Every once in a while, I mention to my wife I am worth more dead than alive, and she will respond “I know, but I don’t really want to find out.” This saying also applies to farm income taxes.
During their lifetime, farmers can use deductions to create large amounts of income when the asset is sold versus when their heirs sell it after they die. Some of the most common assets that have this treatment are:
- Fully-depreciated machinery or breeding livestock
- Harvested grain that has not been sold
- Raised livestock inventory that has not been sold
- Inventory of post-planting/pre-harvest growing costs
- Supply inventories
- Farmland, buildings and other farm real estate
Spouse Savings. For cash-basis farmers, almost all of these assets have a zero cost basis on their financial statement. When the asset is sold, the farmer is subject to ordinary income taxes and, in many cases, self-employment taxes on the gain. Yet if farmers own these assets at the time of death, their heirs may liquidate the asset and pay little or no income tax.
Consider two examples. In the first scenario, Farmer David has $1 million of equipment that is fully depreciated and $1 million dollars of unsold grain inventory. He is retiring and liquidating his assets.
The sale of the machinery is taxed at ordinary rates. In a 45% combined federal and state income tax bracket, he pays taxes of $450,000. The grain sale results in the same amount of income tax. He also owes about $50,000 of self-employment tax. Thus, Farmer David sells $2 million of assets, pays income tax of about $950,000 and is left with $1.05 million.
In the second scenario, assume Farmer David dies and leaves the assets to his spouse. She can sell the equipment and grain inventory for $1 million each and owe no income tax. If she sells them for more than that, she will only be taxed on the excess. If she sells for less than that amount, she has a deductible loss.
Many times, a spouse owns 50% of the asset. In this case, the heir would only be allowed to step up the basis to fair market value for the half owned by the farmer who died.
Corporation Considerations. Many farm operations are incorporated, and the rules that apply to corporations are not as generous to the farmer. In such cases, the farm owns stock, and though the value of the machinery and grain inventory inside of the corporation is much higher than cost, the only asset that gets a step up is the corporate common stock. This can result in a nasty tax surprise for heirs.
Suppose Farmer David’s assets are owned by a C-corporation. When he dies, his wife gets a new stock basis of $2 million. Yet when the corporation liquidates the equipment and inventory, it must pay corporate income tax of about $800,000. The corporation then liquidates and distributes the remaining $1.2 million to the spouse, generating a capital loss of about $800,000. She may use that amount at a rate of $3,000 per year or use it to offset other capital gains.
If an S-corporation owns the assets, the corporation owes no income tax. Yet the spouse will be taxed on $2 million of income, resulting in about $900,000 of total income taxes, as the individual tax rate is higher than the corporate tax rate. She will end up with about $1.1 million. After liquidating, the farmer’s wife will have a loss of about $2 million. As in the previous scenario, she may deduct it by $3,000 per year.
Either way, the spouse is going to owe a large amount of income tax when assets are sold. We would rather assign ownership of operating assets to a limited liability entity (LLE). If an LLE owns these assets at death, the heirs are allowed to step up the basis in the underlying assets, and when the LLE sells the asset, it will result in little or no gain to the heir.
Ease The Burden. There is a saying that death cures all tax ills, and it certainly applies to many farms. Care in how you structure your farm can dramatically reduce the income tax burden on your heirs.