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RAISING ALPACAS WITH YOUR PARTNER, THE IRS
by Mike Safley of Northwest Alpacas
America's forefathers were uniformly against taxation. Indeed our nation sprang
from ancestors who refused to send King George the tax he felt was due from the colonies. Today we have only one
alternative to paying taxes--death. But this is not to say that we can't arrange our affairs to pay the least possible
amount of tax to our revenue-hungry government. Alpaca farming can help you reach that goal.
Raising alpacas can offer the farmer some very attractive tax advantages. If they are raised for profit, all
the expenses attributable to the endeavor can be written off against your income. Expenses would include not only
feed, fertilizer, veterinarian care, etc., but depreciation of such tangible property as breeding stock, barns,
and fences, which help shelter current cash flow from tax. Beyond these basics are several strategic tax advantages
for the alpaca farmer.
Alpaca breeding allows for wealth building, while deferring tax on your investment's increased value. A
small farmer can purchase several alpacas and then allow his herd to grow over time without paying tax on its increased
size and value. If the same amount of money was invested in a Certificate of Deposit, any interest earned would
be currently taxable. In addition, the C.D. could not be depreciated, thereby offsetting the amount of tax due.
The tax law recently proposed by President Clinton includes provision for a lower tax rate on capital gain
than on ordinary income. Alpacas held as breeding stock can be sold and the proceeds taxed at the lower capital
gains rate. I have been involved in the investment market for over twenty years; I've seen assets gain and lose
value due to tax legislation. Investment real estate, for instance, lost considerable value as a result of the
1986 tax laws which were passed by Congress. Most people's taxes were lowered and most tax shelters were eliminated.
With increased taxes as the order of day, I would speculate that the tax advantages attributable to alpacas will
tend to make them more valuable in the near future.
I recommend that you engage an accountant for advice in setting up your books and determining the proper
use of the concepts discussed in this article. The aim of this discussion of
I.R.S. rules is to make you more conversant
in the issues of taxation.
The first step in qualifying for favorable tax treatment as a farmer is establishing that you are in business
to make a profit. You cannot raise alpacas as a hobby farmer and receive the same tax preferences as a for profit
farmer. A farming operation is presumed to be for profit if it has reported a profit in three of the last five
tax years, including the current year.
If you fail the three years of profit test, you may still qualify as a "for profit" enterprise if
your intention is to be profitable. Some of the factors considered when assessing your intent are:
You operate your farm in a businesslike manner. The time and effort you spend on farming indicates you intend
to make it profitable. You depend on income from farming for you livelihood. Your losses are due to circumstances
beyond your control or are normal in the start-up phase of farming. You change your methods of operation in an attempt to improve profitability. That you make a profit from farming
in some years and how much profit you make. You or your advisors have the knowledge needed to carry on the farming
activity as a successful business. You made a profit in similar activities in the past. You are not carrying on the farming activity for personal
pleasure or recreation.
You don't have to qualify on each of these factors--the cumulative picture drawn by your answers will provide
the determination.
One of the frustrating factors in dealing with the IRS rules is getting to a definitive answer. The code
is often more grey, than black or white; consider the following statement which is found in IRS publication 225,
Farmers Tax Guide.
"This publication covers some subjects on which a court may have made a decision more favorable to
taxpayers than the interpretation of the Service. Until these differing interpretations are resolved by higher
court decisions or in some other way, this publication will continue to present the interpretation of the Service."
I recommend everyone who farms alpacas obtain a copy of this handy guide at your local IRS office. It is
very informative.
I must confess, I don't like to pay taxes; I always do, but I'm never happy about it. I inherited this bias,
I believe, from my father. Dad, for those who don't know him, is always fully convinced of his beliefs, and he
believes that IRS agents are the bad guys.
Dad was one of the first full time llama farmers in the U.S. to be audited by the IRS. It was quite a task
to prove to the agent who conducted Dad's audit that llamas were in fact a profit making enterprise. The agent
decided that before he completed his review of Dad's tax return, he wanted to see these llamas with his own eyes;
just to make sure, of course, that everything was on the up and up.
