DRAFT 11/15/00 Tax Planning and Management Considerations for Farmers in 2000 by George F. Patrick Extension Agricultural Economist Purdue University Cooperative Extension Service Paper No. CES- December 2000
Table of Contents TAX PLANNING AND MANAGEMENT CONSIDERATIONS FOR FARMERS IN 2000...1 RECENT CHANGES AFFECTING 2000 AND 2001...1 Depreciation and Like-Kind Exchanges...1 Capital Gains Tax Rate Reduction...2 Uniform Capitalization (UNICAP) Rules... 3 Escape from Accrual Accounting...4 YEAR-END TAX PLANNING CONSIDERATIONS...4 Government Payments...5 INCOME AVERAGING FOR FARMERS... 6 UPDATES ON RATES, EXEMPTIONS AND DEDUCTIONS... 9 DEPRECIATION AND EXPENSING... 9 Section 179 Expensing... 10 Class Lives and Depreciation Rates...12 Final Quarter Limitation...13 Alternative Depreciation Methods...14 SELF-EMPLOYMENT AND SOCIAL SECURITY TAXES...15 Social Security Benefits...16 SE Tax-Reduction Techniques...17 TAX CONSIDERATIONS FOR RETIRING FARMERS...20 Depreciation Recapture and Installment Sales...20 Installment Sales and Tax Planning...21 Leasing of Assets...22 TAX PLANNING IN DIFFICULT TIMES...22 Earned Income Credit...22 Net Operating Losses...23 Tax Consequences of Asset Dispositions...25 Tax Implications of Financial Distress...26 TAX MANAGEMENT...28 REFERENCES...29
TAX PLANNING AND MANAGEMENT CONSIDERATIONS FOR FARMERS IN 2000 * George F. Patrick, Professor Department of Agricultural Economics Purdue University Almost every year is an active year as far as tax legislation is concerned. Like previous years, the year 2000 saw many, many tax proposals introduced in Congress. Repeal of the so-called marriage penalty and elimination of the estate tax were two of the tax proposals passed and sent to President Clinton. However, all of the proposed tax law changes were vetoed. In spite of the lack of new legislation, there are some significant changes for farmers which take effect in 2000 or 2001. These are discussed in the first section of the paper. Many Midwestern producers have received or can receive a number of payments from the government. Assessing the impact of these payments on taxable income is critical for year-end tax planning. Government payments and the options which producers have are discussed in the second section of this paper. The paper also includes a discussion of income averaging and new IRS instructions, a review of depreciation and Section 179 expensing, and recent development in the social security and selfemployment tax area. The paper closes with some issues involved with tax planning in conditions of financial distress and selected other topics. RECENT CHANGES AFFECTING 2000 and 2001 Depreciation and Like-Kind Exchanges Farmers and other business people often trade or swap assets in like-kind exchanges. For example, an old planter may be traded for a new planter or other piece of qualifying farm machinery. Real estate may also be traded for other real estate. Any gain or loss on a like-kind exchange is not recognized (reported) for trade purposes. For like-kind exchanges and involuntary conversions on or after January 3, 2000, IRS Notice 2000-4 indicates that one continues to depreciate the basis (remaining book value) which carries over to the acquired asset using the same life and method. Essentially this treats the basis in the old asset as if it not been traded. The boot portion of the new asset is depreciated over the class life of the asset. Under the old tax rules, for trades and involuntary conversions before January 3, 2000, the adjusted tax basis of the old asset was added to the boot paid for the new asset and the entire amount was * For information on specific tax situations, consult a competent tax advisor. Appreciation is expressed to Purdue colleagues, Freddie Barnard, Howard Doster, Gerry Harrision, Laura Hoelscher, Jess Lowenberg-DeBoer, Alan Miller, Bob Taylor and to Charles Cuykendall, Cornell University; David Frette, CPA, Washington, IN and David Miller, Ohio State University; for helpful comments on earlier versions. For a more basic discussion of income taxes and agriculture see, Patrick and Harris, Income Tax Management for Farmers, NCR#2, MWPS, Iowa State University, 1997. 1
depreciated over the life of the new asset. For example, assume that a tractor (7-year property) purchased for $100,000 in 1996 was traded for a new $100,000 tractor on July 1, 2000 and the farmer paid $60,000 boot. Effectively the farmer got a $40,000 trade-in allowance for the old tractor. With onehalf year or $6,125 of depreciation being allowed for 2000, the adjusted tax basis of the tractor traded in would have been $36,755. The $36,755 would have been added to the $60,000 boot for a basis of $96,755 in the new tractor for depreciation ($96,755 X 10.71% or $10,362 in the year of trade). Thus, under the old system, the total depreciation deduction for 2000 would be $16,487. Under the new IRS rules, to the extent that the basis of the old tractor transfers, the new tractor is depreciated over the remaining recovery period of the tractor using the same method and convention. The additional basis, the boot, is treated as newly purchased MACRS property. In other words, the old tractor continues to be depreciated as if it had not been traded. Thus, $12,250 of depreciation ($100,000 X 12.25%) will be claimed on the old tractor in 2000. In addition, the $60,000 boot for the new tractor will be depreciated over the 7-year recovery period. This results in $6,426 ($60,000 X 10.71%) depreciation on the new tractor in 2000. The total depreciation under the new system, $18,676, is greater than the $16,487 under the old system in the year of trade. In 2001, 2002 and 2003, depreciation would be computed for both the tractor traded in and the new tractor. After 2003, the old tractor would be fully depreciated and could be taken off the depreciation schedule. The primary tax effect of the new rules is to allow more rapid cost recovery, at least in the year of trade. However, the depreciation schedule for an individual who trades machinery and equipment frequently will be much more complicated. For Section 179 expensing, only the boot portion on a like-kind trade is eligible to be expensed. Furthermore, only the boot portion is considered in determining whether more than $200,000 of qualifying Section 179 property was purchased and placed