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 Knowledge for the CommonWealth

Five Mistakes to Avoid With Your Tobacco Buyout

Farm Business Management Update, June/July 2005

By Brian Lacefield, (, Agricultural Extension Specialist, Agricultural Economics, University of Kentucky at Hopkinsville

On October 22, 2004 President Bush signed into law a bill ending the price support of tobacco through production control. This has become known as the "tobacco buyout" and eliminates the quota system. Current quota owners and active producers during the past three years will receive payments. The quota owner will receive payments of $7/lb. and growers will receive $3/lb. based on the 2002 quota. The money will be paid by the tobacco companies and administered by the USDA in ten annual payments.

Quota owners and growers totaling over 150,000 in Kentucky will receive $2.5 billion from the buyout. Provisions in the law allow recipients to get a discounted lump sum through a third party, such as a lending institution. Regardless of whether you are taking an annual payment or lump sum, you are dealing with a unique cash inflow. Five mistakes you must avoid to get the most out of your buyout are:

1. Failure to sign up - Sign up is currently underway. You must sign up by June 17, 2005 to be eligible for your payments. Also, you must sign up in each county that you raise tobacco in.

2. Getting in too big of a hurry - When making a decision on whether to take your payment over 10 years or take a lump sum, many factors need careful consideration. All recipients must take the first annual payment before September 30th. Take your time to get all the information before making an irrevocable decision. If you are considering taking a lump sum, make sure you compare discount rates and fees to make sure you are getting the best deal.

3. Making poor investment choices - When evaluating lump sum or annual payments, it is important to consider what you will do with the money.

During conversations I have had with buyout recipients, one common statement I have heard is "I will buy land and not pay any tax." The quota payment may qualify for a like kind exchange (1031 Exchange), the grower payment will not. This will translate to a maximum tax deferral of 15%, the current maximum long term capital gains rate. The like kind exchange only defers tax. When you sell the new property you will realize the federal tax and also Kentucky tax. The buyout payments are not subject to Kentucky State tax. However, the proceeds from a like kind exchange will be subject to the state tax. Paying too much for your exchange property negates the tax advantage.

Another option I have heard and suggested to recipients is paying down debt. This is an excellent strategy for high interest debt. Taking a lump sum with a discount rate of 5.5% and paying off debt at 8% is a good deal. Taking the lump sum at a 6% discount rate and putting it in a money market account with a 2.5% return is not a good deal.

4. Mental accounting - Mental accounting is a behavioral economics term that refers to the tendency of individuals to categorize and treat money differently depending on where it comes from (Example: Spending $20 found in the parking lot with less thought than $20 from your paycheck). Use of mental accounting can affect a person's marginal spending rate, often exceeding one. This means that a person given $100 as a gift may end up spending $150 "justifying" purchases. Be aware of this tendency and try to manage and control them. I know it is difficult. I have been studying this for 10 years and I have an ionic air freshener, bought with cash from my Grandmother, that I see every morning reminding me to watch my mental accounting.

5. Going it alone - This last mistake could lead to making the previous four in addition to costing you extra in taxes. Everyone's tax situation is unique. I cannot stress enough the importance of getting competent help with making decisions with lump sum options. There are different tax treatments for different options. What is the best option and strategy for your neighbor or brother-in-law may not be your best option. Talk with your tax practioner, C.P.A., tax attorney, financial planner, and farm analysis specialist to evaluate your options and your best strategy.

The tobacco buyout is a once in a lifetime event. With this money, quota owners and growers have an opportunity to increase their net worth, invest in their operation, and/or pursue other ventures. Regardless of your decisions, I encourage you to do something so that 10 years from now you can say "I am better off today because of the money from tobacco buyout." I end this with three of my favorite quotes concerning saving and thrift:

"An investment in knowledge always pays the best interest." - Ben Franklin

"You cannot keep out of trouble by spending more than your income." - A. Lincoln

"If you don't need it, don't buy it." - Rush Midkiff

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