agricultural economics tobacco buyout tax implications economic subject matter training october...

Agricultural Economics

Tobacco Buyout Tax ImplicationsTobacco Buyout Tax ImplicationsTobacco Buyout Tax ImplicationsTobacco Buyout Tax Implications

Economic Subject Matter Training

October 17-21, 2005

Extension Farm Management SpecialistsDepartment of Agricultural Economics

University of Kentucky


DisclaimerDisclaimerDisclaimerDisclaimer

• 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.


Tobacco BuyoutTobacco BuyoutTobacco BuyoutTobacco 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


Kentucky Tax TreatmentKentucky Tax TreatmentKentucky Tax TreatmentKentucky Tax Treatment

• Kentucky WILL NOT TAX any tobacco buyout payments.


Quota PaymentQuota PaymentQuota PaymentQuota 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


Quota Payment Cont’dQuota Payment Cont’dQuota Payment Cont’dQuota 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.


Quota Payment Cont’dQuota Payment Cont’dQuota Payment Cont’dQuota 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


Section 1031 RulesSection 1031 RulesSection 1031 RulesSection 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.


Grower PaymentsGrower PaymentsGrower PaymentsGrower 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!


Payment Allocation to InterestPayment Allocation to InterestPayment Allocation to InterestPayment 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.


Payment Allocation to InterestPayment Allocation to InterestPayment Allocation to InterestPayment 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


Lump Sum PaymentsLump Sum PaymentsLump Sum PaymentsLump 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 %



• 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.



• 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


Net Present ValueNet Present ValueNet Present ValueNet 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


NPV Cont.NPV Cont.NPV Cont.NPV Cont.

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


NPV of Lump Sum PaymentsNPV of Lump Sum PaymentsNPV of Lump Sum PaymentsNPV 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.


Discount rates for 9 yr successor-in-interest contract with Discount rates for 9 yr successor-in-interest contract with Jan ‘06-’14 paymentsJan ‘06-’14 payments

Discount rates for 9 yr successor-in-interest contract with Discount rates for 9 yr successor-in-interest contract with Jan ‘06-’14 paymentsJan ‘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%


Net Present ValueNet Present ValueNet Present ValueNet 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)


Investment optionsInvestment options Investment optionsInvestment options

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


Lump Sum or Not?Lump Sum or Not?Lump Sum or Not?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


Invest In OperationInvest In OperationInvest In OperationInvest In Operation

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


Pay Down DebtPay Down DebtPay Down DebtPay 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.


Off Farm InvestingOff Farm InvestingOff Farm InvestingOff 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


Family LivingFamily LivingFamily LivingFamily Living

• No economic benefit to take a discounted amount for consumption

• Again this ties back to goals• Utility



• 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


Methods of Lump Sum PaymentMethods of Lump Sum PaymentMethods of Lump Sum PaymentMethods 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.


Tax Planning ManagementTax Planning ManagementTax Planning ManagementTax 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.


Tax Planning ManagementTax Planning ManagementTax Planning ManagementTax 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


Lump sum or annual paymentsLump sum or annual payments Lump sum or annual paymentsLump 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.

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