Tobacco Buyout Tax Implications

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					      Tobacco Buyout Tax Implications


      Economic Subject Matter Training
                         October 17-21, 2005

      Extension Farm Management Specialists
       Department of Agricultural Economics
              University of Kentucky




Agricultural Economics
                          Disclaimer
• US Treas Notice 2005-57 released July 05, 2005
  clarified tax treatment of many items, but left
  some unanswered.
• We hope to get IRS guidance yet on grower
  payments.
• This presentation is for information only and is
  not to be considered final tax or legal advice.
• Tax planning with a tax preparer will be
  beneficial, as significant tax problems may be
  avoided or postponed with prior planning.



 Agricultural Economics
                         Tobacco Buyout

• Quota Payments = $7 per pound on 2002
  basic quota

• Grower Payments = $3 per pound on
  2002 quota for growers who grew
  tobacco in 2002, 2003, and 2004.
    – Payments prorated if not a grower all years.

• Payments will be made over a 10 year
  period or
• Discounted lump sum payment

Agricultural Economics
            Kentucky Tax Treatment


• Kentucky WILL NOT TAX any tobacco
  buyout payments.




Agricultural Economics
                          Quota Payment
• Is a Section 1231 asset
     – Capital gain treatment (5% or 15% rate)
     – Part of payment will be characterized as interest
     – not subject to self-employment tax
• Will not qualify for farm income averaging.
• Most quota will have a tax basis
     –   Quota by Grant (no basis)
     –   Quota by Inheritance
     –   Quota by Gift (donor’s basis)
     –   Quota by Purchase
            • Before separated from land
            • After separated from land



 Agricultural Economics
                Quota Payment Cont‟d

• What if no records of Basis Allocation ?
    – Allocation of value of basis may be made by a
      good faith effort. Historical data should be
      used.
    – Will have a spreadsheet to help determine
      pounds of quota in any given year.
    – Sources of information are County Ag Agents,
      real estate professionals, FSA offices, and
      lenders
• Determine tax savings vs. cost of getting
  basis determined.

Agricultural Economics
                Quota Payment Cont‟d
• Will qualify for Section 1031 exchange
  (tax free exchange)

• Issues will be the timing necessary to
  comply with S1031 rules considering the
  timing of payments

• Tax free exchanges only defer tax, may
  not eliminate tax.

• Seek Qualified Professional Advice

Agricultural Economics
                             Section 1031 Rules
• Must sign an agreement with a “qualified
  intermediary” by September 16, 2005

• Must deposit first payment with QI within 5 days of
  signing agreement

• Must do a successor-in-interest contract for
  remaining nine payments

• Money from lump sum must go directly to QI

• Have 45 days to identify replacement property

• Have 180 days to close on property.
    Agricultural Economics
                           Grower Payments
• For farmer who has been growing and
  reporting tobacco sales on Sch F, payments
  will also go on Sch F
  –   Taxed as ordinary income
  –   (10, 15, 25, 28, 33. or 35%)
  –   Subject to Self-Employment Tax (15.3%)
  –   Part of payment will be characterized as interest
• Share rent landlord would report payment
  on Form 4835
  – Taxed as ordinary income.
  – Not subject to self-employment tax !
• Will qualify for farm income averaging!
  Agricultural Economics
    Payment Allocation to Interest
• Treas Regs say any contract sale must
  have a minimum interest rate and
  proceeds of contract must be allocated
  between principal and interest.

• In the case of no stated rate, an imputed
  rate is used by taking the applicable
  federal rate as published.

• Only exception is for contracts less than
  $3000.

Agricultural Economics
        Payment Allocation to Interest
•         Assume $10,000 total contract and 4% rate
         Year                 Interest    Principal
         2005                   $ 0         $ 1000
         2006                     152          848
         2007                     269          731
         2008                     240          760
         2009                     210          790
         2010                     178          822
         2011                     145          855
         2012                     112          889
         2013                      75          925
         2014                      38          962
         Total                $ 1419       $ 8581
    Agricultural Economics
                  Lump Sum Payments
• Will be done by financial institution
    – Lender will discount the income stream to give
      you the lump sum payment.

• What will you do with the money??
    – Will your use of the money give you a better
      return than the discount rate you are paying??

• Is the Discount Rate Fair ??
    – Rates quoted from ?? % to 9.0 %


Agricultural Economics
                  Lump Sum Payments


• First Payment will be by 9-30-05

• Everyone will be required to take this
  payment

• Second Payment will be in January 2006

• Assignment must be done by Dec 2, 2005
  for this payment to be assigned.

Agricultural Economics
                      Lump Sum Payments


•     Payment # 1 -           Sept 15, 2005
•     Payment # 2 -           Jan 15, 2006
•     Payment # 3 -           Jan 15, 2007
•     Payment # 4 .. 9 -      Jan 15, 2008..20013
•     Payment # 10 -          Jan 15, 2014




    Agricultural Economics
                          Net Present Value

• Discounting future income stream into today‟s
  dollars

• “Simply – A dollar in the hand today is worth
  more than the promise to receive a dollar
  sometime in the future”

• Worth more today because:
     – Dollar today can be invested and generate earnings
     – Inflation can erode your purchasing power
     – Risk – Uncertainty of receiving money in the future


 Agricultural Economics
                         NPV Cont.


