Recent tax regulation changes may spell good news for horsemen. With new laws governing depreciation, estate planning, sales tax, and more, there are many ways to save money from year to year. In addition, there are still some old tax regulations you should be taking advantage of.
Additional First-Year Depreciation
An additional first year depreciation is now being allowed for horses, equipment and certain vehicles acquired after September 10, 2001.
Many horsemen are aware that purchased horses, equipment, machinery and vehicles have been eligible for depreciation. These depreciation deductions are computed based on the purchase price of the asset over a designated period of time (usually 3, 5 or 7 years for non-real estate assets) as outlined by the IRS. All of this remains the same as under the old rules, except that there is an additional 30 percent of first-year depreciation deductions. As background for the horseman, racehorses over 24 months old and other horses over 12 years old are depreciated over a 3-year period. All other horses are depreciated over a five-year period.
Example: A 3-year old racehorse is acquired on June 30, 2002 for $50,000. Using the old rules on depreciation, the horse would be depreciated over a 3-year period and would qualify for some additional depreciation. The total depreciation would have been $32,658. With the new rules, the same horse would have depreciation in 2002 of $37,861. The amazing part of these new rules is that the horseman is writing off approximately 74 percent of the total horse cost all in the first year.
Machinery and Equipment
A similar computation would be made for machinery and equipment but the depreciable lives are longer. Most of this type of property is seven years (sometimes five years) and it has a different schedule. But, even with a seven-year life, the depreciation computation would yield a greater deduction then in the past. For higher-priced assets, the horseman will have a higher depreciation deduction than under the old rules.
Heavy-duty vehicles such as certain SUVs would also likely qualify for this better depreciation calculation.
For many automobiles used in the farm business, the first year limitation has been a very small $3,060. Now, the first year depreciation amount will be $7,660.
Traditional planning often involves deferring (putting off) income to a later year and accelerating deductions to the current year. This means such year-end maneuvers as postponing collecting that last commission, fee or boarding invoice until next year, or having your employer pay your bonus in the following year so it is not on your current W-2. Deductions are accelerated into the current year by paying your next year’s property taxes, feed or veterinarian bill in this year.
Additional ideas for planning
1. Income split with the children. Remember that children under 18 can work for their parents on the farm, get paid up to approximately $4,500 each and still have little or no income tax and no social security tax (FICA). That’s right, there is usually no income tax or social security tax on up to approximately $4,500 per child, per year, when paid by their parents. The parents should pay the children a reasonable amount for their services (cleaning the office, washing the business vehicles, running errands, cleaning stalls). The older the child is, then the more the parent/employer should be able to pay them since they can do more for the business. The amount that you pay your child is deductible by you and can save you income and social security tax (FICA). This tax savings can be in excess of $2,000 per child.
“...the amazing part of these new rules is that the horseman is writing off approximately 74 percent of the total horse cost all in the first year.”
2. Hire the children as your legitimate employees and use the educational assistance program of $5,250 per year, per employee/child. It is not necessary that the educational assistance be job-related. This payment is deductible by the parent/employer and is not taxable to the child.
3. Do not forget about your ability to save tax on the sale of your personal residence/farm. With at least a two-year holding period, you can eliminate up to $500,000 in gain if married and $250,000 if single. Plan your holding period accordingly. A farm where acreage is included with your residence may also qualify if the acreage is similar to surrounding properties.
4. Do not sell that investment property or extra farm acreage—exchange it. But, exchange it the right way where you will not pay current capital gains. There is a way to keep doing qualified exchanges of real estate until you die, and then the capital gains will be forgiven. Congress is discussing changing this loophole but not for several years.
5. Set aside up to $50,000 per child in a special tuition account for their schooling. This is not deductible by you but the account builds up in value without a tax and can be withdrawn without a tax when children want to go to school. This is a great program (Section 529) that most states have initiated.
Even bigger and better deductions
If you really need a larger deduction and have maximized your various pension plan(s) then take a look at a special defined benefit (DB) plan, where the deductions are sometimes five to eight times greater then typical plans. Under Internal Revenue Code provision, 412 (i) there are ways to greatly enlarge your pension deductions. With the special provisions of 412 (i), this contribution can be as much as $850,000. Part time employees can usually be excluded from the plan, leaving more of the contribution to the horse professional.
Another idea is to establish a severance pay plan. This deduction is in addition to, or instead of, your normal pension contribution. In this plan, you can contribute as much as two times your compensation. In other words, if you had $200,000 in compensation you could contribute as much as $400,000 this year into a severance pay plan by year’s end and deduct it. There are some peculiarities with these plans but if they are well structured then the deduction could not be better. There are also ways to let the distribution build up tax-free similar to a pension plan and ways to take distributions that are not subject to the normal pension rules of 59.5 years and 70.5 years. Estate planning should be integrated into this technique since the deduction is large and you want to avoid having it taxed in your estate.
There are many other tax planning ideas still available that are not mentioned in this article. Although Congress is working to eliminate as many of these as possible, there are still fertile minds seeking to find those hidden tax deductions for you. [sm]