Thursday, June 14, 2018
Self-employment tax is a concern for many farmers and ranchers, with many having an as an objective the avoidance of self-employment tax through whatever planning techniques can be utilized. That’s especially the case for those farmers and ranchers that are fully “vested” in the Social Security system.
But, what about the farmer that leases out machinery and equipment to someone else? Is the income from machinery and equipment leases subject to self-employment tax? Such an arrangement may be entered into, for example, to assist another person get established in farming or supply a need that another person has with respect to that other person’s farming operation.
As is the case with many answers to tax questions, the answer is “it depends.” Today’s post takes a look at leases of farm machinery and equipment and the self-employment tax implications.
Under I.R.C. §1402(a) “net earnings” from self-employment” means the gross income derived by an individual from any trade or business that the individual conducts. However, rental income is generally reported on Schedule E of Form 1040. From there, it flows to page one of the Form 1040. As such, it is not subject to self-employment tax. A rental activity is just that – it’s a rental activity. Under I.R.C. §1402(a)(1), “rentals from real estate” are excluded from the I.R.C. §1402(a) definition of “net earnings from self-employment.”
Exception for Personal Property Leases
The I.R.C. §1402(a)(1) exception from self-employment tax for “rentals from real estate” says, in full, “there shall be excluded rentals from real estate and from personal property leased with the real estate…” [emphasis added]. But, the non-application of self-employment tax only applies to the rental of real estate or the rental of personal property in connection with real estate.
Inapplicability of Exception
If the personal property is not tied to a land lease, the income from leasing personal property is subject to self-employment tax if the rental activity is conducted as a regular business activity of the taxpayer. See, e.g., Stevenson v. Comr., T.C. Memo. 1989-357. Indeed, a notation at the top of Schedule E indicates that if the taxpayer has a business of renting personal property then the income should be reported on Schedule C. Those same instructions also direct a taxpayer to use Schedule C to report income an expense associated with renting personal property if the rental activity is a business activity of the taxpayer. The rental activity constitutes a business if it is engaged in with the primary purpose of making a profit and the activity is engaged in with regularity and continuity. See, e.g., Comr. v. Groetzinger, 480 U.S. 23 (1987).
But, if an activity is engaged in on a one-time only basis the income derived from the activity will not be subject to self-employment tax because the activity is not engaged in on a basis that is regular and continuous. See, e.g., Batok v. Comr., T.C. Memo. 1992-727. Thus, if the rental of personal property is merely casual the Schedule E instructions state that the rental receipts should be reported as “Other Income” on page 1 of Form 1040. Any related deductions are to be reported on the total deduction line (Total Adjustments) on the bottom of page 1 of Form 1040 and the notation “PPR” is to be entered on the dotted line next to the amount. That is what indicates a personal property rental.
For a farmer that owns machinery and equipment and leases it to someone else or to their own farming business entity, the risk is real that the rental income will be subject to self-employment tax. That will be the result if the rental activity in engaged in with regularity and continuity such that the activity rises to the level of a trade or business. Self-employment tax can be avoided if the lease of the personal property is tied in with a land lease. Alternatively, a farm taxpayer could transfer the machinery and equipment to a pass-through entity with the income flowing through to the taxpayer without self-employment tax. In that situation, however, compensation from the entity would be required for any personal services provided.
An additional consideration is that, at least in some states, paying rent to lease farm equipment and machinery is subject to sales tax at the state level. Also, income from a rental activity may trigger the application of the passive loss rules under I.R.C. §469. That last point is a topic for discussion in a subsequent post.
Tuesday, June 12, 2018
Normally, property is valued in a decedent's estate at its fair market value as of the date of the decedent's death. The Code and Treasury Regulations bear this our. See I.R.C. §1014). But, neither the Code nor the regulations rule out the possibility that post-death events can have a bearing on the value for assets in a decedent’s estate. The real question is what post-death events are relevant for determining the actual date-of-death value of property for estate tax purposes.
Post-death events and their impact on valuation, that’s the topic of today’s post.
Cases on the Valuation Issue
The cases reveal that consideration may be given to subsequent events that are reasonably foreseeable at the date of death. Those events have a bearing on date-of-death value.
Numerous cases illustrate that it is simply not true that, except for the alternate valuation election under I.R.C. §2032, changes in valuation after death are immaterial. The following cases are illustrative:
- In Gettysburg National Bank v. United States, 1:CV-90-1607, 1992 U.S. Dist. LEXIS 12152 (D. M.D. Pa. Jul. 17, 1992), property was sold to a third party in an arm’s length transaction 16 months after the decedent’s death (13 months after its appraisal for estate tax purposes) for less than 75 percent of the value at which it was included in the gross estate. The court allowed the estate to reduce its value, stating that the subsequent sale may be relevant evidence that the appraised fair market value was incorrect.
- In Estate of Scull v. Comr., C. Memo. 1994-211, sales of artwork at auction 10 months after the valuation date were the best indicators of fair market value for federal estate tax purposes notwithstanding that the market had changed in the interim, and the court applied a 15 percent discount to reflect appreciation in the market between the date of the decedent’s death and the auction.
- In Rubenstein v. United States, 826 F. Supp. 448 (S.D. Fla. 1993), the court determined that the best evidence of a claim’s value is the amount for which the claim was settled after the decedent’s death.
- In Estate of Andrews v. United States, 850 F. Supp. 1279 (E.D. Va. 1994), the court reasoned that reasonably foreseeable post-death facts relating to a publication contract under negotiation when the decedent died were germane to the determination of what a willing buyer would pay for the right to use the decedent’s name.
- In Estate of Necastro v. Comr., C. Memo. 1994-352, environmental contamination was discovered five years after the decedent’s death and the court allowed the estate to file a claim for refund, reducing the value from the value as reported, which was based on facts known at the date of death; the revaluation resulted in a reduction of over 33 percent from the value of the property determined before the contamination was discovered. The court’s opinion did not, however, address the substantive issue whether facts discovered after death may influence valuation if willing buyers and sellers would not have known the relevant facts as of the valuation date.
- In Estate of Jephson v. Comr., 81 T.C. 999 (1983), the court concluded that “[e]vents subsequent to the valuation date may, in certain circumstances, be considered in determining the value as of the valuation date.”
- In Estate of Keller v. Comr., C. Memo. 1980-450, the court stated that a “sale of property to an unrelated party shortly after date of death tends to establish such value at date of death. The property sold involved a farm and growing crop where both the sale of the farm and the harvesting of the crop occurred post-death.
- In Estate of Stanton, C. Memo. 1989-341, the court stated that the sale of the property shortly after death is the best evidence of fair market value. Under the facts of the case, the selling price of comparable property sold six months after the decedent’s death was also considered with a downward adjustment to reflect the greater development potential of the comparable property and the 10 months of appreciation that occurred after the decedent’s death in the actual estate property owned and sold.
- In Estate of Trompeter v. Comr., 279 F.3d 767 (9th Cir. 2002), the Tax Court was reversed for failing to sufficiently articulate the basis for its decision regarding omitted assets and the rationale for the valuation discount selected, but the court nevertheless considered the value of assets using post-death developments, including redemption for $1,000 per share of stock valued at $10 per share 16 months earlier, and a coin collection returned at roughly half the value subsequently assigned to it by the taxpayer’s estate in an effort to enjoin auction of that asset.
- In Morris v. Comr., 761 F.2d 1195 (6th Cir. 1985), the court considered speculative post-death commercial development events for purposes of valuing farmland in the decedent’s estate as of the date of the decedent’s death. The decedent’s farmland was approximately 15 miles north of downtown Kansas City and approximately five miles west of the Kansas City International Airport. At the time of death, plans were in place for a sewer line to service the larger of the two tracts the decedent owned. Also, residential development was planned within two miles of the same tract. In addition, significant roadways and the site for the planned construction of a major interstate were located close to the property. While none of these events had occurred as of the date of death, the court found them probative for determining the value of the farmland as of the date the decedent died. The decedent’s son, the owner of the farmland as surviving joint tenant, tried to introduce evidence of the failed closing of some post-death sales to support his claim that the post-death events were speculative. But, the court disagreed, establishing the value of the farmland at $990,000 rather than the estate’s valuation of $332,151.
The court’s opinion makes it look like that evidence to confirm an appraiser’s date-of-death prediction of future events is more likely to be received than evidence adduced to prove wrong an appraiser’s prediction concerning future events. In any event, however, the case stands for the proposition that post-death events are relevant for establishing death-time value – even if they are somewhat speculative.
- In Okerlund v. United States, 365 F.3d 1044 (Fed. Cir. 2004), the court dealt with the issue of stock valuation in a closely held company for stock that was gifted shortly before the company founder died and the company (a milk processing operation) suffered a salmonella outbreak. The taxpayers argued that these events should result in a lower gift tax value of the stock, with the issue being the relevance of post-death events on the value of the gifts. The court stated that “[i]t would be absurd to rule an arms-length stock sale made moments after a gift of that same stock inadmissible as post-valuation date data….The key to use of any data in a valuation remains that all evidence must be proffered in support of finding the value of the stock on the donative date.” The court ultimately affirmed the trial court’s denial of a lower gift tax valuation based on the reality that the risk factors (the founder’s death and matters that could materially affect the business) had already been accounted for in the valuation of the stock.
Clearly, post-death events and other facts that are reasonably predictable as of the date of death or otherwise relevant to the date of death value can serve as helpful evidence of value and allow either an increase (to obtain a higher income tax basis) or decrease (to reduce federal estate tax) in value as a matter or record. For farmland (and other real estate) the market is not static as of the date of death. Thus, appraisers can reasonably look to the arc of sales extending from pre-death dates to post-death dates in arriving at the date-of-death value.
Friday, June 8, 2018
Wind “farms” can present land-use conflict issues for nearby landowners by creating nuisance-related issues associated with turbine noise, eyesore from flicker effects, broken blades, ice-throws, and collapsing towers, for example.