in service during the tax year. Thus, the treatment is the same under both the new and old rules. The depreciation recapture rules require that the lesser of the gain realized or the depreciation previously taken is treated as ordinary income on the sale or other disposition of the asset. In the case of an asset acquired in a like-kind exchange, the taxpayer is required to include the depreciation on the asset traded-in to the extent of deferred gain. In the example above, the $40,000 trade-in allowance for the old tractor has a deferred gain of $40,000 - $36,755 or $3,245. This deferred gain would be included in depreciation recapture of the new tractor. It appears that these procedures are unchanged by the new rules. Capital Gains Tax Rate Reduction The maximum tax rate on capital gains on qualifying assets held by an individual for more than five years is reduced. Beginning in 2001, the maximum rate on assets held for more than five years will be 8 percent for individuals in the 15-percent ordinary income tax bracket (a 2001 taxable income of $45,200 or less for married, filing jointly). For example, a couple with a taxable income of $35,000, including a capital gain of $10,000 on an asset held for more than five years, would be taxed only $800 on the gain from sales and exchanges after December 31, 2000. If the sale or exchange had occurred before January 1, 2001, the tax would be 10 percent or $1,000. 2
For taxpayers in the 28-percent or higher tax rate on ordinary income (a 2001 taxable income of over $45,200 for married, filing jointly) the maximum 18-percent tax rate applies only to assets acquired after December 31, 2000. Thus, the reduced capital gain tax rate for individuals in the 28 percent or higher tax bracket will not become effective until 2006, and then only for assets acquired after 2000. However, when filing their 2001 tax return, individuals may elect to treat an asset which they had acquired before January 1, 2001 as if it had been sold on January 2, 2001 and reacquired at fair market value. Tax would be due on the capital gain associated with the deemed sale and repurchase of the asset, but losses are not deductible. For example, a couple purchased ABC stock for $10,000 in 1998. On January 2, 2001, the stock was worth $12,000. If they made the deemed sale and repurchase election, the $2,000 unrealized capital gain would be taxed at the 20 percent maximum rate and they would pay $400 tax. They would receive a new holding period beginning January 3, 2001 and a new tax basis of $12,000. If the asset was sold for $20,000 after the five year holding period, then the capital gain of $8,000 would be taxed at a maximum rate of 18 percent or $1,440 for a total tax of $1,840. If the election had not been made, the tax would have been $2,000. These new rules further complicate tax planning. Note that both the entire capital gain and ordinary income is included in determining taxable income. The capital gain associated with the disposition of an asset might increase the income of a taxpayer such that they would not be eligible for the lower maximum rate. If the time value of money is considered, the tax associated with the deemed sale and repurchase election to establish a new holding period may more than offset the later tax savings. However, if a taxpayer has capital losses in 2001, then the gain associated with the deemed sale and repurchase may offset the losses. In other instances, the gain expected after 2001 may be so great that the early payment of some tax may be worthwhile. Uniform Capitalization (UNICAP) Rules IRS has issued final regulations with respect to the capitalization of property produced in the trade or business of farming with a preproductive period of more than two years. As originally enacted by Congress, both animals and plants were included. However, repeal of the so-called heifer tax excluded livestock. The regulations specify that it is the average U.S. preproductive period, not an individual producer s experience, which determines whether a crop is subject to the UNICAP rules. Some of the Indiana crops which would be subject to the UNICAP requirements include new plantings of apples, apricots, blackberries, blueberries, cherries, chestnuts, grapes, nectarines, peaches, pears, persimmons, raspberries and walnuts. Purchases of established, producing plantings or orchards are not subject to the UNICAP rules. Under the UNICAP rules, the costs of planting, cultivation and development are capitalized and then depreciated over a ten-year period when the plants become productive. Producers who first become subject to UNICAP rules can elect out of the UNICAP requirements. However, the alternative depreciation system must be used for all assets used in farming. The alternative depreciation system uses a longer life and slower rate of depreciation than the regular depreciation allowed for assets used in farming. 3
Escape from Accrual Accounting Most farmers currently use the cash method of accounting for tax purposes. However, there are a few producers using the accrual method. In addition, some farmers, such as greenhouses and garden centers, have been required to account for inventories if the production, purchase or sale of merchandise is an income-producing factor in the business. Revenue Procedure 2000-22 allows businesses with gross receipts of $1,000,000 or less to shift to cash accounting for their first tax year ending after December 17, 2000. Thus, taxpayers reporting on the calendar year who wish to take advantage of the chance to change must do so in 2000. Essentially this change allows taxpayers to deduct the cost of plants purchased for resale when the item is sold (like feeder livestock). Costs of growing plants, even if the preproduction period is more than two years, can be deducted for the year in which the cost was incurred. Revenue Procedure 2000-22 provides information on the procedures to be used to make the change in accounting methods. YEAR-END TAX PLANNING CONSIDERATIONS For farmers using the cash accounting method, when an input is paid for, rather than when that input is used, determines when the cost is deductible for tax purposes. Expenses which were prepaid in 1999 cannot be deducted in 2000. On the other hand, producers who typically prepay many expenses may find deductible expenses