At the Northwest Ag Bankers conference yesterday Corey Brock a local attorney spoke on various issues related to estate and tax planning for farmers.

In most parts of the Columbia Basin water project a farmer is limited to owning 960 acres. If you go over this limit certain penalties will apply including possible loss of water to the excess land which can quickly destroy the value of the land. Current values for irrigated land might approach $12,000 while non-irrigated land might only fetch $500.

In his case, grandparents had set up a trust calling for land to be distributed to their heirs at a certain point in time. One of the heirs already owned 960 acres so any additional acres distributed to them would cause this penalty to apply. They are working to resolve the issue, but the point is that care must be taken to make sure that any estate documents created such as a trust is designed and reviewed for local Ag laws and rules.

Without this review nasty non-tax costs can arise.

I was talking with a new farm client the other day about his estate plan and what struck me the most was not how much farm land value he had accumulated but rather the amount he had tucked away into his retirement plans. This amount was over 6 figures and he had only been contributing for a little more than a decade.

His annual contributions were in the $50,000 range and with a little bit of compounding a tidy sum can result. One of the benefits that arises is the flexibility in your estate planning. This can be a good vehicle to fund charitable intents at death or can be used to help equalize values between farm and non-farm heirs. One drawback is that these funds are subject to income tax when the heirs withdraw them.

We see too many farmers that are land rich and cash poor and with some some care these pension contributions can  save you income taxes and make you more liquid.

Paul Neiffer, CPA

It seems like it was only three months ago that we had a new law making the lifetime estate tax exemption $5.0 million indexed to inflation ($5.25 million in 2013).  Wait! It was only three months ago.

President Obama today release a 2014 budget proposal calling for changes to this “permanent” law.  Beginning in 2018, the budget would return the estate tax laws back to 2009 levels.  This would result in a $3.5 million lifetime exemption (not indexed for inflation) and a 40% tax rate.  This may also include the elimination of estate exemption portability since that was not in effect in 2009.

Based on assumed 3% inflation rate, we estimate that the current lifetime exemption would increase to $6 million in 2018.  If the President’s proposal goes into effect, about $2.5 million of additional estate value would be subject to a 40% estate tax.

The proposal also calls for certain “loopholes” to be closed.  Most likely these relate to discounts for private entity gifts and estate values and other related items (these “loopholes” are always in these types of budget proposals, but rarely get passed).

On the direct farming side, the President’s proposal, as expected, calls for the elimination of direct payments (saving about $3.3 billion per year ) and a reduction in crop insurance premium subsidies by about $500 million in 2014 rising to slightly more than $1.25 billion a couples years thereafter.

Paul Neiffer, CPA

We get this question from farmers approaching retirement age a lot:

“I have had very low income for most of my career and should I try to maximize my income as I approach retirement to increase my social security benefits”

Chris Hesse, who is one of my partners at CliftonLarsonAllen, LLP had provided me with an Excel spreadsheet that can calculate this answer fairly quickly.  It is based on the method that Social Security uses to determine your retirement benefits and the key issue for our farmer is what your average indexed monthly income has been during your career.

Social security benefits are calculated based upon the average of your highest 35 years of earnings indexed for inflation.  For example, the maximum wage that you could use for 2012 was $110,100.  In 1975 the maximum wage was $14,100, however the inflation index for that year was 4.98 so the equivalent 2012 number is about $70,200.  Therefore, you input all of your wages during your career and the computer then indexes them based on inflation.  It then takes the top 35 years and divides by 420 (35 years times 12).  This results in a very important number known as the Average Monthly Indexed Earnings (AMIE). 

The AMIE is then divided into three tiers.  The first tier (currently about $800) is valued at 90%.  The next tier (the next approximately $4,000) is valued at 32% and the remaining tier is valued at 15%.  Each of these tiers is then multiplied by these percentages and the cumulative result is your estimated monthly retirement benefit when you retire. 

Assuming a farmer has paid in the maximum amount for at least 35 years, the estimated monthly social security benefit at full retirement is slightly more than $2,500 per month.  However, the interesting part is how these tiers break down.

Tier 1 has a value of $712, Tier 2 $1,273 and Tier 3 is $565.  Tier 3 monthly earnings amount is calculated at about $3,800 which is almost 5 times higher than Tier 1, but the value of Tier 3 is about 20% lower than Tier 1.

