Business help - depreciation & income

[LisaW]

I just talked to my accountant. Either he doesn't know his ear from a hole in the ground, or I'm the one totally confused. I thought I'd see what y'all think.

Our trouble is two-fold. I agreed to let him re-file our taxes for the two years previous to last year as well as last year including the farm for the first time. I had a sneaking suspicion at the time that I shouldn't have amended the two prior years but he talked me into it. See, we're just coming out of the 'start up' phase so our expenses were higher than our income for quite a while. (aside from the fact that the place we got was trashed for about 20 years so there was a lot of pasture management issues and fencing issues to take care of) Anyway, the three years we filed were losses, though each year the loss was less. Now we've maxed our 3/7 year loss ability and need to operate with a profit this year and the following 3 years. I knew that we would be able to have an income this year, like we did last year, but not as much as last year. We also won't have expenses anymore like we did in the past. Still, I figured our income wouldn't be like it was last year - it'd be a bit less. One issue this year is with the depreciation issue.

There is no way we could sell enough animals to cover the depreciation value without getting ourselves stuck in a bind for next year. We're running a cow-calf operation and want to grow our herd every year if possible till we max out our grass (still have 15 acres we haven't been able to fence, so we've got time before we max out). We are operating with intent to generate income, we are keeping diligent records, and doing all we can to run it like a business. But facts are that the depreciation values for 2005 will be higher than our income for the year. If we don't take the full depreciation or any of it, we'll be in the black this year and we'll meet the 4/7 year requirement. So my question is this: If you take schedule F depreciations in previous years, are you required to take them in following years? I'm okay with not taking the full depreciations, or any of it if necessary, because I think that we could make it work. This year all our expenses have been is feed for this coming winter. My accountant tells me that because we took them in the past 3 years that we are required to take them this year until the depreciations run out. If it weren't for a $2,000 difference in the depreciation and income/expense values then it'd be different. That $2,000 is going to sink me, according to my accountant. I only need a $1 profit at the end of the year to have a profit. I can't take a $2,000 loss again without causing trouble for myself - and I want to avoid trouble.

My next scenario is this: Cows calve and your herd increases in size. You breed the heiffers and now have have breeding stock/cows. This happens every year. We started out with a handful of bred cows/hieffers and now have multiplied our herd 3 times (we sell the steers when they're ready for slaughter). How does that work for taxes? Our accountant has us depreciating the original purchased animals every year but nowhere does our herd increase show up. To me, that'd be like buying a $600 animal for $0 so my inventory increases without any expenses. A neighbor tells me that the value of calves every year counts as income. Is this true?

If I scramble to meet the $2,000 difference then I sell animals I have reserved for sale next year and screw myself for next year as well.

Any of your suggestions would be great.

The accountant tells me today to do this: Buy some bred cows today and sell the calves. He'll depreciate each cow a certain amount and I should have income from the calves. Well, that doesn't solve my problem - besides, who is going to buy calves going into winter anyway? If anything I could buy animals to slaughter at the end of the season - provided we have buyers.

My 12 yo daughter has a good little 4H lamb business that turns her a profit every year. Should we consider rolling her lambs into our beef business? Part of her income, though, is through the Jr. Livestock Sale here so we couldn't use her income there, only the private sale lambs.

Thanks.

Lisa

 

[Bez]

Well, I am from out of country so cannot answer your questions - but - you need to get a different accountant - or one with an ability to create a relationship with you and yours.

You also need to learn one thing - it is important:

Accountants are people and they screw up - they are members of a professional organization and as such we tend to put them a little higher on the pedestal than regular folks. Boy is that WRONG!!

He caused this screw up - time for HIM to solve it.

Final note - do not ever accept a professional opinion as cast in stone. Doctors do medicine and kill people / lawyers do law and get the wrong person off or convicted once in a while / accountants do TAXES not financial strategy and they have cause more than just a few folks to go down. When an accountant starts talking financial strategy time to run - right to your nearest agricultural financial strategist - they MUST work as a team for ANY strategy to work.