Courts have a great deal of flexibility in fashioning a remedy to deal with nuisance issues. A recent order by a public regulatory commission is an illustration of this point.
Wind Farm Nuisance Litigation
Nuisance litigation involving large-scale “wind farms” is in its early stages, but there have been a few important court decisions. A case decided by the West Virginia Supreme Court in 2007 illustrates the land-use conflict issues that wind-farms can present. In Burch, et al. v. Nedpower Mount Storm, LLC and Shell Windenergy, Inc., 220 W. Va. 443, 647 S.E.2d 879 (2007), the Court ruled that a proposed wind farm consisting of approximately 200 wind turbines in close proximity to residential property could constitute a nuisance. Seven homeowners living within a two-mile radius from the location of where the turbines were to be erected sought a permanent injunction against the construction and operation of the wind farm on the grounds that they would be negatively impacted by turbine noise, the eyesore of the flicker effect of the light atop the turbines, potential danger from broken blades, blades throwing ice, collapsing towers and a reduction in their property values. The court held that even though the state had approved the wind farm, the common-law doctrine of nuisance still applied. While the court found that the wind-farm was not a nuisance per se, the court noted that the wind-farm could become a nuisance. As such the plaintiffs’ allegations were sufficient to state a claim permitting the court to enjoin the creation of the wind farm.
In another case involving nuisance-related aspects of large-scale wind farms, the Kansas Supreme Court upheld a county ordinance banning commercial wind farms in the county. Zimmerman v. Board of County Commissioners, 218 P.3d 400 (Kan. 2009). The court determined that the county had properly followed state statutory procedures in adopting the ordinance, and that the ordinance was reasonable based on the county’s consideration of aesthetics, ecology, flora and fauna of the Flint Hills. The Court cited the numerous adverse effects of commercial wind farms including damage to the local ecology and the prairie chicken habitat (including breeding grounds, nesting and feeding areas and flight patterns) and the unsightly nature of large wind turbines. The Court also noted that commercial wind farms have a negative impact on property values, and that agricultural and nature-based tourism would also suffer.
A recent settlement order of the Minnesota Public Utilities Commission (Commission)requires a wind energy firm to buy-out two families whose health and lives were materially disaffected by a wind farm complex near Albert Lea, Minnesota. As a result, it is likely that the homes will be demolished so that the wind farm can proceed unimpeded by local landowners that might object to the operation. That’s because the order stated that if the homes remained and housed new residents, those residents could not waive the wind energy company’s duty to meet noise standards even if the homeowners were willing to live with violations of the Minnesota Pollution Control Agency’s ambient noise standard in exchange for payment or through some other agreement.
In re Wisconsin Power and Light, Co., No. ET-6657/WS-08-573, Minn. Pub. Util. Commission (Jun. 5, 2018) has a rather lengthy procedural history preceding the Commission’s order. On October 20, 2009, the Commission issued a large wind energy conversion system site permit to Wisconsin Power and Light Company (WPL) for the approximately 200-megawatt first phase of the Bent Tree Wind Project, located in Freeborn County, Minnesota. The project commenced commercial operation in February 2011. On August 24, 2016, the Commission issued an order requiring noise monitoring and a noise study at the project site. During the period of September 2016 through February 2018 several landowners in the vicinity filed over 20 letters regarding the health effects that they claim were caused by the project. On September 28, 2017, the Department of Commerce Energy Environmental Review Analysis Unit (EERA) filed a post-construction noise assessment report for the project, identifying 10 hours of non-compliance with Minnesota Pollution Control Agency (MPCA) ambient noise standards during the two-week monitoring period.
On February 7, 2018, EERA filed a phase-two post construction noise assessment report concluding that certain project turbines are a significant contributor to the exceedances of MPCA ambient noise standards at certain wind speeds. The next day, WPL filed a letter informing the Commission that it would respond to the Phase 2 report at a later date and would immediately curtail three turbines that were part of the project, two of which were identified in the phase 2 report. On February 20, 2018, the landowners filed a Motion for Order to Show Cause and for Hearing, requesting that the Commission issue an Order to Show Cause why the site permit for the project should not be revoked, and requested a contested-case hearing on the matter.
On April 19, 2018, WPL filed with the Commission a Notice of Confidential Settlement Agreement and Joint Recommendation and Request, under which WPL entered into a confidential settlement with each landowner, by which the parties agreed to the terms of sale of their properties to WPL, execution of easements on the property, and release of all the landowners’ claims against WPL. The agreement also outlined the terms by which the agreement would be executed. The finality of the agreement was conditioned upon the Commission making specific findings on which the parties and the Department agreed. These findings include, among others: dismissal of the landowners’ February 2018 motion and all other noise-related complaints filed in this matter; termination of the required curtailment of turbines; transfer of possession of each property to WPL; and a requirement that compliance filing be filed with commission. The Commission determined that resolving the dispute and the terms of the agreement were in the public interest and would result in a reasonable and prudent resolution of the issues raised in the landowner’s complaints. Therefore, the Commission approved the agreement with the additional requirement that upon the sale of either of the landowners’ property, WPL shall file with the Commission notification of the sale and indicate whether the property will be used as a residence. If the property is intended to be used as a residence after sale or upon lease, the permittee must file with the Commission several things - notification of sale or lease; documentation of present compliance with noise standards of turbines; documentation of any written notice to the potential residence of past noise studies alleging noise standards exceedances, and if applicable, allegations of present noise standards exceedances related to the property; and any mitigation plans or other relevant information.
The order issued in the Minnesota matter is not entirely unique. Several decades ago, the Arizona Supreme Court ordered a real estate developer to pay the cost of a cattle feedlot to move their feeding operations further away from the area where the developer was expanding into. Spur Industries, Inc. v. Del E. Webb Development Co., 108 Ariz. 178, 494 P.2d 700 (1972).
However, the bottom-line is that the matter in Minnesota is an illustration of what can happen to a rural area when a wind energy company initiates development in the community.
Wednesday, June 6, 2018
Much of tort law centers around the concept of negligence. The negligence system is designed to provide compensation to those who suffer personal injury or property damage. It’s also a fault-based system in most instances. When negligence is based on fault, the injured party (plaintiff) must be able to prove that their injury was the defendant’s fault. Without that proof, the defendant will not be liable. In addition, the plaintiff must prove each element of their negligent tort case by a preponderance of the evidence
Establishing fault and, as a result, liability – that’s the focus of today’s post.
For a person to be deemed legally negligent, certain conditions must exist. These conditions can be thought of as links in a chain. Each condition must be present before a finding of negligence can be obtained.
Legal duty. The first condition is that of a legal duty giving rise to a standard of care. To be liable for a negligent tort, the defendant's conduct must have fallen below that of a “reasonable and prudent person” under the circumstances. A reasonable and prudent person is what a jury has in mind when they measure an individual's conduct in retrospect - after the fact, when the case is in court. The conduct of a particular tortfeasor (the one causing the tort) who is not held out as a professional is compared with the mythical standard of conduct of the reasonable and prudent person in terms of judgment, knowledge, perception, experience, skill, physical, mental and emotional characteristics as well as age and sanity. For those held out as having the knowledge, skill, experience or education of a professional, the standard of care reflects those factors.
Breach. If a legal duty exists, it is necessary to determine whether the defendant's conduct fell short of the conduct of a “reasonable and prudent person (or professional) under the circumstances.” This is called a breach, and is the second element of a negligent tort case.
Causation. Once a legal duty and breach of that duty are shown to exist, a causal connection (the third element) must be established between the defendant's act and (the fourth element) the plaintiff's injuries (whether to person or property). In other words, the resulting harm to the plaintiff must have been a reasonably foreseeable result of the defendant's conduct at the time the conduct occurred. Reasonable foreseeability is the essence of causality (also known as proximate cause).
Damages. If the plaintiff is able to establish that the defendant breached a duty that was owed to the plaintiff, the plaintiff must also prove that the breach of the duty caused damages. The damages must be more than trivial and must be proved.
A recent case involving a dairy operation from the state of Washington illustrates the importance of being able to prove damages and that those damages were causally related to the defendant’s conduct. In White River Feed Co. v. Kruse Family, LP, No. 76562-1-I, 2018 Wash. App. LEXIS 1031(Wash. Ct. App. Apr. 30, 2018), the plaintiff claimed that the defendant supplied contaminated feed that caused illness in the plaintiff’s milking cows. During April of 2013 the plaintiff fed the cows the plaintiff’s own “green-chop” as well as the defendant’s custom grain feed blend. The dry cows (i.e., cows that were not milking) and the bulls were fed only “green-chop.” The “green-chop” had been incorporated into the rations on April 17. The third grain delivery had been fed as soon as it had been delivered on the 18th. On April 19, the milking cows showed a decreased appetite and developed diarrhea. By April 22, the plaintiff’s veterinarian, had been called to examine and treat the milking cows.
The veterinarian initially diagnosed the cows with an ionophore toxicity. Further investigations, however, revealed that the cows had salmonella poisoning. Grain from the calf barn, which the plaintiff stated came from the April 18 feed delivery, tested negative for salmonella. The “green-chop” was never tested as it had all been fed to the herd. The plaintiff’s veterinarian concluded with an eighty percent probability that the milking cows had become ill from the defendant’s grain. Most of the veterinarian’s opinion was based upon the fact that the dry cows and bulls had not become ill because they had not been fed any grain. The plaintiff’s veterinarian did acknowledge, however, that the calves were fed the grain and did not become ill. However, he hypothesized that the milk in their diet kept them from eating the grain or the industry practice of feeding calves the “crumbs” from the cows limited the salmonella.
