Tax Implications of Farm Liquidation, Debt Forgiveness, and Bankruptcy

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1 Tax Implications of Farm Liquidation, Debt Forgiveness, and Bankruptcy Prepared by C. Robert Holcomb, EA, Extension Educator, University of Minnesota Extension Revised December 9, 2009 Introduction: A farmer facing liquidation or some type of debt restructure may trigger a number of unintended income tax consequences. In this fact sheet, I will briefly examine the tax implications of farm liquidation. This discussion will also include potential tax consequences of debt forgiveness and bankruptcy. Note: this information piece is offered as educational information only and not intended to be legal or financial advice. For questions specific to your farm business or individual situation, consult with your tax preparer or legal counsel. Categories of Farm Income: It is very important to accurately identify the categories of income when dealing with financial stress. The categories of farm income are: 1. Income resulting from sales of inventory or earned income tied to the farming operation a. Grain b. Livestock (raised or purchased feeder livestock) c. Government Farm Program Payments (including CRP payments providing the taxpayer is not drawing social security benefits) d. Cooperative Patronage e. Custom Work f. Other Income i. Refunds and Rebates ii. Insurance Income iii. Gains from Hedging Accounts Total farm income is offset by Ordinary Farm Expenses, which include: a. Feed b. Fertilizer c. Seed d. Chemicals e. Fuel f. Farm Interest g. Depreciation (including section 179 and 50% bonus depreciation) Farm income and expense is reported on Schedule F. The net farm profit from Schedule F flows to the front page of the Schedule F profits are taxed as ordinary income and subject to self employment tax. 2. Capital Income a. Reported on Schedule D 1

2 i. Income flows through from Form 4797 ii. Includes Raised Breeding Stock Held more than one year Cattle and Horses must be held for 24 months iii. Farmland Held for more than one year Taxed on excess of sale above basis iv. Buildings and Improvements Held more than one year Taxed on excess of sale above basis (subject to depreciation recapture) v. Machinery and Equipment Held more than one year Taxed on excess of sale above basis (subject to depreciation recapture) b. Basis (Depreciable and Non-Depreciable) i. Depreciable: When a capital asset is purchased, the asset is placed on the depreciation schedule. The asset is expensed or depreciated over a pre-determined period of time based on the type of property a. Machinery = Normally 7 years (for 2009, NEW equipment is 5 years) b. Beef breeding stock = 5 years c. Drainage Tile = 15 years You get a half year of depreciation in the year of purchase The other half is picked up at the end of the class life Utilize Section 179 for fast expense write off (year of purchase) Elect Bonus Depreciation (year of purchase)(if applicable for the current tax year) ii. Non-Depreciable: Land Purchase price stays with the property until disposal or passes through an estate Raised Breeding Stock cost of production was deducted on Schedule F so assumed to have zero basis. iii. Basis Calculations Example #1 Tractor Purchase $100,000 Less Section 179 Expense -$100,000 Basis of the Tractor = 0 Example #2 Combine Purchase $200,000 Less 50% Bonus Depreciation -$100,000 Less Normal Depreciation - $10,000 Basis of the Combine= $ 90,000 c. Depreciation Recapture versus Capital Gain i. Depreciation recapture results from the sale of assets that have been depreciated. ii. Gain is categorized as depreciation recapture if the gain is less than the depreciation taken (or the purchase price) of the asset that was sold. 2

3 iii. In the event that the asset was sold for more money than was taken for depreciation (or the purchase price), the excess gain is taxed as a capital gain. Example #3 (see figure 1) Machinery Purchase $10,000 Depreciation -$5,000 Sale price $20,000 Example #3 results in $5,000 of depreciation recapture and a $10,000 capital gain. Figure 1 Example of Depreciation Recapture Depreciation Recapture $20,000 sale price $10,000 purchase Capital Gain - $10,000 Rate: applicable capital gain rate Depreciation Recapture - $5,000 Depreciation Rate: ordinary income $5,000 no SE tax $5,000 adjusted basis (not taxed) Example #4 Assuming the property (land) has been held for at least one year this sale is considered capital gain. Land Sale $250,000 Basis -$80,000 Capital Gain $170, How are the various categories of farm income taxed? a. Ordinary or Inventory Income i. Tax bracket plus Self Employment Tax 2009 and 2010 Federal and State tax brackets are located in the Appendix Federal rates run from 10% to 35% ii. Self Employment Tax Self employment tax remains a split calculation as follows: 12.4% for social security and 2.9% for Medicare for a total of 15.3%. The maximum income amount you will pay social security tax on is $106,800 for 2009 and There is currently no cap on the Medicare portion. Figure 2 illustrates federal and self employment tax rates 3

