retirement
Retirement means different things to different farmers. For some, retirement is the slow, gradual process of turning over the farming operation to the next generation. For others, retirement may be the immediate sale of operating assets when there is not an heir to take over the farming operation. Regardless of the type of retirement, operating assets will often be transferred. This article will discuss the different strategies to transfer operating assets and the implications of each strategy.
Strategy #1. Gifting
The gifting of assets is the simplest transfer strategy. Gifting works best when the assets are being transferred to a family member and no income is needed from the assets. While gifting may seem like the obvious best solution if transferring to a family member, there are significant negative tax implications to gifting that should be considered.
Advantages
- Simple
- Ownership is transferred relieving owner of liability and responsibility for repairs and maintenance
- Helps next generation
Disadvantages
- No income to owner
- Loss of stepped-up tax basis
Strategy #2. Outright Sale
When income is needed from operating assets, a sale may be the best transfer strategy. Because many operating assets are untitled, a sale can be completed rather easily. The buyer provides the funds and the sale is completed. An outright sale is considered to be a sale that involves all assets being transferred simultaneously with a payment for the entire sale.
Advantages
- Creates income
- Relieves owner of liability and maintenance responsibilities
Disadvantages
- Tax liability is usually significant due to little or no tax basis and depreciation recapture
- Will use resources of next generation of farmer
Strategy #3. Gradual Sale
Instead of an outright sale, assets can be sold gradually, over time. Usually in this strategy, a few items are sold each year until transfer is complete. The sales can happen somewhat uniformly each year or be adjusted as the seller needs income and/or the buyer has available resources to purchase.
Advantages
- May help keep seller in lower income tax brackets by spreading out income
- Relatively simple
Disadvantages
- Owner must wait to receive income for all assets
- Owner retains some ownership and thus retains some liability and responsibility for maintenance
Strategy #4. Installment Sale
An installment sale involves the sale of the assets with payment being made over a number of years. This strategy may seem attractive as a way to sell assets and spread income over time. However, an installment sale is often the worst strategy when selling operating assets because the IRS requires all depreciation recapture taxes to be paid in the first year of the installment sale. Be sure to discuss an installment sale with your tax advisor before implementing this strategy.
Advantages
- Transfers ownership immediately to eliminate liability and maintenance
- After the taxes are paid in year 1, little or no taxes may be owed on the remaining payments
Disadvantages
- All depreciation recapture tax is due in the first year of the installment sale
- Risk of buyer not making payments
Strategy #5. Lease with Purchase Option
A lease allows payments to be spread over the term of the lease with taxes due upon receipt of each payment, rather than all due up front. The person leasing the machinery can then be given the option to purchase the machinery upon the expiration of the lease. For the retiring farmer who needs income from their machinery, this is a strategy worth exploring.
Advantages
- Spreads income and tax liability over the term of the lease
- May help cash flow for buyer and lease payments are a deductible expense
Disadvantages
- Ownership is retained so remain liable for the asset
- The “Buyer” does not own the asset so cannot use as collateral
- It can be complicated to determine lease rates when machinery is traded, replaced or sold
Strategy #6. Integrating a Business Entity into the Transfer Plan
Using a business entity, such as a limited liability company (LLC) , for the transfer of operating assets can have multiple benefits. An LLC can reduce liability exposure, simplify the transfer process, and reduce tax liability. Anyone transferring operating assets should consider incorporating an LLC into the process.
Advantages
- Will provide liability protection for the owner of the assets
- Sale of entity ownership is usually considered a capital gain which is taxed at lower rates
Disadvantages
- Can cost up to several thousand dollars to set up
- Business entity requires management such as accounting, bank accounts and tax returns
Strategy #7. Charitable Remainder Trust
A Charitable Remainder Trust (CRT) can be an excellent strategy for the retiring farmer to sell operating assets without immediate tax liability, receive a long-term flow of income and make a charitable contribution. The strategy involves establishing a charitable trust, transferring operating assets to the trust, then selling the assets through the trust. Due to the charitable nature of the CRT, no tax is due upon the sale of the assets. The CRT then establishes an annuity for the retiring farmer which generates annual income. At the termination of the CRT, the remaining principal in the CRT is donated to the charitable beneficiary. The CRT strategy is the most complicated strategy and will require the most legal and accounting fees.
For a detailed discussion of the CRT strategy, see the Charitable Remainder Trusts as a Retirement Strategy for Farmers bulletin available at farmoffice.osu.edu.
