My post from yesterday resulted in several comments and questions that I would like to respond to.

One comment is that code section 4975 deals with prohibited transactions regarding you and your pension plan or IRA.  There are severe penalties for not obeying the rules regarding these transactions.  However, if you obey the rules, the penalties do not apply to you.  I sometimes find that other tax advisers are not comfortable with these rules and would rather not have to deal with these types of transactions, however, if you follow the rules and use a company that is extremely familiar with the rules, you should be in compliance.

The majority of these rules do not allow you to sell or rent land, equipment, etc. between your pension plan or IRA and yourself.  However, in my post yesterday, the transaction described involved the purchase of the employer’s stock directly from the employer to the pension plan.  This is one of the transactions allowed by the code as long as you follow the rules.

Another question was whether you can use an IRA to do this.  The general answer is no, however, in most cases, once you set up your 401(k) or other pension plan with your new corporation, you can roll over your IRA to the pension plan and then have it purchase the stock.  This will allow you to use the IRA in an indirect way.  Certain types of IRA rollovers may not work, so like in call cases with my posts regarding tax laws, talk this over with your qualified tax advisor. 

Another question asked if you could purchase farm land using this method.  The answer is yes, no and maybe.  For it to be yes, the corporation would need to purchase the land if you are going to farm it.  If you are simply purchasing the farmland to rent out to a non-related third party, you can use the IRA or pension plan to purchase the land directly.  However, if you fund any of the purchase with debt, there are several rules that come into play.  You can not personally guarantee the debt.  In most cases, it would need to be seller financing for the deal to work.  If you personally are going to farm the land, then you can not have the IRA or pension plan own the land and rent it to you.

I know that many of our readers currently have jobs not related to farming, however, you would like to leave that job and start farming on a full-time basis.   One of the major drawbacks to doing this is the lack of capital.  However, many of you could have a substantial asset that you could tap to create the working capital needed to get started in farming.  This asset is your 401(k) plan.

Here is how it works:

• You will need to create a corporation (generally taxed as a C corporation).
• This corporation will establish a 401(k) plan.
• You will roll over your current 401(k) at the old employer into this new 401(k) plan.
• The new 401(k) plan will then purchase shares in the new corporation and will become an owner of the corporation (this is very similar to an ESOP).
• The money put into the corporation becomes the working capital that the corporation can use to purchase equipment, plant crops, etc.

There is no limit on how much stock the 401(k) can purchase.  This means, that unlike borrowing money from a 401(k) plan which is limited to $50,000 or cashing in the plan and paying taxes and a 10% penalty on the funds received, you are able to maximize the amount of capital you can put into the farm business.

There is a recent article in Bloomberg Businessweek concerning this type of transaction.  The primary topic of the article is that the IRS has noted some abuses in this type of transaction.  Some taxpayers have set up a corporation simply to purchase a motor home, etc.  This will most likely get disallowed on an audit.  However, if you are using the cash to create a farming entity and will be actively farming, there should be no issue with using your 401(k) to fund it.

As in all cases, you need to discuss this with your tax advisor.  Also, the article does refer to a company that has helped do several hundreds of these transactions.

In my post yesterday, I indicated that maximizing your net return per acre was more important than the most yield per acre.  One of our readers wrote a great comment regarding how their operation tries to maximize their yield to achieve the most net revenue per acre.

My post should have stressed that your farm operation should try to maximize your yield up to what I call the point of diminishing returns.  For example, if you can increase your yield by an extra 10 bushels (for corn) by spending $15 on good seed or fertilizer, then your return at $4 corn is $40/$15 or 2.67 to one.  As you do your analysis for your farm, anytime this number is greater than 2, it makes sense to spend the extra money.

If the number is between 1 and 2, then you need to crunch your numbers and get comfortable with your probability of the extra yield happening.  For example, if you think you can make an extra $20 per acre by spending $10, your ratio is 2 to 1, however, if the chance of this happening is 50%, your expected ratio becomes 1 to 1.  At this point, you are simply at the break even point and you are not receiving any extra to cover your overhead related to this extra cost.

If you were to chart your options related to maximizing your yield compared to your input costs, the return yield to cost would look very similar to the horsepower chart on my BMW motorcycle.  As I add RPM, the horsepower output increases at about a 45 degree angle up to about 8,000 RPM.  At this point, as I add more RPM, the horsepower output slightly increases and then as I get near the redline, the horsepower starts to drop off dramatically.

