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Taxation in Agriculture Chapter 19. Kelly Braswell Robby Adams Jordan Smith. This Chapter covers:. Tax laws that extend special treatment to farmers (especially income and estate). Changes in federal tax legislation since 1986. Tax Reform Act of 1986.
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Taxation in AgricultureChapter 19 Kelly Braswell Robby Adams Jordan Smith
This Chapter covers: • Tax laws that extend special treatment to farmers (especially income and estate). • Changes in federal tax legislation since 1986.
Tax Reform Act of 1986 • Prior to the Tax Reform Act of 1986, tax benefits were available to nonfarm investors as well as farm operators. • The 1986 tax legislation curtailed the tax shelters and significantly reduced the attractiveness of investments in agriculture to nonfarm investors.
Taxpayer Relief Act of 1997 • Brought the most significant tax reforms since the 1986 by providing targeted tax relief to many groups, including farmers.
Economic and Tax Reconciliation Act of 2001 • Begins the series of tax reductions over ten years. • Also, this act greatly increases the uncertainty of tax law because it includes a provision that repeals all of the 2001 tax law changes at the end of 2010!
Questions to think about: • What are the major tax advantages in agriculture? • How are tax advantages related to the system of progressive taxes? • What are the implications of tax preferences for agriculture?
Marginal Tax Rates and the Progressive Income Tax • Taxation affects personal decisions related to work that generates taxable income which will affect individual productivity. • It is expressed: marginal tax rate= Change in tax liability Change in taxable income
MTR continued… • For example if the marginal tax bracket is 28% and a persons taxable income is $100 then they must pay $28 in taxes. • The structure of the federal income taxes in the United States is progressive, which means that as the income increases the marginal tax rate increases so a person must pay more of taxable income. • The highest it has been is 38.6 in 2002.
MTR continued… • There are two different approaches • The first being the Keynesian approach which stresses the importance of maintaining a high level of aggregate demand. Ex. increased government spending will lead to economic growth. • Taxes are merely a transfer and tax rates can vary with little impact on production.
MTR continued… • The second is the newest thought which stresses the disincentive effects of taxes. • This thought process is rooted all the way back to Adam Smith and other classical economists. • Does three things • First, when mtr increases the opportunity cost of leisure decreases.
MTR continued… • Second, high mtr not only discourage work, but also cause people to work on jobs where they are less producitive. • Third, high rates increase individual’s incentive to engage in illegal activities and to evade taxes on legal economic transactions. Also known as the underground economy including drug trafficking, smuggling, prostitution, etc. • Legal but unreported include tips and cash sales sometimes called working “off the books.”
MTR continued… • Finally, high mtr means that many valuable resources are devoted to the tax shelter industry. This means that people are willing to pay to have others find them tax breaks. • The 1986 Tax Reform Act significantly reduced the progressivity of the federal income tax. • Many changes to the Federal income tax system have been made making the system more complex. The amount of brackets has increased over the years.
Federal Income Tax and Agriculture • The most important tax advantages for agriculture are cash accounting and favorable depreciation rules, including the deductibility of certain capital expenditures.
Accrual verses Cash Accounting • Accrual accounting is generally required in calculating net income in the ordinary course of business. • Records must be kept on expenses, production, inventories, and sales for each year. • All sales are in a given year are treated as income in the year of sale regardless of whether the payment is received that year. • Expenses related to goods sold, are taken as offsets against income in the year of sale. • Unsold goods and purchased inputs are inventoried and included with income from sales of products in determining profits for tax purposes. • Inventories of unsold goods are counted as revenues even though they have not been sold.
Accrual verses Cash Accounting Continued… • In cash accounting, income from the sale of a commodity is taxed in the year payment is received. • Inventories of unsold goods are ignored under cash accounting, but the cost related to these goods are deducted when the cost are paid. • Expenses generally can be deducted from taxable income in the year the expenses are paid rather than in the year in which the goods are sold excluding livestock purchased for resale.
Accrual verses Cash accounting continued… • Farmers and other small business firms are permitted to use cash accounting rather than accrual because of the complex record keeping requirements required in accrual accounting. • Helps farmers because of the relatively long time period between the purchase of inputs and the sale of the commodity. • Before 1987 Corporations that were called “family firms” such as Tyson Foods, Hudson Foods Inc. and Perdue Farms Inc. received huge tax benefits from cash accounting. Today if receipts are over $25 million they must use accrual methods of accounting.
