Vineyard Tax Workshop
Dr. Kent Fleming
Department of Applied Economics, OSU
January 15, 2015
OSU- SOREC
January 16, 2015
UCC - SOWI
January 20, 2015
OSU- Yamhill
1
Tax Avoidance
Workshop Purpose:
To help you make economic decisions that
will more likely lower your cost of income
tax, providing greater after-tax profitability in
the long run.
Tax evasion is a crime, but tax avoidance is good
farm management.
The Key
Key to lowering tax is to lower “taxable income”
• Taxable income: annual gross income minus
cash costs paid that year to produce that income minus
depreciation on the assets used that year to produce that
income.
• Depreciation of vineyard assets
most important way in which to lower your taxable income
because depreciation is not a simple, objective cash cost.
a financial concept that can be interpreted in different ways.
Financial Risk
• Always some uncertainty about your future vineyard
circumstances & the business environment in which must
operate => always some risk about how best to depreciate
your assets over time.
• Depreciation is a major financial risk.
• Risk cannot be eliminated but it can be can be managed with
better economic decision-making.
What is Depreciation?
• Assets that last longer than one production year are
depreciated over time rather than “expensed” during
the production year.
• Productive resources, such as fertilizer, are consumed
during the production cycle and are expensed, i.e.,
taken as a deduction (Line 17 in Sch. F) against the
farm’s gross income for that year.
• During production cycle a portion of the initial value of
the machinery and equipment asset was used up. This
amount should be deducted (as depreciation on line 14)
against the crop revenue to reduce the taxable income
and to better reflect net farm income.
The Choice
2 primary ways to depreciate assets:
• General Depreciation System (GDS) and
• Alternative Depreciation System (ADS).
• IRS expects you will use GDS = the default ,but
• Can opt-out & use the alternative , ADS.
One Advantage of GDS
• Allows you to depreciate more of you asset value
each year and to depreciate this value over a shorter
time period.
• In general, it will give you back more of your cash
investment sooner. Ultimately, in 20 or 30 years
when you have depreciated your asset down to zero,
ADS should give you the same cash value back as
GDS.
• The same amount of money in the end BUT when
receiving cash, sooner is better. (When paying out
cash, later is better.)
Time Value of Money (TMV)
If I am going to pay you $100, would you rather receive
it today or receive it in 20 years?
• Why?
Examples of the Dynamics of Depreciation
We will compare ADS and GDS by looking at the
consequence of using each of them over 10 years
when:
1. You have purchased a well-established mature
vineyard (Vineyard M) and
2. When you have purchased the same resources (land,
etc. but not the producing vines) and are
planting a new vineyard (Vineyard R.)
Scenarios
Mature Vineyard
(M)
Re-Planted
Vineyard (R)
General
Depreciation
(GDS)
M-G
R-G
Alternative
Depreciation
(ADS)
M-A
R-A
Example Vineyard
• Based on the OSU cost-and-returns
study of establishing and growing Pinot
Noir winegrapes on a 10-acre vineyard
in Western Oregon using typical best
management practices with current
expected yields, prices and costs.
• Additional assumptions:
– Umpqua Valley vineyard purchased in
2012.
– We are now looking at this year’s
(2014) tax return.
– Vineyard uses a higher yield and price
than OSU study.
Basic Assumptions
• OSU cost study: “Income tax consequences
are … ignored for this study.” But income tax is
just another cost of production.
• OSU study does not include everything
needed to calculate the taxable income.
• Enterprise budget & IRS Schedule F, “Profit or
Loss from a Farm,” compute annual loss in
investment’s value very differently.
• IRS uses depreciation -- enterprise budget
uses a capital cost recovery system.
What is Profit?
• Profit = “economic profit”
– “Economic profit” considers all cash expenses and
opportunity costs, i.e., non-cash expenses, for a
particular production cycle.
• IRS uses same term “profit” for something quite
different. Its profit = “taxable income.” Includes
all cash costs but does not include opportunity
costs.
What the IRS cares about…
• IRS does not care about real profit.
• IRS (and a banker) concerns are more financial:
– annual cash flow into the business less annual cash flow
out of the business less depreciation
– Depreciation, not a cash cost, is a somewhat arbitrary
estimated allowance for lost value of investment (using up
some of then asset) during production.
Which is better?
• Economic profitability of an enterprise is
critical for management because in the longrun, a sustainable farming operation must be
profitable.
• After-tax cash flow is important in short-run as
the take-home profit or disposable income.
Financing Assumption
• The purchase was financed with a $100,000 30-year mortgage
@ 6.5% interest per annum, secured by the land and the
existing land improvements and building.
• 2014 mortgage interest = $6,345; no other term debt.
