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December 2013 Archive for The Farm CPA

RSS By: Paul Neiffer, Top Producer

Paul is now part of the fourth generation in America that is involved in farming and hopes the next generation will be involved also. Through his blog he provides analysis and insight to farmer tax questions.

Some Quick Year-End Tax Tips

Dec 24, 2013

Since it is Christmas the day after tomorrow, I am simply going to give you some quick year-end tax tips. But first, Merry Christmas to all of our readers. I now have three sons living in the Los Angeles area, so my wife, youngest son and I are headed down Christmas day to spend the holidays with them. Although today was unseasonably warm at 60 degrees, I think the weather will be warmer down there than here. Now for some tax tips:

  • Make sure to pay your kids. If you are a schedule F farmer with children under age 18, make sure to pay them what they really earned this year. Children with no other income can earn about $6,000 this year tax-free (some states may require a little bit of tax) and the wages paid are completely deductible and even better, no payroll taxes are owed. Also, the child can take those earnings and contribute to a Roth account. If they put in $5,000 into an Roth IRA at age 17 and let it compound for 48 years until age 65, they will have about $80,000. That is just for one payment of $5,000.
  • If you do not itemize and plan on giving money to your church or other charity at year-end, consider giving a commodity gift instead. This helps reduce your taxable income (you are still allowed the standard deduction) and reduces your self-employment tax burden (if a schedule F farmer or partner).
  • On a similar vein, consider gifting grain to your child. You reduce your self-employment tax and if they hold the grain for at least a year after harvest will qualify for long-term capital gains treatment. If you make this gift, make sure to gift a prior year crop, not the current year crop.
  • If you are over 70 1/2 or over and have not taken out your required minimum distribution from your IRA, consider making a direct gift to a charity. This can save taxes by reducing your adjusted gross income and in no case will it increase your tax. The maximum amount allowed is $100,000.
  • Consider selling some grain on a deferred payment contract. This gives you flexibility after year-end if you need to bring income into 2013.
  • Remember that prepaid expenses must be for a specific quantity of a specific product. If your prepaid simply shows "deposit", have your input company give you a correct invoice reflecting what was actually purchased (assuming you did make a correct prepayment).
  • Section 179 is scheduled to drop to $25,000 next year. There is a good chance this will be higher, but we may not know until after the mid-term elections. If you need to upgrade equipment, purchase it this year.
  • Review your tax for 2012 to determine if it makes sense to pay an estimated tax payment on January 15 and pay the remainder on April 15, 2014. This may be better than filing and paying all tax owed on March 1.

These are just some quick year-end tax tips. Most have been discussed in previous posts, but just wanted to remind you of certain things to do before year-end. You can always search the blog to read up on these tips in more detail.

Again, Merry Christmas to everyone!

Tax Filing Begins January 31, 2014

Dec 18, 2013

The IRS announced in Notice 2013-100 that the official start of the filing season for 2013 tax returns will begin on January 31. This is one day later than for 2012 tax returns. The 2012 tax season filing delay was due to the many changes brought about by the tax law signed into law on January 1, 2013. This required the IRS to completely revamp their computer system to allow for filing to begin.

Quoting the notice:

"The government closure meant the IRS had to change the original opening date from Jan. 21 to Jan. 31, 2014. The 2014 date is one day later than the 2013 filing season opening, which started on Jan. 30, 2013, following January tax law changes made by Congress on Jan. 1 under the American Taxpayer Relief Act (ATRA). The extensive set of ATRA tax changes affected many 2012 tax returns, which led to the late January opening."

Somehow the shutdown on the government for 16 days in October (a full two months before January 1) caused the IRS to delay the beginning filing date by at least one day. We are certain that politics did not a role in this extra delay (well, maybe a little).

We will keep you posted if there are any more delays. Last year's delay was much worse than a January 30 start date. Most farmers could not file until after March 1.