for 2000 will be low and taxable income higher than anticipated, unless some input purchases for 2001 are made before the end of 2000. Receipts are generally reported as income the year in which they are received. Many farmers carried 1999 grain over and did not sell until after January 1, 2000. Some farmers may have sold commodities in 1999, but deferred payment into 2000. In both cases, these sales would be counted as income in 1999. Other producers may have deferred 1999 crop insurance payments to 2000. For effective tax planning, it is critical for farmers to review their 2000 year-to-date receipts and expenses. For a married couple, because of the standard deduction and personal exemptions, there is no federal income tax on the first $12,950 of 2000 income. This increases to $18,550 for a family of four; and, depending on their situation, the family may qualify for the new child tax credit and earned income tax credit. Unlike many tax provisions, if not used, the standard deduction and personal exemptions for 2000 cannot be carried to another tax year. Thus, if the year-to-date review indicates that adjusted gross income will be less than this tax-free amount, attempts should be made to increase income for 2000 tax purposes. Delaying purchases or postponing payment for items already purchased until after January 1, 2001 will reduce expenses for 2000. For assets acquired in 2000, straight-line depreciation and longer lives for depreciation may be elected; however, no changes are possible for assets already on the depreciation schedule. Selling some commodities or culling livestock and taking payment before the end of the year would increase 2000 receipts. Taking the 2001 Production Flexibility Contract payment before December 31, 2000 will increase 2000 income. Simply assuming that 2000 will be a low taxable income year may lead to poor tax planning. Check your tax situation while there is still time to make potentially money-saving adjustments. 4
Government Payments Government payments are a significant portion of farm income for many Indiana producers. Farmers using the cash method of accounting generally report receipts as income when constructively received and deduct expenses when actually paid. However, farmers may have some control over when government program payments are received and reported for income tax purposes. This allows some yearend tax planning by producers. Most producers can put their wheat, corn and soybeans under the marketing loan program with the Commodity Credit Corporation (CCC). For tax purposes, farmers can treat this loan like any other loan and not include the proceeds in income. Receipts from the sale of the crop would be reported as income when the crop was sold. Alternatively, producers can elect to report the CCC loan as income when received. In this case, the later redemption of the loan results in the farmer having a tax basis in the redeemed commodity, which is used in determining gain or loss, equal to the amount previously reported as income. However, once a CCC loan is reported as income when received, all subsequent CCC loans must be reported as income when received. Under the marketing loan program, if market prices remain below the loan rate, a producer may repay the CCC loan at the posted county price (PCP), and there is no interest expense. The difference between the loan rate and the PCP is referred to as the marketing loan gain. Producers who treated the CCC loan as a loan must include the marketing loan gain in income when the CCC loan is repaid. The sales price of the commodity would be included in income if the commodity is sold, and there would be no feed deduction if the commodity were fed. Producers who reported the CCC loan as income would also report the marketing loan gain on Schedule F, but not include the gain as taxable income. In this case the PCP, rather than the loan rate, would be their tax basis for computing gain or loss on the sale of the commodity. If fed, they could deduct the tax basis as a feed cost. Farmers can lock in a CCC loan repayment rate based on the PCP for a 60-day period and speculate on higher cash prices. If the repayment is not made until after January 1, 2001, then the marketing loan gain income is deferred into 2001. A loan deficiency payment (LDP) can be claimed by a producer on the commodity produced. Rather than taking a CCC loan and paying it off, the producer takes the LDP for the difference between the loan rate and PCP (based on the prior day s market) on the date the LDP is claimed. Although the LDP is based on specific dates, farmers do have some control over their reporting of activities which influences when the LDP will be paid by the Farm Service Agency (FSA) and included in income for tax purposes. If grain is harvested and sold when delivered to the elevator, the CCC-709 form is filed with FSA. Although the LDP rate is based on delivery date, actual payment will not be made until FSA receives acceptable evidence of production. For producers who store their grain on-farm or in commercial storage, the LDP is set using the FSA form CCC-666. FSA generally processes these forms and makes the LDP 5
payment within 30 days. Thus, producers can establish the LDP, but by delaying reporting to FSA can defer payment and reporting of income into 2001. Producers may request their 2001 production flexibility contract (PFC) payments (these are also referred to as the Agricultural Market Transition Act, AMTA payments) after October 1, 2000. Although the payments are available to qualifying producers in 2000, because of a special provision enacted by Congress, these payments are not considered as income until actually received by the producer. Thus, producers with a low taxable income may want to take their 2001 payment before December 31, 2000. Producers wishing to defer income into 2001 can delay requesting their payment until after January 1, 2001. INCOME AVERAGING FOR FARMERS For tax years beginning after 1997, farmers can choose to average part or all of their farm income over three years. The law was passed in 1997, and made permanent in 1999, and the proposed regulations detailing the procedures of income averaging were released in October 1999. Instructions for the 2000 Schedule J make a number of changes which are farmer friendly. Farm income is