2009 Income Tax Planning
If your tax goal is to owe zero income and payroll taxes, then this year’s low milk prices make it easy. But if your objective is to get income through the tax system with paying the lowest taxes, then planning may be more challenging. First are some facts about this year’s taxes.
• Tax rates are lower this year and next year and scheduled to increase in 2011. The 10% tax bracket will disappear after 2010 so the lowest bracket will be 15%. The highest bracket will increase from 35% to 39.6% for ordinary income. The long term capital gains rate (used for raised, cull cows that are sold) increases from 0% or 15% to 10% or 20%. These will happen without Congress changing any laws.
Dairy farmers may want to minimize deductions and increase income for this year if their taxable income is low or negative. Depreciation can be reduced but only for items placed into service in 2009. This would include electing out of 50% bonus depreciation. Items previously placed into service already have a method that cannot be changed now. Prepaid expenses may still be used but fewer farmers will use them this year. If a taxpayer has the 0% long term capital gains bracket available (for taxable income below the 25% ordinary income tax bracket), it makes sense to use this bracket. If profits are made in the next 3 years, then income averaging still might use these brackets if unable to use them this year.
Another way to increase income is to convert a traditional IRA, SEP-IRA or a SIMPLE IRA to a Roth IRA. As of 2008 an employer-sponsored retirement plan like a 401(k) or 403(b) also may be directly converted to a Roth IRA. These were usually not taxed when contributions were made and will be taxed when distributions are made.
The amounts converted count as taxable income in the conversion year but if the tax rate is zero, then there will be no tax. Future qualified distributions from a Roth IRA will not be taxable income. Converting may be done by a farmer or even a spouse if married, filing jointly.
A further complication may arise if milk income was deferred from the end of 2008 to the beginning of 2009. The IRS has a program to audit dairy farmers to check for this. Any deferral of income from milk sales is being disallowed based on a Minnesota court case where grain delivered to a cooperative was not considered a sale until it was later sold by the cooperative.
Because the farmer did not “sell” the grain to the cooperative, no installment sale (or deferral of income) was possible in spite of having a contract in place before delivery of the commodity. Although our goal is to use up our lower brackets, there may not be enough income to use them and there may be a loss from the farm operation.
A NOL can be claimed by an individual, C Corporation, partner, LLC member or S Corporation shareholder. A taxpayer must have negative taxable income but only business losses can be carried back or forward. So if a spouse’s wage income, for example, makes taxable income positive, then the taxpayer does not have a NOL even though the farm or business had a loss.
Some items are not part of a NOL and will reduce or eliminate it. These include dependent and personal exemptions ($3,650 per person in 2009), some non-business deductions, and excess capital losses (like investments). Another item that reduces the NOL is the Domestic Production Activities Deduction (DPAD) which many farmers have used and can be quite large for members of cooperatives.
When income is carried back to earlier years, the loss is absorbed by the Modified Adjusted Gross Income (MAGI) from that year. The MAGI is the taxpayer’s adjusted gross income plus personal and dependent exemptions plus the DPAD and some other items. Any loss greater than the amount absorbed is carried over to the succeeding year (or years) until the loss is used up. A NOL can be carried forward up to 20 years.
For example, a sole proprietorship has a NOL. The taxpayer is married, filing jointly with no children. Because of low milk prices and high input costs, their taxable income for 2009 is negative $60,000. When personal exemptions (2 times $3,650 = $7,300) and the standard deduction ($11,400) are added back, then the NOL is -$41,300 (-60,000 + 7,300 + 11,400). To illustrate how the carry back works, the table below shows an adjusted gross income and taxable income for 2007 and 2008. Using these to calculate the taxes refunded:
Thus, the total federal taxes saved were $2,653 (1,250 + 1,403). In 2007 the $41,000 NOL carried back from 2009 absorbed all $20,300 of MAGI and reduced taxes by $1,250. In 2008 the remaining $21,000 NOL carried over from 2007 was completely absorbed and left $11,100 of taxable income which reduced income taxes to $1,110 (using the 10% tax bracket). This resulted in $1,403 taxes saved for year 2008. All of the NOL was absorbed and $2,653 federal taxes can be refunded.
Carrying back NOLs will not reduce self-employment taxes. Your social security and Medicare payments do not change from the amounts paid or due.
A NOL cannot be made larger by using section 179 direct expensing on depreciable items placed into service. One of the limits on direct expensing is that business income must be positive and if it was positive, there probably would not be a NOL. However, if eligible for using 50% bonus depreciation, it doesn’t have the business income limit so that can make a NOL larger.
Some tax brackets in the past have been quite low. The federal long term capital gain rates have been 0%, 5% and 15% while the ordinary rates have been 10%, 15%, 25% and higher. If you absorb taxable income from last year at 0%, that doesn’t put any cash in your refund although it may be necessary in order to use tax brackets that will increase your refund.
If more than one business has a NOL, then calculations become more complex. If one business is a farm and the other business is not, they both can be carried back under slightly different rules. Also, prior income averaging or the Alternative Minimum Tax may complicate the calculations for some.
A NOL may also be carried back to past years or forward to future years for Michigan income taxes. An allowed NOL is also a deduction from household income in those years and may be used to increase the amount of homestead property tax credit and farmland preservation tax credit.
Generally, income and self-employment taxes are less when income is stable over time and the lower tax brackets are used up every year (10% and 15%). Carrying back NOLs is one way to get some cash if income taxes were paid in previous years. Given up in this process is that the NOL gets absorbed faster than the benefit from it. Your tax practitioner’s computer software should help with the complex calculations to see if there is a benefit. If a taxpayer expects a NOL, tax planning and action before January may increase the amount of refund.
Contact for questions: Larry Borton, Michigan State University Telfarm, 517-355-4700, bortonL@msu.edu.
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