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.

3. 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

4. Kentucky Tax Treatment • Kentucky WILL NOT TAX any tobacco buyout payments.

5. 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

6. 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.

7. 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

8. 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.

9. 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!

10. 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.

11. Payment Allocation to Interest • Assume $10,000 total contract and 4% rate

12. 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 betterreturn than the discount rate you are paying?? • Is the Discount Rate Fair ?? • Rates quoted from ?? % to 9.0 %

13. 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.

14. 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

15. 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

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

17. 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.

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

19. Net 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)

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

21. 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

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

23. 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.

24. 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

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

26. 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

27. 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.

28. 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.

29. 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

30. 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.