In your farm operation, try to determine where the extra yield maximizes the return to the bottom line.

I was watching Agday yesterday and noted in the business section that Mark Gold of Top-Third Marketing was the guest and had a discussion on how gross revenue per acre was more important than yield per acre.  His insight is that it can be more important to budget for getting top marketing dollars for your crop than to worry about the greatest yield per acre.  With the improvements in technology, a farmer can get great yields on their crops, however, if they end up with the bottom third for their price, they will end up net losers for the crop year.

I believe that you need to take this concept one step further and key in on net revenue per acre, not gross revenue.  My definition of net revenue per acre is to take your gross revenues from crop sales and government payments and then subtract all direct input costs related to this crop.  For example, lets take two farms.  One farmer is able to achieve 175 bushels of corn per acre and sells it for $3.75.  The farmer spends $300 per acre on direct inputs (fertilizer, oil and gas, labor, etc.).  The other farmer only gets 160 bushels per acre, however, they sell it for $4.00 per bushel and only spends $250 per acre on direct input costs.  Which farmer makes the most money?

The answer is the second farmer.  Farmer number 1 has gross revenue of $656.25 per acre and net revenue per acre of $356.25.  Farmer # 2 only has gross revenue per acre of $640.00 per acre, however their net revenue is $390.00 per acre which is about $34 higher than farmer number 1.

As you can see, a farmer needs to key in on maximizing their net revenue per acre, not just the yield per acre.

It is projected by 2019 that Russia may become the world’s largest wheat exporter and Russian, Ukranian and Kazakhstan (RUK) wheat exports collectively may double the United States wheat exports according to the June 2010 issue of Amber Waves.  This growth in wheat exports may help mitigate global food security concerns and help offset the the shift in US acreage to corn, soybeans and other more profitable crops.

USDA is projecting that wheat exports by there three counties could increase by about 50 percent to over 50 million metric tons by 2019 or about 1.9 billion bushels.  The region may account for over half of the increase in wheat exports and could supplant the US as the “wheat breadbasket of the world”.

The US has been in second place since World War II but could easily slip to second place especially if the trend to more corn and bean acres at the expense of wheat production continues.

The US share of wheat exports may drop from the current 24 percent range for 2001-09 to an estimated 16 percent by 2019.  The European Union, Canada and Argentina will also lose market share while Australia is expected to remain flat.  The three former Soviet Union counties should see their market share go less than 20 percent to over 33 percent by 2019.

There are two main reasons why RUK have become larger wheat exporters.

1. The region’s transition from planned to market-orientated economies that began with collapse of the former USSR in the early 1990s.  During the late Soviet period of 1987-91, the USSR imported 35 mmt of grain, while in 2009, the former USSR nations exported nearly 55 mmt.  This is a turnaround of over 90 mmt or about 3 billion bushels of grain.  Also, the large contraction in the livestock sectors led to market driven importation of meat and exports of grain.
2. The region’s yield has risen steadily during the 2000s.  During the 1990s, wheat yields actually decreased primarily due to bad weather and a lack of inputs, especially fertilizer.  However, during the 2000s, wheat yields have risen about 32 percent in Russia and about 25 percent in Kazakhstan.  A lot of this increase is due to the large vertically integrated enterprises that are in charge of the crop from the very beginning to the final wheat sale.

If the world market for grain was expected to remain steady, this increase in Soviet production could lead to much lower prices, however, the world will add another 750,000 or so people over the next 10 years and they will eat a lot of wheat so wheat prices may actually rise over this period.

The April 29, 2010 issue of Bloomberg Businessweek had a good article on how the seed companies are developing drought resistant corn seed that may expand the corn belt farther into Kansas, Nebraska, and Oklahoma.

Another benefit of the seed is a reduction in the amount of irrigation that is needed.  This can lead to reduced crop insurance premiums and can boost the value of this crop land.  Also, the article states that agriculture accounts for 70% of global freshwater use and the single biggest issue facing agriculture is the availability of water.  By creating seed that uses less irrigation water or requires less natural water, a farmer can increase their net income, and in some cases, substantially.

Dupont indicates that in their test trials, the new seeds are creating yields that about 6% better than the old seeds.  Syngenta is aiming for a 10% increase in yields.  The seed companies believe that by 2020, over 55 million acres of corn will be planted with the new drought resistant seed. 

