Taxes Chapter 8 PDF

Taxes DXP02708 —UN—23FEB11 INTRODUCTION DXP01841 —19—26OCT10 Farm business managers have many important fact...

Taxes DXP02708 —UN—23FEB11 INTRODUCTION DXP01841 —19—26OCT10 Farm business managers have many important factors to affect the agricultural sector. But changes in the tax law consider in the running of their operations. However, one are continually being made, so this material should not of the more significant factors any farm business manager be considered as an interpretation or a replacement of must weigh carefully is the effect taxation will have on the legislation. Specific problems regarding tax management operation of the farm business. should be referred to a tax professional who is aware of the exact wording of the law and any changes that may To help farm business managers with these concerns, have happened since the preparation of these materials. this chapter will discuss various tax strategies that may MD48206,0000E88 -19-24FEB11-1/1 8-1 090117 PN=120  Taxes INCOME TAXES Roy and Mary Snyder are meeting with their tax professional, Betty Olson, for their mid-year income tax review. Ms. Olson has prepared a brief overview of income tax management and various income tax strategies. She explains that by having a basic understanding of the income tax rules and the various tax strategy alternatives available to the farm business, they should be able to ask the right questions when considering alternatives. DXP01841 —19—26OCT10 INCOME TAX MANAGEMENT Ms. Olson begins by explaining that farm families, such as the Snyders, need to know that significant income tax strategies are available to them. And these tools need to be incorporated into the management of the farm business. Ms. Olson says that for many of her clients, income tax management simply means filing their income Fig. 1 — The farm or ranch manager must closely examine taxes tax returns each year. A popular goal in this activity is to get the final line on the tax form to zero. Other factors to be considered include the relevant But the bottom line means more than just that zero on income tax laws, bank interest rates, and inflation rates. the tax form. The important thing to keep in mind, as far The prime objective in income tax planning should be to as income tax management is concerned, is that the ensure that taxable income from any transaction either objective should be to maximize after-tax income, not occurs or can be reported in the year it will be most lightly just to minimize the tax obligation. Ms. Olson explains taxed. Ms. Olson tells Roy and Mary that when planning that from both a business and personal point of view, the your affairs, it is important to keep in mind that what works more dollars you make, the further ahead you are. As well for someone else may not necessarily be satisfactory long as you take home part of the last dollar of income, in your situation. She reminds them of the importance it is worth earning that dollar. By looking at the after-tax of keeping good records because they will tell you what financial effects of production, marketing, and tax planning your specific situation is and can provide the information alternatives, you can direct the farm business toward to decide which tax alternatives are best for guiding your achieving both personal and business goals (Fig. 1). farm business toward economic and personal goals. INCOME TAX PLANNING HOW TO GET TAX HELP Income tax planning is generally concerned with making a Ms. Olson explains to Roy and Mary that most farm and choice of one or more legitimate alternatives, a choice that ranch managers are not tax experts. A basic knowledge leads to creating the least amount of tax. Tax planning and awareness of tax rules can assist them in this falls into one of the following categories: decision-making process. Besides their tax professional, Deferral of tax — Concerned with the timing of the income tax information is available in many government payment of any tax liability and may not necessarily publications. Some of the more popular publications for reduce the overall taxes paid. A deferral of tax may, farmers and ranchers are: given consistent levels of inflation, lead to real savings Form 1040 Instructions if the future tax liability is to be paid using dollars that Publication 225, The Farmer's Tax Guide are not worth as much as today's dollars. Savings of tax — Serves to reduce the overall amount You can get help with unresolved tax issues, order free of taxes actually paid. Ms. Olson explains that an publications, ask tax questions, and get more information example could be splitting income between husband from the IRS in several ways. and wife or using various business arrangements can serve in reducing the total tax bill. Walk in — You can walk in to many post offices, libraries, IRS offices, and other locations to pick up Ms. Olson emphasizes that income tax planning should be certain forms, instructions, and publications. Some a year-round activity, and it must always be balanced with locations have products available to print from a sound business judgement and personal considerations. CD-ROM or photocopy from reproducible proofs. Effective tax planning requires: Personal computer — You can access the IRS on the Internet at www.irs.gov. Personal financial goals, Phone — You can order forms, instructions, and Up-to-date records and financial information, and publications by calling 1-800-829-3676. Other phone Reliable long-range projection of size and source of numbers are available for solving problems, asking tax income. questions, and for TeleTax topics. Continued on next page MD48206,0000E89 -19-28FEB11-1/14 8-2 090117 PN=121  Taxes Mail — You can send your order for forms, instructions, Federal Tax Products, and IRS Publication 3207, Small and publications to the Distribution Center nearest to Business Resource Guide. you. To find out what services are available, get Publication CD-ROM — Many tax products are now available on 910, Guide to Free Tax Services. It contains a list of CD-ROM. Examples include: IRS Publication 1796, free tax publications and index of tax topics. MD48206,0000E89 -19-28FEB11-2/14 WHO IS A FARMER OR RANCHER? Agriculture includes many highly specialized areas. No matter what the enterprises are, however, the business of agriculture requires a large investment with comparatively low returns (Fig. 2). In response to this, the tax laws for agriculture may be very complex and specialized. Three general examples of these laws include: Farmers and ranchers can use special accounting methods despite high year-end inventories. There are special capital expenditure deductions. The treatment of livestock as a capital asset is unique. For example, you can raise a brood cow from calf and treat it as a manufacturing plant. You can