Clearly calculate farm earnings
Sometimes relationships surface among things that seem unrelated.
Trading hours that expanded for grain futures triggered thoughts on timing:
• Commodity exchanges establish settlement prices on futures to determine gains and losses.
• Farmers establish farm income to determine earnings and income taxes.
In May, the Chicago Mercantile Exchange Group expanded electronic trading hours for most grain and oilseed futures and options contracts at the Chicago Board of Trade. Daily settlements continue to be based on market values at or around 1:15 p.m. Central time. That’s when open-outcry trading in exchange pits closes. The CBOT uses those settlements to:
• adjust account balances to reflect gains for traders whose positions gained during the trading session and to reflect losses in accounts of traders whose positions lost money
• issue margin calls as needed
The purpose of marking positions to the market is to make account balances reflect current value of the positions each trader holds.
Not marking income to market
Farmers can use cash or accrual accounting. Accrual accounting marks farm income to the market at the end of the fiscal year. Cash-basis accounting does not. This gives farmers who pay income taxes on the cash basis a huge near-term edge.
Cash-basis taxpayers turn grain into a taxable event for income tax purposes when they sell it. As grain prices ratcheted higher over recent years, farmers have used delaying grain sales into the next year as an effective tool to defer paying income taxes. Buying and applying fertilizer in the fall for the next year’s crop is another technique to delay taxes.
As with many management practices, such moves have advantages and disadvantages. On the plus side, paying taxes later is almost always preferred over paying taxes sooner. The exception is if the taxpayer will face a higher tax rate later.
During farm growth phases, farmers can accumulate significant amounts of grain (and livestock) inventory. For example, if a cash-basis farmer produces $800,000 of grain, but only sells $600,000, the farmer can defer taxes on the earnings from $200,000 of the grain until later.
Couple of downsides
While a farmer is building grain inventory and possibly storage to stash it, the farmer still has to generate the cash flow to pay the bills. Fortunately, some of that cash can come through delaying taxes.
If the farmer ever wants to retire or downsize the business, he’ll face tax implications on the income from inventory that he has rolled forward.
The biggest drawback is that cash-basis farmers playing income-shifting games need to avoid confusing themselves on how much profit their farms earn. Profitability pits value of production against value of resources used to generate the production. Rolling this year’s crop income into next year at the same time you pull next year’s expenses into this year for tax purposes complicates the calculation and can distort profitability.
Having it both ways
Farmers, who have substantial gains in hedge positions, would likely revolt if the exchange waited until year-end to mark those gains to the market.
Farmers would also likely revolt if lawmakers suggested phasing out cash-basis taxpaying that lets them avoid marking their income to the market at year-end.
This article published in the August, 2012 edition of WALLACES FARMER.