After much negotiating between my dad's accountant and the agent, it was agreed that the agent could view
the llamas from the road in front of Dad's farm; he wasn't to be allowed on the property. When the fateful day
arrived, Sam, the IRS agent, appeared at the fence in front of Dad's ranch. It wasn't long before Bonnie, his big
black llama, wandered up to the fence and offered Sam a kiss. I still to this day believe that my dad's audit is
the only one ever closed as a result of a llama's kiss. Thank God, she didn't spit!
Once you've established that you are farming alpacas with the intent to make a profit, you can deduct all
qualifying expenses from your gross income. The discussion from here forward presumes you are a cash basis taxpayer
and you keep good records. Accrual basis tax payers would also be allowed the same tax treatment, but their timing
might be different.
First, the following items must be included in your gross income calculations:
1. Income from the sale of livestock
2. Income from sale of crops, i.e., fiber
3. Rents
4. Agriculture program payments
5. Income from cooperatives
6. Cancellation of debts
7. Income from other sources, such as services 8. Breeding fees
Then the following expenses may be deducted from this income:
1. Vehicle mileage at 28 cents a mile for all farm business miles
2. Fees for the preparation of your income tax return farm schedule
3. Livestock feed
4. Labor hired to run and maintain your farm (remember, you must not deduct the expense of maintaining your personal
residence)
5. Repairs and maintenance
6. Interest
7. Breeding fees
8. Fertilizer
9. Taxes and insurance
10. Rent and lease costs
11. Depreciation on animals used for breeding, real property improvements such as barns and equipment
12. Farm-related travel expenses
13. Educational expenses, which improve your farming expertise 14. Advertising
15. Attorney fees
16. Farm fuel and oil
17. Farm publications
18. AOBA dues
19. Miscellaneous chemicals i.e. weed killer
20. Vet care
21. Small tools having a useful life of less then one year
Please note: Personal and business expenses must be allocated between farm use and personal use, for instance,
with such expenses as telephone, utilities, property taxes, accounting, etc. Only the farm use portion can be expensed.
Once you've determined your net income or loss, it is included on your tax return as an addition to or a
deduction from your ordinary income. Losses can be carried back for three years and forward for 15 years. To deduct
any loss, you must be at risk for an amount equal to or exceeding the losses claimed. The "at risk" rules
mean that the deductible loss from an activity is limited to the amount you have at risk in the activity. You are
generally at risk for:
1. The amount of money you contribute to an activity
2. The amount you borrow for use in the activity
You must establish the cost basis of your assets for tax purposes. This basis is used to determine the gain
or loss on sale of an asset and to figure depreciation. In determining basis, you must follow the uniform capitalization
rules found in the IRS code. Animals raised for sale are generally exempt from the uniform capitalization rules,
and there are other exceptions for certain farm property. You need to become familiar with these rules.
Once you've established the cost basis of your various assets, you take a charge for depreciation against
your annual income. This process allows you to expense the historic cost of an asset to offset present income.
The effect is to create non-taxable cash flow on a current basis. This benefit is especially attractive in an environment
of higher taxes.
Alpacas, in which you have cost basis, can be written off over five years if they are being held as breeding
stock. There are several methods of writing them off, beginning with the straight line method which allows you
to deduct one-fifth of their cost each year, except the first year, in which the code allows for only six months
of write-off. There are also several accelerated schedules which allow for a larger percentage of the asset to
be written off early. Alpacas born at your ranch have no cost basis and cannot be written off, although they may
qualify for capital gain treatment on sale.
Capital improvements to your ranch can also be written off against income. Barns, fences, pond construction,
driveways, parking lots all can be expensed over their useful life. Equipment such as tractors, pickups, trailers
and scales each have an appropriate schedule for write off. The depreciation schedule for each asset class varies
from three years to forty years.
