Debt obligations should be a priority before making a large purchase to “save” money
One of the most difficult issues we deal with as agricultural producers and bankers is determining proper tax management practices to maximize the profitability and viability of our farming operations. Changes in the tax code over the last several years have provided what appears to be enticing tools to avoid taxes, but they do not come without pitfalls that must be considered in making informed farm management decisions.
For example, beef prices were hitting record highs in 2014 and 2015. Farmers were presented with economic opportunities that many had not seen in their lifetimes. Many took this as an opportunity to reduce debt obligations and ease cash flow burdens. Others took the opportunity to make capital improvements to their farms. Many miles of needed fence repairs were done, water systems were installed, barns were built and repaired, and pastures and hayfields were brought up to test. Unfortunately, other producers made capital decisions to avoid tax liability, which is still having a negative impact on their cash flow and liquidity and will continue to have a negative impact into the future.
In an oversimplified nutshell, Section 179 of the IRS Tax Code allows farmers to generally deduct 100 percent of a qualifying purchase as an expense in the year it is incurred. This typically applies to farm machinery and equipment but through a bonus depreciation provision of the code, may also be applied to farm buildings. This is where things get interesting. As an ag lender, over and over, I have experienced farmers who feel they must purchase a new tractor, truck or make some other type of expenditure to avoid taxes in years where they have had stronger than normal income. Often, they say their tax preparer or CPA has coached them in this. Regrettably, the borrower is requesting a five- to seven- year loan to purchase this equipment. This year’s cash flow may be very strong, and they can easily support the debt service. However, as we all know, farm income fluctuates widely, and most likely, there will be more challenging years ahead before the note is paid off. This same scenario applies to small business owners as they seek to minimize their tax burden. In some cases, it may make more economic sense for the producer to pay the taxes due for profitable years and not risk their cash flow or deplete their working capital to save on their tax obligation.
I truly believe most tax preparers and CPAs have their client’s best interests at heart. They may very well make suggestions on ways to minimize tax obligations, but they often do not have access to the whole financial picture of their client. They often do not know what debt obligations their client may have and what the repayment terms are on that debt. They also aren’t aware of what deposits or investments their client has should their cash flow be squeezed. I believe if they had the full financial picture of many of their clients, they would not encourage taking on more debt on a long-term basis to reduce short-term tax liability. It often makes sense to build equity and working capital reserves in the good years rather than making unnecessary capital investments simply to reduce tax burdens.
In conclusion, tax planning should be a team approach. Before decisions are made that could have a negative impact for several years, consult with your tax professional and your banker. The best recommendations you get will come as a result of your financial professionals having access to your complete financial picture.
Kim Light is the president and senior credit officer at Heritage Bank of the Ozarks. He may be reached at (417) 532-BANK