Speaking of March 1, most farmers always file and pay by that date. However, if your tax bill for 2012 was very low and you expect a large tax bill for 2013, it may make sense to make a January 15 estimate payment and then pay the remainder on April 15. For example:

Assume your 2012 total tax owed was $1,200. For 2013, you expect to owe $125,000. Your required farm tax estimated payment due on January 15, 2014 is only $1,200 (lesser of 100% of 2012 tax owed or 66.67% of 2013 tax liability). You now have until April 15, 2014 to pay the remaining $123,800 without owing any interest on the funds. Or you can pay the full $125,000 and file by March 1. Paying interest @ 3% on $1,200 for 90 days costs you about $9. Paying interest on $125,000 from March 1 to April 15 costs you about $462. Which would you rather do?

How Many Tax Brackets for 2013?

Dec 16, 2013

I made a bet with my wife the other day that there was at least 30 tax brackets for 2013. Now my wife really does not care how many tax brackets there are and she knew I was teasing her about this, but for 2013, there is probably at least 60 or more tax brackets for the year depending on how many personal exemptions you have.

Under 2012 law, there were essentially 6 tax brackets, 10%, 15%, 25%, 28%, 33% and 35%. Now, for 2013, we have these same brackets plus the 39.6% new top bracket. In addition, if your income exceeds a certain level ($300,000 for married couples) 3% of your itemized deductions will now be phased out. This now adds another 7 tax brackets.

The phase-out of your personal exemptions is what really adds more tax brackets. Each exemption is phased-out by 2.5% for each dollar in excess of these same thresholds. Therefore, as you add kids, your marginal ordinary tax rate goes up. I worked up this handy little table based upon a married couple with a family of four:

    Tax Bracket
Normal   10.0% 15.0% 25.0% 28.0% 33.0% 35.0% 39.6%
I/D Phaseout   10.3% 15.5% 25.8% 28.8% 34.0% 36.1% 40.8%
Exemptons 1 10.3% 15.5% 25.8% 28.9% 34.0% 35.0% 39.6%
Exemptons 2 10.6% 16.0% 26.6% 29.8% 35.1% 35.0% 39.6%
Exemptons 3 11.0% 16.5% 27.4% 30.7% 36.2% 35.0% 39.6%
Exemptons 4 11.3% 17.0% 28.3% 31.7% 37.4% 35.0% 39.6%
Exemptons 5 11.7% 17.6% 29.3% 32.8% 38.7% 35.0% 39.6%
Exemptons 6 12.1% 18.2% 30.3% 33.9% 40.0% 35.0% 39.6%

 

As you can see, based on a married couple with four children, there are now actually at least 44 different tax brackets. The Itemized Deduction phase-out bracket and the phase-out for one personal exemption are actually not the same %. The itemized deduction is phased out by 3% for 2013 while the exemption is phased-out by 3.12%, but when this is rounded in the table, they both show as 3%. If we combine the 3% itemized deduction phase-out plus each exemption phase-out, we would probably have another 40 or so tax brackets.

Another unique feature of the exemption phase-out is the 33% tax bracket will be higher than the 39.6% tax bracket when you have 4 or more children. As you can see from the table, with 4 kids (6 exemptions), your marginal tax rate is 40%, whereas, the 39.6% tax bracket remains constant. This is due to all personal exemptions being phased-out before the top bracket kicks in. Also, I am not even counting all the different capital gains tax brackets.

So, as we always say when someone asks us a tax question "It Depends!". This year, the answer will be even more relevent when someone asks us what their tax bracket is.

Is It Time for an IC-DISC

Dec 11, 2013

Many farmers or groups of farmers are starting to earn a greater percentage of their income from sale of products directly for exports. If this applies to your farm operation and the amount of foreign exports is greater than $1 million, then you should consider forming an interest charge - domestic international sales corporation (IC-DISC). This is not a type of Frisbee, but a very efficient way of permanently reducing your income tax burden, assuming you meet the criteria.

Essentially, the IC-DISC is a C corporation that earns a commission from your farm operation related to your foreign sales. The amount of commission is the greater of 1) 4% of your farm's gross receipts from qualified exports, or 2) 50% of your farm's net income from qualified exports. Usually most companies use #1 since it is much easier to compute.

