As a presidential candidate, Joe Biden campaigned on raising individual and corporate income taxes to fund a variety of social programs.  As president, he unquestionably delivered on his tax-increase promise, releasing his Fiscal Year 2022 (FY2022) budget proposal on May 28, 2021.  President Biden proposed FY2022 budget contains several provisions detrimental to family farms and businesses, including ones that sharply raise taxes and eliminate the step-up in basis on inherited assets.  This blog will explore some of these provisions and suggest steps to avoid or minimize the tax bite.

Tax Rate Increases – C Corps and Individuals

C Corporation Tax Rate Increase

Before delving into President Biden’s budget proposal, it’s worth revisiting the advantages and disadvantages of operating a farm in a C Corp structure.  On the plus side, a C Corp provides a layer of personal liability protection.  In addition, C Corps can provide tax-free meals to employees and spouses/dependents if meals are served on farm premises and provided for the convenience of the employer. (Livestock operations are easier to justify than grain operations, but courts have held that grain farm employees are also eligible for the exclusion.) S Corp employees and partners in farm partnerships are not eligible for meal exclusions, so this is a significant tax-free fringe benefit for C Corp employees.  Also, C Corporations historically have had a low marginal tax rate on the first dollars of taxable income.  2017’s Tax Cuts and Jobs Act (TCJA) raised the corporate tax rate to a flat 21% on all taxable income, eliminating the 15% bracket on the first $50,000 of taxable income. 

A major C Corp disadvantage has always been double taxation, that is paying individual income taxes on dividend income that’s already been subject to corporate income taxes.  Individual tax rates on dividend income vary, but at times the effective double-tax rate on corporate dividends has been nearly 70%.  Currently, the highest effective rate on doubled-taxed income is around 50%.

Another farming C Corp downside is a possible limit on using the cash method accounting.  This affects only corporations with 3-year average annual gross receipts exceeding $25,000,000, so most farming operations are unaffected by this limitation. 

Having revisited C Corp tax advantages and disadvantages, we’ll turn to the proposed C Corp tax rate increase. President Biden’s budget will raise the statutory corporate tax rate over 33% (from 21 percent to 28 percent) in hopes of raising nearly $1 trillion over the next ten years. Remember, C Corp tax rates apply not only to operating income but also gains on sales of capital assets such as farms.  This means the effective double tax rate on farm income or farm sales could be more than 67% when C Corp and Individual tax increases are combined. 

C Corporation Tax Increase Workarounds

Many family farm corporations can elect to be taxed as an S Corporation, which can reduce or eliminate double taxation with effective tax planning.  This could also be an escape valve for sales of highly appreciated farmland, ranches and businesses.  To avoid double taxation, a Corp that elects to be taxed as an S Corporation must wait five years before selling an asset with a built-in gain.  After the 5-year waiting period, appreciated assets can be sold with a single level of tax at individual rates. 

Individual Income Tax Rates

Unlike C Corporations, individuals pay different tax rates on different types of income.  Ordinary income is subject to one set of tax brackets, while long-term capital gains are often subject to lower rates.  We’ll discuss President Biden’s budget proposal’s effect on each. 

Ordinary income tax rates are the ones most frequently mentioned when someone talks about his or her “tax bracket.”  Tax brackets start at a 10% on the first dollar of taxable income (calculated after deducting standard or itemized deductions) and increase six times until reaching a top rate of 37% at taxable income of $523,601 for singles and $628,301 for married couples filing joint returns.  Biden’s budget proposal would raise the top tax rate to 39.6% for singles making $452,700 and joint filers making $509,300. 

Long-Term Capital Gain tax rates apply to sale or exchange transactions involving capital assets, such as farmland, held for more than a year.  Currently capped at 23.8%, President Biden’s budget proposal wants to raise the long-term capital gain tax rate to 43.4% on taxpayers with adjusted gross incomes of more than $1,000,000.  Considering state income taxes (such as Nebraska’s 6.84% tax rate), sellers could find themselves losing over half of their capital gains to taxes!  This combined tax rate would be higher than the highest rate on wage income and highest among countries in the Organization for Economic Co-operation and Development (OECD). 