Expensing verses Depreciation • Operating expenses incurred by farmers and other businesses are generally deductible as an offset to earned income. • Capital expenses are treated differently from operating expenses; they are not deductible they must be depreciated. • A capital expense is a payment or debt incurred for the acquisition of an asset having a useful life of more than one year. • Beginning in 2003, farmers are able to deduct $25,000 of newly acquired depreciable tangible personal property. Ex machinery and equipment
Expensing verses Depreciation continued… • Depreciation periods generally are short relative to the expected life for most types of farm equipment. • Ex. Farm machinery and equipment items have a seven-year recovery • Ex. Single purpose agriculture buildings have a ten-year period. • The special tax treatment in depreciation rules for capital leads to use of too much capital in agriculture, relative to labor and land.
Expensing verses Depreciation continued… • Expenditures incurred in the production of some farm products can be expensed, or fully deducted, in the year of purchase. • Ex. Cost of lime, fertilizer, and other materials that enrich the land for more than one year. Soil and water conservation expenditures on USDA-conservation projects. • Some farmers use the straight line depreciation method where others use the declining balance depreciation method. • There are tax benefits from being able to deduct the entire amount of capital expenditure in the year of purchase rather than merely deducting the amount of depreciation because the benefit from a cost deducted now is greater than if deducted later. Ex.
Gains on the Sale of Capital Assets • A change in value of a capital asset is not treated as income for tax purposes until the asset is sold. • Capital gains tax rates were reduced by the Taxpayer Relief Act of 1997 for taxpayers in lower and higher tax brackets. The rates ranged from 8% to 28% in 2002. • The capital gains provision of the tax law is especially important to farmers because they are three times more likely to report capital gains than nonfarmers.
Estimated Taxes • Taxpayers generally are required either to have federal income taxes withheld on income received during the year or to make quarterly estimated tax payments and to file Form 1040 by April 15 of the following year. • If more than 2/3 of the income is from farming, however, quarterly estimated tax payments are not required. • There is, of course, an economic advantage to delaying the date on which taxes must be paid because of the time value of money. Qualified farmers however are allowed to file taxes March 1 of the following year.
The Estate tax • The federal estate tax is a progressive tax on wealth transferred because of death. The tax is computed on the value of the property owned by the deceased and the tax is generally due nine months after death. • Two exceptions exist in ag: • First, the FET may be calculated on the basis of “agricultural use value” rather than on the basis of market value. • Second, qualifying farms and other small businesses are given and extended time to pay the tax, during which time interest on estate taxes due accrues at a rate well below market rates.
Corporate Farming • Federal law generally does not place direct restrictions on the corporate form of ownership in farming. • Nine states which include Kansas, North Dakota, Oklahoma, Minnesota, South Dakota, Missouri, Iowa, Nebraska, and Wisconsin currently have restrictions on ownerships of farmland and operation of farm businesses by corporations except for family corporations. • Texas, West Virginia, and South Carolina also have minor restrictions.
Corporate Farming Continued… • Two forms of taxing the income of farm corporations include the standard method which taxes income to the corporation and the alternative method permits shareholders to choose to have corporate income taxed to them individually. • There are some benefits to farmers for incorporating. • First, the total tax cost on corporate income will sometimes be lower than would be the case if the income were earned by an individual.
Corporate Farming continued… • Second, with the incorporation and the transfer of shares of stock each year, farm transfers can be made more easily without physically dividing a farm. • Third, the cost of fringe benefits such as meals, health insurance, and group life insurance can be deducted by the corporation, by their value need not be included in the gross income of shareholders. • In addition, corporate ownership has the advantages of limited liability, and it provides a means of pooling capital.
Corporate Farming continued… • There are two types of farm corporation: • Family-held corporations and those with nonfamily stockholders. • Family-held are far more common and most have not more than ten stockholders. These represent only about 4 % of all farms and approximately 23% of all farm product sales in 1997. • Non family corporate farms constituted less than one-half of one percent of all farms in 1997, but accounted for approximately 6% of total farm product sales.
Farming As A Tax Shelter • A tax shelter is an investment that allows taxpayers to reduce or eliminate tax liabilities on income by using preferential provisions of income tax laws. • Prior to the Tax Reform Act of 1986, U.S. tax laws favored agriculture investments in four ways. 1) the option of using cash rather than accrual accounting 2) The opportunity to expense certain capital investments 3) a lower tax rate on capital gains than on ordinary income 4)investment tax credits.
Implications for Agriculture • Three reasons why tax laws have an impact on agriculture. • First, tax preferences are more valuable the higher the marginal tax return. • Second, the federal tax system affects the resource mix within agriculture. • Third, preferential tax policies tend to attract additional resources into agriculture, bringing about an increase in farm output. The Tax Reform Act of 1986, however, reduced the attractiveness of agriculture as a tax shelter and the incentive to invest in agriculture.
