AgDM newsletter article, December 1996

Deferring taxable income -- How important?

By William M. Edwards, Extension Economist, 515-294-6161, wedwards@iastate.edu

Some Iowa farmers are finding a pleasant surprise as they prepare to close their records for 1996-cash incomes are up. The most positive factor, of course, has been grain prices.

Now comes the bad news. There will be taxes to pay on this income. Although there are worse things than paying taxes (like not having any income), no one enjoys writing large checks to Uncle Sam.

Tax deferral

The most common reaction to a potentially large tax bill is to try to defer some of that income into the future. For cash basis taxpayers this usually involves delaying the receipt of income or moving up the payment of expenses.

Deferring taxable income has two benefits. First, progressive tax rates cause more total tax to be paid when high incomes are reported in some years and low incomes in other years. In the long run less total tax will be paid if about the same amount of income is reported in each year. Second, deferring taxes for a year allows the operator to use the capital for a year. This reduces interest expense on borrowed money, or earns extra interest on savings.

An additional advantage could be gained if income tax rates are lower in 1997 than in 1996. This appears more likely for Iowa taxes than federal taxes. On the other hand, the maximum income subject to self-employment tax will increase from $62,700 to $65,400 in 1997.

Value of tax deferral

Just how much is tax deferral worth? The answer depends on each taxpayer’s filing status, income level, and financial situation. Let’s examine the combined marginal tax rate (added tax payable on the last dollar of income) for federal and Iowa income tax, and self-employment income. Table 1 shows how the combined marginal rate changes as gross income (for tax purposes) increases. These rates are for married taxpayers filing jointly with four exemptions. All income is assumed to be ordinary income subject to self employment tax. The deductibility of last year’s federal tax from Iowa taxable income (and vice versa) is not taken into account.

Surprisingly, the marginal tax rate over a very wide range of incomes (roughly $17,000 to $111,000) is very close to forty percent. This begins when the federal income tax rate increases from 15 to 28 percent, and ends when the self-employment tax rate falls from 15.3 to 2.9 percent. The exception is for a very short interval around $60,000, where the rate is over fifty percent.

Table 1. Federal and Iowa income tax rates, self-employment tax rate. *

Gross Income
Federal
Iowa
Self-employment
Total
 
(percent)
(percent)
(percent)
(percent)
$0 to $8620
0
0
15.3
15.3
$8620 to $12989
0
5
15.3
20.3
$12989 to $16550
0
6.8
15.3
22.1
$16550 to $19415
15
6.8
15.3
37.1
$19415 to $24770
15
7.2
15.3
37.5
$24770 to $35480
15
7.55
15.3
37.9
$35480 to $51545
15
8.8
15.3
39.1
$51545 to $55550
15
9.98
15.3
40.28
$55550 to $62700
28
9.98
15.3
53.28
$62700 to $110800
28
9.98
2.9
40.88
$110800 to $160150
31
9.98
2.9
43.88

*Rates are for the 1996 tax year. Gross income ranges assume that the Iowa standard deduction and four personal credits offset the taxability of $8,620 of income, and the federal standard deduction and exemptions offset the taxability of $16,550 of income.

Examples

Suppose a married farmer filing a joint return with four exemptions has a potential gross taxable income of $90,000. The total federal, state, and self-employment tax is $32,982. Further, suppose than for 1997 a more typical income of $30,000 is expected, which would result in a total tax of $8,044. The two year combined tax bill would be $41,026.

Now suppose that $30,000 of income is deferred from 1996 into 1997. Gross taxable income would now be $60,000 each year, with taxes of $20,383 due each year. The total tax bill would be $40,766, only $260 less than when no income is deferred. This occurs because most of the “extra” income in 1996 is not subject to the full self-employment tax rate, which offsets the effect of higher income tax rates.

In Example 2 the potential gross taxable income is $60,000 in 1996 and $20,000 in 1997 versus reporting $40,000 in each year. Total tax savings are $768. The savings are larger than in the first example because all income is subject to the maximum self-employment tax rate. Although this savings is desirable, other circumstances such as a decline in grain prices after the firs of the year could easily negate it.

These examples are shown for the purpose of illustrating the tax effects of deferring income only. The actual tax due will vary according to the circumstances of each individual situation.

Example 1. Deferring $30,000 of income.

    1996   1997  
 
Gross
Income
Tax
Gross
Income
Tax
Total
Tax
No deferral
$90,000
$32,982
$30,000
$8,044
$41,026
Deferral of $30,000
60,000
20,383
60,000
20,383
40,766
           

 

Example 2. Deferring $20,000 of income.

    1996   1997  
 
Gross
Income
Tax
Gross
Income
Tax
Total
Tax
No deferral
$60,000
$20,383
$20,000
$4,275
$24,658
Deferral of $20,000
40,000
20,383
40,000
11,945
23,890
           

Corporate rates

For a farming operation organized as a regular corporation, leveling of taxable income is more significant because the increase in tax rates for incomes over $75,000 is steeper than for individual rates. Moreover, instead of paying self-employment tax, the corporation and its employees would each pay FICA taxes on wages and salaries.

Interest reduced (earned) from deferral

If you defer taxes for a year, you can invest the money (i.e. savings) and earn additional income, or repay debt and reduce interest payments. Let’s assume an 8 percent interest rate. Dollars placed in a savings account might earn less than this, but borrowed capital might cost more. In Example 1 deferring income reduces 1996 taxes by $12,412, which would produce an interest savings of $993. In Example 2 a total of $8,438 in tax is postponed for a year, for an interest savings of $685.

Summary

As a caution, when tax deferral strategies such as delaying sales or prepaying expenses are used one year, they may have to be continued year after year. Only when taxable income will be very low or negative can this be discontinued.

The use of tax deferral strategies can generate tax savings, but the overall long term effects on after tax income need to be considered. Tax management decisions should take into account factors such as near term commodity price movements and the farm’s immediate cash flow needs, as well as tax savings in the current tax year.

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