Farmers are included among a select few taxpayers who are allowed to utilize the "cash method" of accounting for tax purposes. The vast majority of taxpayers are required to use the "accrual method."

Most professionals view the ability to utilize the cash method of accounting for tax purposes as an opportunity. In general, I agree; however, be warned that if mismanaged or abused, the cash method could prove to be very costly in the end.

Simply defined, under the cash method you are required to include income in the year it is actually received and deduct expenses in the year that they are paid. You are not required to include as income amounts owed to you at the end of the year (accounts receivable), nor are you allowed to deduct expenses incurred that have not been paid (accounts payable). On top of that, you are not required to record your change in inventory as an income or expense item for the year.

Pros

  • Effectively manage your taxable income
  • Simpler and easier to understand – minimizing mistakes and surprises
  • Moderate income swings and average income:
    • Ability to prepay certain input costs or purchase inventory
    • Ability to carry inventory into the new tax year and defer the tax

Cons

  • Proper planning takes time and will generate additional accounting costs
  • Post year-end options are limited (no ability to accrue wages or bonuses)
  • Negative tax consequences may prevent farmers from making proper marketing decisions
  • Financing prepayments and inventory purchases may be an issue

Tips

  • Understand your industry: The dairy industry is not as volatile as other sectors. Income is generally quite consistent, and large swings in income are not as common.
  • Understand your business: Determine what income the business makes available to you and what uses you have for that income (loan payments, cost of living, capital purchases, tax).
  • Pick the brain of your accountant:
    • Understand the pros and cons of various business structures (proprietorship, partnership, corporation).
    • Gain a basic understanding of tax brackets and rates (very different depending on structure).
    • Look for alternative methods for managing your tax bill. Deferring income by abusing or mismanaging the opportunities the cash basis provides may end up costing you money.
    • Consideration should be given to managing the rate of tax not the amount of tax.

Traps

  • Paying little or no tax year over year is very attractive. Beware of the consequences.
  • The supply-managed sector is very capital intensive. The tax deductions afforded you by purchasing quota will over time no longer offset the income generated. Tax deferral achieved by using cash basis opportunities to defer tax is not a long-term solution.
  • Profitable businesses will be forced to spend more and more money year over year to defer taxes. Financing this may become a problem.
  • Consider the consequences of having to bring all of the deferrals into income in one year (death, disability, etc.). The likelihood of paying a much higher rate of tax than you would have if you had not deferred is very high.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.