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This chapter describes the most significant Federal taxes
affecting farmers (income, self-employment, and estate/gift
tax) and how they affect farm businesses and farm households.
Among this chapter's highlights:
- Farmers, like other taxpayers, are subject to a variety
of taxes at all levels of government. Federal taxes
account for about three-quarters of total tax burden
on farm households (see more on taxes
paid by farmers).
- In recent years, Federal income taxes on both farm
and nonfarm income accounted for nearly two-thirds of
farmers' total Federal tax burden, while Social Security
and self-employment taxes represented nearly a third.
These taxes can have a significant effect on the financial
well-being of farm households with the impact varying
by farm household type (see more on Federal
income and social security taxes).
- Federal estate and gift taxes can affect the ability
to transfer the farm business to the next generation
as land values have greatly appreciated, and average
farm size has grown in recent years. However, tax changes
have significantly reduced the share of farm estates
that owe Federal estate taxes (see more on federal
estate taxes).
- Changes in Federal tax policies are of considerable
importance to the farm community since they not only
influence the financial well-being of the farm household
but can also have important effects on the number and
size of farms, their organizational structure, and their
use of land, labor, and capital inputs. Tax legislation
enacted over the last several years has greatly reduced
both Federal income and estate taxes (see more on federal
tax policy developments and farmers).
Taxes Paid by Farmers
Farmers, like other taxpayers, are subject to a variety
of taxes at all levels of government. At the Federal level,
these include income taxes, Social Security and self-employment
taxes, and estate taxes. At the State and local level,
the most significant taxes include property and income
taxes. Other taxes such as excise taxes, corporate income
taxes, and retail sales taxes are significant for only
a small number of farmers.
In 1996 (the latest year complete Federal, State, and
local tax data are available for farmers), farmers paid:
- $19.2 billion in Federal income taxes (48.2% of their
total tax payments)
- $10.2 billion in Social Security and self-employment
taxes (25.6%)
- $5.2 billion in State and local property taxes (13.1%)
- $4.7 billion in State and local income taxes (11.8%)
- $0.5 billion in Federal estate taxes (1.3%).
These taxes—$29.9 billion at the Federal level
and $9.9 billion at the State and local level—were
levied on nearly $122 billion in farm and nonfarm income
reported by farm households for Federal tax purposes.
The Social Security tax total includes $1.8 billion in
self-employment taxes on farm income plus $8.4 billion
for both the employers' and employees' share of the payroll
tax on wages. Tax legislation enacted since 1996 has lowered
farmers' Federal income tax liabilities by as much as
10 percent from these levels on a constant-income basis.
While, in the aggregate, Federal income taxes impose
the largest tax burden on the broadest group of farmers,
the relative importance of the different taxes varies
for individual farmers with the size and other aspects
of the farm business and household. The average effective
Federal income tax rate for all farmers was about 16 percent
in 1996. Most farmers, though, pay less tax than the aggregate
rate suggests. About 80 percent of farmers have income
of less than $60,000 and pay less than a 10-percent average
effective rate. On average, farmers earning less than
$60,000 pay more in Social Security taxes than in Federal
income taxes.
State and local governments rely on individual and corporate
income taxes, sales taxes, and property taxes. Individual
income taxes exist in 43 States, and while the rates vary,
they are less than Federal income tax rates. The average
effective State income tax rate for all farmers was about
4 percent and was fairly constant across all income levels.
Sales tax rates vary widely by location, but purchases
of farm inputs are often exempt from retail sales taxes.
While many States have reduced their reliance on property
taxes, real estate taxes are the most important State
and local tax for farmers. Farmers have large investments
in land, as well as improvements and buildings that are
subject to the tax. These taxes vary widely based on local
tax jurisdictions. All States currently have some form
of preferential property assessment that taxes farmland
based on its agricultural value rather than its fair market
value. Such assessment is especially important where urban
sprawl has raised land prices.
