Having just recently returned from my taping for the Legacy Project on farm succession planning, I will be trying to do several posts over the next few weeks on this very important subject.

Elizabeth Williams from the DTN/Progressive Farmer had a very good post on the five steps needed for the farm transition.  The article dealt with a young farmer who lost his mother due to brain cancer.  The estate did not owe any current tax since the assets passed free of estate tax to the husband, but if he had passed away that same year, they would have had a major estate tax problem.

The five steps mentioned were:

1. Get Experienced Legal Help – Find a good agricultural estate tax attorney (or a good farm cpa) to help design an estate plan to meet the unique needs of the farm estate plan.
2. Recognize that your Paperwork will Increase – If your estate goal is to reduce estate taxes, transfer property to the next generation with the least income/capital gain tax and divide your assets equitable among your children, that usually means multiple farm entities.  This requires separate bank accounts, year-end meetings and compliance, etc.  However, to do it right, more paperwork will result.
3. Allow the Next Generation to Control or Own Something that is “Theirs” – It is important for the children to have some skin in the game to promote the pride of ownership.
4. Listen and Talk to Each Other – No one can read your mind.  Not being transparent can cause a multitude of problems.  “A lot of animosity can build up when off-farm family members don’t know what the deal is. What is the on-farm sibling getting?”
5. Respect the Division of Labor – The most successful family farm operations have distinct, complementary divisions of labor.  As I said on my TV taping, find what each member does best and let them do it.  The farm will be better off and the family member will feel best about themselves.  Part of that comes from clearly defining the expectations that go along with ownership and management of the farm.

The cost of not planning can be very high!  Even a 500 acre farm can generate a large amount of estate tax starting in 2011 if no changes are made to the estate tax laws.

For a primer on “Transferring the Farm”, go to the University of Minnesota’s Center for Farm Financial Management.

Most farmers are assuming that since there is no estate tax for 2010, that this must be a good thing for all taxpayers.  The reality is that many farmers may end up paying more in taxes than under the law in effect for 2009.  This is due to the fact that carryover basis will no longer be in effect for many estates.

Under the old law, when a person died, all of their assets were revalued for income tax purposes  based upon the value at the time of death.  Then when the heirs sold the assets, this was the “cost” that they could use in determining their gain or loss.

For example, suppose, a farmer died owning equipment that was worth $1 million dollars that had been fully written off.  Under the old law, you could step up the value to $1 million dollars and depreciate it over 5 to 7 years.  If instead, you decided to sell the farm equipment for $1 million immediately, there would be no tax owed.

Now, when you inherit the equipment, you get no step up in basis, and when you elect to sell the equipment, the gain will be completely taxable.  Also, this sale will not qualify for capital gains treatment, therefore it will be subject to ordinary income tax rates.  At a 35% bracket, this would result in owing $350,000 of tax.

Therefore, due to not having an estate tax, we went from (1)  complete step up in value to date of death value, (2) no estate tax being owed for all estates under $3,5 million, and (3) full write of assets over time as depreciation against other income  to owing $350,000 in income taxes.  This does not sound too good to me. 

I am hoping that Congress gets their act together and fixes this, but I am not too hopeful.  I will keep you updated.

Mike Walsten from the “Your Precious Land” has posted recently that farmland sold at auctions are still enjoying high prices.

Mike also was interviewed on Ag Day last week and one of his interesting comments related to the trend of farmers in the metro Chicago area.  When pricing for development land was very high during the mid 2000’s, these farmers were able to sell their farm land for upwards of $15,000 an acre and then reinvest it tax-deferred under Section 1031 of the Internal Revenue Code.  They mostly reinvested in three or four times the land located in more rural areas.

Now, with the drying up of development potential, many of these farmers are now going back to the people they sold their land to for maybe $20,000 an acre and re-purchasing it for $5,000 to $7,500.  I think you will see this trend continue for a couple of more years.  Then, when the development trend starts again (and based upon a growing population, it will start again sometime), these same farmers might be able to sell the land for $20,000 an acre or more again.

It seems like some of the best investors over the last decade have been our farmers.  It has been a long-time since we could say that.

Many dairy and other farmers will need to make a decision this year that they may not have had to make for several years.  I would say almost all dairy farmers for 2009 will have a tax operating loss and it may be substantial.  With a net operating loss, the tax laws allow you in most years to  either carry it back for two years or carry it forward for up to 20 years.

However, for farmers they can carry back their net operating losses for up to five years and if they have losses from other businesses for 2008 or 2009, they can carry those losses back for up to five years.

