We had a reader ask the following question:

“I’m thinking about selling a tract of timber on land that was gifted to me 7 years ago. What can I expect the tax consequences to be? I’m a self-employed farmer.”

We have done a couple of posts lately on capital gains treatment of the sale of equipment and other farm business property.

We thought it would be good to review the rules of Section 1231 since they apply to most of these sales.  Section 1231 governs how the sale of business assets is reported and taxed.  It is actually a fairly nice feature in that any Section 1231 gains are usually treated as capital gains and any losses are treated as ordinary and immediately deductible losses.

For example, lets assume a farmer sells a tractor for $25,000.  They paid $20,000 for it ten years ago and have fully depreciated it.  The first $20,000 of cost basis is considered Section 1245 recapture and is always treated as ordinary income.  The excess $5,000 gain is considered Section 1231 and will enjoy capital gains treatment.

Now lets assume the farmer sold the tractor for $15,000 and they had just purchased it for $20,000 and had not taken any depreciation.  In this case, the $5,000 loss is considered a Section 1231 loss and will be ordinary and immediately deductible.  The reason for it being ordinary is that the law assumes the taxpayer had not yet been able to take the full depreciation allowed to get it down to its actual value at the time of sale.

There is one negative to Section 1231 gains and that is the five year look-back recapture.  If, during the last five years, the farmer had net Section 1231 losses reported on their return and they have a Section 1231 gain this year, part or all of this gain would be ordinary. 

For example, assume a farmer had reported a Section 1231 loss in 2008 of $5,000 and had a Section 1231 gain this year of $10,000, then $5,000 would be ordinary and $5,000 would be capital gains.

For our reader, since it appears this tract of timber was gifted as an investment, the gain on the sale should be treated as a capital gain and subject to a maximum federal tax of 15%.

Of the 2,401 Minnesota farms included in the “FINBIN” survey for 2009, the median farm saw a 63% decrease in net income from $91,242 to $33,417.  Each year, the Center for Farm Financial Management performs a survey of Minnesota farmers.  Their response for 2009 represented about 3% of overall farms and about 10% of the farms with total sales over $100,000.

A summary of the results for 2009 show the following:

• Median farm income peaked in 2007 at about $105 thousand and have declined in two years to about $33 thousand.   The 2009 numbers are also the worst net income for any year in this decade other than 2001 when the median net income was about $24 thousand.
• Incomes were down substantially for virtually every type and size of farm.
• Livestock farms of all types, on average, did not provide enough income to support family living expenses.
• While crop farms were more profitable than livestock farms, the median earnings of crop farms dropped 55% to about $60 thousand.
• Dairy farm profits were down substantially falling to an average of about $5 thousand per farm.  The average price for milk dropped from about $19 to $13 in one year.
• Hog farms eked out a small profit as their income dropped about 87%.
• The average return on assets dropped from 10.5% in 2008 to 3.1% in 2009
• The average farm’s net worth increased by about $60,000, however, almost all of this increase was due to increasing land prices and not earned net worth growth.
• The average farm spent $52,000 on living expenses and needed to generate $72,000 from farm and non-farm income to cover family living, income taxes and other ongoing non-farm expenses.

To maximize your profit for your farm, it is very important to determine what your annual fixed costs are and determine if you are maximizing your amortization of these costs on your farm.  Fixed costs are those costs that do not materially change with production increases and decreases. 

Some examples of fixed costs are:

• Depreciation on your equipment
• Insurance costs on equipment
• Your annual salary cost for providing services to the farm operation
• Office related costs
• Other annuals salaries for workers who are not at full capacity

These costs are mostly fixed and if you can increase your production to full capacity, these costs per unit of production will decrease substantially.  The goal is to maximize your production to equal the full amortization of these fixed costs.

Lets say you have a farm with 1,000 acres of production and your total annual fixed costs are $100,000.  This means your average fixed cost per acre is $100.  If you have enough equipment and capacity to farm 2,000 acres and all of your variable costs will remain the same, you will reduce your fixed cost amortization from $100 to $50.  This will result in additional profits to the farm operation of $50,000.

Try calculating these costs for your farm operation and see how it would effect your bottom line.

However, you also need to be careful that as you approach full capacity, you may have to make major investments to go slightly over full capacity.  This can then put your back with higher fixed cost amortization.

The Kansas State University Department of Agricultural Economics periodically produces a recap of the high 1/3, mid 1/3 and low 1/3 of various farms in their state.  They just released the latest analysis for corn, sorghum, wheat, soybeans and alfalfa for the three years 2006-2008.  The total number of crop farms reporting for all three years during this analysis was 629 farms.  There are several pages of producer returns, but I thought I would try to recap the major trends that I spotted.  These trends are based upon the differences between the top 1/3 and the bottom 1/3.

CORN

• The yield per acre difference was about 16 bushels for non-irrigated corn or about 18% while the price difference was only 13 cents or 3.6%.  The total average revenue difference was $61 per acre.
• Major costs variances were in fertilizer and machinery with these costs being about $49 lower for the top 1/3.
• The overall net return to management in the top third was $150 more than the bottom third.

SOYBEANS

• Yields for good producers was about 6 bushels higher or about 20%.  The net selling price was about 55 cents higher or about 7%.
• Total revenue was $72 higher or about 31%
• Again, machinery costs were materially lower for good producers at about $30 per acre lower.
• Good producers returned $130 more per acre than the low producers.

WHEAT

• Yield was about 6 bushels higher or about 19% better for the top 1/3.
• Prices were only about 4% higher than the bottom third or 23 cents overall.
• Again, machinery and fertilizer costs were about $46 lower for the better producers.
• Overall, the best producers gained $120 per acre over the bottom producers.

