© Mcgraw-Hill Companies, 2008 Farm Management Chapter 16 Managing Income Taxes

© Mcgraw-Hill Companies, 2008 Chapter Outline Objectives of Tax Management Tax Accounting Methods The Tax System and Tax Rates Some Tax Management Strategies Depreciation Capital Gains

© Mcgraw-Hill Companies, 2008 Chapter Objectives 1.Show the importance of income tax management 2.Identify the objectives of income tax management 3.Discuss the difference between cash and accrual methods of computing taxable income 4.Explain how marginal tax rates and social security taxes are applied to taxable income 5.Review some tax management strategies 6.Show how depreciation is computed for tax purposes 7.Know the difference between ordinary income and capital gains income

© Mcgraw-Hill Companies, 2008 Objectives of Tax Management The goal of the manager should be to maximize long-run, after-tax profit. Effective tax management requires continuous evaluation of how decisions will affect income taxes. The manager will want to avoid payment of any taxes not legally due and to postpone payment of taxes whenever possible.

© Mcgraw-Hill Companies, 2008 Tax Accounting Methods The cash method The accrual method

© Mcgraw-Hill Companies, 2008 The Cash Method Income is taxable when it is received as cash or “constructively received” Income is constructively received when it is made available for use before the end of a tax period Expenses are deducted when they are paid Inventories do not figure into taxable income

© Mcgraw-Hill Companies, 2008 Advantages of Cash Method 1.Simplicity 2.Flexibility 3.Sale of raised breeding livestock likely to qualify for capital gains treatment 4.Delaying tax on growing inventory

© Mcgraw-Hill Companies, 2008 Disadvantages of Cash Method 1.Poor measure of income 2.Potential for income variation 3.More tax paid in years of declining inventory

© Mcgraw-Hill Companies, 2008 The Accrual Method Income is taxable when earned or produced Expenses deductible when incurred Inventories figure into taxable income

© Mcgraw-Hill Companies, 2008 Advantages of Accrual Method 1.Better measure of income 2.Reduces income fluctuations 3.Less taxes paid during times of declining inventories

© Mcgraw-Hill Companies, 2008 Disadvantages of Accrual Method 1.Increased record requirements 2.More taxes paid when inventory is increasing 3.Loss of capital gains treatment on sale of raised breeding livestock 4.Less flexibility

© Mcgraw-Hill Companies, 2008 Tax Record Requirements Complete and accurate records essential for good tax management and proper reporting of taxable income Complete records include a list of receipts and expenses for the year, a depreciation schedule, and records on real estate and other capital items Computerized systems can be helpful

© Mcgraw-Hill Companies, 2008 The Tax System and Tax Rates Federal taxes based on marginal rates Rates and income brackets for rates change and need to be checked each year Taxable income includes farm income as well as income from all other sources minus personal exemptions and deductions. Self-employment tax includes Social Security and Medicare taxes.

© Mcgraw-Hill Companies, 2008 Federal Income Tax, 2006

© Mcgraw-Hill Companies, 2008 Example: Calculating Income Tax Due Income = $80,000 Married filing jointly

© Mcgraw-Hill Companies, 2008 Self-Employment Tax

© Mcgraw-Hill Companies, 2008 Some Tax Management Strategies Form of business organization Income leveling Income averaging Deferring or postponing taxes Net operating loss (NOL) Tax-free exchanges

© Mcgraw-Hill Companies, 2008 Depreciation Depreciation plays an important role in tax management. It is a non-cash, tax-deductible expense. Some flexibility is permitted in calculating tax depreciation.

© Mcgraw-Hill Companies, 2008 Tax Basis The tax basis of an asset is its value for tax purposes at a point in time. At the time of purchase, it is called a beginning tax basis. As it changes, it is called an adjusted tax basis.

© Mcgraw-Hill Companies, 2008 Beginning Tax Basis Any asset, new or used, purchased directly has a beginning tax basis equal to the purchase price. When an asset purchase includes a trade-in, the traded-in asset continues to be depreciated as if it were still owned. Beginning basis on the new asset is equal to the cash paid to complete the trade (called the “cash boot”).

© Mcgraw-Hill Companies, 2008 MACRS Depreciation 3-year: breeding hogs 5-year: cars, pickups, breeding cattle and sheep, dairy cattle, computers, trucks 7-year: most machinery and equipment, fences, grain bins, silos, furniture 10-year: single-purpose agricultural and horticultural structures, fruit or nut trees 15-year: paved lots, wells, drainage tile 20-year: general purpose buildings

© Mcgraw-Hill Companies, 2008 Table 16-1 Regular MACRS Recovery Rates Be sure to always check current tax code

© Mcgraw-Hill Companies, 2008 Alternative Depreciation Methods Regular MACRS class life or recovery period, with straight-line depreciation Alternative MACRS recovery periods (usually longer than regular MACRS) and 150 percent declining balance Alternative MACRS recovery periods with straight-line depreciation

© Mcgraw-Hill Companies, 2008 Expensing Section 179 of the tax regulations provides for “expensing,” an optional deduction which can be taken only in the year an asset is purchased. Most 3-, 5-, 7-, and 10-year class property is eligible. The maximum allowed has increased several times in the past and was $108,000 in 2006.

© Mcgraw-Hill Companies, 2008 Depreciation Recapture Whenever an asset is sold for more than its adjusted basis, the difference is called depreciation recapture. Depreciation recapture is taxed as ordinary income for the year of sale.

© Mcgraw-Hill Companies, 2008 Capital Gains Capital gains can result from the sale or exchange of certain types of qualified assets. It is the gain or profit made by selling an asset for more than its original purchase price. To qualify, the asset has to have been held for a specified minimum amount of time.

© Mcgraw-Hill Companies, 2008 Taxation of Long-Term Capital Gains 1.Capital gains income is not subject to the self-employment tax. 2.Capital gains income is generally taxed at a lower rate than ordinary income.

© Mcgraw-Hill Companies, 2008 Capital Gains and Livestock Cash-basis farmers have a basis of zero on raised breeding or working livestock; hence the entire sales value can often be treated as capital gains. Purchased livestock may also be eligible, but only if sales price is above original purchase price.

© Mcgraw-Hill Companies, 2008 Summary A business manager should seek to maximize long-run, after-tax income. A number of tax management strategies are available.