Tax Management and Depreciation

1. Tax Management and Depreciation Unit 4: Agribusiness Management Lesson: AM6

2. Objectives Lesson Objective: • After completing the lesson on tax management and depreciation, students will demonstrate their ability to apply the concept in real-world situations by obtaining a minimum score of 80% on a Tax Management News Report. Enabling Objectives: • Calculate taxable income and analyze the advantages and methods of maximizing after-tax income. • Categorize income and expenses. • Define depreciation, calculate basis, and calculate expensing. • Recognize the importance and benefits of reducing and increasing taxable income. • Calculate MACRS depreciation.

3. Key Terms • Deductible • Non-Deductible • Capital • Depreciation • Basis

4. Ben Franklin "In this world nothing can be said to be certain, except death and taxes."

5. Goal of Tax Management • Maximize after-tax income • Taxable Income Gross income (total amount of income) - Exclusions (income not subject to tax) - Deductions (business expenses, depreciation, home mortgage interest) - Exemptions (deductions for self and dependents)____________________________________________________________ Adjusted gross income - Taxes due ____________________________________________________________ After-tax income

6. Why is the goal not to pay lowest amount of taxes possible? • To pay no income tax, business would either have to make very little money or have an enormous amount of deductions to offset any taxes • Having large deductions may lower taxes, but business may not be able to afford the extra expenses • Very true in agricultural businesses that may have a profitable year on year and operate at a loss the next year

7. Methods of Maximizing After-Tax Income • Maintain complete and accurate records of all possible deductions that can be used to lower taxable income • Often overlooked tax-deductible items • Dues to agricultural organizations • Costs of agricultural magazines and other references and business materials • Farm share of utility bills • Wages to children and giving children livestock or crops • Mileage on family car • Cost of child care • Retirement plan set up with professional advice • Mortgage and business interest

8. Methods of Maximizing After-Tax Income cont. • Maintain a constant level of income • Extremely profitable year = business is taxed at higher rate • Very poor year = may not be able to use deductions if deductions exceed income

9. Methods of Maximizing After-Tax Income cont. • Postpone income to the next year • Often used when business has a good year and manager realizes business will have to pay large amount in taxes • Sign a contract to provide a service or product before end of year and not take payment until after first of the year

10. During the year, a farmer pays $1,800 principal and $500 interest on a tractor loan. His annual depreciation is $2,000. His deductible operating expenses (fuel, oil, repairs, etc.) associated with operating the tractor totaled $500. His marginal tax rate is 30%. What is his after-tax cash cost of using the tractor for the year? • Cash • $1,800 principal + $500 interest + $500 operating costs = $2,800 • Tax • $2,000 depreciation + $500 interest + $500 operating costs = $3,000 • $3,000 x .30 marginal tax rate = $900 • $2,800 cash - $900 = $1,900

11. Categorizing Income

12. Categorizing Expenses

13. Depreciation Depreciated value declining over useful life • The loss of value each year due to wear, age, or obsolescence • Agricultural items with a useful life of more than one year are deducted throughout their useful life until the value of the asset is zero • Assets like a greenhouse, tractor, farm building, etc. contribute to agricultural production over several years, so it is beneficial to have their costs written off over their useful life • Net worth statement shows true value of depreciable assets • Management Depreciation and Tax Depreciation

14. Depreciation Tax Depreciation Management Depreciation Reduction in value of an asset applied as a cost to the business’s annual Profit & Loss statement Recovers the cost of the asset to reflect actual useful life, wear and tear, and obsolescence • Reduction in Book Value of an asset for tax purposes • Recovers the cost of the asset through calculated depreciation using IRS guidelines • Follows IRS guidelines but does not necessarily reflect the true wear and obsolescence of the asset

15. Straight Line Mid-Year Depreciation • SLMY • Used for consistency and fairness • Most clearly reflects “real” depreciation • IRS changes / tweaks methods for computing taxdepreciation almost every year.

