NEWS for North Dakotans
Agriculture Communication, North Dakota State
University
7 Morrill Hall, Fargo, ND 58105-5665
April 16, 1998
Farmers and ranchers planning to call it quits should plan carefully for the tax burdens they'll encounter as they liquidate, according to Ron Haugen, farm economist for the North Dakota State University Extension Service. People on the way out of farming can incur significant taxes, in some cases so burdensome that an individual may find he "can't afford to quit."
One common error in calculating the financial outcome of a liquidation is to forget to figure the effects of deferred tax liabilities.
"It is possible," says Haugen, "that a producer's balance sheet will show a favorable equity position before liquidation if deferred tax liabilities are not included—but when deferred tax liabilities are included, the equity position may be reduced or may show insolvency."
Haugen says that anyone planning to get out of farming should focus on three important elements: inventory liquidation, sale of capital assets and the possibility of debt forgiveness.
"First, income from liquidation of current inventory needs, of course, to be reported as income," says Haugen. "The trouble is that there are no current expenses, accounts payable or accrued expenses to offset this income. If this income is used to pay principal from a previous operating loan, there may not be anything left to pay the taxes."
The selling of capital assets involves two elements that need to be analyzed for tax consequences: depreciation recapture and capital gains.
"The capital gains tax rates have been reduced by the 1997 Taxpayer Relief Act," says Haugen, "and there is a misconception that this may help minimize the tax burden upon liquidation of assets. This may be true for farmland liquidation, but may not be true for machinery and equipment liquidation. Only gain above the original purchase price is treated as capital gain, and depreciable property such as farm equipment is likely to have a zero or very low tax basis, so in that situation the new act doesn't help at all. Any gain above the tax basis would be taxed as ordinary income up to the original purchase price."
For example, if a tractor originally purchased for $20,000 were depreciated to zero and then sold for $15,000, the ordinary gain would be $15,000. But if that tractor were sold for $23,000, there would be $20,000 of ordinary gain and $3,000 of capital gain. Only the last $3,000 would benefit from the new tax rules.
"Usually farmers are very surprised to learn of the tax consequences of selling equipment," says Haugen.
Debt forgiveness is the third thing to consider when calculating tax consequences. To get someone to agree to cancel your debt sounds like a good deal, and may be. The problem is that canceled debt is income, and in many cases tax will need to be paid on that income.
"Debt forgiveness may be excluded from income in certain situations," says Haugen. "Farmers who are insolvent, or who are solvent but fit the `qualifying farmer' definition may qualify for this exclusion.
"One other helpful thing to remember is that forgiven debt may include interest from a previously refinanced transaction. This interest can be deducted upon cancellation because it would have been deductible had it been paid."
Haugen points out that people getting out of farming may find ways to avoid the tax burden by spreading out taxable events over two or more tax years. Leasing equipment may be one way of doing this, or selling assets under the installment method. Installment sales may work for selling land, but may not for selling equipment, since depreciation recapture must be included in the year of the sale as ordinary income.
"People who owe income taxes and do not have the ability to pay have two options," says Haugen. "They may make arrangements with the Internal Revenue Service to pay in installments over time, and/or they may negotiate `offers in compromise' with the IRS, by offering a payment amount. But offers in compromise involve very complicated procedures and may take months to work out."
For more information on these procedures, Haugen suggests contacting a tax professional who has experience with them. For income tax guidance of all kinds, contact the IRS at 1-800-829-1040, or a tax professional.
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Source: Ron Haugen (701) 231-8103
Editor: Barry Brissman (701) 231-7866