Tobacco Buyout and Tax Issues
Farm Business Management Update, June/July 2005
By L. Leon Geyer, (email@example.com), Professor, Agricultural Law, Agricultural and Applied Economics, Virginia Tech
The American Jobs Creation Act of 2004 signed into law on October 22, 2004, created authority for farm producers and quota holders to receive funds for quota and production rights in tobacco. The repeal of the tobacco price support program has major tax and financial implications for farmers, quota holders, and those who serve the farmers needs.
Under the legislation, the quota holder is to receive $7.00 per pound based upon quota held in 2002 and producers are to receive $3.00 per pound of tobacco based upon their production in the 2002, 2003 and/or 2004 crop. Many farm producers owned quota as well as rented additional quota tobacco from relatives, neighbors, and other quota owners. For example, if Grandma Kent owned 1,000 lbs. of tobacco quota and rented the quota to her grandson Winston, Grandma Kent will receive $700 a year for 10 years and Winston will receive $300 per year for 10 years for his production rights to the quota. If Winston also owned 2,000 lbs. of quota, he will receive $2,000 per year for his quota and production rights ($1,400 for the quota and $600 for production of the quota). In our example, Grandma will receive $700 and Winston $2,300. But how will each report the income for tax purposes from the tobacco buy out?
The $3.00 ($900) a pound paid for loss of tobacco production to Winston is ordinary income. Winston will report the $900 on his schedule F. Thus the $900 is subject to self employment tax and ordinary income tax.
Because tobacco quota is an interest in real estate, it is treated as §1231 asset used in a trade or business. If the quota was held for more than a year, the gains are treated as capital gains and losses are treated as ordinary losses. Therefore, Grandma Kent will report the $700 each year as a capital gain and Winston will report $1,400 as a capital gain. They will have to subtract their basis in their quota from the buyout payments to determine their capital gain.
The following examples are illustrative of the tax consequences of the payments provided to procedure and quota holders, including how to determine basis. Since quota is an interest in land a Sec. 1231 asset, the gains (or losses) are reported on Form 4797.
1. Tax Issues for the Production Payments ($3/lb.)
2. Basis of purchased Quota
Leif Brown purchased quota. What is his basis to calculate capital gains? What he paid for quota is his basis.
3. Basis of Quota if inherited.
Jane Jones inherited quota from her father. What is her basis to use to calculate her gain on the quota? Quota basis is stepped up to the fair market value (FMV) at the date of death or alternate valuation date (6 months after death) of Jane's father. Jane's basis is stepped up to fair market value on date of decedent's death.
4. Quota Basis if quota was previously amortized.
Bob Smith amortized quota in 1994. What is his basis in the quota today?
Bob's purchase price of quota (original basis) is adjusted downward by the amount he amortized.
5. Quota Basis with no record of value at time of death or what I paid for it.
If one has no records,
6. Example 6:
7. Capital gain calculation
Example 7. Lisa Holder owns 25,000 pounds of tobacco quota. Her basis is $30,000 or $1.20 per lb. As an owner of quota, Lisa will receive $175,000 over ten years with an annual payment of $17,500.
Gain is calculated by subtracting her basis
8. Production and quota gain calculation
Philip Reynolds raised 12,000 lbs. of tobacco in 2002 and 14,000 lbs. in 2003.
Computation of income Capital gain
c. $36,000/10 = $3,600 (x tax rate & SE)
9. Like kind exchange and tobacco buy out.
Arguably tobacco quota is an asset that qualifies for I.R.C. §1031 like-kind exchange. Real property is an interest in land. Several letter rulings allow for like-kind exchange of interests in land for other real property.
Two primary rules must be followed:
Property that Qualifies for §Sec. 1031 Exchange includes the following:
10. Farmers could also use the buyout money as follows:
11. The legislation allows for securitization of quota payments.
12. Other issues
Some Virginia counties have had a property tax on tobacco quota. Since the tobacco quota no longer exists as an asset, the property tax value, if any, should become zero. Tobacco is grown in 22 percent of Virginia counties. In jurisdictions with tobacco quota, 47 percent considered the add-on quota value when assessing the use-value of agricultural land. The rest (53 percent) do not. You should check with your county or city governments to make sure that quota property taxation is removed, since quota no longer has value.
Quota payment dollars do not qualify for farm income averaging payments and payments will be reported on forms 1099-gov. Farmers should consult their CPA or tax practitioner as well as their financial advisors in managing both taxes and the long-term consequences of the tobacco buyout.
For additional information, see http://www.ag-econ.ncsu.edu/faculty/vanderhoeven/guido.htm
Using the Tobacco Net Present Value Calculator
For further information on operations of the tobacco buyout program, consult your Farm Service Agency and Farm Management Agent.
Visit Virginia Cooperative Extension