Tax Letter

SHOULD YOU INCORPORATE YOUR FARM OR RANCH?

by: Darrell L. Dunteman

Dunteman and Company, Accountants

The popular press is full of articles concerning cor­porations.  Sometimes corporations have been a status symbol:  “My neighbors are all corporations, so if I’m to be perceived as successful, I need to be a corpora­tion too!”  In reality, not every operation should be in a corporation. 

Our tax law has changed over the years since I’ve been in practice.  The personal income tax rates have decreased.  Health insurance is now 100% deduct­ible for self employed individuals.  Retirement plans have almost the same tax advantages regardless of your form of business organization.  In reality, there is little income tax reason to become a corporation in 2004.  However, advantages still exist in the area of self employment taxation.

I decided to take a look at various income levels to determine the advantages of the corporate form of business today.  I compared a sole proprietorship with an S Corporation as well as a C type Corporation and the results are shown in three different tables in this article.  If my analysis is to be accurate, I must be comparing “apples with apples”.  So, I made a set of assumptions that are present in each of three tables:

     1.) I used a married couple, with no dependents, in each of the example tables. To keep it simple I assumed there was no off farm income.  Off farm income can increase the tax rate but could also affect the deductibility or cost of health insurance.  I used the 2003 tax rates and exemption levels for the purpose of analysis since I don’t have the final 2004 tax program yet.

     2.) I used a salary of $ 36,000 as compensation in both the S  Corporation and the C type corporation.  The ability to determine the level of income that you expose to social security or self employment taxation is the major advantage of a corporate form of business organization.  If you are self employed, in a partnership, or a active partner in a limited liability company (LLC), your entire earnings are subject to self employment tax. Why $36,000?  Our recent Ag Executive/Farm and Ranch Tax Letter Salary Survey indicated the average salary for management employees was around $ 36,000.  Your risk is that if you pay less than this $ 36,000 (or some other reasonable salary) the Internal Revenue Service may assess self employment tax on all the earnings of your corporation.  A number of resourceful taxpayers have tried to just pay dividends to escape social security taxes but have not been successful when their cases ended up in tax court.  I assumed that the farm paid the social security taxes of the employee in our example so that the actual W-2 wages were $ 38,754 for the year.

     3.) It costs more to operate as a corporation.  My personal experience is that a taxpayer should plan to spend an additional $ 600 per year in additional accounting and legal fees.  Some operations will spend more depending on the skills of their staff in keeping a balanced set of books.

     4.) Health insurance deductions do make some difference within each entity.  Even though the self employed health insurance is deductible for income tax purposes for a self-employed individual, you still pay self employment tax on the total Schedule F earnings since the health insurance is not deducted on Schedule F unless your spouse is an employee of your farm and you have a qualified plan.

     5.) The best comparison for evaluating a form of business organization is to calculate how many dollars are left over at the end of the year after subtracting additional costs of doing business and calculating the loss in taxes.  Again, to compare apples with apples, I assumed that all available funds would be removed from the business at the end of the year.

TABLE 1

*	Sole Proprietor	S Corporation	C Corporation
Farm Profit	80,000	80,000	80,000
Health Insurance	0	0	(10,000)
Salary	0	(36,000)	(36,000)
Soc Sec Tax	0	( 5,508)	( 5,508)
Add Acct/Legal	0	(   600)	(   600)
Net Farm Income	80,000	37,892	27,892
Corporate Tax	0	0	4,184
W-2 Earnings	0	38,754	38,754
Dividend	0	37,892	23,708
Gross Income	80,000	76,646	62,462
50% SE Tax	( 5,652)	0	0
Health Insurance	( 10,000)	( 10,000)	0
Adj Gross Income	64,348	66,646	62,462
Std Deduction	( 9,500)	( 9,500)	( 9,500)
Exemptions	( 6,100)	( 6,100)	( 6,100)
Taxable Income	48,748	51,046	46,862
Income Tax	6,609	6,954	3,961
SE Tax	11,304	0	0
Remaining Cash	52,087	56,938	55,747

 

Our first example used a net farm profit of $ 80,000.  Health insurance is a deduction to the C type corporation.  Health insurance is a deduction from Gross Income in both the S corporation and the sole proprietorship.  Our example would show that the best form of business organization, given our assumptions, was the S Corporation.  The S corporation owner had $ 4,851 more dollars left than the sole proprietor.  The C corporation owner did not fare as well as the S corporation due to the “double taxation” of the profits.  The dividends are not a deduction to the C corporation shareholder, yet they are taxable when received by the shareholder-owner.  Since I’m using 2003 tax tables, the corporate owner would actually lose a few more dollars when the special dividend and capital gains rates disappear in the future.

TABLE 2

When we increase the net farm profit to $ 100,000, the advantage continues to favor the S Corporation by $ 6,521.  The self employed individual paid only the medicare portion of self employment tax above $ 87,000 farm profit.

TABLE 3

My third example dropped the net farm income to $ 53,000.  Why $ 53,000? You would note that the net income of the C type corporation drops to only $ 892 at this level.  If I lowered the net farm income lower, then the corporation would experience a loss, which could not benefit the corporation unless it showed some profit in the future.  At the $ 53,000 level, the S corpora­tion still has an advantage over the sole proprietor, but that advantage has decreased to only $ 1,328 dollars.  The advantage decreases because the self employment income becomes closer to the salary of the individual.

I calculated the “breakeven” net farm income where there was no advantage to the S corporation and found that the breakeven net farm income was approximately $ 43,000.  The additional corporate costs eliminated the social security tax savings at this level.  So, it would appear that there is no advantage of incor­porating your business unless your net farm income exceeds $ 43,000. 

Are you lowering your social security benefits by lowering the amount of social security tax paid into the system?  The short answer is  “yes”.  However, if you review some of the previous articles we have prepared in Ag Executive and Farm and Ranch Tax Letter, you’ll find that you are not likely to reduce your benefit by a substantial amount.  You are better off using your social security tax savings to make new investments or pay down debt faster rather than investing in the social security tax system.

Another item to consider is “Will you be able to draw your full social security check in the future?”  The social security system is facing some challenges in the next fifteen years.  Top economists such as Alan Greenspan are calling for cuts in benefits or increasing the retirement age to allow the Social Security system to remain solvent.  I believe that it’s quite possible that means testing will be used in the future to lower your social security benefits.  If you have a certain level of income from investments or retirement funds, you’ll receive less social security.  A possible trade-off may be that the government may allow you to draw a speci­fied amount out of your retirement plan tax free in exchange for the reduced benefit.

Our example did not address the option of paying a portion of your salary in commodities if you use the corporate form of business organization.  Paying a por­tion of your salary in commodities could increase the advantage of the corporate form of business organiza­tion.  You need to be careful with your documentation and discuss the potential pitfalls of this strategy with your tax preparer and again review previous articles on payment in commodity that have appeared in this newsletter.

Take a copy of this article to your tax preparer.  Use your own numbers to determine the benefits in your own operation.  Use a good corporate attorney and place a minimum number of assets in your corporation to avoid future problems at retirement.

9/2004

Darrell L. Dunteman is an agricultural financial consultant and accountant with office in Bushnell, Illinois.  Dunteman can be contacted at (309) 772-2166.

AG EXECUTIVE—Copyright© 2004 This material is based on factual information believed to be accuratebut not guaranteed. Action taken as a result of this advice is solely the responsibility of the user.