Other trends are:

• In all cases, the lower 1/3 of farms reporting had negative net income for this three year period, with wheat and corn growers being the worst off compared to the other crops.
• For non-irrigated crops, soybeans appeared to be the best return per acre compared to the other crops, however, the difference between returns for each 1/3 was only about $25 plus or minus per acre.
• As we have discussed in other posts, it appears that the best way to increase your return per acre is to minimize your equipment cost per acre.  This is by far the most consistent cost that is almost always higher for the lower third than the top third.

How does your operation stack up.

The Iowa Farm Business Association, comprised of various farm management companies, recently issued a nice 4 page newsletter that had a lot of good information on farm profit trends.  All of this information relates to farms in Iowa but the trends show hold true for most states that grow corn and s0ybeans.

The newsletter recapped the overall net income from 1998 to 2008.  The low net income was in 1998 at $4,547 per average farm.  The high net income year was 2007 at $176,401.  The interesting trend is that only three years was over $100,000 per year which is the last three years of 2006 – 2008 and the top five years are the last five years.

Another really interesting trend is the amount of gross farm income per full-time equivalent employee.  In 1998, this was about $143,000.    In both 2007 and 2008, this amount was greater than $400,000 per man.  This is a very important calculation that should perform on your farm each year.  I am assuming you have your history of total income and number of employees for the last five to ten years.  I would work up these numbers on a historical basis and compare it to these averages.  You should try to shoot for exceeding this average since this is probably one of the better indicators for farm profitability.

Machinery costs had held steady at about $60-65 per acre from 1998 to 2003.  Beginning in 2004, this number rapidly increase from $73 per acre to $106 per acre in 2008.  I think a lot of farmers bought new equipment in 2007 and 2008 so I think a lot of this increase is due to new iron purchases.

Another indicator of increase farm profitability is the ratio of gross farm profit to total cash expenses.  The greater this number is the higher your overall profit should be.  In 1998 this was at a low of 1.07 and averaged around 1.2 to 1.3 until 2006 and 2007 when it was over 1.5.  For 2008, the number dropped back to 1.5.  Any number over 1.4 would indicate good farm profitability. Do you know your number.

I think every good profitable farmer will know these numbers and try to exceed the averages each year.  Are you doing it?!!!!!!!!!!!!!!!!!

As a CPA, I get asked many times by small business owners what their business is worth.  As part of calculating that value we usually work up what the net bottom line earnings of the business is.  To detemine that, we take the profit and loss of the company and make certain adjustments.  Normally, we add back interest paid, depreciation and amortization and other one-time items.

From this number, we then make various deductions, of which, usually the major one is the deduction for compensating the owner for their time and effort in running the business.  In some cases, we actually need to add back an amount since the owner has taken out to much compensation, but in most cases, we need to deduct owner’s compensation.

In many cases, after deducting a fair amount for the value of the services provided by the owner to the business, we can end up with negative income.  When this happens, we usually tell the client that they do not have a valuable business, but rather a job.  It may be a well paying job, but for business valuation purposes, it is just a job.

For farmers, in arriving at the bottom line profit of the business, many do not deduct a fair value for their services provided to the farm.  You need to do this in order to detemine if the farm is profitable and by how much.  Many farm decisions are made based upon erroneous data and this mistake can be huge.

For example, the Center for Farm Financial Management provides an excellent database of what various farm operations are earning per year since 1993.  In all cases, these farm returns include an allocation for labor and management charge for the owners.  For corn production, this charge was in the $30 to $40 range per acre and for soybeans, it was about $10 per acre lower.  If you do not make this allocation, then you will think your farm was more profitable than it actually was.

For either very large or very small farms, this allocation could be distorted.  If the farm is very large, but managed very efficiently, then the charge per acre may be smaller.  If the farm is only 500 acres and the farmer is working it full time, then this charge could easily be $100 per acre or greater. 

You need to review this closely to see how profitable you really are.

Most farmers prepare a budget at the end of the year to present to their bankers and then promptly put it away and forget about it until the following fall.  I like to envision a budget is similar to a road map.  A map has many ways to get from point A to point B.  Sometimes, you may want to take the most direct and fastest route for your trip and other times, you may get lost because you did not refer to your map.

A budget gives you the fastest way to get from point A to point B, i.e. your bottom line profit.  At the start of your journey, you look at what is your projection for crop yields and pricing.  You then project your total costs including the value of your time and management costs.  The end result is your bottom line profit, or point B on the road map.

When you start on the trip, you must continue to look at the road map to see if you are still on the direct highway to point B.  If your costs start to get out of whack, what steps can you do to reduce or eliminate certain costs.  Have you hedged your fuel and fertilizer costs if pricing is at a optimum point. 

Also, right now is a seasonally good time to be locking in pricing for your current year crop.  Are you using a good marketing service to help you with this.  This is all part of the road map to get you to point B.

Just like a good traveler continues to review their road map when they are on their journey, as a good farmer, you should review your budget each month or even each week to see if you are still on the right road to your profit objective.  The sooner that you catch either larger costs or lower revenues, the easier it is to get back on track.  There is some point, where it becomes impossible to get back on track.  You do not want to reach that point.

Remember, use your map (BUDGET).

Uncle Sam offers a tax advantage to farmers and fishermen that no other taxpayers receive. When your income is very high compared to previous years, the tax laws allow you to assume that you were able to average all of your farm income over a four year period.

This can save you several thousand dollars of tax. For example, if you had zero income for 2005, 2006, 2007 and then had $300,000 of farm income in 2008, with out this income averaging, your tax bill for 2008 would be about $72,000. By income averaging, your tax bill for 2008 would fall to $42,000, or a savings of about $30,000.

You need to make sure that your tax preparer is aware of this in any year where your income is much higher than the last three years.