Unintended Consequences: The Inflation Reduction Act of 2022’s Farm Debt Relief Causes Farmers Massive Tax Headaches (Deep Dive)

Posted on: February 17th, 2023 by

On August 16, 2022, President Biden signed the Inflation Reduction Act (IRA) into law. Section 22006 of the IRA provided $3.1 billion for the United States Department of Agriculture (USDA) to provide relief for distressed borrowers under certain Farm Service Agency (FSA) direct and guaranteed loans.

On October 18, 2022, USDA provided nearly $800 million in assistance to distressed borrowers to help cure delinquencies and resolve uncollectable farm loan debts.

Unintended Consequences of the IRA Payments

Farm debt relief is certainly welcome, especially to its recipients. However, when Congress authorized the IRA payments it did not consider that those payments would be counted as income for many recipients, leading to:

Two Distressed Borrowers, Similar Problems

Consider these two typical borrowers with FSA debts who are in currently not collectible (CNC) status, both of whom benefitted from IRA farm debt relief:

Scenario 1: In 2010, Robert defaulted on his FSA-direct loan, which was secured by a lien on his property. When he could not obtain further financing, he could not continue his farming business and the loan went into default. FSA foreclosed, leaving a $100,000 deficiency judgment. Although FSA initially contacted Robert to collect on the debt after the foreclosure, the account was moved into CNC status, where it has remained for 12 years. As of 2022, his past due balance was $150,000, with interest.[1]

Scenario 2: Charles has been in default on his FSA-guaranteed loan from a local bank for several years. Charles has continued to farm while working with his bank under forbearance agreements. The debt was moved to the CNC status in 2019. In October of 2022, FSA repaid his entire guaranteed loan to local bank. The payment consisted of principal of $400,000 and interest of $12,000. Now, instead of owing a long-term debt to his bank, with low payments and the option of obtaining a forbearance, he faces a large tax liability (equal to multiple years of payments) due all at once.

IRA’s Effects: Increased Taxes

While the IRA’s debt relief payments could have many consequences for recipients, for Robert and Charles the primary consequences are increased federal income taxes.

In 2022, the IRA program paid Robert’s deficiency, including interest, triggering $150,000 in 2022 taxable income. FSA will send Robert and the IRS a 1099‑G to report this income. Although Robert can deduct the $50,000 in interest paid on his behalf, he is liable for around $24,000 in federal tax, which he cannot pay. If Robert’s state levies an income tax, Robert might also owe state income taxes.

When the IRA program paid Charles’s $412,000 debt, he also faced the prospect of significant income taxes, possibly exceeding $100,000. Fortunately, his CPA assisted him in avoiding payment of the income taxes in 2023 for his 2022 income.

When FSA notified Charles of the debt repayment to his local bank, Charles immediately turned to his CPA who helped him prepare for this unexpected income surge. The interest is deductible, and won’t increase Charles’s taxable income, but the principal is not deductible. Charles was able to defer collection on some grain sales into 2023, he had Net Operating Losses (NOL) he could use to offset some of the income, and he purchased his 2023 inputs in 2022 to decrease his 2022 Schedule F income and minimize his 2022 self-employment taxes.

Current Nonviable and Viable Options

Robert and Charles do have options to address their taxes, but all of them have significant downsides.

Bankruptcy is not a viable option.

Right off the bat, one of the primary tools for dealing with debts is off the table: Any income taxes that Robert or Charles cannot pay would be priority debts in a bankruptcy and not dischargeable in bankruptcy until at least 2026. In that time the IRS and state departments of revenue are likely to file tax liens. There is nothing exempt from an IRS lien, meaning that if the taxpayer had any property with equity, like an exempt homestead, the tax lien would make the tax debt a secured claim in any bankruptcy. While a bankruptcy in several years could discharge the tax debt, it would not eliminate the tax lien, and the IRS or state department of revenue could levy on the property and sell it to collect the tax debt.

The insolvency exception to tax liability for debt cancelation is not available.

IRC § 108 provides an avenue to avoid the taxes due because of debt cancelation or debt forgiveness. § 108 is commonly referred to as the insolvent taxpayer exception. It allows taxpayers that were insolvent before the debt cancelation to exclude the income from taxation to the extent of their insolvency.[2] Because the debt was paid, not canceled, Robert and Charles cannot reduce their tax liability under IRC § 108. If the debt had been canceled instead of repaid, IRC § 108 would have been available to them to potentially eliminate the income occasioned by the cancelation of the debt. Alas, Congress did not take this route.

Installment agreement.

It is possible that Robert or Charles could work with the IRS to set up an installment agreement to pay off his tax debt over six years. This could put a significant strain on their finances until the tax debt is repaid. The IRS usually places a tax lien on the taxpayer’s assets until the installment agreement is completed. Moreover, interest and penalties continue to accrue until the debt is paid in full, and the IRS is not required to accept a payment plan.

Offer in compromise.

