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Fruit Notes |
Tax Pointers for Farmers and
Landowners in 1998 |
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Fruit Notes |
P. Geoffrey Allen |
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Fruit Notes |
Tax advice given below is intended as general advice and is believed to be correct. It does not substitute for a detailed review of the circumstances of an individual taxpayer by a professional tax practitioner. For more details, you and your tax adviser may wish to consult the sources referenced in the square brackets [thus] (see footnote). Taxpayers filing returns other than for calendar year 1998 may face different rules than those described here . New Legislation Life seems to be getting ever more complicated. • On January 1, 1998, many of the provisions of the Taxpayer Relief Act of 1997 "TRA97" (Public Law 105-34) became effective. • On July 22, 1998, the IRS Restructuring and Reform Act/ Taxpayer Bill of Rights 3 "RRA98"(H.R. 2676) was enacted into law (P.L. 105-206), and many of its provisions became effective on that date. While mostly concerned with internal operations of the IRS, changes in laws governing collection of taxes and "innocent spouse" provisions will affect some taxpayers. The Act also makes technical corrections to TRA97 that affect treatment of some capital gains and losses and sale of a principal residence. • Finally, as the last act of the 105th Congress, the Omnibus Appropriations Act for FY99 "OAA99" (H.R. 4328) was enacted into law on October 21, 1998 as P.L. 105-277. It contains several retroactive tax provisions of specific interest to farmers. They are discussed below. Income Averaging for Farmers Made Permanent [IRC §1301] TRA97 introduced income averaging for farmers for 1998-2000. OAA99 made the averaging provisions permanent. Use income averaging if you had a successful year in 1998 and less profit in prior years. The idea is to shift some of your income from the high marginal tax rate you would otherwise face in 1998 to the rate it would have been taxed in earlier years. Schedule J of Form 1040 is used for calculations. Step 1. Calculate the tax on your taxable income (farm and non-farm) in 1998. If the last dollar of income is in a higher tax bracket than the last dollar of taxable income in any of the three prior years then income averaging will reduce your 1998 taxes. Step 2. Elect the amount of farm income to be averaged. Only farm income can be averaged. However, if your family has high taxable income in 1998 because of both farm and non-farm income, you can average the farm income part. Farm income includes gains from the sale of assets (except land) used in the farming business for a "substantial period" (not defined). Sales of machinery and breeding livestock reported on Form 4797 would be eligible. Elect as much of the current year's eligible farm income as you want to distribute over the three prior years. The principle is to get income after averaging approximately level across the years. The more detailed operational rule is explained after the example. Step 3. Divide the elected amount of income into three equal parts and add each part to your taxable income (farm and non-farm) in each of the three prior years. Subtract the elected amount from 1998 income. Step 4. Using the income levels from step 3, figure the tax for each year using the tax table for that year and add the tax amounts together. Step 5. Add the actual taxes paid in the three prior years to the 1998 taxes from step 1. Step 6. Compare the total from step 4 with the total from step 5. If the total from step 4 is smaller then income averaging will be advantageous. Example: Andy Farmer, who is married, filing jointly, has both farm and non-farm income for the last four years as shown in Table 1. Net losses are within parentheses. If Andy does not elect income averaging then the family income tax liability for 1998 will be $32,346. [.15 x $42,350 + .28 x ($102,300 - $42,350) + .31 x ($132,000 - $102,300)]. Andy can elect to average up to $117,000 of 1998 income (the total of the Schedule F and Form 4797 amounts). If he elects to average $90,000, then $30,000 is added to the taxable income of 1995, 1996 and 1997. Results of averaging are shown in Table 2. Note that if Andy elects to income average in 1999 the amounts in Table 2 become the initial taxable incomes. The saving from averaging is $12,546 [= $36,096 - $23,550]. The 1998 tax liability is $19,800 [$23,550 - $900 - $1,200 - $1,650]. Note: the tax is figured at 15% of taxable income. Use of tax tables will give slightly different answers ($4 more in each case). The operational rule is to increase the amount of the election as long as the average marginal tax rate over the three prior years is as low or lower after averaging than the marginal rate on the income remaining in 1998. In the example, the last dollar of taxable income before averaging (Table 1) in each of the prior years is taxed at 15%, against the marginal rate for 1998 of 31%. Therefore, moving $3 from 1998 to the prior years reduces the tax rate on that income from 31% to 15%. After averaging (Table 2) the marginal rates are 15% throughout. If