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March 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.

You Can Always Do An IRA!

Mar 27, 2013

About 20 years ago Congress passed a law that still provides confusion to both taxpayers and many members of the media.  Many people thought the new law outlawed IRA contributions if you were covered by a retirement plan at work.  Assuming you have sufficient compensation or self-employment earnings, the law simply disallowed the deduction if you were covered by a retirement plan AND your adjusted gross income was over a certain threshold.

The law never eliminated the ability to make an IRA contribution. 

In general, the rules are as follows (assumes you and your spouse have at least combined earnings of $10-12,000 or more (if over age 49):

  • Not covered by a retirement plan - Both spouses can deduct up to $5,000 (in 2012, increases to $5,500 in 2013) plus if age 50 or over, you can each contribute another $1,000 for a total of $6,000 each. 
  • If both are covered by a retirement plan, you can still deduct a full IRA until your combined adjusted gross income hits $92,000.  At this point, the deduction is reduced 50 cents for each dollar increase.  Once you hit $112,000, no more deduction (the numbers for single are $58,000-$68,000).
  • One covered by retirement plan, one not.  The non-covered spouse can deduct a full IRA until the couple's adjusted gross income hits $173,000 and is fully phased out at $183,000.

 

The ROTH IRA makes it a little more confusing.  You can only contribute up to $5,000 ($6,000 if 50 and over) between a regular IRA and a ROTH IRA.  This can be allocated in any manner you want, but the combined amount cannot exceed the limit.  However, ROTH IRA's are reduced once your adjusted gross income hits $173,000 and is fully disallowed at $183,000 (same limits for one non-active spouse).  The single limits start at $110,000 and is fully phased out at $125,000.

Remember, an IRA or ROTH IRA contribution for 2012 tax returns must be fully funded by April 15, 2013.  This applies even if you get an extension of time to file, it does not extend the IRA due date.

Also, if you file early in the year and get a nice size refund from the IRS, you can use that refund to fund your IRA.  There is no requirement to have the money in the IRA before you file your return.  You can even have part of your refund automatically deposited into your IRA by the IRS.

We have roughly 19 days of tax season left and we know they will be hectic for all of us.  Spring planting is just around the corner for our farmers, while us CPA's are finishing up our "harvest".

Heads They Win - Tails You Lose

Mar 25, 2013

This is the first year of the new .9% increase in Medicare tax based on earned income being higher than a threshold amount ($200,000 single/$250,000 married).  If your wages exceed the threshold amount the extra Medicare tax will be withheld by the employer.

Earned income includes both wages and net earnings from being a self-employed farmer.  If you have both wages and farm income, these two numbers are added together to arrive at the total amount of extra Medicare tax owed.

For example, assume a single taxpayer with wages of $300,000 and a net Schedule F income of $150,000.  The wages had $900 of extra Medicare tax withheld ($300k-$200k times .9%) and the net schedule F earnings are subject to $1,350 of additional Medicare tax for a total of $2,250.

However, lets assume the taxpayer has a farm loss of $100,000.  In this case, we would assume the farmer could net their wages against the $100,000 loss, be below the threshold and get a refund of the extra $900 paid in.  This is not the case.  The taxpayer still owes the extra tax and gets no refund.  This is a case of Heads They Win and Tails We Lose.

If you might be in a situation with high wages and a possible farm loss, you may want to consider taking step to reduce wages and your farm loss (if possible).  Many times, the amount of extra Medicare tax owed is not worth the effort, but it is worth taking a look at now while you can still do something about it.

As you may have noticed, we only posted once last week and between now and April 15 our normal 3-5 times a week posting schedule may get reduced.  If you have a burning question, please send it to us.  We may not respond immediately, but will get back to you as soon as we can.

Don't Forget Farm Income Averaging for 2012 tax returns

Mar 19, 2013

Just a reminder if your income is dramatically higher this year, remember to consider using farm income averaging.  Even if it does not reduce your income tax for the year, if may help you reduce your income tax in 2013 or beyond.

