Minimize Farmland's Exit Taxes

Fix Land Trapped in a C Corporation

Many farm families formed C corporations to hold farmland in the 1970s, only to suffer punishing capital gains rates when tax law changed. (DTN file photo by Scott Kemper)

HADDONFIELD, N.J. (DTN) -- "I have been searching all over the Internet to figure out how to get out of the C corporation (land only) formed by our deceased parents in 1975 without a huge tax bite and still provide some income for the current farming generation nearing their 70s and the non-farm siblings," writes a DTN reader from Kentucky. She's hardly alone.

One of the hangovers of 1970s farm tax advice is that many farm families now own farmland trapped in a C corporation. Unfortunately, thanks to tax rule changes and runaway land markets, that exposes owners to double taxation and unimaginable capital gains bills if the farmland is sold. It's also one of the trickier issues a good tax adviser can help fix if you have a long timetable.

Since 1990, C corporations have not been able to use capital gains rates available to individuals. That means a C corporation's sale of farmland with relatively low tax basis can easily trigger federal and state income taxes of 40%-50% or more. Paul Neiffer, a farm tax principal with the accounting firm of CliftonLarsonAllen LLP and instructor in an upcoming DTN webinar on retirement tax planning, cites this example:

Farmer Brown personally owns 500 acres of good farmland he bought in the 1970s for $500,000 that is now worth $5 million. He passes away in 2016 and leaves it to his children. Their cost basis in this farmland will now be $5 million, so no capital gains is due if they sold it immediately at that market value.

Unfortunately, Farmer Green and his wife bought an identical 500 acres in the 1970s also, but they put the land into a C corporation. "When Farmer Green passes away, his half of the stock in the C corporation is stepped-up to fair market value, which is likely less than $2.5 million. It is discounted for lack of marketability and minority interest. None of the farmland value inside of the corporation gets a step-up. If the corporation sells the farmland for $5 million, it will then owe federal and state tax on a full $4.5 million gain," Neiffer says.

Generally, that means the corporation would pay 35% federal income tax rates on the gain from any land sale. Next, shareholders would likely pay a capital gains rate of 20% on any remaining dividends or distribution, plus the new 3.8% investment surcharge due to the Affordable Health Care Act, plus possible state taxes.

S corporations result in the same scenario for tax basis: "No step-up in basis for the farmland. Full gain when the land is sold," Neiffer says. "However, if that is the only asset inside the S corporation, then the corporation can be liquidated and likely there will be a loss on liquidation to help offset the gain on the sale of the farmland. This is true, if and only if, capital assets such as farmland are inside the corporation." What's more, land in an S corporation is only taxed once for federal income tax, at the 20% capital gains rates, plus the 3.8% investment surcharge if land was not actively farmed. Additional state income taxes may also apply.

Converting a C corporation to an S, and unwinding the land inside of it can take five years, but it's one of the strategies Neiffer and his partner Nick Houle, another CliftonLarsonAllen CPA and Wealth Management Consultant will discuss at a DTN webinar Thursday, Feb. 18. They will also tackle how to minimize the tax shocks of depreciation recapture when farm equipment is liquidated at retirement as well as affordable strategies for transferring ownership to a successor generation.

Exiting agriculture and farmland ownership without a plan can be the largest tax event in a farmer's career -- even more than many would owe in estate taxes, cautioned Neiffer. "If someone wants to quit out of the blue and hasn't been working with a tax adviser, their normal reaction is to have a deer-in-the-headlights kind of look. Then they ask what is the pain threshold for some alternatives."

The DTN webinar, "How to Exit Ag Without Paying a Monster Tax Bill," is scheduled for Feb. 18 at 9 a.m. Central Time. Recordings will be available for those who can't attend live. Registration costs $50. For details, go to…

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