Ask the Taxman by Andy Biebl

Can I Afford Income Tax If I Sell a Spare Combine?

Late model equipment that's been largely depreciated could face a steep income tax bill when sold. (DTN Photo by Jim Patrico)

QUESTION:

I need to downsize my operation next year for financial reasons and plan to sell a combine I purchased in 2012. The combine is mostly depreciated. Can you give me an example of how much tax I might owe if I choose this option?

ANSWER:

As an illustration, let's assume the combine can be sold for $220,000, and your remaining undepreciated tax cost is only $20,000. Obviously, you have a gain of $200,000 on the sale. The good news is that this income is not subject to self-employed social security tax, but the bad news is that it must be reported as ordinary income on Form 4797 (a schedule used to report gains from the sale of business property). A gain of that magnitude could run through several tax rates, touching perhaps the 25%, 28% or even 33% brackets. If we use 30% as an average rate, your federal tax cost on the sale would be an additional $60,000 of tax ($200,000 x 30%).

I am assuming that all of the gain is attributable to the depreciation (i.e., you are selling the 2012 combine for less than your original cost, and the gain arises entirely from the depreciation deductions that reduced your original cost). If a machinery item is sold for more than its original cost, the excess over the purchase price is capital gain. But that is exceptionally rare with the sale of used farm equipment.

Assuming you go ahead with the sale, you will want to build that gain into your year-end tax planning projection with your tax adviser. If the gain is large, it may make sense to reduce the Schedule F income with additional prepaid expenses or deferred sales. Also, be sure to check on the use of Schedule J, farming income averaging. The combine sale gain qualifies for farm income averaging. This will allow you to apply lower tax rates from the prior three years to any higher farm income this year.

[A career of deferred taxation poses hardships for any operator who attempts to retire cold turkey. To learn how to minimize the tax consequences, attend DTN University's "How to Retire Without a Monster Tax Bill," Dec. 6 just prior to the DTN Ag Summit in Chicago. See http://goo.gl/… for details.]

QUESTION:

I am hearing that a lot of the lease arrangements, particularly for farm buildings, do not meet the tests of a true lease and are simply disguised purchase agreements. What are the rules in case I am audited?

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ANSWER:

Before we get to the factors on what characterizes a lease versus a purchase, we should be clear that this is simply a matter of timing of the deductions. If it is a true lease, all payments are deductible as rent expense when disbursed.

If it is a purchase (or a "conditional sales contract" in IRS lingo), a small portion of each payment is treated as deductible interest expense when disbursed. The balance of all of the payments over the term of the contract represents the cost of the asset that is subject to depreciation. Farm machinery and bins are recovered over 7 years, specialty livestock buildings over 10 years, and general purpose machine sheds and shops are depreciated over 20 years. New assets, but not used, can qualify for the first year 50% bonus depreciation deduction (this is not officially in the law yet for 2015, but there is every expectation that Congress will renew the provision). There is also the Section 179 first year deduction, expected to be renewed at $500,000, which works for all assets except general purpose 20 year buildings.

So if the lease is recharacterized as a purchase, the taxpayer has significant flexibility as to how the depreciation deductions are claimed. Nevertheless, if a taxpayer is several years into a building lease that is being deducted as rent on a six-year lease arrangement and the IRS recharacterizes the deal as a purchase subject to a 20-year depreciation schedule, there will be some tax deductions deferred when the IRS swings the treatment from rent to depreciation.

And now the tough part: What factors help determine whether it is a true lease or a disguised purchase? Some of the best material on this is in IRS Publication 225, "Farmers Tax Guide," on page 22 under the "Lease or Purchase" heading. The IRS correctly points out that no single test applies. Rather, a combination of factors around the terms of the deal must be considered. Factors that suggest a lease is a disguised purchase include the following:

--The lessee gets title to the property after making a stated amount of payments.

--The annual lease payments are much more than the current fair rental amount for the use of the asset.

--There is an option to buy the property at a nominal price at the end of the lease (with "nominal" being defined by comparison of the buy-out price to today's expectation of the value of the asset at that future buy-out point).

--The agreement applies part of each payment toward an equity interest in the asset.

Finally, recognize that the label at the top of the document is not going to govern for tax purposes. If the piece of paper says lease, but the terms are clearly nothing more than a financed purchase, it is better to recognize the reality, treat the asset as a purchase, and take advantage of the flexibility built into today's depreciation rules.

QUESTION:

Mom died two years ago in July 2013. About a week later, her husband, my stepdad, passed away. One of his children filed their final joint Form 1040 for 2013 on time, but the IRS has not issued an income tax refund yet. The missing refund is forcing both estates to stay open. What advice do you have regarding that refund?

ANSWER:

I would begin by checking with the son or daughter that filed the tax return. Was a proper address used on that tax return and was any correspondence received from the IRS? Letters and notices from the IRS can be confusing, and a query from the IRS may have been overlooked or mishandled.

The next item to check is whether a Form 1310 accompanied that final Form 1040. When a 1040 is filed claiming a refund for a deceased person, a Form 1310, "Statement of Person Claiming Refund Due a Deceased Taxpayer," must accompany the return. This form identifies the party filing the Form 1040 on behalf of the deceased taxpayer, and their authority for acting on that person's behalf (e.g., they are the court-appointed personal representative).

If there have been no mishandled communications from the IRS and the Form 1310 was attached to that 2013 Form 1040, then I would recommend contacting the Taxpayer Advocate office within the IRS, and ask them to investigate (phone is 877-777-4778). However, the child acting on behalf of the deceased couple will need to have an IRS Form 56, "Notice Concerning Fiduciary Relationship," on file with the IRS, in order to act on behalf of the deceased couple.

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/BAS)

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