The illness caused the plaintiff loss of twenty to twenty-five head which either died or were culled and another thirty head were sold for beef due to substantial weight loss In addition to claiming damages for the loss of cows, the plaintiff reported a decrease in milk production and loss of fetuses in the infected cows. The plaintiff sued for damages from the salmonella illness, and the defendant countered with claims of breach of contract and unjust enrichment for the outstanding accounts. The defendant also requested a jury trial and moved for summary judgment based on their own veterinarian’s expert opinion. The defendant’s veterinarian stated that the data was insufficient to pinpoint salmonella from the grain as the cause of the illness. Due to the negative test results, the fact the calves or any other farms experienced the same illness, and low moisture content of the grain, the defendant’s expert believed that no expert could have arrived at the diagnosis that the plaintiff’s veterinarian did.
The trial court granted the defendant’s summary judgment motion. The plaintiff moved for reconsideration, and submitted a declaration of an opinion from another veterinarian. This declaration stated that the negative results from the test may not be representative of the entire batch of feed. The trial court denied the motion to reconsider, The appellate court affirmed. The appellate court did not give much weight to the hypothetical projections of the initial veterinarian’s diagnosis. Also, the appellate court questioned why the veterinarian ignored the negative test results for salmonella or did not test for non-feed sources of salmonella that the other expert stated could be a cause. In addition, the court found that the expert opinion was abstract evidence rather than an issue of fact that could overcome the motion for summary judgment.
Proving damages is an essential element of a negligent tort case. Even though the defendant may have owed a duty to the plaintiff, breach that duty and the breach caused the plaintiff’s damages, if those damages can’t be proven or can’t be shown to be causally related to the defendant’s conduct, the plaintiff will not prevail on the claim. In the farm and ranch setting there can be many intervening factors that may cut-off the defendant’s liability. Make sure to think through each element before bringing suit.
Monday, June 4, 2018
Federal law regulates the handling of agricultural commodities in commerce by establishing marketing orders with the purpose of insuring that consumers receive an adequate supply of a commodity at a stable price. Marketing orders have long been used in the fruit, nut, vegetable and milk industries and typically require that a handler (dealer) pay a fixed minimum price to the producer of a commodity. In addition, the marketing of a commodity must follow a system of rules.
Separate legislation has established mandatory assessments for promotion of particular agricultural products. An assessment (or “check-off”) is typically levied on handlers or producers of commodities with the collected funds to be used to support research promotion and information concerning the product. Such check-off programs have been challenged on First Amendment free-speech grounds. Indeed, a recent case from California involved a mandatory assessment for the generic marketing of grapes. A group of grape producers that believed they produced high quality grapes objected to being required to pay for the advertising of grapes in general.
Mandatory assessments for generic advertising of ag commodities – that’s the focus of today’s post.
In United States v. United Foods, Inc., 533 U.S. 405 (2001), the U.S. Supreme Court held that mandatory assessments for mushroom promotion under the Mushroom Promotion, Research, and Consumer Identification Act violated the First Amendment. The assessments were directed into generic advertising, and some handlers objected to the ideas being advertised. In an earlier decision, Glickman v. Wileman Brothers & Elliott, Inc., 521 U.S. 457 (1997), the Court had upheld a marketing order that was part of a greater regulatory scheme with respect to California tree fruits. In that case, producers were compelled to contribute funds for cooperative advertising and were required to market their products according to cooperative rules. In addition, the marketing orders had received an antitrust exemption. None of those facts was present in the United Foods case, where the producers were entirely free to make their own marketing decisions and the assessments were not tied to a marketing order. The Supreme Court did not address, however, whether the check-offs at issue were government speech and, therefore, not subject to challenge as an unconstitutional proscription of private speech.
The government speech issue was before the court in 2005. In Johanns v. Livestock Marketing Association, 544 U.S. 550 (2005), the Supreme Court upheld the beef check-off as government speech. Under the Beef Checkoff, a $1.00/head fee is imposed at the time cattle are sold. The money generated funds promotional campaigns and research, and state beef councils can collect the funds and retain half of the collected amount with the balance going to the Cattleman’s Beef Production and Research Board (Beef Board). But, a producer can direct that all of the producer’s assessment go to the Beef Board.
The case involved (in the majority’s view) a narrow facial attack on whether the statutory language of the legislation authorizing the beef check-off created an advertising program that could be classified as government speech. That was the only issue before the Court. At the time, the government speech doctrine was relatively new not well-developed but, prior Supreme Court opinions not involving agricultural commodity check-offs indicated that to constitute government speech, a check-off must clear three hurdles - (1) the government must exercise sufficient control over the content of the check-off to be deemed ultimately responsible for the message; (2) the source of the check-off assessments must come from a large, non-discrete group; and (3) the central purpose of the check-off must be identified as the government’s.
Based on that analysis, it was believed that the beef check-off would clear only the first and (perhaps) the third hurdle, but that the program would fail to clear the second hurdle. Indeed, the source of funding for the beef check-off comes from a discrete identifiable source (cattle producers) rather than a large, non-discrete group. The point is that if the government can compel a targeted group of individuals to fund speech with which they do not agree, greater care is required to ensure political accountability as a democratic check against the compelled speech. That is less of a concern if the funding source is the taxpaying public which has access to the ballot box as a means of neutralizing the government program at issue and/or the politicians in support of the program. While the dissent focused on this point, arguing that the Act does not establish sufficient democratic checks, Justice Scalia, writing for the majority, opined that the compelled-subsidy analysis is unaffected by whether the funds for the promotions are raised by general taxes or through a targeted assessment. That effectively eliminates the second prong of the government speech test. The Court held that the other two requirements were satisfied in as much as the legislation vested substantial control over the administration of the check-off and the content of the ads in the Secretary.
The court did not address (indeed, the issue was not before the court) whether the advertisements, most of which are credited to “America’s Beef Producers,” give the impression that the objecting cattlemen (or their organizations) endorse the message. Because the case only involved a facial challenge to the statutory language of the Act, the majority examined only the Act’s language and concluded that neither the statute nor the accompanying Order required attribution of the ads to “America’s Beef Producers” or to anyone else. Thus, neither the statute nor the Order could be facially invalid on this theory. However, the Court noted that the record did not contain evidence from which the Court could determine whether the actual application of the check-off program resulted in the message of the ads being associated with the plaintiffs. Indeed, Justice Thomas, in his concurring opinion, noted that the government may not associate individuals or organizations involuntarily with speech by attributing an unwanted message to them whether or not those individuals fund the speech and whether or not the message is under the government’s control.
After the Supreme Court’s decision in the beef-checkoff case, the U.S. Circuit Court of Appeals for the Ninth Circuit decided a case involving the California Pistachio check-off. Paramount Land Company, LP v. California Pistachio Commission, 491 F.3d 1003 (9th Cir. 2007). The court determined that the First Amendment was not implicated because, consistent with Johanns, the Secretary of the California Department of Food and Agriculture retained sufficient authority to control both the activities and the message under the Pistachio Act. The court reasoned that the fact that the Secretary had not actually played an active role in controlling pistachio advertising could not be equated with the Secretary abdicating his regulatory role.
In another California case, a court held that milk producer assessments used for generic advertising to stimulate milk sales were constitutional under the Johanns rationale. Gallo Cattle Co. v. A.G. Kawamura, 159 Cal. App. 4th 948, 72 Cal. Rptr. 3d 1 (2008).
In more recent litigation, Ranchers-Cattlemen Action Legal Fund, United Stockgrowers of America v. Vilsack, No. CV-16-41-GF-BMM-JTL, D. Mont. Dec. 12, 2016), the plaintiff (cattle producers) claimed that the federal law requiring funding of the Montana Beef Council (MBC) via funds from the federal beef checkoff was constitutionally defective. The court, as part of the findings and recommendations of a U.S. Magistrate Judge, determined that the plaintiff had standing and had stated a claim upon which relief could be granted. The cattle producers claimed that the use of the collected funds violated their First Amendment rights by forcing them to pay for “speech” with which they did not agree. The cattle producers objected to being forced to fund a generic message that “beef is beef” regardless of where the cattle from which the beef was derived or born. That message, the cattle producers claimed, was contrary to their interests of capitalizing on marketing their superior beef products produced from cattle produced in the United States.
The defendant (USDA) motioned to dismiss, but the Magistrate Judge denied the motion. The court determined that the plaintiffs had standing, and that the U.S. Supreme Court had held in prior cases that forcing an individual to fund a private message that they did not agree with violated the First Amendment. Any legal effect of an existing “opt-out” provision was not evaluated. The court also rejected the defendant’s claim that the case should be delayed until federal regulations with respect to the opt-out provision were finalized because the defendant was needlessly dragging its heels on developing those rules and had no timeline for finalization. The court entered a preliminary injunction barring the MBC from spending funds received from the checkoff. Upon further review, the federal trial court upheld the preliminary injunction. Ranchers- Cattlemen Action Legal Fund, United Stockgrowers of America v. Perdue, No. CV 16-41-GF-BMM, 2017 U.S. Dist. LEXIS 95861 (D. Mont. Jun. 21, 2017).
On further review, the U.S. Court of Appeals for the Ninth Circuit affirmed. Ranchers-Cattlemen Action Legal Fund, United Stockgrowers of America v. Perdue, 718 Fed. Appx. 541 (9th Cir. 2018). The Ninth Circuit determined that the trial court had properly evaluated the beef-checkoff under the standards set forth in Johanns and Paramount.
In Delano Farms Company v. California Table Grape Commission, No. S226538, 2018 Cal. LEXIS 3634 (Cal. Sup. Ct. May 24, 2018), the plaintiffs were several California grape growers. They claimed that the defendant violated the plaintiffs’ First Amendment free speech rights by collecting mandated fees to pay for a range of services including advertising and marketing. Specifically, the plaintiffs claimed the collection of assessments by the defendant under the California Ketchum Act subsidized promotional speech on behalf of California table grapes as a generic category that violated their rights to free speech, free association, due process, liberty and privacy under the California Constitution (Article I, Section 2). They took this position because the claimed to have developed specialty grapes that they wanted to market in their own manner without also being forced to pay for generic grape advertising that sponsored a viewpoint that they disagreed with.