In brief, farm income averaging allows you to elect to spread a certain amount of your income over the last three years.  If you are in a 25% or higher tax bracket this year and the last three years are in a lower tax bracket, you will be able to reduce this year's tax.  The allocation of this spread of income is done equally to each of the past three years.  You can not pick and choose how much to allocate to each year, but rather, they must be spread equally.

Farm income averaging does not reduce your self-employment tax and for 2013 it will also not reduce your net investment income tax that may arise if your AGI is greater than the threshold.  These taxes are imposed without regard to your taxable income.

Some farmers think that if there is no tax saved, they do not need to utilize farm income averaging.  This is not always correct.  Let's assume a farm couple made $70,000 each year for 2009-2011 and in 2012, they made $140,000.  Since they are in 25% tax bracket for all four years, they elect to not use farm income averaging.  In 2013, they now make $200,000.  Since about $60,000 is in the 28% tax bracket, they elect to carry this back to 2010, 11 and 12 to soak up those 25% tax brackets.  This works for 2010 and 2011, but since they did not elect farm income average in 2012, they are still in the 28% tax bracket and owe an extra $600.  It would have been very easy to save the $600 by doing farm income averaging in 2012 to reduce their 25% tax bracket for that year.

Will Larger Farmers Still Be Able to Use Cash Method in the Future

Mar 14, 2013

One of the advantages that all farmers (other than some farm "syndicates" and related entities) have is that they are allowed to use the cash method of accounting.  This method is allowed whether you are a sole proprietor, partnership, corporation or LLC.  Additionally, there is no limit based on the sales of the entity.

This may change if the proposal that the House Ways and Means Committee just issued this week ever passes.  Under their proposal, the cash method of accounting would be available to all natural persons (i.e. sole proprietors) regardless of sales levels, however, it would only be available to other business entities if their annual sales were less than $10 million.  Once your sales exceed this number (even once) you would be required to switch to the accrual method of accounting.  It is likely that some type of related party rules would be in place to bring in all entities owned by same family, etc. into the calculation.

For example, assume a father and two sons each have a corporation that farms 3,500 acres of land.  With the rapid rise in farm prices, each of their farm corporations generate $4 million of income.  Each entity's sales amount is less than $10 million, however, on a combined basis, they exceed $10 million in sales.  Most likely all three corporations would need to switch to the accrual method of accounting.

If this happens, a large amount of income may be required to be recognized by the entity (think of all of your unsold grain at year-end).  Since this is a mandatory change in accounting, the IRS does allow you to spread this income over 4 years to lesson the impact on your operations.

However, if this proposal goes into effect, many of our farmers will lose a tax benefit that has been around for several years.

When Congress Says "Simplified" Watch Out

Mar 13, 2013

WARNING - THIS IS MY LONGEST POST EVER

The House Ways and Means Committee just issued a proposal to "simplify" the treatment of small business (including most of our farmers).   I will attempt to summarize it:

Core Changes:

  • Permanently expanding Section 179 from the current $25,000 level (for 2014) to $250,000 with a phase-out starting at $800,000,
  • Allowing all taxpayers to use the cash method of accounting if their annual sales are less than $10 million (most farmers can use this already),
  • Somehow they believe making partnership tax returns have a due date of March 15, S corporations have a due date of March 31 and C corporations have a due date of April 15 will help tax compliance (this assumes a calendar year-end and individuals remain at April 15)

There are two options regarding S corporations and partnerships:

Option #1 offers changes as follows:

For S Corporations:

  • Reduce to five years the built-in period (GOOD),
  • Increase to 60% the portion of an S corporation's earnings that may be passive without triggering an entity-level tax and eliminate the rule that terminates an S corporation if it has excess passive income for three consecutive years (GOOD),
  • Simplify the procedure and extend the time for making an S corporation election, permitting it to make the election on its first tax return (GOOD).