The commission paid to the IC-DISC by your farm is deductible, whereas the commission earned by the IC-DISC is non-taxable. This almost sounds too good to be true and there is one more catch. If you leave the money in the IC-DISC it is tax-free, however, most farmers want their money. Therefore, when the funds are paid from the IC-DISC to the farmer, it is treated as a dividend. If you are in the highest tax bracket, this will be taxed at most likely 23.8%.

However, the permanent tax benefit relates to your farm operation being in the highest income tax rate of 39.6% and the dividend only being taxed at 23.8%. Let's look at a couple of examples:

Farmer Bean sells non-GMO beans to Japan. His direct foreign sales average about $4 million each year and he is in the highest individual tax bracket. He creates an IC-DISC and during the year pays a commission of $160,000 to the IC-DISC. He deducts this commission on his tax return saving $63,360. However, he also pays out a dividend of $160,000 that is taxed at 23.8% or $38,080. He has permanently saved $25,280 (his tax savings maybe even higher if he is self-employed). His cost for preparing the tax return and the related paperwork should be less than $5,000 each year.

Let's assume that Farmer Bean is in a lower tax bracket and normally has about $125,000 of net farm income to be reported each year. This results in him paying about $30,000 a year of self-employment and income taxes. If he forms the IC-DISC and let's assume the IC-DISC commission is exactly $125,000. This results in his Schedule F income now be zero, however, he has a dividend of $125,000. Dividend income in lower tax brackets is taxed as zero. If Farmer Bean is married, it is likely that about $100,000 of this dividend would be taxed at zero and the remainder at 15% or about $4,000 of income tax. Even though Farmer Bean is in a lower tax bracket, he ends up saving about $25,000 which is about the same as being in a high income tax bracket.

To set up an IC-DISC requires someone who is qualified to set these up and help you manage them. Once they are created, in many cases, there will only be about five or so transactions a year that flow through them. The commission coming in, the dividends going out and the administration fees to prepare the tax return and related services.

If you have large foreign sales, make sure to discuss an IC-DISC with your tax advisor.

What Crop Insurance Level Should I Get for 2014?

Dec 10, 2013

Crop insurance is a risk management tool for farmers. Over the last couple of years it has, in many cases, paid off in substantial claims based primarily on the high spring or fall price. The University of Illinois just released a projection of the crop insurance premiums for productive soil in that state. Although large claims have been paid out recently, they are projecting a small decrease in corn premiums. This is primarily due to the projected spring price of $4.60 instead of $5.65 for this year.

Based on a Trend APH of 187 bpa, the estimated premiums from 70% coverage to 85% coverage are as follows:

  • 70% - $3.65
  • 75% - $6.12
  • 80% - $12.47
  • 85% - $24.41

 

This results in a guaranteed revenue base of $602 at 70% rising by $43 for each 5% increase to a final number of $731. The premium increase from 70% to 75% is only $2.47 whereas the increase from 80% to 85% is almost a full $10. On the face of it, the 85% coverage level seems to be much more expensive. However, you must determine the expected probability of having claim at each coverage level. For example, at the 85% coverage level, you might expect a full claim (from the 80% to 85% level) approximately 55-65% of the time. At the 70% level, your expectation for a claim might drop to only 10-20% of the time.

Therefore, you must run your numbers to determine your expected claim amount and then divide that by the marginal amount of extra premium to arrive at your expected return. When you perform these calculations, you may find that the 85% coverage level costs about the same as the 75% or less coverage. Also, for 2014 if prices stay low, it is even more important that farmers truly lock in their cash input costs. This may lead you to getting the highest coverage possible and if prices rally back to the $5.65 range, you may even get a bonus.

Every farmer's situation is different, but the key is that you cannot just look at the difference in premium, you must determine your "expected" yield versus the extra cost.

How $12,000 Becomes $6,000 or less

Dec 09, 2013

As corn prices continue to range near multi-year lows and the expectations for increases in interest rates start to perk up (taper anyone), the value of farmland may start to reverse their strong decade or longer advance.  For example, assume we have a farmland owner in Northern Iowa who has 190+ bushel acre corn ground.  Last year, his neighbor's quarter section sold for $12,000 per acre.  Top cash rent ground in the area was going for close to $400 per acre.  Over time, about 1/3 of revenues related to farmland is usually earned by the landlord. 

