| Purchase price (one or more alpacas) |
$100,000 |
| Section 179 tax deduction ($100,000) |
|
| Tax savings 45% (tax bracket 45%) |
($45,000) |
| Actual after tax cost out of pocket |
$55,000 |
In other words, if you are in the 45% tax bracket
(state & federal) the government will reduce your taxes by
45% of the cost of $100,000 worth of alpacas. This deduction
is available for all taxpayers. To see how much this will
benefit you, simple calculate your state and federal tax
bracket and multiply it by the amount of your purchase up to
$100,000.
Please Note: 1) that you must have sufficient income to use
the deduction. If you have no ordinary income then the
deduction will be limited, 2) the unused portion of the
deduction can be carried forward to subsequent years, 3) you
may want to forgo electing to take the deduction and simply
depreciate the cost of your alpacas. This approach would allow
you to create a net operating loss which could be carried back
two years and you may obtain a refund of previously paid tax,
and 4) to benefit from the 179 deduction the tax payer can not
place more than $400,000 of qualifying assets in service in
the year that the deduction is taken
AN ADDITIONAL 50% FIRST YEAR DEPRECIATION.
There are even more important changes for alpaca breeders in
the recently enacted 2003 tax law. In an effort to stimulate
the economy, Congress is giving taxpayers a bonus 50%
first-year depreciation write-off for most new capital assets,
including single purpose agricultural buildings placed in
service after May 5, 2003, and before December 31, 2004.
(Please note that agricultural buildings as defined below also
qualify for the Section 179 deduction.)
"Single purpose agricultural (livestock) or horticultural
structures. A single purpose agricultural (livestock) or
horticultural structure is qualifying property for purposes of
the section 179 deduction. For purposes of determining whether
a structure is a single purpose agricultural structure,
poultry is considered livestock.
Agricultural Structure. A single purpose agricultural
(livestock) structure is any building or enclosure designed,
constructed, and used for both the following purposes:
- To house, raise, and feed a particular type of livestock
and its produce.
- To house the equipment, including any replacements,
needed to house, raise or feed livestock."
Section 179 Deduction
IRS Publication 225, "Farmer's Tax Guide", Chapter 8
- Depreciation, Depletion, and Amortization
In effect, this additional write-off means that you can
recover more of the cost of a business asset, such as an
alpaca or a barn, in the year you place it in service.
HOBBY FARM RULES
The first step in qualifying for favorable tax treatment as a
farmer is establishing that you are in business to make a
profit. You can not raise alpacas as a hobby farmer and
receive the same tax preferences as a for-profit farmer. A
farming operation is presumed to be for profit if it has
reported a profit in three of the last five tax years,
including the current year.
If you fail the three years of profit test, you may still
qualify as a "for profit" enterprise if your
intention is to be profitable. Some of the factors considered
when assessing your intent are:
You operate your farm in a business-like manner.
The time and effort you spend on farming indicates you intend
to make it profitable.
You depend on income from farming for your livelihood.
Your losses are due to circumstances beyond your control or
are normal in the start-up phase of farming.
You change your methods of operation in an attempt to improve
profitability.
That you make a profit from farming in some years and how much
profit you make.
You or your advisors have the knowledge needed to carry on the
farming activity as a successful business.
You made a profit in similar activities in the past.
You are not carrying on the farming for personal pleasure or
recreation.
You don't have to qualify on each of these factors - the
cumulative picture drawn by your answers will provide the
basis for the determination.
FARMERS TAX GUIDE
One of the frustrating factors in dealing with the IRS rules
is getting to a definitive answer. The code is often more gray
than black or white; consider the following statement which is
found in IRS Publication 225, "Farmer's Tax Guide":
"This publication covers some subjects on which a court
may have made a decision more favorable to taxpayers than the
interpretation of the Service. Until these differing
interpretations are resolved by higher court decisions or in
some other way, this publication will continue to present the
interpretation of the Service."
I recommend everyone who farms alpacas obtain a copy of this
handy guide at your local IRS office or at the IRS
website" at
www.irs.gov. It is very informative.
I must confess, I don't like to pay taxes; I always do, but
I'm never happy about it. I inherited this bias, I believe,
from my father. Dad was always fully convinced of his beliefs,
and he believed that IRS agents were the bad guys.
Dad was one of the first full time llama farmers in the U.S.
to be audited by the IRS. It was quite a task to prove to the
agent who conducted Dad's audit that llamas were in fact a
profit making enterprise. The agent decided that before he
completed his review of Dad's tax return, he wanted to see
these llamas with his own eyes; just to make sure, of course,
that everything was on the up and up.
After much negotiating between my dad's accountant and the
agent, it was agreed that the agent could view the llamas from
the road in front of Dad's farm; he wasn't to be allowed on
the property. When the fateful day arrived, Sam, the IRS
agent, appeared at the fence in front of Dad's ranch. It
wasn't long before Bonnie, his big black llama, wandered up to
the fence and offered Sam a kiss. I still to this day believe
that my dad's audit was the only one ever closed as a result
of a llama's kiss. Thank God, she didn't spit!