• Operating line of credit @ 8.0%; 2014 interest = $920.
• No lease or rent of any land, vehicles, machinery or equip.
• Contracts grape harvesting (@ $170/ton) & hauling ($60/ton.)
Land Assumption
• Land not depreciable, but the land cost often includes
“hidden assets” that can be extracted from the purchase
price and treated appropriately
– Example: land improvements, such as roads and fences) can be
depreciated & AVA can be amortized .
• Difficult to make a convincing case for the value of
“hidden assets” SO seller and buyer should agree on
values at time of sale and/or a qualified land appraiser
called in to provide a relevant opinion.
Labor Expense
• Vineyard manager is owner/operator & supervises all vineyard activities.
• Farm labor hired at one of two hourly rates:
$17.00 for machine operators & $13.50 for general labor
(both include 34% payroll overhead.)
• 2014: 208.5 hrs. hand labor = $2,822/ac. & total vineyard = $28,215.
• 2014: 15.7 machine operator hrs. = $267/acre & $2,670 total.
• Total hired labor cost = $29,765.
• Labor contracted to hand harvest @ $170 per ton. In 2014 350 tons were
harvested for a vineyard total of $5,950.
• Hauling to crusher contracted @ $60 /ton. 2014: 350 tons x 60 = $2,100.
Annual cash overhead costs:
• Office expense: The cost for office supplies, telephones, bookkeeping,
accounting, legal fees, and misc. administrative charges and annual fees is
$1,600 ($160 /ac.)
• Utilities: Shop & office electricity at $15 /ac. = $150.
• Insurance: Property and liability insurance for the entire farm = $250
($25/ac.)
• Sanitation services: Vineyard portable toilets at $20 /ac. = $200.
• Vineyard manager’s salary (from above) = $0.
• Property taxes: A % of assessed value of equip., buildings, etc. at $30 /ac. =
$300.
• Crop insurance: Catastrophic coverage estimated at $50 ($5 /ac.).
• Vehicle expense: $530 (Pick-up use @ $35 + ATV use @ $18 /planted ac.)
• Investment repairs (including vine replacement): $100 /ac. = $1,000.
Total = $4,080 /year
The Purchase of Vineyard M Assets:
The buyer and seller, after some negotiation, agreed on the purchase valuation
of the various components. For both scenarios these assets are the same:
Land (10 acres @ $10,000/productive acre)
100,000
Land Improvements
600
Machinery & Equipment (a mix of used & new)
56,700
Building
1,200
Pumping Station (pump & well)
0
Sub-total basic resources = 158,500
The established Vineyard M assets also include:
Vines
Trellis & Drip Irrigation System (drip, filters, injectors
50,000
45,000
Sub-total other assets = 95,000
TOTAL Vineyard M =
$253,500
Completing the Schedule F
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
Line 10. Car & truck expense:
Line 11. Chemicals:
Line 13. Custom hire (machine work):
Line 14. Depreciation & amortization
Line 17. Fertilizer & lime:
Line 18. Freight & trucking:
Line 19. Gas, fuel & oil
Line 20. Insurance (other than health & crop):
Line. 21. Interest:
21a. Mortgage (paid to banks, etc.):
21b. Other [Operating line-of-credit]:
Line 22. Labor hired (less employment credits):
Line 25. Repairs and maintenance:
Line 28. Supplies:
Line 29. Taxes [property taxes]:
Line 30. Utilities [electricity]:
Line 32. Other expenses (specify):
32a. Office & grower assessment
32b. Sanitation services:
32c. Manager’s salary:
32d. Crop insurance:
32e. Investment repairs:
32f. Irrigation
$530
2450
5950
17919 not included in total cash costs below
100
2100
9810
250
6345
920
29765
480
40
300
150
2475
200
0
50
1000
540
Total cash costs = $63,138 /year
Calculating Depreciation
Step 1: Depreciation recovery period
• A “life” assigned to each general kind of asset.
given a common lifetime of service.
• For example, the machinery purchased as a part of
the farming operation is assigned a 7-year life.
• The vines, like all other fruit and nut orchards, are
considered to be 10-year property.
• The IRS assigns asset lives somewhat arbitrarily,
ignoring that these assets last longer in real life.
Step 2: Depreciation convention
• Conventional ways to estimate the length of
time an asset was in service for the first and
last year of its life.
• The “half-year convention” is popular because
it is simple to use. It takes half of the normal
depreciation in the asset’s first year of service
and half in its final year.
Step 3: Depreciation method
• Possible to take extra depreciation in the asset’s first year of
depreciation. Section 179 (abbreviated as “§179”) can only be taken
in 1st year the asset put into service; can be either new or previously
owned by another user.
