Estate Plan Edge: As retirement nears, there are a few strategies for dealing with that final year, which involves a lot of income and very few expenses.
Does your accountant remind you each year of all the deferred taxes you would pay if you decided to retire? Of how prepaying next years’ expenses, carrying grain sales over to the year after the crop is grown, and writing off equipment as it is purchased instead of depreciating it over its useful life is building a “tax time bomb” that will explode when you decide to retire?
For example, say on a relatively small farm operation you have self-employment income of $150,000. You get to that from selling last year’s crop for $1 million, incurring $350,000 in expenses during the year, prepaying expenses of $350,000 for next, and spending $100,000 on equipment. What happens at retirement? Your income increases by $450,000 in the last growing year: no prepays and no equipment. The following year you sell $1 million with virtually no expenses. If you sell equipment, every dollar received is additional taxable income.
The government loves it when you retire!
There are a variety of ways to make retirement more joyful for you and less so for the IRS, but there are no magic bullets. Some work well if you don’t have a successor in the family. Others are more appropriate if you have a family member as your successor.
One principle to understand is progressive tax rates. As your level of income goes up in a given year, your tax rate also goes up. The taxes on $1 million in one year is much more than the taxes on $100,000 each year for 10 years. With this in mind, consider incrementally increasing your income during the years leading up to retirement, to avoid the large spike that sends you into the highest rates.
Step by step
To do this, you must bite the bullet and sell a little more of your crop before year-end. Instead of carrying all $1 million of grain over to the following year, you go ahead and sell $100,000 of it before year-end, and carry $900,000 over to next year; the following year, you sell $200,000 before year-end, carrying over $800,000.
This works especially well if the extra income you are realizing is above the self-employment tax limit ($147,000 in 2022). That income will be subject to the 2.9% Medicare tax, but not the 12.4% for Social Security.
Many farmers have not invested in retirement accounts. Your land was your retirement plan. But if you intentionally increase your income in the years approaching retirement, consider making tax-deductible contributions to a retirement account. If you are at least 50 years old, in 2022 you could deduct contributions of $7,000 to an ordinary individual retirement account, $17,000 to a SIMPLE-IRA (Savings Incentive Match Plan for Employees) or $27,000 to a 401(k).
The inflation-adjusted numbers for 2023 are $7,500 to an ordinary IRA, $19,000 to a SIMPLE-IRA or $30,000 to a 401(k). Conditions apply, of course, but you can likely manipulate your income as needed.
If that won’t work
If you have not prepared ahead incrementally to avoid the large income spike as you retire, and you do not have a successor in the family, one option is to give most of your crop, and possibly your equipment as well, to a charitable remainder unitrust, or CRUT. This can allow you to convert those assets into a stream of income, and only pay the tax on the income as you receive it during retirement. This strategy was discussed in more detail in the July 2020 issue of Prairie Farmer.
If you have a successor in the family, retirement includes other options. Establish a limited liability company and gradually transfer ownership to the successor. However, this is often done improperly. If the LLC is the farm operator with all the crops and accounts worth $1 million, transferring 10% of it per year is not excluded from gift tax filings.
If you haven’t incrementally transferred the operation approaching retirement, consider a strategy described in the April 2016 issue of Prairie Farmer. By using two LLCs (taxed as S corporations), your successor can effectively move into your shoes. Your spike in income is flattened into post-retirement annual payments from the successor, taxed as capital gain instead of ordinary income.
If your estate does not exceed the estate tax exemption limit, try to keep the equipment in your estate until death. This way your successor can inherit it with a stepped-up basis and depreciate it again.
Since many retirement strategies will affect the way your estate passes on death, be sure to consult your estate planning attorney before you take any significant retirement planning steps.
Ferguson is an attorney who owns The Estate Planning Center in Salem, Ill. Learn more at thefarmersestateplanningattorneys.com.
