Taxlink by Andy Biebl

QUESTION:

When my grandfather retired from the farm, he transferred most of his business assets to his children. Each year, each child gifts $14,000 back to grandpa for his living expenses. What are the advantages and disadvantages of this arrangement?

ANSWER:

Normally, gifts are not taxable income to the recipient. But the substance of this deal is a sale. Grandpa transferred a significant amount of assets to his children who now pay him annually; the IRS is not going to accept that these reciprocal transfers were gifts for no consideration. The tax law is way too sophisticated to allow labels to govern over the substance of the transaction. The IRS would be quick to recharacterize this arrangement as an installment sale and assess grandpa for all of the past income taxes on those annual payments from the children. And if grandpa has not been filing an annual Form 1040 because he does not, on paper, appear to have any income, the statute of limitations is not running and the IRS has open season on the full history of this deal.

This arrangement also has estate tax risk. Given that the payments back from the children are implicitly for grandpa's lifetime, the IRS could also apply Section 2036 to pull the property back into his estate at death (assuming grandpa's net worth exceeded the estate tax exemption and the IRS had estate tax to collect also).

This family needs to engage good legal and tax professionals who can examine all aspects of what has been done and advise on how to best repair the situation. If the IRS gets there first, my concern is that it would get very expensive.

QUESTION:

We are nearing the end of a five-year transition where our children are taking over our farming and trucking businesses. When we determine how much income we need to retire, what's the best way to handle that? For example, can the farming business still pay for our vehicles, cell phones, and health insurance? We only own a few hundred acres out of several thousand acres that the children are farming now, so rent alone will not provide sufficient retirement income.

ANSWER:

Land rental is the ideal form of retirement income, as it is not subject to self-employed Social Security tax, moves up with inflation, and does not require the owner's labor or involvement. But if that is inadequate, how about selling some of the business assets to the kids on a long-term contract? You indicate the children are "taking over" the farming and trucking businesses. Is there still an opportunity to arrange an installment sale of some portion of the business assets that could provide long-term retirement cash flow to you?

Your specific inquiry concerns compensation-related fringe benefits, such as use of a vehicle, cell phone, and employer-provided health insurance. Those tie to employment and can be deductible business expenses to the employer and tax-free benefits to the employee. This assumes that you are rendering some part-time services to the business and that these benefits represent a portion of a reasonable compensation package. The use of a company vehicle is a sensitive subject with the IRS and must be for business use in order to be tax-free. I would advise a written employment agreement between you and the business for those part-time services, with that agreement defining both the cash wage portion and the fringe benefit portion of your compensation.

There is one caution regarding the health insurance: The Affordable Care Act market reforms can penalize a business that reimburses an employee's individual insurance premiums. If the insurance is through a group plan offered by the employer, or the business uses the one-employee exception, the arrangement may be exempt from the ACA penalty.

QUESTION:

Financial planners tell us you should have 35 years of income to maximize Social Security in retirement. I'm in my early 60s now, but when farm incomes were low, so was my income. How much income should I report over the next few years to bump up my Social Security benefits? I assume there is no point in going hog wild, since Social Security benefits are capped.

ANSWER:

Your starting assumption is correct; Social Security uses the 35 best years in your work history to determine your retirement benefit. But making the assessment of how strong your earnings history is, and whether some current high earning years would replace earlier low income years, is more difficult. Your earnings history is inflation-indexed to determine the best 35 years. For example, if you were born in 1952, are currently age 63, and had $10,000 of reported earnings in the early 1970s when you were in your early 20s, those earning years are multiplied by a factor of over five for inflation-indexing.

The Social Security website (http://socialsecurity.gov) has worksheets which allow you to translate your actual working history into the indexed history that is used to determine the top 35 years for computing benefits (search the SSA website for the term: "Your Retirement Benefit: How it is Figured," and get the right table for your year of birth).

The additional aspect, of course, is that a current high earning year is averaged in as part of the top 35, so a big year now only increases your average indexed earnings by 1/35th. If your average indexed earnings history is very low (say under $10,000), increasing your base provides a good rate of return. And this strategy also can make sense if there are some very low or zero years that should be replaced in the top 35. But clarity can only come from running the numbers.

Social Security has several online benefit calculators, including one which can pull up your personal history for a precise computation. That personalized calculator requires you to enter your most recent year of earnings (because the IRS is slow to transmit your last tax return earnings amount to the Social Security Administration). Entering differing amounts for that most recent year of earnings in the calculator will quantify how improving the history today specifically affects your benefits. But note that the current self-employed Social Security rate is 15.3%, so a $100,000 earnings year today requires an upfront payment of $15,300 to produce a better monthly retirement benefit. How many years will it take to get a payback on that additional tax cost?

EDITOR'S NOTE: Andy Biebl is a nationally recognized CPA and tax principal who specializes in agriculture with CliftonLarsonAllen LLP in Minneapolis and New Ulm, Minnesota. He writes tax columns for DTN and its sister publication, The Progressive Farmer magazine. To submit questions for future columns, email AskAndy@dtn.com. Subscribers can always find Biebl's columns in Town Hall, on the Farm Business page or online using the Search feature under News.

(MZT/CZ)

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