You need to review your actual income tax paid for the last five years.  You will need to determine the amount of tax actually paid and the overall tax bracket that you were in for each year and in total for the appropriate years.

• You need to estimate what your income tax bracket will be over the next few years.  In general, if the prior years overall tax bracket is 15% or less and you expect to be in the 25% or higher bracket going forward, it makes more sense to carry it forward.
• You need to review whether you took advantage of farm income averaging in those years and whether you will take advantage of it going forward. 
• If the loss is very large and you need the cash, carry back the loss and what is left over can still be carried forward to 2010 and beyond.
• You can elect to carry the non-farming loss back three, four or five years or the normal two.

If you make no election, then the loss is automatically carried back two or five  years.  To carry it forward, you must make an election with the tax filing.

Here is a link to the IRS website dealing with the net operating loss rules for farmers and other related farm tax publications and links.

As a tax preparer, I  normally file all of my client tax returns electronically.  However, for this tax season, for all of my clients that are claiming the homeowner credit, we will need to send in a paper return to the IRS.  Many farmers may qualify, either for the first time credit of $8,000 or the long-time ownership credit of $6,500.

To claim the credit, you will need to fill out form 5405.  For the first time credit, you will need to attach either of the following to the tax return:

• A copy of your closing statement from the home purchase, or
• If purchasing a mobile home, a copy of the retail sales contract, or
• If building a house, the certificate of occupancy and most likely the bills from the contractor to back up the cost claimed on the form.

If you are claiming the long-time credit (which means you lived in the same house for five consecutive years), you will most likely need to provide five consecutive years of either:

• Home mortgage interest statements,
• Real estate tax records, or
• Homeowners insurance.

The IRS has indicated they will not start processing any of these returns until mid-February and the soonest that any refund checks will be mailed will be around late March.

Remember, if you are claiming the homeowner credit, file your return by mail.

Most of the farmers that I deal with from an income tax filing standpoint try to file and pay their income taxes by March 1 of each year.  This is primarily due to no estimated taxes needing to be paid during the tax year if the farmer files and pays by March 1.  If they do not file by this date, than a penalty for not paying estimated taxes can be due.

Normally, a farmer will pay this estimated tax payment on January 15 for the previous year.   For example, for calendar year 2009, the estimated tax payment for a farmer is due on January 15, 2010.  This estimated tax payment can either be the tax paid in the previous year or 90% of the tax owed for this year.

Let suppose that for 2008, the farmer owed total income taxes of $5,000 and for 2009, they expect to owe $10,000.  They are required to pay in on January 15, 2010 $5,000.  Now if they only expect to pay $2,000 for 2009, then they only need to pay in $1,800.

Since farmers and other taxpayers get used to doing the same thing every year, if they are used to filing on March 1, they file on March 1.  If they are used to paying estimates on January 15 and filing on April 15, that is what they do.

What they should do each year toward year-end is determine what works best for that year.  If they owed very little tax for the previous year, it would probably make a lot more sense to make an estimated tax payment based upon the previous year’s tax and then just pay the tax on April 15.  This will save both interest cost on the money owed and give the farmer and extra 45 days or so to get their tax return done.

Please make sure to check this out each year and determine what works best for you.

Thanks to Senate gridlock, taxpayers who are trying to do effective estate tax planning are in for a case of estate tax whiplash over the next few months.  The federal estate tax is due to disappear for one year starting in about two weeks, however, it may reappear unexpectedly and retroactively.

When the Senate refused to act this week, it opened the door for the estate tax to disappear in two weeks, although nobody knows for how long.  Under current law, the estate tax disappears on January 1, 2010 for the whole year and then reappears on January 1, 2011 at the old 2001 rates.  Also, the gift tax maximum rate will fall to 35% and for some assets inherited in 2010, the step up in basis will disappear (with the step up in basis, the capital gains tax is based upon the difference in value between what you sell it for and what it was worth at the time of death.  With the new law, you use “carry over basis” which means you need to go back and find out what the heir originally paid for it and use that basis.  This could end up being an accounting mess).  All this happens because the 2001 tax act phased out the estate tax over a 10 year period, repealing it entirely in 2010.  But the estate tax returns in 2011 under 2001 rules – a $ 1 million exemption and a 55-percent top rate.

The House had passed a law a couple of weeks ago making the current top rate of 45% and exemption amount of $3.5 million permanent.  Senate republicans wanted the rate lowered to 35% and the exemption at $5 million.  But lacking any unity in the Senate, Democrats failed to even get the Senate to vote on the issue.

