In my most recent article, we reviewed options on how to best structure the transition of your farm business. A similar review of the options available to transfer your equipment and subsequent exercise of process of elimination is a great way to start the conversation. So, here we go:
More often than not the cash flow needs of the retiring generation guides us through this process. If the equity in the equipment is needed to pay down farm debt or support your income needs in retirement, then the option of selling the equipment usually comes to the forefront. However, we suggest you ask your tax advisors to estimate what the tax burden may be to avoid any surprises. Sometimes the tax bill of selling a fully depreciated line of equipment subject to income recapture is jaw dropping.
Sell on contract
Can this tax be spread out over a period of years by selling the equipment on an installment sale? The quick answer is no. Although we love this strategy for the sale of capital gain assets, such as farmland, breeding livestock, and corporation stock, it is not as favorable for equipment since all income tax recapture on depreciation must be recognized in the first year of the sale, regardless if the equipment is sold outright or on contract terms.
This tends to lead to a discussion about a gradual transition of the equipment over a period of years. When it comes time to trade or update a piece of equipment the incoming generation can bring the boot and own the new implement. The existing machinery line eventually falls off the retiring generations depreciation schedule. Or, the retiring generation can sell a select few pieces of equipment each year to spread the tax over a period of years.
Lease to own
A lease to own, or rent to own, may offer another alternative. This concept involves setting up annual lease payments with a balloon payment due at the end of the lease. This is not much different than what you might set up with your local implement dealer. As the lessor, you pay income tax on your annual lease payments over a period of years (not a lump sum upfront) and incur a much less tax bill at the end on a smaller residual value of the equipment at that time. As the lessee, the lease payments typically offer a much more feasible way to transition into the equipment versus the capital required to purchase all the equipment upfront.
Gifting or a combination gift and sale strategy is a consideration for those who don’t necessarily need the equity from the equipment to service debt or other needs. Some would rather make a gift of equipment knowing their tax savings will go towards helping the next generation get started. This option may lead to a conversation about fair versus equal among farming and non-farming heirs. This looks different for every family and contributions of labor and sweat equity may be given consideration. If compensation is needed, some have charged the farming heir more rent to lease your farmland until you feel the gift of equipment has been fairly accounted for. Or, perhaps the non-farming heirs inherit more non-farm assets to offset this gift of the equipment to your farming heir.
A more formal way to structure the transition is put the equipment into an entity such as a limited liability company or corporation. Ownership units of an LLC or stock of a corporation can more easily be transitioned over a period of years by sale, gift, or a combination of both. Some of have gone to the extreme of putting their equipment into a corporation so they can now set up a contract sale of the stock, which as noted above will now allow the sellers to spread the tax over a period of years since stock is considered a capital gain asset. Entities offer other advantages such as liability protection against unforeseen events such as death, divorce, or lawsuits.
Oddly enough our current tax laws reward the do nothing approach. The reason being is basis step up and the fact depreciated farm assets such as grain, machinery, and livestock receive a new basis at death (under current laws). This allows the surviving spouse or next generation to sell these assets with minimal or no tax after receiving this new basis adjustment. We certainly favor the more pro-active approaches as noted above, however, if nothing else, consider backstopping your estate plan with provisions for how you wish to distribute your equipment. Otherwise, the do nothing most likely leaves your children all owing an equal share of the equipment which may not be very rewarding for them to sort out.