16. Basis • The value of an item that can be depreciated • Book value of trade-in property plus cash difference paid • Basis on property already owned is the remaining undepreciated value, or book value, or the property • NOT the list or replacement cost • Provides the starting point to determine tax depreciation

17. A business purchases a pickup for $15,000 • The business trades in an old pickup with an undepreciated value of $3,000 and pays the $12,000 cash difference • This makes the basis $15,000 (3,000 + 12,000) • If the pickup is strictly used for business, the $15,000 can be depreciated using tax depreciation. • If the pickup is partially used for business and partially used for personal use, the percent of time used for business is multiplied by the basis to determine the amount that can be used for depreciation

18. Expensing • An option that allows manager to deduct up to $10,000 per year from the basis of a capital item to be used in the business • Deduction is counted as a business expense in the year purchased • Lowers business’s taxable income by amount expensed • $10,000 limit can be applied to one item or a combination of items • Full $10,000 does not have to be used • Remaining amount that is not expensed falls under regular rules of depreciation • Limitations • Up to $10,000 per year on capital items purchased that year can be expensed • Amount expensed cannot be depreciated. Basis is lowered by amount expensed • One can only expense cash difference paid • Expensing cannot be used to create a loss • Can create larger first year deduction by expensing up to the limit and claiming depreciation on the same item during one year

19. Reducing Taxable Income • When one expects to pay a large amount in taxes, business owners might… • Postpone sales to next year • Use deferred sales contract • Allows delivery of item sold, but delays income until next year • Make advanced payments for items such as feed, fertilizer, fuel, etc. • Purchase needed equipment and machinery before end of year to utilize depreciation • Use expense to allow additional deduction from the basis of depreciable items in year purchased • Use accelerated depreciation to increase amount of depreciation • Contribute to Individual Retirement Account (IRA)

20. Increasing Taxable Income • Done so deductions and personal exemptions are not lost • Increase sales in current year • Postpone expenses and investments until after January 1 • Pay bills after January 1 • Do not use expensing • Use straight-line depreciation • Get a supplemental income – Off-farm labor or custom work • Withdraw money from an IRA

21. By increasing and decreasing taxable income when appropriate, income can be evened out effectively. Over a period of years, this should result in maximizing after-tax income.

22. MACRS Depreciation • The Modified Accelerated Cost Recovery System • Used to recover the basis of most business and investment property placed in service after 1986 • 2 depreciation systems • General Depreciation System (GDS) • Alternative Depreciation System (ADS)

24. GDS Property Class

25. GDS Property Class cont.

26. GDS Property Class cont.

27. Placed-In-Service Date • When property is ready and available for a specific use, whether in a business activity, an income producing activity, a tax-exempt activity, or a personal activity • Even if you are not using the property, it is in service when it is ready and available for its specific use.

28. Farm Equipment Placed-In-Service Date • A farmer buys a planter, and it was delivered in December 2011 after harvest was over • Depreciation begins on the planter in 2011 because it was ready and available for its use in 2011 even though it will not be used until the spring of 2012 • If planter comes unassembled in December 2011 and is put together in March of 2012, it is placed in service in 2012 • Depreciation begins in 2012

29. Immature Livestock Placed-In-Service Date • Depreciation begins when livestock reaches age of maturity • Bought for drafting purposes • Depreciation begins when livestock can be worked • Bought for dairy purposes • Depreciation begins when livestock can be milked • Bought for breeding purposes • Depreciation begins when livestock can be bred • Basis for depreciation is initial cost of immature livestock

30. Basis for Depreciation • Property’s cost • Basis multiplied by percentage of business use

31. Recovery Period • Number of years over which an owner recovers the property’s cost

32. Convention

33. Mid-Month Convention • Nonresidential real property, residential rental property, and any railroad grading or tunnel bore • Treats property as being purchased or sold in middle of month • Rental house purchased in March will receive 9 ½ months of depreciation during first year and 2 ½ months of depreciation that last year

