Tobacco Buyout and Tax Issues

Farm Business Management Update, June/July 2005

By L. Leon Geyer, (geyer@vt.edu), 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.)

Example 1:

• Dusty Lief produced 1,000 lbs. of tobacco under quota.
• Dusty Leif will receive $30,000 over ten years or $3,000 per year.
• Assume Dusty's marginal tax rates: 25% federal, 5.75% state, and 15.3% SE tax*
• Marginal Tax is 46.05%; therefore, Dusty will pay $1,381.50 in total taxes on $3,000 income annually for the ten-year period.

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.

Example 2:

• Leif Brown purchases 5,000 lbs. for $2.00 per pound.
• Basis is $10,000 in the "lot" or "block" of quota.
• Avg. prior reduction in quota changes the basis per pound, not basis per "lot."
• If Leif's still has the 5,000 lbs. of quota, his basis $2.00 per pound. If Leif's basis were reduced by 20%, he would have 4,000 lbs. of quota and $2.50 per pound of quota.

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.

Example 3:

• Jane Jones inherits quota from Father.
• FMV at date of his death was $50,000 for land and 7,500 lbs. of quota.
• Land was worth $35,000 without the quota.
• $15,000 is the value of tobacco quota ($2/lb.).
• If Jane's quota was reduced by 30%, her 5,250 lbs. of quota is worth $15,000 or $2.86 per lb.

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.

Example 5:

• Bob Smith amortized quota in 1994.
• Bob bought quota in January 1994 for $10,000. He deducted $333 for one year's amortization on his 1994 tax return.
• Adjusted basis is now $9,667, not the $10,000 he paid for the quota.

5. Quota Basis with no record of value at time of death or what I paid for it.

If one has no records,

1. Good faith effort must be made that is reasonable. IRS default position is no records, basis is zero.
2. Historical data may be available and helpful.
3. Other sources may be used.
1. Permanent farm records of others.
2. County Commissioner of Revenue office.
3. Real Estate Agents.
4. USDA
4. For example, if neighbors paid $1.50 a pound in the year that Grandpa died, then his 5,000 lbs. of tobacco quota was worth $7,500.

6. Example 6:

No Records

1. Dyrt Clodd bought 100 acre farm for $185,000 and did not make allocation of basis to land and quota. Historical records show quota sold for $1/lb. and the farm had 800 pounds per acre attached at time of purchase. $80,000 of quota basis might be argued to be reasonable and the balance, $105,000 is allocated to the land.
2. Dad died in 1995. What did others pay for quota that year? If you can establish that neighbors paid $1.75 to $1.85 for quota, then $1.80 per pound would be reasonable.
3. If you were the original owner of quota given to you by the government, your basis is zero.

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

1. $175,000 - $30,000 = $145,000 ($14,500/year)
2. And treated as capital gain of $14,500/year
3. $30,087.50 in taxes (assuming 15% federal capital gain rate and 5.75% state income tax rate)

8. Production and quota gain calculation

Philip Reynolds raised 12,000 lbs. of tobacco in 2002 and 14,000 lbs. in 2003.

1. Philip owned 10,000 of quota and rented 2,000 and 4,000 lbs. (2002 & 2003).
2. Philip purchased 5,000 lbs. for $3.00 and inherited 5,000 lbs. when tobacco quota was selling for $1.00 per pound.

Computation of income Capital gain

1. $35,000 Ð $10,000 = $25,000/10 = $2,500
2. $35,000 Ð $5,000 = $30,000/10 = $3,000

Ordinary income
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:

1. Money paid for relinquished property must be held by a qualified intermediary until used to purchase replacement property.
2. Strict time limits must be met: replacement property must be identified in 45 days from transfer date.
3. Replacement property must be acquired within 180 days from transfer date
4. Legislation is silent as to ¤1031 exchanges and transfer date. Transfer date arguably is when consideration is received by either the qualified intermediary or the taxpayer.
5. A like-kind exchange is more easily executed with a lump-sum payment. Like-kind exchanges can be executed with mortgages and installment contracts but are very messy.

Property that Qualifies for ¤Sec. 1031 Exchange includes the following:

• Quota for farm
• Quota for timberland
• Quota for Beach Rental unit
• Quota for rental 4-Plex
• Quota for a commercial rental office building

10. Farmers could also use the buyout money as follows:

1. Reduce debt and phase out of tobacco
2. Expand farm with purchase (use of ¤1031)
3. Enter into new business activities
4. Gift to family or charitable organizations
5. Diversify family income stream (invest)
6. Retirement
7. Other options

11. The legislation allows for securitization of quota payments.

1. A third party (financial institution) may offer to quota owners a lump-sum payment at a discount.
2. The present value and tax consequence must be evaluated for such a transaction.
3. The lump-sum will retain the character of income as the original payment stream: capital gain and production payments on a pro-rata share basis.

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

1. Tobacco Quota Buyout and Potential Tax Consequences and Planning Opportunities 10/22/2004
2. Homework: Calculate Tobacco Quota Basis 2/20/2003
3. Net Present Value Calculator for Lump Sum Options for the Tobacco Quota Buyout 10/28/2004

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