The Farm CPA
Paul is now part of the fourth generation in America that is involved in farming and hopes the next generation will be involved also. Through his blog he provides analysis and insight to farmer tax questions.
How to Handle Allocation of Purchase Price
Nov 05, 2010
One of our readers wrote in the following question:
"Our son is in the process of taking over our hog operation. They would like to buy all the buildings, equipment, and house on a contract. Do we need an appraisal for this transaction? Some of the buildings and equipment are 16 years old and fully depreciated. Can we take original cost and value them based on a 20 life? How do we value old equipment to be broken out for tax purposes? Any suggestions on how to handle this transaction?"
Since this is a transaction between related parties (father and son), you must make sure to document this transaction properly. On any material items of equipment with a value greater than $10,000 or so, I would like to see you get an independent equipment appraisal from your local implement dealership. It does not have to be fancy, but as long as it is on their letterhead and a reputable dealership, this should be sufficient. On the equipment with minor value, document how you arrive at the value and if reasonable, the IRS should agree to the allocation.
If the value of the buildings are over $100,000 or so, I would suggest at least getting a local real estate agent to review and give you an estimated value for each building. In today's environment, that can be tough to do with all of the mortgage mess, but it is worth a try. Another option is to review your real estate tax assessed value and see if that is prepared on a fair market value basis. If so, you should be able to use that value and the IRS would not be able normally to make much of an adjustment to those values. If the real estate agent value and the real estate tax value have dramatic differences, you will need to review this with the agent to determine why and document it in writing.
Even though each party in this transaction will agree to the values arrived at in writing, the IRS is not bound by this valuation. Since these are related parties, the IRS can come in and revalued the transaction to whatever they feel is appropriate. Therefore, the more documentation that a farmer has showing how they arrived at the values and the methodology, the more likely the IRS is to agree with valuations.
Let's see an example of how this could dramatically hurt the farmer.
Let's assume the farmer values their property at the following values:
Equipment - $25,000
Buildings - $250,000
House - $125,000
Let's also assume that the father is selling this on an installment contract with $25,000 down and the remainder paid over a 20 year period with 5% interest. Let's also assume the equipment and the buildings have been fully deprecated. Under the installment rules, the equipment gain is all taxed in the year of sale and the building gain will have a small gain to report. If the farmer is in the 25% tax bracket, then the total tax owed will be about $7,000 or so.
Now, let's have the IRS come in and audit the transaction and reallocate $50,000 of value from the buildings to the equipment. This now means the farmer is taxed on $75,000 of equipment gain at 25% or about $20,000 in tax. This results in a tax increase of $13,000 to the farmer, however, they did not receive another dime of cash in the first year.
This is why it is important to properly document any purchase and sale between related parties.