Disclaimer: Information provided here is for educational purposes only. Nothing herein constitutes the provision of legal advice or accounting services. Quota holders and tobacco producers should contact their tax practioner and other professional advisers relative to their circumstances in regards to these issues.

Overview
The tobacco buyout legislation has a provision for both producers, who receive the $3 payment, and quota owners, who receive the $7 payment, to receive a lump-sum payment in 2005 instead of yearly installments of the buyout. In deciding whether or not to take a lump-sum payment, growers and owners need to be aware of several important issues:

• The procedure for setting up a lump-sum option.
• Tax implications.
• The financial return, advantages or disadvantages of a lump-sum payment.

Individuals interested in taking a lump-sum should work closely with their tax preparer and other financial advisers as soon as possible before making a decision, since the tax effects and financial returns will vary widely according to each individual's situation.

Procedure for Setting up a Lump-Sum Payment
A quota holder or tobacco producer can enter into an agreement with a private party to receive a lump- sum payment from them (not the government agency issuing the buyout payments) in return for the rights to future payments. This is also referred to as "securitization" of the buyout payment contract, and it is distinctly different from taking out a loan and assigning future payments to a lender. In this process, a buyout recipient transfers all rights from the buyout contract to the private party by executing a successor-in-interest contract with the private party and the Commodity Credit Corporation (CCC). These contract forms are available from local USDA Service Centers and explain how to transfer buyout payments from the CCC to another party. Only the last nine of the ten buyout payments, beginning with the 2006 payment, are eligible for a lump-sum payment. The first payment in 2005 will come directly to the quota owner or producer. Payments two through 10, scheduled to be paid in January of each succeeding year through 2014, will then go directly to the private party named in the contract.

A quota owner or producer may do a successor-in-interest contract at any time during the buyout period after the first payment. All of the last nine payments do not have to be taken as a lump-sum in 2005. For example, a quota owner could take payments 2 to 4 directly from CCC in years 2006, 2007, and 2008. Then, sometime in 2008, he or she could do a successor-in-interest contract for payments 5 to 10 and receive a lump-sum for those payments in 2008, completing a "partial" instead of a "full" lump-sum. This flexibility may be especially helpful to quota holders or producers in managing their tax liability, and it gives them another tool for planning and managing their financial situation. This assumes, however, that a market will still exist for lump-sum offers after 2005. Financial institutions may or may not be willing to make offers on partial securitizations of less than nine payments in a future year, which makes the availability of this partial lump-sum option in the future less certain than doing a full lump-sum in 2005.

Tax Implications of a Lump-sum Payment
Because the quota owner or producer, through a full lump-sum of all nine payments, receives all of the cash from the buyout in 2005, taxes are also due on the total amount received in 2005. For many taxpayers this will result in a large increase in taxable income in 2005 and quite likely an increase in the rate at which the buyout payment will be taxed. Some taxpayers on the other hand-most likely growers receiving the $3 portion whose net farm income per year is below the wage base ceiling for self-employment tax-may find that a full lump-sum payment results in a lower tax rate in 2005 than if they take payments each year over a remaining nine-year period. Although a lower tax rate is possible, the majority of taxpayers should think in terms of paying a higher tax rate if they take a full lump-sum payment in 2005. For this reason, recipients may want to consider waiting to do a partial lump-sum in a later year. The tax effect will vary widely dependent upon the type of buyout payment (i.e., $3 producer vs.$7 quota), the amount of payment, basis in the quota, amount of other taxable income, filing status (single, married, etc.), and other individual factors. Thus, to get the exact amount of tax that will be due from a lump-sum compared to receiving the buyout in yearly installments, recipients must consult with their tax preparer about their individual situation. The amount of difference in tax payable is a very important major piece of information needed to make an informed decision about whether or not to take a lump-sum payment.

Recipients should also be aware that, with a lump-sum, only the amount received is taxable.

Example: George Grower will receive $10,000 from the buyout in 2005 and $90,000 in years 2006-2014. George transfers his rights for the $90,000 portion to ABC Financial in exchange for a $72,000 lump-sum payment in 2005. The $72,000 cash received, not the $90,000 face amount, is taxable (along with the $10,000 payment received directly from the CCC) in 2005.

An additional consequence, while not a tax per se, of the producer portion ($3) of the buyout is the impact on social security benefits. Because the producer payment is earned income, it may affect the amount of benefit that an individual taking early social security, before their full retirement age, will receive from age 62 to 65. (Note: The full retirement age is not exactly 65 years anymore; it is somewhere between 65 and 67 depending on the year of birth.) Taking a lump-sum before age 62 may be an advantage in this respect instead of receiving producer payments in the 62-65 age years. Or, taking a lump-sum between ages 62-65 may suggest that a producer should wait until the full retirement age of 65 before drawing social security. Or, producers drawing early social security benefits may want to take direct payments from CCC through age 65 and do a partial lump-sum of the remaining payments after age 65.

Financial Return from a Lump-Sum Payment
One of the primary questions a buyout recipient will have about a lump-sum offer is "How do I know whether or not I am getting a good deal from the company/private party offering me a lump-sum? How much should that lump-sum be?" The exact answer will vary depending on other financial factors for each individual, but the following guidelines can be a useful starting point for interpreting a lump-sum offer.

