Tobacco Buyout Tax Implications

1
Tobacco Buyout Tax Implications

• Economic Subject Matter Training
• October 17-21, 2005
• Extension Farm Management Specialists
• Department of Agricultural Economics
• University of Kentucky

2
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.

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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

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Kentucky Tax Treatment

• Kentucky WILL NOT TAX any tobacco buyout payments.

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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 (donors basis)
• Quota by Purchase
• Before separated from land
• After separated from land

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Quota Payment Contd

• 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.

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Quota Payment Contd

• 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

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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.

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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!

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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.

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Payment Allocation to Interest

• Assume 10,000 total contract and 4 rate

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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

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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.

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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

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Net Present Value

• Discounting future income stream into todays
  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

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NPV Cont.

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

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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.

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Discount rates for 9 yr successor-in-interest
contract with Jan 06-14 payments
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Net Present Value

• What is a fair discount rate??
• Whats fair to you?
• Whats 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)

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Investment options

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

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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

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Invest In Operation

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

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Pay Down Debt

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

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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

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Family Living

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

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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 its 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

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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.

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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.

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Retirement Planning

• Several options available for self-employed
• Must match plan with your objectives
• Do you have W-2 employees?
• How much do you want to contribute
• IRAs Roth and Traditional
• SEP, Simple IRA,
• Solo 401K Relatively New
• Roth 401K coming in 2006

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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

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Lump sum or annual payments

• Significant tax implications
• Seek competent tax advice.
• Provide copy of buyout contract to tax advisor
• Seek competent investment advice.
• Dont rush into lump sum arrangement.