Tax Implications of the Tobacco Quota Buyout

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Tax Implications of theTobacco Quota Buyout

• Arnold W. Oltmans
• Associate Professor Extension Specialist
• NC State University
• March 10, 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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Tax Overview

• Tax issues, rates, rules are different for
• 3 production payment----ordinary income
• -- 7 quota holder payment----capital gain
• Tax effect varies by individual situations
• Guidelines and principles only
• No one-answer-fits-all.
• Buyout recipients need to work closely with their
  tax preparer, accountant, etc. in 2005 to
  determine their individual tax situation.

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Production Payment (3)Tax Issues

• Relatively simple and straight-forward.
• Payment is ordinary business income (Schedule
  F) subject to
• Self-employment tax---15.3
• Federal tax---from 10 to 35
• NC State tax---from 6 to 8.25
• Combined tax rate effect will vary from 30 to
  51 for most producers.
• Eligible for farm income averaging to reduce the
  amount of tax paid for certain individuals.

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Two Other Important Tax Implications for Producers

• Effect on social security benefits.
• Producer payment is earned income.
• May reduce benefits for individuals taking early
  social security (i.e., before age 65).
• Effect of taking a lump sum payment in 2005.
• Will vary widely among individuals.
• Discussed in other publications.
• Recipients should closely work with their
  professional advisers on these issues.

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Quota Holder Payment (7)Tax Issues

• More complicated, requiring more knowledge,
  information and work.
• Tobacco quota is an interest in land, Section
  1231 asset.
• Has unique tax treatment.

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Quota Holder Payment (7)Tax Issues

• Not subject to self-employment tax.
• Only the capital gain portion is taxable.
• Amount of payment above the cost basis.
• Capital gains tax rates from 5 to15.
• NC State tax rates from 6 to 8.25.
• Combined tax rate from 11 to 23.
• Capital gain income does not affect social
  security benefits.
• Not eligible for farm income averaging.

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Quota Holder Payment (7)Tax Issues

• Capital gains tax treatment implies other
  important tax issues.
• Tax basis of quota.
• Like-kind exchange to defer taxes.
• Lump-sum payment effect on 2005 taxes.
• Recipients should closely work with their
  professional advisers on these issuesSOON.in
  2005---dont wait until 2006 when filing 2005 tax
  returns!!!

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Quota Basis

• Basis is needed to determine capital gain.
• Three basic ways have to acquired quota and a
  basis in quota (different rules for each).
• By purchase---basis is amount paid (cost).
• By inheritance---basis is the Fair Market Value
  (FMV) on date of inheritance.
• By gift---basis is the basis of the person making
  the gift.

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Quota Basis---Common Complications to Resolve

• Quota purchased as part of an entire land
  purchase or inheritance.
• Amount paid for quota should have been separated
  from the land itself.
• If not, quota holder faces a challenge to
  retroactively separate and determine the quota
  portion for a basis.
• No standard way for doing this.
• Requires individual work and thought.

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Quota Basis---Common Complications to Resolve

• Quota received as a gift.
• The previous owners (i.e., person making the
  gift) basis should have been recorded as part of
  the gift transaction.
• If not, quota holder must somehow determine what
  that persons basis was.

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Quota Basis---Common Complications to Resolve

• What if no records were made or if records are
  unavailable?
• A good faith effort must be made to calculate
  quota basis from other historical records.
• No specific method for doing this.
• Cannot simply pick a number or guess.
• No record zero basis (entire payment is
  taxable).

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Quota Basis

• Owners should think in terms of owning and having
  a basis in different lots instead of pounds.
• Pounds purchased, inherited, or gifted are
  different than the buyout pounds.
• Basis per lot of quota remains the same.
• Thinking in basis-per-pound instead of
  basis-per-lot will be confusing.

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Like-Kind Exchangeto Defer Capital Gains Tax

• Legislation (and IRS so far) is silent about
  this.
• It can be legitimately argued, however, that
  Tobacco Quota is an asset that qualifies for
  I.R.C. 1031 like-kind exchange.
• Real Property as an interest in land
• Several letter rulings allow for like-kind
  exchange of interests in land for other real
  property
• LTR 200404044 perpetual water right is like-kind
  for Section 1031 exchange for fee simple interest
  in land

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Like-Kind Exchangeto Defer Capital Gains Tax

• Capital gain and basis from quota rolls over into
  property being purchased.
• Huge potential tax savings.
• Details are complex and require professional
  assistance.
• Limited time frame for making this decision.
• Will require action SOON in 2005.

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Like-Kind Exchange

• Three primary rules must be followed
• Property being purchased (replacement property)
  must be of like-kind category.
• Money paid for relinquished property must be held
  by a qualified intermediary until used to
  purchase replacement property
• Strict time limits MUST be met
• Replacement property must be identified in 45
  days from transfer date
• Replacement property must be acquired within 180
  days from transfer date

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Property that is of a like-kind category.

• Quota for farm
• Quota for timberland
• Quota for Beach RENTAL unit
• Quota for rental 4-Plex
• Quota for common tenancy in a commercial rental
  office building
• REITs that issue a common tenancy in property

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Like-Kind Exchange

• What is the transfer date? (i.e., when does the
  45-day and 180-day time limit begin?)
• Legislation is silent as to the legal transfer
  date.
• Two arguments for the transfer date seem
  reasonable.
• When the quota holder signs up for the buyout
  program (enters into the contract).
• When consideration is first received (i.e., first
  payment check is issued) by the taxpayer.
• Hopefully, IRS or other legislation will define
  the transfer date. If not????????.....make a
  good faith judgement.

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Like-Kind Exchange

• It appears as though a quota holder will have to
  take a lump-sum payment option of the 2006-2014
  payments in order to meet all of the guidelines
  for like-kind exchange.
• Like-kind exchanges might be able to be executed
  with mortgages and installment contracts, but are
  these are very messy. (not good methods in this
  situtation).

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Lump-Sum Payment Option

• Nine payments from 2006-2014 are eligible for a
  lump-sum payment in 2005.
• Lump-sum is received from a private party, not
  the governmental CCC agency.
• The lump-sum amount received in 2005 is taxable
  in 2005, not the contract buyout amount.
• More fully discussed with details elsewhere.

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New Information may change the outcomes as
presented

• IRS may issue rulings and regulations that affect
  these topics.
• Consult with professional tax practitioner for a
  more accurate and complete tax evaluation of
  circumstances.

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BECOME EDUCATED

• Alternatives exist, quota holders and producers
  will have many decisions to make in the near
  term.
• Choose wisely and with knowledge.