November 28, 2018
As tough times continue in the farm sector, more farmers are calling it quits. Farmers who have little equity in land and rent most of the land they farm are most vulnerable to financial problems due to low commodity prices. Some are selling farm assets and securing full-time, off-farm employment to make ends meet. It may be a quiet exodus, but it comes with hidden danger.
Liquidating assets without a careful plan can generate tax consequences that will impair any hope for a fresh start down the road. As farmers weigh these tough decisions, seeking good counsel regarding their options is imperative. Although cash flow is tight, good advice is worth the investment.
Beware of recapture trap
It’s important to remember that selling depreciated assets generates ordinary income tax liability. Depreciation is intended to allow farmers to write off the cost of a business asset over its useful life. Tools such as bonus depreciation and Section 179 expensing, however, mean these costs are often written off long before the life of the asset ends.
If the owner sells the asset while it still has value, federal tax law (Section 1245) steps in to “recapture” ordinary income tax on the difference between the current basis of the asset and the sales price. The current basis is the original cost, less any depreciation or expensing taken. In many cases, the basis may be zero. For example, selling $100,000 of fully depreciated machinery will result in $100,000 of ordinary income, which is subject to income tax but not self-employment tax.
Thus, in many cases selling $500,000 of machinery to pay $500,000 of debt will leave a farmer with significant tax liability that he or she may be unable to pay. In some cases — as calls to our center indicate — this tax liability is unexpected. Debtors should work with an experienced professional before choosing to sell assets to ensure that all options are considered. Once the tax liability is incurred, options are limited.
Tax debt is generally non-dischargeable in bankruptcy. Chapter 12, the special provision for farmers and fishermen, however, does provide an exception. To use this provision, specific income and debt requirements must be met.
In proper cases, even a farmer intending to leave the farming business may be eligible to use Chapter 12 to discharge tax liability from asset sales if he or she can create a feasible plan. This plan may include using off-farm income to make payments. Only an attorney experienced in farm financial distress and bankruptcy, however, can properly advise a client in these matters.
Avoid health insurance trap
Another trap for the unwary stems from the Affordable Care Act’s advance premium tax credit. Many farmers are self-employed and must buy insurance on the individual market. Unless they have a grandfathered plan, the only option for purchasing these plans in 2018 has been on the ACA’s Marketplace Exchange.
If income is below 400% of the federal poverty limit, the enrollee is eligible for an advance premium tax credit, which pays the difference between the actual cost of the plan and a premium cap set by the ACA for taxpayers who meet income requirements. In most states, 400% of the federal poverty limit is $48,560 in 2018 for a single person, $65,840 for a married couple and $100,400 for a family of four.
If the taxpayer enrolls in a policy and elects to have the advance premium tax credit apply, the taxpayer never sees that money. It is automatically applied to offset the cost of the premium. Because the premium tax credit has no upper limit, but makes up the difference between the actual cost of the policy and the premium cap, the difference between the premium paid and the actual cost of the policy can be significant.
For example, data from the Iowa Insurance Division last year show that a family of four with income just below the 400% federal poverty limit would qualify for a premium tax credit and pay around $9,511 a year for a policy. If they crossed the 400% limit, that same policy would cost $27,000. The difference is the amount of the premium tax credit.
The danger is when income exceeds expectations, and by year-end, the taxpayer’s income exceeds 400% of the federal poverty limit. In these cases, the law requires the taxpayer to pay back the entire premium tax credit paid on the taxpayer’s behalf that year. It is calculated on Form 8962 and assessed as additional tax liability.
You may fall into both traps
What does this mean for financially distressed farmers? Selling assets to get cash to pay debt may trigger both recapture deprecation and repayment of ACA advance premium credits. Both may be wholly unexpected.
A farmer enrolled in an ACA insurance policy, relying on advance premium tax credits must realize that if year-end income exceeds 400% of the federal poverty limit, he or she may face a hefty tax bill. If the farmer enrolled in the insurance policy because he or she was expecting household income of $45,000 — but ends the year with $49,000 in income — the advance premium tax credit that must be repaid can climb into the thousands.
Many who receive the advance premium tax credit do not understand the associated risks. A recent tax court case affirmed that no equitable relief is available, even under sympathetic circumstances. In that case, the widow’s income climbed above 400% of the federal poverty limit because she and her husband sold family heirlooms to pay living expenses and their son’s tuition while her husband suffered terminal cancer. The court ruled that the credit had to be repaid.
These are just several of many traps for the unwary when navigating financial distress. The word of caution for financially distressed farmers is don’t let bad circumstances become worse. Consult with an attorney or tax adviser experienced in these matters before engaging in self-help measures, such as selling farm assets. The advice will be worth the cost.
Tidgren is an attorney and director of the Center for Ag Law and Taxation at ISU. Contact her at [email protected].
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