the farm income alone. This is your starting point to determine if the amount of tax owed ($20,440) is acceptable, or if you can adjust your income/expense before year-end to get your tax liability to a more desirable level.

In the example above, most of the tax liability ($18,640) is due to the Schedule F profit of $95,000, as you must pay both ordinary income tax and the additional self-employment tax of 15.3% on that amount.

The $20,000 of raised cow sales is capital gain income and since we’re in the 12% tax bracket, the tax rate is 0%, and the tax on the equipment gain of $15,000 is only $1,800. This tells us that we need to concentrate on managing the Schedule F profit to make any big difference in the tax owed.

Be flexible

Almost all farmers report their income and expenses on a cash basis, rather than accrual. This gives farmers a lot of flexibility when tax planning.

For example, if you get a $10,000 load of feed delivered on Dec. 30 and you normally pay the bill five days later to get the cash discount — on Jan. 4, 2023 — then that $10,000 feed expense goes into 2023. However, if you write the check on Dec. 31, then it’s a 2022 expense.

The same scenario holds true for income. If you send a cull cow to the auction on Dec. 30, but don’t get the check for her until January 2023, then that income is reported in 2023. 

Cash basis means income or expense that is recognized on the date the cash is received or paid regardless of the date the item or product was sold or purchased. A word of caution: If your milk check is in your mailbox on Dec. 30, and for tax planning reasons you decide not to deposit it until Jan. 1, the IRS has a rule called constructive receipt — meaning if the cash is available to you on Dec. 30 and you choose not to physically retrieve or deposit it until Jan. 1, then it is still reported in the prior year when it was made available to you.

Maxwell is a tax consultant for Farm Credit East. This article originally ran in the organization’s Today’s Harvest blog.

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