September 9, 2005

Updated Information
Tobacco Quota Buyout
Tax Considerations

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Tax Implications of Tobacco Quota Buyout
Summary version 2.0

Arnold W. Oltmans, Associate Professor and Extension Specialist, North Carolina State University
March, 2005

Full Text Version

Disclaimer: Information provided here is for educational purposes only. Nothing herein constitutes the provision of legal advice or accounting services. Quota holders and tobacco producers should contact their tax practitioner and other professional advisers relative to their circumstances in regards to these issues.

Overview
Tobacco quota buyout payments, beginning in 2005 and ending in 2014, have important income tax implications for tobacco producers and quota owners. They need to work closely with their accountant, tax preparer, lender, or other professional advisers in 2005 to determine the specific tax impact on their individual situation. Tax issues, tax rates and reporting rules are different for producers receiving the $3 production payment and quota holders receiving the $7 quota payment. The $3 production payment will be taxed as ordinary business income while the $7 quota payment will be taxed as capital gain income.

Production Payment ($3) Tax Issues
The tax implications for the production payments to producers are relatively simple and straight forward. Payments will be treated as ordinary business income in the year payments are received and will be subject to:

• Self-employment (FICA) tax at 15.3%.
• Federal tax at ordinary tax rates of 10% to 35% in 2005.
• State tax at ordinary tax rates of 6% to 8.25% in North Carolina in 2005.

Thus, the amount of tax will vary widely among individual producers depending on their individual situation. The combined tax rate could be as low as 30% and as high as 51%.

Beyond the applicable tax rate, producers should also consider two other tax implications.

• Effect of production payments on social security benefits
• Effect of taking a lump sum payment in 2005.

Because the producer payment is earned income, it may reduce the eligible benefit for individuals taking early social security. Taking a lump sum in 2005 has tax advantages or disadvantages that will vary among individual situations. Recipients of production payments should work closely with a professional financial adviser in making decisions about taking a lump sum payment or taking social security early.

Quota Holder Payment ($7) Tax Issues
Tax issues and planning for quota owners are more complicated, requiring more knowledge, information and work by recipients. Tobacco quota, which is an interest in land, qualifies as a Section 1231 asset with unique tax treatment.

• Payments are not subject to self-employment (FICA) tax.
• Only the portion of the payment which is a gain above the cost basis of the quota is taxed as a capital gain.
• Gains are taxed at federal capital gains tax rates of 5, 10, or 15%.
• Gains do not qualify for farm income averaging (since gains are not "farm income")
• Capital gain income does not affect social security benefits.
• State taxes apply according to individual state tax rates (6% to 8.25% in NC).

While the tax rate on quota payments can still vary among individuals, the rates are much lower than for production payments. For a North Carolina taxpayer, the combined federal and state tax rate on the capital gain portion could be as low as 11% or as high as 23%.

Capital gains tax treatment of quota holder payments implies some other important issues that individuals must consider and work through with their tax preparer, accountant, financial adviser, etc., as soon as possible in 2005 (i.e., don't wait until the 2006 tax season for doing 2005 tax returns to work through these tax issues.) Three issues merit particular attention:

• Determining the tax basis of quota.
• Considering a like-kind exchange to defer the tax.
• Evaluating the effect of taking a lump-sum payment in 2005.

Quota Basis
The taxable capital gain portion of the quota buyout payment is the total amount received minus the total cost basis in quota acquired over time. There are basically three ways to have acquired quota, and the rules for establishing a basis are different for each.

• Quota purchased -most often the basis is the amount of cash paid.
• Quota received by inheritance-the basis is the fair market value (FMV) of the quota on the date it was inherited.
• Quota received as a gift-the basis is whatever the basis was of the person making the gift.

While these rules for establishing basis are simple and straight forward, determining the correct dollar amount for each is not so easy for many quota holders. One complication arises when quota was acquired as part of an entire land purchase. At the time that the land was purchased or inherited, the dollar amount the quota attached to the land should have been established separate from the land itself. If the quota and land values were not separated at the time of acquisition, the quota holder faces a challenge in retroactively determining the portion of the total value to assign to the quota. In the case of a gift, the previous owner's basis in the quota should have been recorded as part of the gift transaction. If not, the current quota holder must somehow determine what that basis was.

What if no precise records of quota basis were made or if records are unavailable? Quota owners must make a good faith effort to calculate a basis value from historical information pertinent to their individual situation, but there is no specific methodology for doing this. In other words, they cannot simply pick a number that looks reasonable or "guess" at what the basis could be. In the absence of adequate records or a good faith effort to establish a record of basis, the IRS default position is that the basis is zero and the entire payment is a taxable capital gain.

Quota owners should also think in terms of owning different "lots" of quota instead of pounds and determine the basis for each lot rather than for each pound owned. The reason is because the number of pounds owned in a particular lot when the quota was obtained is most likely different than the number of pounds of 2002 effective quota upon which the buyout is based. Thinking in terms of a basis-per-pound rather than a basis-per-lot can lead to confusion.

Like-Kind Exchange to Defer the Capital Gains Tax
Some quota holders may want to seriously consider a method for deferring the tax on all or part of their buyout payment through a simultaneous exchange of their payment for like-kind property. In this process, the basis and capital gains from their quota payment roll over into the property being purchased, and the tax consequence is delayed (deferred) until that property is sold. While the details of a like-kind exchange are somewhat complex and require the professional assistance of the quota owner's tax preparer, accountant, real estate broker, lawyer, etc., any quota holder who wants to do so must follow three specific rules.

• The replacement property must be from a like-kind category.
• A qualified intermediary must hold payment funds until transactions are completed.
• Transactions must be completed within strict time limits.

A like-kind exchange is not something a quota holder can decide or complete without the help of third-party professionals. And the window of time for making such a decision is limited and will require action soon in 2005 by quota holders.

Lump-Sum Payment
Buyout payments from the government to both producers and quota holders will be made in equal installments over 10 years. As an installment sale contract, the tax liability of buyout payments will be spread out over 10 years. However, a taxpayer can "elect out" and report the entire amount of income in 2005, making future payments tax free, which may be advantageous to some taxpayers. A more likely exception to the installment reporting of taxes is for quota holders and producers who choose to take a lump-sum in 2005 of the nine buyout payments for 2006-2014. Because the quota owner or producer is receiving all of the funds from the buyout in 2005, all taxes also accrue to the 2005 tax year. However, only the amount actually received in the lump sum is taxable, not the entire buyout amount. The decision to take a lump-sum payment involves several economic and personal considerations which individuals should discuss thoroughly with their tax preparer and other financial advisers as soon as possible in order to make an informed decision.

New Information
Additional information and clarifications on tax implications of the tobacco quota buyout may become available in the coming months. Quota holders and producers should stay informed beyond the information written here as they make decisions in 2005.

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