In the year of retirement, a farmer may find themselves with an entire year (or more) of crops or livestock to sell and no expenses to offset the income. Additionally, machinery and livestock that will no longer be needed for production will need to be sold. Selling all these assets upon retirement without offsetting expenses can result in tremendous tax liability.
One strategy for retiring farmers to consider is using a charitable remainder trust (CRT). The CRT is a special kind of trust that can sell assets without triggering tax liability while providing annual income for the retiring farmer. The CRT essentially spreads out the income from the sale of the assets over many years to keep the farmer in a lower tax rate bracket. Also, the CRT allows the retiring farmer to make a donation to the charity of their choice.
The primary component of a CRT strategy is: It does not pay tax upon the sale of assets. Due to its charitable nature, a CRT can sell assets and pay no capital gains tax nor depreciation recapture tax. The retiring farmer establishes a CRT, then transfers the assets they want to sell into the CRT. The CRT then sells the assets. For the strategy to work, the trust must be a CRT. A non-charitable trust will owe taxes upon the sale of the assets.
The proceeds from the sale of the assets are then invested in a financial account. The farmer works with an investment adviser to determine the desired annual income needed from the proceeds, and an appropriate investment portfolio is created. It is important to note the income calculations must include leaving at least 10% of the principal to a charity. The farmer may not receive all the income or the trust will not qualify as a charitable trust. The term of the payments from the investment portfolio cannot exceed 20 years.
After the financial account is established, the farmer will receive annual income. This income is taxed at the farmer’s individual tax rate. By paying the sale proceeds out over a number of years, the farmer’s income tax bracket can be moderated. Selling all assets in one year would likely cause the farmer to be pushed into the highest income tax and capital gains tax bracket; spreading out the income keeps the farmer in a lower tax bracket.
Another important component of a CRT is the charitable giving. As stated above, the farmer must plan to give 10% of the principal to a charity. The funds are provided to the charity when the term of the investment expires or when the farmer dies. Depending on the performance of the investment, the charity may receive more than 10% or less than 10%. The farmer must be able to show that when the investment account was established, the intention was for the charity to receive at least 10% of the original principal.
Consider the following examples, one with a CRT and one without:
Scenario without CRT. Farmer A decided to retire at the end of 2021. Farmer A owned $800,000 of machinery and $500,000 of cattle. Farmer A sold all the machinery and cattle before the end of 2021. Farmer A owed tax on $1.3 million due to depreciation recapture on the machinery and capital gains on the cattle. Farmer A’s tax liability was $450,000 for the sale of the assets.
- Scenario with CRT. Farmer B owned $800,000 of machinery and $500,000 of cattle and decided to retire at the end of 2021. Farmer B established a CRT and transferred the machinery and cattle into the CRT. The CRT sold the machinery and cattle but did not pay tax on the sale proceeds due to its charitable status. Farmer B established an annuity to pay out over 20 years. Each year, Farmer B receives $90,000 of income from the CRT. Farmer B pays income tax on the payment but at a lower rate than the previous scenario. At the end of the 20-year term, a charity receives $150,000 (original 10% of principal plus interest).
As the scenarios show, a CRT can save significant taxes for the retiring farmer. These scenarios only address federal taxes. State income taxes may also play a key role in developing a retirement strategy and should be analyzed as well.
A retirement strategy using a CRT is not without its disadvantages. One disadvantage is the cost to implement the plan. A CRT plan is complicated and requires the assistance of an attorney, accountant and financial adviser. The combined professional fees could be $25,000 or more. Another disadvantage is the inflexible nature of the plan. The CRT is an irrevocable trust; once the CRT is implemented, the plan cannot be changed. If the retired farmer finds they need more income than allocated from the CRT, they are unable to make such a change.
Anyone considering retiring from farming should explore the possibility of incorporating a CRT into their plan. CRTs can save significant income taxes and provide for charitable giving, but it’s not for everyone. The potential tax savings must be enough to justify the significant costs to establish the CRT, and the farmer must be willing to give up control of the sale proceeds. Retiring farmers should consult with their attorney, accountant and/or financial adviser to assess how a CRT might fit into their retirement plan.
PHOTO: Getty image.
This article is provided for information purposes only. Readers should consult their own professional advisers for specific advice tailored to their needs. Information contained in this article may be subject to change without notice.
- Ohio State University Extension Agricultural & Resource Law Program
- Email Robert Moore