Is to set a target taxable income. It will serve as an average taxable income to shoot for.
"Aim for at least the level at which you are expending money," Murken suggests. "I like to calculate what a client's earned net growth is from their net worth statement and then add in family living costs."
Net earned growth is the growth in net worth that doesn't come from inflation. In other words, it's the amount that came from profit. Profit, minus some personal deductions allowed on your federal Form 1040, is really what IRS is looking to tax you for. Since profit also has to provide the money for family living expenses, Murken adds family living expenses to the net earned growth to get that target taxable income number.
"If you don't aim for that kind of target income every year, even in the low income years, you are asking for serious problems down the road," Murken warns. At retirement, for example, you're going to hit the high tax brackets with a lot of income if your target is too low and you have continually held off sales (income) and bought supplies (deductions) ahead to keep your income tax low.
"The worst case scenario might be if you were to get into financial trouble and be forced to liquidate," says Murken. Just because you're broke doesn't mean IRS is going to back off if you've delayed paying tax on a lot of income. Just ask some farmers who got knocked out in the 1980's farm crisis.
So far, we've dealt with lower income years caused by price cycles. Don't overlook other things that might cause a low income year such as repopulation of your breeding herd, especially high input costs (like corn hitting $5) or production problems that cause a downturn, says Murken. The key is to be on top of tax planning every year no matter what your income/expense situation.
Consider this example of why a target taxable income makes sense. Say your taxable income and federal income tax is as follows:
Now, look at what happens if you were to spread that taxable income evenly over those three years.
By paying $1,500 more federal income tax the first year, you save $2,800 the second year. This is a case where you lose the use of that $1,500 for a year. Plus, social security tax would be paid on $10,000 a year earlier than necessary.
But, let's say you pay $3,000 a year early and lose 10% of time value of that - or $300. With the $1,300 total tax savings, you're still a cool $1,000 ahead.
Those figures are all based on a couple filing a joint return and 1998 tax rates. Here's the only difference. In 1998, a married couple filing a joint federal income tax return pays tax at 15% on all taxable income up to $42,350. Once taxable income tops that, the rate goes to 28%. With income at $32,350, there's $10,000 of 15% tax bracket that is wasted.
By pulling some income into 1998 or delaying some expense to 1999, a producer can grab hold of $10,000 more taxable income and have it taxed at 15% now rather than 28% later when the cycle moves back up.
New Capital Gains Your tax bracket planning gets more cloudy for 1998 and beyond. Last year's tax law changes brought back more favorable taxation of capital gains. It also tied the percentage of tax on capital gains to the tax bracket you are in on other income.
For example, the tax rate on capital gains is 10% if your taxable income is in the regular 15% federal bracket. But, it's 20% if you are in the 28% tax range.
"The key is that tax bracket planning becomes even more important if you have capital gains income," Murken says. "Breeding hogs can generate a big capital gains.
"If you buy your breeding stock, it probably isn't going to make a difference," he explains. "Because of depreciation recapture (taxed as ordinary income rather than as capital gain), you're probably not going to sell at a gain.
"But if you put your own gilts into your herd, you could have a lot of capital gains." Then, you definitely want to do some tax bracket investigation to see what maneuvers might capture the 10% rate rather than 20%.
Free Deductions IRS gives you some deductions; they're free for the taking as long as you have enough income to use them. They're lost forever if you don't use them up every year.
The standard deduction is $7,100 for a couple under age 65 and $4,250 for a single taxpayer under age 65. You also get a personal exemption deduction for each - you, your spouse and each dependent child you can claim on your tax return. It's $2,700 each for 1998 federal tax returns. Those numbers are indexed for inflation, so they go up every year.
You also get to deduct 45% of the cost of your health insurance premium in 1998 if you are self-employed. For example, let's say you can claim yourself, your spouse and two dependent children on your return. Your health insurance premium is $5,000 for the year. Here's the amount of income you can have and still avoid paying federal income tax because of those deductions. 4 personal exemptions ($2,700 ea.) $10,800 Standard deduction (joint return) 7,100 Health insurance deduction 2,250 Total $20,150
You can, in this example, have $20,150 of income on the front page of your federal Form 1040 and not owe a cent of federal income tax. In fact, if that is earned income and you are self-employed, you can have even more and pay no tax. That's because 50% of any self-employment (social security) tax you pay is also deductible. In this example, that would jump that income figure to about $22,000 before there would be any federal income tax.
