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As a farmer, it’s critical to find ways to minimize your tax burden and improve your bottom line when filing farm taxes. After all, effective tax planning strategies can help you save money that can be reinvested in your farm or saved for future projects and expenses.
But, how do you get started? Whether you’re filing your taxes for the first time as a farmer or you're a seasoned veteran, it’s common to have questions about how to reduce your taxation. We’ve outlined these six tips to help you understand your tax-saving options.
1. Set Up a Retirement Account
Whether retirement is on the horizon or years away, it’s always a good idea to diversify. Contributing to a retirement account can give you a legal tax break upfront and income upon withdrawal. Options include individual retirement accounts (IRAs), 401(k) plans, Simplified Employee Pension (SEP) IRA and Savings Incentive Match Plan for Employees (SIMPLE). Here’s a quick description of each:
- IRA: Traditional and Roth IRAs are tax-advantaged accounts that can hold investments and traditionally have more flexibility than an individual 401(k) plan.
- Individual 401(k) plan: A popular option to build up your retirement account quickly, allowing greater annual contribution limits.
- SEP IRA: A tax-deferred plan for anyone self-employed. It’s a good plan for farmers since account fees are low and contribution limits are high.
- SIMPLE IRA: An option if you have employees who want to make retirement contributions. You can keep investing with this type of an account even after you’ve hired others, but you must match your employee’s contributions up to a certain amount.
If one retirement plan isn’t enough, you can diversify with multiple options. You can also create an entity for a purpose of transitioning or transferring your assets, specifically land, as you prepare for the next generation. The most popular entities for farmers include a sole proprietorship, partnership or limited liability company (LLC). By setting up a retirement plan, you can take advantage of tax savings as well as prepare for your financial future.
2. Write Off Costs Through Bonus Depreciation and Section 179 Deduction
If you purchased farming assets, you have several options to write off the costs through bonus depreciation and Section 179. Bonus depreciation allows you to expense the cost of fixed asset purchases instead of depreciating them over years. It allows for depreciation on qualified property, including multi-purpose farm buildings, equipment, and drainage tile. Beginning in 2023, the bonus depreciation deduction will generally begin to phase down to 80% if placed in service after December 31, 2022, and before January 1, 2024.
Section 179 allows you to deduct the cost of machinery, single-purpose agricultural buildings, drainage tiles and storage bins. However, it cannot be used to pay for multi-purpose farm buildings. Assets must be used for business purposes more than 50% of the time, actively used in the current financial year and purchased outright. There’s also a limit on the amount you can write off. You should consult with your tax advisor regarding the specific rules of bonus depreciation and the Section 179 deduction.
3. Consider Prepaying Expenses
It is often beneficial to prepay for some of your farm inputs, such as chemicals, fertilizer, and seed, that won’t be used until the next growing season. Prepayment can allow you to receive prices that are more favorable or ensure on-time delivery; and you can take the deduction for the expense in an earlier tax year, subject to certain limitations.
Prepaid expenses cannot exceed 50% of other deductible farm expenses, including depreciation, unless you meet one of these exceptions:
- The prepaid farm supplies expense is more than 50% of the other deductible farm expenses because of a change in business operations caused by unusual circumstances.
- The total prepaid farm supplies expense for the preceding three tax years is less than 50% of the total other deductible farm expenses for those three tax years.
4. Check Out a Deferred Grain Contract
One of the most overlooked tax planning tools is a deferred grain contract. This type of contract allows grain to be sold and the payment deferred to a future date. Usually, the payment date is the first of the next calendar year. For example, you can sell grain in November and take a deferred payment contract in January. The tax law allows you to elect out of installment sale treatment by reporting the deferred grain as income in the current year. Then the next year you get a deduction as an expense on the amount taxed in the prior year.
5. Increase Your Charitable Giving
A good option for reducing taxable income is to increase your charitable giving. Instead of selling the grain or livestock and then donating the proceeds, you can gift a raised commodity directly to qualified organizations identified by the IRS, typically churches or nonprofit foundations. If you decide to donate to a charity and let the elevator know it’s unloaded, the charity can tell the elevator to sell the grain and will receive the income. By donating the grain, you won’t report the grain as income, but you'll still be able to deduct all the expenses used to produce the crop.
However, you cannot also use the grain as a charitable deduction. If you are gifting the grain, you cannot sell the grain in your name. If you decide to sell the grain and then contribute the proceeds to a charity, the income must be reported as income; then the contribution is a deduction. Charitable deductions aren’t unlimited, and there are certain exceptions to gifting rules, so talk to your accountant before making a contribution.
6. Take Advantage of Farm Income Averaging
You can often use farm income averaging to reduce your overall tax liability when your current year income is high and taxable income from farming in one or more of the three prior tax years was lower. When you make an income-averaging election, the income tax liability is reduced in the current year because farm income is spread out over a three-year period. Farm income is increased, but it is taxed at the marginal rates available for those three years. This can be beneficial for you, especially when it results in a lower average tax rate across the impacted tax years.
Operating a farm often involves several different income sources and expenses, deductions and credits, all of which can complicate things when it’s time to file your taxes. Make sure you consult your tax, legal and accounting advisors before filing your tax return for your farm. They can help you maximize your eligible tax deductions and credits to reduce your tax liability as much as possible.
Reach out to a tax expert today to learn more about financial planning and other tax preparation tips.
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