based on taxable farm income. It includes all income, gains, losses, and deductions attributable to any farming business. Gain from the sale or other disposition of land is not included, nor is timber considered farm income. The instructions for Schedule J indicate that farm-related items are generally reported on Schedule D, Schedule F, Form 4797, and Schedule E, Part II (Income or Loss from Partnerships and S Corporations). Thus, farm income from flow-through entities such as S corporations and partnerships does qualify. The 2000 instructions add wages and other compensation received as a shareholder in an S corporation engaged in farming. Income reported on Form 4835 by share lease landowners who do not materially participate in the business for self-employment tax purposes is also generally eligible. Farm income averaging is not available to regular corporations, trusts or estates. Cash rent landowners are also excluded. The basic concept of farm income averaging is simple and uses Schedule J. A farmer may elect to average part or all of the farm income in the election year, e.g., 2000, and have that elected farm income treated as if it have been earned equally over the preceding three base years, 1997 to 1999, and taxed at the rates for those years. Note that the elected income is spread equally over the three prior or base years. If one of the three preceding years has a very low income or loss, there is no possibility of allocating more of the elected farm income to that year. Furthermore, for future income tax averaging, say in 2001, taxable income for 1998 and 1999 is increased by the previously averaged income. Although income averaging may reduce the income tax liability of a producer, income averaging has no effect on self-employment tax liability. To illustrate income averaging, assume that a farmer (married, filing jointly) has a taxable income of $123,000 in 2000 and taxable income had been $10,000 each of the three preceding years. Without 6
income averaging, the farmer s 2000 income tax liability would be $29,251. The last dollars of the farmer s income are taxed at the 31-percent marginal income tax rate. However, in the three preceding base years the farmer s marginal tax rate was only 15 percent. If the farmer elected to average $81,000 of 2000 taxable income, the 2000 income would be reduced to $42,000. This is close to the top of the 15-percent tax bracket for a married couple, filing jointly. The $81,000 of 2000 elected farm income would be treated as if $27,000 had been income in each of the three preceding base years and taxed at that year s tax rate. Note that income is not carried back to a prior year, rather the unused tax brackets are brought forward. Thus, after averaging, taxable incomes in 1997, 1998 and 1999 would be $37,000 each year. In this example, all of the elected farm income would be taxed at a marginal tax rate of 15 percent, thus the total income tax would be $18,450. (The 2000 self-employment tax is not affected by the income averaging.) Total income taxes would be $29,251 without averaging and $18,450 with averaging, for a savings of $10,801. However, income averaging may make the farmer liable to the alternative minimum tax (AMT). If the $123,000 was the alternative minimum tax income in 2000, the AMT would be $123,000 minus $45,000 multiplied by 28 percent or $21,840, reducing the savings to $7,421. If in 2001, the farmer had another high-income year, the tax saving associated with averaging would be less. For example, assume that 2001 taxable income was $120,000. The income tax liability would be about $28,321 (using 2000 rates). If the farmer elected to average $78,000, income in each of the three preceding years would be increased by $26,000. For 1998 and 1999, taxable income would be the original $10,000, plus $27,000 from income averaging in 2000, and $26,000 from 2001 averaging, for a total of $63,000 each year. The 2000 income would be $42,000 after averaging plus $26,000, for a total of $68,000. In this situation, much of the elected farm income will be taxed at the 28-percent marginal tax rate rather than the 15-percent rate as in the 2000 income averaging. The total tax liability with averaging would be $25,767.50, a savings of $2,553.50. It should be noted that other elected amounts might increase the tax-savings some, but tax savings in 2001 will be much lower than in 2000 because of the effect of the prior income averaging. Farmers can elect, subject to some restrictions, the amount and type of income which they wish to average. Commonly, farmers will have ordinary income from Schedule F and depreciation recapture. They may also have Section 1231 gains reported on Form 4797 which are treated as long-term capital gains. In the 1997 tax year, capital gain income was taxed at the lower of the taxpayer s regular tax rate or 28 percent. In contrast, for 2000, the maximum tax rate on long-term capital gains is 20 percent. A farmer can elect to average ordinary income and allocate 2000 farm capital gain income (unless offset by non-farm capital losses) to the 2000 year. For example, assume a producer has $50,000 of Schedule F net income, $30,000 of farm Section 1231 gains and no non-farm income or losses. The farmer could elect to average up to $50,000 of farm income and allocate all of the Section 1231 gain to 2000. All of the elected income would be ordinary income and allocated equally to the three prior years. However, if the farmer elected to average $60,000 of farm income, at least $10,000 would be Section 1231 gains. In this situation, one-third of the elected Section 1231 gain would be allocated to each of the prior years and taxed according to the rules for that year. Farmers who are subject to the alternative minimum tax (AMT) in a year will not reduce their tax liability for that year by filing Schedule J. In some instances, use of Schedule J may make a farmer subject 7
