Pay Now and Play Later and The Wimpy Doctrine.
In most years, a tax estimate prepared prior to the end of the year is a valuable tool to allow operators to make decisions on end of year purchases to manage what income tax bracket the operator falls into .
This year, with the looming expiration of decades long tax rates and a return of higher rates, the estimate may take on extra significance, as deciding to trigger income in 2012 may net savings in a lower tax rate than taking the income in 2013. As the law stands today, tax brackets are going to be compressed (meaning more people pay higher rates) and the higher rates are higher than current rates. Additionally, capital gains rates move upward, dividend rates expire, and married tax payers will once again, be penalized in the form of a lower standard deduction than if the tax payers where single and the child tax credit is slashed in half. And finally, section 179, which allowed accelerated expensing of machinery and sheds over the last years, looks to be limited in the future.
Pay Now and Play Later:
Many farm operators spend money at the end of the year on prepaid expenses as a way to adjust income. Interest cannot be prepaid past what is due and rent prepayments are limited to 12 months. In order to pass the smell test regarding expenses from the IRS, farm operators would do well to remember the following guide posts:
1. Terms. Price, quantity and grade without refund or sale back options must be included in the purchase. No throwing money “on the books” to be applied to whatever expenses come up in the future.
2. Valid, non tax reason, for purchase. Farm operators should document the incentive to prepay (like better price or concerns regarding specific quantities not being available at a later date (think seed numbers)).
3. No giant swing in income. Purchasing a limestone quarry and then attempting to expense it all off as fertilizer expense is distorting. Purchasing a pile of lime to apply with in the next 12 months is likely not.
4. Only Half. Prepaid expenses should only be about 50% of non prepaid expense. Operators can look at the last three years in total to show the 50% test is met.
5. Proof and Payment. Keeping the written offer regarding prepay discounts are a great idea. Additionally, payment by credit card is fine, but offering a check to the supplier and asking them to hold it upon receipt or postdating a check is not acceptable. Likewise, offering a check on an overdrawn account (unless backed by a line of credit) is not a legitimate prepay. Borrowed funds are also okay, as long as the seller is not providing direct financing. Be ware of wholly owned subsidiaries of the input supplier offering financing as it may knock the operator out of the benefit they are seeking to maximize.
The Wimpy Doctrine:
Deferring income is another technique for end of year tax planning. Wimpy from Popeye (yes, I realize that reference may date me) who offers to pay on Tuesday for a hamburger purchased today has been advocating this technique for years!
Farm operators have to claim income if the income is available , regardless of when the operators convert the income to use. For example, a cattle check in November is current year income, regardless of when the operator goes to the sale barn to pick it up until January.
Installment contracts are different. If the operator can meet certain terms, the operator defer the income to a later date. Here are some criteria to consider when entering into an installment sales contract
1. Written, binding, non assignable contract that prevents entitlement to the proceeds by the seller prior to the agreed upon date that is executed before the actual payment is due.
2. No use of the contract as collateral for a loan.
3. The buyer doesn’t credit the seller’s account during the contract’s life to allow charges for inputs.
4. No promissory note is executed, just a contract, but the contract may provide for interest on the delayed payment.
By using multiple bushel specific contracts, the farm operator can op out of the installment contract and report the income in the current tax year if they desire a higher income level. The risk with older operators is that if they die, the contract doesn’t have a step up in basis like on hand grain would receive. Another risk is that under the Federal laws regarding sales of livestock, all settlements need to occur within 72 hours of sale. This is at odds with the installment contract principles. Finally, a risk exists that the delayed payment will never happen with a grain elevator or livestock sales barn failing and closing up shop before making good on the payment. In that case, paying the tax would have been a far better proposition.