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Critically examining prepaids as the go-to tax strategy

Mark Fetzer and Karl Skinner for Progressive Dairyman Published on 11 December 2018

Paying taxes is painful. We all hate to write a check to the IRS; however, sometimes paying taxes is more important for operational health and long-term wealth generation than spending profits to avoid them.

The fundamental flaw of spending profits to avoid taxes is: You need to spend approximately $100 to save $20 in taxes. While this may seem appealing when you think about being able to purchase a new truck, feed, equipment or other operational assets, you are effectively stepping over dollars to pick up dimes. Although, and importantly because 2018 has been a particularly difficult year for the dairy industry, now is the time to re-examine the reliance on prepaids as a default tax strategy.

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For example, if I own a dairy with 1,000 head, have a cull rate of 35 percent and a projected sale price of $834 per head in 2018, I would clear $291,900. Typically, this amount of income would put me into the 24 percent tax bracket, with a federal tax liability of approximately $58,635.

Since cow sales are taxed at the capital gains rate of 15 percent, my federal tax liability drops significantly to approximately $32,205, leaving me with $259,695 of after-tax profit. Although it may be painful to write a check for $32,205 to the IRS, in order to save this amount, I would need to spend the full $259,695. In other words, I need to spend $1 in order to save 12 cents in taxes.

Granted, there are some situations where it is prudent to use prepaids for the next year to decrease a tax bill; however, it is imperative this strategy is undertaken carefully. There must be a careful balance among how much inventory is purchased, the price of inventory versus the projected price of inventory in the next year, the price of milk per hundredweight (cwt), the projected number of cows to be culled and the cull price.

If inventory pricing is good in the current year with a projected rise in the following year matched with a projected decrease in the price of milk per cwt and, therefore, a realistic possibility of decreased cull prices, it may be a great idea to buy inventory to reduce the current year’s tax bill and also hedge against a more difficult year to come where a tax bill will inevitably be lower.

However, relying on that strategy as the sole method of reducing a tax bill may likely lead to a build-up of prepaids, which will cause frustration and large tax bills when business transition occurs, as we have seen firsthand with clients. A competent tax adviser can help you navigate through this scenario. Please be wary of an adviser who insists on prepaids as the only strategy to decrease a tax bill.

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True wealth does not come from spending profits to avoid taxes. True wealth is only generated from after-tax dollars. Regardless of how hard we try to prevent it, we will always be accountable to the tax man. To become cash rich, where our bank accounts, investment accounts and other wealth accumulation vehicles show significant accumulation and not just paper wealth, where you are sitting on business assets that are offset by huge lines of credit or other debt obligations, you need to pay some taxes.

In fact, writing a check to the IRS indicates you made money during a given year rather than deferred your tax liability until you sell out of the business or tap assets for retirement in some other way. As an alternative, try paying some taxes and then strategically redeploy the remaining profits. The following are some ideas of how a redeployment may work for your operation.

  1. Evaluate each business segment or unit annually and reallocate capital based on market opportunity.

  2. Purchase additional farmground to increase forage production.

  3. Replace outdated and inefficient equipment. This should not only improve profitability per cwt but also provides an asset that may be depreciated to offset tax costs.

  4. Invest in monitoring systems to tailor nutrition and care to specific cows. Often, cows are not fed optimally. Each cow should have a specific diet based on production. This diet may be more easily determined with the use of automated monitoring systems.

  5. Invest in an enclosed feed storage unit to cut down on feed loss costs.

  6. Invest in breeding stock to improve herd quality.

Although some of these redeployment strategies may be undertaken with before-tax profits, and therefore completely eliminate a tax bill, doing so defers taxes and does not create opportunities to reduce tax bills in future years. Please use prudence and competent advisers when determining how to redeploy profits and, if so, the best way to do it.

Some downfalls to spending profits to avoid taxes are:

1. Credit – Spending profit at year-end just to avoid taxes skews your balance sheet results. Banks may take issue with how this looks from a lending perspective and push harder to understand why you are operating in this manner. In good times, when credit is easy to obtain, you may not have any issues with this; however, if there is a downturn, you may find yourself fighting to keep your line of credit to stay in operation. Paying some taxes on profits and investing those wisely will do more for your business in the long run than spending profits to avoid taxes.

2. Opportunity costs – By spending profits at the end of the year, you hinder your organization from being nimble and ready to take on new opportunities. An opportunity for increased sustained growth could be passed on due to a cash shortage or limits on lines of credit.

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3. Deferral – It may feel good to not write a check to the IRS, but instead you have just pushed it down the road. If your effective tax rate decreases in the future when the deferred tax bill comes due, you have made a great choice, but if the tax rate increases, you have lost money. Although the current tax structure is favorable, considering the financial state of our government, it is likely tax rates will increase over the long run. This possibility becomes even more apparent when considering a change of administration.

4. Financing purchases – This is the ultimate in tax traps. If you spend your profits to avoid tax by buying equipment or other assets, while you are still hurting your business and ultimately your long-term wealth, you are exacerbating that harm if you finance any portion of year-end purchases. The only way you can repay debt is with after-tax dollars. If you continue to spend profits to avoid taxes, your basis in the partnership may be negatively impacted, resulting in a potentially larger tax bill in the future.

Strategy has everything to do with context, where you are positioned and what is happening in the industry and the world at large. By taking advantage of the favorable tax laws governing capital gains and tax strategies to offset your tax liability, you will be able to reduce your overall tax liability while creating more opportunity and stability for your dairy and your family.

With after-tax profits, you will be able to grow your business capital to hedge against economic downturns and be able to take advantage of growth opportunities. Furthermore, by strategically redeploying after-tax profits, you will be able to grow your business or create tax-free wealth to enjoy after retirement. Please consider talking to your tax adviser about strategies to preserve and grow your wealth rather than stepping over dollars to pick up dimes.  end mark

Karl Skinner is a partner with Cooper Norman.

Mark Fetzer
  • Mark Fetzer

  • Tax Consultant
  • Cooper Norman
  • Email Mark Fetzer

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