A farmer harvests his crop and deducts all of the costs in the year before retirement. He has a crop in the bin with little or no tax cost basis and is faced with a large tax bill upon sale.
Let’s say this farmer also has equipment valued at more than $1 million that he needs to sell. To maximize income, he might want to sell his equipment in an installment sale, earning 4% to 5%; however, unfavorable tax laws would apply. If the farmer sells his equipment in an installment sale, all of the depreciation recapture will be recognized in the year of sale.
Consider this example: Farmer Jones has equipment (fully depreciated) worth $1 million at retirement. His neighbor would like to buy the equipment with a down payment of $250,000 and a contract for five years with 5% interest.
"The after-tax value of these
10 payments is almost always greater than selling and paying the tax, plus the farmer has invested $1 million."
This sale will create ordinary income of $1 million, all recognized that year. With a combined tax bracket of 45%, his tax liability might exceed $450,000, resulting in negative cash flow. Jones could rent out the equipment to his neighbor, but rent income might be subject to self-employment tax and requires a Schedule C each year.
One option is the use of a charitable remainder trust (CRT). Even if the farmer isn’t charitably minded, the trust can mitigate the negative income tax effect.
Charitable Remainder Trust. There are four parties to a CRT, three of which can be the farmer. The first party is the farmer, or grantor. The farmer transfers crop inventory and/or farm equipment to the trust.
Second, the trust has a trustee (who can be the farmer).
Third, a beneficiary (the farmer) receives an annual income stream from the trust until it is terminated.
Last, upon termination, the funds left will go to a charity. In order to qualify as charity for tax purposes, the amount projected to pass to the charity at the end of the trust term must be at least 10% of the original value.
A charitable remainder annuity trust (CRAT) provides a yearly payment to the donor of either a fixed amount or a percentage of the initial trust’s value. A charitable remainder unitrust (CRUT) provides the donor a yearly payment computed as a percentage of the trust assets’ market value, which is redetermined annually.
Farmer Benefit. When inventory is transferred to the CRT, there is no gain generated to the farmer. The CRT can then sell the inventory and receive cash to be invested in stocks, bonds or mutual funds. The amount of net income recognized by the CRT is accumulated and accounted for annually.
The annual distributions to the farmer are taxed based upon the character of the income generated by the trust on a cumulative basis. The highest income tax-rate (crop sales and depreciation recaptured from the sale of equipment) is passed through to the farmer first. Next, it goes to qualified dividends, followed by capital gains and, last, tax-exempt income.
The farmer’s primary benefit is being able to defer the payment of income taxes in one lump sum at the highest tax rate by spreading his payments over a number of years at a potentially lower tax rate.
Example continued: Our farmer has $1 million of fully depreciated equipment. If he sells his equipment for cash and pays the taxes, he might have about $550,000 to invest at 4%. This results in annual income of about $22,000. If he places the equipment into a 10-year fixed CRT, he can draw out about $98,000 per year. The after-tax value of these 10 payments is almost always greater than selling and paying the tax, plus the farmer has invested $1 million (rather than $550,000).
There are costs to set up a CRT and annual expenses. If you have a large inventory on hand with no tax basis at retirement, discuss the use of a CRT with your tax adviser. You might be surprised.