Individual Tax Increase Workarounds

Two strategies spring to mind to deal with the long-term capital gain tax rate increase.  First, consider using the installment sale method to defer income from property sale transactions into future years.  This could result in keeping adjusted gross income below the $1,000,000 level at which President Biden’s proposed long-term capital gain tax rate would apply.  The Installment sale method allows taxpayers to decide when payments will be received and, therefore, taxed. 

Second, business taxpayers have significant control over taxable income through bonus depreciation’s 100% expense deduction.  Depreciable asset purchases, when timed right, could help keep income below $1,000,000.  Judicious use of these tactics could allow taxpayers to escape the proposed confiscatory 50+% tax rate. 

Income Subject to Tax

This next section deals with President Biden’s proposal provisions that would tax more income.  As a reminder, federal income tax is computed on taxable income, that is, gross income less deductions and exclusions.  Gross income is broadly defined as all income from whatever source derived.  Examples of tax-exempt income include life insurance proceeds, municipal bond interest and child support.  Here are two types of income that have consistently been excluded from taxation that would be taxable under President Biden’s proposal.   

Like-kind/Section 1031 Exchange

Recognized gains on a real estate exchange – called a like-kind or Section 1031 exchange, where a seller fully reinvests his or her equity in relinquished property into like kind property – have long been excluded from taxation.  In such a transaction, the seller doesn’t take any sale proceeds in cash, and US tax laws have allowed these gains to be excluded from current taxation.  Under this provision, a taxpayer’s gain that would have been recognized is effectively deferred until the replacement property is sold.  President Biden’s budget proposal limits like kind exchange deferrals to $500,000 or $1million if filing a married-filing-joint return.  Gains more than these amounts will be taxed.

Inherited Property – Step-up in Basis at Death

One other type of income has consistently been excluded from taxes: gains from sales of inherited appreciated property.  Property inherited from a decedent has its cost basis adjusted to fair market value at the date of the decedent’s death, making pre-death gains nontaxable.  This is known as a step-up in basis (though it can work the other way when a property’s value is less than cost at a decedent’s death, in which case a step-down in basis occurs).  Under this rule, inheritors of property owe taxes only on post-death appreciation.

There are many good tax policy reasons for basis step-up, including fairness and simplicity.  Without a step-up in basis, heirs would need to know the cost basis of inherited assets or be forced to pay tax on the entire value of property received. (IRS rules require taxpayers to prove the basis of assets sold.  If you can’t prove an asset’s cost basis, the IRS assumes 100% of sale proceeds are taxable.) This would be a nightmare for heirs who often have no idea of the amount paid for a certain asset. 

Not only would President Biden’s plan repeal the step-up in basis for amounts more than $1 million ($2 million for joint filers), it would also trigger gains on appreciated assets at death, much of which is due simply to inflation, not any real increase in value.  The proposal would exclude from recognition any gains on tangible personal property such as household furnishings and personal effects (which seldom appreciate anyway).  However, it could mean heirs would need to sell investment property to pay this tax if the decedent had insufficient cash to pay it.  It would further require the creation of a new tax form and regulations to implement.  In a stroke of fairness, the existing $250,000/$500,000 exclusion would continue to apply for gains on primary residences. 

Family-owned Farms and Businesses

Payment of tax on the appreciation of certain family-owned and operated businesses would not be due until the business interest is sold or ceases to be family-owned and operated.  While this might provide some relief, it would be difficult for successive generations to operate a family business when tax debts are piling up against it after each sale. 

Tax law changes are coming.  There is still uncertainty on exact proposals and effective dates, but taxpayers who want to minimize taxes might be wise to structure transactions to close in 2021. If you have any questions, please contact us. You can also read related articles on our accounting blog.

America’s agricultural sector has been facing challenges in workforce availability, climate, technology, among many other issues. With the world population expected to hit 9 billion by the year 2050, agriculture businesses will need to ramp up production by up to 70% to accommodate the growing population.