In this case, 190+ bushel corn at $6 per bushel (2012 prices) would equal about $1,200 of revenue.  $400 cash rent is 1/3 of this number, so the actual cash rent earned on the investment is about right.

Since the person purchasing the property could only earn less than a 1% return on their money in a risk-free investments (savings at the bank, US Treasury bills), they were OK with a 3-4% rate of return on their farmland purchase.  Cash rents of $400 less real estate taxes of about $15 per acre resulted in net cash rent income of $385.  This results in a 3.2% rate of return.  Again, within the range the investor needs.

Now, let's go forward a few years.  Corn prices have stayed in the $3.75 to $4.25 range while yields have increased to about 200 bushels per acre.  This results in about $850 of gross income on average.  Cash rents at 35% drops the cash return to the investor from a net of $385 to about $280.  The elimination of "tapering" by the Federal Reserve has now increased long-term interest rates from an artificially low 2-3% to the more normal 5-6%.  This results in our investor requiring a 5% rate of return on their farmland investment.

His farmland now has a value of $280 divided by 5% or $5,600.  Therefore, a farmland investor using a rational analysis of income and yield would now drop their purchase price from $12,000 to $6,000.  I am not stating this will happen, however, if this fact pattern (or similar facts) occur for enough years in a row, I can almost guarantee this will happen.  The key question for farmers anticipating purchasing ground for $12,000 under current conditions is how stressful to their farm operation is this same farmland when revenues are lower and interest rates are higher?

IRS Almosts Eliminates the 1/2 cent

Dec 06, 2013

The IRS just announced the standard mileage rates for 2014. They are as follows:

  • Business Mileage - 56 cents per mile
  • Charity Mileage - 14 cents per mile
  • Medical Mileage - 23.5 cents per mile

 

The nice thing is that they finally eliminated the 1/2 per mile for business miles, but did retain it for medical mileage. The rate for business mileage in 2013 had been 56.5 cents per mile, so this is a drop of .5 cents per mile. Also, for purposes of calculating the depreciation portion of the mileage rate, this dropped from 23 cents per mile to 22 cents per mile.

2014 Cash Rents Equals Negative Returns For Farmers

Dec 05, 2013

In a post from the University of Illinois today, they essentially said that based on current crop prices, farmers who are cash renting ground in Illinois will either make about $10 per acre or in the case of Southern Illinois farmers lose about $30 per acre.

These numbers are for the averages. In areas where high cash rents are projected, the loss per acre will range from about $45 in Central Illinois to over $100 in Southern Illinois. Farmers have enjoyed several good years (assuming adequate crop insurance coverage), however, unless crop prices rise a $1 or so for corn and couple of dollars for beans, not much profit will be there for cash rent tenants.

Farmers who have a good mix of cash rent and owned property (at lower prices) should be in fairly good shape. The farmers I worry about are the ones that are primarily cash rent with high rates locked in for three or more years. Those farmers tend to have the lowest amount of liquidity and maybe in big trouble if low prices continue for more than one year.

Spring wheat farmers may be in for a tough year or two with news out of Canada that their crop is about 10% larger than originally projected and Australia seems to have a larger crop too. Farming is cyclical and these facts are just pointing to more subdued profits over the next year or so.

The Rich Are Different - They Pay More

Dec 03, 2013

The Tax Court released a very interesting and to some degree an entertaining case on Tuesday. Michael D. Brown was considered a super life insurance agent to the Forbes 400. He normally would not handle any life insurance policies with a face value less than $10 million and in many cases, he was the agent for $300 million plus policies.

During his career it became apparent that he needed a private jet to get him quickly to meet with his rich clients (they don't like to wait). Over time, he had acquired one smaller private jet, which was found lacking since it was considered a "4 hour" jet. It could not get from Los Angeles to New York without refueling. This led him to look for a better jet and he finally found one for the reasonable price of $22 million at the end of 2003.