the election was increased by more than $600 (to over $90,600) this would bring 1997 taxable income over $41,200, increasing the marginal rate of tax in 1997 to 28%. Now the average marginal tax rate of the three prior years (15% + 15% + 28%)/3 = 19.3% exceeds the marginal rate for 1998, which has dropped to 15%. Caution: If you are subject to alternative minimum tax in the year for which averaging is elected (1998 in the example) then income averaging will be of no benefit. Averaging Does Not Alter Self-employment Tax [IRC §1301] Andy's self-employment tax in 1998 in the example above would be $11,535. [92.35% of $114,000 = $105,279. The first $68,400 is taxed at 15.3% = $10,465. The balance, $105,279 - $68,400 = $36,879 is taxed at 2.9% = $1070.] Income averaging does not change the self-employment tax amount. Conservation Reserve Payments Are Rent Not Farm Income, Are Not Subject to Self-employment Tax, and Are Reportable on Schedule E [Wuebker vs Commissioner, 110 T.C. No. 31 (June 23, 1998); IRC §1402] For several years the IRS has taken the position that Conservation Reserve Program (CRP) payments to materially participating farmers are subject to self-employment tax. (If you do not fall under the material participation rules, see below, you were not and still are not subject to SE tax on CRP payments.) . The Tax Court in the Wuebker case determined that CRP payments are rent; however, CRP agreements prevent the land from being used for agricultural production. Therefore, the language in IRC §1402 that called for the payment of SE tax on rent by a materially participating farmer does not apply. The IRS may appeal the Court's decision. Note: There are reasons why you might not wish to treat CRP payments as rent. Some estate tax benefits might be lost. For example, to get the favorable valuation as farmland rather than fair market value (in highest and best use), the deceased owner must have materially participated in using the land for farming purposes. In this situation, you would want to report the CRP payments on Schedule F and pay SE tax on them. If taking this position, filing the disclosure form, Form 8275, is probably wise, relying on the past IRS position and its likely appeal of the Wuebker decision. [IRC §1402(a)(1)] Material Participation There are two sets of material participation rules. A taxpayer who is materially participating for the purposes of self-employment tax may or may not be materially participating for the purposes of passive activity loss rules. The reverse is true: a taxpayer who materially participates for the purposes of passive activity loss rules may not be materially participating for the purposes of self-employment tax. The Farmer's Tax Guide (IRS Publication 225) lists the tests of material participation of a farm-landlord to determine whether or not self-employment tax must be paid. You are materially participating if you have an arrangement with your tenant and you meet one of the following tests: Test No. 1. You do any three of the following: (1) pay or stand good (e.g. sign for materials bought on credit) for at least half the direct costs of producing the crop; (2) furnish at least half the tools, equipment, and livestock used in producing the crop; (3) consult with your tenant; and (4) inspect the production activities periodically. Test No. 2. You regularly and frequently make, or take an important part in making, management decisions substantially contributing to or affecting the success of the enterprise. Test No. 3. You work 100 hours or more spread over a period of 5 weeks or more in activities connected with crop production. (Note: these numbers do not appear in either the tax code or the regulations.) Test No. 4. You do things which, considered in their total effect, show that you are materially and significantly involved in the production of the farm commodities. If you pass the test for material participation you file Schedule F and are subject to self-employment tax on the income. [I.R.C. §1402. Treas. Reg. §1.1402(a)-4(b)(6) gives six examples] Capital Gains Changes TRA97 set up three rate groups of assets: 1. 28%. Short-term gains and losses, assets held not more than 12 months; all collectibles (coins, paintings, stamps, wine, etc.); long-term capital loss carryovers. (Note: Excess depreciation (above straight-line amounts) recaptured from the sale of §1250 property (basically, buildings) is ordinary income, does not appear on Schedule D.) 2. 25% Long-term gains (no losses in this group) from sale of buildings and improvements that result from straight-line depreciation (generally, the rest of the depreciation you have taken), limited by net §1231 gain [Technical correction in RRA98 to IRC §1(h)(7)(B)]. Section 1231 property is those durable assets used in a trade or business (not in inventory, not supplies). 3. 20%All other long term gains and losses, including the gain over purchase price from selling a building. The 1997 Act also set complicated holding periods. RRA98 has simplified matters in several areas. 1. Sales on or after January 1, 1998, of assets held more than 12 months qualify for long term capital gains. 