The trial court ruled that the defendant was a governmental entity, and therefore its speech was government speech that could be funded by assessments collected from the plaintiffs under a constitutional analysis that is significantly deferential and is not subject to heightened scrutiny. As such, the trial court determined that the speech did not implicate Article 1, Section 2.
On appeal, the California Supreme Court affirmed. The Court noted that the relevant circumstances established sufficient government responsibility for and control over the messaging at issue such that the advertising constituted government speech that the plaintiffs could be required to subsidize without any implication of their constitutional rights under Article 1, Section 2. Specifically, the Court noted that the California legislature developed and endorsed the central message that the defendant promulgated with respect to California fresh grapes generically. The articulation and broadcasting of that message was entrusted to market participants acting through the defendant. The Court viewed this as meaningful oversight by the public and other governmental actors and included oversight mechanisms serving to ensure that the defendant’s messaging remained within the statutory parameters. The Court also stated that there is no right not to fund government speech, and also determined that the Ketchum Act did not bar the plaintiffs from speaking.
Mandatory assessments for generic advertising for ag commodities is understandably frustrating for some producers. However, the U.S. Supreme Court has provided a measuring stick for evaluating the constitutionality of such programs. If the administration of the particular check-off is substantially controlled by the government, and the government controls the contents of the ads at issue, the assessments are likely to be upheld as government speech.
Thursday, May 31, 2018
Numerous states have enacted agritourism legislation designed to limit landowner liability to those persons engaging in an “agritourism activity.” Typically, such legislation protects the landowner (commonly defined as a “person who is engaged in the business of farming or ranching and provides one or more agritourism activities, whether or not for compensation”) from liability for injuries to participants or spectators associated with the inherent risks of a covered activity. There’s a lot packed into that definition, and unpacking it is not the purpose of today’s post.
What today’s post takes a brief look at is one aspect of agritourism statutes – the extent to which the statutes can be used to exempt activities from county zoning. Indeed, that was the focus of a recent court decision in North Carolina.
State agritourism statues tend to be written very broadly and can apply to such things as corn mazes, hay rides and even hunting and fishing activities. Under the Maine statute, for example, inherent risks associated with being on an active farm include hazards from the natural surface and subsurface conditions of land, vegetation, and waters; the behavior of wild and domestic animals; ordinary dangers of structures and equipment used in farming and ranching; and potential injuries caused by the participant’s or others’ failure to follow instructions given or in failing to exercise reasonable caution while engaging in activities. Maine Rev. Stat. Title 7, Part 1, Chapter 8-E, Section 251, Subsection 5.
Quite often, the state laws related to agritourism relate to financial incentives via tax credits or cost-sharing, promotion, protecting the ag real property tax classification of the property involved, or liability protection. But, to get the protection of the statute the use of the land must be for agricultural purposes. That’s particularly the case when county zoning rules are implicated – as they were in a recent North Carolina case.
In Jeffries v. Harnett County, No. COA17-729, 2018 N.C. App. LEXIS 494 (N.C. Ct. App. May 15, 2018), a property owner operated a sport hunting business on the their 12-acre parcel. The business activities included shooting ranges, 3-D archery courses, clay targets and pistol pits. Initially, the defendant raised fowl on the property for controlled hunting. Over time, however, the business evolved into a multi-function facility.
Adjacent landowners wrote to the county to inquire if the defendant was exempt from zoning as an “agritourism” business. The county zoning board responded that the ranges and controlled hunting were agritourism and, as such, were exempt from county zoning. The neighbors appealed to the County Board of Adjustment which upheld the zoning authority’s decision. Over the next several years, litigation ensued involving the issue of which activities on the land constituted agritourism that were exempt from county zoning. Ultimately, the matter came before the appellate court which determined that the various activities on the farm did not constitute “agriculture” and, therefore, were subject to county zoning. Being “agriculture” was a precondition to being an agritourism activity.
Specifically, the appellate court determined that the hunting-associated activities were not agritourism and were, therefore, not exempt from county zoning. The mere fact that the activities occurred on agricultural land was not enough for the appellate court to conclude that the hunting business qualified as agritourism. The governing statute (N.C. Gen. Stat. § 153A-340(b)(2a)), set forth the definition of agritourism, mentioning “rural activities” but it did not list hunting per se. The appellate court turned to other precedents to determine if rural activities included hunting.
Prior case law held that domestically raised animals for controlled hunting qualified as a rural activity, but that is as far as they went. The cases did not extend that rationale to other types of shooting sports. The appellate court determined that activities that are based in agriculture and the natural use of the land qualify as agritourism. Because shooting ranges did not produce anything “natural” from the land, they didn’t count. Furthermore, the part of the statute explaining the inherent risk of agritourism provided only “farming and ranching” but did not include hunting in the list of dangers. The appellate court believed it was critical that the legislature left out any mention of hunting activities in the statute. Thus, shooting ranges and other hunting sports that do not include the harvesting of animals, did not fit squarely within the statute as a rural activity or a natural activity even if operated on farm ground. That meant that county zoning applied – it wasn’t an agricultural activity and, therefore, was not agritourism.
Agritourism statutes are important to farmers, ranchers and rural landowners. They do provide liability protection to activities on farm and ranch land that can generate additional income sources to farming and ranching operations. However, the particulars of the state statue must be closely followed. Failure to conform to the statutory requirements can result in liability exposure and having the activity subjected to county zoning because it is not “agriculture.”
Tuesday, May 29, 2018
Economic times continue to be difficult in much of agriculture. Many crop prices have declined from their peak a few years ago. The same is true for much of livestock agriculture. What’s more, great yields rarely if ever make up for low prices. As a result, farm bankruptcy filings are occurring at an increased rate, particularly in areas that have both crops and dairy operations.
An important issue that can come up in a farm bankruptcy is known as the “preferential payment rule.” It can be a surprise not only to farmers in financial distress, but also to creditors who receive payment or buy agricultural goods shortly before the debtor files bankruptcy. It’s an issue that can arise in the normal course of doing business before bankruptcy is filed when nothing “unusual” appears to be happening.
Today’s post takes a look at this unique bankruptcy provision – the preferential payment rule.
11 U.S.C. §547 provides in general that when a debtor makes a payment to a creditor and the debtor files bankruptcy within 90 days of making the payment, the bankruptcy trustee can “avoid” the payment by making the creditor pay the amount received to the bankruptcy estate where it will be distributed to the general creditors of the debtor. The timeframe expands from 90 days to one year is the creditor is an “insider.” The rule can come as a shock to a creditor that has received payment, paid their own creditors from the funds received from the debtor, and now has no funds to pay the bankruptcy estate to satisfy the bankruptcy trustee’s avoidance claim.
The preferential payment rule does come with some exceptions. The exceptions basically comport with usual business operations. In other words, if the transaction between the debtor and the creditor occurred in the normal course of the parties doing business with each other, then the trustee’s “avoidance” claim will likely fail. So, if the payment was made as part of a contemporaneous exchange for new value given, the trustee’s avoidance claim will be rejected. Also, if the payment was made in the “ordinary course of business” between the debtor and the creditor where invoices are paid in the time period required on the invoice, or payment is made in accordance with industry custom or past dealings, the trustee’s claim will likely fail. Likewise, if the transfer creates a security interest in property that the debtor acquires that secures new value given in accordance with a security agreement, the trustee’s claim will also likely not be granted.
A recent court decision from Arkansas illustrates how the preferential payment rule can apply in an agricultural setting. In Rice v. Prairie Gold Farms, No. 2:17CV126 JLH, 2018 U.S. Dist. LEXIS 51678 (E.D. Ark. Mar. 28, 2018), the debtor was a partnership engaged in wheat farming activities. The debtor entered into two contracts for the sale of wheat with a grain broker. The contracts called for a total of 10,000 bushels of wheat to be delivered to the broker anytime between June 1, 2014 and July 31, 2014. In return, the debtor was to be paid $6.78/bushel for 5,000 bushels and $7.09/bushel for the other 5,000 bushels for a total price of $69,350. The debtor delivered the wheat in fulfillment of the contracts on July 21, 2014 and August 4, 2014 and received $71,957.10 later in August, in return for a total delivery of 10,813.07 bushels.
The debtor subsequently filed Chapter 11 bankruptcy on October 23, 2014 (which was later converted to Chapter 7). The Chapter 7 trustee sought to avoid the transfer of the debtor’s wheat crop as a preferential transfer under 11 U.S.C. §547(b) and return the wheat crop to the bankruptcy estate for distribution to creditors. The trial court disagreed with the trustee, noting that 11 U.S.C. §547(c)(1) disallowed avoidance of a transfer if it is made in a contemporaneous exchange for new value that the debtor received. The trustee claimed that the transfer of wheat was not contemporaneous because the contract was entered into in May and the wheat was not delivered and payment made until over two months later.
The trial court determined that the transfer was for new value and payment occurred in a substantially contemporaneous manner corresponding to the delivery of the wheat. Thus, the exception of 11 U.S.C. §547(c)(1) applied. The court also noted that the wheat sale contracts were entered into in the ordinary course of the debtor’s business and, thus, also met the exception of 11 U.S.C. §547(c)(2). The debtor and the grain broker had a business history of similar transactions, and the court noted that the trustee failed to establish that the wheat contracts were inconsistent with the parties’ history of business dealings.
The preferential payment rule is important to know about, especially in the context of agricultural bankruptcies. The matter can get complicated in agricultural settings with the use of deferred payment contracts, forward grain contracts and the various types of unique business relationships that farmers often find themselves in. In the Arkansas case, the court noted that the parties had prior dealings that they conducted in the same manner and that nothing was out of the ordinary. There wasn’t any attempt to defraud creditors or shield assets from the reach of creditors. That’s really the point behind the rule. Continue conducting business as usual and the rule won’t likely come into play.