The first step for our farmer is to maximize their Tier 1 AMIE amount.   If your average annual earnings have been less than about $10,000 indexed for inflation, then reporting greater farm earnings will dramatically increase your social secuity benefits.  For example. if a farmer during his career reported an average of $5,000 per year (in 2013 numbers), his current expected Social Security benefit is about $374 per month.  If over the next couple of years, he reports an extra $157,000 or so of earnings (does not need to be in one year), his monthly benefit will jump to about $712.  The extra social security cost will be about $24,000, but in return he will receive a lifetime annuity indexed for inflation paying $338 per month.  A simple calculation shows that he would fully recover his investment in about 6 years.

In our example, we are only trying to get up to the Tier 1 amount of about $800 per month.  As you go over Tier 1 into Tier 2, your return on investment drops dramatically.  Tier 1 has a 90% value, whereas Tier 2 only has a 32% value, therefore, as you enter Tier 2, instead of a 6 year payback, it becomes a 18 year payback.  Tier 3 amounts are even worse.  At that point, your payback period is in excess of 30 years.

In conclusion, if your earnings are still in Tier 1, it would definitely pay to pay in extra FICA tax to maximize your social security earnings.

Paul Neiffer, CPA

A common question that arises in our meetings with clients is about making sure that the farm remains in the family for multiple generations.  One option for accomplishing this is the use of a Dynasty Trust.  Many states such as South Dakota, Delaware and Alaska allow for trusts that are either perpetual or last for 100′s of years.  This allows the farm family to place land into the trust and make sure that the farmland will remain in the family for multiple generations.  However, there are several questions that you must answer before doing this:

• Is this what all of the family wants to happen?  Has this been discussed with all of the next generation?  Even though the assets may be placed into a trust, if communication has not occurred, “fights” about this may occur.
• Is the property large enough to support the dynasty trust structure?  The passing of 500 acres to the next generation in a dynasty trust may make sense, however, once it passes onto the next generation or the one after that and there are suddenly 45 beneficiaries of the trust; the use of a trust may not make sense from an administration standpoint.  The fees to properly allocate income and prepare the tax return may exceed the income generated by the trust.
• How much control from the “grave” are you trying to achieve.  My friend told me the only way to take his fortune to the grave with him was to write a check that could not be cashed.  Is your desire to control this from the grave or do what is best for the next generation(s).  Sometimes this is the same answer, but many times it is not.
• Is it better to transfer assets now than to wait for the estate?  In many cases, a transfer during life make more sense than waiting for a step-up in basis.  If the land will remain in the family for multiple generations, there will be no sale anyway.  By gifting now, you may be able to escape estate taxes later.  The dynasty trust can be used during your lifetime.

These are some of the important questions that must be answered.  There are most likely many others that apply to your situation.  Now is the time to get help from your advisor on how best to accomplish this.

Paul Neiffer, CPA

We got this question from one of our readers:

“My wife received about 160 acres when her mother passed away 3 years ago in a trust, which came from her grandfather who left it to her mom in trust.  We were told that we will have to pay capital gains tax on what the value of land was back when her grandfather passed away in 1979.  I found the land was valued at $559 an acre then and she sold it in 2012 for $9000.00 an acre.  Is this true and what will we be paying in capital gain tax’s?”

This was not quite the verbatim question (I changed some of the facts to make it more general for purposes of this post and edited some of the sentence structure), but this answer will most likely apply to 1,000s of farm families in 2012 since many sold their inherited land to escape the higher 2013 capital gains tax rates.

Since the land was left to her mother in trust, the value to be used for capital gains tax purposes is based upon the value when the grandfather passed away.  This trust was most likely set up as a “Grandfather” skipping trust and that is why the land did not get a step up in basis when the mother passed away 3 years ago.  These trusts are designed to skip a generation (or more) and not have to pay any estate tax when the mother passes away, however, the potential drawback is that the land does not get stepped up in value when mom passed away.

Therefore, the total gain is about 160 acres times $8,441 per acre or about $1.35 million.  Inherited property always qualifies for long-term capital gains treatment (even held for less than a year) and therefore, the maximum federal tax is 15% or about $203,000.  If the taxpayer’s state imposes an income tax, then that rate would be applied to the same gain.  Let’s assume that rate is 9%, then the state income tax would be about $122,000 in state taxes for total combined taxes of $325,000.