2. The amount of gain at the 25% rate is limited to the net §1231 gain. [IRC §1(h)(7)(b)] Generally, this change only becomes a concern during a year when you sell some property for less than you paid for it. Example: In 1998, Bruce Bullock sells a piece of land for $80,000 that he had purchased for $100,000. He also sold a building for $80,000 that he purchased for $70,000. He had taken $40,000 of straight line depreciation on the building. He had no unrecaptured §1231 losses from prior years. Bruce also sold some mutual fund shares for a gain of $20,000. The basis of the building is $30,000 ($70,000 - $40,000). Therefore, in 1998 Bruce has: Gain on building $50,000 Loss on land (20,000) Net §1231 gain $30,000 On the building alone, Bruce has $40,000 of gain taxed at 25% (the straight-line depreciation) and $10,000 of gain taxed at 20%. (Refer to the rate groups listed above.) However, because of the loss on sale of his land, the amount of gain subject to the 25% rate is only $30,000. Note that the gain on sale of the mutual funds offsets the loss on the sale of the land and normally these would be netted out, since they are in the same (20%) rate group, to give a net gain of zero for that group. But the limitation described in the example is done first. 3. Netting of gains and losses. Form 4979 and the worksheet on page seven of the instructions for Schedule D together perform the desired calculations. If you have losses in the 28% or 20% rate group and a gain from selling depreciable property (25% group) the worksheet will reduce the recapture amount you enter on line 25 of Schedule D. Details of the netting are as follows: (1) Within each group, net out the gains and losses for that group. (2) Short term losses first reduce short-term gains, if any. (3) Any residue from (2) is applied first to reduce long-term gains at the 28% rate, then to reduce gains at the 25% rate then to reduce gains at the 20% rate. (4) A net loss from the 28% group (including long-term loss carryovers) is applied first to reduce gains at the 25% rate , then to reduce gains at the 20% rate. (5) A net loss from the 20% group is applied first to reduce gains in the 28% rate, then to reduce gains at the 25% rate. Order of computing tax on gains. For taxpayers in the 15% bracket, the capital gains rate will be less than the amounts given in the rate groups above. Schedule D does a masterful job of figuring out the amounts subject to the various rates of tax. It performs computations by taking income in the following order: ordinary income, taxed at 15%; gains in the 25% class , taxed at 15%; gains in the 28% class, taxed at 15%; and gains in the 20% class, taxed at the reduced rate of 10%. Once the 15% bracket has been used up, the rate of the asset group is applied to the capital gains. Sale of Farm and Principal Residence TRA97 and corrections in RRA98 permit much or all of the capital gain on the sale of your principal residence ($250,000 if single, $500,000 if married filing jointly) to be excluded from income if you meet ownership and occupancy requirements (generally, to have owned and occupied the house in two out of the last five years). [IRC §121] Instead of the single lifetime exclusion available previously, you can now use the exclusion every time you sell your home. Farmers, therefore, have an even bigger incentive to declare their house a principal residence and not part of the farm. To get the exclusion you must show that your house is residential not agricultural. For example, use the area around it to graze horses used for pleasure by your children; maintain the area around it as a garden giving scenic enjoyment; report mortgage interest and property taxes on Schedule A rather than on Schedule F; retain the house and some land for some period of time after the sale of the farm. Net Operating Losses on the Farming Business Now Carried Back Five Years [IRC §172(b)(1)(G)] RRA98 added a five-year carryback for the net operating loss that would result if only income and deductions attributable to farming businesses were taken into account (i.e., "farming losses", reduced by the amount of profit, if any, from other businesses). [IRC §172(b)(1)(G)] "Farming business" means the trade or business of farming, including operating a nursery or sod farm and raising or harvesting fruit trees and ornamental trees. [IRC §263A(e)(4)] If you want to make use of the net operating loss provisions to lower your taxes, the five-year carryback is now the default. If you want to use the regular net operating loss provisions you must elect to do so. Such election must be made by the due date (including extensions) for filing the return for the year with the loss. Once made, the election is irrevocable. [IRC §172(b)(3)] Regular net operating loss provisions have also changed. In 1998 and future years losses can be carried back two years (instead of three) and carried forward 20 years (instead of 15). [TRA97; IRC §172(b)(1)(A)]. Farmers in "Presidentially declared disaster areas" can use a three year carryback for disasters but not for "farming losses" (i.e. not for losses incurred in the ordinary business), so this is of little use to most farmers. If you want to use these regular provisions you can elect to use only the carryforward