to AMT, and the farmer will not receive all of the potential benefit from income averaging. Furthermore, in most instances, the AMT associated with income averaging does not result from deferral items (e.g., depreciation adjustments) and does not result in an AMT credit for regular tax purposes in a future year. Instructions for the 2000 Schedule J allow negative taxable incomes to be entered in the base years. Instructions for previous years had not allowed negative numbers. Any elected farm income would resulted in a positive taxable income in the base years. Farmers who income averaged in 1998 or 1999 and who had a negative taxable incomes in base years can file an amended return. Farmers with a negative taxable income in the base years who did not income average in 1998 or 1999 can also file an amended return and use Schedule J. Special worksheets are included in the instructions. The decision to average income in a year is an irrevocable election, except as provided by the Secretary of the Treasury. However, if a producer amends a prior year s return or an adjustment is made by the IRS, those changes allow an individual to reconsider income averaging for the year affected. Income averaging does not affect earned income credit or other tax benefits generated in a prior year. Income averaging does not affect tax calculations and computations of prior years. Effectively, the unused portions of the lower marginal tax rate brackets of the prior years are brought forward to the election year. Income averaging can be used even if it does not reduce tax liability for the current year. An individual might be in a situation in which taxable incomes in the three base years were very low. If 2000 farm income were averaged, this might not reduce the 2000 tax liability. However, reducing 2000 income for future income averaging might increase potential tax savings for an individual who expected a substantially higher farm income in a future year. For example, a married individual might have taxable income of $25,000 in 2000 and very low taxable incomes in the 1997 to 1999 period. Electing to average the $25,000 of farm income in 2000 would not reduce the tax liability because the income would be taxed at the 15-percent rate for prior years. However, the taxable income for 2000 could be reduced to $0, which could benefit future income averaging. If taxable income had been negative in any of the base years, 1997-1999, then income averaging in 2000 might reduce taxes and reduce 2000 taxable income to $0. Income averaging will have the greatest attraction for farmers whose income in one year is much higher than in the preceding three years. Beginning farmers with limited income in prior years could be in this situation. Individuals do not have to have been in farming in the base years to qualify for farm income averaging. Farm families whose off-farm income increased sharply would be eligible to average their farm income and perhaps reduce their current tax liability. Note that only farm income is eligible for income averaging. Retiring farmers and others disposing of assets may also be able to take advantage of income averaging. Depreciation recapture on machinery, equipment, buildings, and purchased breeding stock is reported as ordinary income. The disposition of these assets in one year may result in a high marginal tax rate and benefits from income averaging. Dispositions of assets for up to a year after an individual ceases farming are presumed to be within a reasonable time and would be eligible for farm income averaging. Depending on individual circumstances, dispositions of assets over longer periods may also be acceptable for income averaging. Income averaging may also be helpful for an individual in a situation in which the usual 8
year-end tax planning strategies do not apply. However, income averaging is not likely to substitute for regular year-end tax planning and keeping taxable income relatively stable from year-to-year. 9
UPDATE ON RATES, EXEMPTIONS AND DEDUCTIONS The tax brackets and rates for the married, filing jointly status for 2000 are in Table 1. An additional tax, a 10-percent surtax, is imposed on taxable incomes in excess of $288,350. Thus, the maximum tax rate is 39.6 percent for some individuals. The effective maximum tax rate is actually even higher for many of these taxpayers, because their personal exemptions and itemized deductions are being phased out by other provisions of the tax law. The tax brackets for 2001 will be increased about 3 percent as an adjustment for inflation. For example, the beginning of the 28 percent tax rate is $45,2000 for a married couple, filing jointly in 2001. Table 1. Taxes and Tax Rates for Married, Filing Jointly in 2000 Taxable Income Pay Plus Percent on On Amount Over Excess $0-43,850 $0 15 percent $0 $43,850-105,950 $6,577.50 28 percent $43,850 $105,950-161,450 $23,965.50 31 percent $105,950 $161,450-288,350 $41,170.50 36 percent $161,550 Over $288,350 $86,854.50 39.6 percent $288,350 To arrive at taxable income, taxpayers can reduce their adjusted gross income by their personal exemptions and the larger of their standard deduction or itemized deductions. These amounts for 2000 and 2001 are: 2000 2001 Personal exemption $2,800 $2,900 Standard deductions Married, filing jointly $7,350 $7,600 Single $4,400 $4,550 Over 65/blind (married) an additional $850 $900 Over 65/blind (single) an additional $1,100 $1,100 Individual claimed as dependent by another (or earned income plus $250 unearned income up to a maximum of $4,350 in 2000 and $4,550 in 2001) $700 $750 Thus, a married couple, filing jointly, with two dependents and claiming the standard deduction could have an adjusted gross income of $18,550 in 2000 and $19,200 in 2001 without having a federal income tax liability. DEPRECIATION AND EXPENSING Legislation in 1997 made only minor changes in expensing and depreciation. First, as indicated in Table 2, Section 179 expensing increases gradually from $20,000 in 2000 to $25,000 for tax years beginning after December 31, 2002. Second, it was clarified that horses which meet the qualifications of 10