Add in the $42,350 amount that is taxed at only 15% on a married couple filing a joint return and that couple could have at least $64,000 (more with more self employment tax deduction) total income on their federal Form 1040 and not pay any federal income tax at more than the 15% rate.
Low-Year Strategy Tax haters can be a little tougher for Murken to deal with in lower income years. In this case, "tax haters" are producers who look at dollars of tax rather than tax brackets and don't want to pay a cent more tax any year than they absolutely have to.
"All I have to do in the high income years is show my clients the potential tax bill they will have to pay if they don't do additional planning and they are usually very willing to lower it," says Murken. "That's an easy sell.
"The more difficult argument is when they are in a low income year and you're telling them they should make changes so they will pay more tax," he adds. "They don't have enough cash flow and you're telling them to do something that's going to take more dollars for something they hate to pay anyway."
Regular income, regular expenses and depreciation (regular and expensing) are the major planning tools you've probably used to adjust your taxable income from the time you started farming. Tax deductible retirement plans add another tool to consider, especially in high income years.
Other than some law changes that have already been mentioned, Murken says there's really nothing new this year. What might be new, however, is how you use those old tools.
"Timing of sales may be the oldest tool," he says. "It works well to hold back sales until your next tax year if your income is high and speed up some sales, pulling them into the present tax year when income is low.
Prepayment of feed and supplies, however, can give large hog operations a huge "swing" margin. You can prepay 50% of your gross income from farming, he says. "If you have $500,000 of hog sales this year, for example, you can prepay and deduct up to $250,000."
If you prepay, follow the rules. It has to be a legitimate purchase, not just a deposit with the feed supplier, for example. Murken wants his clients to specify price and quantity. If you are paid interest on the money you have prepaid, it's not deductible.
Tax law also allows you to expense up to $18,500 this year that you spend for assets that would otherwise have to be depreciated and deducted over a period of years.
"Just because you can write off up to $18,500 of those purchases in a single year doesn't mean you should do it every year," says Murken. "A low income year, like 1998 might be for you, is a good example. "If some or all of that is going to be offsetting dollars that would be taxed at only the 15% federal tax rate, you may not want to currently deduct that amount. It's not like it's going to be lost. It may have a lot more tax savings value in the future when it might offset income taxed at 28% or 31% than it has this year at 15%."
Take a look at why you're buying those assets. If you're buying them for tax reasons rather than for good business management, maybe it's time to look at a major change in your business structure, such as incorporation, to broaden the 15% tax bracket.
What To Expense You would expect some tax planning decisions to be easy. They're not. Even with expensing of depreciable items, which assets you expense and which ones you depreciate out over a number of years, can make a difference, Murken says.
"Say you have installed $18,500 of (drainage) tile this year that would be depreciated out over 15 years," he explains. "Suppose you have also bought $18,500 of breeding stock that can be depreciated out over three years."
Which is best to write off this year and which should you depreciate?
"If you have a high income year and are looking for the biggest total amount of deduction, you would expense the tile and depreciate the breeding stock," he explains.
To keep it simple, use straight line depreciation. The breeding stock over three years would give you $6,167 of depreciation this year; the tile over 15 years would give you only about $1,233.
In a low income year, you might do the opposite. But there's more to the decision.
"If you are a sole proprietor and looking at your social security tax, you may want to expense the breeding stock that you're going to sell in the shorter term," says Murken. "Depreciation deductions reduce the social security tax; depreciation recapture on sale of those animals doesn't increase your income subject to the social security tax."
If you have $1 to invest today because you didn't pay it out as tax at the 15% tax rate and earn 10% annually on it, that $1 will grow to $3.79 in 14 years.
At that time, you could pay tax on that money at 56.85% and be just as well off as paying 15% now, says Murken. If the tax rate is less than 56.85%, you'll be ahead.
Murken provides Table 1 to show the breakeven tax brackets if you delay paying tax at 15% for different number of years the tax is delayed and different interest rates you can earn on that delayed tax money.