4 b. Capital Income i. Depreciation recapture Taxed at the applicable federal rate Not subject to Self Employment Tax Unrecaptured Section 1250 gain a. This section generally applies to farm building and structures b. Unrecaptured Section 1250 gain is taxed at 25% (not subject to SE tax) c. Unrecaptured Section 1250 gain is calculated as the smaller of (1) depreciation or (2) total gain less any recaptured depreciation that is taxed at ordinary rates (accelerated depreciation in excess of SL). 1 ii. Long Term Capital Gain Capital gains rate is zero for taxpayers in the 10% and 15% federal bracket Long term capital gains are taxed at 15% for taxpayers in the 25% federal bracket (or higher). This zero percent capital gain provision is scheduled to sunset December 31, Figure Federal Income Tax Rates (Married Filing Joint) 2009 INCOME TAX RATES (MFJ) 45% 40% 35% 30% Tax Rate 25% 20% 15% 10% 5% 0% Income in Thousands Income Tax Self Employment Tax Combined Tax Copyright University of Minnesota. All Rights Reserved. 1 Premium Quickfinder Handbook, 2008 Edition, Thomson Reuters, p

5 4. Bankruptcy/Debt Forgiveness (Cancellation of Debt) a. Full or partial cancellation of a debt is generally considered income for tax purposes. b. It is very important to note as part of this discussion that a bankruptcy proceeding does NOT discharge income tax liability. c. Debt forgiveness in combination with a bankruptcy proceeding makes no difference with regards to cancellation of debt income. There are two general instances (relating to a farmer) when cancellation of debt is NOT considered income for tax purposes (the situations listed below will most often affect farmers. Please consult with legal counsel for additional provisions). i. A farmer who is solvent can exclude from income a cancellation of qualified farm indebtedness [IRC 108(a) (1)]. The farmer is treated as being insolvent to the extent of qualified farm indebtedness. 2 Qualified farm indebtedness is debt from an unrelated lender who is regularly engaged in the business of lending money, and that is incurred directly in connection with farming if it as least 50% of the taxpayer s average annual gross receipts for the preceding three years is from the farming business. 3 ii. A farmer may also exclude from income a cancellation of indebtedness if the farmer is insolvent (but only to the extent of insolvency). [IRC 108] Farmer must have a negative net worth Example Farmer has a negative net worth (-$150,000), Debt forgiveness of $100,000, Results in no taxable income. d. In the case of debt forgiveness due to insolvency, tax attributes must be reduced in a specific order i. Net Operating Loss (NOL) ii. General Business Credit Carryover iii. Minimum Tax Credit iv. Capital Loss v. Basis Personal Property (Equipment) Real Property (Land Buildings) Other Property (Non-Inventory Assets) vi. Passive Activity Loss and Credit Carryovers vii. Foreign Tax Credit e. The current tax code includes several provisions where cancellation of debt may not be taxable. Always check with your tax preparer or legal counsel to examine your individual situation. The following list covers some additional debt cancellation provisions (where debt cancellation is not taxable) that may or may not be applicable to farm families. 4 i. Canceled debt (including interest) that would have been deducted if paid. ii. Student loan canceled after performance of work. [IRC 108(f)] iii. Canceled debt that is qualified principal residence indebtedness. [IRC 108(h)] iv. Debt cancellation intended as a gift. 5. Net Operating Loss (NOL) a. NOL is generated when Adjusted Gross Income is negative i. Negative business (farm) income does not necessarily make an NOL. The losses must be greater than all other income sources. ii. May carry back 2, 3, 4, or 5 years (only farm losses eligible for 5 years). iii. May elect to carry forward until used up (or may be used in a liquidation). iv. Taxpayer loses standard deduction and exemptions for year of loss. v. NOL will not offset SE tax on carry back or carry forward. 2 Ibid., p Ibid., Ibid., 4-3 5

