As we approach the fourth quarter of the year, and especially after harvest, there is an annual event in the farm sector. This is often driven by accountants who are being asked by a producer how they can avoid paying any income taxes on this year’s profitable production (if we are in a year where there is a profit). One of the first suggestions is to purchase farm machinery. This idea has gained in popularity with the bonus depreciation in place with the current tax law.
In addition to the standard depreciation schedules established by the IRS, there is Section 179 depreciation and bonus depreciation. Section 179 allows to depreciate the entire purchase price of equipment up to $500,000. For businesses that spend over $2 million in equipment, there is a phase out provision that eliminates the deduction once the new equipment costs exceed $2.5 million. Bonus depreciation allows for 50% of the equipment cost to be depreciated in in 2017 for equipment purchases that are put into service. This amount drops to 40% in 2018 and 30% in 2019. The accountant is eager to point out the tax savings that can occur once equipment is purchased and the current tax laws are very favorable. But the question remains, is it the right thing to do?
The proper way to assess the new purchase opportunity is to look at the costs associated with the existing equipment, amount of cash on hand, availability of borrowing, possible returns on alternative investments, and a review of other options to achieve the same goals. The various options to consider are the equipment purchase (cash outlay or credit), leasing the equipment, custom hire for the same work, and short-term rental. Each of these should be viewed according to the factors of capital needed to acquire, ongoing cash flow requirements, repair and maintenance costs, income tax deductions, operating labor needs, and risk of obsolescence. I will focus on the final three options before going back to the ownership strategy.
Equipment leasing may require no investment or capital to be paid upon acquiring. The ongoing cash flow needs will be all operating expenses plus any lease payments. Repairs and maintenance are typically at the cost of the lessee, but these costs need to be considered in light of the repair costs on the existing equipment that is being replaced and any warranties on the new should be factored in. Operating leases allow for the full lease payment and operating costs to be deducted from income tax and the risk of obsolescence is low. If the lease is a finance lease, the farmer can deduct the depreciation, interest (not the full lease payment) and operating costs from taxes and is fully at risk for any obsolescence risk. The farmer must supply labor to operate the machinery. The farmer remains in total control over the use and timeliness of operation.
In a short-term rental, no capital outlay is required. All operating costs and rental fees are required to be paid by the farmer. The lessee may have to pay some of the repair and maintenance costs, depending on the lease covenants. All rental fees are deductible as a business expense. Labor is supplied by the farm operator. The farmer has limited control over the timeliness and use of the equipment. Also, since the equipment is now owned, there is no risk of owning obsolete equipment.
Custom hire is a typical option we see. This does not require any capital outlay and only taxes the cash flow on the custom hire cost. Repair and maintenance is the responsibility of the person you are hiring. All custom charges are deductible from income for tax purposes. Ongoing labor is provided by the custom owner, but the farmer is at risk and has no control over the timeliness and use. The risk for obsolescence is borne by the custom worker and not the farmer.
The last option is for the producer to purchase and own the equipment. This is done with either a full cash outlay for the cost or a loan on all or part of the purchase price, less any trade-in. Ongoing cash flow will satisfy all operating costs and any loan payments. It is also important to look at the opportunity costs associated with this strategy as the purchase may tax the ability of the farmer’s cash flow to meet other needs of the operation and may increase the need for operating loans. Another factor is additional cash may be earned if the farmer rents his equipment out for custom work. Repair and maintenance costs are the responsibility of the farmer, but these need to be looked at considering any R&M costs on the machinery this is replacing. Taxes allow for depreciating the equipment and also any interest paid on the loan. Labor is supplied by the farmer and he remains in control of the use and timeliness of operating. The farmer also bears risk of anything going obsolete.
So, as you see, there are more factors to consider in purchasing equipment than just the tax implications. Making purchases just to save money on taxes can lead to poor investment choices. The return on the equipment should be considered with the return on other forms of investment such as securities. These are often more liquid and can be sold for cash quicker in times of financial stress.
One metric that should be used to quantify investment results is the Internal Rate of Return (IRR). This is calculated by first finding a discount rate that sets the present value of an investment’s cash flows to zero. When the IRR of cash flows is considered from an expected machinery purchase in light of the risk, the farmer can determine if they are better off upgrading to the new tractor or keeping the old one while investing their money into the financial market.
These calculations are often complex. Fortunately, there are some pretty good resources out there to help make this simpler. I found some great resources from Iowa State University at https://www.extension.iastate.edu/agdm/decisionaidscd.html This provides several excel sheets that allow the producer and lender to determine which option may be the best for equipment. Using tools such as this should be a requirement of the producer as he weighs the equipment purchase decision.
An example of the required hurdle return that new equipment requires was found in studies by the University of Illinois. Using all the variables in this study concluded that a rate or return of 5% of the purchase prices is required to breakeven on an IRR basis. So, a farmer who purchases a tractor for $200,000 would need to see at least $10,000 improvement in after tax productivity in order to classify this as a wise investment. This also shows the returns of a productive asset vs and idle one. Purchasing a new tractor to save on taxes when it is used primarily as a front yard ornament or pulling a float in a local parade is a poor use of money.
The purpose of these studies is to try to quantify most of the drivers of financial performance a farmer needs to view considering a machinery purchase. Many times, the investment decision is driven only by the tax savings. In most cases the focus should be on the gains in productivity, future resale value, and overall impact on cash flow as deciding factors for the equipment purchase. This principal should be used and applied not only to farmers but also to other businesses in their weighing of equipment purchases.