By the end of 2011, the dairy industry thought it had taken a turn to better days, but instead it was just a “U-turn” to higher feed prices and dropping milk prices in 2012. Some operations still experiencing weak legs from the 2009 downturn might not be able to pick themselves up off the mat this time. If all of your options have been exhausted, including reorganization under Chapter 11, then you might decide it is time to throw in the towel. For those who go this route, it is very important to consult with your CPA on the tax implications of liquidation.
When your CPA puts together a liquidation plan, it should compare the fair market value (FMV) of the company’s balance sheet to its cost basis. (Cost basis is the amount the assets were originally purchased for. For fixed assets the basis should be adjusted using tax depreciation, not book. Other considerations are assets that were contributed to the company that have built-in gains or losses.)
The difference between the FMV of the assets and the cost basis is your deemed taxable gain or loss. For assets owned for more than one year, such as most of the equipment and the barn, they will get preferential tax treatment and taxed at the long-term capital gains rates which generally stand at a maximum of 15 percent.
(A portion of gains on depreciable property will be taxed at rates of 25 percent and higher for depreciation recapture.) Keep in mind that farmers have to play by special rules that require their animals to be held for at least 24 months to receive capital gains treatment.
Items not eligible for capital gains treatment such as inventory and accounts receivable should be factored at ordinary income tax rates, which currently stand at a max of 35 percent.
After determining the value and basis of assets, we determine the amount of gain or loss. This will depend in part on the nature of the entity the farmer has chosen to operate the business. In the case of a partnership or limited liability company, there is usually only one layer of taxation and that is when assets are sold.
The gain or loss is determined by reference to the sale price and there is no separate tax on the winding up and dissolution of the business entity. The same is true for sole proprietorships. Things become considerably more complicated when a corporation has been used as the operating entity.
There are two types of corporations – S corporations and C corporations. Of the two, a C corporation is the worst when a business is being dissolved because the entity is taxable on the sale of the assets and the shareholders are taxed on the dissolution proceeds received from the business.
While there are ways to minimize this double tax, it takes the experienced hand of a qualified CPA to properly structure the transaction. An S corporation is not as bad because the gain derived from the sale of the assets by the corporation are passed through to the shareholders and therefore additional gain on liquidating distributions is minimized. There are a lot of rules and complexities dealing with the dissolutions of S corporations and, again, good advice is a must.
Now that we know the basics for calculating the taxable gain on the liquidation plan, let’s discuss strategy. Before closing on the sale of your company, a conversation needs to take place with the buying party on how the sales proceeds are allocated amongst the assets.
Don’t let this be an afterthought, because this can alter your tax liability significantly and the allocation is required by the IRS. As a seller, one of your goals is to minimize the recognition of ordinary income on depreciable assets and thus allocate more proceeds to non-depreciable property, such as land.
The buyer typically wants to do the opposite so they can recognize larger future depreciation deductions on the acquired property. Depending on the health of the relationship at this point in the negotiations, you should expect some pushing back and forth, but a common ground that pleases both parties is certainly attainable.
Most operations resorting to liquidation these days are unable to pay back the balance of their secured obligations upon liquidation. If the lender agrees to forgive a portion of the debt, the owner(s) must recognize this cancellation of debt as taxable income. I know at this point you are asking yourself, “Is there anything the IRS will not tax me on?” You might be able to find some relief in this department.
The IRS has prescribed several scenarios under which a taxpayer may exclude cancelled debt from their gross income. The three most notable exceptions are filing for bankruptcy under Chapter 11, insolvency, and if the debt was incurred in connection with the farming operation and in the previous three years at least 50 percent of the gross receipts were attributable to farming.
Additionally, if the debt was from a private lender, such as a friend or relative, there is no income if the cancellation was intended as a gift. As the old saying goes, there is no such thing as a free lunch. The exclusion will decrease your tax attributes, such as net operating loss carryforwards or a reduction in the basis of qualified property.
On top of everything, you must also consider the taxable income from operations in the final tax year. The fact that the Internal Revenue Code gives farmers a unique set of tax loopholes such as deferring milk checks and deducting prepaid inventory means that any deferred income from previous tax planning decisions will be recognized in the year you liquidate.
If you have elected to utilize these tax strategies in previous years to keep your tax bill down, that might mean the IRS feels it is time to pay the piper. However, from a tax standpoint the rising feed prices and struggling milk prices we have experienced in 2012 should help you offset some of that deferred income.
In fact, if you must execute a liquidation plan in 2012, there is at least one bright side. The Bush tax cuts are scheduled to expire on January 1, 2013, at which time the tax rates will be increased to the levels before 2001. PD
Kevin Hernandez
Certified Public Accountant
Frazer LLP
