Be aware of changes when calculating net operating losses and business interest expense
If there’s one thing that got through to the architects of last year’s tax reform, it’s that agriculture is not like other businesses.
Farming-related operations typically require significant assets and can be highly leveraged. Whether it’s for yearly operating costs, building a new grain bin or purchasing land, most ag producers access capital through bank loans, not by selling shares of stock or other forms of financing. And that borrowing creates sizeable interest expenses.
Ag businesses also depend on commodity prices that can swing sharply from year to year. Moreover, the industry operates on increasingly slim margins—an average 2 to 3 percent compared to, say, the 8 to 10 percent in the stock market.
Those unique circumstances are why agriculture received special treatment in two key areas under the Tax Cuts and Jobs Act of 2017:
1. Business interest expense.
2. Net operating loss.
Let’s take a closer look.
Under the old tax law, a business could deduct the interest from its loans. Under the new tax law, however, that deduction could be limited. For tax years beginning after Dec. 31, 2017, all businesses with average gross receipts over $25 million, regardless of its form, are limited in their net interest expense deduction to no more than 30 percent of the business’s adjusted taxable income, as represented by earnings before interest, taxes, depreciation and amortization.
In other words, here’s how it works under the new law: When your farming business calculates its EBITDA, you’ll multiply that figure by 30 percent. The resulting amount is the net interest expense you’re allowed to deduct.
While the typical farm won’t see annual gross receipts of more than $25 million, this limitation may indirectly impact you if you have an investment in a related, value-added business such as an ethanol plant, a feedyard, a processing or packing facility, a cotton gin. Those enterprises could easily surpass $25 million in gross receipts and be affected by this new interest expense limitation.
Why should businesses lose so much of the interest-expense deduction they once had? Tax reformers theorized that tax law should not incentivize debt capital over equity capital. Since interest expense is the result of debt capital, the deduction of that expense provides an incentive for debt capital. Also, if the entire cost of the capital asset (land not included) can be deducted using immediate expensing, then the decision to finance the purchase with debt should not provide an additional tax deduction for the interest expense.
But farmers, take heart. You have an option that allows you to deduct all the interest expense for your operation. Farming businesses can elect out of the business interest expense limitation, but you must use the Alternative Depreciation System to depreciate any property used in the farming business that has a recovery period of 10 years or more.
This option makes a lot of sense for those farming operations that have significant operating debt and few capital assets. Cattle feeders are a great example.
Please speak to your tax advisor about how this imitation could impact your farm operation. Have him or her explain the option to elect out of the rule.
If your business has more expenses than revenues in a year, that’s a net operating loss. It’s common in ag in certain years. The previous tax law allowed businesses to carry back that loss for two years and apply it to income—often leading to a refund from the government—or carrying it forward for many years. Farmers also had a sweetheart deal and could carry back their losses for five years.
That’s changed under the new law. NOL deductions are now limited to 80 percent of taxable income in subsequent years with unlimited carry forward. The NOL carryback provisions have been repealed—expect for farming NOLs, which are now permitted a two-year carryback. Losses prior to 2018 are grandfathered in, so this rule doesn’t apply to those amounts.
The new tax law has several layers of complexity. If you have a hard time wrapping your head around how these changes will affect your farming operation, reach out to an expert for help. These days, every deduction and every dollar count. Be sure you’re getting out on the right foot with these new provisions.
Editor’s note: Doug Claussen can be contacted at [email protected].