write this DXP01842 —19—26OCT10 product off to current operating expenses just like a manufacturing company can write off the machines and buildings that it uses to make a product. Ms. Olson explains to the Snyders that to take advantage of these laws, you must be a farmer or rancher. You must cultivate, operate, or manage a farm or ranch for gain or profit. Fig. 2 — Farming and ranching requires a large investment and produces a relatively low return. (It takes many ingredients to make one apple pie.) Continued on next page MD48206,0000E89 -19-28FEB11-3/14 8-3 090117 PN=122  Taxes The farmer and/or rancher must materially participate in the risks involved with the operation of the farm business (Fig. 3). At least two-thirds of your gross income must be from farming to be a qualified farmer. For example, Ms. Olson says, last year the Snyders had a total gross income of $140,000 and a farm gross income of $90,000. Since 67.9% (at least two-thirds) of their gross income was from farming ($95,000 / $140,000 = 0.679), they qualified to use the special estimated tax payment and return due dates. The Snyders had an opportunity to choose either of the following options for last year's tax return: 1. Make their required annual (estimated tax) payment DXP01843 —UN—10NOV10 by January 15 and file their Form 1040 tax return by April 15, or 2. File their Form 1040 tax return by March 1 and pay all their tax due. If the Snyders had not been qualified farmers they would not have been eligible to use the special estimated tax payment and return due dates. They should have made Fig. 3 — A farmer or rancher takes risks in order to gain profit quarterly estimated tax payments and must have filed their Form 1040 tax return by April 15 to avoid penalties and interest. NOTE: Refer to chapter 2, "Record Keeping"; chapter 3, "Financial Analysis"; and chapter 4, "Budget It is not necessary for farmers and ranchers to live on the Analysis" for a more detailed explanation of ground that they work in order to qualify for the agricultural record keeping and uses. tax laws. These laws also apply to partnerships, limited liability corporations (LLC), corporations, and Why Keep Records? S-corporations that own vineyards, orchards, ranches, and land used for farming operations. Part-time farmers Ms. Olson reminds Roy and Mary that everyone in and ranchers also can use the agricultural tax laws. business, including farmers, must keep records. Good records will help them do the following: IMPORTANCE OF GOOD RECORDS A farmer, like other taxpayers, must keep records to Monitor the progress of their farming business. prepare an accurate income tax return and determine the Prepare their financial statements. correct amount of tax. Tax records are not the only type Identify sources of receipts. of records you need to keep for your farming business. Keep track of deductible expenses. You should also keep records that measure your farm's Prepare their tax returns. financial performance. Support items reported on tax returns. Continued on next page MD48206,0000E89 -19-28FEB11-4/14 8-4 090117 PN=123  Taxes KINDS OF RECORDS TO KEEP The income tax laws do not require any special kind of records. You can choose any record-keeping system suited to your farming business that shows your income and expenses. You should set up your record-keeping system using an accounting method that clearly shows your income for your tax year. The most common accounting methods are: Cash (Fig. 4) Accrual (Fig. 5) Your record-keeping system should include a summary of your business transactions. For example, your system might include: DXP01844 —19—26OCT10 Journal or ledger — record income and expenses. Supporting documents — invoices, receipts, checks, electronic fund transfers, credit card receipts. Travel, transportation, entertainment, and gift expenses — special record-keeping rules apply to these expenses. Employment taxes — there are specific employment tax records you must keep. Fig. 4 — The cash method of accounting is used in specific tax situations Excise taxes — there are specific records you must keep to verify your claim for credit or refund of excise taxes on certain fuels. Assets — such as purchased breeding livestock, machinery, equipment, and land. You need records to figure your annual depreciation deduction and the gain or loss when you sell the assets. HOW LONG TO KEEP RECORDS Ms. Olson suggests the Snyders should keep their records as long as they may be needed for the administration of any provision of the Internal Revenue Code. Generally, DXP01845 —19—26OCT10 this means you must keep records that support an item of income or deduction on a return until the period of limitations for that return runs out. The period of limitations is the period of time in which you can amend your return to claim a credit or refund or the IRS can assess additional tax. Employment tax records should be kept for at least four Fig. 5 — The accrual method of accounting helps you level out (4) years after the date the tax becomes due or is paid, peaks and valleys when you pay income taxes whichever is later. Keep records relating to assets until the period of DETERMINING WHEN TO USE INCOME TAX limitations expires for the year in which you dispose of STRATEGIES the property in a taxable disposition. You must keep these records to figure any depreciation, amortization, or Ms. Olson begins her discussion by listing the steps depletion deduction and to figure your basis for computing needed to determine when to use income tax strategies. gain or loss when you sell or otherwise dispose of the property. 1. Determine your normal income tax pattern for the past five years. For example: If Roy and Mary's farm When your records are no longer needed for tax purposes, business has a steady increase in net farm profit, they do not discard them until you check to see if you have to may be moving into higher tax brackets. On the other keep them longer for other purposes. For example: your hand, the trend could be downward or the income insurance company or creditors may require you to keep level may change little. your records longer than the IRS does. 2. Select tax management methods which help you come as close as possible to a normal tax pattern. It is costly, in terms of after-tax dollars, to fluctuate among different tax brackets. Continued on next page MD48206,0000E89 -19-28FEB11-5/14 8-5 090117 PN=124  Taxes the greatest tax advantage consistent with maximum 3. Think “taxes” during the entire year. As good farm after-tax income. managers, Roy and Mary are aware of taxes during all twelve months so that day-to-day decisions result in Continued on next page MD48206,0000E89 -19-28FEB11-6/14 8-6 090117 PN=125  Taxes DXP01846 —19—26OCT10 Fig. 6 — Example of an income tax estimate worksheet 4. Use an income tax estimate