If your taxable income was low or negative in a given year, don't waste that bottom tax bracket with its nice low marginal rate. Capture it with an optional inventory adjustment - and reduce your exposure to higher marginal rates in future years.
For example, 2003 was a very bleak year for many farmers. Farm income dropped significantly for cattle producers, grain growers, and hog producers. Many recorded significant losses for that year. When completing the 2003 tax returns, producers with very low income or losses should have considered income tax elections like the Optional Inventory Adjustment (OIA) to help ensure their best tax position.
The extent to which farm losses are fully deductible, partially deductible, or non-deductible from other non-farming income depends on the nature of your business. If farming is your main source of income, your losses are fully deductible. Losses can be carried back 3 years or forward 20 years to be applied against income from all sources.
Losses are partially deductible if farming is not your chief source of income, but your farm is still operated as a commercial business. If your off-farm income is greater than your farm income and you had a net farm loss, the loss you can deduct depends on the amount of your net farm loss. For example, if your net farm loss is $15,000 or more you can deduct a maximum of $8,750 from your other income. These "restricted" farm losses can also be carried back 3 years or forward 20 years but only against positive net farm income.
Finally, if you do not operate your farm as a business for profit, your farm losses are non-deductible from other income.
If you follow the cash basis of accounting and your 2012 income is very low or negative, consider taking an OIA. It is designed to help you average out your income from year to year, and it applies to your inventory on hand at year-end.
In this context, farm inventory is defined as items held by your business that will either be consumed by the business or sold to customers. It is tangible property such as harvested grain held for sale; seed or feed used in the production of salable goods, and standing crops or feeder livestock in the process of being produced. Purchased inventory is inventory you have bought and paid for - the coming season's seed or fertilizer for example.
In making an OIA, you can opt to increase your income for the current year by any amount up to the fair market value (FMV) of inventories you have on hand minus the mandatory inventory adjustment (MIA) (see below). Then, in the next fiscal year when hopefully your income is higher, you will deduct the amount of the OIA from income, in effect reducing that year's net income which would be taxed at a higher rate. In other words, an OIA will let you access the full bottom tax bracket in both 2011 and 2012 (table). If 2012's farm income remains low you can elect an OIA amount for 2012 to benefit 2013.
Obviously it's best to make an OIA in a year of low income when you feel next year's income is going to be significantly higher. In choosing the OIA amount, you want to increase your income at least to a point where you can use up all of your non-refundable tax credits, such as your basic exemption, age exemption, spousal exemption and credits such as disability and medical. These amounts cannot generally be carried forward, so it's a question of either using them in a given year or losing them.
Save taxes with optional inventory adjustment
|2011||2012||Total tax payable|
|Farming income (based on year-end inventory)||$100,000|
|Optional inventory adjustment||30,000||(30,000)|
|Total tax savings $3,461 ($26,243-22,782)|
In addition, you should consider bringing your current year's income up to the higher end of the lowest tax rate bracket (15% federally for taxable incomes under $42,707for 2012).
If you have a cash loss in 2012, you must decrease this loss to the extent of purchased inventory still on hand at the end of the year. This Mandatory Inventory Adjustment (MIA) is calculated by adding to income the lesser of the loss amount (including recaptured depreciation and capital cost allowance) and the FMV of purchased inventory such as livestock, feed, fertilizer, fuel and other supplies on hand. In your next fiscal year, you will deduct from your farm income the MIA you added to your net loss in 2012.
For MIA purposes, inventory is generally valued at the lower of its original purchase price and FMV. Specified animals are valued at their original purchase price less 30% per annum on a diminishing balance basis, unless you elect to value them at a greater amount not exceeding their original cost. All horses are specified animals; cattle registered under the Livestock Pedigree Act may also be treated as specified animals at a taxpayer's option.
Regardless of what you opt to do in 2012, be cautious of tax deferrals over an extended period. If you actually have a profit each year, deferral simply pushes income forward to the future. And when you retire or sell your business, you may have accumulated a significant tax deferral and a large accompanying tax liability. It's usually best to have a tax strategy to maintain the lowest possible tax rate each year and spread your liabilities over time. Timely use of OIA can help here.