Today’s farm situation reminds me of the Bible story about Joseph interpreting Pharaoh’s dream. Pharaoh had a dream of seven lean cattle eating seven fat cattle. He tried to get his magicians to interpret the dream, but only Joseph was able to tell Pharaoh that the seven fat cattle represented seven years of good crops, which would be followed by seven lean cattle representing seven years of famine. Joseph’s advice to the Pharaoh was to store up seven years of good crops so Egypt could get through the lean years.
You might ask how this applies 4,000 years later in 2013. Farmers have had at least seven good years, and my concern is whether they have been storing up the good crops to get them through perhaps seven years of lean crops.
Have you built working capital by saving extra income generated during the past seven years? Or have you depleted working capital by purchasing long-term assets, such as equipment or land, that aren’t easily converted to working capital when needed? Or have you distributed working capital from your farm to fund what I call the assets covered in the old Steve Martin movie, "Trains, Planes and Automobiles?" A trend that we have noticed is the expanding lifestyle creep of many farmers during the last few years.
Once your lifestyle budget is set, it’s extremely difficult to reduce this budget in lean years. Many studies indicate that most farmers take out at least $100,000 for personal consumption, and in many cases, $200,000 or more. When times are good, these expenditures are generally easy to cover. However, what happens if lean times come and the farm only generates operating income of $100,000 and your lifestyle costs are $150,000? Can you trim these expenditures to $100,000, or will it be extremely painful?
The rapid buildup of gigantic deferred tax liabilities might bite some farmers in lean years. As I have stated in previous columns, I believe farmers have a genetic chip built into them at birth about aversion to income taxes.
However, deferring too much income tax in good years can result in compounded tax pain during lean years. For example, let’s assume a farmer purchased $500,000 of equipment, which was fully depreciated, during the good times. He also continues to roll an extra $500,000 of grain sales. Then, lean times hit, and his banker requires him to sell the equipment and grain to pay down the operating line that ballooned with $3 to $4 corn. Even though the farm might be in the red from an accrual basis, he has to pay income taxes on $1 million from equipment and grain sales. This removes another $500,000 of cash from his farm when he can least afford it.
Plan for Excess. With the very low interest rate environment, now is the time to fix your financial structure. If your working capital divided by annual costs is lower than 20% to 30%, do you have excess liquidity in your land or equipment that you can tap at very low interest rates? This frees up extra cash to put into working capital to get you through the lean years. Remember, this excess cash is not for toys and lifestyle, but for operations.
One last thought for our young farmers who are aggressively growing their operations: to quote Warren Buffett, "You never know who is swimming naked until the tide goes out." Have you stress-tested your farm to make sure you are not "naked" when the seven lean years come? Have you built up sufficient working capital that will help you get through a few years of $4 corn? The parental bank might not be there to bail you out.
In closing, most crop farmers have enjoyed several good years. Let’s make sure that these years can cover any lean years that might be headed our way. I was around for the 1980s; let’s not repeat those mistakes.
Paul Neiffer is a tax accountant with CliftonLarsonAllen and author of the blog, The Farm CPA. He grew up on a wheat farm in Washington and owns a corn and soybean farm in Missouri. Contact him at paul.neiffer@CLAconnect.com.