Retiring From Farming Soon? Proactive Tax Planning Is Critical

Two things are apparent in the world of farming:  Farmers are getting older (the average age of farmers is now 58), and retirement and transition is becoming a major issue in the farming community. Most farmers have aggressively used tactics to lower their income taxes throughout their farming careers, and this has created a problem for them as they transition out of actively farming. Many farmers took advantage of the cash method of accounting to accelerate expenses or delay income. On the expense side, they often prepaid expenses to the limit allowed by the Internal Revenue Code and purchased equipment to take advantage of the Section 179 rules that allow a first-year deduction of up to $500,000.

Both strategies had a lot of appeal and made a lot of sense from a practical business planning perspective. Why would you want to pay the IRS cash today when you can postpone payment until a later date? The thing is, you don’t want to forget about that “later” part, and it almost always becomes a major problem at retirement time. We rarely see this deferred tax liability on farm operations’ balance sheets, and it can be a monster. For illustration purposes, here’s a sample balance sheet without deferred tax:

This example demonstrates a very modest farming operation with very reasonable debt. The equipment debt (or intermediate debt) of $400,000 on an $800,000 line of equipment and land debt of $3,500 per acre are not too bad. A net worth of $1,900,000 is pretty impressive for an operation of this size.

But…Let’s Look for Monsters

We’ll assume that the business owners in our example, Bob and Sue, are ready to retire, and they plan to get out of farming completely. Bob and Sue intend to have a sale to liquidate all of the farm assets, and they consult their accountant about taxes. Let’s lay out where they stand. First, they will have $250,000 of income from the grain that they will sell. Second, since they have taken full depreciation on all of their equipment, when they sell the equipment for $800,000, it will be considered 100% taxable income. Lastly, they will sell their land for the fair market value (FMV) of $2,000,000, and the taxable portion will be $1,200,000 ($10,000 less $4,000 x 200 acres). This computes to taxable income of $2,250,000. Various tax rates would apply to the different types of income, and every individual’s situation and tax rate may be slightly different, but in our example, assuming Bob and Sue have no other income, the federal and state tax (3.75%) would compute to $697,812 if we put it on a mock Form 1040. This would reduce their true net worth to $1,202,188. This is a nearly 37% reduction in net worth and would certainly affect their retirement plans.

So how do they make that monster go away? There is no easy answer, but to have the best results, there are several key things to consider.

The first step toward a solution is identifying and facing the problem—and the earlier the better. Several important questions need to be addressed. Are you transferring the operation to a family member? Do you want to retain ownership of the land and become a landlord? If you sell the land, would an installment plan make sense? Should you start funding a retirement plan? What happens if you spread the income out over several years? Would income averaging help? Answering these types of questions and then implementing strategic tax planning can put you well on the way to reducing your tax problem and putting more money in your pocket for retirement. We recommend developing a five-year (at minimum) plan. Put it in writing, and review it at least annually. 

Put Expertise on Your Side

Wipfli has many experts dedicated to the agriculture industry who can help you with tax, retirement, and family transition planning and much more. Contact a member of the Ag practice or your relationship executive today.