worksheet. Ms. Olson easy to follow a format for a tax estimate. Records and provides the Snyders with an income tax estimate information needed may include: worksheet she uses with other clients (Fig. 6). She explains that the income tax estimate worksheet is a Farm receipts tool to determine expected tax liability. It is based on Receipts from the sale of items purchased for resale what has happened to date in an accounting year and Cost of items purchased for resale that were sold an estimate on what will happen for the remainder of Farm expenses the year. Depreciation records Asset records RECORDS AND INFORMATION NEEDED TO FILL OUT - Amount of capital gains sales AN INCOME TAX ESTIMATE WORKSHEET - Amount of capital sales that do not qualify for capital gains Ms. Olson emphasizes that if the farm and personal - Amount of capital purchases records are complete and up-to-date, it is relatively Continued on next page MD48206,0000E89 -19-28FEB11-7/14 8-7 090117 PN=126  Taxes Non-farm income - Wages - Rental income - Dividends - Interest received - Other personal income Adjustments to income - Individual Retirement Account deduction - One-half (1/2) of self-employment tax - Self-employed health insurance deduction DXP01847 —19—26OCT10 - Self-employed SEP, SIMPLE, and qualified plans deduction - Other: educator expense, student loan deduction, tuition and fees deduction, moving expenses, penalty on early withdrawal of savings, and alimony paid Filing status — single, married filing jointly, married filing separately, head of household, or qualifying widow(er) Personal exemptions Fig. 7 — Assets are depreciated until their “value” is zero Standard or itemized deductions Payments — federal and state income tax withheld; federal and state estimated tax payments From a management viewpoint, it is not advantageous Qualified tax credits to write off the entire cost of a new tractor or newly Current year's tax tables (federal and state) constructed farm building in the year acquired. These Schedule SE or worksheet to calculate self-employment assets are durable and provide productive services over tax time. Since these assets can contribute to production over several years, their costs are written off over their INCOME AND EXPENSES useful life. Income from farming included on Schedule F — Profit or Depreciation is a procedure that spreads out the value Loss from Farming includes amounts you receive from of these assets over the period they are used. By cultivating, operating, or managing a farm for gain or profit, depreciating an asset, an allowance is made for the loss either as an owner or tenant. Income reported on Schedule in the asset's value caused by: F does not include gains or losses from sales or other dispositions of the following farm assets: land, depreciable Wear and tear due to use farm equipment, buildings and structures, and livestock Obsolescence due to new technology held for draft, breeding, dairy, or sporting purposes. Deterioration due to the elements of nature The ordinary and necessary costs of operating a farm for The proportion of the original cost to be depreciated in profit are deductible business expenses and are reported any one year is largely a matter of judgment and financial on Schedule F. Current costs are expenses you do not management. One aspect of financial management is the have to capitalize or include in inventory costs. influence depreciation will have on income taxes. Another is the desire to have the undepreciated value of an asset DEPRECIATION reflect the resale value of that asset. The depreciation Income tax law states that assets such as machinery, allowance taken in any year reflects the actual decline in livestock, orchards, equipment, and farm buildings with a the value of the asset. Therefore, the net worth statement useful life of more than one year may not be deducted as shows the true value of depreciable assets. an expense in the year of purchase. Instead, part of the cost of the asset is deducted each year over the expected useful life of the asset until the value is zero (Fig. 7). Continued on next page MD48206,0000E89 -19-28FEB11-8/14 8-8 090117 PN=127  Taxes GUIDELINES FOR DETERMINING PROPERTY SUBJECT TO DEPRECIATION Roy and Mary use the following guidelines to determine if their capital assets can be depreciated (Fig. 8). Depreciable farm property includes all assets used in the business of farming that have a useful life of more than one year. Only assets that have a limited and determined useful life may be depreciated. Capital expenditures for assets DXP01848 —19—26OCT10 that do not have a determined life, such as land or leasehold interests, which are continuously renewed, are not deductible. Tax benefits of these assets are never realized until they are sold or lost. FACTORS TO KNOW BEFORE FIGURING DEPRECIATION Roy and Mary evaluate each asset before they figure Fig. 8 — Only assets with an expected useful life are depreciated depreciation. They must know three things about them (Fig. 9): What is their basis in the property? This includes the cash paid or the cash difference paid plus the depreciable balance of their trade-in. When is the property placed in service? Which method of depreciation is used? SECTION 179 DEDUCTION Ms. Olson wants to make sure Roy and Mary are aware of the Section 179 deduction for depreciable property. She explains that under Section 179 of the Internal Revenue Code, you can choose to recover all or part of the cost of certain qualifying property, up to a limit, by deducting DXP01849 —19—26OCT10 it in the year you place the property in service. You can recover through depreciation certain costs not recovered through the Section 179 deduction. For example, Ms. Olson explains, Roy and Mary bought and placed in service a tractor and a mower in 2002. The tractor cost $20,000 and the mower $6,200. Because of income tax strategies determined for 2002, Roy and Mary elected to deduct the entire $6,200 for the mower and Fig. 9 — There are three factors of depreciation $17,800 for the tractor for a total of $24,000. This was the most they could deduct. The $6,200 deduction for the regular depreciation under the Modified Accelerated Cost mower completely recovered its cost. Their basis in the Recovery System (MACRS) for the year you placed mower is zero. The basis of their tractor for depreciation the property in service. This deduction is claimed after was $2,200. They figured this by subtracting the amount the Section 179 deduction, but before the calculation of of their Section 179 deduction, $17,800, from the cost of regular depreciation. the tractor, $20,000. METHODS OF DEPRECIATION SPECIAL DEPRECIATION ALLOWANCE In the IRS publications, depreciation is referred to as Another tax strategy available to Roy and Mary is to claim recovery costs. The MACRS is