Unfair Tax Regime Puts Farmers Steps Away From Agricultural Ruin

Crop farmers, growers, and cultivators have long battled natural disasters, climate change, fertilizer and fuel prices, and a host of other perils that regularly place them one step away from ruin. But perhaps their biggest obstacle to success in the US is the tax regime imposed on them by federal, state, and local governments.

The tax code allows farmers, growers, and cultivators to defer all federal and state income taxes. Leveraging this strategy returns nearly 100% of the proceeds earned in a given year to the taxpayer, with ordinary income taxes deferred for 30 years. Not only is this approach legally compliant, but it’s also good tax law practice.

For farmers who use the cash method of accounting, deferred payment has been a tax strategy to defer the reporting of income into the following tax year. The deferred payment of farm sales is known an installment sale. Deferred payments on personal property, such as grain and livestock, also qualify for installment sale reporting.

Traditionally, the seller structures the installment sale of farmland to receive a series of equal annual payments over 10, 15, 20, or 30 years. This was designed partially so the seller could spread out income taxes on the sale of appreciated farm assets over the life of the contract.

As long as the seller received at least one payment from the sale after the close of the sale’s taxable year, the transaction was classified as an installment sale under Section 453 of the tax code. The agricultural seller only had to report and pay income taxes for the portion of the payments received in that year relative to the overall gain on the sale.

Monetization

When monetizing an installment sale, the transaction remains a sale of farmland or farm commodities with an installment contract. Thus, we have a traditional agricultural seller and purchaser with terms of the sale that mirror the traditional installment sale transaction.

The contract must allow the purchaser to assign its obligations to make installment payments to a third-party obligor. The purchaser pays the entire purchase price, less proration, fees, and costs at the preliminary closing. When the obligations are assigned by the purchaser to the obligor, the obligor holds the seller’s closing proceeds, which allows the obligor to complete the payment to the seller under the terms of the installment sale contract.

This transaction looks similar to a like-kind exchange under Section 1031. In the same way a qualified intermediary steps in to complete the purchase of like-kind property in a 1031 exchange, the obligor must step into the purchaser’s shoes.

The documents makes clear that the obligor is taking receipt of the funds to fulfill the installment payment contract and is stepping into the shoes of the purchaser through an assignment of the purchaser’s obligation to complete the transaction as part of the installment contract. Immediately following the preliminary closing, the purchaser is out of the transaction, and the obligor steps in to complete the payments.

Once the nonnegotiable promissory note is in the seller’s hands, the asset (for example, the promissory note) and the collateral are in place for the seller to obtain a loan for nearly the entire installment sale contract price. Since this loan is 100% collateralized, the seller can borrow at favorable interest rates that are slightly above the amount that the seller would receive on the nonnegotiable promissory note.

The loan, which is obtained by the seller for nearly the entire sales amount, less transaction fees and costs, isn’t considered sales proceeds that will trigger income taxes. Rather, the monetization (for example, getting cash from a loan) for the entire value of the net sales price in the installment sales will receive favorable installment sale income tax reporting under Section 453.

After the ultimate closing, at the end of the installment sales contract, the transaction is complete. The purchase proceeds held by the obligor are delivered to the seller in exchange for return and cancellation of the nonnegotiable promissory note. In turn, the seller uses the proceeds to retire the loan with the lender. Once the transaction is closed, the seller will have to report gain on the sale proceeds in excess of the seller’s basis.

But Is It Legal?

The Omnibus Budget Reconciliation Act of 1987 included Section 453A(b)(3), which exempted farm property from both the interest charge exception and the pledge rule. The exemption extends to “any property used or produced in the trade or business of farming, within the meaning of Code § 2032(A)(e)(4) or (5).”

The definition of farm includes “stock, dairy, poultry, fruit, furbearing animal, as well as truck farms, plantations, ranches, nurseries, ranges, greenhouses, and other similar structures used primarily for the raising of agricultural or horticultural commodities, orchards, and woodlands.” The cultivation of cannabis in states where it’s legal also falls within this definition.

The definition of farming purposes in Section 2032(A)(e)(5) has three subsections that cover the range of farming-related activities conducted on agricultural land:

• Subsection A defines farming purposes as “cultivating the soil or raising or harvesting any agricultural or horticultural commodity (including the raising, shearing, feeding, caring for, training, and management of animals) on a farm.”
• Subsection B defines “handling, drying, packing, grading, or storing on a farm any agricultural or horticultural commodity in its unmanufactured state, but only if the owner, tenant, or operator of the farm regularly produces more than one-half of the commodity so treated.”
• Subsection C defines the “planting, cultivating, caring for, cutting, and preparation (other than milling) of trees for market.”

The express exception to the pledge rule is what allows monetized installment sales reporting to be available for property used in the trade or business of farming. The availability of this pledge of cash, or an irrevocable standby letter of credit to provide security for the future installment obligation, is the conduit that permits the seller to secure a current loan without taking constructive or actual receipt, or possession of the buyer’s proceeds.

The monetization of installment sales in an agricultural context under Section 453A must be distinguished from the so-called monetized installment sales that are being promoted in a non-agricultural context pursuant to Section 453 with respect to the deferral of capital gains taxes on the sale of capital assets. I don’t endorse or do any work with this latter strategy, as it’s far too aggressive and has even made the IRS’ annual Dirty Dozen list.

The unique aspects of Section 453A create a significant and underutilized opportunity for farmers, growers, and cultivators to legally seek and obtain agricultural tax deferral on ordinary income.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Michael J. Burwick is a partner at Armstrong Teasdale LLP with nearly 30 years of experience as a tax, corporate and securities lawyer, focusing on tax deferral, mitigation and minimization. He works to implementing tax strategies with clients across industry sectors, from sports and entertainment to agribusiness.

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