Conclusion
There are several strategies that can be implemented to transfer operating assets at retirement. There is no perfect strategy, each one has advantages and disadvantages. A thorough analysis of the implications to income, taxes, liability and cash flow of each strategy should be performed before deciding on the preferred strategy. Working with knowledgeable tax and legal counsel can help with the decision-making process and reduce the chances of unwanted or unexpected outcomes.
For more information on these strategies, see the Strategies for Transferring Farm Operating Assets bulletin available at farmoffice.osu.edu.
Tags: retirement, transfer of assets
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One of the primary challenges for a retiring farmer is the large tax burden that retirement may cause. Throughout their farming careers, farmers do a good job of managing income taxes, in part, by delaying sales and prepaying expenses. This strategy works well while the farm is operating but can cause significant tax liability upon retirement. The combination of a large increase in revenue from the sale of assets and little or no expenses to offset the revenue can cause a retiring farmer to be pushed into high tax brackets. It is not unusual for 40% or more of the sale proceeds from a retirement sale to go to taxes. One strategy to reduce income tax liability at retirement is a Charitable Remainder Trust (CRT). A CRT can be an effective way of managing income taxes at retirement, but it is not for everyone.
A CRT is a charitable trust because at least some of the assets in the CRT must eventually pass to a qualified U.S. charitable organization such as a church or 501(c)(3) corporation. This charitable nature of the CRT is central to the CRT strategy. As a charitable trust, the CRT may sell assets without paying tax on the sale. So, instead of the retiring farmer selling assets in their own name, they donate the assets to the CRT and then the CRT sells the assets. The retiring farmer then receives an income stream from the CRT. After a period of time, the income stream stops and the remaining trust assets are contributed to the named charity. The following are the steps of the CRT strategy:
- Assemble a team of advisors and develop a CRT strategy.
- Donor establishes a CRT. The trust document declares the income beneficiaries and the charitable beneficiaries.
- Donor determines the assets to be contributed to the CRT.
- Donor contributes assets into the CRT, typically grain, machinery and/or livestock.
- The CRT sells the assets but does not pay tax.
- The Trustee of the CRT uses the sale proceeds to establish an annuity. The annuity must be designed to provide at least 10% of the sale proceeds to the charity.
- The annuity pays out to the Donor over a number of years. The Donor pays income tax on the annuity distributions.
- When the trust is terminated, the charity is paid the remaining assets.
Consider the following example to help further explain how a CRT strategy works:
Farmer decides to retire at the end of the 2023 crop year. After harvesting the 2023 crop, Farmer owns $1 million of grain and $1.5 million of farm equipment. Farmer’s accountant tells him that if he sells all the grain and machinery in one year, he will pay around $1 million in taxes. Farmer decides to implement the CRT strategy. He establishes a CRT and names himself and his spouse as the income beneficiaries and the local children’s hospital as the charitable beneficiary. Farmer transfers his grain and machinery into the CRT. The CRT sells the grain and machinery and receives $2.5 million in sale proceeds.
The CRT establishes an annuity that will pay out $125,000 for the next 20 years. Farmer pays income tax on each $125,000 payment which results in $20,000 of annual income taxes. After 20 years, the trust is terminated, and the children’s hospital receives the remaining funds in the CRT.
As the example shows, the strategy avoids a large, up-front tax payment in the year of the asset sale. Farmer pays taxes on each annual $125,000 payment which allows him to stay in a lower tax bracket. In the example, instead of paying $1 million in taxes in 2023, Farmer spreads the payments out and ultimately pays $400,000 over 20 years.
The primary disadvantage of a CRT is that it is an irrevocable trust. Once the CRT is set into motion, it cannot generally be undone. A CRT may not be the best option for farmers who wish to keep flexibility with managing their assets or who are transitioning the farming operation to family members. While a CRT provides many tax and business benefits, it is not an adaptable plan that can be changed in the future.
Another disadvantage of a CRT is the cost. It is usually a rather complicated process to establish the trust, calculate the potential tax savings, file a tax return, and establish an annuity. Legal and other professional fees will often be tens of thousands of dollars. It is important early in the planning process to weigh the potential tax savings against the cost of establishing the CRT.
For more information on CRTs, see the newly published bulletin Charitable Remainder Trusts as a Retirement Strategy for Farmers available at farmoffice.osu.edu. This bulleting provides details on how a CRT strategy is implemented and its advantages and disadvantages. Be sure to consult with an attorney, tax advisor and financial advisor before deciding on a CRT for your retirement strategy.
Tags: retirement, Estate Planning, farm transition planning, charitable remainder trust, trust, CRT
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