The federal tax law has changed a lot recently. Some changes from the 2012 tax year to 2013 are shown below.
In 2012, the top individual federal income tax rate was 35 percent. In 2013, that will increase to 39.5 percent. The top rate for capitals gain rate and dividends was 15 percent in 2012. In 2013, that will go up to 20 percent. It will be 15 percent for individuals in the 15 and 35 percent tax brackets, and a 0 percent rate stays in place for individuals in the 10 percent income tax bracket.
Self-employment tax is paid on "earned" income. This was 2 percent lower for 2012, but goes back to 15.3 percent. It has two components. The FICA portion is 12.4 percent and is paid on the first $112,500. The remaining 2.9 percent is the Medicare portion paid on all income from being self-employed.
High-income earners (individuals making more than $200,000 or couples making more than $250,000) will have some additional tax in 2013. Exactly 0.9 percent will be added to the 2.9 percent Medicare portion of self-employment taxes. An additional 3.9 percent will be added to the tax on investment income.
Changes were also made in depreciation rules. Section 179 is an election to expense a portion of the purchase of qualified assets. In 2012, the limit was $139,000, meaning that up to that amount could be expensed on qualified purchases rather than depreciating a portion each year over the asset's life. In January, this was increased to $500,000 not only for 2013, but retroactively for 2012.
Additional first-year depreciation is only allowed on purchases of new qualified assets. For 2012, 50 percent of the cost could be deducted in the first year as additional depreciation. This provision was extended through the end of 2013.
The $5 million exclusion amount for estate taxes was made permanent, but the top tax rate increased from 35 percent to 40 percent. The provision for portability was also made permanent. Portability allows that when the first spouse dies any amount of the exclusion not used can be used by the surviving spouse, in addition to their own exclusion amount.
As you look at the changes in tax law, now is a critical time to examine your own situation and tax management strategy. One of the main aspects of tax management is managing the "timing" of the income or the year in which taxes are owed.
Most farm income tax returns are filed on a "cash basis," meaning that revenue is recognized when crops and livestock are sold and expenses are deducted when paid. By delaying selling a crop until the following year, revenue can be deferred into a future year. This affects the timing of the taxable income and hence the income taxes due in various years.
For example, potatoes harvested in fall 2012 are sold in February 2013. The income from the sale of the potatoes was deferred from the 2012 tax year to the 2013 tax year. This will result in lower taxable income and taxes paid in 2012 and leave a larger amount for 2013. The tax management did not eliminate the taxes. It deferred the taxes.
Taxes can also be deferred by prepaying expenses or accelerating depreciation of equipment purchases through a Section 179 election to expense an asset and additional first-year deprecation. The result is that more deductions are taken "up front," leaving lower deductions and hence higher taxable income in future years.
Deferred tax on current assets is a measure of the income and self-employment tax that has been deferred into the future. It's fairly simple to calculate. Take the value of the inventory of crops and other current assets at the end of the year and subtract any expenses that if paid could be deducted. The difference would be the taxable income. Multiply this amount by a tax rate.
In the example below, $700,000 in taxable income has been deferred in to a future tax year. If an average tax rate of 28 percent is used, the resulting deferred tax is $196,000. (The average tax rate is found by taking the tax paid in a year divided by all the sources of income.)
Deferring taxes can be useful to keep the taxpayer out of a higher tax bracket in a year when income is high. It also makes sense if the same dollars of tax will be owed to pay it in the future.
On the other hand, deferring income taxes by borrowing money and paying interest may not be a good strategy. It can also come with risk. Sometimes in a bad year, a grower may have higher taxes because he does not have the funds to defer income by buying more machinery to take depreciation on or prepaying expenses.
Deferring taxes may not make sense if the rate paid on the taxable income will be higher. In the above example, if the tax rate were 47.6 percent (top income tax rate of 39.5 percent plus 3.8 percent for Medicare and 5 percent for state income taxes) the deferred tax would be $333,200.
No one can say exactly where tax rates will go in the future, but there is some indication rates will go up.
Understand the choices that your tax preparer is making and look at a tax management strategy that will minimize the taxes paid over a period of years and not a single year.