Factors to Consider When thinking about Purchasing Year-end Assets.

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 they are in a year where there is a profit).  One of the first suggestion is to purchase farm machinery.  This idea has gained popularity with the bonus depreciation in place with the current tax law. 

Now as we begin I want to specify that we are not accountants.  Any tax advice needs to be vetted with your own accountant.  Also, this strategy not only applies to farmers but to any business that uses equipment.  If the business is having a profitable year, they may look at finding ways to reduce their expected tax liability.

First, tax depreciation schedules are often more aggressive than actual economic depreciation, meaning a new tractor may be fully depreciated on the tax records years before it is retired from use.  The IRS calls these standard depreciation schedules, and they vary by the type of equipment. 

In addition to these standard depreciation schedules, 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. 

Many accountants push their business and agriculture clients to do make these purchases.  The problem is if the only reason why someone buys equipment is to save money on taxes, it does not take into account the real factors that should be looked at when they purchase.

The proper way to look at equipment purchases is to look at the costs associated with the existing equipment being replaced; cash flows from the new 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. This should be estimated over the entire term that you expect to use the asset, and an estimate of how much it can be sold for will be factored in. 

Maybe, you still need to consider the availability of labor to operate the equipment, the level of control you need to have over the equipment, and if you want to take the risk that the equipment will be obsolete when you sell it and you get nothing.

To do this, the farmer, or businessman, need to figure out the various options they have to get the work done from the equipment they are thinking about purchasing. 

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. 

Equipment leasing may require no money 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. 

That needs to be factored in since one option is to keep what you have now.  Also, you need to consider any down production time that is caused by equipment not available for use when it is being repaired. 

That could cause a lot of pain to a farmer who needs to get the combine in the field for harvest but cannot since it is broke.  Or a trucking company that cannot haul as much freight with some of their power units in the shop. 

There are operating and capital leases.  The difference between the two is defined by the tax code and generally accepted accounting principles.  On the tax side, 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. 

That may be a good option if there is not a need to have the equipment on hand for use all the time.  If you only need it for a short time, you may be able to rent it from someone else.  It is like going down to the rent-it center to rent a power tool that you only need for a particular job.  It would keep you from buying tools yourself!

Another option is to just outsource the entire job.  Companies may do this on a short-term or permanent basis. We see this a lot in farming.  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 of obsolescence of the equipment is borne by the custom worker and not the farmer.

Right.  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.  A problem we see is a farmer who purchases a new combine to get the tax deduction but who may borrow money over five years for the equipment.  Sometimes the new equipment loan may have additional costs rolled in from a poor trade in that had a loan on it.  It may be very easy for the farmer to get into a negative cash flow situation when they had a great tax deduction in the first year.

What if they did not have to borrow money to buy the new combine?  Does that may a difference?  Perhaps, but 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 or other sources of borrowing.  Also, the equipment purchase should be looked at like another investment.  The farmer could take that money and put it in the stock market or a savings account.

Could there be income if the farmer were to rent the equipment out?  Yes, and that needs to be calculated in.  The farmer could rent the combine, or the business may rent a machine out for jobs when it is not in use for their company.  This is a business strategy we see with farmers who may custom cut silage or who go from field to field harvesting. 

What about repair costs?  Those would be the responsibility of the owner.  Yes, but you also need to consider any repair and maintenance (R&M) costs on the machinery this is replacing as well as up and downtime.  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. 

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 of 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. 

These is the decision process that every high-performing firm goes through when considering major equipment purchases.  We teach lenders this thought process needs to be used when they are asked to finance equipment or if a company should purchase equipment.  I use this cost-benefit analysis when deciding whether to purchase a new computer program for the company.

All these factors are complicated when you put them together.  How are they measured to get numbers to make a decision?  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. 

Someone with a good command of Excel can build a spreadsheet.  Fortunately, there are some pretty good resources out there to help make this simpler.  I found some great resources from Iowa State University at their website for farm equipment.  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.

Now all results are varied by the inputs into the model, so two companies considering the same purchase may have two different results.  One example of the required hurdle return that new equipment requires was found in studies completed by FarmerMac with tools at the University of Illinois.  Using all the variables in this study concluded that a rate or return of 5% of the purchase price is required to break even 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 versus 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 or business 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.