Section 179 do qualify for Section 179 expensing. Like other property, horses must be used in a trade or business to qualify for Section 179 treatment. Third, the alternative minimum tax (AMT) adjustment for depreciation was repealed for property placed in service after December 31, 1998. Thus, for assets purchased in 1999 and later years, the same depreciation schedule can be used for regular tax and AMT calculations. Table 2. Section 179 Expensing Allowed Taxable year beginning Maximum expensing election 2000 $20,000 2001-02 $24,000 after 2002 $25,000 Section 179 Expensing Farmers and others in an active trade or business can elect to treat the cost of up to $20,000 of qualifying property purchased during 2000 as an expense (rather than as a depreciable capital expenditure). Although the annual expensing limit increases in the future, other limitations remain the same. Tangible personal property used in a trade or business qualifies if it would have been eligible for investment tax credit. (Currently, reference is made to Section 1245 property which does include horses.) Purchased new or used property can be expensed. However, only the boot portion paid on trades is eligible for expensing. Property previously used by the purchaser is not eligible for expensing. Inherited property or property acquired from a spouse, ancestors, or lineal descendants is also not eligible for Section 179 expensing. The entire Section 179 expensing deduction can be taken on one large item, reducing the basis for cost recovery. Alternatively, several small items can be completely written off in the year of purchase. Less than the full $20,000 expensing deduction can also be used. The amounts expensed are treated the same as depreciation when the property is sold or traded, and for depreciation recapture purposes. If a Section 179 expensing election is made, notations regarding the specific allocations should be made on the depreciation schedule. If no allocations are specified, IRS prorates the expensing election among all eligible assets. The expensing deduction is phased out on a dollar-for-dollar basis if over $200,000 of qualified property is placed in service during a tax year. Only the boot portion on like-kind trades is considered for the $200,000 limit. For example, if a farmer buys $205,000 of machinery in 2000, the maximum Section 179 expensing allowed would be $15,000 that year ($20,000 - $5,000). An individual is not allowed to elect the full $20,000 and carryover the $5,000 excess. However, if the boot portion of the $205,000 purchase with a like-kind trade-in was only $150,000, then the full $20,000 expensing could be elected. The expensing deduction is also limited to the taxable income from any active trade or business before any Section 179 expensing. A farmer's and/or spouse's off-farm wage or business income can be combined with Schedule F loss so that aggregate taxable income would be positive. This would permit a 11
Section 179 expense for an asset acquired by the farm business. Gain or loss from the sale of livestock, machinery and business assets reported on Form 4797 is also included in taxable income for Section 179 purposes. Recent regulations also clarify that suspended losses are not considered in determining the taxable income limit. For example, a farmer with a net income from active trades and businesses of $2,600 would be limited to a Section 179 deduction of $2,600. If more than $2,600 of qualifying property had been purchased in 1999, the excess could be carried over to 2000 or later years. The amount carried over to 2000 could be deducted, assuming sufficient taxable income, even if no qualifying property has been purchased in 2000. However, the total Section 179 expensing cannot exceed $20,000 (the new limit) in 2000, even with carryovers. The carryover Section 179 expensing is used after new Section 179 expensing for 2000 is used. Example: Assume that $10,000 of qualifying assets has been purchased in 1999, but taxable income of the business was only $3,100. Thus, only $3,100 would be allowed as Section 179 expensing in 1999, and $6,900 would be carried to 2000. In 2000, taxable income is $32,000 and $15,000 of Section 179 qualifying property is purchased. The 2000 Section 179 would be limited to $20,000 ($5,000 of the carryover plus $15,000 of new purchases). The remaining $1,900 of 1999 purchases ($6,900 minus $5,000) could be carried to 2001. CAUTION: Reducing taxable income of a business to $0, as in the example above, is generally not good tax management. Using Section 179 expensing to reduce the income subject to tax below the personal exemptions and standard deduction wastes potential future depreciation deductions. Farmers should review their 2000 tax situation before claiming the maximum Section 179 deduction. For individuals involved in partnerships and/or S corporations, the Section 179 expensing and taxable limitations apply to both the business and the individual level. For example, George and David are equal partners in DG Partnership. In 2000, the DG partnership acquires $100,000 of qualifying property and elects a $20,000 Section 179 deduction which passes through to David and George. If David and George are not involved in other businesses, each would be limited to a $10,000 Section 179 expensing deduction. However, if David is also involved in a sole proprietorship, his total Section 179 for 2000 expensing is limited to $20,000. David would qualify for the additional $10,000 Section 179 deduction only if his sole proprietorship made qualifying investments and the income limitations were met. If George had been involved in three partnerships, each expensing $10,000, George would be limited to a $20,000 deduction, and the remaining $10,000 would be lost rather than carried over. With Section 179 expensing there is a trade-off between the tax deductions for income and selfemployment tax purposes in one year versus tax savings spread over several years. Expensing a seven-year MACRS class asset gains the tax savings in one year rather than over the eight years of the recovery period. The time value of money and expected future income are important in making the expensing decision. The present value of tax benefits from expensing is generally higher for assets with longer MACRS lives, like drainage tile. Thus, the expensing election is usually applied to qualifying property which 12
has the longest life and is the least likely to be resold or traded. However, expensing may not reduce taxes for the farmer who expects income to increase and the marginal tax rate to be higher in the future. Both income and SE taxes should be considered in making decisions with respect to the Section 179 expensing election. Because of reduced taxable incomes, many farmers with low taxable incomes may decide to forgo Section 179 expensing for 2000. 13