34. Mid-Quarter Convention • Applies when 40% or more of basis of 3-year to 20-year property purchased in the tax year is bought in the last quarter • Sam purchased $2,000 worth of breeding heifers on March 1st and purchased a $5,000 used pickup on November 1st • 1) Determine in what quarter each was purchased • 2) Calculate total basis for the year ($2,000 + $5,000 = $7,000) • 3) Calculate 40% of total basis ($7,000 x .40 = $2,800) • 4) Since basis for last quarter exceeds 40%, determine first-year depreciation for each item purchased and multiply by quarter purchased • Heifers were purchased at midpoint of first quarter, leaving 7/8 of the year to depreciation • Pickup was purchased at midpoint of fourth quarter, leaving 1/8 of year for depreciation

35. Mid-Year Convention • Applies to 3-year to 20-year property if mid-quarter convention does NOT apply • Applies on sale of 3-year to 20-year property • All property put into service during the year is treated as if it were purchased at midpoint of the year • If only depreciable purchase was in March, item will receive ½ year depreciation the first year

36. Conventions

37. Depreciation Method • 3 choices for MACRS Depreciation • Regular MACRS • Optional Straight-line • Alternative MACRS

38. Regular MACRS • 200% Declining Balance • 150% Declining Balance • Straight-line

39. 200% Declining Balance • Applies to nonfarm 3-year to 10-year property • Switchover provision applies when appropriate 200%------------------- x undepreciated value = annual depreciationproperty class • For a $5,000 used pickup (five-year property), the formula for the first year is 200% ---------- x $5,000 x appropriate convention = first year depreciation 5

40. 150% Declining Balance • Applies to 15-year and 20-year property and all property used in a farming business (except real property) • Switchover provision applies when appropriate 150%------------------ x undepreciated value = annual depreciationproperty class • For a $3,000 machine shed (20-year property), the formula for the first year is 150%------------ x $3,000 x appropriate convention = first year depreciation 3

41. Straight-Line • Applies to nonresidential real property and residential rental property • Mid-month convention applies • Switchover provision does NOT apply basis------------------- = annual depreciationproperty class • For a $40,000 rental house (27 ½ year property), the formula for the first year is $40,000------------------- x midmonth convention = first year depreciation 27.5

42. Regular MACRS • Declining-balance methods calculate depreciation as a fraction of each year’s remaining balance. • To recapture full amount of depreciation, switchover to straight-line comparison method of depreciation during last part of recovery period • Straight-line comparison method uses the remaining basis of the declining balance method and the remaining years in the regular straight-line formula. • Straight-line comparison method shows when to make a switchover to regular straight-line method. • Switchover should occur when amount calculated under straight-line comparison method exceeds amount calculated using declining-balance method.

43. Optional Straight-Line • Option to use straight-line depreciation instead of 200% or 150% declining balance methods on 3-year to 20-year property • Once item is depreciated using straight-line depreciation, it must continue on straight-line basis---------------------- = annual depreciation property class

44. Alternative MACRS • Longer recovery period • Use straight-line formula to calculate annual depreciation basis----------------------------------------- = annual depreciation alternative MACRS years • First year depreciation calculated using rules that apply to mid-year, mid-quarter, or mid-month conventions

45. Conclusion • The goal of tax management is to increase after-tax income. Tax management strategies may be one of the most profitable ways of reaching this goal. Occasionally income will need to be increased or decreased in an attempt to have an even level of income. This will result in the lowest taxes in the long run. It is also important to be able to categorize income and expenses as the different categories can have a significant impact on taxes. • Tax depreciation is a very useful tool in income tax management. • Basis provides the first step in determining depreciation. It must be determined if expensing, depreciation, or both are going to be used. • The type of item will determine the property class and the depreciation method used. The time of year in which the item is purchased may affect which convention is used to calculate the first year depreciation. • All items depreciated using the declining-balance method must switchover to straight-line depreciation when the amount that could be claimed using straight-line depreciation exceeds the amount calculated using the declining-balance method.

46. Exit Card • What did you learn today about tax management and depreciation? • What questions do you still have about tax management or calculating depreciation?