Income Managing Taxes
(Chapter 16)
1
Objectives
1. 2. 3. 4. 5. Show the importance of income tax management. Discuss the differences between cash and accrual methods of computing taxable income. Explain the marginal tax system and social security taxes. Review some tax management strategies. Illustrate how depreciation is computed for tax purposes and how it can be used in tax management. Discuss the taxation differences between ordinary and capital gain income.
2
6.
Income Taxes
The unavoidable result of operating a profitable business! Imposed since 1913. Management decisions can have a large impact on the timing and amount of income tax due. Tax management is a year-round issue. Rules and regulations change frequently:
IRS Publication 225 for a farm business.
3
1
Tax Management Objectives
Managing income, expenses, and the purchases and sales of capital assets in a manner that will maximize long-run afterlongaftertax profits profits.
4
Tax Management Objectives
Long-Run Goal: Maximize long-run, after-tax profit.
The goal is not to minimize income taxes:
Can be accomplished by having little or no taxable income.
Short-Run Goal: Minimize taxes due on a given years income.
5
Tax Management Objectives
Tax management is not tax evasion:
Tax management is avoiding the payment of any taxes that are not legally due, and postponing the payment of taxes whenever possible:
Tax avoidance is legal. Tax evasion is illegal.
Any tax payment that can be put off until later represents cash available for business use for one or more years:
General rule is defer, defer, defer!
6
2
Tax Accounting Methods
Farmers and ranchers: Can use either the cash or accrual method of accounting. All other taxpayers engaged in the production and sale of goods where inventories may exist: Required to use the accrual method. Whichever method is used on the first tax return shall be used in the following years:
Can change, but not a given and not automatic.
7
The Cash Method
Income is taxable in the year it is received as cash or constructively received.
When it is credited to an account. When it was available for use before the end of the taxable year.
Inventories are not used to determine taxable income.
8
The Cash Method
Expenses are tax deductible: In the year they are actually paid, regardless of when the item was purchased or used. The exception is the cost of items purchased for resale: For example, feeder livestock. Deducted only in the year they are sold.
9
3
The Cash Method
Advantages Disadvantages
Simple Poor measure of income. Flexible Capital gain from the Potential for income variation. sale of raised breeding stock. Declining inventory. Delaying tax on larger inventories.
10
The Accrual Method
Income is taxable in the year it is earned or produced:
Includes any change from the beginning to the end of the taxable year: Value of crops or livestock in inventory. Plus cash income received.
Inventory increases are taxable income. Inventory decreases reduce taxable income. Accounts receivable are earned income.
11
The Accrual Method
Expenses are tax deductible:
In the tax year in which they are incurred. Whether or not they are paid.
Accounts payable at the end of the tax year are deductible as expenses. The cost of items purchased for resale:
Can be deducted in the year of purchase, even though the items havent been resold.
12
4
The Accrual Method
Advantages
Better measure of income. Reduces income fluctuations. Declining inventory offsets sales.
Disadvantages
Increased record requirements. Increasing inventory. Loss of capital gain on raised breeding stock. Less flexible.
13
Tax Record Requirements
Complete and accurate records: Receipts and expenses for the year. Tax depreciation schedules. Records on real estate and other capital items:
Purchase date and cost. Depreciation taken. Cost of improvements. Selling price. Taxpayer is responsible for providing information!
14
The Tax System & Rates
Taxable Income: Farm income as well as income earned from other sources minus personal exemptions and deductions:
Income tax rates for a married couple filing a joint tax return in 2008 (will change):
Taxable Income $0.00 - $16,050 $16,050 - $65,100 $65,100 - $131,450 $131,450 - $200,300 $200,300 - $357,700 $357,700 - no limit Marginal Tax Rate 10% 15% 25% 28% 33% 35%
15
5
The Tax System & Rates
Self-employed individuals like farmers and ranchers are subject to selfemployment tax:
Applied to income before personal exemptions or deductions. Includes Social Security and Medicare taxes. (Income of $102,000 for 2008
Self Employment Tax Social Security (maximum of $12,648) Medicare (no maximum) Rate 12.4% 2.9%
16
Tax Management Strategies
Form of Business Organization Income Leveling Deferring or Postponing Taxes Net Operating Loss (NOL) Tax-Free Exchanges
17
Tax Management Strategies
Form of Business Organization:
Different business forms have different methods of taxation:
Sole Proprietorship Partnership Corporation Cooperative
18
6
Tax Management Strategies
Income Leveling:
Two reasons for trying to maintain a steady income level:
1. Years of higher than normal income - may put the taxpayer in a higher marginal tax bracket. 2. In years of low income - some personal exemptions and deductions may be lost.
If not possible, farmers can use Income Averaging.
