Self-employment tax considerations for farmers

Self-employment is a real option in today’s working world for many farmers. But many that choose to work for themselves are often surprised by the distinctive challenges they face when it comes to taxes. Knowing how to navigate those challenges is important and working with an experienced CPA is your best bet in order to avoid issues along the way. Here some consider for any self-employed farmers.

 

Material participation

The Internal Revenue Code imposes self-employment tax on the net income from a taxpayer’s trade or business or from a partnership in which the farmer is a member. Rent received from personal property (machinery and equipment) is also subject to the tax if the farmer is in the business of renting personal property.

Focus on liability. Self-employed individuals are liable for self-employment tax, which means they must pay both the employee and employer portions of FICA taxes. The good news is that you may deduct the employer portion of these taxes. Plus, you might be able to make significantly larger retirement contributions than you would as an employee.

However, you’ll likely be required to make quarterly estimated tax payments, because income taxes aren’t withheld from your self-employment income as they are from wages. If you fail to fully make these payments, you could face an unexpectedly high tax bill and underpayment penalties.

Many farmers pay more self-employment taxes than income taxes because the lowest self-employment tax rate (15.3%) is more than the lowest income tax rate (15%), and because personal deductions do not reduce self-employment income. For example, farm couples that have two children, file a joint return, and claim the standard deduction will pay $5,646 of income tax on $75,000 of farm income, but will also pay $10,597 of self-employment tax.

Unlike income tax planning, planning to reduce self-employment taxes must take into account the corresponding social security benefit to be received in the future. Reducing the self-employment income reduces the earnings base in which social security benefits are computed. Thus, farmers must compare the self-employment tax savings with the reduction in social security benefits to ultimately maximize their after tax wealth.

 

Know what’s deductible

Under IRS rules, deductible business expenses for the self-employed must be “ordinary” and “necessary.” Basically, these are costs that are commonly incurred by businesses similar to yours and readily justifiable as needed to run your operations.

The tax agency stipulates, “An expense does not have to be indispensable to be considered necessary.” But pushing this grey area too far can trigger an audit. Common examples of deductible business expenses for the self-employed include licenses, accounting fees, equipment, supplies, legal expenses and business-related software.

Does your home office qualify? You may deduct many direct expenses (such as business-only phone and data lines, as well as office supplies) and indirect expenses (such as real estate taxes and maintenance) associated with your home office. The tax break for indirect expenses is based on just how much of your home is used for business purposes, which you can generally determine by either measuring the square footage of your workspace as a percentage of the home’s total area or using a fraction based on the number of rooms.

The IRS typically looks at two questions to determine whether a taxpayer qualifies for the home office deduction:

  1. Is the specific area of the home that’s used for business purposes used only for business purposes, not personal ones?
  2. Is the space used regularly and continuously for business?

If you can answer in the affirmative to these questions, you’ll likely qualify.

 

CRP payments are typically subject to self-employment

Conservation Reserve Program (CRP) payments (“annual rent payments”) are includable in the net income from self-employment and subject to self-employment tax. Per the IRS instruction in Publication 225, Unless the taxpayer is receiving Social Security retirement or disability benefits, CRP “annual rental payments” are includible in net income from self-employment subject to self-employment tax. Note: Payments that are for the permanent retirement of cropland base and allotment history are not includible in net income from self-employment subject to self-employment tax because they are for the sale of section 1231 property or a capital asset.

 

Do some long term planning

Planning to reduce self-employment tax liability must include an analysis on the effect of the reduction on social security benefits to be sure the present value of the tax savings is greater than the present value of the decrease in social security benefits. Work with your accountant or a social security specialist that can assist with this type of planning. As always, reach out to me with any questions you may have.

 

Brian E. Ravencraft, CPA, CGMA is a Principal with Holbrook & Manter, CPAs. Brian has been with Holbrook & Manter since 1995, primarily focusing on the areas of Tax Consulting and Management Advisory Services within several firm service areas, focusing on agri-business and closely held businesses and their owners. Holbrook & Manter is a professional services firm founded in 1919 and we are unique in that we offer the resources of a large firm without compromising the focused and responsive personal attention that each client deserves. You can reach Brian through www.HolbrookManter.com or at BRavencraft@HolbrookManter.com.

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