used to recover the the special depreciation allowance. Ms. Olson explains basis of most business and investment property placed that you can take the special depreciation allowance in service. The MACRS consists of two depreciation to recover part of the cost of qualified property placed systems, the General Depreciation System (GDS) and the in service during the tax year. The allowance applies Alternative Depreciation System (ADS). Generally, these for the year you place the property in service. It is an systems provide different methods and recovery periods additional 50% deduction you can take before you figure to use in figuring depreciation deductions. Continued on next page MD48206,0000E89 -19-28FEB11-9/14 8-9 090117 PN=128  Taxes Because calculating depreciation may become very OTHER CHARACTERISTICS OF DEPRECIATION complex, Ms. Olson suggests the Snyders consider consulting a tax professional or up-to-date computer Roy points out that there are several characteristics of software to develop their depreciation schedule. She also depreciation that have not been discussed or need to be suggests that they consider the following questions when reemphasized. they acquire or dispose of depreciable property. Income tax benefits arise because the cost of the capital asset is recovered over the useful life of the asset. The Should we choose the Section 179 deduction? shorter the life assigned to the asset, the quicker the Should we claim the special election allowance? income tax benefit is received. Which depreciation system (GDS or ADS) applies? Raised livestock may not be depreciated when the cash Which property class applies under GDS? accounting method is used because all costs have What is the placed-in-service date? been deducted as cash expenses. There are none left What is the basis for depreciation? to depreciate. Which recovery period applies? Non-breeding livestock in inventory may not be Which convention applies? depreciated using the cash accounting method. Which depreciation method applies? Expensing will affect cost recovery by reducing the cost How is the depreciation deduction figured? basis of the property. When do you recapture MACRS depreciation? MD48206,0000E89 -19-28FEB11-10/14 INCOME TAX MANAGEMENT STRATEGIES TO LEVEL OUT INCOME Roy and Mary agree that income tax management strategies should only be used if they are consistent with other good farm management decisions. An example of this is the time when Roy used a partial budget to see if he would gain or lose by holding 5000 bushels of wheat into another year. In this situation he decided that he would lose $100 profit to save $60 in taxes. Roy and Mary have used several strategies to maintain a level income and maximize after-tax income (Fig. 10). DXP01850 —19—26OCT10 Fig. 10 — Roy and Mary plan tax strategy to level out tax obligations from year to year Continued on next page MD48206,0000E89 -19-28FEB11-11/14 8-10 090117 PN=129  Taxes STRATEGIES TO INCREASE TAXABLE INCOME The Snyders are cash method taxpayers. They use the following strategies to increase their taxable income (Fig. 11): Postpone expenditures and investments until after the beginning of the next tax year. DXP01851 —19—26OCT10 Sell marketable grain and livestock before the end of the tax year. Work with suppliers to pay bills after the beginning of the next tax year. Do not use the expensing options (Section 179 deduction or special depreciation allowance) for depreciable property. Do some off-farm or custom work (Mary occasionally Fig. 11 — The cash method taxpayer has options to in- works a second job and Roy has harvested for other crease taxable income farmers in the area). Review the three-year farm averaging or five-year net operating loss carry-back provisions, if appropriate. Continued on next page MD48206,0000E89 -19-28FEB11-12/14 8-11 090117 PN=130  Taxes STRATEGIES TO REDUCE TAXABLE INCOME They use the following strategies to delay or decrease taxable income (Fig. 12): Postpone some sales to next year. Use deferred sales contracts. Buy needed machinery, equipment, and other supplies DXP01852 —19—26OCT10 before the end of the tax year to get depreciation. Use the expensing options (Section 179 deduction and/or special depreciation allowance) for the maximum deduction on depreciable property. Make advanced purchases of feed and fertilizer. Review the three-year farm averaging or five-year net operating loss carry-back provisions, if appropriate. Fig. 12 — There also are strategies to decrease taxable income SPECIAL TAX SITUATIONS There are a number of situations that may affect a farmers income bracket by changing the tax structure of the farm or ranch. Some examples are shown in Fig. 13. Fig. 13 — Situations that May Affect a Farmer's Income Bracket Situation Examples Major business expansion Usually means a large capital investment in both depreciable and nondepreciable property; it is important to know how fast these investments can be recovered, what the effect will be on cash flow, and the effects of sales of the acquired property Improvement in labor Improved fringe benefits and bonus plans for key employees management practices Sale of capital items Farm land, mineral rights or deposits, herd or breeding livestock; it is important to consider the effects of an installment sale Change in type of business Sole proprietorship to a partnership or corporation Leasing or renting major Consider tax advantages as an alternative to outright purchase machinery and equipment Planning for retirement Postpone income until retirement years by investing in an approved retirement plan Estate planning Transfer of ownership from one generation to the next; consider the implications of gift, estate, and income taxes Farm investments versus Evaluate advantages and disadvantages of investing more in farm investments rather than nonfarm investments; nonfarm investments consider opportunity costs INCOME TAX DIFFERENCES BETWEEN TYPES OF FARMS One factor that should be discussed in income tax management is the primary income tax differences between types of farm business ownership (Fig. 14). Fig. 14 — Income Tax Differences between Types of Farm Business Ownership Primary Income Tax Difference Sole Proprietorship Partnership S Corporation Subchapter C Corporation Federal tax rate Earnings taxed as personal Distribute earnings to Distribute earnings to Undistributed earnings income to owner owners; earnings then shareholders; earnings then taxed only once, usually taxed as personal income taxed as personal income lower rates; distributed for each owner for each shareholder earnings (dividends) taxed twice, (1) as part of earnings of corporation and (2) personal income to shareholder Net operating loss Operating loss offsets Operating loss offsets Operating loss offsets other Operating loss cannot be