19
Tax Management Strategies
(married filing jointly)
Income Leveling (an example):
Situation A (variable income) Year 1 = $25,000 Year 2 = $100,000 Year 3 = $25,000 Total = $150,000 Situation B (level income) Year 1 = $50,000 Year 2 = $50,000 Year 3 = $50,000 Total = $150,000
20
Tax Management Strategies
(married filing jointly)
Income Leveling (an example):
Situation A (variable income) Year 1 = $25,000 Tax = (0.10) x 16,050 = $1,605.00 + (0.15) x 8,950 = $1,342.50 Year 2 = $100,000 Tax = (0.10) x 16,050 = $1,605.00 + (0.15) x 49,050 = $7,357.50 + (0.25) x 34,900 = $8,725.00 Situation B (level income) Year 1 = $50,000 Tax = (0.10) x 16,050 = $1,605.00 + (0.15) x 33,950 = $5,092.50 Year 2 = $50,000 Tax = (0.10) x 16,050 = $1,605.00 + (0.15) x 33,950 = $5,092.50
Year 3 = $25,000 Tax = (0.10) x 16,050 = $1,605.00 + (0.15) x 8,950 = $1,342.50
Year 3 = $50,000 Tax = (0.10) x 16,050 = $1,605.00 + (0.15) x 33,950 = $5,092.50
Total Tax (3 years)= $23,582.50 Avg. tax rate = 23,582.50/150,000 = 15.72%
$20,092.50 20,092.50/150,000 = 13.40%
21
7
Tax Management Strategies
Deferring or Postponing Taxes:
Taxes can be deferred or postponed by delaying taxable income until a later year:
Saves taxes in the current year. Money saved can be invested or used to reduce borrowing during the next year.
Taxable income can be deferred by:
Increasing expenses in the current year. Deferring sales until the next year.
22
Tax Management Strategies
Net Operating Loss (NOL):
Any net operating loss from a farm business can first be used to reduce past and/or future taxable income:
If the loss is greater than nonfarm income, any remaining loss can be carried back for 5 years and then forward for up to 20 years. When carried back - the net operating loss is used to reduce taxable income for these prior years, and tax a refund is requested. When carried forward - the net operating loss is used to reduce taxable income in future years.
23
Tax Management Strategies
Tax-Free Exchanges:
The sale of a capital asset (land) will generally incur some taxes whenever the sale price is above the assets cost or tax basis. If the land being sold is to be replaced by the purchase of another farm, an exchange can eliminate, or reduce, the tax caused by the sale:
The farm you wish to own is purchased by the person who wants to purchase your farm. You then trade/exchange farms. Transfer the basis on the original farm to the new farm: No tax is due if the sale price on both farms is equal.
24
8
Depreciation
Noncash but tax-deductible expense. Reduces taxable income without being a cash outflow. Calculating tax depreciation is flexible, so can do both (goals are different):
Tax depreciation. Depreciation for management decision-making purposes.
25
Some Review Questions from Lab 13
What is the US federal income tax system called a graduated tax?
Think about the relationship between marginal and average rates. As income goes up, higher income is taxed at a higher rate (marginal rate is increasing), so average tax rate goes up as well.
26
Some Review Questions from Lab 13
What was left out of the lab regarding the process of determining taxable income?
Form 1040, which is personal income tax form. Using form 1040, other available deductions available to a married couple are incorporated to determine taxable income:
So farming profit in lab is not same as taxable income.
27
9
Depreciation
Tax Basis:
The assets value for tax purposes at any point in time:
Beginning tax basis at time of purchase. Adjusted tax basis when its value changes.
Any asset purchased directly (new or used) has a beginning tax basis equal to its purchase price.
28
Depreciation
Tax Basis:
When a used asset is traded in as partial payment on a new purchase:
The beginning tax basis on the newly acquired asset is equal to the adjusted tax basis of the trade-in plus any cash difference paid.
29
Depreciation
Tax Basis:
The basis on a non-depreciable asset such as land generally remains as its original cost for as long as it is owned:
Exception: A capital improvement to the land itself, when the cost of the improvement may not be tax deductible in the current year nor depreciable:
Terraces Dams
The cost of the improvement is added to the original basis to find the new adjusted basis.
30
10
Depreciation
MACRS Depreciation:
Modified Accelerated Cost Recovery System Property classes determine an assets useful life:
3 - year: 5 - year: 7 - year: 10 - year: 15 - year: 20 - year: Breeding hogs Cars, pickups, breeding cattle and sheep, dairy cattle, computers, trucks Most machinery and equipment, fences, grain bins, silos, furniture Single-purpose agriculture and horticulture structures, trees bearing fruit or nuts Paved lots and drainage tile General-purpose buildings such as machine sheds and hay barns
31
Depreciation
MACRS Depreciation:
Assumed salvage value of zero for all assets. Automatic one-half year of depreciation in the year of purchase. Fixed percentage recovery rates:
Recovery Percentages Recovery Year 1 2 3 4 5 6 7 8 3 - year Class 25.00 37.50 25.00 12.50 5 - year Class 15.00 25.50 17.85 16.66 16.66 8.33 7 - year Class 10.71 19.13 15.03 12.25 12.25 12.25 12.25 6.124
32
Depreciation
Alternative Depreciation Methods:
Three alternatives that result in slower depreciation than regular MACRS:
1. Regular MARCS class life or recovery period, with straight-line depreciation. 2. Alternative MACRS recovery periods and 150 percent declining balance method. 3. Alternative MACRS recovery periods with straight-line depreciation.
33
11
Depreciation
Expensing:
An optional deduction, which can be elected only in the year an asset is purchased:
Same effect on basis and taxable income as depreciation. Maximum expensing for 2007 tax year is $125,000 (restricted if over $500,000 placed in service during the tax year). Most 3, 5, 7, and 10 - year class property is eligible.
34
Depreciation
Depreciation Recapture:
When a depreciable assets selling price is more than its adjusted basis, the difference is called depreciation recapture: Represents excess depreciation taken: The asset didnt lose market valu...