If a farmer’s old corn yield was 120 bushels per acre and they can create a 10% yield increase at $3.50 bushel price, this would increase the net bottom line by about $42 per acre less any increase in seed cost plus any reduction in irrigation costs.  This can be a substantial increase to the bottom line.

Congress recently passed the Hiring Incentives to Restore Employment (HIRE) Act.  This act provided a couple of new credits that in a lot of cases will help our farmers.

The first credit is basically a direct reduction in the 6.2% employer FICA cost for new employees hired who have been un-employed after March 18, 2010 and before the end of the year.  This credit will be claimed on your form 941 (or in most cases, the form 943 filed by farmers at the end of the year).  In order to claim the credit, you must get a Form W-11  from the employee that states they have not been employed for the previous 60 days.  This credit can add up fairly fast.

For example, assume a dairy farmer hires three new employees making $3,000 per month who were un-employed.  For the nine months ended December 31, 2010, they would have been paid $81,000 in wages and the employer’s FICA portion would have been $5,022.  This cost is completely eliminated by the Act.  This also allows you not to have to make this deposit during the year.

The IRS has a nice question and answer page regarding this new credit.

The other credit is a general business credit of up to $1,000 per employee hired that you can claim on your 2011 tax return.  To claim this credit, you must have retained the employee for 52 consecutive weeks and the credit is equal to the lessor of $1,000 or the 6.2% of wages paid.  If you pay wages of at least $16,129, then you will qualify for the maximum credit.  Again, this is a business credit, so you are not guaranteed an immediate benefit and you will need to reduce your wage deduction by the amount of the credit.

Again, the IRS has a question and answer page on this particular credit.

Although I am usually on the other side from the IRS, I will admit that their web-site is one of the best sites I have used for accessing tax information.  The recent Health Care Reform law enacted a new employer credit for certain employers who pay for their employee’s health care premiums.  I would estimate that 90% or more of the farmers will qualify for this credit if they pay their employees premiums.

To be eligible, you must be a small employer as follows:

• You employ on average less than 25 full-time equivalent employees during the year.   The way to calculate this is to take your total paid employee hours (but subtract any hours for employees that work more than 2,080 hours in the year) and then divide by 2,080 (number of hours in a 52 week / 40 hour per week).  If the number is less than 25, you qualify, if more than 25, you do not qualify.
• The average wage paid to your employees is less than $50,000 per year.  Again, you will most likely have to do this calculations using the FTE examples.
• The employer must pay the health insurance premiums under a “qualifying arrangement”.

A qualifying arrangement” is where the employer pays at least 50% of the employees health insurance (assuming a single employee).  The amount of the premium that is eligible for the credit is based upon the actual premium paid by the employer.  This amount is also subject to a cap based upon what the employer’s premiums would have been for the small group market for their state (or states).  Also, if the employer pays 80% of the premium, then this cap is based upon 80% also.

The maximum credit for years 2010 to 2013 is 35%.

Let’s take an example for 2010.  If the farmer employs 10 employees and pays and average wage of $24,000 and pays $45,000 in health insurance premiums for the year and this amount is more than 50% of the total health insurance premiums, the credit would be 35% of $45,000 or $15,750.

This credit is reduced if you employ more than 10 FTE or your average annual wage is more than $25,000.

In determining your FTE for the year, you do not include any seasonal employees which is based upon working less than 120 days during the year.

You do not include yourself or any of your family in arriving at determining FTE, however, you also do not get the credit for any of these premiums paid.

This credit is treated as a general business credit which means you have to have income tax to offset the credit.  If the credit is not used completely, the amount not used can be carried back one year and forward 20 years.

Another negative to the credit is that you must reduce your health insurance deduction by the amount of the credit.

For 2010, all employee health insurance premiums paid qualify for the credit (even though paid before the law was enacted).

In my opinion, a farmer who has more than $200,000 in taxable income will generally take advantage of the credit since they will normally be able to offset the credit against their income tax.  For those farmers with taxable income between $100,000 and $200,000, the credit will probably be better than the deduction, but certainly not in all cases.  For farmers under $100,000 of taxable income, in many cases taking a full deduction will be better than the credit since it will reduce self-employment income and in most cases, the farmer will not have enough regular income tax to offset the credit.

You will need to review this each year to determine which method works best for you.