For Partnerships:

  • Repeal the rules relating to guaranteed payments to partners, replacing with treating payments as either payments in their capacity as partners or as non-partners (MAYBE GOOD),
  • Require mandatory adjustment of partnership's basis in partnership property when a partner distributes property or transfers his interest (Normally anytime the word mandatory is in the law, it is BAD),
  • Clarify that all distributions of inventory are treated as a sale between the partnership and partner (most likely BAD),

Option # 2 - New Simple, Unified Pass-through Rules

This option would repeal current Subchapter K (partnership rules ) and Subchapter S and replace it with one uniform set of rules.

  • It would encourge the formation of new businesses by allowing contributions of property and money on a tax-free basis (GOOD),
  • Maintain the current relationship that the character of the income and loss pass through to the owners (NO CHANGE),
  • Reduce the use of complex structures to engage in tax avoidance by permitting only net ordinary income or loss, net capital gain or loss and tax credits to be specifically allocated (THIS IS WHEN YOU HAVE TO WATCH OUT),
  • Close the tax gap while also "simplifying" owner's current quarterly estimated tax responsibility by requiring entity-level withholding on the pass-through income (THIS MEANS THEY WANT THEIR MONEY SOONER AND YOU HAVE TO WAIT TO GET YOUR MONEY BACK IF DO NOT OWE ANY TAXES),
  • Prevent owners from gaming the system by using losses to reduce tax liability by limiting deductions for losses to an owner's basis in the pass-through interest, but allowing excess losses to be carried forward indefinitely (WHEN THEY USING THE WORD GAMING "WATCH OUT"),
  • Ensure that taxes are paid on real, economic gains (but not on returns of capital) by limiting tax-free distributions to the owner's basis in the business (MOST OF THIS IS IN EFFECT NOW),
  • Prevent the use of pass-through entities to shift gains and losses by requiring pass-through entities to recognize gain on all distributions of appreciated property (OUCH FOR PARTNERSHIPS),
  • Conform to the basis rules that currently apply to partnerships by allowing owner's basis in their ownership interests for entity-level debt (both recourse and non-recourse) (THIS IS GOOD)
  • Provide certainly with respect to owners who actively participate in the business by allowing them to be treated as employees (COULD BE GOOD).

As you can see, I probably just set my new record for longest post ever, but in my opinion these rules are the first step in Congress taking away the flexibility that farmers have enjoyed for the last several decades on the proper use of partnerships, corporations and limited liability companies.

The proposal does not address the employment and self-employment taxes of partners and shareholders and with this year's implementation of the 3.8% Medicare/net investment income tax on all income except pass-through income from material S corporations, it would not surprise me that all business income will become subject to this tax very soon.

It seems like every time Congress uses the term "Simple" it simply means an easier way for them to get more money from farmers.  We shall see.

Update to Social Security Post

Mar 11, 2013

Just a couple of items to add to our Social Security Post of yesterday.

First, if the farmer's spouse works outside of the farm and has made a substantial amount of money during their career, then it may not make sense for the farmer to pay any more into the system.  A retired person is allowed to collect the HIGHER of:

  • Their calculated benefit, or
  • 1/2 of their spouse's benefit

Therefore, if their spouse's retirement benefit is equal to approximately twice the Tier 1 amount (or about $1,600 in retirement benefits), then a farmer paying into the system is at best increasing their Tier 2 benefit amount which as we explained in the post only gets credited at a 32% rate and the simple payback in years is at least 18.

Second, if the spouse has not worked outside the farm and has generated less than the 40 quarters of service needed to get their own social security benefits, then the actual return to the farmer is potentially greater than the amount shown in the post.  The retiring spouse will be entitled to 1/2 of the farmers benefits, so in these unique cases, it will make even more sense to pay into Social Security.

For example, assume the spouse has never worked outside of the farm and did not get paid on the farm.  In our example of a farmer making an average of $5,000 (in 2013 dollars), his current benefit is about $374 per month.  His spouse's benefit is 1/2 of that or about $187 or a total of $561 per month for the couple.