other income for owner other income for owners income for shareholders passed to shareholders; (review net operating loss (review net operating loss (review net operating loss can be carried over to offset provisions) provisions) provisions) corporate income Continued on next page MD48206,0000E89 -19-28FEB11-13/14 8-12 PN=131 090117  Taxes Fig. 14 — Income Tax Differences between Types of Farm Business Ownership Primary Income Tax Difference Sole Proprietorship Partnership S Corporation Subchapter C Corporation Social Security tax Self-employment taxes Self-employment taxes Require both corporation Require both corporation and employee to pay FICA and employee to pay FICA tax (employer's share is tax tax (employer's share is tax deductible expense for the deductible expense for the business) business) State income tax Owner's income Owners' share of income Stockholders' share of Distributed earnings (NOTE: Income tax laws income (dividends), corporate vary from state to state.) income, franchise taxes SUMMARY OF INCOME TAX MANAGEMENT work with a tax professional who can help focus an owner on some of the tax issues that can affect his or her farm Ms. Olson has enjoyed visiting with Roy and Mary business. Snyder and providing them with an overview of income tax management. She concludes their visit with these Ms. Olson recommends that farm business owners meet remarks. with a tax professional four times a year, or at least twice a year. Of course, you will meet during tax season, but Income tax management is the managing of income, you should also make an appointment for May or June to expenses, and capital to maximize after-tax income. To plan for the rest of the year. The other sessions can help reemphasize both a business and personal point of view, you be sure your business is on track. the more dollars you make, the further ahead you are. As long as you take home part of the last dollar of income, it Planning will help you make major decisions. Planning is worth earning that dollar. will also help you achieve much in the way of day-to-day tax savings. Planning helps in two ways: (1) with periodic The biggest mistake many farm business owners make prodding from your tax professional, you're more likely when it comes to income taxes is waiting until January or to keep better records and pay more attention to the February to start thinking about them. Taxes should be expenses you need to keep track of, and (2) planning also an ever-present consideration, a factor in most business means a different mindset, one that will help you run your decisions, and not a once-a-year event. business in a more systematic, ordered way. The problem for many farmers and ranchers is that Ms. Olson concludes by saying that the Snyders should they are so immersed in building their farm business, continually be looking at their tax bill as they go through particularly as business improves in a healthier economy, the year. that they don't think taxes, or they aren't aware of changes in the tax law that might benefit them. One antidote is to MD48206,0000E89 -19-28FEB11-14/14 8-13 PN=132 090117  Taxes FEDERAL INSURANCE CONTRIBUTIONS ACT (FICA) Roy and Mary have asked Ms. Olson to explain in more depth why FICA taxes have to be paid and how they apply to agricultural labor. WHAT'S FICA AGAIN? Under the Federal Insurance Contributions Act (FICA) a percent of your earned income up to an annual limit must be paid into Social Security, and an additional percentage must be paid into Medicare. These percentages and income limits may change each year. If you are a wage or salaried employee, you pay only half the FICA bill and DXP01853 —19—26OCT10 the tax is automatically withheld. Your employer must contribute the other half. If you are self-employed, however, you're expected to cough up both the employee and the employer share of FICA. Ms. Olson does point out that Roy and Mary, as self-employed farmers, will be permitted to deduct half of this self-employment tax as a business expense. Fig. 15 — Types of social security and medicare benefits SOCIAL SECURITY BENEFITS AND MEDICARE children or adult children disabled before age 22 may Before she discusses agricultural labor, Ms. Olson briefly also receive benefits. explains the benefits of Social Security and Medicare (Fig. 15). Survivors — When you die, certain members of your family may be eligible for benefits. (Your spouse age 60 Retirement — If you were born before 1938, your full or older (50 or older if disabled, or any age if caring for retirement age is 65. Because of a change in the law, your children younger than age 16); and your children if the full retirement age will increase gradually to 67 for unmarried and younger than age 18, still in school and people born in 1960 or later. You can retire as early as younger than 19 years old, or adult children disabled age 62 and take your benefits at a reduced rate. before age 22.) Disability — If you become disabled (a physical or Hospital and medical benefits (Medicare) that provide mental impairment that's expected to prevent you from hospital insurance and voluntary medical insurance doing “substantial” work for a year or more or result pays hospital expenses and doctor bills for most people in death) before full retirement age you may receive 65 and over. payments if you meet qualifications. Family — If you are eligible for disability or retirement benefits, your current or divorced spouse, minor MD48206,0000E8A -19-24FEB11-1/2 CHECKING SOCIAL SECURITY RECORDS Ms. Olson also explained that the Social Security Administration (SSA) maintains records of earnings of each citizen and uses this data to calculate benefits DXP01854 —19—26OCT10 (Fig. 16). Usually the SSA sends you an updated Your Social Security Statement annually. Be sure to read this statement carefully. If you think there is a mistake, please let the SSA know. That's important because your benefits will be based on the SSA's record of your lifetime earnings. To learn more about Social Security contact www.socialsecurity.gov on the internet, call 1-800-772-1213, or contact any Social Security office. Fig. 16 — The social security office keeps a record of earnings for each taxpayer MD48206,0000E8A -19-24FEB11-2/2 8-14 090117 PN=133  Taxes AGRICULTURE LABOR DEFINED Agricultural labor generally includes all the work that is performed on a farm or ranch in the employ of any person. This is in connection with the cultivation of the soil or raising commodities or livestock. The laborer's services are in the employ of the owner, tenant, or operator in connection with farm operation and maintenance and the major portion of the service is performed on the farm. WHAT IS EMPLOYMENT? DXP01855 —UN—10NOV10 John Jones is a hired farm laborer. He is an employee of Roy Snyder. For purposes of determining whether John