The original cost bases of an asset is reduced by the annual amount of depreciation taken against the asset.
Other costs add to basis, such as certain improvements or fees on sale. The changes to basis result in the adjusted
cost basis of the asset. Upon sale excess depreciation, previously expensed, must be recaptured at ordinary income
rates. The recapture rules are a bit complex, as are most IRS rules, but the IRS Farmers Publication I've mentioned
explains them well.
When an asset is sold, say for instance a female alpaca, which was purchased for breeding purposes and held
for several years, the gain or loss must be determined for tax purposes. If this alpaca was purchased for $20,000
depreciated for two and a half years or, say, 50% of its value, and then resold for $20,000, there would be a gain
for tax purposes of $10,000. In other words, your adjusted costs basis is deducted from your sale price to determine
gain or loss.
Once you've determined the amount of a gain, you must classify it as either ordinary income or capital gain.
Ordinary income is currently taxed at a maximum rate of, up to, 31 percent and capital gains are taxed at rates
of, up to, 28 percent. The sale of breeding stock qualifies for capital gains treatment (excepting that portion
of the gain which is subject to depreciation recapture rules). Any alpacas held for resale, such as newborn cria
which you do not intend to use in your breeding program, would be inventory and produce ordinary income on sale.
If the present administration is successful at raising the tax on ordinary income to 39 percent and capital gains
remain taxable at 28 percent, the capital gains treatment of sale proceeds will become an attractive benefit of
raising alpaca breeding stock.
There are other tax-saving strategies that can be utilized in concert with operating your farm. For instance,
you are entitled to claim a charitable deduction for the fair market value of a capital asset, which you contribute
to a qualifying charity or institution. You can also exchange like for like assets and avoid the tax of a sale.
An example of this strategy would be a breeder who wanted to diversify his bloodstock. If he sold his alpacas and
simply bought more, he would be required to pay tax on his gains. If he exchanged his alpacas for others, there
would be no tax due. Employing the exchange concept can be very beneficial; for it to work efficiently, a third-party
buyer is usually introduced into the transaction. The model for this type of transaction would be a real estate
exchange. I'm sure your C.P.A. would be familiar with the use of like kind exchanges and how it might benefit you.
Installment sale rules allow you to defer income to future years. If you sell an alpaca with credit terms,
you can defer your gain until you receive payment (excepting that portion of the gain which is subject to depreciation
recapture rules). If an animal dies of disease and is insured, you can use the involuntary conversion rules in
the code. These rules allow tax-free replacement of the your animal.
Please bear in mind that I am not an accountant. This discussion of tax issues omits a number of rules which
will impact your taxes. I did not discuss tax preference items, alternate minimum taxes, employment taxes and other
concepts of importance. Whether we like it or not, this is a complicated world we live in; it often requires CPA's
and on occasion an attorney. Whatever happened to the days when all you needed to farm was a mule, a plow, and
a strong back.
In summary, the major tax advantages of conducting an alpaca business include the employment of depreciation,
capital gains treatment, and the benefit of offsetting your ordinary income from other sources with losses from
your farming business. Wealth building by deferring taxes on the increased value of your herd is also a big plus.
It pays to keep your eye on the tax law changes instituted by Congress. On occasion, you may find a silver lining
in the clouds of government.
In closing I wanted to let you know that the idea of taxes is not new nor an exclusive sin of the United States
Government. Caesar Augustus decreed, in Roman times, "that all the world should be taxed," The politicians
have taken taxation to heart for centuries. We have, on occasion though, been given good advice about our responsibility
to pay tax. The Honorable Supreme Court Justice Learned Hand had the opportunity to instruct the IRS, in a high
court decision, that it was not a citizen's duty to conduct himself so as to pay the maximum tax possible, but
that a common man might arrange his affairs so as to pay the least amount of tax possible. God bless the judge,
and God bless our alpacas!
A special thanks to Mr. Mike Safley of Northwest Alpacas, for allowing
us to post this fine article.
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