If they elect to pay in about $24,000 of extra social security tax over the next couple of years, his monthly benefit increases to $712 and hers would increase to $356 for a total monthly benefit of $1,068 or a combined increase of $507.  In this case, the couples payback would drop from the 6 years shown in our original post to about 4 years.  This is a good return on the farmer's investment.

When It Pays to Increase Your Earnings

Mar 10, 2013

We get this question from farmers approaching retirement age a lot:

"I have had very low income for most of my career and should I try to maximize my income as I approach retirement to increase my social security benefits"

Chris Hesse, who is one of my partners at CliftonLarsonAllen, LLP had provided me with an Excel spreadsheet that can calculate this answer fairly quickly.  It is based on the method that Social Security uses to determine your retirement benefits and the key issue for our farmer is what your average indexed monthly income has been during your career.

Social security benefits are calculated based upon the average of your highest 35 years of earnings indexed for inflation.  For example, the maximum wage that you could use for 2012 was $110,100.  In 1975 the maximum wage was $14,100, however the inflation index for that year was 4.98 so the equivalent 2012 number is about $70,200.  Therefore, you input all of your wages during your career and the computer then indexes them based on inflation.  It then takes the top 35 years and divides by 420 (35 years times 12).  This results in a very important number known as the Average Monthly Indexed Earnings (AMIE). 

The AMIE is then divided into three tiers.  The first tier (currently about $800) is valued at 90%.  The next tier (the next approximately $4,000) is valued at 32% and the remaining tier is valued at 15%.  Each of these tiers is then multiplied by these percentages and the cumulative result is your estimated monthly retirement benefit when you retire. 

Assuming a farmer has paid in the maximum amount for at least 35 years, the estimated monthly social security benefit at full retirement is slightly more than $2,500 per month.  However, the interesting part is how these tiers break down.

Tier 1 has a value of $712, Tier 2 $1,273 and Tier 3 is $565.  Tier 3 monthly earnings amount is calculated at about $3,800 which is almost 5 times higher than Tier 1, but the value of Tier 3 is about 20% lower than Tier 1.

The first step for our farmer is to maximize their Tier 1 AMIE amount.   If your average annual earnings have been less than about $10,000 indexed for inflation, then reporting greater farm earnings will dramatically increase your social secuity benefits.  For example. if a farmer during his career reported an average of $5,000 per year (in 2013 numbers), his current expected Social Security benefit is about $374 per month.  If over the next couple of years, he reports an extra $157,000 or so of earnings (does not need to be in one year), his monthly benefit will jump to about $712.  The extra social security cost will be about $24,000, but in return he will receive a lifetime annuity indexed for inflation paying $338 per month.  A simple calculation shows that he would fully recover his investment in about 6 years.

In our example, we are only trying to get up to the Tier 1 amount of about $800 per month.  As you go over Tier 1 into Tier 2, your return on investment drops dramatically.  Tier 1 has a 90% value, whereas Tier 2 only has a 32% value, therefore, as you enter Tier 2, instead of a 6 year payback, it becomes a 18 year payback.  Tier 3 amounts are even worse.  At that point, your payback period is in excess of 30 years.

In conclusion, if your earnings are still in Tier 1, it would definitely pay to pay in extra FICA tax to maximize your social security earnings.

Read more about maximizing Social Security.

What are W2 Wages for DPAD?

Mar 07, 2013

One of the bigger deductions that farmers qualify for is the Domestic Production Activities Deduction (DPAD).  In brief, the farmer is allowed to deduct 9% of their net farm income (in some cases this may be very limited if all of the farm products are sold through a cooperative).  This 9% deduction has a limit based upon 50% of W2 wages.

