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

Agricultural EconomicsDisclaimer US Treas Notice 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 – 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 $10,000 total contract and 4% rate YearInterestPrincipal 2005$ 0$ 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 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 # Jan 15, 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 Percentage Discount Rate for Aug ‘05 payout Discount Rate for 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 Treasury4.13 % –5 Year Equipment Loan6.90% –15 Year Fixed Farm Loan6.90% By law, discount rate may not be more than 2% plus prime rounded to nearest whole percent. ( = 8.5% rounds to 9.0 % max)

Agricultural Economics Investment options 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 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 –IRA’s –Roth and Traditional –SEP, Simple IRA, –Solo 401K –Relatively New –Roth 401K coming in 2006

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 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.