The whiplash mess is that we are not sure if Congress will get their act together in early 2010 and pass a new estate tax law and whether it will be retroactive to January 1, 2010.  Senate Finance Committee Chair Max Baucus (D-Montana) has promised to revive the issue next month and make it retroactive to January 1, 2010, but that may not happen. 

In the meantime, I would not be making any large gifts assuming the new law will be in place.  You will want to watch and see what happens and when the dust settles, make your plans then.

One of the deductions available to farmers that I see missed on tax returns (and I must admit I have missed it until I review the return) is the deduction for Domestic Production Activities.  This can be one of the most complicated tax deductions of all times for larger businesses, but for farmers who follow the simplified method, it is not too hard to calculate.

In brief, you take your total farm income (excluding certain items such as interest income, etc.) and you subtract your farm expenses.  This net income from domestic farm activities is then multiplied by a certain percentage.  For 2009, this percentage is 6% and for 2010 and thereafter, it will be 9%.

There is an overall limit on the deduction which is the amount of W-2 wages that you paid during the year times 50%.  I will give you an example here:

• Let’s assume your gross farm income is $750,000, your gross farm expenses are $475,000 and your W-2 wages are $75,000.  This means that the Domestic Production deduction would be equal to ($750,000-$475,000) times 6% or $16,500.  If your W-2 wages were less than $33,000, the deduction would be limited to 50% of your W-2 wages.

This deduction does not reduce your self-employment income.

For those farmers who are sole proprietorship’s, you may not qualify for the deduction if you do not have any employees or minimal employee expense.  This is another good reason to pay reasonable wages to your children if they work on the farm.  I have a couple posts on why this makes sense, but if you can maximize your Domestic Production Activities deduction by paying them wages, this is another reason to do it.

The House on December 3, 2009 passed the Permanent Estate Tax Relief for Families, Farmers and Small Businesses Bill of 2009.  The Act would permanently extend the current exemption of estates of up to $3.5 million for a single taxpayer and $7.0 million for married couples.  For estates larger than there amounts, they would be taxed at the current 45% top rate.

As the title suggests, the House is trying to provide relief to Families, Farmers and Small Businesses.  Additionally, the bill repeals the enactment of carryover basis that was to start in 2011.  This means that people inheriting assets will still be able to use the date of death values (like you can now), instead of using what the basis was for the person that died.  This would probably led to an accounting nightmare.  This bill simply continues the present 2009 law for rates and exemptions.

The negative is that the Bill does not increase the lifetime exemption amount for gifts.  This is still limited to $1 million during life.  It is unclear if the Senate will review this before year-end, so this Bill may not get passed until early 2010 and there may be some changes, but at least it has passed the house.

You should be reviewing your estate plan right now to make sure it is up to date, but with the current law and the proposed changes.

With the end of 2009 less than three weeks away (where does the time fly), I thought I would post a year-end tax planning update for farmers.  Most of this information applies to non-farmers also, but wanted to give you something to plan for.  Again, make sure to review this with your tax advisor before implementing any of these recommendations.

• Required minimum distributions from individual retirement accounts were waived for 2009.  Also, if you are turning 70 1/2 this year, remember that you must take out your first distribution by April 30, 2010, however, if you wait till 2010, you will be required to take two distributions, one for 2009 and one 2010.  This may put in into a larger tax bracket.  Check this out before deciding to take next year.
• Review the expected tax rates for 2010 and 2011 to determine how much income or expense to record in 2009.
• Vehicle sales tax are deductible for those who do not itemize.  Limit is based upon a purchase of up to $49,500.
• If you are planning on larger charitable contributions, you may want to consider a direct transfer from your IRA.  This can save taxes on your social security income, if applicable.  This applies to people 70 1/2 and older.
• If you are selling land on an installment contract, you may want to consider electing out of the installment method.  Capital gains rates are probably as low as they will be for the next several years.  It may make sense to pay taxes now (CPA do not say that too often).
• There is a $8,000/$6,500 homeowner’s tax credit for home purchases through April 30, 2010.  You can claim the credit in 2009 even if the house is purchased in 2010 by that date.
• College education credits are enhanced.  It now has a larger credit, higher income limits and 40% of the credit is refundable even if you owe no tax.
• Review your Roth IRA conversion opportunities for 2010.  In 2010, you can convert any amount with-out worrying about any income limitation and the amount converted is reported as income 1/2 in 2011 and 2012.
• You can give $13,000 to any individual without filing a gift tax return.  This is also true for the spouse.
• Remember that 50% of new equipment purchases can be deducted immediately.
• Remember that Section 179 expense for 2009 is $250,000.
• Most farming equipment is now deprecated over five years instead of the old seven year life.