Last updated: Dec. 22, 2023
Inventory adjustments can stabilize farm income and help you pay less tax over time
One of the biggest tax planning challenges a farmer can face is income fluctuations.
The good news is, if your farm uses cash accounting, you can average out these income swings by using two inventory adjustment tools:
- Optional Inventory Adjustments (OIA)
- Mandatory Inventory Adjustments (MIA)
A note on farm losses and inventory adjustments
You may be able to deduct farm losses from non-farm income if you earn both types of income. The amount you can deduct could be either full or partial - the extent depends on the nature of your business:
- Farming is not your main source of income, but your farm is operated as a commercial business.
- Your losses are partially deductible. The portion of the loss you cannot deduct becomes a Restricted Farm Loss. (RFL). A RFL after 2005, can be carried back 3 years or forward 20 years to be applied against farm income.
- Farming is your main income source.
- The Canada Revenue Agency (CRA) has established Mandatory Inventory Adjustment (MIA) tax rules. These rules limit the amount of loss you can declare, depending on your inventory situation at the end of the year.
Optional Inventory Adjustment (OIA)
Cash-based accounting farmers can use Optional Inventory Adjustments (OIA). This allows them to optionally claim an income amount against the year-end inventory they have on hand.
Spread over a two-year tax cycle, OIA allows you to balance out your current tax bill with the future tax you will have to pay when you sell your inventory, and your income rises.
In year one, you claim any amount up to the full Fair Market Value (FMV) of your inventory as income. The FMV is essentially the highest dollar value you could get for your inventory in an open market.
Although you can use OIA to boost your income level, if you keep it within the lowest tax bracket, you will only be taxed at the federal marginal rate (currently 15%).
The following year, or second tax year, the same amount is deducted from a cash-accounting farm’s income even if the inventory isn’t sold.
Although your income is higher from the sale of your farm inventory in year two, the OIA deduction lowers your income, so you are taxed less.
Depending on the results in year two, you can again decide if you want to add in a new OIA amount for that year. This trend can continue until there is no more closing inventory value.
Additional benefits of OIA
OIA’s main benefit is building up a deduction to offset the higher income level in the year you sell your inventory, but there are some additional advantages.
1. The OIA is essentially a tax deferral.
Consider building up your OIA before you go to sell the farm/retire as that is usually your highest income-earning year. The OIA would then lower your overall tax burden.
2. OIA can help boost your taxable income in years where you wouldn’t otherwise qualify for non-refundable tax credits, such as basic exemption, age exemption, spousal exemption, disability and medical.
Many provinces also have income thresholds and other criteria around farm status in order to qualify for certain programs and services, such as grants and fuel benefits.
3. When you increase your income, you also increase your Registered Retirement Savings Plan (RRSP) contribution limit.
Because it is calculated as 18% of your previous year’s earned income up to the maximum contribution limit, the more income you earn, the higher your contribution limit will be (up to the yearly maximum).
An example – income with and without OIA
In this example, a farmer has $10,000 in farming income in 2021 and $100,000 in 2022.
They operate their farm in the province of Ontario and are not incorporated, so they would be subject to personal tax rates. By comparing the two-year tax cycle with OIA and without OIA, you can see that using OIA results in a total savings of $2,766.
*Please note, this example only illustrates how OIA could work – it’s best to seek advice from a tax specialist before making tax decisions.
Mandatory Inventory Adjustment (MIA)
With MIA a cash-based accounting farmer in a loss position is required by law to add the cost of purchased year-end inventory on hand to their income in order to increase it up to the point where the loss is eliminated.
With MIA, the cost of any purchased inventory on hand – regardless of the actual year of purchase – must be added to farm income up to the point where the loss is eliminated.
Calculating Mandatory Inventory Adjustments
Before you can calculate MIA, you need to know the total cost of purchased inventory on-hand at the end of the year. This cost is the maximum MIA that can be included to take the loss to zero.
For MIA purposes, inventory is generally valued at the lower of its original Cash Cost (or purchase price), and Fair Market Value.
Specified animals are valued at their original purchase price less 30% per annum on a diminishing balance basis, unless you elect to value them at a greater amount not exceeding their original cost. All horses are specified animals in addition to cattle that are registered under the Animal Pedigree Act.
An example of using MIA
In the following example, the farm income is $20,000 and the purchased inventory value on-hand at the end of the year, is $43,000.
Recall that even though the purchased inventory value is $43,000, the maximum MIA that can be applied is the lesser of the income loss and the inventory value. In this case, it’s $20,000.
The MIA is then deducted from the $25,000 income for the following year bringing the adjusted income down to $5,000. Again, this example is not tax advice – always consult with a tax specialist.
The best tax strategy for farms
When creating a tax strategy for your farm, it’s usually best to maintain the lowest possible tax rate each year and spread your liabilities over time. Timely use of OIA can certainly help with this.
When it comes to OIA, however, it is best to exercise a little caution in your calculations and strategy. Plan for the best outcome based on the information you actually have, but ensure you use numbers based on current market trends and not wishful thinking.
As always, seeking advice from a tax specialist may help you determine the best course of action for your farm and specific tax situation.
[Free Download] Full Guide - Tax Planning for Farmers
Need to learn more about how inventory adjustments can help to stabilize your farming income and pay less tax over time? Download the complete guide to Tax Planning for Farmers.
It also includes the advantages and disadvantages of inventory adjustments as well as real world examples to help you understand their application.
Download your free guide here
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