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Why Not Have Uncle Sam Help You Buy Your Alpacas
By Mike Safley
Raising alpacas can offer the farmer some very
attractive tax advantages. If they are raised for profit, all
the expenses attributable to the endeavor can be written off
against your income. Expenses would include not only feed, fertilizer,
veterinarian care, etc., but depreciation of such tangible property
as breeding stock, barns, and fences, which help shelter current
cash flow from tax. Beyond these basics there are several strategic
tax advantages for the alpaca farmer.
In fact, Uncle Sam will pay for a portion of the
cost of acquiring your herd, assuming you are currently paying
income tax and plan to continue paying income tax over the next
six years. If you are in the 50% tax bracket, the deductions
for depreciation that the animals are eligible for may save
you 50% or more, in cash, of your original purchase price, over
six years. In the example found later in the article, a person
purchasing a herd for $100,000 would have an after-tax cost
of only $56,258, if they paid cash for their animals and owned
them for six years.
I recommend that you engage an accountant for
advice in setting up your books and determining the proper use
of the concepts discussed in this article. The aim of this discussion
of IRS rules is to make you more conversant with the issues
of taxation.
Tax Defferred Wealth Building
Alpaca breeding also allows for wealth building,
while deferring tax on your investment’s increased value.
A small farmer can purchase several alpacas and then allow their
herd to grow over time without paying tax on its increased size
and value. If the same amount of money was invested in a Certificate
of Deposit, any interest earned would be currently taxable.
In addition, the C.D. could not be depreciated, thereby offsetting
the amount of tax due.
IRS Code Section 179 Deduction
This deduction is available every year when you
purchase certain assets, assuming that you have not used the
deduction on a computer or some other qualifying asset. Many
people do not understand that you can use this deduction to
write off your purchase of up to $24,000 worth of alpacas annually.
This following example takes into consideration IRS code section
179. (If you would like a copy of the code section, please give
us a call at 503-628-3110.
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| Purchase price (one or more alpacas): |
$24,000 |
| Section 179 tax deduction |
(24,000) |
| Tax savings 50% (tax bracket 50%) |
(12,000) |
| Actual after tax cost out of pocket |
$12,000 |
In other words, if you are in the 50% tax bracket,
the government will reduce your taxes by 50% of the cost of
$24,000 worth of alpacas each year. This deduction is available
for all taxpayers. To see how much this will benefit you, simple
calculate your tax bracket and multiply it by the amount of
your purchase up to $24,000. The amount of this deduction is
scheduled to go higher in future years.
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 255, Farmers 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 fulltime 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!
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 34.5 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 and
real property improvements, such as 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 20 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.
Alpaca 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 (MACRS) which allows
animals to be written off as follows: 20% year 1, 32% year 2,
19.2% year 3, 11.52% years 4 and 5, and 5.76% 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 of 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 $100,000. In this scenario, we will assume you are
in the 50% overall tax bracket, use the section 179 deduction
in year one, use the MACRS depreciation method, finance the herd
at 7% interest for four years, and insure the herd for the balance
owed after a 30% down payment.