6 6. Alternative Minimum Tax a. Alternative Minimum Tax (AMT) is calculated using a different set of tax rules than those used for regular tax. Under the AMT rules, some deductions taken for regular tax are not allowed (or are limited). Also, certain income and expenses are recognized under different rules for AMT. b. If the AMT calculation results in a higher tax than regular income tax, the difference is added to regular income tax on Form In effect, the taxpayer is liable for either the AMT or regular income tax, whichever is higher. c. Some or all of AMT paid MAY be refundable in future years as a Minimum Tax Credit Installment Sales a. Machinery and Purchased Breeding Livestock do not work for installment sales because the total amount of recapture must be reported as income in the first year of the agreement. i. This often results in the tax liability exceeding the payment amount in the first year. b. Buildings and Improvements work for the installment method. i. Tax is paid on the unrecaptured Section 1250 gain first. Capital gain income is reported after the 1250 gain is exhausted. c. Land works well for the installment method. i. A profit margin is established at the beginning of the agreement. The seller reports an equal amount of income for each year of the installment agreement. ii. Interest income is reported separately. 8. Farm Liquidation a. Liquidation of the business without multiple-year planning can be very costly. b. In a forced liquidation, deferred income and pre-paid expenses can contribute to generating a significant tax liability. c. Grain and feeder livestock sales are the most expensive. i. Taxed at marginal rate plus self employment tax. d. Capital Income i. Land and raised breeding stock taxed as capital gains (assuming holding periods have been met). ii. Machinery and purchased breeding stock taxed mostly as recapture (potential for some capital gain). e. Debt Forgiveness i. May be taxable depending on individual circumstances. 9. Farm Liquidation Examples (Estimated calculations based upon 2008 tax tables) a. Example #1: i. Inventory (grain & raised livestock) $ 250,000 ii. Equipment $ 300,000 iii. Equipment Basis -$ 125,000 iv. Land $ 600,000 v. Land Basis -$ 200,000 vi. NOL Carry forward -$ 150,000 MFJ Return with two dependents Federal Tax Liability $ 150,135 Minnesota Tax Liability $ 49,086 Total Liability $ 199,221 5 Ibid.,

7 b. Example #2: (Same as #1 with no Net Operating Loss) i. Inventory (grain & raised livestock) $ 250,000 ii. Equipment $ 300,000 iii. Equipment Basis -$ 125,000 iv. Land $ 600,000 v. Land Basis -$ 200,000 MFJ Return with two dependents Federal Tax Liability $ 192,135 Minnesota Tax Liability $ 60,861 Total Liability $ 252,996 c. Example #3 i. Same as example #2 except liquidation occurs in two separate years. Liquidate inventory in year one, and liquidate capital items (machinery and land) in year two. Year One: Federal Tax Liability $ 69,872 Minnesota Tax Liability $ 15,364 Total Liability $ 85,236 Year Two: Federal Tax Liability $ 105,500 Minnesota Tax Liability $ 41,995 Total Liability $ 147,495 Totals from both years Federal Tax Liability $ 175,372 Minnesota Tax Liability $ 57,359 Total Liability $ 232,731 Difference from Example #2 $ 20,265 7

8 References: National Income Tax Workbook 2009 Land Grant University Tax Education Foundation, Inc. College Station, TX Internal Revenue Service Website Quickfinder Premium Handbook 2008 Edition Practitioners Publishing Company Fort Worth, TX Minnesota Department of Revenue Tax Year 2009 Individual Income Tax Manual St. Paul, MN. National Association of Tax Professionals U.S. Master Tax Guide 2008 Edition CCH Editorial Staff Publication Chicago, IL. 8

9 Appendix FEDERAL TAX RATES FOR 2009: TABLE 1: MARRIED INDIVIDUALS FILING JOINT RETURNS AND SURVIVING SPOUSES Not over $16,700 Over $16,700 but not over $67,900 $1,670 plus 15% of the excess over $16,700 Over $67,900 but not over $137,050 $9,350 plus 25% of the excess over $67,900 Over $137,050 but not over $208,850 $26, plus 28% of the excess over $137,050 Over $208,850 but not over $372,950 $46, plus 33% of the excess over $208,850 Over $372,950 $100, plus 35% of the excess over $372,950 TABLE 2: HEADS OF HOUSEHOLDS Not over $11,950 Over $11,950 but not over $45,500 $1,195 plus 15% of the excess over $11,950 Over $45,500 but not over $117,450 $6, plus 25% of the excess over $45,500 Over $117,450 but not over $190,200 $24,215 plus 28% of the excess over $117,450 Over $190,200 but not over $372,950 $44,585 plus 33% of the excess over $190,200 Over $372,950 $104,892 plus 35% of the excess over $372,950 TABLE 3: SINGLE INDIVIDUALS (OTHER THAN SURVIVING SPOUSES AND HEADS OF HOUSEHOLDS) Not over $8,350 Over $8,350 but not over $33,950 $835 plus 15% of the excess over $8,350 Over $33,950 but not over $82,250 $4,675 plus 25% of the excess over $33,950 Over $82,250 but not over $171,550 $16,750 plus 28% of the excess over $82,250 Over $171,550 but not over $372,950 $41,754 plus 33% of the excess over $171,550 Over $372,950 $103,216 plus 35% of the excess over $372,950 3 TABLE 4: MARRIED INDIVIDUALS FILING SEPARATE RETURNS Not over $8,350 Over $8,350 but not over $33,950 $835 plus 15% of the excess over $8,350 Over $33,950 but not over $68,525 $4,675 plus 25% of the excess over $33,950 Over $68,525 but not over $104,425 $13,318 plus 28% of the excess over $68,525 Over $104,425 but not over $186,475 $23, plus 33% of the excess over $104,425 Over $186,475 $50, plus 35% of the excess over $186,475 Source: 2009 National Income Tax Workbook 9