Friday, May 25, 2018
The Tax Cuts and Jobs Act (TCJA) made significant changes to individual income taxes, the tax on C corporations, and also created a new deduction for pass-through entities. The TCJA also modified some of the rules applicable to I.R.C. 529 College Savings Plans (“Section 529 Plans”). In light of the changes applicable to Section 529 plans, it’s worth examining those changes and how they might impact planning.
That’s the focus of today’s post – the TCJA changes to Section 529 plans.
Origination. Section 529 plans originated at the state level, particularly the pre-paid tuition program of the State of Michigan. The idea was to provide a vehicle to help minimize the cost of college tuition be creating a fund to which Michigan residents could pay a fixed amount in exchange for a promise that the fund would pay a designated beneficiary’s college tuition at a Michigan public college or university. The trust invested the contributed amounts to pay tuition costs of beneficiaries in the future. Basically, this allowed the prepayment of college education at a fixed rate un-impacted by tuition increases in future years. The concept was aided by the IRS when the IRS determined that purchasers of the "prepaid tuition contract" were not taxed on the contract value accruing value until the year(s) in which funds were either distributed or refunded. 1996 federal legislation authorized qualified state tuition programs.
Types. A Section 529 plan can be one of two types – a prepaid tuition plan or a college savings plan. All states have at least one type of plan. Under a prepaid tuition plan, the account holder buys units (credits) at a participating “eligible educational institution” for future tuition and fees at current prices for the beneficiary of the account. With a “college savings plan,” a person opens an investment account to save for the beneficiary’s future tuition fees as well as room and board.
There can be numerous tax benefits at the state level that apply to contributions to a Section 529 plan. These can include the ability to deduct contributions from state income tax or the availability of matching grants. If funds in an account are withdrawn to pay qualified education expenses, then the account earnings are not subject to federal (and often) state income tax. If the withdrawals aren’t used to pay qualified educational expenses, a penalty applies. In that situation, each withdrawal is treated as containing a pro-rata portion of earnings and principal. The earnings portion of a non-qualified withdrawal is taxed at ordinary income rates and is also subjected to a 10 percent additional tax absent an exception.
Distributions from a Section 529 plan for an eligible student that are used for qualifying higher education expenses at an eligible institution are not include in income. An “eligible student” is one that is enrolled in a program leading to recognized educational credentials; enrolled at least one-half time; and without any federal or state felony drug conviction.
Eligible Educational Institution
An “eligible educational institution” includes colleges, universities, vocational schools, or other postsecondary schools eligible to participate in a student aid program of the Department of Education. Under the TCJA, an “eligible educational institution” is expanded to include public, private or religious elementary schools and secondary schools. As originally proposed, homeschool expenses would have also qualified for Section 529 plans but were struck by the parliamentarian in the Senate as a violation of the “Byrd Rule.”
Section 529 plans can be used to fund up to $10,000 of tuition cost per year per beneficiary that is required for attendance at an eligible educational institution. In other words, under the TCJA Section 529 plan funds can be used to pay tuition expenses of up to $10,000 per student annually from all of a taxpayer’s Section 529 accounts for tuition of a beneficiary that is incurred for enrollment or attendance at a public, private or religious elementary or secondary level.
Definition. “Qualified Expenses” include reasonable costs for room and board. That is generally limited to the lesser of room and board costs of attendance as published by the educational institution or actual expenses. However, if the student beneficiary is living on campus, actual costs can be used even if in excess of published room and board costs. Likewise, Section 529 plan funds can be used to cover fees, books, supplies and equipment but only if they are required for enrollment or attendance at an eligible educational institution.
“Qualified higher education expenses” included tuition, fees, books, supplies, and required equipment, as well as reasonable room and board if the student was enrolled at least half-time. Eligible schools included colleges, universities, vocational schools, or other postsecondary schools eligible to participate in a student aid program of the Department of Education. This includes nearly all accredited public, nonprofit, and proprietary (for-profit) postsecondary institutions.
The TCJA retools the definition of what constitutes “qualified expenses” for purposes of distributions from a Section 529 plan. For distributions after Dec. 31, 2017, “qualified higher education expenses” is broadened to include (as noted above) tuition at an elementary or secondary public, private, or religious school, up to a $10,000 limit per tax year. I.R.C. §529(c)(7).
As for computer-related technology, qualified costs include the computer and any necessary peripheral equipment. Also included is computer software, internet access and related services. However, expenses associated with computer technology can only be covered by Section 529 funds if the technology is used by a plan beneficiary during the years that they are enrolled in an eligible educational institution. Importantly, computer technology expenses do not include software designed for sports, games, and hobbies unless the software is predominantly educational in nature.
Reduction. Qualifying expenses must be reduced for tax-free scholarships that the beneficiary receives as well as other educational assistance. They must also be reduced for the amount of qualifying expenses that are used to obtain education credit.
Special Needs Beneficiary and ABLE Accounts.
Section 529 plan funds can also be used to provide for expenses associated with a special needs beneficiary. These include special needs services incurred in connection with the enrollment or attendance at an eligible educational institution.
For distributions after December 22, 2017, the TCJA allows amounts from a Section 529 plan to be rolled over to an ABLE account without penalty if the ABLE account owner is either the designated beneficiary of the Section 529 plan account or a member of the designated beneficiary’s family. I.R.C. §529(c)(3). Created by legislation in 2014, ABLE accounts are tax-advantaged savings accounts for individuals with disabilities and their families. The account beneficiary is the account owner, and account earns income tax-free. Contributions to the account (which can be made by any person) must be made using post-tax dollars. As such, account contributions are not tax deductible at the federal level. It is possible, however, that some states may allow deductible contributions on the state return.
Any amount that is rolled-over from a Section 529 plan account to an ABLE account is counted towards the overall limitation on amounts that can be contributed to an ABLE account within a tax year ($15,000 for 2018), and any amount rolled over in excess of this limitation is includible in the distributee’s gross income.
Some expenses cannot be paid with funds from a Section 529 plan. Non-qualifying expenses include books, supplies, or equipment that is not required for enrollment or classes. Also not qualifying are transportation expenses to and from school. This includes car travel expenses, airline tickets and parking, etc.). Health insurance covering the beneficiary also is not a qualifying expenses, nor is any expense for athletic events or activities not required for coursework. Fraternity or sorority dues are likewise not qualified expenses, nor are the costs of cell phones or student loan repayment amounts.
Section 529 plans have been around for some time now. However, the amendments made by the TCJA make them a more powerful tool to fund the education of a beneficiary on a tax-favored basis.
Wednesday, May 23, 2018
The Tax Cuts and Jobs Act (TCJA) that was signed into law on December 22, 2017, represents a major change to many provisions of the tax Code that impact individuals and business entities. I have discussed of the major changes impacting farm and ranch taxpayers and businesses in prior posts. But, the TCJA also makes substantial changes with respect to the income taxation of trusts and estates. Those changes could have an impact on the use of trusts as an estate planning/wealth transfer device. Likewise, the TCJA changes that impact decedent’s estate must also be noted.
The TCJA’s changes that impact trusts and estates – that’s the focus of today’s post.
While the media has largely focused on the TCJA’s rate reductions for individuals and C corporations, the rates and bracket amounts were also modified for trusts and estates. The new rate structure for trusts and estates are located in I.R.C. §1(j)(2)(E) and are as follows: 10%: $0: $2,550; 24%: $2,551-$9,150; 35%: $9,151-$12,500; 37% - over $12,500. As can be noted, the bracket structure for trusts and estates remains very compressed. Thus, the pre-TCJA planning approach of not trapping income or gains inside a trust or an estate remains the standard advice. That’s because the TCJA did not change the tax rates for qualified dividends and long-term capital gains, although the bracket cut-offs are modified slightly as follows: 0%: $0-$2,600; 15%: $2,601-$12,700; 20%: Over $12,700. Those rates and brackets remain advantageous compared to having the income or gain taxed at the trust or estate level.
Other Aspects of Trust/Estate Taxation
Post-TCJA, it remains true that an estate or trust’s taxable income is computed in the same manner as is income for an individual. I.R.C. §641(b). However, the TCJA amends I.R.C. §164(b) to limit the aggregate deduction for state and local real property taxes and income taxes to a $10,000 maximum annually. But, this limit does not apply to any real estate taxes or personal property taxes that a trust or an estate incurs in the conduct of a trade or business (or an activity that is defined under I.R.C. §212). Thus, an active farm business conducted by a trust or an estate will not be subject to the limitation.
The TCJA also suspends miscellaneous itemized deductions for a trust or an estate. That means, for example, that investment fees and expenses as well as unreimbursed business expenses are not deductible. This will generally cause an increased tax liability at the trust or estate level as compared to prior law. Why? With fewer deductions, the adjusted taxable income (ATI) of a trust or an estate will be higher. For simple trusts, this is also a function of distributable net income (DNI) which, in turn, is a function of the income distribution deduction (IDD). I.R.C. §651(b) allows a simple trust to claim an IDD limited to the lesser of fiduciary accounting income (FAI) or DNI. Under prior law, all trust expenses could be claimed when determining DNI, but only some of those expenses were allocated to principal for purposes of calculating FAI. Now, post-TCJA, ATI for a trust or an estate will be higher due to the loss of various miscellaneous itemized deductions (such as investment management fees). As ATI rises, DNI will decline but FAI won’t change (the allocation of expenses is determined by the trust language or state law). The more common result is likely to be that FAI will be the actual limitation on the IDD, and more income will be trapped inside the estate or the trust. That’s what will cause the trust or the estate to pay more tax post-TCJA compared to prior years.
