Agricultural News
Long-Term Tax Strategies Leave More Money in Producers' Pockets, Ag Economist Says
Wed, 05 Dec 2012 17:33:24 CST
Job Springer, an agricultural economist at the Samuel Roberst Noble Foundation, offers some strategies to limit the government's tax bite come next April in his current article in the foundation's Ag News and Views Newsletter.
As Ben Franklin once noted, the only two things one can count on with certainty are death and taxes. Most Americans go to extra lengths in order to delay them both as long as possible. This article will share some tips on how to minimize income tax obligation across time.
Income and expenses generated from entities such as a sole proprietorship, partnership, limited liability company (taxed as a partnership) and a sub S corporation are reported on the owner's personal income tax return. It is in the best interest of each business to eliminate all unnecessary expenses, and, from a business standpoint, taxes are considered an expense. Following are some steps taken each fall by individual taxpayers or taxpayers using the assistance of a tax preparer.
Understanding the Income Tax System
First, one needs to understand the tax rates that are expected for 2012. A table, which is available by clicking here, reports the estimated 2012 income tax brackets, based on inflation adjustments, released from the IRS on Nov. 7, 2011, for a husband and wife filing jointly as well as those filing singly. The numbers in the table correspond to a taxpayer's adjusted gross income (AGI).
Second, it is important to understand the rules. Many do not know that a filer's taxable income is not all taxed at the same rate according to the highest applicable bracket. Instead, income is taxed progressively. For example, assume a married couple filing jointly has an AGI of $120,000. In a progressive tax system, only the portion of the income between $70,700 and $120,000 is taxed at the 25 percent rate while the portion of income between $17,400 and $70,700 is taxed at 15 percent, and the first $17,400 is taxed at 10 percent. This is what is meant by a progressive tax system.
When one understands that taxes are paid at different tax rates progressively, it becomes less important for one's income to fall at the top of the lowest possible tax bracket when pursuing a tax minimization strategy. For instance, an uninformed married couple with an AGI of $120,000 per year might believe that all of their income will be taxed at the highest possible tax rate for that income (25 percent in this case) if they file as married filing jointly. Such a couple might believe their required tax payment is $30,000 per year when in fact it is only $22,060. This $7,940 difference ($30,000 - $22,060) will create a large error in their tax planning and can be thought of as the cost of not understanding the income tax system.
It is also a good idea to divide the amount paid in taxes for the year by the AGI to know what percentage of the AGI is paid in taxes. This percentage is a good number to know for developing a strategy to lower taxable income, and, in most cases, the percentage is not as high as one thinks. In our example, the percentage of AGI paid in taxes is 18.38 percent, as calculated by the formula {(10% x 17,400) + (15% x (70,700 - 17,400)) + (25% x (120,000 - 70,700))} ÷ 120,000. This percentage will always be less than the percentage associated with the highest tax bracket (25 percent in this case), except for cases where the AGI falls within the lowest income tax bracket.
Strategies of Lowering Taxable Income
What should be the target long-term income tax bracket for a taxpayer? It may not be the best decision to be in the 10 percent income tax bracket one year and the 25 percent tax bracket the next year. One way to determine this is to look at what the filer's AGI has been in the past and what the best estimate is for what it will be in the future. A second question is what will the tax brackets look like in the near future? That is, will tax rates be going up or down, and by how much? If one expects income tax rates to go up in the future or for the taxpayer's AGI to increase, it may not be the best strategy to delay recognition of this year's income. If a person expects tax rates to go down or for their AGI to fall, it may be in their best interest to delay income to future years.
There are two strategies that can be implemented to delay income. The first is to prepay for expenses that one expects to incur in the coming year. However, one should be careful that this is done correctly - the IRS frowns on this strategy if they deem it an attempt to distort taxable income. The second is to purchase necessary capital assets. It is important that a business purchase a capital asset that will create a future savings or a cash flow stream that pays for itself minus the income tax savings. This means that capital asset purchases should only be made if it makes good business sense, not simply to reduce a tax obligation in the short term. It is important to remember the salvage value of the asset and the income tax that will be paid on it.
Therefore, it is important to know your expected AGI prior to the end of the year. Once this is determined, it is important to deduce whether or not it falls within your targeted income tax bracket. If the AGI needs raised, then delay payment of bills until after the first of the year. If the AGI needs to be lowered, then first understand what expenses you will encounter in the coming year and pay for those in the current year. If the AGI still needs lowered, look for a capital asset that will truly be an asset and not a liability.
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