Once you've established that you are farming alpacas with the
intent to make a profit, you can deduct all qualifying
expenses from your gross income. The discussion from here
forward presumes you are a cash basis taxpayer and you keep
good records. Accrual basis tax payers would also be allowed
the same tax treatment, but their timing might be different.
First, the following items must be included in your gross
income calculations:
- Income from the sale of livestock
- Income from sale of crops, i.e., fiber
- Rents
- Agriculture program payments
- Income from cooperatives
- Cancellation of debts
- Income from other sources, such as services
- Breeding fees
Then the following expenses may be deducted from this
income:
- Vehicle mileage at .36 cents a mile for all farm
business miles
- Fees for the preparation of your income tax return farm
schedule
- Livestock feed
- Labor hired to run and maintain your farm (remember, you
must not deduct the expense of maintaining your personal
residence)
- Repairs and maintenance
- Interest
- Breeding fees
- Fertilizer
- Taxes and insurance
- Rent and lease costs
- Depreciation on animals used for breeding, real property
improvements, barns and equipment
- Farm-related travel expenses
- Educational expenses, which improve your farming
expertise
- Advertising
- Attorney fees
- Farm fuel and oil
- Farm publications
- AOBA dues and registry fees
- Miscellaneous chemicals i.e. weed killer
- Vet care
- Small tools having a useful life of less then one year
Please note: Personal and business expenses must be
allocated between farm use and personal use, for instance,
with such expenses as utilities, property taxes, accounting,
etc. Only the farm use portion can be expensed.
AT RISK RULES
Once you've determined your net income or loss, it is included
on your tax return as an addition to or a deduction from your
ordinary income. Losses can be carried back for two years and
forward for twenty years. To deduct any loss, you must be at
risk for an amount equal to or exceeding the losses claimed.
The "at risk" rules mean that the deductible loss
from an activity is limited to the amount you have at risk in
the activity. You are generally at risk for:
- The amount of money you contribute to an activity
- The amount you borrow for use in the activity
You must establish the cost basis of your assets for tax
purposes. This basis is used to determine the gain or loss on
sale of an asset and to figure depreciation. In determining
basis, you must follow the uniform capitalization rules found
in the IRS code. Animals raised for sale are generally exempt
from the uniform capitalization rules, and there are other
exceptions for certain farm property. You need to become
familiar with these rules.
Once you've established the cost basis of your various assets,
you take a charge for depreciation against your annual income.
This process allows you to expense the historic cost of an
asset to offset present income. The effect is to create
non-taxable cash flow on a current basis. This benefit is
especially attractive in an environment of higher taxes.
ALPACAS SIX YEAR WRITE-OFF
There are several methods of writing alpacas off, beginning
with the straight line method which allows you to deduct
one-fifth of their cost each year, except the first year, in
which the code allows for a prorated write off based on the
month of your purchase. The net result of this method is that
it takes six years to write off your alpacas, unless you buy
them in January. The straight line system can only be used by
making an election. There is also the modified accelerated
cost recovery system using 150% declining balance and the
half-year or mid-quarter convention (MACRS) which allows
animals to be written off as follows: 15% year 1, 25.5% year
2, 17.85% year 3, 16.66% years 4 and 5, and 8.33% year 6. This
is an accelerated schedule allowing for a larger percentage of
the asset to be written off early. The MACRS system is the
system preferred by the IRS since it does not require an
election. Alpacas born at your ranch have no cost basis and
cannot be written off, although they may qualify for capital
gain treatment on sale. The costs related to financing or
interest on your purchase is also deductible. Many people pay
cash for their animals so writing off the interest is not an
issue. The following examples articulate the benefits of tax
deductions derived from an investment in alpacas. The examples
do not include expenses for feed, veterinarian care, supplies,
and transportation.
FINANCING
Let's consider what would happen if you purchased a herd of
six alpacas for $150,000. In this scenario we will assume you
are in the 45% overall tax bracket (state and federal), use
the section 179 deduction in year one, use the MACRS
depreciation method, finance the herd at 8% interest for four
years, and insure the herd for the balance owed after a 30%
down payment. If you would like to receive a customized
projection, similar to the following, for your purchase,
please email Alan Cousill at alan@alpacas.com. All purchases
of less than $100,000 are 100% expensible in the year of
purchase. (Please consult your accountant to determine how
these benefits pertain to your actual taxable circumstances.)
FIVE YEAR AFTER TAX PURCHASE PROJECTIONThe total after tax cost of purchasing a $150,000
herd for taxpayers in the 45% bracket (state and federal) is
$106,798, spread over six years, including principal, interest,
and insurance.