But, guidance is needed concerning the deductibility of administrative expenses such as trustee fees. It’s not clear whether the TCJA impacts I.R.C. §67. That Code section does not apply the two percent limitation to administrative expenses that are incurred solely because the property is held inside a trust or an estate. There is some support for continuing to deduct these amounts. I.R.C. §67(g) applies to miscellaneous itemized deductions, but trustee fees and similar expenses are above-the-line deductions for a trust or an estate that impact the trust or estate’s AGI. Thus, I.R.C. §67 may not apply. I am told that guidance will be forthcoming on that issue during the summer of 2018. We shall see.
A trust as well as an estate can still claim a $600 personal exemption (with the amount unchanged) under I.R.C. §642. Don’t confuse that with the TCJA’s suspension of the personal exemption for individuals. Also, don’t confuse the removal of the alternative minimum tax (AMT) for corporations or the increased exemption and phaseout range for individuals with the application of the AMT to trusts and estates. No change was made concerning how the AMT applies to a trust or an estate. See I.R.C. §55.(d)(3). The exemption stays at $24,600 with a phaseout threshold of $82,050. Those amounts apply for 2018 and they will be subsequently adjusted for inflation (in accordance with the “chained” CPI).
Other TCJA Impacts on Trusts and Estates
The new 20 percent deduction for pass-through entities under I.R.C. §199A can be claimed by an estate or a trust with non-C corporate business income. The deduction is claimed at the trust or the estate level, with the $157,500 threshold that applies to a taxpayer filing as a single person applying to a trust or an estate. The rules under the now-repealed I.R.C. §199 apply for apportioning between fiduciaries and beneficiaries any W-2 wages and unadjusted basis of qualified property under the limitation based on W-2 wages and capital. There is no separate computation required for alternative minimum tax purposes.
The eligibility of a trust or an estate for the I.R.C. §199A deduction may provide some planning opportunities to route pass-through income from a business that is otherwise limited or barred from claiming the deduction through a non-grantor trust so that the deduction can be claimed or claimed to a greater extent. For example, assume that a sole proprietorship farming operation nets $1,000,000 annually, but pays no qualified wages and has no qualifying property (both factors that result in an elimination of the deduction for the business). If business income is routed through a trust (or multiple truss) with the amount of trust income not exceeding the $157,500 threshold, then an I.R.C. §199A deduction can be generated. However, before this strategy is utilized, there are numerous factors to consider including overall family estate planning/succession planning goals and the economics of the business activity at issue.
Clarification is needed with respect to a charitable remainder trust (CRT) that has unrelated business taxable income (UBIT). UBIT is income of the CRT that comes from an unrelated trade or business less deductions “allowed by Chapter 1 of the Code” that are “directly connected” with the conduct of a trade or business. Treas. Reg. §1.512(a)-1(a). Is the new I.R.C. §199A deduction a directly connected deduction? It would seem to me that it is because it is tied to business activity conducted by the trust. If that construction is correct, I.R.C. §199A would reduce the impact of the UBIT on a CRT. Certainly, guidance is needed from the Treasury on this point.
Related to the CRT issue, the TCJA would appear to allow an electing small business trust (ESBT) to claim the I.R.C. §199A deduction on S corporate income. But, again, guidance is needed. An ESBT calculates the tax on S corporate income separately from all other trust income via a separate schedule. The result is then added to the total tax calculated for the trust’s non-S corporate income. Thus, the ESBT pays tax on all S corporate income. It makes no difference whether the income has been distributed to the ESBT beneficiaries. Also, in computing its tax, the deductions that an ESBT can claim are set forth in I.R.C. §641(c)(2). However, the TCJA does not include the I.R.C. §199A deduction in that list. Was that intentional? Was that an oversight? Your guess is as good as mine.
Another limiting factor for an ESBT is that an ESBT can no longer (post-2017 and on a permanent basis) deduct 100 percent of charitable contributions made from the S corporation’s gross income. Instead, the same limitations that apply to individuals apply to an ESBT – at least as to the “S portion” of the ESBT. But, the charitable contribution need not be made from the gross income of the ESBT. In addition, the charitable contribution must be made by the S corporation for the ESBT to claim the deduction. If the ESBT makes the contribution, it is reported on the non-ESBT portion of the return. It is not allocated to the ESBT portion.
Under the TCJA, an ESBT can have a nonresident alien as a potential current beneficiary.
If a trust or an estate incurs a business-related loss, the TCJA caps the loss at $250,000 for 2018 (inflation-adjust for future years). The $250,000 amount is in the aggregate – it applies at the trust or estate level rather than the entity level (if the trust or estate is a partner of a partnership or an S corporation shareholder). I.R.C. §461(l)(2). Amounts over the threshold can be carried over and used in a future year.
The TCJA impacts a broad array of taxpayers. Its impacts are not limited to individuals and corporate taxpayers. Trusts and estates are also affected. For those with trusts or involved with an estate, make sure to consult tax counsel to make sure the changes are being dealt with appropriately.
Monday, May 21, 2018
In Part One last Thursday, I examined the basics of valuation discounting in the context of a family limited partnership (FLP). In Part Two today, I dig deeper on the I.R.C. §2036 issue, recent cases that have involved IRS challenges to valuation discounts under that Code section, and possible techniques for avoiding IRS challenges.
I.R.C. §2036 – The Basics
Historically, the most litigated issues involving valuation discounts surround I.R.C. §2036. Section 2036(a) specifies as follows:
(a) General rule. The value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money’s worth), by trust or otherwise, under which he has retained for his life or for any period not ascertainable without reference to his death or for any period which does not in fact end before his death—
(1) the possession or enjoyment of, or the right to the income from, the property, or
(2) the right, either alone or in conjunction with any person, to designate the persons who shall
possess or enjoy the property or the income therefrom.
(b) Voting rights
(1) In general. For purposes of subsection (a)(1), the retention of the right to vote (directly or indirectly) shares of stock of a controlled shall be considered to be a retention of the enjoyment of transferred property.
Retained interest. As you can imagine, a big issue under I.R.C. §2036 is whether assets that are contributed to an FLP (or an LLC) are pulled back into the transferor’s estate at death without any discount without the application of any discount on account of the restrictions that apply to the decedent’s FLP interest. The basic argument of the IRS is that the assets should be included in the decedent’s estate due to an implied agreement of retained enjoyment, even where the decedent had transferred the assets before death. See, e.g., Estate of Harper v. Comr., T.C. Memo. 2002-121; Estate of Korby v. Comr., 471 F.3d 848 (8th Cir. 2006).
In the statutory language laid out above, the parenthetical language of subsection (a) is important. That’s the language that estate planners use to circumvent the application of I.R.C. §2036. The drafting of the FLP agreement and the associated planning and implementation of the entity should ensure that there are legitimate and significant non-tax reasons for the use of the FLP/LLC. That doesn’t mean that a tax reason creating the entity cannot be present, but there must be a major non-tax reason present also.
If the IRS denies a valuation discount in the context of an FLP/LLC and the taxpayer cannot rely on the parenthetical language, the focus then becomes whether there existed an implied agreement of retained enjoyment in the transferred assets. There aren’t many cases that taxpayer’s win where the taxpayer’s argument is outside of the parenthetical exception and is based on the lack of retained enjoyment in the transferred assets, but there are some. See, e.g., Estate of Mirowski v. Comr., T.C. Memo. 2008-74; Estate of Kelley v. Comr., T.C. Memo. 2005-235.
Designating possession or enjoyment. What about the retained right to designate the persons who will possess or enjoy the transferred property or its income? In other words, what about the potential problem of subsection (a)(2)? A basic issue with the application of this subsection is whether the taxpayer can be a general partner of the FLP (or manager of an LLC). There is some caselaw on this question, but those cases involve unique facts. In both cases, the court determined that I.R.C. §2036(a)(2) applied to cause inclusion of the transferred property in the decedent’s gross estate. See, e.g., Estate of Strangi v. Comr., T.C. Memo. 2003-145, aff’d., 417 F.3d 468 (5th Cir. 2005); Estate of Turner v. Comr., T.C. Memo. 2011-209. In an earlier case in 1982, the Tax Court determined that co-trustee status does not trigger inclusion under (a)(2) if there are clearly identifiable limits on distributions. Estate of Cohen v. Comr., 79 T.C. 1015 (1982). That Tax Court opinion has generally led to the conclusion that (a)(2) also does not apply to investment powers.
While the Strangi litigation indicates that (a)(2) can apply if the decedent is a co-general partner or co-manager, the IRS appears to focus almost solely on situations where the decedent was a sole general partner or manager. The presence of a co-partner or co-manager is similar to a co-trustee situation and also can help build the argument that the entity was created with a significant non-tax reason.
Succession planning. From a succession planning perspective, it may be best for one parent to be the transferor of the limited partnership interests and the other to be the general partner. For example, both parents could make contributions to the partnership in the necessary amounts so that one parent receives a 1 percent general partnership interest and the other parent receives the 99 percent limited partnership interest. The parent holding the limited partnership interest then could make gifts of the limited partnership interests to the children (or their trusts). The other parent is able to retain control of the “family assets” while the parent holding the limited partnership interest is the transferor of the interests. Unlike IRC §672(e), which treats the grantor as holding the powers of the grantor’s spouse, IRC §2036 does not have a similar provision. Thus, if one spouse is able to retain control of the partnership and the other spouse is the transferor of the limited partnership interests, then IRC §2036 should not be applicable.
I.R.C. §2703 and Indirect Gifts
The IRS may also take an audit position against an FLP/LLC that certain built-in restrictions in partnership agreements should be ignored for tax purposes. This argument invokes I.R.C. §2703. That Code section reads as follows:
(a) General rule. For purposes of this subtitle, the value of any property shall be determined without regard to—
(1) any option, agreement, or other right to acquire or use the property at a price less than the fair market value of the property (without regard to such option, agreement, or right), or
(2) any restriction on the right to sell or use such property.
(b) Exceptions. Subsection (a) shall not apply to any option, agreement, right, or restriction which meets each of the following requirements:
(1) It is a bona fide business arrangement.