Ask those stupid questions and demand plain talk answers. If you do not get them - do not pay him.

Remember - he is your employee.

Try to keep out of the kid's piggy bank.

You might PM madbeancounter and chat with him.

Best of luck Lisa,

Bez

 

[LisaW]

I'm looking for a new accountant on Monday first thing. I'm also contacting the IRS to get an answer to the depreciation question, but I almost expect some financial lingo that doesn't make sense to me. :lol: Honestly, I trust people here more at the moment.

No, I don't intend to take any of his advice as of now. What he advised today was nonsense. It took about 30 minutes to get a yes or no answer, that drove me round the twist.

I don't honestly trust him to fix any trouble that may have been created. He came as a recommendation by a few friends who are also self employed carpenters, like my husband. He's also a 'distant personal friend' from years back when we served on the board of a youth ministry together. I think that based on our friends recommendations and my personal experiences with him is why I ignored my gut feelings. (mental note to never do that again!)

I guess what I need, that I can't seem to find, is what you mentioned - a financial strategist. So far I'm doing it all on my own (as DH doesn't have much concern or interest in doing it, other than to help me by saying "sounds good to me". his parents live with us because they never planned a day in their lives). Any suggestions how to find one? LOL I'm sure I could ask our accountant for suggestions. :lol:

 

[Bez]

Lisa

Check your PM please.

Bez

 

[Arnold Ziffle]

Lisa:

First of all you need to keep in mind that the 4/7 or 3/5 "presumption" rules of Internal Revenue Code Section 183 (the section that deals with hobby losses – activities not engaged in for profit) are refutable presumptions and safe harbor rules. There are literally thousands of examples of taxpayers running losses for numerous years, not coming even close to meeting those presumption rules, and successfully rebutting any IRS contention that the hobby loss rules should be enforced to limit their losses. It's all about keeping good business records, really treating it as a business, consulting "experts" in the ag business and establishing a plan that is followed, making meaningful changes to the plan and the way the business is conducted if losses persist, keeping a darn good paper trail documenting things you did and time spent, level financial commitment made to the business as compared to the overall financial status of the taxpayer, lack of spending on frivolous or personal items, etc., etc. Really treat it as a business and not something that is a more akin to a mere personal indulgence. All the items I just listed are based on factors that have been considered to be important by judges, juries, IRS appeals agents, etc. in hundreds, perhaps thousands, of court cases and administrative rulings over the years. Also, if I were you I wouldn't take much comfort in showing a mere $1.00 "profit" or some other really small amount or a profit that was merely a contrived, accounting aberration.

It sounds like your new accountant was of the opinion that your tax losses were "legitimate" and so he wanted to help you get a refund by filing amended returns to claim the losses. The initial preparer of those returns is probably the one that screwed up by not claiming the losses in the first place, because it is certainly preferable to claim farm & ranch losses on the originally filed return as opposed to an amended return.

Most relatively new or start up businesses that have heavy depreciation deductions are going to have an awfully hard time showing the requisite profit as per the presumption rules. And your accountant is right --- in a manner of speaking once you start depreciating an asset you are "locked in" to depreciating it. This is called the "allowed or allowable" rule, best illustrated by the following example. Say you buy an asset for $1,000 and elect to depreciate it straight line over 5 years. Generally speaking, you take $200 depreciation per year. If you forget to claim depreciation in say year 3 and 4, or make a conscious decision not to claim it, the depreciation for those two years is "eaten up" and you can't then claim those two years worth of deductions, say in year 6 and 7. But there's no law that forces you to actually claim the deduction on your Schedule F.

If you are hell-bent to show a "profit" in 2005 I suppose you can simply choose to forgo claiming some deductions for depreciation, feed, supplies, etc. in order to force the numbers to be a profit. I'd very rarely advise a client to do that and most of my clients would look at me like I'd gone crazy if I suggested it. If a taxpayer has a legitimate ag business going and is confident of his records and manner in which the business is conducted I'd not be afraid to continue to file with the losses. But my clients have to be big boys & girls and acknowledge that there are of course tax risks and if they are ultimately challenged by the IRS and lose on the issues, or prudently choose to throw in the towel, it is they that have to pay the back taxes, interest and possible penalties, not me! But nothing ventured, nothing gained. Different people/clients have different risk tolerance levels regarding the IRS, just like risk tolerance levels vary among people regarding stock investing, etc.

