Zero is the Most Expensive Number
Do you plan to make money with your business?
If yes, plan on paying income tax. People who make money owe taxes.
Most farmers cringe at the thought of paying income tax. They hate the idea so much, they’d rather risk losing money than pay income tax.
Depreciation of machinery, prepaid expenses, and crop income deferral are three ways to play a temporary timing game to avoid paying income tax.
There’s nothing illegal about using these pieces of the tax code. These deductions are right in the tax code for everyone to see and use. But if you use them year after year and always show zero taxable income, you’re either losing money or setting yourself up for a huge tax bill when you unwind the timing game.
The benefit of a timing strategy is rooted in time value of money theory — a dollar today is better than a dollar one year from now. Unfortunately what I hear more often from farmers is more along the lines of “I’m not giving the government one penny more than I have to.” You may be familiar with the sentiment.
Unfortunately, these deductions and deferrals are only temporary. The timing game can flip around and result in taxable income in a period of tight cash flow. This double edge sword of accrual losses, but taxable income, is even more prevalent in a cyclical industry like agriculture.
Instead of shooting for zero taxable income, I argue that you should aim for some taxable income every year. Depending on your filing status (single, married filing joint, etc) and your spouse’s employment situation, your farm business income target may be as $75,000 or even $150,000.
If your business is high risk, high leverage, and on the edge of failure, then maybe you should have a year by year tax planning time horizon. But if your business projects to be profitable over your career, you need a long term view of tax planning. You should be looking for permanent benefits within the tax code to minimize your effective tax rate over the life of the business.
For me, the low hanging fruit, the number one place for permanent benefits in the tax code is managing marginal tax rates. Over the life of your business, you want as much of your income in the lowest possible tax brackets.
For example, think about a year where you utilize Section 179 to show zero taxable income on Schedule F for your farming activity. You give up the opportunity to have income offset by standard deductions and personal exemptions for a 0% effective tax rate, you give up using the 10% tax bracket, the 15% bracket, and so on.
Those lower tax brackets don’t get bigger in future years if they are unused this year. Only a certain amount of income can be taxed at 10%, 15%, and 25% each year.
If you foresee a high probability of making money over the life of your business, fill those lower tax rate buckets every year. Try to avoid a lumpy taxable income trend that results in years of paying no tax, but other years when a large amount of income is taxed at 33%, 35%, and 39.6%.
Maybe you’re thinking, “hey, what about net loss carry back and carry forward?” That’s true, there are some other opportunities to smooth taxable income and utilize lower effective tax rates over a time horizon. NOL carry backs fruit is just higher on the tree and will cost more in tax prep fees to achieve.
I encourage the farmers I work with to avoid the temptation to manufacture losses. Sometimes paper losses turn into realized cash losses. I don’t want you sinking cash into something just to defer taxable income for one year. I want you focused on profitable, ROI based decisions for your business over the long term.
If you plan on making money, plan on paying taxes.
For this reason your goal should be to avoid a $0 taxable income. Ask your tax preparer how to get the maximum benefit from the lowest tax brackets over the course of your career and the life of your business investment.