Some Implications of the Tobacco Buyout

Farm Business Management Update, February/March 2005

By Dixie Watts Reaves (dixie@vt.edu), Associate Professor, Agribusiness Management and Marketing, Agricultural and Applied Economics, Virginia Tech

With the passage of the Fair and Equitable Tobacco Reform Act of 2004, the federal tobacco program ended. After years of considering numerous different proposals with many different payment amounts, funding sources, and degrees of regulation, Congress passed the tobacco buyout as a part of the American Jobs Creation Act, which President Bush signed into law on October 22, 2004. Despite widespread news coverage of the buyout, some individuals are still not aware of the details and implications of the buyout.

What exactly does the buyout do?
As of the 2005 production season, there is no longer a quota system. No restrictions are on who can grow tobacco, and no limits are on how much can be produced. No geographic limitations are placed on production, no price support levels, and no "no-net-cost assessment." Basically, the tobacco program as it has been known since the 1930's no longer exists.

The Farm Service Agency (FSA) of the United States Department of Agriculture (USDA) is responsible for drafting the regulations to implement the buyout. FSA will determine the application procedure and guidelines for the disbursement of the funds.

What is not included in the buyout and what is lost?
Although earlier buyout proposals included oversight of manufactured tobacco products by the Food and Drug Administration (FDA), FDA is not a part of the tobacco buyout. Earlier proposals also included dollars for community development in selected tobacco-dependent regions, but this proposal too was eliminated from the final language. Because the buyout is funded by a quarterly assessment on manufacturers of tobacco products, Phase II payments end. This wording is not due to the buyout legislation, but rather to wording in the initial Phase II agreement where it was stated that if and when a manufacturer-funded buyout occurred, obligations to Phase II payments would end. As of the enactment date of the tobacco buyout, manufacturers had already made payments into a trust fund for the first three quarters of 2004. With the passage of the buyout, the companies sued to get those payments refunded, arguing that they were not required to make payments in 2004 once the buyout passed. Grower representatives argued that 2004 payments should be made, since no buyout payments would be forthcoming until 2005, or that at least the first three quarters of payments should be made since the buyout legislation was not signed by the President until October. The courts sided with the manufacturers, and the case has been appealed to the North Carolina Supreme Court.

How much will growers and quota owners receive?
The $10.14 billion buyout includes $500 million for disposition of stocks, with the remaining amount going to growers and quota holders. Quota owners as of the date of enactment (October 22, 2004) are eligible to receive $7 per pound based on basic quota levels in 2002. Equal installments will be offered over a ten-year period, resulting in payments of 70 cents per pound, starting in Fiscal Year 2005 which ends September 30. Thus, initial payments can be expected some time before the end of September. An estimated 416,000 people own quota, including about 57,000 active producers and 359,000 landlords. Total expected payout to quota owners is $6.7 billion. Producers will receive $3 per pound if they produced in 2002, 2003, and 2004. Payments are tied to 2002 effective quota levels. Any year during 2002-2004 a producer did not produce, payments are reduced by one-third. Thus, producers will receive 30 cents per pound over a ten-year period if they produced in all three years. Approximately 57,000 producers are in the United States, and the total expected payout to producers is $2.9 billion.

An option available to buyout payment recipients is to assign their ten years of payments to a financial institution in return for a lump sum payment from that institution. The amount of the lump sum payment will depend on the discount rate offered by the financial institution. Discount rates are chosen based on the level of certainty associated with the ten-year stream of payments, the institution's cost of doing business and desired profit margin, among other factors. If the discount rate were 4%, a producer/quota owner who would have received $10,000 for ten years (for a total of $100,000 at the end of ten years) could instead elect to take approximately $81,000 as a lump sum. At a higher discount rate, for example 7.5%, the recipient would only receive approximately $68,000. It is anticipated that a number of financial institutions will be offering the lump sum payment option. Producers and quota owners are encouraged to shop for the best discount rate if considering the lump sum payment option.

The tobacco buyout is different from the Phase II payments. Some producers and quota owners are expressing concern that the ten years of payments might not last, similarly to the current situation with Phase II payments. However, producers knew that Phase II payments would end in the event a manufacturer-funded buyout occurred. The buyout, on the other hand, is the result of legislation that indicates payments of $7 per pound to owners and $3 per pound to producers. All reasonable expectations are that the payments will continue for the full ten years. Therefore, an individual should NOT make a decision to take the lump sum JUST BECAUSE of a fear that the payments will not last. Depending on financial situation, tax bracket, and offered discount rate, a producer or quota owner may decide that the lump sum is in his/her best interest.

It is anticipated that quota payments will be taxed as capital gains, the difference between the current value of quota ($7 per pound as of the date of enactment of the buyout) and its basis (in essence, its original value). Thus, one of the challenges for owners will be to determine their basis in quota. Depending on how the quota was obtained, determination of basis will vary. If quota was purchased, the basis is the purchase price for the entire "lot" of quota. For example, if a farmer purchased 50,000 pounds of quota in 1997 for $2 per pound, the basis for that lot of quota is $100,000. As of the date of enactment of the tobacco buyout, due to quota cuts, the producer now owns only 25,000 pounds. The value of that 25,000 pounds is the $7 per pound offered through the buyout for a total value of $175,000. Since the basis was $100,000, the capital gains on the quota is the $7,500 ($175,000 minus $100,000), and the farmer will pay capital gains tax on that $7,500.

If quota is inherited, basis is the fair market value at the time of death. If the farmer inherited a farm that had quota on it, the fair market value must be divided between value of quota and value of land. For example, suppose a farm was appraised at a value of $150,000 at the time of death. The farm included 25,000 pounds of quota, which, at the time, was valued at $2 per pound. Basis would be $50,000, and the remaining $100,000 would be designated as the value of the farmland.

Finally, if quota is gifted, the basis of the previous owner is passed along to the new owner.

If a farmer acquired quota over a period of time, basis will need to be determined for each "lot" of quota obtained. If personal farm records do not include values of quota at the time of acquisition, other sources of information could be used to document basis: county appraisers office, real estate agents, or the USDA publication on farm real estate values in the U.S. by county.

Producer payments are expected to be treated as ordinary income. Thus, producers will pay federal, state, and self-employment tax.

Accepting payments over the ten year period versus one lump sum could have a substantial impact on the amount of taxes paid. Guido van der Hoeven, North Carolina State University, has developed an Excel spreadsheet that allows a person to compare the lump sum payment (at a chosen discount rate) to the ten-year payment stream in terms of total taxes paid and total dollars delivered to the producer or quota owner. The spreadsheet can be accessed at http://www.ag-econ.ncsu.edu/faculty/vanderhoeven/Tobacco_NPV_calc.xls.

Individuals will enter the number of pounds of quota owned, basis in that quota, the number of pounds rented, the discount rate, and marginal tax rates.

The tobacco buyout legislation is the biggest change in farm policy in decades. The tobacco industry has been shrouded in uncertainty in recent years and has faced unprecedented challenges. Even though a number of unanswered questions and a period of adjustment to production and prices in a post-buyout world exist, producers and quota owners no longer have to wonder if and when a buyout will occur. The time has come to make decisions about wise investments to put the buyout dollars to good use.

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