The IRS has a more detailed question and answer memo on the credit.

For the last couple of years, farmers and other taxpayers have enjoyed a very low tax rate on dividend income.  This income used to be taxed at regular income tax rates (as high as 50% when combined with some state and city taxes).  However, starting a couple of years ago, the top rate on dividend income was 15% for federal and if you were in the 15% tax bracket, this rate was zero.

Beginning January 1, 2011, this special rate is scheduled to disappear.  The problem is that we are not sure what the new rate will be.  There is a chance that dividend tax rates will continue to be taxed the same as capital gains.  These rates are currently scheduled to go from 15% to 20%.  There is also a good chance that dividend tax rates will go back to the regular tax rates.

Under this scenario, the top tax rate on dividends would probably by 39.6% in 2011 and beginning in 2013, this top rate would go up another 3.8% if your income exceeds $200k or $250 for married couples.  This extra rate is due to the new Health Care Reform Law that was recently enacted.

In that law, the current Medicare tax of 2.9% on wages and self-employment income is scheduled to increase by .9% for people earning more than $200k or $250k for married couples.  In addition, Congress decided to make the Medicare tax due on almost all unearned income for those taxpayers making the same amount of money.

Therefore, there is potential for the top tax rate on dividends to go from 15% federal to a minimum of 43.5% (plus there are some other phase-outs that might get the top rate over 45%).

What does this mean for you for 2010.  The key thing is to review your income tax situation and if you have a C corporation, determine whether you need to distribute retained earnings a s a dividend to take advantage of the current low rates.  If you are in the 15% tax bracket, make sure to distribute enough dividends to soak up this tax bracket since they would be tax free.

Let’s take an example of a farmer with a C corporation who is nearing retirement and wants to liquidate his corporation.  Lets assume there is $400,000 of retained earnings.  If they distribute the income in 2010, there total tax bill would be $60,000 (assuming no state income taxes).  If they wait until 2011, and pay the maximum rate, then the tax bill might be about $158,000 and if they wait until 2013, then the tax bill might be as high as $174,000.  As you can see, it makes sense to consider distributing the income this year.

We should know in the next few months what Congress plans to do, however, the surest thing I know now is that the dividend tax rate will most likely be higher in 2011.

I have taken a couple of days off from writing a post due to tax season ending on April 15.  As a CPA, you tend to build up a large adrenalin rush until April 15 and then it takes a big dump and all you want to do is nothing and get a lot of sleep.  I now seem to be recovered and should get back to my normal posting schedule.

I also want to let my readers know that I will be taking my BMW motorcycle on a cross country trip beginning on or around May 10 and returning on or around May 23.  I will be traveling from Washington state to a wedding in Kansas.  From Kansas I am going to Los Angeles and then heading north back to Yakima.  I will try to write a few posts about the trip while I am gone assuming I get good access to a computer.  These posts will probably be more of a personal nature, but I will try to incorporate some tax or farming issues if they are pertinent.

Now for the blog post.

About a year ago, I had a client that was involved in a small sub-division in the local area.  He was a 50/50 partner with another person.  The lots were listed for sale for about $45,000, however, the project was not quite complete.  With the downturn in the economy, the client decided to sell his 50% interest in the LLC back to his partner.  The consideration was no cash and the other partner would take over the debt.

The client went on his merry way until he got a call from the State of Washington wanting the excise taxes that he owed on the transfer.  In our state (and there are many others just like it), if you sell a 50% or more interest in an LLC during a 12 month period, then you owe the real estate excise tax on the full fair market value of the property excluding any debt.  Even though you only sold 50%, you owe the excise tax on the full 100% of value.

In this case, there were let’s say about 50 lots advertised at $45,000, so the state assessed the excise tax of about 1.9% on $2,250,000 or about $42,750.  He had to pay  the whole excise tax even though not one of the lots had ever sold and the actual value of each lot was probably closer to $25,000 at that time.

Now, what I think is even more of money grab by the state is when the lots are actually sold, then the excise tax of 1.9% is, you guessed it, owed again.  There is no credit to offset any of the tax previously paid.

I now recommend that any of my clients that are involved in a 50/50 LLC and want to get out of the LLC, to only sell 49.5% of the LLC and wait over a year to sell the remaining .5% interest.

For many of our farmers who are doing succession planning to their children, they need to make sure to watch out for these excise taxes.