Vineyard Tax Workshop

Dr. Kent FlemingDepartment of Applied Economics, OSU

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January 15, 2015OSU- SOREC

January 16, 2015UCC - SOWI

January 20, 2015OSU- Yamhill

Tax Avoidance

Tax evasion is a crime, but tax avoidance is good farm management.

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.

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.

• 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.

What is Depreciation?

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.)

If I am going to pay you $100, would you rather receive it today or receive it in 20 years?

• Why?

Time Value of Money (TMV)

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.)

Examples of the Dynamics of Depreciation

Scenarios

Mature Vineyard (M)

Re-Planted Vineyard (R)

General Depreciation

(GDS)M-G R-G

Alternative Depreciation

(ADS)M-A R-A

• 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.

Example Vineyard

• 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.

Basic Assumptions

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.

• Economic profitability of an enterprise is critical for management because in the long-run, a sustainable farming operation must be profitable.

• After-tax cash flow is important in short-run as the take-home profit or disposable income.

Which is better?

• 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.)

Financing 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.

Land Assumption

• 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.

Labor Expense

• 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

Annual cash overhead costs:

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) 100,000Land Improvements 600

Machinery & Equipment (a mix of used & new) 56,700Building 1,200

Pumping Station (pump & well) 0 Sub-total basic resources = 158,500

The established Vineyard M assets also include:Vines 50,000Trellis & Drip Irrigation System (drip, filters, injectors 45,000

Sub-total other assets = 95,000

TOTAL Vineyard M = $253,500

The Purchase of Vineyard M Assets:

• Line 10. Car & truck expense: $530• Line 11. Chemicals: 2450• Line 13. Custom hire (machine work): 5950• Line 14. Depreciation & amortization 17919 not included in total cash costs below• Line 17. Fertilizer & lime: 100• Line 18. Freight & trucking: 2100• Line 19. Gas, fuel & oil 9810• Line 20. Insurance (other than health & crop): 250• Line. 21. Interest:• 21a. Mortgage (paid to banks, etc.): 6345

21b. Other [Operating line-of-credit]: 920• Line 22. Labor hired (less employment credits): 29765

Line 25. Repairs and maintenance: 480• Line 28. Supplies: 40• Line 29. Taxes [property taxes]: 300• Line 30. Utilities [electricity]: 150• Line 32. Other expenses (specify):• 32a. Office & grower assessment 2475• 32b. Sanitation services: 200• 32c. Manager’s salary: 0• 32d. Crop insurance: 50• 32e. Investment repairs: 1000• 32f. Irrigation 540

Total cash costs = $63,138 /year

Completing the Schedule F

• 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.

Calculating Depreciation Step 1: Depreciation recovery period

• 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 2: Depreciation convention

• 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 3: Depreciation method

• 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

Step 4: Use the tables

Gross cash farm income = $101,500minus 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

Putting it All Together => “Taxable Income

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.

Calculate the Income Tax

• 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.

Consider the Time Value of Money (TMV)

• 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.

Default (GDS) or Alternative (ADS)?

• 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 …

Bonus Depreciation

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

Vineyard R: Replanting Grapevines

• 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

How Vineyard R differs from Vineyard M

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 1. Pre-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.

Stage 2. Planting

Annual pre-production cultural costs (Stage 3), recorded using similar IRS Schedule F cost categories, =

$7,127/acre or $71,270 for the vineyard.

3. Pre-productive cultural costs (yrs 1 - 3):

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:

Stage 4: Production:

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.)

Expense or capitalize pre-productive viticultural costs?

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

Which way to go?

• 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 I

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.

Summary Results II

• 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.

Concluding Remarks