Federal Income and Social Security
Taxes
The Federal income tax is a progressive tax imposed on
net income. Taxable income is computed by subtracting
allowable adjustments, deductions, and personal exemptions
from total income. Numerous provisions of Federal income
tax law allow taxpayers to reduce their tax liability
if they undertake certain tax-favored activities. Farmers
benefit from both general tax provisions available to
all taxpayers and from provisions specifically designed
for farmers.
These tax benefits generally accrue to those with higher
incomes—generally large farms with high farm income
and very small farms with high levels of off-farm income.
Although very small farms do not generate enough farm
income to support a family, most small farms benefit from
farm losses for tax purposes because these losses reduce
taxes on nonfarm income. At the same time, many farmers
devoting full time to the farming operation do not generate
enough taxable income—either farm or nonfarm—to
fully utilize available tax benefits.
Examples of special tax treatment for farmers include
cash accounting, farm income averaging, depreciation,
the current deductibility of certain capital costs, and
capital gains treatment for certain assets used in farming.
These and other provisions reduce the farm income tax
base. Such incentives have likely encouraged greater investment
in productive capacity than would have been warranted
without tax incentives, and this has affected farmland
prices, organizational structure, and farm profitability.
The favorable tax treatment for farm income is reflected
in the size of farm profits and losses reported for income
tax purposes. Since 1980, IRS data indicate that farmers
have reported negative aggregate net farm income for taxes.
These farm losses reduce taxes by offsetting taxable income
from nonfarm sources.
Many of these farm losses are reported by smaller farms
that are not the operator's primary source of income.
Farms classified as "lifestyle-residential farms"
comprise two-thirds of U.S. farms with losses, and their
losses amount to nearly three-fifths of the total farm
losses. Therefore, while many commercial-size farmers
pay taxes on their farm income, farm sole proprietors,
in the aggregate, pay little in Federal income tax on
farm income.
Unlike Federal income tax rates, which rise as income
increases, the Social Security tax is a flat rate with
a maximum taxable amount. Farmers pay self-employment
taxes on their net farm income from Schedule F, on partnership
income, and on net income from any nonfarm businesses.
Farmers and spouses with off-farm employment pay Social
Security taxes on their wages.
Social Security taxes have risen since 1980 due to increases
in the tax rate and the amount of income subject to the
tax. The rate increases began in 1983 and by 1990 had
risen to the current 15.3 percent (7.65 percent for both
the employer and employee). The 15.3-percent rate is comprised
of the 12.4-percent old-age and survivor disability insurance
(OASDI) tax plus the 2.9-percent Medicare hospital insurance
(HI) tax. All self-employment income is subject to the
Medicare tax portion. Only the first $94,200 of earned
income (in 2006) is subject to OASDI.
While both Social Security tax rates and the amount of
income subject to tax have increased, total self-employment
taxes paid by farmers have not increased as fast. The
primary reason is the drop in the number of farms reporting
a farm profit—from 44 percent in 1989 to about 27
percent in 1998.
Federal Estate Taxes
The current Federal estate and gift tax system applies
a unified tax rate structure and a cumulative lifetime
credit to gifts and transfers of money and other property
at death. Under the system, individuals can transfer a
specified amount ($2 million in 2006 and $3.5 million
by 2009) in cash and other property without Federal estate
or gift tax liability as a result of the unified lifetime
credit. The estate tax will be repealed in 2010. However,
without further legislation, repeal will last only 1 year
before the law reverts to the provisions in effect in
2001.
Although every estate with more than $2 million in gross
assets must file an estate tax return, the taxable amount
is reduced by deductions for funeral expenses, administrative
expenses, debts, charitable contributions, and transfers
to one's spouse. As a result, less than half of all estates
required to file a return are actually taxable. Gifts
of up to $12,000 annually to an unlimited number of individuals
are also exempt and do not count against the amount exempted
from tax by the unified credit.