CAPITAL IMPROVEMENTS
Capital improvements to your ranch can also be written off against
income. Barns, fences, pond construction, driveways, parking lots
all can be expensed over their useful life. Equipment such as
tractors, pickups, trailers and scales each have an appropriate
schedule for write off. The depreciation schedule for each asset
class varies from three years to forty years. A barn or special
purpose agricultural building can be written off pursuant to
Section 179 in the year it is put in service. If you do not chose
to write the barn off as a Section 179 asset then you can
depreciate it and take advantage of the bonus depreciation. To
qualify for a 179 deduction it must be put in service after May 5,
2003 and before 2005.
The original cost basis of an asset is reduced by the annual
amount of depreciation taken against the asset. Other costs add to
basis, such as certain improvements or fees on sale. The changes
to basis result in the adjusted cost basis of the asset. Upon sale
excess depreciation, previously expensed, must be recaptured at
ordinary income rates. The recapture rules are a bit complex, as
are most IRS rules, but the IRS Farmers Publication I've mentioned
explains them well.
CAPITAL GAINS VS. ORDINARY INCOME
When an asset is sold, say for instance a female alpaca, which was
purchased for breeding purposes and held for several years, the
gain or loss must be determined for tax purposes. If this alpaca
was purchased for $20,000 depreciated for two and a half years or,
say, 50% of its value, and then resold for $20,000, there would be
a gain for tax purposes of $10,000. In other words, your adjusted
costs basis is deducted from your sale price to determine gain or
loss.
Once you've determined the amount of a gain, you must classify it
as either ordinary income or capital gain. This year ordinary
income will be taxed at a maximum rate of, up to, 35% and capital
gains are taxed at rates of, up to, 15%. Previously these rates
were 39+% and 20% respectively. The sale of breeding stock
qualifies for capital gains treatment (excepting that portion of
the gain which is subject to depreciation recapture rules). Any
alpacas held for resale, such as newborn cria which you do not
intend to use in your breeding program, would be inventory and
produce ordinary income on sale. Animals born on your ranch and
held for breeding purposes, which usually involves holding them
for more than two years, can be taxed at capital gain rates on
sale. The capital gains treatment of sale proceeds are an
attractive benefit of raising alpaca breeding stock.
CHARITABLE DEDUCTIONS AND EXCHANGES
There are other tax-saving strategies that can be utilized in
concert with operating your farm. For instance, you are entitled
to claim a charitable deduction for the fair market value of a
capital asset, which you contribute to a qualifying charity or
institution. You can also exchange like for like (Section 1031)
assets and avoid the tax of a sale. An example of this strategy
would be a breeder who wanted to diversify his bloodstock. If he
sold his alpacas and simply bought more, he would be required to
pay tax on his gains. If he exchanged his alpacas for others,
there would be no tax due. Employing the exchange concept can be
very beneficial; for it to work efficiently; a third-party buyer
is usually introduced into the transaction. The model for this
type of transaction would be a real estate exchange. I'm sure your
C.P.A. would be familiar with the use of like kind exchanges and
how it might benefit you.
INSTALLMENT SALES
Installment sale rules allow you to defer income to future years.
If you sell an alpaca with credit terms, you can defer your gain
until you receive payment (excepting that portion of the gain
which is subject to depreciation recapture rules). If an animal
dies of disease and is insured, you can use the involuntary
conversion rules in the code. These rules allow tax-free
replacement of your animal.
CONCLUSION
Please bear in mind that I am not an accountant. This discussion
of tax issues omits a number of rules which will impact your
taxes. I did not discuss tax preference items, alternate minimum
taxes, employment taxes and other concepts of importance. Whether
we like it or not, this is a complicated world we live in; it
often requires CPA's and on occasion an attorney. Whatever
happened to the days when all you needed to farm was a mule, a
plow, and a strong back?
In summary, the major tax advantages of conducting an alpaca
business include the employment of expensing capital assets
depreciation, capital gains treatment, and the benefit of
offsetting your ordinary income from other sources with losses
from your farming business. Wealth building by deferring taxes on
the increased value of your herd is also a big plus. It pays to
keep your eye on the tax law changes instituted by Congress. On
occasion, like in the year 2003, you may find a silver lining in
the clouds of government.
In closing I wanted to let you know that the idea of taxes is not
new nor an exclusive sin of the United States Government. Caesar
Augustus decreed, in Roman times, "that all the world should
be taxed," The politicians have taken taxation to heart for
centuries. We have, on occasion though, been given good advice
about our responsibility to pay tax. The Honorable Supreme Court
Justice Learned Hand had the opportunity to instruct the IRS, in a
high court decision, that it was not a citizen's duty to conduct
himself so as to pay the maximum tax possible, but that a common
man might arrange his affairs so as to pay the least amount of tax
possible. God bless the judge, and God bless our alpacas!