Robert and Charles’s best legal remedy may be to hire legal counsel and seek to negotiate an offer in compromise (OIC) with the IRS to lower the amount of tax for which they are liable. The OIC process is complicated and time consuming.[3] It can take many months to finalize, and it includes costly fees. There is no guarantee the IRS will accept an OIC, but IRS states that it generally approves offers in compromise when the amount offered represents the most the IRS can expect to collect within a reasonable period of time.[4]

Before the IRS can consider an OIC, the debtor must (1) file all tax returns legally required, (2) have received a bill for at least one tax debt included on the offer, (3) make all required estimated tax payments for the current year, and (4) if a business owner with employees, make all required federal tax deposits for the current quarter and the two preceding quarters.

If the IRS does not reject or return the OIC within two years, it is automatically accepted. That is a long time to wait in limbo.

USDA is Considering Options to Assist Farmers with their Income Tax Problems.

After being informed of the significant problems caused by the repayment of the debt for over 13,000 farmers, USDA has held a series of meeting and considered three options to ease the income tax problems experienced by farmers.

Option One–Streamline the OIC Process.

Given Congress’s intent to provide relief as expeditiously as possible to financially distressed farm debtors, the USDA could work with the IRS to explore options for streamlining an offer in compromise process for those who cannot pay the associated tax. IRC § 7122 grants Treasury broad authority to compromise tax liability. 26 CFR § 301.7122-1 authorizes the Commissioner of Internal Revenue to compromise a liability on any one of three grounds: Doubt as to Collectability (DATC), Doubt as to Liability (DATL), or to promote Effective Tax Administration (ETA). ETA allows compromise in the following situations:

  • A compromise may be entered into to promote effective tax administration when the Secretary determines that, although collection in full could be achieved, collection of the full liability would cause the taxpayer economic hardship within the meaning of § 301.6343‑1. This condition applies if satisfaction of the debt will cause an individual taxpayer to be unable to pay his or her reasonable basic living expenses. The determination of a reasonable amount for basic living expenses will be made by the director and will vary according to the unique circumstances of the individual taxpayer.
  • If there are no standard grounds for compromise, the IRS may compromise to promote effective tax administration where compelling public policy or equity considerations identified by the taxpayer provide a sufficient basis for compromising the liability. Compromise will be justified only where, due to exceptional circumstances, collection of the full liability would undermine public confidence that the tax laws are being administered in a fair and equitable manner.

The USDA could work with the IRS to establish special criteria or standards that would give farm debtors who received IRA debt relief a presumption that either collection would cause them economic hardship, or, perhaps more fruitfully, that the public policy Congress demonstrated by enacting farm debt relief through the IRA—relieving farmers of debts they could not pay—constitute “compelling public policy or equity considerations” and that “collection of the full liability would undermine public confidence that the tax laws are being administered in a fair and equitable manner.”

Option Two—Debtor Opt-Outs.

USDA could give the farmer the option to opt out of the debt payments made on their behalf last October. If Robert or Charles were to opt out of the payment, they would receive a corrected 1099-G and be back where they were before the debts were paid. Robert would owe a $150,000 debt to FSA that would continue to accrue interest, and Charles would owe $412,000 to his bank, with an FSA guarantee. While Robert’s opting out would allow FSA to theoretically attempt to collect his debt, unless Robert’s circumstances had changed in the last six months, he might rationally believe that since he had been in CNC status for 12 years that status would not likely change. Similarly, Charles could continue to work with his local bank on forbearances and payment plans that he can afford, instead of working with the IRS’s understaffed (and therefore slow-to-respond) bureaucracy. Perhaps more importantly, opting out would give them a new option: they could file bankruptcy to discharge their debt and eliminate any income tax liability from that debt’s discharge in bankruptcy,[5] whereas the tax debt they currently owe will be nondischargeable until at least 2026.

Option Three—Debt Cancellation.

If Robert[6] had the option to have his debt canceled instead of paid and took that option, FSA would write down the balance of his unpaid debt to zero. Canceled debt is taxable, absent exceptions or exclusions. But many debtors in Robert’s position may qualify for an exception. First, any portion of the canceled debt attributed to interest would be excluded from tax. Next, IRC § 108 provides that cancelation of indebtedness may be excluded from tax if:

  • It is discharged in bankruptcy (including Chapters 7 and 12)
  • The discharge occurred when the taxpayer was insolvent (discharge is nontaxable only to the extent the canceled debt does not make the debtor solvent)
  • The indebtedness was “qualified farm indebtedness.”

Canceled debt is “qualified farm indebtedness” in 2022 if:

  • The debt was incurred directly in the trade or business of farming;
  • 50 percent or more of the debtor’s total gross receipts for 2019, 2020, and 2021 were from the trade or business of farming; and
  • The cancellation was made by a qualified person, such as the FSA or a bank (not a related party).

Because Robert has not farmed for 12 years, his debt is not qualified farm indebtedness. His debt was also not discharged in bankruptcy. As such, Robert must determine whether he was insolvent before the debt was canceled. If he was insolvent before the debt was canceled, and he was insolvent after the debt was forgiven, it will be not taxable.

