Placing a farm operation and farmland into a corporation was a common tax strategy prior to 1986 when the top individual tax rate was much higher than the top corporate tax rate. There was an incentive to take advantage of this difference; however, there might be a ticking time bomb for these farmers.
I’ll illustrate with a story. As a farmer approaches retirement, he visits his CPA and asks how much cash he will have after selling his farmland and liquidating the corporation (for this story, we will assume the corporation has only land).
"What did you pay for the land," asks the CPA. The farmer says he bought 640 acres in 1970 for $100,000. The CPA asks what it is worth now. "My neighbor will buy it for $9,600,000," the farmers says.
"It is possible to purchase $9.6 million worth of land for a $2 to $3 million discount and still have the seller be better off."
The CPA crunches his numbers and says "Since you live in California, the federal and state tax must be calculated on the gain. Corporations do not enjoy a reduced capital gains rate. The federal tax rate of 34% applies or $3,230,000. California’s corporate tax rate is 8.84% for $839,800 of state income taxes. The state taxes are usually allowed as a deduction against federal tax, so the final federal and state income tax bill will be $3,785,000."
The farmer gulps. "I hope that is all the tax I owe," he says. The CPA says not quite. "After you pay corporate income taxes, you have $5.8 million left. We need to distribute this cash to you in the form of a liquidating distribution. I need to know how much you paid for your stock."
The farmer ponders for a moment and says "Not much; let’s use zero." The CPA goes back to crunching numbers and says "The federal capital gains tax rate is 23.8% and the state rate is 13.3% (Alternative Minimum Tax does not allow the state tax deduction). This results in a 37.1% combined rate or $2.2 million of tax.
The farmer asks "How much do I get after paying all of the taxes?" The CPA says that of the $9.6 million, "you will end up with $3.6 million."
Now this has been simplified, but for farmers who have land in a corporation with a low tax basis and want to sell land, liquidate the corporation and retire on the proceeds, this is accurate. You might not live in California, but the federal tax applies and if land was acquired prior to 1990, most of the sales price will be a gain.
Instead of focusing on reducing this tax, let’s look at the opportunity for farmers to acquire land at a discount. You can make an informed purchase decision by estimating the tax amount the farmer might pay using the calculations in the story. Many times the seller will share this information. If not, you can estimate it by finding out the year he purchased the property (to estimate cost) and what it is worth now. Take the estimated gain and run the calculations in our story, but use your state income tax rate.
Land at a Discount. Let’s use the same numbers in this example. We know $3.6 million is the after-tax cash amount, but we need to calculate the pre-tax amount. Divide the after-tax amount by 1, minus the combined federal and state income tax rate on capital gains (1-(23.8%+13.3%) or 62.9%). This gives a pre-tax amount of $5.7 million. Paying $5.7 million for his stock is equivalent to the corporation selling the land for $9.6 million. This is almost a $4 million discount.
As a buyer, acquiring a land-based corporation with a basis of $100,000 and buying the stock for $5.7 million only gives you basis in the stock. The land basis remains the same. However, you cannot depreciate land. If the goal is to keep the land in the family for future generations, you might not care about this gain since it’s not likely the land will be sold.
It is possible to purchase $9.6 million worth of land for a $2 to $3 million discount and still have the seller be better off. These transactions are happening across the country and I expect the trend to accelerate.
These situations are complicated and need to be discussed with your tax adviser and legal counsel before finalizing a common stock purchase of farmland.
Paul Neiffer is a tax accountant with CliftonLarsonAllen and author of the blog The Farm CPA. He grew up on a wheat farm in Washington and owns a corn and soybean farm in Missouri. Contact him at email@example.com.