An example: One argument with incorporation is that the money will come out someday and it will have to be taxed. However, by delaying the tax, those tax dollars can be used, interest free. As the table shows, the tax rate could someday be much higher and you would still be ahead - maybe by a lot.
Another example is with tax deductible and tax deferred retirement plans. Some people argue against them because they are going to be taxed someday and "the tax rate will probably be higher then."
Murken's table won't fully argue against that because it doesn't consider the current income tax savings. Actually, the benefit of deductible retirement plans will be even greater than this table shows.
Go back to your 1995, 1996 and 1997 federal tax returns to see if you missed using any 15% tax rate. If you did, income averaging may save you some tax dollars. This first check is something you can do yourself. We'll show you how. This will work if you are a sole proprietor; not if you are incorporated.
Here are the top limits of taxable income for the 15% federal income tax rate for those three years:
If your taxable income was less than those amounts in any of those years, work with your tax advisors to see if you ought to increase your taxable income now to be able to pick up that lost 15% tax rate.
Your next tax return (for 1998) will be the last chance to pick up any lost 15% in 1995.
You can only use income averaging back three years.
Since income averaging is new this year, work closely with a tax advisor who has learned the rules and knows the calculations.
Farmers often pay more social security tax than they pay federal income tax. There's no standard deduction or personal exemptions to subtract before you figure it. You pay it on all earned income.
As Murken puts it: "Social security dollars are not lost, they are just usually a poor investment."
Young farmers probably ought to pay a fair amount into social security until they have their disability and death (benefits for survivors) benefit built up and enough quarters of coverage to qualify.
But if you are looking at retirement benefits and have paid quite a bit into the system already, additional money paid in is usually not the best investment you could make, says Murken. The key is to look at those things - get an estimate of your benefits from the Social Security Administration - and then, if additional tax you pay will be a poor investment, look at ways you might cut the tax cost.
One is to pay your children who are under age 18 for work they do on the farm. After 18, that opportunity disappears.
Some income such as interest, dividends, rent (if you can show you don't materially participate in the rental activity), depreciation recapture and capital gains don't count as earned income that is subject to the social security tax.
Therefore, the more you can convert earned income to unearned income, the less social security tax you will pay, says Murken.
If it fits your operation, for example, using your own, raised gilts rather than buying them can increase your capital gains and lower your earned income.
Purchased breeding stock gives you depreciation that lowers your earned income. When you sell, depreciation recapture on those is considered to be unearned income.
"Just be sure to keep track of those sows when they're sold," says Murken. "Let a sow you raised that's a year or more old get recorded on your record sheet as a market hog and you could lose the favorable income tax rate and also have to pay social security tax on that money. Sale of a purchased sow could be as bad on the social security end of that."
Some of it is recordkeeping. But you also want to work with your tax advisor to plan the best you can on breeding stock sales to save on the social security tax.
Incorporation is probably the best way for most highly profitable farmers to lower their social security tax. Part of your pay package would be wages. But you can probably also shift more of your income to be rent, interest and dividends.
It's not unusual for farmers to save $5,000 or more annually on just their social security tax by incorporating.
Think about these questions for your business:
* Are you having to hold off more sales or buy more supplies ahead every year to keep out of the 28% or higher tax bracket?
* Are you buying assets to get the expensing deduction ($18,500 for 1998) every year?
* Are some of those asset purchases more to save tax than because they are a good business decision? Would a $90,000-plus 15% tax bracket help?
* Would you like to deduct some things you can't deduct now as a sole proprietor?
* Would you pay less social security tax if you could?
There may be some tricks in those questions. But if you answer yes to most or all of them, it's probably time to take a look at a different business structure. Incorporation is the most likely for most producers.
"Probably the biggest advantage with incorporation is wider brackets," says Murken. "Rather than about $41,200 taxable at 15% on a joint tax return in 1998, it would be $91,200."
Here are the corporation tax rates:
Plus, of course, you would still have the first $42,200 of your own taxable income taxed at 15%. You and the corporation are separate taxpayers.
Some other tax advantages of a corporation are that all medical insurance can be deducted. With a medical reimbursement plan, health costs not paid by insurance can also be deducted. Some home utilities and some food for employees may add deductions you can't take as a sole proprietor.
Other advantages include fringe benefits, limited liability and family business continuity. For many large producers, it's certainly worth some study.