Farms across the U.S are incorporating new and innovative techniques to deal with issues of pesticides, fertilizers, contamination, spoiled produce, harvesting, and diminishing labor force. Thankfully, federal tax credits are available for corporations, individuals, and businesses undertaking research and development efforts to alleviate the current farming and produce challenges while enhancing better yields.

The Research & Development Tax Credit

Research & Development Tax Credits are a government incentive aimed at helping businesses by encouraging and rewarding innovation. The federal Research and Development (R&D) Tax Credit act was enacted in 1981 and allows a credit of up to 13% of eligible spending for new or improved processes and products. R&D tax credits are available to companies engaged in research and development activity, regardless of their size, albeit subject to eligibility.

R&D Eligibility Requirements

Your research/project can qualify for tax credits if it meets the following criteria:

• Improved or new products, processes, or software– Your research qualifies if it relates to a new or enhanced performance, function, or quality of an agricultural component (i.e., process, product, formula, software, or technique).
• Technological in nature- This is to say that the activity(s) to be undertaken must be primarily technical. As such, the activity must be based on principles of science such as biology, computer science, or engineering.
• Eliminates uncertainties- The activity must also tackle uncertainties in the methodology, capabilities, or development process of the business component.
• Process of experimentation- For the research to qualify for the R&D tax credit, the activity must also entail evaluation and experimentation of one or more options through development, refinement, and testing of different alternatives.

Qualified costs include costs of supplies, testing, or patents, research expenses, and employee wages.

Are You Missing Out?

The agricultural sector is rife with activities that are eligible for the R&D tax credit. Check out a few brief examples of the R&D tax credit for agriculture to help you determine your eligibility.

Common Examples of R&D Tax Credits for Agriculture

1. Development of New or Enhanced Storage Techniques

This may entail developing packaging to control temperature and moisture or even a structural design to prevent the produce/product from degradation, contamination, molding, fermentation, or grain clumping.

2. Development of New or Improved Conveyance Chains/Systems

As a product is moved through production, there can be changes to the conveyance design or process to reduce waste/material loss, improve speed, or enhance the process’s dependability. Transport designs such as refrigeration or trucking may also qualify.

3. Development of New or Improved Products or Processes to Maximize Yield

As you seek to improve the growth or returns on livestock or crops, there is a wide range of activities that may qualify here. These include:

• Testing of new or improved techniques of planting and harvesting
• Testing of new or improved fertilizers or chemical additives
• Testing of new or enhanced feeding techniques and feeds to enhance livestock growth and health
• Examining new soil blends including nutrient density, mineral content, and pH 
• Evaluation of new products and methods for preventing disease or pest infestation

4. Development of new or improved software

This may entail developing software meant to facilitate land tracking, produce or material monitoring, and crop selection based on soil characteristics.

5. Development of New or Improved Irrigation Technologies

If you are creating a mechanical, electrical system, or software to automate or streamline an irrigation process, your project is may be eligible for R&D tax credits.

6. Development of New or Improved Techniques or Equipment to Minimize Environmental Impact

This involves equipment or techniques to enhance compliance with evolving environmental legislation or, generally, any other interventions in agriculture meant to promote environmental conservation.

Common Exclusionary Items

It is worth noting that the following items are usually not eligible for R&D tax credits:

1. Equipment investment subject to depreciation
2. Small adjustments to livestock diet or feed components
3. Adapting an existing product to a customer’s specifications
4. Administrative or functional operations that do not contribute or amount to agricultural innovation

How We Can Help

Many agricultural corporations and businesses are still unaware that the government is offering generous R&D incentives or believe that such incentives do not apply to the agricultural sector. Even those aware may fail to grasp the full extent of R&D tax credits that they are entitled to. Have questions? Contact us today to learn more about these unique tax credits and how they might benefit you.

In the farm industry, you quickly learn that farming incomes can fluctuate a great deal from year to year. Yields are affected by many elements outside of your control, such as drought, insect infestations, fire, flood, and the general weather conditions of the year. Some years you will yield significant profits and be subject to higher tax rates. Other years you will be subject to minimum tax liability as your yields provided little profits or even loss. The best way to plan ahead for this income fluctuation and sustain your farm operation is to utilize farm income averaging. Here is everything you need to know about farm income averaging and how to best utilize this tax management tool. 

