Peter Callan, Extension Agent, Farm Business Management, Northern District
In the first six months of 2014, the prices for feeder and fat cattle and milk have reached record levels. These high prices in conjunction with declining grain prices will likely result in many producers generating significant tax liabilities for 2014. The management and reinvestment of profits generated during times of high prices can impact the long term viability of the business. Based analysis of the farm’s financial situation, consider paying down short and long term debt as a possible place to spend profits. After addressing the farm’s debt load, plan on accumulating cash reserve equivalent to a minimum of three months’ operating expenses. The next question is where should the profits be spent (e.g., Machinery, retirement accounts, etc.).
Over the years, many producers have invested in new trucks and equipment to generate depreciation on their tax returns as a means to reduce tax liabilities. Before investing in new equipment, however, producers should calculate how this equipment will realistically increase the profitability of their business. What is the anticipated payback for the new equipment and will this purchase reduce costs or improve efficiency that will improve the farm’s bottom line?
In some areas of the Midwest, older farmers are contracting to have their crops planted by custom operators who own planters equipped with the latest GIS technology, which provides the platform for variable fertilizer and seed monitors, etc., as a way to benefit from the latest advances in technology without owning the equipment
Historically, farmers have reinvested in their businesses with little thought of diversifying their investments into nonfarm assets. An Individual Retirement Account (IRA) is a savings plan that provides the taxpayer (farmer) with tax advantages for setting aside money for retirement and diversifies investments. There are two types of IRAs for retirement saving. Traditional IRAs are funded with before tax contributions and the Roth IRAs are funded with after-tax contributions. A taxpayer can open and make a contribution to a traditional IRA and/or a Roth IRA if the taxpayer (or if filing a joint return, their spouse) receives taxable compensation (e.g. earned income – wages, salaries, commissions, self-employment income – net earnings from schedule F or C) during the year. A taxpayer whose age is more than age 70 ½ years by December 31, 2014 cannot make a contribution to a traditional IRA. On the other hand, there are no age constraints for contributions to a Roth IRA. Contributions to traditional and Roth IRAs can be made at any time during the year and up to the due date for filing a tax return for that year, not including extensions. For tax year 2014, contributions must be made by April 15, 2015.
The amount contributed to an IRA is based on the amount of taxable income received by the taxpayer during the year. In 2014, the maximum contribution for a traditional IRA and Roth IRA is the lesser of $5,500 or 100 percent earned income ($6,500 age 50 or older). For example, a farmer with $4,000 in earned income (net schedule F after depreciation) would be limited to a maximum contribution of $4,000 to an IRA. The maximum contribution to a spousal traditional or Roth IRA (for a spouse with little or no earned income in 2014) is the lesser of $5,500 or 100 percent of combined earned income ($6,500 age 50 or older). A taxpayer may contribute 100 percent of earned income to a traditional IRA, a Roth IRA, or split between both types of IRAs up to the annual contribution limit.
The benefit of a traditional IRA is that the contributions are tax-deductible in the year that the taxpayer makes the contribution. For example, the taxable income for a couple is $95,000 in 2014 and each spouse contributes $5,500 in a traditional IRA. They will be able to deduct the contributions from their income taxes. Thus they will pay tax on $84,000 in income to the IRS. Assuming that the couple is in the 25 percent marginal tax bracket (Federal) and their IRA contributions are $11,000, they will save $2,750 in Federal income taxes in 2014. The earnings generated by a traditional IRA are tax-deferred. The tax deductible contributions and earnings are taxable as ordinary income when they are withdrawn from the account after age 59 ½. The IRS will assess a 10 percent early withdrawal penalty for distributions made before the farmer reaches age 59 ½ from the IRA.
Another strategy to reduce taxable income is for the sole proprietor farm owner to pay children who work on the farm wages at rates equivalent to those paid to other employees performing the same tasks.
Internal Revenue Service (IRS) states “Payments for the services of your child under age 18 who works for you in your trade or business (including a farm) are not subject to social security and Medicare taxes.” This ruling applies only to farms operated as sole proprietorships.
The tax law is different for business entities. IRS Publication 225 states:
“Payments for the services of your child or spouse are subject to federal income tax withholding as well as social security, Medicare, and FUTA (Federal Unemployment) taxes if he or she works for any of the following entities.
- A corporation, even if it is controlled by you.
- A partnership, even if you are a partner. This does not apply to wages paid to your child if each partner is a parent of the child.
- An estate or trust, even if it is the estate of a deceased parent.
In these situations, the child or spouse is considered to work for the corporation, partnership, or estate, not you.”
By paying children wages at rates that are comparable to rates paid to non family members for similar tasks and responsibilities, the farm owner can shift income to their children who will be in lower tax brackets. Thus, over several years the children will be able to accumulate “significant” nest eggs that can be used to pay for college expenses.
Finally, retirement plans for farm employees provide another means to reduce a farm’s taxable income. Based on my previous work experience, few farms provide retirement programs for their employees. Today, there is intense competition to hire and retain key employees who are in management positions on farms. Providing retirement plans for employees is a tax deductible fringe benefit to help retain employees. It is a way for the farm owner to pay for longevity and share the profits in a business. There are a number of different types of retirement programs that can be implemented by a farm owner. It is recommended that farm owners talk with an investment advisor on setting up a retirement plan that best meets their needs.
The strategic investment of profits generated from recent record cattle and milk prices will lay the foundation for the long term viability of cattle and dairy producers. By working together with their lenders, accountants, and, investment advisors, producers can develop a plan to prioritize the investment of profits into the farm’s infrastructure that will maximize returns to their land, labor and capital in the cyclical beef and dairy industries, as well as preserve and grow hard earned profits for their retirement years.