Cattle Profits and Taxes

During the Ranching for Profit School, we introduce three issues involving money: economics, finance, and income taxes. We spend most of our time on economics (generating value and keeping profit) then some time on finance (cash flow and investment), and less time on income taxes. The reason for that order is based on the overall importance of each issue in decision making! Dallas started a trio of ProfitTips articles with Windfall Profits and Shanon wrote Think Beyond Profit, so I will finish it with everyone’s favorite: income taxes. 

The general rule of thumb is that income taxes are good problems, and that you should want to have an income tax bill. Having an income tax bill is the result of having a profitable business; it is then up to agri-business managers to pay them accordingly, either now or defer to the future. Income tax avoidance can be a poor business management strategy, but profitable businesses should do some income tax planning when they become a significant expense.

First let’s go over some basic income tax knowledge. There are multiple types of income tax paid when you file your federal tax return: ordinary, ordinary plus self-employment, and long-term capital gains. Ordinary income is the most common, and that’s usually what people are referring to when they speak about what tax bracket they are in. Self-employment is higher than ordinary because it includes paying Social Security and Medicare taxes. Long-term capital gains is the lowest tax bracket. Your entity selection may change these taxes, always refer back to your tax advisor for specific advice for your status. I am writing in very general sole-proprietor terms below.

Cattle ranches generally have three different types of female sales: raised calves, raised cows, and purchased cows. Calves are considered raised products while cows are considered capital assets.

1. Raised heifer calves under 2 years old will be reported on the Schedule F and subject to ordinary income tax and self-employment tax. Bred heifers should be reported on the Schedule F if they are under two years old. After two years of age or when they have a calf, they will then be considered cows in the next bullet point.
2. Raised mature cows over 2 years old will be reported on Form 4797 Part I, which is long-term capital gains income. Raised cows are considered asset sales and have zero tax basis because all expenses have been deducted on the Schedule F as incurred over the past two years.
3. Purchased cows intended for breeding are placed on the depreciation schedule just like machinery. After they are held for over two years, the sale proceeds will have different layers of taxable income depending on sale price and prior depreciation. The 2 year holding period for cattle is important! That’s where the long-term capital gains income tax rates come in. In between 1-2 years is ordinary income. If less than 1 year, that is an inventory animal and that sale needs to be reported on the Schedule F. Those purchases cannot be deducted until the sale is reported and taxable income will be the net difference.The purchase intent will determine when and where the sales and purchases are recorded.
4. A whole-herd sale could include all the above breeding female classes. If it is due from drought, there are a couple deferral methods the IRS allows. Or if it is from a business choice like retirement or capturing the market when it’s available, then talk to your tax advisor before, during, and after major decisions like this. The capital gains rates and Schedule J Farm Income Averaging election might make the tax pretty minimal compared to the whole herd value.

Here is a simple example of buying a bred cow and selling her 3 years later, using a very simplified straight line depreciation method. In real life, your tax preparer should work with you on whether or not to use regular or accelerated depreciation methods depending on your profitability, debt payments, family living expenses, and taxable income.

Knowing the value of different cattle classes and their tax implications could have big impacts on many ranches. For example, assuming a $100,000 Schedule F is the only taxable income for a couple, there will be about a $25,000 tax bill between federal, self-employment, and possibly state income taxes. If you take that same ranch and have $100,000 of raised bred cows as the only taxable income, it is possible there would be zero tax due to the lower capital gains rates and no self-employment tax (I don’t recommend always skipping out on social security tax especially for young families). That’s a win-win scenario, sell a more expensive animal and owe less tax! However if you can make more money by running short term steers and pay more tax, stay in your lane and stay out of the breeding herd game. Whatever leaves the most amount of money to be reinvested into your business for future operations.

A good goal is to maximize after-tax wealth increases, year to year. And once again, to develop a profitable business, have a close relationship with your tax advisors. Meet with them multiple times throughout the year and bring donuts to their office; everyone will be happy to see you! If you want to learn more about ranch business management as a whole, join us at a Ranching for Profit School (this winter’s schools are almost full) or check out our Economics Intensive if you want a deeper dive into just the numbers portion for your business.