by Paul G. Neiffer, CPA
Our readers have had several comments on our Farm Entity Structure Lessons Tax Burden article that was filed on March 2, 2010. We thought we would update the article with our response to several of their questions.
There seems to be some confusion on what self-employment taxes are. These taxes are comprised of (1) social security taxes and (2) Medicare taxes. Social security taxes are limited to 12.4% of the taxpayers wage base, which for 2010 is $106,800, which was unchanged from 2009. This amount generally increases with inflation each year. Therefore, your self-employment social security tax is limited to approximately $16,000.
The Medicare self-employment tax is a flat 2.9% on all net farm income earned. If you make $100,000 it is about $3,000. However, if you make $1,000,000, it is about $30,000 in taxes. It is unlimited.
In our original article, we used the example of a farmer making $75,000 per year. This farmer is subject to both the social security and Medicare portion of self-employment taxes. The tax savings discussed can have a substantial percentage reduction in overall taxes.
However, a farmer earning $1,000,000 who takes advantage of splitting their operations into a corporation and a LLC to own the land can still cut their taxes by at least $20,000 per year. For example assume the farmer sets up a corporation and pays owner salaries of $106,800. They will have no social security tax savings, however, they will eliminate Medicare taxes on $900,000 of earnings. This is an approximate tax savings of least $25,000.
Normally, we would never change the entity structure of a farm operation for just tax reasons. There are many other business and financial reasons for setting up a corporation or LLC.
These include the following:
- Legal protection – As a sole proprietorship, if there is an accident on the farm and somebody gets injured or dies that is not covered by industrial insurance, they can sue the farm and the owner for everything that they own. With a corporation or LLC, they can only sue the legal entity that is operating the farm or owns the farm. All of the other assets of the farmer are generally secure from these lawsuits.
- Ease of transfer to next generation – If a farmer owns farmland and has six heirs, it is very difficult to transfer this land by a quit claim deed over time of partial interests. A LLC allows the farmer to simply transfer units each year to each of their heirs. This is much simpler than recording a deed each year at the courthouse.
- Equalizing values between operating and non-operating heirs – In many cases, a farmer will have both heirs that live on the farm and ones that live off of the farm. In these cases, a corporation allows the farmer to transfer the operating assets to the on-farm heirs and the land in a LLC to both the off-farm and on-farm heirs to equalize the estate. This also allows the farm operation to remain in the control of the on-farm operators.
Some readers wanted to know how much setting up these entities would cost. In our area, the cost to set up a corporation or limited liability company is generally about $1,000 to $1,500. The amount in your area may vary, but it should be close to these numbers.
On an annual basis, you will be required to file a separate tax return for the new entity which will probably cost around $1,000, however, since you are no longer filing a schedule F on your personal return, you should see a substantial reduction in that cost.
Another question that was rendered was how does this affect the amount that a farmer can put into their retirement plan. As a sole proprietorship, the farmer is allowed to base their pension contribution on all their net farm income. This means if they make $100,000, then generally can put in at least $20,000 or more. With a reduction in salary, this would normally limit them to 25% of the gross salary. So if their salary is $30,000, they can only put in $7,500 for their pension. However, if they set up a 401k plan, they can easily put in $20,000 or more and if they employ their spouse, they can double up on the contributions.
For More Information
Farm Entity Structure Lessons Tax Burden
Visit Neiffer’s blog at www.farmcpatoday.com.