Estate and gift tax receipts have historically accounted
for a relatively small share of total Federal revenues
annually. However, while the aggregate importance of estate
and gift taxes is small relative to other Federal revenue
sources, the potential impact of these taxes on an individual
or group of individuals, such as farmers and other small
business owners, can be substantial.
The appreciation in land values, the increase in farm
size, and the rising investment in farm machinery and
equipment have increased farm estate values and taxes.
Over the years, congressional concern that these increased
estate and gift taxes might cause the breakup of some
family farms and other small businesses has led to the
enactment of targeted provisions to provide relief to
farmers and other small business owners. These include
the special-use valuation of farmland, the installment
payment of estate taxes, and a deduction for family-owned
business interests. Concern for the effects of the Federal
estate tax on farmers and other small businesses was the
primary impetus for the changes enacted as part of the
Taxpayer Relief Act of 1997 and a major objective of the
2001 phaseout and eventual repeal of the Federal estate
tax.
While only about 4 percent of all farm estates have owed
Federal estate tax, a much larger percentage have been
required to file an estate tax return, utilize special
farm provisions, alter business practices, or engage in
estate planning to reduce the impact of the estate tax
on their farm business. Thus, the phaseout and repeal
of the Federal estate tax will affect a much broader group
of farmers than those who owe tax. In fact, during the
phaseout period, the significant increase in the unified
credit will substantially reduce the share of estates
that are required to file but that owe no tax. However,
the primary beneficiaries of complete repeal are farm
estates with assets in excess of $5 million; such estates
currently account for an estimated two-thirds of all Federal
estate taxes paid by farm estates.
Federal Tax Policy Developments
and Farmers
Federal income tax policy has undergone major revisions
over the last several years. The enactment of the Jobs
and Growth Tax Relief Reconciliation Act of 2003 following
the Economic
Growth and Tax Relief Reconciliation Act of 2001 and
the Jobs Creation and Worker Assistance Act of 2002, has
reduced Federal income and estate/gift taxes for farmers.
Changes in Federal income tax policies in the 2003 Act
are estimated to have provided farm households with about
$4 billion in tax relief in 2004, reducing average income
tax rates to about 14 percent from about 18 percent in
2000. Changes to Federal estate tax policies in the Economic
Growth and Tax Relief Reconciliation Act of 2001, primarily
an increase in the amount that can be transferred free
of tax, have significantly reduced both the number of
farm estates required to file an estate tax return and
the number that owe tax. As a result of these changes,
in 2004, only about 2 percent of all farm estates owed
any Federal estate taxes. While current law provides for
the phase-in of additional reductions in Federal estate
taxes, considerable uncertainty exists due to the 1-year
repeal of the tax in 2010.
Two major tax bills were enacted into law in 2004: the
Working Families Relief Act of 2004 and the American Jobs
Creation Act of 2004. The most significant feature for
farm households of the former was the extension through
2010 of several of the tax cuts for individual taxpayers
enacted in the 2001 and 2003 Acts. These include the full
elimination of the marriage penalty for the standard deduction
and 15-percent bracket and the retention of the fully
expanded 10-percent brackets and $1,000 child tax credit
(see table).
The focus of the American Jobs Creation Act of 2004 was
on business tax provisions. The Act represented a major
overhaul of U.S. Federal income tax laws applicable to
farmers and other business taxpayers. The primary focus
of the Act was the replacement of the foreign sales corporation/extraterritorial
income (FSC/ETI) provisions that had been declared a prohibited
export subsidy by the World Trade Organization (WTO).
The Act replaced the FSC/ETI exclusion with a new tax
deduction for income from domestic production activities
for U.S. manufacturers. The new deduction goes well beyond
the FSC/ETI exclusion and applies to all qualifying manufacturers,
including farmers, regardless of whether or not they export.
The Act also lengthened the replacement period from 2
years to 4 years or more for livestock sold on account
of weather-related conditions, allowed farmers to utilize
income averaging without triggering the alternative minimum
tax, and extended the $100,000 small business expensing
provision through 2007.
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