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For a person experiencing extreme financial distress, income tax liability usually is not a major concern. After all, the lack of income is at least partially responsible for the person's financial difficulties. In the case of farming operations, however, income tax liabilities present real difficulties.

For farm debtors using the cash method of accounting, the income tax basis of raised animals or stored grain is zero. Machinery and equipment have often been depreciated rapidly, with a resulting low basis, and land that was purchased some time ago frequently has a low basis derived from the original purchase price and adjusted for improvements made in depreciation claimed. Thus, there is a potential income tax liability created when assets are sold or turned over to creditors (where the sole value exceeds the adjusted tax basis). In addition, income taxes may be generated when debt is forgiven.

There are several options available to the farmer dealing with these income tax problems.

Liquidation Liabilities
If farm assets are liquidated outside of bankruptcy, any resulting tax liability is solely the responsibility of the debtor as the taxpayer. In the event of a liquidation, tax liabilities may take several forms:

1. Ordinary income will result from the sale of assets—such as grain or live-stock—held for resale.
   
   
2. Ordinary income will result from the recapture of certain previously claimed tax benefits such as depreciation, soil and water conservation expenses, land clearing expenses, and government cost sharing payments excluded from in-come.
   
   
3. If capital assets such as real estate are sold to pay debts, capital gains may result from the sale.
   
   
4. An alternative minimum tax may be imposed on preference income that includes the portion of capital gains that individuals do not include as income.
   
   
5. If a taxpayer negotiates an arrangement with his creditors to transfer property to the creditor in forgiveness of the debt, such debt forgiveness may generate ordinary income.

If, rather than selling assets, the taxpayer turns the assets over to a creditor in partial or total satisfaction of the debt or the creditor exercises the right to foreclose on the assets, the outcome is essentially the same. The transfer of property to a creditor and a foreclosure are both treated as a sale of the property for an amount equal to the property fair market value. There is, of course, the possibility of further income tax liability if the indebtedness discharged by the transfer or foreclosure is greater than the value of the assets. When property is transferred or foreclosed upon in satisfaction of a debt the general rule is that the taxpayer realizes:

1. Gain on the property transferred (possibly capital gain) to the extent that the fair market value of the property exceeds the income tax basis in the property.
   
   
2. Debt discharge income to the extent the amount of debt discharged exceeds the fair market value of the property.

To illustrate, assume that Fred Farmer purchased his farm for $100,000. He borrowed money to purchase a confinement hog feeding operation. The farm was used as collateral for the loan. The bank foreclosed on the farm, now worth $500,000. At the foreclosure sale, the bank purchased the farm for the full amount of its debt, $650,000. In this case, Fred has realized a capital gain of $400,000, which is taxed at a federal rate of 20 percent (i.e., $80,000). In addition, Fred has realized $100,000 as debt discharge income. This income from discharge of indebtedness may or may not be recognized, depending on whether Fred was solvent, insolvent, or in bankruptcy. If he was in bankruptcy when the debt was forgiven, he does not have to report the forgiven debt as income. If he was not in bankruptcy when the debt was forgiven but was insolvent, he is treated as though he were in bankruptcy. If, however, he was solvent, he may be able to exclude from income the forgiven debt if the debt was classified as "qualified farm debt" and Fred meets several other special rules. Even if such debt discharge income is not recognized, the debtor's tax attributes will be reduced to the extent of such debt discharge income. The law sets forth a detailed order in which the tax attributes are reduced:

1. Net operating loss.
   
   
2. Certain credit carryovers, namely, investment tax credit and other credits not applying to farmers.
   
   
3. Capital loss carryovers.
   
   
4. Basis reduction by reducing basis of property of the taxpayer.

Fred's problems are not confined to capital gains and debt discharge income. He also may be subject to the alternative minimum tax. This tax was included in the tax code to prevent a taxpayer with substantial economic income (income without regard to special exclusions or deductions) from avoiding substantial tax liability by using tax preferences. Some common examples of tax preference items for farmers include the excess of accelerated depreciation over straight-line depreciation on real property, accelerated depreciation on leased personal property and an increase to gain on the sale of property sold or foreclosed on. The alternative minimum tax is calculated according to the following formula:

      Tax preference items +
      Certain itemized deductions –
      Allowed exemption amount
      Alternative minimum taxable income

Only certain itemized deductions qualify as a deduction for alternative minimum taxable income calculations. State and local taxes are not allowed. The allowed exemption amount for calculating alternative minimum tax depends on the filing status of the taxpayer. For a taxpayer who is married and files jointly, the allowed exemption is $45,000. For a single person or head of household, it is $33,750. For a married taxpayer filing separately or for estates, it is $22,500. The gross alternative minimum tax is 26 percent of the first $175,000 of alternative minimum taxable income in excess of the exemption amount and 28 percent of any excess amount. The regular income tax that has otherwise been computed by the taxpayer must be subtracted from this gross alternative minimum tax.

