Taxation in Agriculture Chapter 19

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Taxation in AgricultureChapter 19

• Kelly Braswell
• Robby Adams
• Jordan Smith

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This Chapter covers

• Tax laws that extend special treatment to farmers
  (especially income and estate).
• Changes in federal tax legislation since 1986.

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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.

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Taxpayer Relief Act of 1997

• Brought the most significant tax reforms since
  the 1986 by providing targeted tax relief to many
  groups, including farmers.

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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!

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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?

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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

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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.

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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.

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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.

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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 individuals 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.

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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.

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Type of incentive by tax Advantage to farmers
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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.

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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.

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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.

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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.

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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

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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The End