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Tax Considerations for the Tobacco Buyout
Farm Business Management Update, February/March 2005
By Daniel Osborne (email@example.com), Extension Agent, Farm Business Management, Smyth County
With the passage of "The Fair and Equitable Tobacco Reform Act of 2004," also known as the "Tobacco Buyout," comes the payment to quota holders of $7 per pound and the payment to producers of quota tobacco of up to $3 per pound. Almost inevitably when farmers receive a payment, tax consequences follow. For Tobacco Buyout payments, the tax treatment and considerations vary depending on whether the payments are received as a quota holder or as a producer. Below is a brief overview of the tax considerations that must be made. If you find these considerations difficult to decipher, you may prefer to share and discuss them with your tax preparer. Keep in mind, the IRS may issue rulings after the writing of this article that may alter the considerations listed herein.
Tax Considerations for Quota Holders
- Payments will be taxed as long term capital gains (5% or 15% for years 2005-2008 and 10% or 20% after 2008) if held more than 1 year.
- Payments will be taxed as short term capital gains (ordinary tax rate) if held 1 year or less.
- The taxable gain, whether long term or short term, equals the total payments less the cost basis. (Determining the cost basis of tobacco quota is beyond the scope of this article; however, questions on the subject may be directed to the author.)
- Payments will not be subject to self-employment taxes unless the quota holder is a dealer of tobacco quota.
- The transaction must be reported as an installment sale on Form 6252 unless a lump sum is received or an election is made to recognize the income in the year of sale.
- For installment sales with the total of all payments over $3,000, part of each payment must be allocated to interest based on the federal applicable rate. The interest portion will be taxed as ordinary income.
- Taxes may be reduced or eliminated by using a section 1031 like-kind exchange. Tobacco quota could qualify for a like-kind exchange for real property, improved or unimproved, that is used for business or investment purposes. A qualified intermediary or qualified escrow account should be used to conduct a like-kind exchange transaction. (Some banks, lawyers, or real estate companies will serve as qualified intermediaries.)
Tax Considerations for Producers of Quota Tobacco
- Payments will be taxed as ordinary income (10% - 35% for the years 2005-2010 and 15% - 39.6% for years 2011 and later).
- Payments will be subject to self-employment taxes unless the share of risk as a "producer of quota tobacco" was for rental income without material participation.
- The maximum earnings subject to the social security part (12.4%) of self-employment taxes are $90,000 for 2005.
- Tax liability resulting from tobacco buyout payments for producers of quota tobacco may be reduced or deferred by using tax strategies applicable to ordinary farm income. Examples of such strategies include income averaging, the section 179 deduction, contributions to traditional IRAs or retirement plans, and others. See Publication 225 for more information on these tax strategies.
Not only will these consideration help with tax compliance, but hopefully they will also help address the questions of whether to take a lump sum or installments and how to minimize the tax liability resulting from buyout payments. Feel free to direct questions regarding this article to the author at firstname.lastname@example.org or (276) 783-5175.
Virginia Cooperative Extension