Jones is an employee, the law turns to legal definitions that have been developed over many years. These rules are not always clear, but certain basic ideas can be found. An employee performs services for another, and is subject to the control of the employer. This does not mean that Fig. 17 — Farm Laborers Are Supervised by the Farmer or Rancher Roy must stand by and constantly observe and supervise. It does mean that Roy has the right, whether he exercises it or not, to have the work performed in such manner and Employees may include a hired farm hand, a sales clerk, detail as he directs, and that John has a duty to perform feed mill hand, or a truck driver. the work as directed (Fig. 17). FB87413,000008E -19-01APR14-1/5 AGRICULTURAL LABOR — EMPLOYEE As a hired laborer and an employee of Roy Snyder, John Jones is paid a fixed weekly wage for his labor. He is under the supervision of Roy. As a farm employee, John has FICA payments deducted from his wages by Roy. As the employer, Roy also contributes to John's FICA account (Fig. 18). A farm employee is covered by Social Security and Medicare benefits, and the employer is subject to FICA tax if any of these situations occur: DXP01856 —UN—10NOV10 The employee receives cash wages of at least $150 from any one farm employer during the calendar year. The employee works for any one farm employer on twenty or more days for cash wages computed on a time basis. The employer pays wages of $2,500 or more during the year to all employees. Fig. 18 — Roy must pay FICA obligations for his hired workers After listening to this discussion, Mary decided to review her Form W-2 from her employment in 2013. She found ($2,263 for Social Security and $529 for Medicare). This that her wages subject to the FICA tax were $36,492. meant that her employer had also contributed the same FICA taxes withheld from her wages totaled $2,792 amount to her FICA account. Continued on next page FB87413,000008E -19-01APR14-2/5 8-15 090117 PN=134  Taxes FAMILY LABOR There are certain family situations in which no tax is due and no benefits result: A spouse who works for the other spouse (Fig. 19) A parent who works for his or her child unless the parent works in the child's trade or business A child under 21 who works for his or her parent DXP01857 —UN—10NOV10 Fig. 19 — There is no FICA payment for spouse labor FB87413,000008E -19-01APR14-3/5 INDEPENDENT CONTRACTORS An independent contractor is one who agrees to perform certain services for a fixed price. The contractor must meet the specifications as outlined by the employer (Fig. 20). The contractor retains the manner of doing the job and the control over methods and details. The independent contractor is the employer of his own employees. He must pay his own self-employment taxes DXP01858 —19—26OCT10 and the employer taxes for his employees. An example of an independent contractor is a professional electrician who is hired for a fee to repair an irrigation well pump. The independent contractor needs no direction or supervision to do the job. The farmer or rancher does not pay Social Security taxes for the independent contractor or deduct Social Security taxes from the fee that is paid Fig. 20 — Independent contractors pay their own employees a to the contractor. The contractor is responsible for the salary and pay their own tax obligations contractor's own self-employment taxes and the employer taxes of his employees. Roy decides to review his 2013 federal tax return SELF-EMPLOYED FARMERS for self-employment tax. His Schedule SE shows a net profit from farming of $66,014, net earnings from Roy is a self-employed farmer. He supports himself. He self-employment of $60,964 ($66,014 x 0.9235), and must pay self-employment tax. The self-employment tax a self-employment tax of $9,327 ($60,964 x 0.153). is based on the net earnings from the farm business. One-half of the self-employment tax ($4,664) was entered This is shown on Schedule F (Form 1040). The tax is on his 2013 Form 1040 as an adjustment to income. computed on Schedule SE (Form 1040) and paid when Roy files his income tax return. Roy and Mary's children may be self-employed if they carry on an activity of their own, such as a 4-H or an FFA project. They must have net earnings of $400 or more. Continued on next page FB87413,000008E -19-01APR14-4/5 8-16 090117 PN=135  Taxes EMPLOYERS OF AGRICULTURAL LABOR As an employer of agricultural labor, Roy and Mary are responsible for several administrative tasks for their employees (Fig. 21). Roy and Mary must: Have an Employer's Identification Number that is used on all forms that report the employer's FICA tax payments. Keep records of each employee's name, Social Security number, cash wages, daily records of time worked, basis of payment, and the amount deducted as the employee's share of the FICA tax. DXP01859 —19—26OCT10 Withhold tax from employee's wages. FICA tax rates and income limits may change from year to year. Check the tax laws each year. Make reports to the Internal Revenue Service by January 31 each year, and send a W-2 form showing the employee's wages and taxes withheld to the employee. Pay FICA taxes levied upon employer and employee. Fig. 21 — Employers of agricultural laborers have many responsibilities The cash amount of taxes for agricultural labor may be deposited in a government depository (usually a local borrowing institution). Depending on the amount collected, employers may have to pay FICA taxes on a periodic basis (usually monthly or quarterly). FB87413,000008E -19-01APR14-5/5 8-17 090117 PN=136  Taxes ESTATE TAXES One of the major factors in estate planning is the impact of taxes. Estate taxes or inheritance taxes can deplete an estate and reduce the amount of property, which can be left to a spouse, children, and other heirs. The Federal Government levies a gift tax on transfers during life and an estate tax at death. State governments generally collect inheritance tax. DXP01860 —UN—10NOV10 ESTATE PLANNING Roy and Mary Snyder have decided to meet with Joe Talbot, an estate-planning professional, to learn more about estate planning (Fig. 22). Mr. Talbot explains to Roy and Mary that estate planning is the process of controlling your assets during your life as well as after your death. He states that an estate plan should focus on Fig. 22 — Roy and Mary meet with an estate-planning professional three objectives. These objectives are: 1. To ensure that your assets will provide you with the Mr. Talbot emphasizes to Roy and Mary that estate necessary income and resources on which to live. planning is an ongoing process. As tax laws change and as 2. To ensure that upon your death, your assets go to the life situations change, review of your estate plan is crucial. people and/or organizations you intended. WHO NEEDS AN ESTATE PLAN? 3. To minimize your