When touring a similar plane, he noted a conference table and decided he wanted that in his new plane and an upgrade from 17" monitors to 20" monitors. Since this would entail substantial modifications to the plane, the seller indicated they would need to have the plane in the shop for 5-6 weeks.

Normally, this would not be a big deal, but during 2003 and 2004, the Tax Code allowed a 50% bonus depreciation on new assets placed in service by December 31, 2004. Mr. Brown wanted the deduction in 2003, so he took delivery of the plane on December 29; flew it from Portland to Seattle, then to Chicago and back to Seattle all in the same day. These trips were all for "business".

As you can tell, the IRS audited his return and disallowed the depreciation deduction of over $11 million. As part of the audit, they then determined that Mr. Brown seemed to be "shall we say" very creative with his accounting and asserted a 75% fraud penalty on underreporting of over $30 million of taxable income. Since the tax on this would be over $10 million, the fraud penalty alone was over $7 million. Mr. Brown settled with the IRS on all of other audit issues except for the 50% bonus depreciation on the airplane right before trial. Most likely the primary reason for going to trial was not related to the deduction (it would be allowed in 2004), but the 75% fraud penalty the IRS was trying to collect.

The Tax Court agreed with the IRS that the plane was not placed in service by December 31, 2003, but rather early in 2004. This resulted in moving the deduction from 2003 to 2004. The Court indicated that the plane delivered to Mr. Brown in 2003 was not ultimately the plane he placed in service which happened in 2004. Yes, he flew the plane around for a day before year-end on "business", but the actual plane he placed in service included the conference table and upgraded monitors which was not completed until 2004. Also, Mr. Brown appears to have prepared documentation substantiating the business use only when he was finally audited. However, the Tax Court was kind to Mr. Brown and did not allow the 75% fraud penalty on the early deduction.

Now you are probably asking what this court case has to do with farming. Other than it being an interesting case to read, we have many farmers who "shall we say" speedily purchase farm equipment at year-end to get a Section 179 or bonus depreciation deduction. Also, since farm buildings qualify for bonus depreciation, there is sometimes a mad rush to get the building "finished" by year-end. Most of these assets are placed in service properly and timely, but this court case is a good example of what happens when you do it wrong. As this case sometimes proves, the "Rich are Different - They Pay More".

If you are interested in reading the case, you can find it here. Also, Janet Novak of Forbes has more detail on the case here.

Losses Can Offset Investment Income

Dec 03, 2013

Another nice feature of the final net investment tax regulations released last week is that certain losses are now allowed to offset other net investment income. In the original proposed regulations, you could not have a loss (such as the sale of stock) reduce your other net investment income. Once you reached zero, you were stuck at that number.

The final regulations now allow at least three new ways of using losses:

  1. If you have a net capital loss for the year, the regular tax laws limit this loss to $3,000. The final regulations now allow this $3,000 loss to offset other investment income.
  2. If you have a passive loss such as Section 1231 losses, as long as that loss is allowed for regular income tax purposes, you will be allowed to offset that against other investment income.
  3. Finally, if you have a net operating loss carryforward that contains some amount of net investment losses, you will be allowed to use that portion of the NOL to offset other investment income.

 

The final regulations are much more favorable to taxpayers than the original proposed regulations in these areas. The computations on these allowed losses can be very complex so I would suggest having a qualified tax advisor help you with this.

On a personal note, my scheming wife somehow talked me into staying in Cabo a few more days. I must admit I did not put up to much of a fight.

Bonus Payments Are Ordinary Income - Not Capital Gains

Dec 02, 2013

The Tax Court issued the Dudek case today concerning whether upfront bonus payments received from an agreement to allow an oil and gas company to lease property is considered ordinary income or capital gains. In the case, Mr. Dudek, a CPA (why are some CPAs more likely to go to tax court when they know they will lose is beyond me) had purchased three separate parcels of real estate totaling 353 acres during 1996-1998.