Your accountant's idea about selling calves now and buying cows might in fact make good sense. He's probably hearing you being very insistent about showing a profit this year, so he's suggested that if you're fairly close to a profit already you sell your "replacement calves" now so that the income is reportable in 2005. Then buy bred cows in the last 3 months of the year and, because of the great flexibility in the tax law regarding the computation of depreciation, he can elect to claim very little depreciation on those cows in 2005. Maybe that would guarantee you a "profit" to report for 2005. Then you're "worries" start over with 2006. You could also consider deferring property tax bill payments until January, 2006, delaying payment for some of your hay & supplies, etc.

As a non-tax note, I would add that there may be some additional benefits to selling calves now and buying cows a little later. You might get lucky and sell calves for our still relatively high prices and wait a while for possibly lower cow prices, meanwhile stockpiling grass that could reduce your winter feeding costs. And many experienced cattlemen and women are of the well founded belief (for reasons I won't go into here) that for a small operation it is better and more efficient to buy replacement cattle rather than raise your own.

You asked "who is going to buy calves going into winter anyway" --- surely you can't be serious about that question ??? Regarding your other questions, income from calf sales is reportable in the year you get the cash from sale. You don't report anything merely for the incremental value of the growing calf each year. And of course you claim depreciation deductions only with respect to purchased animals. There is no depreciation to be claimed with respect to animals that you raise and keep as breeding herd , since you have no tax cost basis in such animals --- you've already written off every dollar you spent raising them (feed, vets, meds, AI fees, etc. ).

There's a lot more I could say to you, but I came to the office today to work on my client's matters and this is long winded enough already. Good luck to you.

 

[madbeancounter1]

Lisa,

I am an accountant. My employer is also a cattleman and we do taxes for many ranchers in our area including some from out of state.

I read briefly your dilemma and will address a couple of your issues others will take more time to explain. If after reading my response you want more info... pm me and I arrange a free consultation by phone for you with my employer.

The easiest one to answer is your question about depreciating calves that you have raised. The answer to that is that calves that you have raised you have no purchase equity (basis) in it therefore nothing to capitalize and depreciate. When you go out a purchase breeding stock or equipment you have financial outlay and therefore a basis to depreciate.

Look at this way: you have spent $100 on a heifer - that's your basis. Instead of counting the cost as an expense you capitalize and depreciate the $100 over 5 years using the MACRES tables. This means that in the first year you will get to take roughly $11.65 of the $100 as depreciation expense.

Now let's say that you bred that heifer and she had a heifer calf that you decided to keep. You paid nothing for the heifer calf to bring her into your herd. So you have nothing to depreciate. - sorry but the accountant's correct on that one.

As for the value of the calves being income... it's only income if you sell them but then you have to figure any farm expenses against that income.

As for the depreciation issue. Once you start depreciating nothing says that you have to take the depreciation as expense. However, if the animal or equipment is sold later on this can work against you in figuring gain or loss because the rule is that you use the depreciation allowable not the depreciation taken unless the two are the same under the depreciation method that you used.

Something to consider is this: change the life of the assets that you are depreciating if possible so that you depreciate over a longer period.

I know that you have already amended your returns as stated but do you know if your accountant took the 30 or 50% bonus depreciation? If so, this is what happened, let's assume 50% bonus. You spent $100 on an asset of that you got to take 50% bonus depreciation right off the top. Then you got 11.65% (assuming a 5-yr life) of the remaining 50%. This means that you got a depreciation deduction in year one of ownership of that asset of $55.83. When normally you would have only taken a deduction of $11.65.

As for personal experience. I can tell you that we have ranchers that haven't shown a profit in years and we don't treat them as hobbiests.

