Depending on how the ownership of farm land, cattle, buildings or equipment is transferred, there can often be differing federal and state tax consequences.
What they are and how the affected parties can use them legally to reduce taxes was the topic for Wisconsin Extension Service farm tax law specialist Phil Harris at the 'What's Your Farm's Future?' farm transition and estate planning workshop that drew a crowd of 83 attendees from east central counties in the state.
Reflecting on the complexity of the whole set of tax law provisions that have been created by Congress and the state legislature, Harris suggested 'these rules are bizarre.' He often wonders what logic or rationale was used to devise some of them.
In addition to income; sales; property; employment and self-employment; social security; and medicare taxes, there are taxes that apply specifically to the transfer of property, whether it takes place by sale, in gifting, at death, by trade or by placement in a business entity, Harris said. Income, gifting, self-employment and death taxes could come into play with in farm succession property transfers.
With income taxes that accompany a property transfer, the goal is to postpone or eliminate any required payment, Harris said. A tax payment is triggered only by the sale of assets, not by gifting or transfer to a spouse or other eligible party at death.
Most farms today enjoy the benefit of the current federal tax law which allows the transfer of up to $5.45 million in property value per person as a gift without triggering a tax, Harris indicated. Wisconsin does not impose any tax on gifting transactions.
Although there is technically a federal tax on asset transfers by gift, annual exclusions of $14,000 per individual on property value make it irrelevant in many cases, Harris said. Gifting could be parlayed up to the $5.45 million lifetime exclusion.
Sale of assets
If an asset is sold, that fact must be reported for federal and state income tax purposes and income taxes or self-employment tax payments might be necessary, Harris said. Gains on the value of the asset, particularly with land, could be taxed in two ways.
Some of the increase in land value since it was purchased would be taxed at the marginal income tax rate of the seller, and some would be taxed as a long-term capital gain at the lesser of the seller's marginal income tax rate or the applicable capital gains rate which ranges from 0 to 28 percent, Harris explained.
Self-employment taxes might also be due on the sale of assets, Harris continued. The social security tax of 12.4 percent and 2.9 percent medicare tax are due on the first $118,500 of ordinary income. An additional medicare tax of 0.9 percent is due on self-employment income above $250,000 for married filed jointly, $125,00 for married filing separately or $200,000 for an individual — numbers that are reduced by the wage totals in such incomes, he pointed out.
For the sale of cows which the owner raised, there is no income tax basis (initial purchase value), which means all the income is taxable because the expense of raising the cattle had previously been deducted from income, Harris said. A custom raiser of heifers who then sells them would face both ordinary income and self-employment taxes.
The taxable amount on the sale of machinery is determined by subtracting the depreciation that has been claimed on it from the purchase value or basis, Harris noted. Any remaining value above the basis number would be taxed as ordinary income but is not subject to a self-employment tax.
Tax rate categories
While the federal income tax rate peaks at 39.6 percent on adjusted gross income, Wisconsin's rates range from 4 to 7.65 percent, Harris noted. He explained that the higher rates apply only to the portion of taxable income that's above certain stipulated amounts – not to all of the taxable income.
The federal capital gain tax rates range from 0 to 28 percent but they are limited to the 10 to 15 percent rates for the taxpayers who are at those rates on their ordinary income, Harris pointed out. In Wisconsin, there is a 60 percent exclusion on long-term capital gains with the balance being taxed at the person's ordinary income tax rate.
For the federal self-employment tax (social security and medicare), the 15.3 percent rate applies to the total ordinary income, Harris said. In many years, this could be the highest amount of tax paid by farmers because no deductions are allowed.
Schedule F categories
On the federal Schedule F, on which farm income and taxes are reported, there are three possibilities for required payments, Harris said. From worst to best, he listed them as having to pay tax both an ordinary income and self-employment tax, a tax on ordinary income and a tax on a capital gain.
Working with one's tax accountant or other advisers, it is possible to shift income between those taxable elements, Harris promised. He also mentioned the 3.8 percent net investment income tax that began in 2013 for income from stock sales, dividends, and sales for taxpayers with adjusted gross incomes over $250,000 for married filing jointly, $125,000 for married filing separately or $200,000 for an individual.
Installment payments – typically on a land contract sale – are a good way to reduce the annual tax effects, Harris pointed out. He warned, however, that if the seller dies during the extended period of the installment sale a settlement must be reached and no basis adjustment at death would be allowed, while the opposite would be true if deceased person still owned the land with no sale being in place.
For installment sales of machinery, all of the previously claimed depreciation must be reported in the first year, Harris emphasized. To soften that potential tax blow, consider leasing equipment or selling it for trade-in value as it wears out.
Carryover of basis value
One example of the intricacies of tax law pertains to how the donor's income tax basis on the property carries over to the recipient, Harris pointed out. To minimize that potential effect, which doesn't often occur in Wisconsin because of the very high annual and lifetime exclusion, donors should give property whose fair market value is closest to what its income tax basis is.
If such gifting occurs within a limited liability company, there would be an upward adjustment of the income tax basis only if it is a partnership, not a corporation. Under a Section 754 provision, the LLC could elect to adjust the deceased partner's portion of the assets, he said.
In Wisconsin and most other states, the marital or community property law allows the transfer of an unlimited amount of property without any federal gift tax obligation but that property must be titled or owned as such, Harris stressed. Both halves of the property are accorded a date of death value basis, thereby allowing selling or gifting without a basis gain, he noted.
But the efforts taken to avoid, defer or minimize taxes also can also come at a price, Harris observed. 'It takes an event to trigger a tax.'
A common complicating factor, especially for the likely next owner, is having to wait to obtain ownership while probably wanting to make other investments or management changes on the property, Harris said. For the owner(s) waiting to sell or transfer, there can often be a tradeoff involving the paying of taxes and eligibility for medicaid or responsibility for nursing home costs.
Trading of assets
Another possibility is the trading of 'like kind' of assets, which has a favorable tax standing, Harris stated. Basis value changes can be deferred until death and a basis step-up is allowed, but there are limits of 45 days for identifying and completing the trade and of 180 days for obtaining legal title to that property, which could often be done with real estate or machinery.
Because of the complexity of like kind exchanges and the strict enforcement of tax implications by the Internal Revenue Service, Harris strongly recommends obtaining the guidance of tax or legal professional before becoming involved in a like-kind purchase or sale agreement.
Transfer to a business entity (partnership, LLC, corporation) is also a possibility because income tax basis carries over from the personal ownership, allowing gifting of up to $5.45 million, Harris noted. As in other scenarios, there are no income tax consequences in most cases for a sale, gifting, or transfer at death.
Harris also reviewed the basic traits of the business entities under which most farms operate. They are sole proprietorship (a default position), an LLC, partnership, C corporation and S corporation – all of which have certain rights and face certain regulations that are similar in most states. Federal tax laws pertaining to them are usually piggybacked by the states, he added.
In a sole proprietorship, no formality is associated with the entity and the individual is responsible for all debts, Harris pointed out. In a partnership, which could a formal or informal business involving at least two persons or entities, all are fully liable unless a party files with the state to obtain limited liability status.
With a corporation, which needs to have officers, each party is responsible to the extent of inputs and dividends are taxable as income. C corporations are also taxed and distributed assets are also taxable while with an S corporation only the shareholders are taxed, he added.
In an LLC, meanwhile, taxes are proportionate to the partner shares while the entity itself, as indicated by its title, has a limit on liability, Harris stated. He acknowledged that taxes should not be an end-all criterion on transferring farm assets because equity among heirs; security for the exiting party; personal and family goals; and good business management also deserve plenty of consideration in many cases.