Looking Ahead at Federal Taxes

Published in the August 2013 Issue Published online: Aug 06, 2013 Dr. Ruby Ward, Department of Applied Economics, Ut
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"The use of cash accounting and deducting equipment purchases does not magically lower taxes. It only shifts the year in which a producer would pay the taxes."

Growers should take note of several changes in federal taxes.

Provisions that take effect this year are shown below.

 The top individual income tax rate increases from 35 percent to 39.6 percent;

 Capital gains rate for individuals in the top bracket will be 20 percent;

 New taxes for high earners, including 3.8 percent additional tax on investment income and an additional 0.9 percent tax for Medicare payroll tax on wages or self-employed income above $200,000 per year for individuals or $250,000 per year for couples.

There is some debate about tax reform. Whether or not legislation is passed for tax reform in 2013, what's currently being discussed will probably be the starting point in the future.

House Ways and Means Committee Chairman Dave Camp (R-MI) released a discussion draft in March about proposed tax reform. Visit www.waysandmeans.house.gov/news.

The idea behind tax reform is to broaden the base (increase the amount of taxable income) and lower the tax rates. Broadening the base is accomplished by decreasing tax deductions and tax credits that can be taken. This may also simplify the tax return and make compliance with tax laws easier.

Main provisions that might impact growers include changes in the ability to expense purchases of equipment rather than depreciating it (Section 179 expense election), use of cash method of accounting and uniform capitalization rules.

Section 179 of the internal revenue code has a provision that allows growers to deduct in the year purchased a portion (or all) of equipment and other qualifying assets purchased. The amount of the purchase not deducted through section 179 can then be depreciated over the assets normal depreciable life. The overall effect of this provision is that a larger deduction can be taken in the year purchased (up front) leaving smaller deductions in later years.

A more detailed discussion of this and other tax issues can be found on ruraltax.org, a website dedicated to farm tax issues.

Use of this provision is limited by a maximum amount and an investment limit. For the 2013 tax year, the maximum amount is $500,000 with an investment limit of $2 million.

This means that growers may choose to deduct up to $500,000 of machinery and equipment purchases and other qualifying assets on their 2013 tax returns. Total purchases in excess of the $2 million limit decreases the amount of the allowed expense deduction that can be used.

If the total purchase is $2.5 million, the deduction is completely reduced and cannot be used. The current tax reform proposal includes a maximum amount of $250,000 for the deduction with an investment limit of $800,000.

Without any legislation to extend this provision, the deduction will revert to $25,000 in 2014 with an investment limit of $200,000. The Section 179 deduction has been increased temporarily over the last 10 years along with other tax cuts through passage of temporary tax extensions.

One of the motivating factors for these extensions was an annual patch for alternative minimum tax (AMT) provisions. The AMT provisions were fixed with legislation early this year and will no longer serve as a motivation for passing end-of-year tax provision extending legislation.

Another provision will impact the use of cash method accounting for filing a federal tax return. Currently, just about all growers use the cash method of accounting instead of the accrual method.

Currently, the accrual method is required for: 1) a non-family corporation with gross receipts over $1 million; 2) A family corporation with gross receipts of more than $25 million in any year after 1985; 3) A partnership with a corporation as a partner; 4) A tax shelter. With this change sole proprietors would be able to continue to use cash accounting, but all other farm businesses with gross receipts over $10 million would be required to use accrual accounting.

Under cash accounting, growers would only include on their tax returns the value of what was sold during the year and deduct the expenses that were paid. Accrual accounting requires records of inventories and adjusts the value of the revenue by the change in the value of the inventory.

Cash accounting allows more flexibility. Taxable income in the current year can be lowered by pre-paying fertilizer or other expenses. Taxable income can also be lowered for the current year by delaying selling crops produced until the following year. This would lower taxable income for the current year but would result in higher income in future years as more crops would be sold and fewer inputs would need to be purchased.

Both cash accounting and the use of section 179 to deduct the purchase of equipment can be beneficial to growers as tools to smooth their taxable income and avoid higher income tax brackets.

Another method of smoothing farm taxable income to avoid the effects of higher tax brackets is farm income averaging. The proposed tax reform legislation is unclear about keeping or doing away with the farm income averaging provisions.

The use of cash accounting and deducting equipment purchases does not magically lower taxes. It only shifts the year in which a producer would pay the taxes. Overuse of the provisions can shift a lot of income and, hence, the tax into the future. Some growers may have used these provisions in the past to the point they avoid retiring because of the income taxes consequences that exist through accelerating deductions and postponing income into the future.

Be sure to check for additional income tax information at www.ruraltax.org. For information on how this might affect your specific situation, consult your tax professional.