Class Lives and Depreciation Rates The Technical and Miscellaneous Revenue Act of 1988 (TAMRA) affected both the class life of some assets and the rate of depreciation for property used in farming. The system is called MACRS (Modified Accelerated Cost Recovery System), and the 150-percent declining-balance method applies to most property acquired by farmers after 1988. Three-year MACRS property includes breeding hogs and the tractor units of semi-trailers for over-the-road use. Five-year MACRS property includes cattle held for breeding or dairy purposes, computers and some construction equipment. Congress specifically included automobiles, pickups and other trucks in the five-year class. Special depreciation limitations and recordkeeping requirements apply to passenger vehicles. For passenger vehicles acquired in 2000, the maximum combined depreciation and Section 179 expensing deduction is $3,060. This increases to $5,000 in the second year, $2,950 in the third year, and $1,775 thereafter. If business use is less than 100 percent, the maximum deductions are reduced accordingly. Pick-ups and other trucks with a gross vehicle weight exceeding 6,000 pounds are not subject to the depreciation and Section 179 limits discussed above. Seven-year MACRS property includes most agricultural machinery and equipment. Grain bins, fences and general office equipment are also included in this seven-year class. Ten-year MACRS property includes single-purpose agricultural and horticultural structures placed in service after 1988, fruit trees and vineyards. For orchards and vineyards placed in service after 1988, depreciation is on the straight-line method. Allowable depreciation for pre-1989 acquisition of these assets is calculated using the double declining-balance (200-percent declining balance) method, shifting to straight line to maximize depreciation. Deductions by year, as a percentage of the initial depreciable basis, for assets acquired after 1988 are shown in Table 3. These MACRS percentages have built in the half-year convention for the year of purchase. The equivalent of six months depreciation is allowed whether an asset is placed in service on January 1 or December 31. If a $100,000 asset were purchased in 2000, the first year s depreciation allowed would generally be $25,000 for three-year MACRS property, $15,000 for five-year property, $10,710 for seven-year property, or $7,500 for ten-year property. The half-year convention is also used for the year of disposition. For example, if a tractor acquired in 1996 is sold in 2000, the fifth recovery year, allowable depreciation for 2000 would be one-half of the 12.25 percent in the table. As discussed previously, if an asset is traded in a like-kind exchange, one continues to depreciate the basis in old asset. Depreciable land improvements, such as field tiling, are assets in the 15-year MACRS class. Farm buildings, such as general purpose barns and machinery sheds, are 20-year MACRS property. The 150-percent declining-balance method with a shift to straight-line depreciation, to maximize the depreciation deduction, is used for property in the 15- and 20-year MACRS classes. 14
Rental houses and apartment buildings acquired in 1987 and later years will have a 27.5-year life. Nonresidential real property such as office buildings, factories and stores will have a 31.5-year life if acquired before May 13, 1993 and 39 years if acquired on or after May 13, 1993. Table 3. MACRS Depreciation Deduction Percentages for Property Used in Farming by Class-Life of MACRS Property Acquired after1988 Class-Life of MACRS Property Recovery 3-Year 5-Year 7-Year 10-Year 1 25.00 15.00 10.71 7.50 2 37.50 25.00 19.13 13.88 3 25.00 17.85 15.03 11.79 4 12.50 16.66 12.25 10.02 5 -- 16.66 12.25 8.74 6 -- 8.33 12.25 8.74 7 -- -- 12.25 8.74 8 -- -- 6.13 8.74 9 -- -- -- 8.74 10 -- -- -- 8.74 11 -- -- -- 4.37 Source: Internal Revenue Service, Depreciation, Pub. 534, 1993 and How to Depreciate Property, Pub. 946, 1995. Final Quarter Limitation A special limitation on depreciation applies if more than 40 percent of the total depreciable bases of property acquired in a tax year is placed in service during the last three months of the year. Nonresidential real property and residential real property is excluded from this calculation. This final quarter limitation affects all assets acquired during the tax year and may substantially reduce the amount of depreciation allowed, especially on end-of-the-year purchases. Example: Assume a $100,000 combine was the only asset acquired during 2000 and it was placed in service after October 1. Then only one and one-half months of depreciation would be allowed. Instead of deducting $10,710 of the half-year depreciation, one could deduct depreciation for only one and onehalf months or $2,680. The depreciation not allowed in the year of purchase would be taken in later years, thus the total depreciation is not affected. For example, 20.85 percent would be allowed in the second year 15
for the combine subject to the final quarter limitation in the year of purchase. For further details see IRS Publication 946, How to Depreciate Property, Table A-18, page 85. This publication has other tables which can be used to determine the appropriate percentage for each depreciation situation. Determination of whether the final quarter limitation applies is made after any Section 179 expensing. Whether Section 179 expensing is elected, which assets are selected for expensing and whether the entire $20,000 allowance for 2000 is used may have a considerable impact on the depreciation for the year. It must be possible to avoid application of the limitation by electing to apply Section 179 expensing to depreciable assets acquired in the final quarter of the year. Example: Assume a farmer acquired a $25,000 machine in the first quarter, a $30,000 machine in the second quarter and a $45,000 machine in the last quarter of the year. If there was no Section 179 expensing, the final quarter limitation would apply, and a mid-quarter convention would apply to all assets purchased that year. Each asset is treated as if it had been acquired on the mid-point of the quarter it was placed in service. Depreciation for this seven-year property would be computed, using percentages from IRS Pub. 964 Tables A-15, A-16, and A-17, as: $25,000 x 18.75 percent = $4,687.50 $30,000 x 13.39 percent = $4,017.00 $45,000 x 2.68 percent = $1,206.00 $100,000 TOTAL $9,910.50 Example: Assume the farmer elected $20,000 Section 179 expensing on the $45,000 machine acquired in the last quarter. Then only $80,000 of qualifying property would have been acquired and only one-third in the fourth quarter. The 40-percent test would not be satisfied, and the half-year convention would apply to all of the purchases. Depreciation would be computed using the percentages from Table 4 above as: $25,000 x 10.71 percent = $2,677.50 $30,000 x 10.71 percent = $3,213.00 $25,000 x 10.71 percent = $2,677.50 $80,000 TOTAL $8,560.00 In this instance, the combined depreciation and expensing deduction would total $28,560.00. The depreciation regulations generally allow one-half year's depreciation in the year of acquisition and one-half year of depreciation in the year of disposition. For assets subject to the mid-quarter convention as a result of the final quarter limitation, depreciation in the year of disposition would be allowed to the mid-quarter of disposition. However, the regulations indicate that if one purchases and disposes of an asset within a tax year, the transaction is assumed to occur on the same day, and one receives NO depreciation on that asset. Only those assets that were acquired during the year and are on hand at the end of the year are considered for the 40-percent test. 16
Alternative Depreciation Methods Section 179 expensing and use of the MACRS table results in a producer recovering the cost of the depreciable assets as rapidly as possible. However, if taxable income is low or negative, the tax saving effect of this depreciation may be largely wasted. For example, if taxable income is low, the income tax savings on another dollar of depreciation may be 15 percent or nothing. However, if the depreciation deduction were postponed until a year when income was higher, the savings could be 28 percent or more. Producers have limited flexibility with respect to depreciation. Once a producer begins depreciating an asset using a method, that method must be continued for the life of the asset. However, decisions with respect to methods can be made when the asset is placed in service. Table 4 compares the annual depreciation deductions for the 7-year MACRS method and straight-line depreciation over the alternative 10-year life (Alternative MACRS). Under regular MACRS, nearly 60 percent of cost recovery occurs within the first four years. In contrast, with alternative MACRS, 65 percent of cost recovery is left after four years. Table 4. Depreciation Alternatives for $100,000 7-year Property Acquired in 2000 MACRS Alternative MACRS Year Depreciation Remaining Balance Depreciation Remaining Balance 2000 10,710 89,290 5,000 95,000 2001 19,130 70,160 10,000 85,000 2002 15,030 55,130 10,000 75,000 2003 12,250 42,880 10,000 65,000 2004 12,250 30,630 10,000 55,000 2005 12,250 18,380 10,000 45,000 2006 6,130 6,130 10,000 35,000 2007 --- 0 10,000 25,000 2008 10,000 15,000 2009 10,000 5,000 2010 5,000 0 SELF-EMPLOYMENT AND SOCIAL SECURITY TAXES 17
Self-employment (SE) taxes are larger than income taxes for many farmers. The SE tax has no personal exemptions or standard deduction and applies to $400 or more of earnings from self-employment. The SE tax rate is higher than the income tax rate for 2000 taxable incomes of less than $43,850 if married, filing jointly. Both the SE and social security taxes have two parts. Of the 7.65- percent social security tax rate which both employees and employers pay, 6.2 percent is social security and 1.45 percent is for the medicare hospital insurance tax. For the SE tax, the corresponding rates are 12.4 percent for social security and 2.9 percent for medicare. The maximum earnings subject to these two different taxes have been separated. The maximum earnings subject to social security taxes are $76,200 in 2000 and $80,400 in 2001. Thus, the maximum social security portion will increase from $9,448.80 in 2000 to $10,371.60 in 2001. As a result of the Revenue Reconciliation Act of 1993, there is no limit on the earnings or wages subject to medicare hospital insurance tax of 2.9 percent. Thus, an individual earning an additional $1,000 will pay an additional $29 of medicare hospital insurance. Net earnings for SE, the amount on which the tax is computed, is 92.35 percent of net farm profit on Schedule F. One-half of the SE tax paid is deducted from income in arriving at taxable income. These adjustments are made to put self-employed individuals and employees on a similar basis. Thus, the effective SE tax rate is about 14.2 percent for an individual in the 15-percent income tax bracket and 13.2 percent for those in the 28-percent bracket. Caution: Retired farmers drawing social security benefits, with carryover grain to sell, must also consider the effect on taxability of their social security benefits. Sales of carryover grain are subject to income and self-employment tax, although this income does not reduce social security benefits. In some cases, the effective tax rate on the last dollar of income from grain sales may exceed 60 percent. This occurs because 50 and 85 percent of social security benefits become taxable above certain incomes. Schedule F net income in the $45,000 to $80,000 range tends to have very high effective tax rates for retired farmers. Social Security Benefits The Social Security system provides benefits in addition to old-age benefits for self-employed individuals. If an individual becomes disabled, a covered individual becomes eligible for disability payments. Benefits may also be provided to surviving spouses and to dependent children under 18 years of age if the covered individual dies. Because social security coverage provides benefits in addition to old-age benefits, many farmers want to ensure that they are covered for these other benefits. Payments under the optional method will contribute toward an individual's currently insured status. For survivor benefits, an individual must have been covered for six of the 12 quarters preceding the quarter of death. To be fully insured an individual needs one quarter of coverage for each year since 1951, or since turning 21, whichever is later. Once 40 quarters of coverage are obtained, an individual is fully insured permanently, even if the person was not covered for six of the last 12 quarters. 18