One question I would have is that you mentioned a startup phase. Were all those expenses that you deemed as startup costs expensed or capitalized?

I would say that your accountant had an ulterior motive in mind when he talked you into amending those past returns...$$$ in the offseason.

In our practice our offseason money comes from our bookkeeping accounts and our payroll service but we have some really large tax clients that expect us to file extensions and do their work in the offseason. ;-)

 

[Susie David]

Madbeancounter...Our tax guy...an former IRS man and rancher who runs cattle and a hay operation...says that we can't depreciate cows until they have calved....what's the skinny on this. Our taxes are on extension also...Dave Mc

 

[madbeancounter1]

Dave,

Seems silly (and shhh... we rarely observe the rule ;-) ) but according to the regs if the replacement breeding stock has not reached sexual maturity you cannot depreciate them until they do.

I would say that your tax guy is being a little ultra conservative though in that he is making you wait and extra year +/- to start depreciation.

As I said we rarely observe this rule when we do the accounting work. Not because of any contempt for the rule but because most of the time when you buy replacements early in the year they are mature enough to begin service before the year is out. The other reason is that exposure on this issue is quite small.

I have a client that up until last year had chicken houses, a few head of beef cattle and a hay cutting/baling business. He has since cut a deal with Tyson and is hauling chicken litter full time now. They have some experiment going on with turning chicken litter into methane. Anyway, I digress... He was audited a few years ago because we were aggressive in taking the special fuels deduction for the diesel he used off road. They looked at everything and including his breeding stock and never once questioned the age of the breeding stock. We did get nailed on the fuels though. Over the course of the three year audit window his penalty was less than $750 in total.

I could tell more stories but I'll be nice.

Publication 225 is the Farmers handbook. I have posted the link from the IRS website below for the chapter on depreciation.

http://www.irs.gov/publications/p225/ch07.html#d0e7863

BTW the example that I gave on the amount of depreciation allowable on 5 year property was using the MACRES 200%DB numbers instead of the 150%DB numbers. The difference is in the precentages deducted each year. For Farm purposes one must use the 150% table or straight-line. 200% is reserved for non-agricultural business assets.

 

[Susie David]

Thanks....we'll see how everything looks when he's done with it.
thought about doing my own taxes again but it is not worth the extra hassle and heartburn anymore...besides Susie isn't sure of my math these days....Dave mc

 

[LisaW]

Let's see if I understand all this properly. As long as I can show that we are operating as a business and with profit motive, then the IRS won't necessarily revoke/penalize everything for the past 3 years? Well that right there is different than what the accountant said, or at least the impression I had when I left his office. That alone makes a HUGE difference in the whole matter.

And your accountant is right --- in a manner of speaking once you start depreciating an asset you are "locked in" to depreciating it. This is called the "allowed or allowable" rule, best illustrated by the following example... If you forget to claim depreciation in say year 3 and 4, or make a conscious decision not to claim it, the depreciation for those two years is "eaten up" and you can't then claim those two years worth of deductions, say in year 6 and 7. But there's no law that forces you to actually claim the deduction on your Schedule F.

As for the depreciation issue. Once you start depreciating nothing says that you have to take the depreciation as expense. However, if the animal or equipment is sold later on this can work against you in figuring gain or loss because the rule is that you use the depreciation allowable not the depreciation taken unless the two are the same under the depreciation method that you used.

So, I can choose to take the deductions or not. I understand the concept of losing the deductions for the year and not being able to make up for them later, that seems a no-brainer. I also understand the issue of selling later on and losing the value I didn't take (my dad did that with a rental house - never depreciated it. really lost out when he sold it 15 years later...) But I still have a choice in the matter - that also is different than what the accountant said.

The thing is that right now, after going round and round with the accountant, I'm not confident of anything. Maybe give me a week to sort things out and I'll find my confidence again.

There is no depreciation to be claimed with respect to animals that you raise and keep as breeding herd , since you have no tax cost basis in such animals --- you've already written off every dollar you spent raising them (feed, vets, meds, AI fees, etc. ).

