The use of charitable remainder trusts in connection with farm liquidations can provide a unique “win-win” for donors and charities, allowing retiring farmers to manage the tax consequences of liquidation (which are often very severe), convert a large one-time cash infusion into a predictable lifetime stream of income and provide for their favorite causes without cutting into their current retirement income stream. As many reading this may be familiar, a charitable remainder trust (CRT) involves a contribution to a charitable trust where the trust then makes annual payments back to the donor(s) during either a fixed period of time or for the rest of the donor(s)’ lifetime, leaving the remainder to charity when the trust terminates. The payments can either be for a set amount each year – a charitable remainder annuity trust (CRAT) or for a fixed percentage of the principal of the trust each year – a charitable remainder unitrust (CRUT). In order for the trust to qualify as a charitable trust, the projected value of the remainder left to the charity at the termination of the trust must be at least 10% of the trust’s original value. Consider a simple example of a donor who contributes $1,000,000 to a 10-year fixed-term CRAT. If the donor chooses to maximize the amount of the annual payments back to himself, the donor will receive a charitable deduction of approximately $110,000 in year one and an annuity payment of approximately $93,000 back from the trust every year for the next 10 years. In 10 years, the charity of the donor’s choice will receive whatever is left in the trust, which will depend of course on how much the trust earns during the 10-year term.
Now consider a farmer nearing retirement. Instead of $1 million in cash, he has $800,000 of fully-depreciated equipment and harvested crops worth $200,000 (with no offsetting expenses because he deducted all of the expenses of that crop in the prior year). If the farmer sells his harvested crop and fully-depreciated equipment, the sales will create $1 million of ordinary income because the depreciation recapture rules will require the $800,000 to be taxed as ordinary income along with the $200,000 of crop sale proceeds. With a combined tax bracket of 45%, the tax liability could be as much as $450,000. This would be the case even if the farmer sold the equipment to his neighbor on an installment sale because tax rules require all of the depreciation recapture to be recognized in the year of sale. In fact, this means that the farmer might even be in a negative cash flow situation because he owes more tax in year one that he would receive on the installment sale before he had to pay the tax. So much for using an installment sale to give the farmer a nice “retirement income” stream. It gets even worse of course, if the farmer still has debt that must be paid off out of the sales proceeds – now we might be in a situation where the farmer is essentially “paying” to quit farming.
One option that can help this situation is the use of a CRT. First, the farmer contributes the harvested crops and equipment to the CRT, which generates no gain to the farmer (and in the case of zero-basis assets, also likely no charitable deduction but as you will see later, that is not really the tax play we are going for here). The CRT can then sell the crops and equipment (without paying the immediate $450,000 tax the farmer would have had to pay) and receive the entire $1 million cash that can then be invested in standard marketable investments such as stocks, bonds, or mutual funds. Assuming the farmer makes the same choices in our simple example above (10 year fixed-term CRAT), the farmer will receive the same $93,000 per year from the trust for the following 10 years. The income of the CRT is accumulated within the trust and the annual distributions back to the farmer will be taxable income to the farmer based on the character of the income generated by the trust on a cumulative basis. The highest rate income (i.e. the ordinary income crop sales and deprecation recapture from the equipment sales) will be passed to the farmer first, with lower rate income such as qualified and capital gains from the invested cash proceeds following, and tax-exempt income coming last.
So, by using the CRT, the farmer is able to defer the payment of income tax on the sale of his final crop and depreciated equipment to match the stream of payments he will get instead of the lump sum payment and is able to get the stream of payments based on the full $1 million rather than just the after-tax net amount. Thus, he has effectively converted $1,000,000 of ordinary income in year one into $93,000 per year of ordinary income over a period of 10 years. Assuming the underlying assets in the trust earn at least a 4% return, the farmer will have received a total of almost $930,000 back from the CRT over its 10-year life – the after-tax value of which is likely greater than the farmer’s return on his after-tax net profit in a typical liquidation ($550,000 in our example) – plus the farmer will have benefited his charity of choice (which can even be a donor advised fund) by almost $364,000!
While the examples here are a simplification and many additional rules and restrictions apply which will require the farmer to plan well in advance of his desired liquidation event, certainly, using a CRT is a potential “win-win” option to consider for the MANY baby-boomer family farmers out there who are looking for an exit plan they can feel good about!