• Net present value depends on:
    –   Date of Lump Sum Payment
    –   Date of First Annual Payment to Discounter
    –   Interest Rate
    –   Number of Payments




Agricultural Economics
      NPV of Lump Sum Payments
• Lump Sum Payment Received on November
  15, 2005

• Payment Jan 15, 2006 Goes to Lender – 9 total
  payments will go to the Lender

• Discounted lump sum through a financial
  institution
     –   4% = $7,681      ( .8534 on the dollar)**
     –   5% = $7,401      ( .8223 on the dollar)
     –   6% = $7,138      ( .7931 on the dollar)
     –   10% = $6,231     ( .6923 on the dollar)

• ** Percent is quoted of the nine payments.

 Agricultural Economics
Discount rates for 9 yr successor-in-interest contract with
                   Jan „06-‟14 payments



    Lump Sum                  Discount Rate for Discount Rate for
    Percentage                Aug „05 payout    Oct „05 payout

    70%                       8.67%             9.06%

    75%                       6.89%             7.19%

    80%                       5.27%             5.50%

    85%                       3.79%             3.95%

     Agricultural Economics
                            Net Present Value

• What is a fair discount rate??
   – What’s fair to you?
   – What’s fair to the lender?

• Benchmarks
   – 10 Year Treasury                     4.13 %
   – 5 Year Equipment Loan                6.90%
   – 15 Year Fixed Farm Loan              6.90%

• By law, discount rate may not be more than 2% plus
  prime rounded to nearest whole percent. (6.5 + 2.0 =
  8.5% rounds to 9.0 % max)

   Agricultural Economics
                             Investment options


•     Pay debt
•     Expand the business
•     Family living
•     Retirement
•     Charitable contributions
•     Invest off-farm
•     Understand tax implications


    Agricultural Economics
                         Lump Sum or Not?


• “What am I going to do with the
  money?”
    –   Invest in my operation
    –   Pay off debt
    –   Invest off farm
    –   Family living




Agricultural Economics
                         Invest In Operation


•     Historic return on Assets in farming
•     Around 4%
•     2004 KFBM Data Avg= 4.2%
•     Can you beat the discount rate?




    Agricultural Economics
                         Pay Down Debt


• What is your cost of money?
• Interest on debt > discount rate
    – Payoff good economic decision
• Interest on debt < discount rate
    – Payoff not a good economic decision, BUT
      cannot put a value on piece of mind, pride,
      accomplishment and goals.



Agricultural Economics
                   Off Farm Investing


• Can you earn more taking the lump sum
  and investing on your own?
• What risk are you willing to assume?
• Good time to diversify
• Good time to increase (or start)
  retirement savings




Agricultural Economics
                         Family Living


• No economic benefit to take a discounted
  amount for consumption
• Again this ties back to goals
• Utility




Agricultural Economics
                     Lump Sum Payments

• Tax Issues
  – Is lump sum payment taxed immediately or is it still taxed
    over the ten years?

• Severability of Payments – Each contract stands on
  it‟s own
  – Lump sum on Quota Payment and not on Grower Payment
  – Severability between grower & landlord share
  – Lump sum on one FSA farm number and not on another farm
    number
  – Lump sum on one type of tobacco and not another



   Agricultural Economics
    Methods of Lump Sum Payment


• Assignment of Payment
  – You still own the contract
  – Taxed over the 10 years as payments are received

• Assignment of Contract (Successor in Interest)
  – You have sold the contract
  – Taxed immediately on the lump sum payment.



   Agricultural Economics
                Tax Planning Management
• Grower Issues and Opportunities
  –   Lump sum or 10 payments?
  –   When to take lump sum?
  –   Capital purchases and S179 depreciation
  –   Prepayment of operating expenses
  –   Net operating losses carried forward
  –   Self employment tax thresholds
  –   Income averaging
  –   Retirement plan contributions
  –   Plans for drawing Social Security
  –   Other thresholds and phase outs.


      Agricultural Economics
             Tax Planning Management

• Quota Owner Issues & Opportunities
  –   Lump Sum or 10 Payments?
  –   When to take lump sum?
  –   Establishing Basis
  –   Should I do a S1031 exchange?
  –   Capital Gains Rate – now and in the future
  –   Taxation of Social Security Benefits
  –   Other thresholds and phase outs.
  –   Fiscal Year



   Agricultural Economics
         Lump sum or annual payments


• Significant tax implications
    – Seek competent tax advice.

    – Provide copy of buyout contract to tax advisor

    – Seek competent investment advice.

    – Don’t rush into lump sum arrangement.




Agricultural Economics