What is Farm Income Averaging? 

Farm income averaging or FIA is a tax management tool that is available to farmers and ranchers in the United States. This tax management tool can be elected after the end of the tax year. Essentially, this tool allows a certain amount of your farm income to be spread over a three-year period. For example, this is available to prevent farmers from being pushed into a higher tax bracket if they sold a large portion of property or yielded abnormally large profits from a single crop season. Overall, this tax management tool allows you to average your farming income equally over a three-year tax period to prevent being taxed at a higher rate. Averaging your farm income reduces the tax burdens associated with both bountiful and lean yielding years. The IRS form associated with farm income averaging is 1040 Schedule J. This form can be found on the official IRS website. 

To file a 1040 Schedule J, it is not necessary for the individual to have been involved in farming in previous years. The only stipulation is that the individual must be involved in the farming industry in the year that they file. Individuals engaged in any farming business, including sole proprietors, partners, or shareholders in an S corporation, can utilize this tax management tool. Individuals involved in the farming industry through estates and trusts are not eligible to utilize the farm income averaging tool. 

What is Classified as Farm Income for FIA Purposes?

The IRS considers a farming business an operation involved in the trade of cultivating land or the trade of raising or harvesting any agricultural commodities. The IRS excludes the buying and reselling of plants or animals raised by someone else under this classification. 

The farm income for farm averaging purposes is considered by the IRS to be the overall income, deduction, gain, and loss attributable to an individual’s farming business. The rental income on a share of production from a tenant’s farming operation is classified as farming income by the IRS. They also consider the gain on the sale or other disposition of non-land property used in an individual’s general farming operation to be considered farm income. However, cash rent farming operations and compensation received by an employee are not considered farm income by the IRS. 

Key Points to Consider When Utilizing Farm Income Averaging

• Election of Schedule J is made available for taxpayers with farm income after the end of the year.
• Farm income averaging spreads high amounts of farm income over the previous three years.
• Utilizing Schedule J does not change income reporting for the three base years. Instead, it utilizes the portion of the lower tax brackets that were left unused in prior years to determine the current year’s taxes.
• Individuals don’t have to have farm income in the previous years, just in the year of election.
• Cash rent farmers are excluded from farm income averaging.
• Election of Schedule J may be revoked with permission from the IRS.

Connect With Us 

At Lutz, we specialize in providing accounting services. We provide the best tax, accounting, assurance, business consulting, and valuation services to every one of our clients. We are the largest locally owned firm of its kind in Nebraska. Being a Nebraska based firm, we have a strong understanding of the farm industry. We can help you get the most out of your farming operation and answer any questions you may have.

Farm income averaging can be a powerful tax management tool for many farm operations. It allows you to better prepare for the ups and downs that are certain to occur when working in the farm industry. Fluctuating income is the only real certainty when it comes to farming. However, the 1040 Schedule J is not beneficial in all scenarios and is not a substitute for crucial year-end planning by farmers. Contact us today with any questions you may have about taxes, accounting, or business consulting surrounding your farm operation. Your success is our success. We are here to help you get the most out of your farming operation.

Curtis Thompson, Lutz Tax Director, was recently featured in the Nebraska Cattleman Magazine, December 2019, Volume 75, Issue 10 on page 42, for an article about 2019 year-end tax reviews relating to the agriculture industry.

“As we near the end of the second year of the Tax Cuts and Jobs Act (TCJA) of 2017, many of the questions we had at this time last year have been answered, but there are still some questions that remain. The most extensive piece of the Tax Cuts and Jobs Act was IRC Section 199A, commonly referred to as the qualified business income (QBI) deduction. In recap, the QBI deduction is a deduction of 20 percent of the net qualified business income from taxable income for all taxpayers other than C Corporations. There are, however, phaseouts for the QBI deduction for 2019, starting with taxable income as follows: married filing jointly $321,400, married filing separately $160,725, and single/head of household $160,700.”