• Not more than the year’s taxable income (and no more than
$500,000.) In the current analysis, §179 is always utilized to the
extent allowed.
• Vineyard M took $24,865 of §179 depreciation, the maximum
allowable give the taxable income in 2012. (2012 is the year the
vineyard was purchased.) Using §179 lowered the initial basis of the
Vines asset from its historic cost of $50,000 to an adjusted basis of
$25,135. Consequently, all the subsequent annual depreciation
amounts will also be lower. However, the net benefit to the grower
of using §179 is $2,588.
Step 4: Use the tables
• Easy way to calculate how much depreciation for year
• For example, to calculate the amount of depreciation on farm
machinery (7-yr. life) in 2014 (the farm’s 3rd year of operation):
go to page 43 of Pub. 225 and use Table 7.2, “150% DB Method
(Half-year Convention.)” Lookup the percentage in the 7-year
property class column and the Year 3 of service row: 15.03%.
• how much of the asset’s original value allowed to be taken in 2014.
The initial value of all farm machinery in the example vineyard is
$56,700.
• Therefore, 2014 depreciation amount is 15.03% of $56,700 = $8,522
Putting it All Together => “Taxable Income
Gross cash farm income =
$101,500
minus total cash costs, depreciation & amortization:
farming cash costs =
$63,138
GDS vineyard assets = 17,919
amortization of AVA =
800
Total operating expenses =
81,837
Net Farm Profit (or Loss) = 19,643
Calculate the Income Tax
The combined marginal IRS tax rate for this income
group is 25%. Since state tax (9% in Oregon) is
deductible on the federal return, the nominal state
rate can be reduced by the IRS rate. The combined
marginal tax rate is thus:
0.25 + ( (1.0 - 0.25) x .09) =
0.25 + 0.07 = 0.32 = 32%
Therefore, the 2014 tax liability to this point would
be 32% of $19,643 = $6,286.
Consider the Time Value of Money (TMV)
• These future values of the tax dollars paid (or saved) can
be discounted back to their present values (PV), using an
appropriate discount rate.
• A convenient discount rate is one’s average cost of
money, i.e., an average of the cost to borrow funds, say
10%, and an expected rate of return on equity, say 6%.)
• Discount the FV @ 8% and add up the resulting the PVs
for each year’s tax payment to determine the present
value of the total 10 years of tax payments.
Default (GDS) or Alternative (ADS)?
• Over the 10-year period being considered, the net
benefit of choosing to opt-out is
NPV of M-A minus the opportunity cost of not
using M-G.
• Given TVM and the timing of annual tax payments,
deciding to use the alternative costs $14,264 more
than staying with the default method .
• With a mature orchard GDS is better.
Bonus Depreciation
• Can only be taken on new property put into service
through 2014.
• §179 depreciation, if allowed, is taken before any 50%
bonus is taken. Therefore, §179 could reduce taxable
income to 0 & then 50% bonus could lower taxable
income further.
• All of Vineyard M’s assets purchased from previous
owner. They had already been put into service for the
first time. Therefore no bonus depreciation is allowed.
• But whether or not Vineyard R should use bonus
depreciation will be a major consideration …
Vineyard R: Replanting Grapevines
Stage 1. Pre-planting (land clearing, trellises, drip irrigation)
Stage 2. Planting (purchase & actual planting of rootstock)
Stage 3. Pre-productive (cultural practices involved in
maintaining & growing vines until vineyard produces a
commercially harvestable crop)
Stage 4. Productive
How Vineyard R differs from Vineyard M
• Vineyard R can be viewed as initially the same as Vineyard M in
terms of land, land improvements, farming equipment and buildings.
• The cost of these assets is $158,500. Vineyard R is valued lower than
M because Vineyard R ’s land preparations ($4,870) have not yet
been done, the trellis and drip irrigation systems ($67,500) are not
yet installed, and its grape vines are not yet planted ($61,680) or
established ($69,141.)
• Vineyard R’s new owner will be developing the vineyard and will
proceed through all four stages of development. Stages 1, 2 and 3
preproductive costs will total $203,191, increasing the Vineyard R
owner’s total preproductive investment to $361,691
Stage 1. Pre-planting:
Land preparation:
• The vines are removed after the fall 2011 harvest at a cost of
$487/acre or $4,870 toward total vineyard development.
• Add this land improvement to the existing land improvement asset
(roads, fences, etc.), which at the time of sale was valued at $60 per
acre. Land preparation includes removal of the old vineyard and any
additional land preparation costs necessary before the new vineyard
can be planted.
• Since the benefit of these various land improvements and field
preparations (which now totaling $547 per acre) will be realized over
the life of the vineyard, the total cost of the improvements ($5,470
for the whole vineyard) is included in the asset value of “Land
improvements” and subsequently depreciated accordingly.