provision. The same conditions apply to this election. You must make the election before the due date to file your return (including extensions) and once made the election is irrevocable. Net operating loss carryback and carryforward is most useful when set against income subject to high marginal tax rates. If you have low incomes and low marginal tax rates in prior years you may wish to use carryforward only. This is a decision that requires careful analysis of past years' incomes and formation of expectation about future net incomes. Form 1045 and its associated Schedules are used to make the complex adjustments to itemized deductions, to figure the allocation of losses and to calculate the amount of the tax reduction. As before, net operating losses are allocated chronologically, that is, to the earliest eligible year first. Massachusetts State Taxes Get Up to Date – Almost After being frozen at January 1, 1988, Massachusetts personal income tax law now follows the Internal Revenue Code in effect on January 1, 1998. Unless they are related to deductions for business expenses or one of the special federal tax provisions such as Roth and Education IRAs, any federal tax law changes that become part of the IRC as amended and in effect after January 1, 1998, will not be adopted by Massachusetts. One place where farmers might be affected is with depreciation. If you took different amounts of depreciation on a property for federal and State purposes, that difference will disappear on your 1998 returns. Example: The life for single purpose agricultural or horticultural buildings placed in service after 1989 is 10 years for federal purposes while it would remain at the 1988 life of 7 years Massachusetts purposes. Possibly amounts on purchased equipment taken as expenses (§179 expensing) might have been higher for federal than for State purposes. These differences would cause the amount of depreciation taken on federal returns to differ from that taken on State returns. Septic Credit Carryover Extended to Five Years The Massachusetts credit for the replacement or repair of failed cesspools or septic systems had been amended to extend the carryover for unused credit from three to five years. The current annual $1,500 maximum credit and $6,000 total maximum credit remains the same. If you claimed the credit in 1997 you have until 2002 to carryover any unused credit. Conversion to Roth IRA: What Did You Miss? If you convert from a traditional IRA to a Roth IRA by December 31, 1998, you meet a special rule that allows you (but does not require you) to spread the taxable income from the conversion over the next four years. This is not as big a deal as some advertising implies. You lose little by converting one fourth of the planned amount in each of the next four years. Most of the advertising by mutual funds or brokers is (or should be) directed at employees. Self-employed individuals have other possibilities (SEP-IRA and SIMPLE-IRA) that remove much of the attraction of the Roth IRA. A contribution to a Roth IRA is income after taxes have been paid while a contribution to a regular (deductible) IRA is before tax income. Both types of IRA accumulate earnings tax-free. Distributions from a Roth IRA are tax-free, while those from a regular IRA are taxable. The key issue appears to be whether the tax rate on contributions will be higher, the same or lower than the tax rate on distributions. If higher, the Roth is an advantage. If lower, it is not. Worksheets that do not employ any "smoke-and-mirrors" appear to show that conversion of a regular to a Roth IRA is advantageous, even when the tax rate during retirement is lower. That is, removing funds from a regular IRA, paying the tax on these funds (which are treated as ordinary income) and depositing the funds in a Roth IRA gives greater retirement income than not making the conversion. The money to pay taxes must come from somewhere, but the result occurs even after factoring in the lost earnings on that money. Why does the conversion "work" even if your tax rates fall after you retire? Because it allows you to shelter more interest and dividend income from taxes. If it is your goal to put a lot of money away for retirement, as an employee you are restricted to $2,000 of earned income each year (and usually less if you participate in another retirement plan). A Roth IRA conversion lets you increase this. Example: You withdraw $10,000 from a regular IRA. If you have sufficient other income to put you in the 28% tax bracket, the tax on this distribution is $2,800. Without any other source of money you only have $7,200 to put into a Roth IRA. If in retirement you are subject to a 28% percent tax rate it turns out that your after-tax retirement income is the same whether you converted or not. (Worse, the $2,800 is treated as a premature withdrawal and incurs a further 10% excise tax penalty.) But if you have other money to pay the $2,800 tax bill, you are effectively putting that same amount into your IRA (in addition to the $2,000 that you could put into a new Roth IRA).
Footnotes: IRC, Internal Revenue Code; T.C., Tax Court; Treas. Reg., Treasury Regulations. |
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