Farm couples often look at their business assets as their retirement fund. They usually plan to sell the machinery, equipment, livestock and grain to create cash, then rent or sell the land. Their biggest hang-up with this plan is the huge income tax tab that comes with selling out. There is an upside, however. There's cash available to pay those taxes.
But, when the closing-out sale results from the business being insolvent, the tax liability is still there, explains William Shafer, a Williamsburg, IA, attorney with experience dealing with farm insolvency cases. Often, the cash from the asset sales all goes to pay against debt. There's little or nothing left to pay taxes.
How can you have income taxes if you're broke? Sale of hogs, whether feeder pigs or market animals you produced, is income subject to both income tax and the Social Security tax. Same holds for grain raised. Machinery and equipment sales are usually subject to depreciation recapture and can result in a lot of ordinary income, all subject to income taxes (but not Social Security).
Breeding livestock sales and land sales often create capital gains income. If debt has been forgiven, there can be other income tax ramifications. All those can result in a tremendous amount of taxable income even if you're broke.
While operating expenses, including interest on loans, can be deducted from those to arrive at taxable income, most or all the money from a closing-out sale usually goes to pay the principal of those loans. Principal payments are not tax deductible. Therefore, a big amount of taxable sales and relatively few tax deductions can result in a sizable tax bill from Internal Revenue Service (IRS).
Even bankruptcy doesn't wipe out an income tax obligation, says Darrell Dunteman, an accountant and accredited agricultural consultant at Bushnell, IL.
Plan For Failure Never plan to fail. But if you are highly leveraged and insolvency appears inevitable, don't fail to plan. Use good strategy to avoid as many additional income tax scars as you can.
"Start by doing an accurate financial statement that includes an estimated tax liability if you were to liquidate your entire business," Shafer suggests. "By going in knowing the tax situation, you can make the best decisions and maybe save a lot of that tax cost." Have your tax accountant do that estimate.
"At the same time, have the accountant take a look at your last three tax returns to see what effect income averaging might have," Dunteman suggests. "Liquidation years is when I see income averaging having the most benefit whether the liquidation is voluntary (retirement) or forced (insolvency)." On loans, it's worth checking to see if there is any interest that has been capitalized and not previously deducted. You might capture some extra interest deductions that could reduce both your income tax and Social Security tax, says Shafer. That's more likely for FmHA and FSA borrowers, he adds. But check with other lenders, too.
Negotiate The IRS may not be as hard-nosed as you've always thought, says Shafer. An option they have that can help when you owe tax but have no money is called Offer In Compromise.
"You make an offer that is less than the amount of tax owed," Shafer explains. "Then IRS will look at your age, education, type of job you have and assets you have. They will usually request bank financial statements, pay stubs from a job or information from a business you are operating and other information that might help them determine your ability to pay."
The process can take six months or more.
But Shafer reports he has seen $10,000 to $20,000 obligations settled for $5,000. He has even seen $100,000 of tax obligation settled for 5 cents on a dollar owed. "It really has nothing to do with how big the amount you owe is," Shafer explains. "It's based on what they can expect to collect and that's based on their view of your ability to pay."
If the taxpayer is 85 years old and has only Social Security as income, they're not going to expect to get much.
But, a 35-year old has a lot of potential earning ability and they're going to expect to get most of the tax that person owes even if they have to set up an installment payment plan. If they're not going to get all they're owed, IRS wants to get things settled and get the taxpayer back to paying tax in the future, Shafer reasons.
One of the stipulations of a compromise is that the taxpayer stays current on all payment of taxes for five years. That brings up another potential tax-saving tip. Insolvency tax planning may run contrary to normal tax planning. Usually you would try to spread income out over more years to try to have more taxable dollars taxed in the lower 15% income tax bracket.
"However, suppose you sell all the grain and livestock in one year and can't pay the tax so you make a deal with (IRS) Offer In Compromise," says Shafer. "Then you sell the machinery the next year and can't pay the income tax on that. You can't use Offer In Compromise because the previous use of it obligated you to pay the tax for the next five years. You might be better off to sell everything in one year.
"If you can't pay the tax and are going to end up paying maybe 10% to 15% of what you owe anyway, it doesn't matter much whether you are in a 15% or 28% tax bracket," says Shafer.
An alternative to the Offer In Compromise option is to arrange with IRS for installment payment of the tax that is due.
Forgiven Debt When you can't pay all your debt and the lender writes off part of it, that can create some adverse income tax consequences, too. But, again, advance planning can help.
Dunteman offers this example. Say your income tax basis in a piece of land is $50,000. That land is worth $130,000. But say you owe $200,000 against it. The land sells for $130,000 and the lender agrees to take that amount and write off the other $70,000.
The first tax consequence, Dunteman explains, is that you have $80,000 of gain - the selling price minus the income tax basis. That is subject to capital gains and you will pay tax at 10% or 20% on that gain.
The second consequence is that the $70,000 debt forgiveness is also income to you. But it is treated differently. First, if you should happen to have any carryover investment credit (from quite a few years ago), that can be used to offset the tax. Second, if you have any carryover net operating losses from previous years, you would use that to reduce the amount taxable.
Suppose you have no investment credit carryover, but you have $20,000 of carryover loss, Dunteman explains. That would reduce the $70,000 taxable forgiven loan amount to $50,000. If you have any other assets left that have a tax basis, that remaining $50,000 will go against it. Say you still had another piece of land with a $90,000 income tax basis. To get rid of that other $50,000, you would have to lower the income tax basis on that land by $50,000 to $40,000. If you sell the land, that adjustment will increase the taxable gain by $50,000 in that example.
"You don't get to eliminate the tax resulting from forgiven debt that way," says Dunteman. "But you get to postpone it." On the other hand, if you didn't own any other asset with a tax basis, that $50,000 liability in our example would simply disappear.
Settle Quickly If You Can There can be a big advantage to getting things settled with IRS. You no longer owe the tax. Dunteman gives this example. "You settle with IRS and they agree you owe nothing or a smaller amount that you negotiated. Then you inherit from your parents or wealthy uncle or maybe you win the lottery. They can't come back and say you owe the tax that was wiped out."
However, if you know you are in danger of becoming insolvent or are in the negotiation stages, consider another precaution on potential inheritances, suggests Shafer.
If you inherit, win the lottery or whatever, before the negotiations are done, you can bet IRS will slow or cancel the negotiations. Faced with that possibility, you might ask your parents to write you out of their wills in favor of your children, for example. A trust for your share of inheritance could also help. But, if you were to get income from that trust, that potential income would likely become a factor in negotiations with IRS.
Hire Good Help Finally, above all, get good, competent help as soon as it looks like you might have a tax obligation and no money to pay it, Shafer urges.
The tips here cover the main tax ramifications and suggestions. But there are details that need to be followed closely. Your advisors - an accountant and an attorney - can make sure you do everything correctly and on time. They will also need to check your state laws and tax rules. The IRS people probably find it easier to work with professionals who understand the process. They know what IRS needs and will provide them with it. But, unlike many taxpayers who try to do it all themselves, the professionals aren't going to say more than they should.
"Just seeing that you have sought help and are trying to be cooperative is viewed much kinder by IRS than if you are dodging their phone calls and letters," Shafer adds.
A free outline titled "Debtor-Creditor Mediation" that cites code sections and cases that might be helpful to you and/or your accountant or attorney is available by contacting:
William Shafer Shafer Law Office 204 W. State Street P.O. Box 779 Williamsburg, IA 52361 Phone (319) 668-2565