Stage 1. Pre-planting:
Trellis & drip irrigation system:
• Before planting, Vineyard R ’s new owner
contracts to have the trellis & drip irrigation
system installed at a cost of $6,750 per acre or
$67,500 for the vineyard.
• This investment is a separate line item in the
depreciation schedule.
Stage 2. Planting
• The total planting cost is $6,168 /acre ($61,680 :
mark & layout vineyard ($39 materials + 30 hrs @ $13.50/hr.) =
$444 per acre
vine purchase ($5,290/acre)
planting labor to dig holes, plant vines, etc. (35 hrs. @
$13.50/ac.) = $473/ac.
•
• The IRS expects the grower to gather these
planting costs into the “Vines” asset and begin
depreciating it after commercial production
commences in the third year.
3. Pre-productive cultural costs (yrs 1 - 3):
Annual pre-production cultural costs (Stage 3),
recorded using similar IRS Schedule F cost
categories, =
$7,127/acre or $71,270 for the vineyard.
Stage 4: Production:
Vineyard development enters into Stage 4 with
the first “commercial” harvest.
Now all cultural costs of the 2 vineyard scenarios
are identical
Table 1 summarizes the farming costs:
Expense or capitalize pre-productive
viticultural costs?
Capital investment (multi-year):
• A capital expense is a payment, or debt incurred, for the
acquisition, improvement or restoration of an asset
having a useful life of more than one year. This expense
in included in the basis of the asset. Depreciation (cost
recovery) of the asset begins when the asset is placed in
service.
Operating expense (annual):
• An operating expense is a payment, or debt incurred, for
goods and services utilized within a production cycle,
usually lasting one year or less. (If some amount
remains after the production cycle, it is included in the
inventory available for use in the following year.)
Which way to go?
So you must decide whether:
•
– to capitalize the preproductive farming costs along with the depreciation
that would have been taken during this time. These are collected into a
“Vineyard Establishment” asset, a portion of which is deducted over the
life of the asset, or
•
– to deduct the pre-productive farming costs (that is, to write these costs off
each year as normal operating expenses reported on the Schedule F form)
•
• There are serious consequences of this decision,
consequences that you should be aware of and be
certain that they are in your best long-term interests.
• The main problem with ADS is that you cannot exercise
the 50% bonus depreciation option. Technically, an ADS
taxpayer can still make the 179 election
Summary Results I
• There really is no option to compare electing the
alternative rather than GDS plus the 50% “bonus”
depreciation all the assets were “used.”
• The NPV (the net benefit of choosing the alternative) is
a cost of $5,664. The alternative will result in paying
more income taxes than necessary.
• When purchasing a vineyard, it is highly unlikely that
using the alternative rather than the default method will
ever be the better option. If the 50% bonus depreciation
had been possible to use allowed, the default method
would certainly to be the better option.
Summary Results II
Vineyard R using ADS
• some of R’s assets are new and so + 50% option (B+) could be
allowable, and
• introduces the possibility to expense the establishment costs, by
opting-out of B, and thus possibly benefiting by the early large
depreciation amounts.
• However, If the taxpayer opts-out of the default, +50% is not
allowed.
• Technically §179 is still allowed in Ⓑ, but since there is no taxable
income in the year it would not be allowed. The net benefit of
electing to use the alternative = $628. (This comes from the
advantage of much greater depreciation in the earlier years.)
Summary Results II
Vineyard R using GDS
• However, unlike Ⓑ, B can use §179. When this extra depreciation of
$19,440 is included in the calculation, the net benefit of choosing the
alternative flips to a cost of $1,662.
• The difference is relatively close. When establishing or replanting a
vineyard, Ⓑ may turn out to be a better depreciation option than B, so the
specific choice between the two deserves to be analyzed carefully.
• However, when using the 50% bonus option in B+, the benefits are so great
that they overwhelm any possible benefit of using Ⓑ. In the current
situation the NPV cost /(benefit) to the grower of choosing Ⓑ is a cost of
$22,700., over $21,000 in saved income tax.
• Using the 50% bonus depreciation option, as long as it exists, will always be
better than expensing the vineyard establishment costs.
Concluding Remarks
• Rational economic decision-making about income tax
depreciation can help a vineyard manager avoid paying more
taxes than necessary.
• IRC provisions that accelerate the process of depreciation,
such as the 50% bonus option, provide methods with a
higher Net Present Value.
• They benefit growers by allowing them to use their limited
resources more productively to generate higher profitability.
• Whatever the macro-economic impact of the bonus might
be, there is little doubt that it can be an economic benefit
for winegrape growers.