Year-End Tax Planning Tips

OMAHA (DTN) -- Year-end tax planning doesn't necessarily mean you have to rush out to buy a large piece of equipment.

That was a little bit of advice from Tina Barrett, executive director of Nebraska Farm Business Inc. Barrett highlighted a few late-year tax issues during a webinar hosted by the Center for Agricultural Profitability at the University of Nebraska-Lincoln.

"As we think about tax planning, I always think that it is really important that we don't think solely about the tax returns," Barrett said. "When it comes to tax planning, we need to think about the management of the business as well."

Barrett highlighted some trends in farm income cycles going back to 2005, noting how the cycle from 2005-11 kind of mirrors what farm income has done from 2017 to now. From 2015-17, what she saw from farms her group works with was a "real deterioration of working capital."

Working capital on farms has improved dramatically over the past couple of years. Typically, that will prompt farmers to look at buying equipment, financing it, and then using Section 179 or bonus depreciation to offset tax liability.

A major question to consider is whether the equipment you are buying to offset tax liability fills a need on the farm. Instead, the purchase should make sense for management purposes, not just for taxes.

"Purchasing equipment is certainly something that has been an option as a way to save taxes," Barrett said. "I always want to step back anytime we're buying something just for saving taxes. It doesn't make financial sense if you're spending $100,000 just to save $30,000-$40,000 in taxes on something that you don't need, whether that's equipment or something else."

Making that big buy for the tax benefit can cost liquidity, Barrett said. "You're spending $100,000 where you could have had $60,000 to $70,000 of cash in your pocket if you just paid the taxes and not spent the $100,000."

If that equipment is necessary, when financing capital purchases, it makes sense to match the depreciation and the principal payments on the equipment. The principal payments aren't tax deductible, but the depreciation on the equipment can offset those payments over time. A five- to seven-year loan may match up quite well with a five- to seven-year depreciation schedule, Barrett explained.

"The thing that happens with taxes is if your taxable income is not higher than your family living (expenses), your principal payments and the income taxes that you're paying, then you're going to be borrowing money in order to make your taxable income work," Barrett said.

Matching the depreciation with principal costs will wash that out.

Otherwise, if a farmer takes a big chunk of the depreciation or a full Section 179 write-off in a single year, then they will be faced with coming up with taxable income in future years while making the principal payment on that equipment. There's no deduction left because it was already used up.

That happened a lot in the 2008-2012 time frame. Producers bought a lot of equipment on finance and immediately wrote it down on their taxes. At least some producers were stacking those Section 179 write-offs in multiple years, then farm income fell, but they were still paying on the financing costs of that equipment.

"We still had all of those payments that are now stacked on top of each other to where we had to make a lot of payments," Barrett said. "But we had no depreciation expense for it, and our liquidity was slipping away."

Essentially, when producers start writing down those large equipment buys but are also financing the purchase, it can cause management issues down the road, Barrett said. It can affect the ability to get financing when farm income falls.

SECTION 179 V BONUS DEPRECIATION

For the 2022 tax year, Section 179 does allow for expensing $1,080,000 in equipment for producers who buy under $2.7 million in total equipment purchases.

There is also bonus depreciation, which remains at 100% for 2022, but starts to phase down next year to 80%, then 60% in 2024, 40% in 2025 and so on.

Bonus depreciation can apply to purchases that Section 179 does not. That's particularly true for buildings, such as machine sheds, because they have a 20-year depreciation schedule. Section 179 doesn't apply to physical buildings.

"Section 179 is good for assets with a class life of less than 20 years," Barrett said. "For bonus depreciation, it's a class life of 20 years or less. And those are very fine words that mean that 20-year-life assets qualify for bonus (depreciation) and not the (Section) 179."

That phase-down in the bonus depreciation rules will start to limit just how much of a machine shed can be deducted off the top or phased down over 20 years.

PREPAID EXPENSES

Looking at the rules for prepaying 2023 expenses, a producer can pay up to 50% of their usual business expenses.

That doesn't mean a producer can't prepay 100% of their seed costs, but they can't prepay more than 50% of total "normal" expenses. If gross expenses are normally $1 million, then a farmer can prepay up to $500,000.

The IRS is a stickler on some prepaid points. First, it must be an actual purchase. A producer needs a receipt for a specific quantity at a specific price. So, if you have locked in 25% of your diesel costs or half of your fertilizer needs, the details need to be spelled out in a receipt. In other words, Barrett said, a $25,000 check at the co-op sitting in an account is not a deductible expense.

"But it's also important to remember that we're not doing this for tax avoidance because you can't deduct a prepaid expense for that purpose -- only," she said. "But as long as there is a discount, or that we're concerned about supply being there, or that we're concerned about prices going up, those would all be management reasons for the prepay."

Also, when it comes to financing prepaid costs, the IRS requires a separate company to finance those rather than the dealer itself. Barrett highlighted that interest costs on financing prepaid expenses also now are much higher. Financing $100,000 of prepaid expenses at a 7.5% or 8% rate is going to be more expensive, even if a farmer is only carrying that debt for a few months.

"We're talking maybe $2,500 of additional costs that you're going to pay in interest in order to save on that tax bill," she said. "So, make sure that you weigh that in. It's something we just haven't had to think about for quite a while, but it's certainly becoming a real cost."

The full webinar can be found at: https://cap.unl.edu/….

Also see "Taxlink: the Pros and Cons of a Cash Balance Plan" here: https://www.dtnpf.com/….

Chris Clayton can be reached at Chris.Clayton@dtn.com

Follow him on Twitter @ChrisClaytonDTN

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