Taxes and Bankruptcy
In the event that the debtor seeks protection of the Bankruptcy Code, additional results and planning opportunities follow. If an individual debtor files bankruptcy under either Chapter 7 or 11, a new taxable entity is created. The bankruptcy estate is a taxable entity separate and distinct from the debtor. All property owned by the debtor at the time the bankruptcy case is initiated passes by operation of the Bankruptcy Code to the bankruptcy estate. The transfer of assets by the debtor to the bankruptcy estate is not treated as a taxable disposition. Thus, the transfer does not require income tax to be paid on the gain in the assets involved. Nor does the transfer trigger income tax liability from the recapture of depreciation, recapture of soil and water conservation or land clearing expense, recapture of government cost sharing payments excluded from income, or recapture of investment tax credit. The estate is treated as the debtor would have been treated had he or she not filed for bankruptcy.

After the bankruptcy case has been initiated, income generated from assets included in a bankruptcy estate is included in the bankruptcy estate's income. Thus, if the bankruptcy estate disposes of assets or suffers a foreclosure and triggers income tax liability in the process, the income tax liability is a priority claim in the estate as an administrative expense. As a result, the tax due is paid ahead of general unsecured creditors. Any income tax liability remaining does not pass back to the debtor, however.

Besides automatically transferring all the debtor's property to the estate, the initiation of a bankruptcy case gives an individual debtor one significant choice. He or she may elect a short tax year, ending the day before the bankruptcy filing, thus creating two short tax years. His or her income tax liability in the first short year becomes a priority claim against assets in the bankruptcy estate, because the bankruptcy estate is responsible for all the debtor's liabilities at the time of bankruptcy, including income taxes that accrue before the date of bankruptcy. As a result, electing to end a tax year before the day of bankruptcy causes the taxes on the income earned to that date to become a debt of the bankruptcy estate. If there are insufficient assets to pay the income tax, the remaining liability is nondischargeable. Any remaining income tax liability for the first short year returns to the debtor and can be collected from him or her later.

In the event the debtor does not elect a short year, the tax on the income earned during the tax year in which bankruptcy occurs will accrue after the date of bankruptcy and will therefore not become a debt of the estate. As a result, none of the debtor's income tax liability can be collected for the year of bankruptcy filing for the bankruptcy estate. To illustrate, assume that a farmer who is a calendar year taxpayer is in financial difficulty and sells some assets in January to pay debts. On the first of May, he or she decides to file for bankruptcy. If he or she does not elect two short tax years the gain on the sale of the assets will be included on the return filed for the full year. Those taxes will not be a debt of the bankruptcy estate. If he or she elects two short years, the income taxes on the gain from the sale of the assets will accrue before the bankruptcy was filed. Therefore, the taxes on the gain will become a debt of the bankruptcy estate and will be properly payable out of the estate assets.

The debtor's selection of a single tax year or two short years also affects the amount of tax attributes that pass from the debtor to the bankruptcy estate. The bankruptcy estate receives the tax attributes of the debtor as of the beginning of the tax year in which the bankruptcy was initiated. Therefore, if the debtor chooses a single tax year, the attributes that he or she has at the beginning of that year will pass to the bankruptcy estate and cannot be used by the debtor on the tax return for that year. If the debtor chooses two short tax years, the attributes do not pass to the bankruptcy estate until the beginning of the second short year. Therefore, the debtor can apply the tax attributes on his or her return for the first short year.

In most cases, if the debtor has income before the date the bankruptcy was initiated, it is usually to his or her advantage to choose short tax years. By doing so, the debtor not only makes the taxes on that income a debt of the estate, but also reduces the amount of taxes owed on that income.

Conclusion
Tax planning is as important for farmers in financial distress as for those who are making a profit. Income tax consequences are triggered by the sale of assets, the foreclosure of debts, and the forgiveness of debts. The difference in income tax treatment for the liquidation of assets provides a strong motivation to file for bankruptcy. The difference in income tax treatment also may be important to creditors. A secured creditor may obtain a larger payment in bankruptcy than if the debtor sells the property and remits the after-tax balance to the creditor. When contemplating bankruptcy or liquidation, farmers must consider carefully the effect of their decisions from a tax point of view.

To order other publications in this series, contact the University of Minnesota Extension Store, 20 Coffey Hall, 1420 Eckles Avenue, St. Paul, MN 55108-6069, e-mail: shopext@umn.edu or credit card orders at 800-876-8636 or (612) 624-4900 (local calls).

• Agricultural Production Contracts (WW-7302).
• Bankruptcy: Chapter 7 Liquidations (WW-7295).
• Bankruptcy: Chapter 11 Reorganizations (WW-7296).
• Bankruptcy: Chapter 12 Reorganizations (WW-7301).
• Bankruptcy: The Last Resort (WW-2598).
• Contracts, Notes and Guaranties (WW-2590).
• Farm Leases (WW-2593).
• Financing the Farm Operation (WW-2589).
• Mortgages and Contracts for Deed (WW-7293).
• Mortgage Foreclosures (WW-7297).
• Rights of Unsecured Creditors (WW-7299).
• Tax Considerations in Liquidations and Reorganizations (WW-7300).
• Termination of Contracts for Deed (WW-7294).
• Termination of Security Interests in Personal Property (WW-7298).

The fifteen publications are also available as a package: Farm Legal Series (WW-7291).

This publication is designed to provide accurate information in regard to the subject matter covered. It is published with the understanding that the authors and the University of Minnesota are not engaged in rendering legal, accounting or other professional services. If legal advice or other professional assistance is required, the services of a competent professional should be sought.

Produced by Communication and Educational Technology Services, University of Minnesota Extension.

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