Come March, farmers may be wondering how to pay this year’s taxes when crop income is still just a twinkle in their eyes.
Here are 10 tax tips from three farm business specialists from University of Vermont Extension: Dennis Kauppila, St. Johnsbury; Bob Parsons, on campus; and Glenn Rogers, St. Albans.
1. Get your Hands on Publication 225
This tax guide for farmers, written by the IRS and farm extension specialists, covers farming tax codes in relatively easy-to-understand terms. Its practice worksheets and depreciation table will make every farmer’s life easier. “Lots of times, [depreciation’s] a puzzle,” Kauppila says. Publication 225 can be ordered or downloaded at www.irs.gov.
2. Find a Great Accountant
All three specialists agree that accountants are invaluable year-round for farmers. An accountant should be consulted on every major farm decision to weigh the tax implications, Parsons says. Rogers estimates a cost of $200-$1000 to hire an accountant – emphasizing finding one who specializes in farming tax code. “Tax accountants don’t see farm returns very often,” Rogers adds.
Farmers can minimize accounting costs by keeping detailed and accurate financial records, Parsons notes, preferably on Quicken or another bookkeeping computer program. “You don’t want to pay your accountant to do record-keeping,” he says.
3. Predict the Future
For farmers, it’s never too early in the year to start thinking about taxes. In fact, Rogers says, good tax planning often starts in December of the previous year.
Farmers can improve their tax returns through strategic purchasing and selling to maximize the benefits of each calendar year. For example, Parsons’ father traditionally sold cows early in January to enjoy the proceeds for a whole year before having to pay taxes on them. This kind of calendar thinking is especially important, given the seasonal nature of farming and what Parsons describes as “lumpy income.”
So, “take early action and know what’s coming so there are no surprises,” Parsons advises. Rogers recommends doing trial tax returns in May, September and December, so that, if a financial problem is looming, there’s time to prepare or offset it with expenses.
4. Don’t Cut off Your Nose to Spite the Taxman
Parsons believes, however, that it’s easy to go overboard trying to avoid paying taxes. He’s seen too many farmers buying equipment solely for its tax-deductibility. Obviously, he says, equipment should be bought only for need, and farmers should be wary of salespeople trying to entice customers with the tax benefits of their products. “You don’t go spending money just to save taxes on it,” he warns.
5. Avoid the “H” Word
H, as in “hobby.” The tax code is much more generous with farms classified as businesses rather than hobbies. Hobby farms get a line on form 1040 to declare expenses, while business farms get a lot more room and categories.
Publication 225 lists nine criteria for establishing a farm as a business, Parsons says, including operating the farm in a businesslike manner, time and effort spent on the farm, depending on the income for livelihood, losses beyond your control, good record keeping, consulting with advisors, and your experience. Unfortunately, the IRS might not just take your word on it. “You’ve got to have a paper trail,” says Parsons.
While profitability is another consideration, you don’t always have to be profitable to be a business. Farms can be declared businesses even if they lose money or make only $10 for the year, Parsons notes. But the IRS will want to see attempts at improving the bottom line in the future.
“On the second year, we’d better see $500 or $1000 [profit],” he says. The farming activity is presumed to be carried on for profit if it produced a profit in three of the last five years, including the current year. With horse operations, the rule is two of last nine years. However, again, one should look at the nine criteria.
6. Put Your Home to Work for You
Farmers should remember to divide farm electricity, insurance and phone expenses from home expenses, since these can be deducted from farm income. Some farms have separate electric meters for home and farm, but Kauppila says the IRS doesn’t need this division to be an exact science.
Farm-related vehicle mileage, now 44 cents per mile, is also deductible.
If part of a home is used for farm business, Kauppila explains that expenses for upkeep of that room(s) are deductible – but make sure the room is used exclusively for business. The IRS has been keeping a close eye on abuses of this deduction. Also, using this option can create repercussions when the building is sold. IRS has a whole publication (Publication 587) on this; farmers should read page 23 of Farmer’s Tax Guide.
7. Make Your New Farm Building Special
Different equipment has different depreciation rates with the IRS, according to Parsons. It usually behooves farmers to depreciate equipment quickly, on paper anyway, to get tax-deduction savings before inflation eats away the value.
Nowhere is this truer than with agricultural buildings, Parsons continues. General-use buildings depreciate with the IRS over 20 years, while special-use buildings depreciate in only 10, so try to make your next new building fit special-use criteria.
8. Good Ol’ Section 179
Section 179 says that farmers who gross under $400,000 a year and buy farm equipment can depreciate up to $108,000 of the cost of that equipment on their taxes in the first year. Some limitations apply, so check Publication 225.
9. Actually Pay Your Kids
While children have been the time-honored free labor force for farms since time immemorial, you might reconsider that tradition. Employee wages are deductible, and the IRS doesn’t care if the employee is a complete stranger or your own flesh and blood. One advantage is you do not owe social security tax on wages paid to your children who are less than 18 years old.
“If your kids work for you, why not employ them?” asks Parsons. Not only are their wages deductible, but their clothes might be as well if they’re needed to perform the job.
Note that you don’t have to actually pay your offspring any extra money. If you’re already paying for their car insurance, for example, just consider that money spent as wages and deduct it. Just be careful not to “pay” your children so much that they’ll have to pay taxes on their earnings. Better yet, Parsons suggests putting those wages directly into an Individual Retirement Account (IRA). “You’ve given the children a start on their retirement and you keep the money out of their hands,” he explains.
You will need to keep records on your children’s work, as with other employees.
10. Oops, I Forgot To Save for My Retirement
About your own golden years. Even if you haven’t made enough taxable earnings to require paying into Social Security, you might still consider paying into it. Otherwise, “you just told Uncle [Sam], ‘Don’t worry, I’m going to handle my own retirement,’” Kauppila says. An option in the tax code allows farmers to pay at least a quarter of their year’s Social Security with each return. Be advised, though, you’ll need 40 credits by the time you’re 62-65 to be eligible for benefits. (See page 72 of Farmer’s Tax Guide, column 2: Earning Credits in 2006; and page 74, column 2, Farm Optional Method.)
Of course, by then, the Social Security system might be as reliable as next year’s rainfall. As in tip #9, it’s a good idea to have another source of retirement income, such as an IRA or Keogh retirement plan.
The IRS has not evaluated these tips; please use these recommendations as discussion points with a professional tax accountant.
Tim Dalton, Associate Professor of Resource Economics and Policy at the University of Maine, works in farm management but was on sabbatical while this article was being prepared. He can be reached at [email protected].
Maine farmers can get information about business planning, marketing, pricing, and other business management-related areas from James C. McConnon, Jr., Extension business and economics specialist, [email protected].
Craig Idlebrook can be reached at [email protected], unless you’re the IRS.