NEWS for North Dakotans
Agriculture Communication, North Dakota State University
7 Morrill Hall, Fargo, ND 58105-5665

March 16, 2000

NDSU Tax Expert: Take a Year-Round Approach to Income Tax Planning

Employees and the self-employed. Rural and urban residents. One personal responsibility many of these people share is their role as taxpayers. Here's another: Regardless of how or where North Dakotans earn their incomes, they should be thinking about state and federal taxes year-round, not just on the days leading up to the filing deadline, says a tax professor at North Dakota State University.

"Taxpayers who plan throughout the year will pay less tax than those who only do year-end planning or who don't plan at all," says Terry Knoepfle, an associate professor of taxation and business law at NDSU. "Making the right moves, from a tax-planning standpoint, can save hundreds and perhaps even thousands of dollars in taxes."

Saving for retirement is one area that provides many tax-reducing opportunities. For example, employees should maximize their contributions to employer savings plans such as a 401 (k). Self-employed taxpayers, including farmers and ranchers, should be utilizing a Keogh or a Simplified Employee Pension (SEP) plan.

Knoepfle says, "Both the 401 (k) and the Keogh or SEP plans involve pretax dollars and will directly reduce an individual's income tax obligation. A key with either type of plan is to make the contributions as early in the year as possible. The sooner you start sheltering income from taxes, the better."

Another savings option is the Roth Individual Retirement Account (IRA), Knoepfle says. Even though investors must contribute post-tax dollars and therefore can't claim a current-year income tax deduction, all subsequent growth and earnings are tax-free upon withdrawal.

Timing the sale of investments such as stocks and mutual funds can also reduce income taxes. Investors who hold onto securities longer than 12 months will benefit from more favorable tax rates, Knoepfle says.

Likewise, the flexible spending accounts (FSAs) offered by employers provide tax advantages for employees. Knoepfle explains, "An FSA uses pretax dollars to pay for medical and dependent care. If a person's combined federal and state tax rate is 40 percent, then contributing $3,000 to an FSA would produce $1,200 in tax savings."

One more point employees should not overlook when considering their tax situation is their rate of payroll withholding. Knoepfle says it's advisable not to use withholding as a way to save because the federal government doesn't pay interest on that money.

"Ag producers really need to have an experienced tax advisor who they can consult year-round," Knoepfle says. "And this advisor should have expertise in farm tax matters."

Knoepfle offers ag producers the following tax tips:

• Do recordkeeping and other types of documentation work on an ongoing basis rather than sporadically. Keep farm and personal records separate. Knoepfle says, "Producers need good records not only for the preparation of tax returns and financial statements but also to plan for deferral and acceleration of income and expenses.
• Keep income balanced from year to year. "This strategy will save taxes over time and can make income averaging more advantageous," Knoepfle says. In high-income years, prepay expenses and defer income. In low-income years, defer payment of expenses as long as possible without jeopardizing creditworthiness while accelerating sales to bolster income.
• Income averaging allows producers to spread income over the prior three years. Knoepfle says this strategy is most beneficial when three low-income years are followed by a high-income year. In addition, those who are retiring can use income averaging to manage the sale of farm machinery.
• Gift commodities to children for them to sell at their lower tax rate (and in some situations, at the lower capital gains rate). Knoepfle says this strategy also reduces income and self-employment taxes for the parents.
• Hire family members, both children and spouse. Knoepfle says, "The advantages are that you can transfer income to the child's lower bracket and pay no FICA (Social Security) taxes if the child is younger than 18. Also, you can use Section 105 with a spouse on the payroll, which results in being able to deduct medical expenses for the parents and dependents." But to satisfy Internal Revenue Service requirements, producers must maintain a true employer-employee relationship with their families; one way to substantiate this relationship would be through an employment contract. Also, the salary must be reasonable for the work performed, and producers will need to maintain and file quarterly and annual employment reports.
• Pay children with commodities instead of cash. This strategy allows producers with dependents 18 and older to avoid paying FICA taxes. But Knoepfle says there are strict IRS guidelines to follow, and producers contemplating this option should consult a professional tax planner.
• Gift commodities instead of cash to charities. Knoepfle explains, "Most farmers and ranchers don't get to claim their charitable contributions because they don't itemize. Producers can forego income tax and self-employment taxes on the commodities they gift."
• When replacing assets such as machinery, consider the tax benefits of trade-ins. Knoepfle says trading avoids paying income tax on the ordinary gain that results from selling outright fully depreciated assets.

General information regarding such topics as IRAs and other educational materials involving family resource management are available through county offices of the NDSU Extension Service.

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Source: Terry Knoepfle (701) 231-7549
Editor: Dean Hulse (701) 231-6136