As the end of 2007 nears, farmers may be able to save thousands of dollars of federal income tax or self-employment (SE) tax with adequate planning. Some possible areas for saving include farm income averaging, taking advantage of the ceiling on the "retirement portion" of the Self Employment Tax, using the Section 179 expense election for small businesses and the Section 199 domestic production activity deduction, and contributing to a retirement plan.

Individuals who are involved in a farm business may elect to calculate their current tax liability as if the current farm income was averaged over the three prior years. The election is made by filing Schedule J, Income Averaging for Farmers and Fishermen with their 2007 tax return. Due to outstanding yields and high crop prices, you should make sure your tax preparer checks to see if income averaging will apply.

Tax law defines a farm business as a trade or business involving the cultivation of land or raising or harvesting of any agricultural or horticultural commodity. It also includes the raising, shearing, feeding, caring for, training and managing of animals. Crop-share landlords are included if a written lease is executed before the tenant begins significant activities on the land. Income earned by individuals working as a farm employee or providing contract harvesting of a commodity does not qualify for the election.

Continue article

ADVERTISEMENT

Farm income passing through from a partnership or S corporation also qualifies for averaging. Federal income tax is calculated using graduated tax rates, called tax brackets. For example, in 2007, married taxpayers filing a joint return pay tax at a rate of 10% on their first $15,650 of taxable income. Additional taxable income in excess of $15,650 but less than $63,700 is taxed at 15%. Additional income up to $128,500 is taxed at 25%. There are also rates of 28%, 33% and, for taxable income in excess of $349,700, the rate is 35%. The tax brackets are adjusted for inflation each year. Therefore, they were somewhat lower in prior years.

Taxpayers determine the amount of farm income they wish to average. This income is then carried equally back to the three prior years. For example, assume Ted and Rhoda Tiller have taxable income of $250,000 in 2007 and qualify as farmers. Therefore, they have $54,150 of income taxed at a 33% rate. In 2004, 2005 and 2006, their marginal tax rate never exceeded 25%. This means they never had any income taxed in the 28% bracket. By electing income averaging, they are able to utilize any unused 25% bracket and the 28% bracket. This will result in at least a five-percent savings on the farm income they elect to average.

Even if the taxpayer has not taken advantage of income averaging in past years, he may want to file amended returns and elect to average the prior years income. While this may not save tax in the amended year, it can free up tax brackets to allow greater tax savings from 2007 averaging.

As another example, assume Ted and Rhoda did not use the entire 25% bracket in 2001, 2002 and 2003. Averaging part of the 2004 income to fill these brackets will further reduce the amount of 2004 income in the 25% bracket. This may allow a greater carryback of 2007 income to the 25% bracket.

If you determine it is advantageous to amend the 2004 return, the amended return must be filed by April 15, 2008 or two years from the date the tax was paid. Unfortunately, income averaging will not reduce the self-employment tax.

Taking advantage of the ceiling on the "retirement portion" of SE Tax In many years the self-employment (SE) tax liability is greater than the income tax liability for many farmers. Thus, the strategy of reducing or delaying SE tax liability by deferring income from one year to the next is often recommended. However, 2007 may not be the year to use such a strategy.

The much higher farm incomes in 2007 may cause a farmer's Net Earnings from Self Employment to exceed the maximum amount subject to the 12.4% "retirement portion" of the SE tax. This amount is capped at $97,500 in 2007 and $102,000 in 2008. Net Earnings from Self Employment that exceed these limits are only taxed at the 2.9% "Medicare rate" of the SE tax. It may not be wise to defer income otherwise taxed in 2007 into 2008, as seen in the following example.

Assume Ted and Rhoda expect unusually high farm income in 2007 and expect their 2007 Self Employment Net Earnings to be $100,000 more than the $97,500 ceiling on earnings subject to the "retirement portion" of the SE tax. This $100,000 will escape the 12.4% "retirement portion" of the SE tax in 2007 (it only will be subject to the 2.9% Medicare portion of the tax).

However, what if Ted and Rhoda, expecting high income in 2007, decide to defer some of this income to 2008 by delaying additional sales of the 2007 crop until 2008 and prepaying additional expenses for the 2008 crop year in 2007? If they succeed in deferring $100,000 of Self Employment Net Earnings from 2007 until 2008, and if their 2008 Self Employment Net Earnings would have been $60,000 without the deferral, then they will pay substantially more SE tax in 2008 than they would have without the deferral.

With the deferral, they will have moved $100,000 of Self Employment Net Earnings out of 2007 (where it escaped the 12.4% "retirement portion" of the SE tax) and added it to their 2008 Self Employment Net Earnings. But $42,000 of the amount deferred from 2007 will be subject to the 12.4% rate in 2008, and only the remainder will exceed the 2008 ceiling of $102,000 subject to the 12.4% "retirement portion" of the SE tax. Therefore, the deferral has cost them $5,208 ($42,000 x 12.4%) of additional self-employment tax.