By Robert Moore, Attorney and Research Specialist, OSU Agricultural & Resource Law Program
Most farmers do a great job of managing their taxable income. They buy inputs or machinery to offset the current year’s income and wait until next year to sell the current crop. This strategy works well but it catches up to the retiring farmer. 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 equipment 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 charitable donation to their charity of choice.
The primary component of a CRT strategy is that a CRT 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 advisor to determine the desired annual income needed from the proceeds and then an appropriate investment portfolio is created. It is important to note that 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, so spreading out the income keeps the farmer in a lower tax bracket.
Another important component of a CRT is the charitable giving requirement. 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 decided to retire after the 2021 crop year. Farmer owned $800,000 of machinery and $200,000 of grain. Farmer sold all the grain and machinery before the end of 2021. Farmer owed tax on $100,000 of ordinary income due to depreciation recapture on the machinery and sale proceeds of the grain. Farmer’s tax liability was $450,000 for the sale of the assets.
Scenario with CRT. Farmer established a CRT and transfered the machinery and grain into the CRT. The CRT sold the machinery and grain but did not pay tax on the sale proceeds due to its charitable status. Farmer established an annuity to pay out over 20 years. Each year Farmer receives $65,000 of income from the CRT. Farmer pays income tax on the payment but at a much 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. Also, a CRT allows a retiring farmer to make a charitable contribution to their charity of choice.
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 advisor. 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 advisor to assess how a CRT might fit into their retirement plan.