Of all the taxes out there, self-employment tax is the one farmers most despise. The burden can be much less, however, if you structure your operation the right way, Lance Fulton, tax consultant with Kennedy & Coe, told farmers at the Top Producer Seminar.
Corporations (including S-corps) don't pay self-employment tax, and limited liability companies (LLCs) structured the right way don't either, Fulton said. "Using multiple entities can spread your tax burden over several tax brackets, eliminate self-employment tax and protect your assets and collateral."
Sole owner tactic. In a sole proprietorship in which the spouse is not part of the operation, a simple way to manage self-employment tax is for the operator to hire the spouse (or offspring) and pay wages in grain, Fulton said.
Paying wages in grain is simply a documented transfer (once a month or quarterly) of bushels from the employer to the employee. The value of the grain on the date of transfer is the dollar amount that goes on the W-2, Fulton said. Although the spouse must pay income tax on the grain, the W-2 has no payroll or self-employment tax withholdings taken on it.
The operator can then put the spouse on a benefit plan that pays health insurance and—if there are no non-family employees—medical expenses, which become fully tax deductible.
"This eliminates a lot of self-employment income, but doesn't change cash flow because the owner had those expenses anyway," Fulton said.
Entity. Another option is to convert the operation to a C corporation, in which the owner becomes an employee. If the employee lives on the land, the entity pays him to watch the land, monitor grain bins, prevent vandalism, etc., and therefore pays for meals and lodging.
"Again, those are things you would have paid for anyway, but you lower your income on which you would pay self-employment taxes," Fulton said.
Another benefit of using an entity such as a corporation or limited partnership to conduct farming activities is that it changes the level of income subject to Social Security taxes, adds Mark Penningroth, CPA and principal with Latta, Harris, Hanon & Penningroth, LLP, a certified public accounting firm in Tipton, Iowa. Social Security taxes aren't paid on land rental payments.
Retire on grain. A producer who converts grain to cash and moves it into the right type of retirement plan can eliminate paying self-employment tax. When the cash comes out of the retirement plan, it is taxed as income, but even so, no self-employment tax applies.
This strategy requires using a retirement plan that allows for higher funding than just an IRA, Fulton said. There are retirement plans available that allow for funding of up to $250,000 per person, depending upon their ages.
Here's how the strategy works: You sell your grain, fund a retirement plan, and the sale of that grain is deductible because it went into a retirement plan, Fulton said. In addition, you don't pay self-employment tax because the grain is not taxable income in that year.
"This is a very effective tax strategy for the older generation who want to shift the farm to the next generation," Fulton said. "In a five-year time frame, a farmer can easily get rid of $500,000 to $1 million in a grain deferral."
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Top Producer, March 2009