To prove insolvency to the IRS and utilize IRC § 108 the taxpayer must list the fair market value of all his assets and liabilities, including the FSA debt, before the discharge, and determine to what extent, if any, liabilities exceed assets. This is the amount of insolvency. Exempt assets, such as a car, house, retirement account, must be included in the insolvency calculation.

In Robert’s case, his liabilities before the cancelation exceed his assets by $152,000 (see insolvency worksheet below). Because this amount exceeds the amount of the debt forgiven, Robert’s cancelation of debt income is not taxable. He was insolvent before the debt forgiveness and insolvent after the forgiveness. If the liabilities exceeded his assets by only $50,000 before the forgiveness, he would still be taxed to the extent he became solvent by the forgiveness—$100,000.

Although § 108 makes Robert’s eligible debt cancellation nontaxable, the price Robert pays for this benefit is the loss of certain tax benefits. Generally, debtors qualifying for the insolvency must the following tax benefits in this order:

  1. NOLs and NOL carryovers for year of discharge
  2. General business credit carryover (reduced by 33.3 cents for each dollar of excluded canceled debt)
  3. Minimum tax credit available as of the following tax year (reduced by 33.3 cents for each dollar of excluded canceled debt)
  4. Net capital loss and capital loss carryovers for year of discharge
  5. Basis reduction of property (including personal use property)
  6. Passive activity loss and carryovers from year of discharge
  7. Foreign tax credit carryover to or from the year of discharge

A taxpayer may also elect to reduce their basis in property first to save other tax attributes. For example, a taxpayer may reduce their basis in property with a long depreciation period (essentially taking bonus depreciation) to preserve an NOL, since the NOL can be applied immediately, while the depreciation provides benefits over years or decades (and taxation may be avoided entirely if the taxpayer holds the property until death and their heirs gain a step-up in basis).

In Robert’s case, the bases of his assets—his house, car, tools, clothing, household goods, tools and firearms—must be reduced proportionately by $150,000. This means that if he sells those assets, he may have more taxable capital gain. The gain from a sale of his home, however, would remain excluded from tax by IRC § 121.

Example Insolvency Worksheet; click to enlarge.

Considerations for Debtors Not in CNC.

CNC debtors are already ineligible to receive new FSA loans. Debt cancelation also renders a debtor ineligible for new FSA loans, but this is not a concern for CNC debtors. For debtors who are not in CNC status but for whom the IRA payments served to catch up their past-due loan payments, an OIC might allow them to remain eligible for future FSA loans, while taking a cancellation option (if one is offered) would end that eligibility.

USDA Considers Sponsoring Tax Professional Assistance and Requesting Extended Filing Deadline.

Given the potentially severe tax consequences for IRA debt relief beneficiaries, these farmers will need professional advice regarding the tax consequences of any decision they make. The USDA is considering sponsoring tax professional assistance to farmers to have a qualified representative work with them to evaluate their individual situation and advise them regarding the impact of each of the options that will be available to them. This advice will necessarily include consideration of:

  • The long-term collectability of the obligation is the debt is not canceled;
  • Whether an OIC would be appropriate;
  • The impact of cancelation of the debt on the eligibility for future government guaranteed loans from FSA and SBA; and,
  • Whether having the debt not be canceled and utilizing bankruptcy would be the best option to utilize to preserve exempt assets and eliminate the tax burden they currently face.

The USDA is also considering requesting the IRS grant farmers who received a 1099‑G from IRA debt relief an extension on the March 1 return deadline. This would allow farmers more time to seek tax advice and plan how they will address this issue.

Get the Advice You Need and Contact your Members of Congress!

If you or someone you know benefitted from IRA farm debt relief but now don’t know how to deal with the tax consequences contact Ag & Business Legal Strategies today! We can assist in assessing the consequences, navigating the options, and making an informed decision. Moreover, contact your members of Congress! Tell them USDA needs to find ways to help farmers with the unforeseen tax consequences of the IRA’s farm debt relief. Download a letter template here.

[1] Thanks to Kristine Tidgren of Iowa State University’s Center for Agricultural Law and Taxation for Robert’s scenario and the corresponding analysis.

[2] Under § 108, the maximum amount of principal debt forgiven that makes the taxpayer solvent is taxed. For purposes of § 108, all assets of the taxpayer are considered, including the taxpayer’s exempt homestead, retirement plans, and tools of the trade.

[3] If the Offer in Compromise proposes a lump sum payment, 20% of the total offer must be submitted with the offer. Complete financials for the individual and any entities must be submitted.

[4] Since no assets are exempt from the claims of the Internal Revenue Service, the taxpayer’s exempt assets will be considered in determining the amount the IRS can expect to collect.

[5] IRC § 108(a)(1)(A) provides for the exclusion from gross income any debt discharged in a bankruptcy.

[6] Not Charles, since for his debt the FSA is only a guarantor and not the creditor, and therefore it cannot cancel the debt, it could only pay it off.

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