If the taxpayers had waited until 2013 to sell the land, their state tax would be the same, but their federal tax rate would be about 25% on most of it or an extra $135,000 of tax.

Paul Neiffer, CPA

Any time a farmer loans money to a corporation that they own (or vice versus), the income tax laws require these loans to bear interest.  If the loans do not bear interest, then the law requires the farmer to calculate an “imputed” interest amount based upon the applicable federal rates published by the IRS each month.  Lately, these rates have been very low (less than 1%).

In the past if the farmer loaned money to an S corporation and did not charge interest, the imputed interest rules normally did not affect the bottom line tax.  The amount of interest income the farmer would report would be offset by the same interest deduction reported on the S corporation.  However, if the S corporation had loaned money to the shareholder, it would change the bottom line tax since the interest “paid” by the farmer would usually be non-deductible.

With the imposition of the 3.8% net investment income tax (NIIT) for this year, this is no longer true for higher income farmers.

If your adjusted gross income (AGI) is $250,000 or less ($200,000 for singles) this tax does not apply.  However, if your AGI is over these levels, then the imputed interest will create an additional 3.8% tax on part or all of this income even though your AGI does not change.

Let’s take a look at some examples on how this works.

Suppose, we have a farm couple with exactly $250,000 of AGI.  In this case, their income tax is $52,213.  They owe no NIIT since their AGI is exactly $250,000 (remember NIIT is computed on the LESSOR of net investment income or AGI minus $250,000). 

Now let’s impute $10,000 of interest income on loans they made to their S corporation.  In this case, they have net investment income of $10,000 subject to the 3.8% tax, but their AGI is still $250,000.  It went up by $10,000 of imputed interest income reported on their Schedule B, but the S corporation income went down by the same $10,000, therefore, they do not owe the extra $380 of NIIT since their AGI still is not over $250,000.

Now let’s assume this is a regular C corporation.  In this case, the farm couple would owe the $380 of NIIT since their AGI went up by $10,000 and the offsetting deduction is reported on their corporation, not their personal return.

Let’s assume their AGI was $255,000 with no investment income.  With the imputed interest of $10,000, they now have investment income of $10,000, but since their AGI is still $255,000, their NIIT is only $5,000 time 3.8% or $190.

Let’s assume their AGI was $260,000 with no investment income.  In this case, the $10,000 imputed interest will be subject to the full 3.8% NIIT since the difference in AGI and net investment income is exactly $10,000.

The rule of thumb is if your AGI is less than $250,000 before imputing interest, then imputing interest will not create the NIIT (assuming a loan to an S corporation).  If the amount of AGI over the $250,000 is less than the imputed interest, then only this amount is subject to the tax and if this amount is greater than imputed interest, then all of the imputed interest will be subject to NIIT.

This is just another added layer of complexity that many farmers will face this year.  Since these applicable federal rates are extremely low right now, it makes sense to “lock” in these low rates so minimize the imposition of this new tax.  Talk to your tax advisor now.

Paul Neiffer, CPA

After reviewing the various phase-outs of itemized deductions and personal exemptions based upon gross income plus the implementation of the new 3.8% investment surtax, for 2013 there now at least 10 different possbile maximum long-term capital gains and qualifying dividends tax rates.  The rates range from zero for that portion in the 10-15% tax bracket up to almost 25% for those taxpayers with income in excess of the 20% maximum capital gains threshold amount (currently $400,000 – single and $450,000 – married filing joint).

We worked up a quick chart showing what the maximum rates might be assuming various levels of gross income and taxable income.  It is extremely difficult to get this chart exactly right since part of the tax is based on adjusted gross income and part is based on taxable income.  It is designed to give you an idea what your actual capital gains rate may be for certain levels of income.  Unlike most tax planning based upon taxable income estimates where we know the rate, for capital gains taxes, you most likely will not know your exact rate until you file your return.

Also, if AMT applies in your situation, the rates associated with the phaseout of personal exemptions may not apply and part of the phase-out of itemized deductions may not apply also. 

Unlike 2012 where we had two maximim capital gains rates (zero and 15%), for 2013 it can be at least 10.

2013 Maximum Capital Gains Rates Examples

The above link provides an example of what the maximum capital gains tax rates would look like for a married couple with two children in 2013.  You will need to click the link twice to get it to come up.

