Tax Traps: Prepaying Expenses and Deferring Tax Payments

June 26, 2014 02:03 AM
Tax Traps: Prepaying Expenses and Deferring Tax Payments

In the second installment of our eight-part series, Farm CPA Paul Neiffer explains the danger of prepaying too many expenses or deferring your tax payments.

In their quest to save money on taxes, farmers often take actions, such as prepaying too much farm expense or deferring tax payments, that come back to bite them in the end. Prepaying expenses may leave them without free cash flow by the end of the year. And deferring taxes can result in a large liability when it comes time to sell the farm.

The practice of prepaying too much expense wasn't as much of a danger in previous years, when farmers were flush with cash. But in coming years, with cash prices for crops very likely to be much lower, producers could find themselves caught in cash-flow bind.

"Prepaying too much expense at year-end may lock you into the wrong inputs and force you to incur interest costs later on because you run out of cash," says Paul Neiffer, tax expert and author of The Farm CPA blog. "It may cost you lost marketing opportunities and lead to bad management decisions."

Farmers, Neiffer says, need to forget about their experience for the last four years. In the years prior to that, farmers who prepaid too much farm expense would be out of cash and digging into their line of credit by the end of the year.

"Then you are making decisions that maybe aren’t the smartest because the tax tail is wagging you," he says. The better approach might be to bite the bullet and pay tax on some working capital "that’s available to use however you want."

A related problem, Neiffer says, is prepaying an incorrect amount of expenses. Many farmers believe the invoice they receive from their local co-op is correct for tax purposes. But in his experience, "there are too many that are wrong."

Paying some tax all along, and keeping a cash reserve, can allow farmers to take advantage of marketing opportunities without incurring a penalty. As an example, Neiffer shares the story of a farmer who called recently, eager to take advantage of an opportunity to buy some land.

"The banker was saying it would take a $100,000 down payment," Neiffer recalls. "But for that farmer, it was more like $135,000, because he’d have to recognize $35,000 of income in order to invest $100,000."

As Neiffer says in the following video, farmers who defer tax payments need to carefully monitor their tax situation.

Neiffer tells the story of one large farmer who had deferred paying taxes on $40 million in equipment and inventory assets. The farmer claimed about $8 million in net worth on his financial statement.

"But in reality he probably had negative net worth of $5 million or $10 million," Neiffer says. "That’s what I call a ticking time bomb. There are lots of farmers with issues like that. They may have a huge tax bill that hits them when they retire."

Farmers can take several actions before they retire to potentially reduce that tax liability, he explains. They can set up a cash-balance pension plan, or perhaps put grain or equipment into a charitable remainder trust.

"In that way, they can do an installment sale on the grain or equipment and not pay self-employment tax. Because a lot of times that self-employment tax can be bigger than the income tax," Neiffer says.


Read more tax tips from Paul Neiffer!

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Andrew Winters, CPA
Carthage, IN
2/17/2015 06:28 AM

  By saying that a large tax burden will come back to bite you in the end (at retirement) you are assuming that farmers will have nothing but "good years" ahead of them. All of my farm clients understand that bad times may be ahead (as they have been in the past). A bad year is a good time to get out of the pre-paying habit. There's nothing wrong with good tax planning. Our office has been doing it for 56 years.