estate tax, fees, and any associated Many people feel that estate planning is for the elderly or court costs. the rich, or is not something they want to discuss because Mr. Talbot explains that estate planning encompasses it focuses on death. No one knows what the future holds many components. and so it is important that everyone have a plan. Mr. Talbot emphasizes that since Roy and Mary are a young Your will or revocable living trust must be adapted or married couple with children, it is crucial to have a will that changed to meet your objectives. designates guardians for those children in the event both Life insurance amounts, policy ownership, and parents die. He further explains that for persons who think beneficiaries must be reviewed. they do not have enough money to worry about estate Property ownership must be examined and tailored to planning but have lots of life insurance, their death can your plan. create an estate tax problem. Persons who are injured Family income requirements must be matched with in an accident and suddenly are not capable of making projected income. their own medical and financial decisions, can name Other items to be considered include fair treatment an individual who will make those decisions for them. of heirs, passing on any business you may own to Mr. Talbot points out that the bottom line is that estate business heirs, tax minimization, administrative and planning is important for everyone. probate cost savings. Continued on next page SP63763,3BAA212 -19-24JUL14-1/5 8-18 090117 PN=137  Taxes EVERYBODY NEEDS A WILL Mr. Talbot explains to Roy and Mary that a will (Fig. 23) is a form of an estate plan. A will tells the world exactly where you want your assets distributed when you die. It is also the best place to name guardians for your children. Dying without a will (also known as dying “intestate”) can be costly to your heirs and leaves you no say over who DXP01861 —19—26OCT10 gets your assets. Without a will, the state will distribute property as it sees fit. Even if you have a trust, you still need a will to take care of any holdings outside of that trust when you die. PROPERTY OWNERSHIP Mr. Talbot explains to Roy and Mary that property can Fig. 23 — A will is a form of estate planning be held in several ways. The method chosen depends upon the individual's estate plan and how they wish their property to transfer to their heirs. Mr. Talbot provides Roy To establish clear title to any assets. and Mary with a list and descriptions of the ways property To pay any necessary income or estate taxes. can be held (Fig. 24). Solely owned property and property owned as Mr. Talbot emphasizes to Roy and Mary that property tenants-in-common are subject to the probate process. ownership is a complex area of tax law. Always check Joint tenancy property, life insurance not owned by the with your attorney. decedent going to beneficiaries other than the estate, and revocable living trust property are not subject to the TRUSTS AREN'T JUST FOR THE WEALTHY probate process. Mr. Talbot wants to point out to Roy and Mary that trusts The probate process can be time consuming and costly as are legal mechanisms that let you put conditions on how well as making the decedent's estate information public. and when your assets will be distributed upon your death. How property is held will dictate if the probate process They also allow you to reduce your estate and gift taxes applies or not. and to distribute assets to your heirs without the cost, delay, and publicity of probate court, which administers WHAT IS THE ESTATE TAX wills. Some trusts also offer greater protection of your Mr. Talbot emphasizes to Roy and Mary that the estate assets from creditors and lawsuits. they build up may not be entirely theirs to give away. PROBATE/NON-PROBATE ASSETS The federal government, and in some cases, state governments stand ready to claim their share. The probate process is established: Do you know what will remain for your family and favorite To prove that the decedent's will is valid. charities, and your other beneficiaries? If you do not, you To pay any debts held by the estate. cannot intelligently estimate what you can give to each. Fig. 24 — Property Ownership Type of Ownership Description Sole ownership Simplest form of ownership. One person owns the property. Upon their death, the property is transferred via their will. If they have no will, state law dictates how assets are transferred to the designated heirs. Joint tenancy Ownership between two people. They own the property together and upon the death of one joint tenant, the surviving joint tenant receives the decedent's property. Typical wording is “Roy and Mary Snyder, as joint tenants with rights of survivorship, not as tenants-in-common.” Upon the death of one joint tenant, his/her portion of the property is included in the estate for estate valuation purposes. Joint tenancy is not subject to the probate process. Tenancy-in-common Allow two or more people to own property together. Upon the death of any tenant, the decedent's portion of the property does not go to the survivor. That property passes via the decedent's will or by state law. At the time of death, the value of the decedent's portion of the property is included in his/her estate and is subject to the probate process. Granted life estate Usually done through a will or living trust. A person can hold title to property as a life tenant or as a remainderman. Retained life estate Occurs when a living person gifts an asset they own to their heirs, while at the same time they retain a life estate or lifetime use of the property until death. The federal estate tax is a tax on the act of transferring estate alone pays the tax, although the property passing property at death. It is not a tax on the right of the to individual beneficiaries may be diminished by the tax. beneficiary to receive the property; the estate and the Continued on next page SP63763,3BAA212 -19-24JUL14-2/5 8-19 090117 PN=138  Taxes Understanding what the word estate means in estate tax but can also include insurance, your interest in trusts or law is important so that you do not underestimate the jointly held property, and certain interests you have in value of your taxable estate. The estate includes your real other estates. estate, bank deposits, securities, and personal property, Continued on next page SP63763,3BAA212 -19-24JUL14-3/5 8-20 090117 PN=139  Taxes HOW THE ESTATE TAX IS APPLIED A single unified rate schedule applies to a decedent's estate (Fig. 25) and all lifetime gifts (Fig. 26) over the annual gift tax exclusion. Under the unified gift and estate tax rate, the overall tax on your property holdings is theoretically the same whether on not you make lifetime gifts. In actual cases, however, lifetime gifts may reduce the potential overall