LumpSum Payment Option of the Tobacco Quota Buyout

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Lump-Sum Payment Option of theTobacco Quota
Buyout

• Arnold W. Oltmans
• Associate Professor Extension Specialist
• NC State University
• March 16, 2005

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Disclaimer

• Information provided here is for educational
  purposes only. Nothing herein constitutes the
  provision of legal advice or accounting services.
  Quota holders and tobacco producers should
  contact their tax practitioner and other
  professional advisers relative to their
  circumstances in regards to these issues.

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Lump-Sum Overview

• Available for both the producer (3) payment and
  the quota (7) payment.
• Important issues
• Procedure for setting up a lump-sum.
• Tax implications.
• Financial return, advantages and disadvantages.

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Lump-Sum Overview

• Advantages and disadvantages of taking a lump-sum
  payment vary by individual situations.
• Guidelines and principles only
• No one-answer-fits-all.
• Recipients considering the lump-sum option need
  to work closely with their tax preparer,
  accountant, etc. SOON in 2005 to determine how it
  fits their individual financial and tax
  situation.

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Procedure for Setting Up a Lump-Sum Payment

• Done through an agreement with a private party
  (lump-sum payment does not come from the
  government CCC agency making the buyout
  payments).
• a.k.a. as securitization of the buyout payment
  contract.

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Procedure for Setting Up a Lump-Sum Payment

• Recipient transfers all rights in his/her buyout
  contract to a private party through a
  successor-in-interest contract
• Forms are available from local USDA office.
• Only the 2006-2014 payments (last 9) are eligible
  for a lump-sum payment.
• This is distinctly different from taking out a
  loan and assigning payments to a lender.

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Procedure for Setting Up a Lump-Sum Payment

• May be done in a later year for the remaining
  payments.
• i.e., dont have to take a lump-sum in 2005
• a partial lump-sum in a later year for the
  remaining payments.
• This flexibility may reduce the tax liability and
  help in planning or managing finances.
• But, how many financial institutions will be
  interested in making partial lump-sum offers
  after 2005? For how long?

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Tax Implications of a Lump-Sum Payment

• All taxes are due on the amount received in the
  year the lump-sum is received (i.e., taxes cannot
  be paid in installments any longer ).
• For many, this will result in a large increase in
  the tax rate on the buyout payment.
• Some however, most likely producers, may lower
  their tax rate.
• Amount of difference in tax is a major piece of
  information for making a decision about the
  lump-sum option.

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Tax Implications of a Lump-Sum Payment

• Exact tax effect will vary widely depending on
  other factors affecting taxation.
• Amount of payment.
• Basis in the quota.
• Other taxable income.
• Filing status (single, married, etc.).
• Recipients must consult their tax preparer before
  deciding on a lump-sum payment.

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Tax Implications of a Lump-Sum Payment

• May have an effect on social security benefits
  for those receiving producer payments.
• Positive effect from not having earned income for
  future years during age 62-65.
• Negative effect if the lump-sum is received
  during age 62-65.
• A partial lump-sum later, after age 65, may be
  advantageous here.

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Tax Implications of a Lump-Sum Payment

• Only the amount of the lump-sum is taxable (not
  the original or face amount of buyout payments).
• Example George will receive 10,000 in 2005 and
  90,000 in years 2006-2014.
• George takes a lump-sum of 72,000 from ABC
  Financial in 2005.
• Only the 72,000 is taxable (along with the
  10,000 not part of the lump sum) in 2005.

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Financial Returnfrom a Lump-Sum Payment

• How do I know if a lump-sum offer is a good
  deal?
• How much should a lump-sum be?
• Exact answer will vary among individuals, but
  some guidelines are a useful starting point.

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Financial Returnfrom a Lump-Sum Payment

• Every lump-sum offer implies an interest rate
  (discount rate) the private party is charging the
  buyout recipient.
• Think of this interest rate as what it is costing
  the recipient to receive a lump-sum today instead
  of waiting for the payments in years 2006-2014.

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Financial Returnfrom a Lump-Sum Payment

• The lump-sum offer will be a percentage of the
  face amount (LS---Lump Sum Percentage).
• Sarah will receive 198,000 in total payments
  from 2006-2014.
• ABC Financial offers her a lump sum of 158,400.
• Sarahs LS is 80. (158,400 / 198,000)
• The LS can be converted into an interest rate
  equivalent.

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Financial Returnfrom a Lump-Sum Payment

• The table of implied interest rates assumes that
  the lump-sum is received in October, 2005 and the
  financial institution making the offer receives
  payments 2-10 in January of 2006-2014.
• If the above dates are different in an offer, the
  implied interest rate will change slightly.

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Rule-of-Thumb for Evaluating A Lump-Sum Offer

• If the recipient of a lump-sum offer can invest
  the lump-sum money at a rate of return greater
  than the implied interest rate in the offer, the
  offer is financially advantageous (a good
  deal).
• If the recipient of a lump-sum offer can invest
  the lump-sum money at a rate of return less than
  the implied interest rate in the offer, the offer
  is financially disadvantageous (a poor deal).

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Rule-of-Thumb for Evaluating A Lump-Sum Offer

• Example Sarah has a lump-sum offer with an
  implied interest rate of 5.6. Sarah will use
  the money to pay off a debt with a 7 rate of
  interest. The offer is a good deal for Sarah.
• Example Betty receives a similar offer with an
  implied rate of 5.6. Betty intends to invest
  the money in CD paying 3. The offer is a poor
  deal for Betty.

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Financial Returnfrom a Lump-Sum Payment

• CCC has established a maximum discount rate that
  can be charged.
• Prime rate plus 2 (rounded to a whole).
• Currently, that equals 7-8.
• The maximum rate can change over time.

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Financial Returnfrom a Lump-Sum Payment

• Reasons other than the interest rate to consider
  in evaluating a lump-sum offer.
• Increased liquidity.
• Simplifies estate planning.
• Greater flexibility.
• Encourages wasteful spending.
• Higher taxes (most likely but not always).

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Financial Returnfrom a Lump-Sum Payment

• Previous slides were done on a before-tax
  basis.
• Decisions about a lump-sum should be made on an
  after-tax basis.
• Tax effect makes the return needed higher than
  the table and rule-of-thumb suggests.
• After-tax analysis requires the help of
  professional financial advisers for exact answers.

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Like-Kind Exchange

• Greatest advantage of a lump-sum offer is its use
  in a tax-deferred like-kind exchange for quota
  holder payments (not the producer payment).
• Like-kind exchange is discussed elsewhere.

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Assignment of Payments to Secure a Loan

• Lump-sum payment is not the same as receiving a
  loan and assigning payments to a lender.
• With a loan the producer or quota holder still
  owns the buyout contract.
• Recipient of a loan has constructive receipt of
  income and pays taxes on payments each year,
  2005-2014, even though no cash is actually
  received in those years (cash from the loan is
  received in 2005 and the lender collects the
  payment in future years).
• Can create difficulty for tax payments in future
  years.

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New Information may change theoutcomes as
presented.

• IRS may issue rulings and regulations that affect
  these topics.
• Consult with professional financial advisers for
  a more accurate and complete evaluation of
  individual circumstances of a lump-sum payment
  offer.
• Alternatives exist, quota holders and producers
  will have many decisions to make in the near
  term.
• Choose wisely and with knowledge.