The easiest one to answer is your question about depreciating calves that you have raised...
As for the value of the calves being income... it's only income if you sell them but then you have to figure any farm expenses against that income.

Maybe I didn't ask my question clear enough. Neighbors of ours also have a cow/calf set up. They said that as they understand it, calves born to them have value to them at the end of the year, accounting wise. That when they start the year with, say 12 animals and end the year with 18, the value of their herd increases and off-sets their depreciation. They were surprised that our accountant wasn't including the claves born to us that we have kept as breeding stock, or the calves that we had at the end of the year. We started off with 3 animals. We have a fair bit more than 3 now. At some point, doesn't the increase in herd size show up somewhere other than depreciation abilities?

Your accountant's idea about selling calves now and buying cows might in fact make good sense.

You asked "who is going to buy calves going into winter anyway" --- surely you can't be serious about that question ???

Well, right now what we sell covers our expenses and that leaves us without extra money, to speak of. Give us a few more years and we'll be in a different position. But right now, what we sell pays the feed expenses and a few other little expenses (like vaccinations, etc). It's the depreciation value that we can't make up for. If we purchased anything, I'm not sure where the money would come from.

We have to start feeding hay here in 6 to 8 weeks. Who wants to buy calves to feed over the winter? Maybe some 'big guy' somewhere or someone with money to burn, but not the majority of the people around here. If I sell at the sale barns, I'm looking at $0.90 a pound where in the spring I'm looking at a fair bit more. Selling in the fall just doesn't seem smart. Yes, someone would buy - that is a given. I am just hardpressed to think that selling in the fall is a wise move.

One question I would have is that you mentioned a startup phase. Were all those expenses that you deemed as startup costs expensed or capitalized?

Huh? Sorry, I'm not following. Our start-up costs were the first 3 cows, material for fencing, corrall, pasture management/reseeding, garbage removal, etc. Of course, the tractor to pull the plow/harrows/mower and such. We were blessed to inherit the land, so there's no cost in the land or outbuildings. Everything was just trashed when we got here. We have since downsized the tractor because we don't need to rip up the fields and replant again, we can manage with a smaller one now. Expensed or capitalized? - I'm not following that part. Sorry.

Something to consider is this: change the life of the assets that you are depreciating if possible so that you depreciate over a longer period.

I'll look into that. If we can do that, it might save me quite a bit in the next few years - on Excedrin. LOL

(btw - the accountant has messed up some of our business things as well - like tax computations for our employee and such)

Thanks guys for helping me understand these things. I hope my frustration doesn't come accross in a negative way toward you all. I do appreciate all your help!!!

Lisa

 

[madbeancounter1]

Lisa,

From my experience the only way that the depreciable value of your herd will increase is the outlay of money for more animals.
Possibly your neighbors are using the accrual method of accounting for their operation. If this is the case then they may be recording their calves inventory. Even so this do not result in a depreciable event.

As for my question as to whether or not your initial outlay was capitalized or expensed. The difference would be that if capitalized you would take a deduction for a portion of the start up costs over a period of time (ie depreciated over 5 years). If expensed you would take the entire deduction at the time you layed out the cash.

I wish that I had been as eloquent as AZ in the explanation of depreciation. The straightline example was much more easy to follow than the MACRS one. We rarely use straightline so I guess that isn't what I think of first.

If we can be of more service let us know.

We have a saying in our office. If I don't know the answer, I know where to find it or someone who does and I'll get back to you with an answer.

 

[LisaW]

Thanks. I think I have a much better handle on this than I did the other day. I'll be getting things ready to meet with someone else - as soon as I find this someone else. My investigations begin today.

I have no clue what the neighbors are doing, and I don't intend to ask specifics any time soon - just will add to my confusion. LOL I don't want to get into anything remotely shady either. So I'll get our plans together, our numbers together and start from there.

I do appreciate y'all walking me through this. Helps a lot to have someone else explain things and be clear about it.