Due to the technological advancements of horizontal drilling and fracking of oil wells, these properties were suddenly more worthwhile to drill on. In 2008, EOG Resources, Inc. (which was a spin-off from Enron before it got in trouble) agreed to pay upfront a $883,250 bonus payment to lock up the property. If EOG drilled a well and it produced marketable oil, then Mr. Dudek would be entitled to a 16% royalty payment.

Mr. Dudek (again a CPA) received a form 1099 showing this payment as miscellaneous income and reported it as a capital gain and argued that this was a sale and not a lease. As you can imagine, the IRS audited his return and assessed additional tax of $147,397 and a $29,479 accuracy penalty on top of it.

I won't go into all of the reasoning by the court since the rules on these payments have been around for a long time. Rather, I just want to inform any farmers who have acreage that may end up with an upfront oil and gas payment or perhaps a wind turbine bonus payment that these payments are ordinary income, not capital gains. Mr. Dudek, being a CPA should have known this and that is why the court upheld the accuracy penalty, but not all farmers are as well informed, but they are more likely to goto a better CPA.

Mr. Dudek also argued that if the payment was ordinary income, he should be entitled to a percentage depletion deduction of 15%. The court shot this down very quickly. In order to have a percentage depletion deduction, the court stated there must be production. In this case, there was no well drilled on the property at the time of payment, therefore no percentage depletion.

In some cases if the payment is for a permanent easement, the payment maybe partially non-taxable, but that was not the case here.

I just got done reading the new book "The Frackers" and I would highly recommend it for anybody that would like to know more about how Fracking and Horizontal drilling has dramatically increased US oil and gas production. There are estimates that we will be the number one producer of oil and gas soon, if not already.

More Good News on Calculating Invesment Gain

Dec 01, 2013

I will probably be doing a few posts this week on the net investment income tax regulations issued by the IRS last week. The IRS also issued new proposed regulations regarding how to calculate the amount of gain required to be included in investment income when you sell a partnership or S corporation interest. In today's post, we will discuss these new proposed regulations.

The old proposed regulations required a taxpayer to take their gain from selling an interest in a partnership or S corporation and then subtract the part of gain that was attributable to non-passive assets to arrive at the amount of gain that should be included in investment income. If the hypothetical gain inside of the entity was greater than your actual gain, then none of the gain would be reported as investment income (assuming no passive or investment assets in the entity). However, if the gain inside of the entity is less than your share of the gain, then part of the gain would be considered investment even though all of the assets are material. Here is a quick example:

Assume John sold a partnership interest for $300,000 and his gain is $100,000 resulting in a $200,000 gain. If his share of the gain inside of the partnership (based on a hypothetical sale) was $200,000 or more, then none of the gain would be considered investment income (assuming all assets are non-investment and non-passive). However, if his share of the gain inside the partnership was $100,000, then $100,000 of his gain would be considered investment income and subject to the 3.8% tax.

Many commentators caught this anomaly plus the administrative burden of trying to determine the gain from a hypothetical sale of all assets inside of the entity caused the IRS to change their proposed methodology to require you to only include gain attributable to investment or passive assets inside the entity. They also provide for an optional simplified method of calculating your gain if you meet one of the following two tests:

Test # 1: Your total gain is less than $250,000, or

Test # 2: Your total gain is less than $5 million and your share of investment income flowing through from the entity is less than 5% of total income (losses are shown as a positive) for the current year plus the last two years.

Here is an example:

Farmer Bean sells his 50% interest in Farmco, Inc. (an S corporation that he materially participates in) for $500,000. His basis is $100,000 resulting in a $400,000 gain. Since his gain is greater than $250,000, we have to look at the items of income flowing to him on his k1 for this year and the previous two years. Assume his ordinary income from farming was $750,000 and he received interest income of $15,000. Since $15,000 is less than 5% of $765,000, he can use the optional simplified method.

Once we determine that we can use this method, we now have to calculate the amount of gain that is investment under this method. We take $15,000 / $765,000 which is 1.961% which is then multiplied by the total gain of $400,000 to arrive at $7,844 of investment gain to report.

For most taxpayers, this may not seem tooooo simplified, but for tax advisors this is much easier for us to calculate than the old proposed regulations requirement.

I will cover other aspects of the new final regulations later this week.

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