10 FEDERAL TAX RATES FOR 2010: TABLE 1: MARRIED INDIVIDUALS FILING JOINT RETURNS AND SURVIVING SPOUSES Not over $16,750 Over $16,750 but not over $68,000 $1,675 plus 15% of the excess over $16,750 Over $68,000 but not over $137,300 $9, plus 25% of the excess over $68,000 Over $137,300 but not over $209,250 $26, plus 28% of the excess over $137,300 Over $209,250 but not over $373,650 $46, plus 33% of the excess over $209,250 Over $373,650 $101, plus 35% of the excess over $373,650 TABLE 2: HEADS OF HOUSEHOLDS Not over $11,950 Over $11,950 but not over $45,500 $1,195 plus 15% of the excess over $11,950 Over $45,500 but not over $117,450 $6, plus 25% of the excess over $45,500 Over $117,450 but not over $190,200 $24,260 plus 28% of the excess over $117,650 Over $190,200 but not over $372,950 $44,672 plus 33% of the excess over $190,550 Over $372,950 $105,095 plus 35% of the excess over $373,650 TABLE 3: SINGLE INDIVIDUALS (OTHER THAN SURVIVING SPOUSES AND HEADS OF HOUSEHOLDS) Not over $8,350 Over $8,350 but not over $33,950 $ plus 15% of the excess over $8,375 Over $33,950 but not over $82,250 $4, plus 25% of the excess over $34,000 Over $82,250 but not over $171,550 $16, plus 28% of the excess over $82,400 Over $171,550 but not over $372,950 $41, plus 33% of the excess over $171,850 Over $372,950 $108, plus 35% of the excess over $373,650 3 TABLE 4: MARRIED INDIVIDUALS FILING SEPARATE RETURNS Not over $8,350 Over $8,350 but not over $33,950 $ plus 15% of the excess over $8,375 Over $33,950 but not over $68,525 $4, plus 25% of the excess over $34,000 Over $68,525 but not over $104,425 $13, plus 28% of the excess over $68,650 Over $104,425 but not over $186,475 $23, plus 33% of the excess over $104,625 Over $186,475 $50, plus 35% of the excess over $186,825 Source: 2009 National Income Tax Workbook 10

11 MINNESOTA STATE TAX RATES FOR 2009: Tax Rate 5.35% 7.05% 7.85% Single $0 - $22,730 $22,731 - $74,650 $74,651 + Head of Household $0 - $27,980 $27,981 - $112,420 $112,421 + Married Filing Jointly $0 - $33,220 $33,221 - $131,970 $131,971 + Married Filing Separate $0 - $16,610 $16,611 - $65,990 $65,991 + Source: Minnesota Department of Revenue - MINNESOTA STATE TAX RATES FOR 2010: Tax Rate 5.35% 7.05% 7.85% Single $0 - $22,770 $22,771 - $74,780 $74,781 + Head of Household $0 - $28,030 $28,031 - $112,620 $112,621 + Married Filing Jointly $0 - $33,280 $33,281 - $132,220 $132,221 + Married Filing Separate $0 - $16,640 $16,641 - $66,110 $66,111 + Source: Minnesota Department of Revenue - University of Minnesota Extension shall provide equal access to and opportunity in its programs, facilities, and employment without regard to race, color, creed, religion, national origin, gender, age, marital status, disability, public assistance status, veteran status, sexual orientation, gender identity, or gender expression. 11