Paul Neiffer, CPA

We are continuing to digest the new tax bill (assuming President Obama signs it today).  One of the unique features in this tax bill is, that for many taxpayers, they will not accurately know their capital gains (or qualified dividends) tax rate until they prepare their tax return.

In brief, we know the following for the 2013 tax year:

• For many lower income and middle income taxpayers who are in the 15% or lower tax bracket, their capital gains will be taxed at zero.
• For most middle income taxpayers their capital gains tax rate will be a maximum of 15% (probably income in the range of $90,000 to $200/$250,000).
• For some middle income taxpayers whose adjusted gross income (not taxable income) exceeds $200/$250,000, their capital gains tax rate will be 18.8%. which is the 15% capital gains rate plus the 3.8% Medicare surtax rate on investment income including capital gains.
• For some of these same middle income taxpayers who have major itemized deductions, each dollar of additional capital gains will wipe out part of their itemized deductions.  This will increase their capital gains rate to about 20%.
• For those taxpayers who are now in the highest marginal tax rate of 39.6% ($400/$450,000 of taxable income) with limited itemized deduction, their capital gains rate will be 23.8%, the maximum capital gains tax rate of 20% plus the Medicare surtax rate of 3.8%.
• Finally, those taxpayers in the highest tax bracket with itemized deductions, their maximum capital gains (and qualified dividend) rate will be about 25%.   This is equal to the maximum capital gains rate of 20%, plus the Medicare surtax rate of 3.8% plus about 1.2% for the phase-out of their itemized deductions.

Therefore, any taxpayer can be subject to six different capital gains tax rates depending on their overall combination of adjusted gross income and taxable income.  Income tax rates are normally applied to taxable income, however, the Medicare surtax is based upon adjusted gross income.  This is why, in many cases, we will not know your actual capital gains tax rate until we prepare the tax return.

Just think if you had to prepare a tax return by hand and you made a change in your income.  You could spend a lot time just trying to calculate your capital gains tax, let alone your other taxes.

Paul Neiffer, CPA

The Senate in the early morning hours of January 1, 2013 passed a bill to avert the “Fiscal Cliff”.  This bill is now headed to the House and it may be passed, not passed or amended and passed back to the Senate for further agreement.

Assuming that the Bill is passed as is, there are several major benefits to farmers included in the Bill:

• The Bush tax rates would be maintained for income under $400,000 single and $450,000 married filing joint.  For income in excess of these amounts, the rate would be 39.6%,
• For those taxpayers in the 39.6% marginal tax rate, their maximum capital gains rate would be 20% (plus the 3.8% Medicare surtax, if applicable for a maximum 23.8% capital gains rate),
• Permanently fixes the alternative minimum tax by increasing the exemption amounts to reflect inflation from the inception of the tax and includes an annual inflation adjustment to the exemption amount,
• The lifetime exemption amount for gifts and estates would be permanently maintained at current levels ($5.12 million indexed for inflation, 2013 amount would be close to $5.25 million), however, the top rate would be 40% instead of the current 35%,
• 50% bonus depreciation would be extended through the end of 2013,
• A major increase of the Section 179 deduction to the old 2010/2011 level of $500,000 for 2012 and 2013 (farm equipment manufacturers will be very happy);  this deduction will revert back to $25,000 beginning in 2014,
• For S corporation in 2012 or 2013, the built-in gains tax only applies for 5 years, not 10 under the old law.

The phase-out of itemized deductions and exemptions for certain high income earners will be brought back into effect for 2013 and beyond.

Certain extenders have been temporarily extended:

• The special exclusion for income from cancellation of qualified mortgage debt (through 2013),
• The deduction for state and local sales tax (through 2013),
• The exclusion from income of IRA donations to charity (through 2013).  This one allows a “do-over” for IRA distributions received in December 2012, if they are transferred to charity before February, 2013.  Also, for 2013, this may allow you to keep your adjusted gross income under the Medicare surtax levels,

The 2% reduction in the FICA rate for employees from 6.2% to 4.2% was allowed to expire.  This will result in a payroll tax increase for all employed workers beginning today.

As we stated at the beginning of the post, this is not the law yet, but if a law is passed by both houses, it is extremely likely that it will retain most if not all of these provisions.  We will keep you posted.

Paul Neiffer, CPA