(2) It is not a device to transfer such property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth.
(3) Its terms are comparable to similar arrangements entered into by persons in an arms’ length transaction.
In both Holman v. Comr., 601 F.3d 763 (8th Cir. 2010) and Fisher v. United States, 1:08-cv-0908-LJM-TAB, 2010 U.S. Dist. LEXIS 91423 (S.D. Ind. Sept. 1, 2010), the IRS claimed that restrictions in a partnership agreement should be ignored in accordance with I.R.C. §2703. In Holman, the restrictions were not a bona fide business arrangement and were disregarded in valuing the gifts at issue. In Fisher, transfer restrictions were likewise ignored.
Several valuation discounting cases have been decided recently that provide further instruction on the pitfalls to avoid in creating an FLP/LLC to derive valuation discounts. Conversely, the cases also provide further detail on the proper roadmap to follow when trying to create valuation discounts via entities.
• Estate of Purdue v. Comr., T.C. Memo. 2015-249. In this case, the decedent and her husband transferred marketable securities, an interest in a building and other assets to an LLC. The decedent also made gifts annually to a Crummey-type trust from 2002 until death in 2007. Post-death, the beneficiaries made a loan to the decedent’s estate to pay the estate taxes. The estate deducted the interest payments as an administration expense. The court concluded that I.R.C. §2036 did not apply because the transfers to the LLC were bona fide and for full consideration. There was also a significant, non-tax reason present for forming the LLC and there was no commingling of the decedent’s personal assets with those of the LLC. In addition, both the decedent and her husband were in good health at that time the LLC was formed and the assets were transferred to it.
• Estate of Holliday v. Comr., T.C. Memo. 2016-51. The decedent’s predeceased husband established trusts and a family limited partnership (FLP). The FLP agreement stated that, “To the extent that the General Partner determines that the Partnership has sufficient funds in excess of its current operating needs to make distributions to the Partners, periodic distributions of Distributable Cash shall be made to the partners on a regular basis according to their respective Partnership Interests.” The decedent, who was living in a nursing home at the time the FLP was formed, contributed approximately $6 million of marketable securities to the FLP and held a 99.9 percent limited partner interest. Before death, the decedent received one check from the FLP (a pro-rata distribution of $35,000). At trial, the General Partner testified that he believed that the FLP language was merely boilerplate and that distributions weren’t made because “no one needed a distribution.” The court viewed the FLP language and the General Partner’s testimony as indicating that the decedent retained an implied right to the possession or enjoyment of the right to income from the property she had transferred to the FLP. The decedent also retained a large amount of valuable assets personally, thus defeating the General Partners’ arguments that distributions were not made to prevent theft and caregiver abuse. The court also noted that the FLP was not necessary for the stated purposes to protect the surviving spouse from others and for centralized management because trusts would have accomplished the same result. The decedent was also not involved in the decision whether to form an FLP or some other structure, indicating that she didn’t really express any desire to insure family assets remained in the family. The court also noted that there was no meaningful bargaining involved in establishing the FLP, with the family simply acquiescing to what the attorney suggested. The FLP also ignored the FLP agreement – no books and records were maintained, and no formal meetings were maintained.
Accordingly, the court determined that there was no non-tax purpose for the formation of the FLP, there was no bona fide sale of assets to the FLP and the decedent had retained an implied right to income from the FLP assets for life under I.R.C. §2036(c) causing inclusion of the FLP assets in the decedent’s estate.
• Estate of Beyer v. Comr., T.C. Memo. 2016-183. In this case, the decedent was in his upper 90s at the time of his death. He had never married and had no children, but he did have four sisters. The decedent had been the CFA of Abbott Lab and had acquired stock options from the company, starting exercising them in 1962 and had accumulated a great deal of Abbott stock. He formed a trust in 1999 and put 800,000 shares of Abbott stock into the trust. He amended the trust in 2001 and again in 2002. Ultimately, the decedent created another trust, and irrevocable trust, and it eventually ended up owning a limited partnership. Within three years of his death, the decedent made substantial gifts to family members from his living trust. Significant gifts were also made to the partnership.
The IRS claimed that the value of the assets that the decedent transferred via the trust were includable in the value of his gross estate under I.R.C. §2036(a). The estate claimed that the transfers to the partnership were designed to keep the Abbott stock in a block and keep his investment portfolio intact, and wanted to transition a family member into managing his assets. The IRS claimed that the sole purpose of the transfers to the partnership were to generate transfer tax savings. The partnership agreement contained a list of the purposes the decedent wanted to accomplish by forming the partnership. None of the decedent’s stated reasons for the transfers were in the list.
The court determined that the facts did not support the decedent’s claims and the transfers were properly included in his estate. The decedent also continued to use assets that he transferred to the partnership and did not retain sufficient assets outside of the partnership to pay his anticipated financial obligations. On the valuation issue, the court disallowed valuation discounts because the partnership held assets in a restricted management account where distributions of principal were prohibited.
As the cases point out, valuation discounts can be achieved even if asset management is consolidated. Also, it is important that the decedent/transferor is not financially dependent on distributions from the FLP/LLC, retains substantial assets outside of the entity to pay living expenses, does not commingle personal and entity funds, is in good health at the time of the transfers, and the entity follows all formalities of the entity structure. For gifted interests, it is important that the donees receive income from the interests. Their rights cannot be overly restricted. See, e.g., Estate of Wimmer v. Comr., T.C. Memo. 2012-157.
Appropriate drafting and planning are critical to preserve valuation discounts. Now that the onerous valuation regulations have been removed, they are planning opportunities. But, care must be taken.
Thursday, May 17, 2018
In 2016, the IRS issued new I.R.C. §2704 proposed regulations that could have seriously impacted the ability to generate valuation discounts associated with the transfer of family-owned entities. The effective date of the proposed regulation reached back to include valuations associated with any lapse of any right created on or after October 8, 1990 occurring on or after the date the proposed regulation was published in the Federal Register as a final regulation. This would have made it nearly impossible to avoid the application of the final regulation by various estate planning techniques.
With the election of President Trump and his subsequent instruction to federal agencies to eliminate unnecessary regulation, the Treasury announced the withdrawal of the I.R.C. §2704 proposed regulations in 2017. That means that valuation discounting as a planning tool is now back in the planner’s toolbox.
Today’s post is part one in a two-part series on valuation discounting in the context of a family limited partnership (FLP) and how the concept can be used properly, as well as the potential pitfalls. Today I look at the basics of valuation discounts and their use in the FLP context. In part two next week, I will examine some recent cases where the IRS has challenged the use of discounting and discuss what can be learned from the cases to properly structure FLPs and obtain valuation discounts.
Valuation Discounting – Interests in Family Limited Partnerships
While discounting can apply to interests in corporations, one of the most common vehicles for discounting is the family limited partnership (FLP). The principal objective of an FLP is to carry on a closely-held business where management and control are important. FLPs have non-tax advantages, but a significant tax advantage is the transfer of present value as well as future appreciation with reduced transfer tax. See, e.g., Estate of Kelley v. Comr., T.C. Memo, 2005-235. Discounts from fair market value in the range of 30-45 percent (combined) are common for minority interests and lack of marketability in closely-held entities. See Estate of Watts, T.C. Memo. 1985-595
Commonly in many family businesses, the parents contribute most of the partnership assets in exchange for general and limited partnership interests. The nature of the partnership interest and whether the transfer creates an assignee interest (an interest where giving the holder the right to income from the interest, but not ownership of the interest) with the assignee becoming a partner only upon the consent of the other partners, as well as state law and provisions in the partnership agreement that restrict liquidation and transfer of the partnership interest can result in discounts from the underlying partnership asset value.
In a typical scenario, the parents that own a family business establish an FLP with the interest of the general partnership totaling 10% of the company's value and the limited partnership's interest totaling 90%. Each year, both parents give each child limited-partnership shares with a market value not to exceed the gift tax annual exclusion amount. In this way, the parents progressively transfer business ownership to their children consistent with the present interest annual exclusion for gift tax purposes, and significantly lessen or eliminate estate taxes at death. Even if the limited partners (children) together own 99% of the company, the general partner (parents) will retain all control and the general partner is the only partnership interest with unlimited liability.
IRS has successfully limited or eliminated valuation discounts upon a finding of certain factors, such as formation shortly before death where the sole purpose for formation was to avoid estate tax or depress asset values with nothing of substance changed as a result of the formation. But, while an FLP formed without a business purpose may be ignored for income tax purposes, lack of business purpose should not prevent an FLP from being given effect for transfer tax purposes, thereby producing valuation discounts if it is formed in accordance with state law and the entity structure is respected.
Also, when an interest in a corporation or partnership is transferred to a family member, and the transferor and family members hold, immediately before the transfer, control of the entity any applicable restrictions (such as a restriction on liquidating the entity that the transferor and family members can collectively remove) are disregarded in valuing the transferred interest.
While the technical aspects of the various tax code provisions governing discounts are important and must be satisfied, the more basic planning aspects that establish the tax benefits of an FLP must not be overlooked:
• The parties must follow all requirements set forth in state law and the partnership agreement in all actions taken with respect to the partnership;
• The general partner must retain only those rights and powers normally associated with a general partnership interest under state law (no extraordinary powers);
• The partnership must hold only business or investment assets, and not assets for the personal use of the general partner, and;
• The general partner must report all partnership actions to the limited partners; and
• The limited partners must act to assure that the general partners do not exercise broader authorities over partnership affairs than those granted under state law and the partnership agreement.
