As tough times continue in the farm sector, more farmers are calling it quits. In particular, many operators who do not own ground and are dependent upon renting the land of others are struggling to hold on. Many are selling farm assets and securing full-time off-farm employment to make ends meet. It’s 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, it is imperative that they seek good counsel regarding their options. Although cash flow is tight, good advice is worth the investment.
It is important to remember that depreciated assets, when sold, generate ordinary income tax liability. Depreciation is intended to allow farmers to write off the cost of a business asset over its useful life. Especially in light of bonus depreciation and Section 179 expensing, 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, IRC § 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 equal to the original cost, less any depreciation or expensing taken. In many cases, the basis may be zero. In other words, the sale of $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.
This means that in many cases selling $500,000 of machinery to pay $500,000 of debt will leave a farmer with significant tax liability he or she may be unable to pay. In some cases—as calls to our Center have indicated—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. In re Williams (Bankr. W.D. Ky., 2016). Only an attorney experienced in farm financial distress and bankruptcy, however, can properly advise a client in these matters.
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 or grandmothered plan, the only option for purchasing these plans as of late has been on the ACA’s Marketplace Exchange. If income is below 400 percent of the federal poverty limit, the enrollee is eligible for an advance premium tax credit, which is 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 percent of the federal poverty limit is $48,560 in 2018 for a single person 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, that money is never seen by the taxpayer. 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 been significant. For example, data from the Iowa Insurance Division last year showed that a family of four with income just below the 400 percent 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 percent 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 percent of the federal poverty limit. In these cases, the law requires the taxpayer to pay back the entire premium tax credit. It is calculated on Form 8962, and assessed as additional tax liability.
What does this mean for financially distressed farmers?
Those who sell assets to pay debt can easily fall into this trap. And for many it’s wholly unexpected. A farmer enrolled in an ACA insurance policy, relying on advanced premium tax credits to pay an affordable monthly premium, must realize that if year-end income exceeds 400 percent of the federal poverty limit, he or she may face a hefty tax bill. If the farmer enrolled in insurance expecting taxable income of $45,000, but ends the year with $49,000 in income, the advanced 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 there is no equitable relief available, even under sympathetic circumstances. In that case, the widow’s income climbed above 400 percent of the federal poverty limit because she and her husband sold family heirlooms to pay medical expenses while her husband suffered terminal cancer. The court found 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 advisor experienced in these matters before engaging in self-help measures, such as selling farm assets. The advice will be worth the cost. We are continuing to follow financial distress issues closely and will be providing additional resources on our website in the months ahead.
Readers looking for additional information on this topic can review more resources on this page.
CALT does not provide legal advice. Any information provided on this website is not intended to be a substitute for legal services from a competent professional. CALT's work is supported by fee-based seminars and generous private gifts. Any opinions, findings, conclusions or recommendations expressed in the material contained on this website do not necessarily reflect the views of Iowa State University.