tax because of the annual gift tax exclusion. REDUCING OR ELIMINATING A POTENTIAL ESTATE DXP01862 —19—26OCT10 TAX Mr. Talbot explains that there are several approaches to eliminating or reducing a potential estate tax. These may include: You may make direct lifetime gifts. Any appreciation of the property transferred will be removed from your Fig. 25 — Estate taxes are levied when estates are transferred estate. Life insurance can be assigned to avoid estate tax, provided the assignment takes place more than three years before death. You can provide in your will for bequests that will qualify for the marital and charitable deductions. Farmland is one asset that can be valued not at fair market value (FMV), but at a Special Use Valuation (SUV) if the estate meets several complex qualifications. SUV usually results in a lower valuation than FMV and may possibly reduce an estate obligation. A special estate tax deduction may be allowed for a family business. The adjusted value of the family-owned business interests generally must exceed 50% of the decedent's adjusted gross estate. DXP01863 —19—26OCT10 INCOME TAXES AFFECT ESTATE PLANNING Income taxes also are of concern in tax planning. Income tax savings during life may create additional capital to be used or passed on. Also, the way a will or trust is drawn will determine how much the beneficiaries will have to pay in income taxes. Fig. 26 — Gift taxes are levied on transfers of assets Mr. Talbot has prepared the previous table for Roy and Mary to examine as they plan their estate (Fig. 27). OTHER CONSIDERATIONS 2. Health Care Directive — writing and attaching a Health Care Directive to your will ensures your wishes Mr. Talbot suggests that Roy and Mary consider the for health care are honored in the event you are following in developing their estate plan. incapable of expressing your wishes. You decide what level of health care you want in a given situation 1. Power-of-Attorney — adding a provision in your will and place those wishes in effect via the Health Care granting someone Power-of-Attorney in the event Directive. Many hospitals and health care providers you are incapable of making financial decisions. The have information on developing the care directive as individual or individuals can manage your assets in well as forms to complete. your best interest if you are unable to do so. Continued on next page SP63763,3BAA212 -19-24JUL14-4/5 8-21 090117 PN=140  Taxes Fig. 27 — Major Income Tax Provisions Related to Estate Planning Income tax basis When selling an asset, you pay tax on the difference between the selling (Important to property holders because it determines the amount of price and the income tax basis (original cost) of the asset. The basis is income tax they will pay on the sale of the asset.) determined by how you acquired the asset. If you purchased the asset: Your basis is what you paid minus any depreciation you have claimed on it. If you inherited the asset: Your basis is the fair market value or special use value assigned the asset as it passed through the estate. If you received the asset as a gift: Your basis is the same as the donor's basis. Installment sales This allows the taxation to be spread out proportionally during the years (Useful to keep as many dollars in the lower tax brackets as possible.) that principal payments are made. Using late in life on low basis assets may not be wise because no stepped-up basis is received on installment contracts. Heirs must continue to pay the income taxes on principal and interest payments as they receive them. House If you sell your farm, which includes your personal residence, parcel out the house sale because it qualifies for a possible exemption from tax. Those provisions apply to the house only, not to land or buildings used as business property Tax free exchange Useful to position the younger generation on the home farm and leave (You find a person who has property that is “like-kind” to yours and work the older generation with more remote, low-maintenance farmland. out a trade. Your tax basis follows to the new property.) Using the tax-free exchange can avoid or postpone taxation of the parent's capital gains on low-basis property. Income averaging This provision allows high income from a current year to be carried back equally to utilize lower tax brackets from the three previous years. Spread out income In most cases, as a farmer retires and they sell off their farm business (Leveling out income usually results in lower taxes paid than bunching assets, a large income and self-employment bill emerges. It may be wise income into one year.) to plan ahead and spread the sales over a two- or three-year period. IN CONCLUSION final. Economic conditions and inflation constantly change values. Estate and gift tax laws may be revised. For In concluding his remarks on estate planning to Roy and these reasons, your plan must be reviewed periodically Mary, Mr. Talbot emphasizes that the death of a farm or as changes occur in your family and business. Changes ranch owner forces an estate transfer. Because of this, may include: and because of the inheritance rights and interests which children have in the property of parents, there will always When a birth or death occurs be problems of transferring property between generations. When you receive a substantial increase or decrease The problems are frequently complicated by having to in income provide for a widow as well as children, plus a desire to When you enter a new business venture or resign from treat all children equally. On top of all this, most parents an old one must depend on the farm and its income for support When you sell, retire from, or bring new persons into during old age. your business Faced with these problems, and not knowing what to do, When a member of your family may no longer need any part of your estate, while others may need more many families do nothing, or delay planning until it is too late. Proper planning can eliminate many problems. When material changes occur that affect the health or life expectancy of one of your beneficiaries Determining the facts in the particular transfer problem, and understanding the alternative ways of handling the GET EXPERT ADVICE problem, are steps that must be taken. Discussing your estate plans with your heirs may prevent disputes or As a final statement to Roy and Mary, Mr. Talbot warns confusion. that estate planning is not a do-it-yourself activity. You should contact experienced professional counsel for PERIODICALLY REVIEW YOUR ESTATE PLAN help in developing a plan for your future estate that will accomplish your tax and personal objective. Mr. Talbot explains that you are now aware that there are costs of transferring an estate. But no estate plan is ever SP63763,3BAA212 -19-24JUL14-5/5 8-22 PN=141 090117