Assuming a recipient has an offer of a lump-sum payment to be received in October 2005, the table below can be used to see the interest rate the private party making the lump-sum offer is charging. In financial circles, this is referred to as the discount rate since the private party must "discount" the full face amount of the buyout contract. No one will offer to pay the full amount in 2005 for payments that will be spread out over the next nine years. So, the lump-sum offer will be for a percentage of the face amount (LS%). That percentage can be converted into an implied interest rate that the private party is charging the recipient.

Example: Sarah Owner will receive $220,000 in quota holder payments--$22,000 in 2005 and the remaining amount of $198,000 in equal installments of $22,000 each in years 2006-2014. ABC Financial offers to pay Sarah a lump-sum of $158,400 in October 2005 for her remaining nine payments that will total $198,400. The lump-sum offer is 80% of the face amount ($158,400 divided by $198,000). Table 1 indicates that ABC Financial is discounting Sarah's buyout payments (i.e., charging Sarah) at an interest rate between 5.5% and 6.0% (closer to 5.5% than 6.0%).

Table 1: Approximate Discount Rate from Lump-Sum Offers

1. LS% is the lump-sum amount divided by the face amount total of all payments to be received in 2006-2014.
2. This table assumes the lump-sum is received October 15, 2005 and future buyout payments are on January 15 of each year, 2006-2014.

After determining the approximate interest rate (discount rate) being charged in the lump-sum offer, the next logical question is "How do I determine if that rate, or if the discount, is a 'good deal' or whether it is too high or not?" While there is no universal single answer to that question, the buyout recipient can use the following rule-of-thumb to help evaluate the offer.

Rule-of-Thumb: If the recipient of a lump-sum offer can invest the lump-sum amount at a rate of return greater than the implied interest rate in the offer, the lump-sum offer is financially advantageous (a "good deal") to the recipient. If the recipient can invest the lump-sum at a rate of return less than the implied interest rate in the offer, the lump-sum offer is financially disadvantageous (a "poor deal") to the recipient.
Example A: The lump-sum offer to Sarah Owner has an implied interest rate of 5.6%. Sarah intends to use the lump-sum payment to pay off a debt which has a 7% rate of interest. The offer is a good deal for Sarah. Example B: Sarah's sister Betty receives a similar lump-sum offer with an implied interest rate of 5.6%. Betty intends to invest the lump-sum payment in a certificate of deposit at 3% interest. The lump-sum offer is not a good deal for Betty.

The Commodity Credit Corporation has established a maximum discount rate that can be charged in a lump-sum successor-in-interest contract. That rate equals the prime rate, as determined by CCC, plus two percentage points (rounded to the nearest whole number. At current rates of prime interest, the maximum rate would be either 7% or 8%, and offers would have a minimum lump-sum percentage of about 73% to 76%. These rates can change over time however and may be different at the time a specific lump-sum offer is made.

Of course, there are financial reasons other than the interest rate to consider in evaluating a lump-sum offer. The lump-sum may be a useful source of financial liquidity. It may simplify estate planning or making gifts to others. A lump-sum may enable the recipient to do things that could not be done otherwise. On the other hand, receiving a large sum of money all in one year may result in wasteful spending more easily than if it was received as installments spread over nine years.

The previous discussion and Table 1 only look at the lump-sum offer on a before-tax basis, but any final decision should be made on an after-tax basis as discussed in an earlier section. The after-tax effect is too variable and complex, preventing a full discussion of an after-tax analysis in this article. However, quota holders and growers considering a lump-sum payment should realize that, if a lump-sum increases the tax rate on the buyout payments, the rate of return needed to make a lump-sum financially advantageous (i.e., a good deal) will be substantially higher than the implied rates in Table 1 and higher than the rule-of-thumb above suggests. The after-tax analysis needs to be discussed and analyzed with the recipient's, tax preparer and/or other financial adviser who can apply the analysis to their individual financial situation.

Lump-Sum Option in a Like-Kind Exchange
The greatest advantage, perhaps, of taking a lump-sum payment is its use in a tax-deferred like-kind exchange of the quota holder's payment (not the producer payment which is not eligible for a like-kind exchange) for other property. The tax advantages, rules and implications for a like-kind exchange, as a tool for reducing the tax impact, are discussed in other publications dedicated to tax implications of the tobacco buyout.

Assignment of Payments to Secure a Loan
The lump-sum payment set up through a successor-in-interest contract is not the same thing as taking out a loan from a lender based on the assignment of future payments to the lender. With a loan and assignment, the tobacco grower or quota holder continues to be the holder (owner) of the buyout contract even though future checks will be written to the lender named in the assignment. Thus, the grower or quota holder will still be the official recipient of income, for tax purposes, in future years (this is known as "constructive receipt" of income) and will pay taxes in installments for each year from 2005-2014.

This may be an option that some buyout recipients will want to consider. One advantage is that the recipient can receive cash upfront in 2005 through the loan without paying all of the taxes in 2005. Only the 2005 payment will be taxable; the cash received from the loan in 2005 is not taxable which is true of any type of loan. A disadvantage is that taxes will have to be paid in future years as buyout payments are made, even though the grower or quota holder who has assigned the payments to the lender will not receive any cash with which to pay the taxes.

New Information
Additional information and clarifications on the lump-sum payment option may become available in the coming months. Buyout recipients should stay informed beyond the information written here as they make decisions in 2005.

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