However, the definition of W2 wages is not simply looking at the W2s provided to your employees during the year and taking 50% of that number as the limit.  These wages cannot include wages paid to your children under age 18 (if a sole proprietor farmer) and commodity wages.  However, wages paid in cash to spouses and children over age 17 are allowed as part of these wages.  For many of our farmers who are self-employed and have little cash wages, this DPAD is usually very minimal.  If the COOP distributes this deduction through to the farmer, they are allowed to deduct this amount even if they have no wages.

Let's run some examples:

Example 1 - Farmer Fred is a sole proprietor who nets $400,000 on the farm.  He is entitled to a DPAD deduction based upon the lower of 9% of the $400,000 or 50% of his qualified W2 wages.  He paid his spouse cash wages of $10,000 and had no other wages during the year.  His net DPAD deduction is $5,000 ($10,000 * 50%).

Example 2 - Same as # 1, but Fred paid other non-related employees $100,000 of wages during the year.  His DPAD deduction is $36,000 (9% of $400,000) since the 50% W2 limit was calculated at $55,000 ($100,000 + $10,000)/2.

Example 3 - Same as #2, except $50,000 of the wages paid to his employees were paid in grain.  In this case, his total W2 wages that are qualified are ($50,000 + $10,000)/2 or $30,000.  In this case, the overall DPAD deduction allowed is $30,000.

As you can see, this calculation can get very complicated very quickly.  If you are generating a large amount of farm income as sole proprietor, it may make sense to pay some wages to your spouse and incur the related payroll taxes.  Although it will generate about 12-13% of net payroll taxes (based on the after-tax effect of deducting the employer share), the allowed DPAD deduction may offset some of this extra cost plus you may be building up extra social security benefits for the spouse.

We find that this deduction can be both missed or miscalculated on many farmer returns and with proper planning can help reduce your tax bill.  Again, as always, discuss this with your tax advisor.

IRS Announces They Are Processing All Remaining Tax Forms

Mar 04, 2013

The IRS announced today that they are now accepting all 2012 related tax forms.  Since it seems like we have had 100s of tax returns backing up in our office waiting for this announcement, this is welcome relief for CPAs and other tax preparers.  One of the negatives we are now certain to get multiple calls asking where their return is.  Even though the return might be done, it still needs to be processed and this may take a couple of extra days, but the major pain of waiting for forms is behind us.

Therefore, for any farmer who had to wait until today to file can automatically wait until April 15 to file and pay their tax due. 

With the Sequester going into effect on Friday, the IRS also announced that many of their services will be cut by at least 5% for the remainder of the government's fiscal year (ending September 30, 2013).  This most likely means that almost any phone call to the IRS will not be answered in a timely manner.  Most of my recent experience with any phone call to the IRS is a wait of at least 45 minutes or getting hung up on.  I do not see this getting any better until the Sequester is resolved.

When an UPRIET Might Make Sense

Mar 03, 2013

Many farmers have seen substantial appreciation in their farmland values over the last decade.  Many of these farmers are approaching retirement age and would like to "cash" in on these values and diversify their holdings.  They do not have any children to take over the farm and are worried that values in their immediate area may see a substantial drop over the next few years or would like to geographically diversify their holdings.

One option to consider is to use a Section 1031 exchange on their farmland into an UPREIT.  There are several UPREITS that are investing in farmland over a broad geographical area and others that are invested strictly in commercial properties.  The possible appeal to a farmer selling their land is the deferral of their income tax and more broadly diversifying their risk.  The UPREIT essentially trades units for the farmers land.  In return, any income from the UPREIT is allocated to the farmer based on their ownership %.

In order to take advantage of these vehicles, you must find the appropriate UPREIT to approach to see if they are interested in purchasing your farmland.  If so, then the transaction can be structured in a tax-efficient manner.  Most UPREITS allow the farmer to cash in their shares at a later point in time.  One drawback to these vehicles is that the farmer is no longer in control.

If this might appeal to you, you need to discuss this with your tax advisor.  These are not common as a regular 1031 exchange, but are very much a viable option.

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