Five Year After Tax
Purchase Projection |
| |
Year 1 |
Year 2 |
Year 3 |
Year 4 |
Year 5 |
Year 6 |
| 1. Purchase price |
100,000 |
--- |
--- |
--- |
--- |
--- |
| 2. Down payment |
30,000 |
--- |
--- |
--- |
--- |
--- |
| 3. Section 179 deduction |
(
24,000) |
--- |
--- |
--- |
--- |
--- |
4. Interest
7% on balance
due beginning of year |
(
4,900) |
(
3,920) |
( 2,940) |
( 1,960) |
-0- |
-0- |
5. MACRS (20%, 32%,19.2%,
11.52%, 11.52%,
and 5.76%)
Depreciation $76,000 |
(15,200) |
(24,320) |
(14,592) |
( 8,755) |
( 8,755) |
( 4,277) |
| 6. Insurance 3% $70,000 |
( 2,100) |
( 2,100) |
( 2,100) |
( 2,100) |
( 2,100) |
( 2,100) |
|
7. Principal
payment 1/5
of $70,000 |
( 17,500) |
( 17,500) |
( 17,500) |
( 17,500) |
-0- |
-0- |
| Total
tax deduction (items 3, 4, 5, 6) |
( 46,200) |
(30,340) |
(19,632) |
(12,815) |
(10,855) |
( 6,377) |
| Total
tax saving 50% |
( 23,100) |
( 15,170) |
( 9,816) |
( 6,407) |
( 5,427) |
( 3,188) |
| Total cash invested (lines 2, 4, 6, 7) |
54,500 |
23,520 |
22,540 |
21,560 |
2,100 |
2,100 |
Cash out of pocket
Net after tax each year |
31,400 |
8,350 |
12,724 |
15,152 |
( 3,327) |
(
1,088) |
| Cumulative
after Tax Cost |
$31,400 |
$39,750 |
$52,474 |
$67,626 |
$64,299 |
$63,211 |
|
Principal
balance end of
year on contact |
|
EOY
Year 1
52,500 |
EOY
Year 2
35,000 |
EOY
Year 3
17,500 |
EOY
Year 4
-0- |
EOY
Year 5
-0- |
The total after tax cost of purchasing a $100,000
herd for taxpayers in the 50% bracket is $63,211, spread over
six years, including principal, interest, and insurance.
Cash Purchase
This scenario assures you pay cash and make the same assumption
on depreciation and insurance as above.
|
Five Year After Tax Purchase Project |
| |
Year 1 |
Year 2 |
Year 3 |
Year 4 |
Year 5 |
Year 6 |
| 1. Purchase price |
100,000 |
--- |
--- |
--- |
--- |
--- |
| 2. Down payment |
100,000 |
--- |
--- |
--- |
--- |
--- |
|
3. MACRS Depreciation $76,000 |
(15,200 |
(24,320) |
(14,592) |
( 8,755) |
( 8,755) |
( 4,377) |
| 4. Section 179 Deduction |
( 24,000) |
--- |
--- |
--- |
--- |
--- |
|
5. Insurance |
( 2,100) |
( 2,100) |
( 2,100) |
( 2,100) |
( 2,100) |
( 2,100) |
| Total tax deduction Line
3, 4, 5 |
( 41,200) |
( 26,420) |
( 16,692) |
( 10,855) |
(
10,855) |
(
6,477) |
|
Total tax savings 50% bracket |
( 20,650) |
( 13,210) |
( 8,346) |
( 5,427) |
( 5,427) |
( 3,282) |
| Total cash invested |
102,100 |
2,100 |
2,100 |
2,100 |
2,100 |
2,100 |
Cash out of pocket
Net after tax each year |
81,450 |
( 11,110) |
( 6,246) |
( 3,327) |
( 3,327) |
( 1,182) |
| Cumulative total cost After tax savings |
$81,450 |
$70,340 |
$64,094 |
$60,767 |
$57,440 |
$56,258 |
The after tax cost of the same six alpacas costing $100,000 is
$56,258, after five years, if you pay in cash. In other words,
the government pays you back $43,742 of your initial $100,000
investment plus insurance in the form of tax savings.
The one thing to keep in mind is that you only receive the tax
benefits of a $43,742 write-off if you are a taxpayer in the
50% bracket for each of the six years.
Capital Improvements
Capital improvements to your ranch can also be written off against
income. Barns, fences, pond construction, driveways,and 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 40 years.
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 cost 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 is currently taxed at a maximum rate of up to 39.1%
and capital gains are taxed at rates of up to 20%. In
2002, the income tax drops slightly. 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 Exchange
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 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 beneficia. 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 CPA 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 a CPA 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 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, 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!
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