FLPs and the IRC §2036 Problem
Clearly, the most litigated issue involving valuation discounting in the context of an FLP is whether assets contributed to an FLP/LLC should be included in the estate under §2036 (without a discount regarding restrictions applicable to the limited partnership interest). I.R.C. § 2036(a)(1) provides that a decedent’s gross estate includes the value of property previously transferred by the decedent if the decedent retained the possession or enjoyment of, or the right to the income from, the transferred property. I.R.C. §2036(a)(2) includes in the gross estate property previously transferred by the decedent if the decedent retained the right, either alone or in conjunction with any person, to designate the persons who are to possess or enjoy the transferred property or its income. However, an exception to the inclusion rules exists for transfers made pursuant to a bona fide sale for an adequate and full consideration in money or money’s worth.
About 40 cases have been decided at the appellate level involving I.R.C. §2036. Many of these have involved taxpayer losses. Part two next week will look at some of the most instructive cases involving I.R.C. §2036 and what planning pointers can be gleaned from those court decisions.
Tuesday, May 15, 2018
Many farm and ranch clients (and others) are asking about the appropriate entity structure for 2018 and going forward in light of the Tax Cuts and Jobs Act (TCJA). Some may be enticed to create a C corporation to get the 21 percent flat tax rate. Other, conversely, may think that a pass-through structure that can get a 20 percent qualified business income deduction is the way to go.
But, what is the correct approach? While the answer to that question depends on the particular facts of a given situation, if an existing C corporation elects S-corporate status, passive income can be a problem. The conversion from C to S may be desirable, for example, if corporate income is in the $50,000-$70,000 range. Under the TCJA, a C corporate income in that range would be taxed at 21 percent. Under prior law it would have been taxed at a lower rate – 15 percent on the first $50,000 of corporate taxable income.
Today’s post takes a look at a problem for S corporations that used to be C corporations – passive income.
S Corporation Passive Income
While S corporations are not subject to the accumulated earnings tax or the personal holding company tax (“penalty” taxes that are in addition to the regular corporate tax) as are C corporations, S corporations that have earnings and profits from prior C corporate years are subject to certain limits on passive investment income. I.R.C. §1362. Under I.R.C. §1375, a 21 percent tax is imposed on "excess net" passive income in the meantime if the corporation has C corporate earnings and profits at the end of the taxable year and greater than 25 percent of its gross receipts are from passive sources of income. For farm and ranch businesses, a major possible source of passive income is cash rent.
If passive income exceeds the 25% limit for three years, the S election is automatically terminated, and the corporation reverts to C status immediately at the end of that third taxable year. I.R.C. §1362(d)(3).
How Can Passive Income Be Avoided?
There may be several strategies that can be utilized to avoid passive income exceeding the 25 percent threshold. Here are some of the more common strategies:
Pre-paying expenses. The S corporation can avoid reporting any excess net passive income if the corporation is able to prepay sufficient expenses to offset all passive investment income and/or create negative net passive income.
Distribution of earnings and profits. In addition, another method for avoiding passive income issues is for the corporation to distribute all accumulated C corporate earnings and profits to shareholders before the end of the first S corporate year-end. I.R.C. §1375(a)(1). However, corporate shareholders will always have to deal with the problem of income tax liability that will be incurred upon the distribution of C corporate earnings and profits unless the corporation is liquidated. Generally, distributions of C corporate earnings and profits should occur when income taxation to the shareholders can be minimized. Consideration should be given to the effect that the distribution of earnings and profits will have upon the taxability of social security benefits for older shareholders. In order to make a distribution of accumulated C corporation earnings and profits, an S corporation within accumulated adjustments account (AAA) can, with the consent of all shareholders, treat distributions for any year is coming first from the subchapter C earnings and profits instead of the AAA. I.R.C. §1368(e)(3).
Deemed dividend election. If the corporation did not have sufficient cash to pay out the entire accumulated C corporation earnings and profits, the corporation may make a deemed dividend election (with the consent of all of the shareholders) under Treas. Reg. §1.1368-1(f)(3). Under this election, the corporation can be treated as having distributed all or part of its accumulated C corporate earnings and profits to the shareholders as of the last day of its taxable year. The shareholders, in turn, are deemed to have contributed the amount back to the corporation in a manner that increases stock basis. With the increased stock basis, the shareholders will be able to extract these proceeds in future years without additional taxation, as S corporate cash flow permits.
The election for a deemed dividend is made by attaching an election statement to the S corporation's timely filed original or amended Form 1120S. The election must state that the corporation is electing to make a deemed dividend under Treas. Reg. §1.1368-1(f)(3). Each shareholder who is deemed to receive a distribution during the tax year must consent to the election. Furthermore, the election must include the amount of the deemed dividend that is distributed to each shareholder. Treas. Reg. §1.1368-1(f)(5).
It should be noted that S corporation distributions are normally taxed to the shareholders as ordinary income dividends to the extent of accumulated earnings and profits (AE&P) after the accumulated adjustments account (AAA) and previously taxed income (pre-1983 S corporation undistributed earnings) have been distributed. Deemed dividends issued proportionately to all shareholders are not subject to one-class-of-stock issues and do not require payments of principal or interest.
A 20 percent tax rate applies for qualified dividends if AGI is greater than $450,000 (MFJ), $400,000 (single), $425,000 (HOH) and $225,000 (MFS). In addition, the 3.8 percent Medicare surtax on net investment income (NIIT) applies to qualified dividends if AGI exceeds $250,000 (MFJ) and $200,000 (single/HoH). However, if accumulated C corporate earnings and profits can be distributed while minimizing shareholder tax rates (keeping total AGI below the net investment income tax (NIIT) thresholds and avoiding AMT) qualified dividend distributions may be a good strategy.
The deemed dividend election can be for all or part of earnings and profits. Furthermore, the deemed dividend election automatically constitutes an election to distribute earnings and profits first as discussed above. The corporation may therefore be able to distribute sufficient cash dividends to the shareholders for them to pay the tax and to treat the balance as the deemed dividend portion. This can make it more affordable to eliminate or significantly reduce the corporation’s earnings and profits.
Modification of rental arrangements. Rents do not constitute passive investment income if the S corporation provides significant services or incurs substantial costs in conjunction with rental activities. Whether significant services are performed or substantial costs are incurred is a facts and circumstances determination. Treas. Reg. §1.1362-2(c)(5)(ii)(B)(2). The significant services test can be met by entering into a lease format that requires significant management involvement by the corporate officers.
For farm C corporations that switch to S corporate status, consideration should be given to entering into a net crop share lease (while retaining significant management decision-making authority) upon making the S election, as an alternative to a cash rent lease or a 50/50 crop share lease. Some form of bonus bushel clause is usually added to a net crop share lease in case a bumper crop is experienced or high crop sale prices result within a particular crop year. Net crop leases in the Midwest, for example, normally provide the landlord with approximately 30-33 percent of the corn and 38-40 percent of the beans grown on the real estate.
Since crop share income is generally not considered "passive" (if the significant management involvement test can be met), a net crop share lease should allow the corporation to limit involvement in the farming operation and avoid passive investment income traps unless the corporation has significant passive investment income from other sources (interest, dividends, etc.) such that passive investment income still exceeds 25 percent of gross receipts.
Other strategies. Gifts of stock to children or grandchildren could be considered so that dividends paid are taxed to those in lower tax brackets. However, tax benefits may be negated for children and grandchildren up to the age of 18–23 if they receive sufficient dividends to cause the "kiddie" tax rules to be invoked. In addition, a corporation may redeem a portion of the stock held by a deceased shareholder and treat such redemption as a capital gain redemption to the extent that the amount of the redemption does not exceed the sum of estate taxes, inheritance taxes and the amount of administration expenses of the estate. IRC §303. The capital gain reported is usually small or nonexistent due to step up in basis of a shareholder’s stock at date of death.
The TCJA may change the equation for the appropriate entity structure for a farm or ranch (or other business). If an existing C corporation elects S status, passive income may be an issue to watch out for.
Friday, May 11, 2018
I just finished up a week on the road with seminars on various ag law and tax topics. Next week is another one with a national tax webinar on Monday, and then an estate planning event for practitioners on Wednesday in Illinois and then the Iowa Bar Spring Tax Institute on Friday in Des Moines. The following week finds me in Indianapolis for an all-day ag tax seminar. This will be a busy year with discussions concerning the new tax law and it's impact on clients. Many of the more significant events are posted on washburnlaw.edu/waltr. There you will find a list of upcoming CPE events.
Summer Seminar in Pennsylvania
For numerous years, I have conducted a summer event or events in choice spots across the country. They provide a great place for practitioners to attend and bring the family and get some high-quality ag tax and estate planning CPE. This summer's event will be in Shippensburg, PA on June 7-8. The Gettysburg National Military Park is nearby and the ag areas of Lancaster County are also not that far away. Also within reasonable distance are Philadelphia and D.C. It's a beautiful part of the country.
You can find information on the PA seminar at: http://washburnlaw.edu/farmandranchtax. It's also webcast, so if you can't attend in person, you can still participate on line. It will be interactive so that you can ask questions and here and see the audience and the speakers. On-site seating is limited, so early registration is recommended.
I hope to see you at an event this summer or fall. Digging through the new tax law and then contemplating its application to client situations is a significant focus of these events. Clients are asking questions and it would be nice if the IRS/Treasury would issue guidance sooner rather than later. We shall see.
Wednesday, May 9, 2018
Under the typical Conservation Reserve Program (CRP) contract, farmland is placed in the CRP for a ten-year period. Contract extensions are available, and the landowner must maintain a grass cover on the ground which may involve planting appropriate wild grasses and other vegetation and to perform mid-contract maintenance of the enrolled land in accordance with USDA/FSA specifications.
But, what happens if the CRP land is sold even though several years remain on the contract? This is particularly the case when crop prices are relatively high and there is an economic incentive to put the CRP-enrolled land back into production.
The possible penalties and tax consequences of not keeping land in the CRP for the duration of the contract – that the topic of today’s post.
Consequences of Early Termination
When a landowner doesn’t keep land in the CRP for the full length of the contract, the landowner of the former CRP-enrolled land must pay back to the USDA all CRP rents already received, plus interest, and liquidated damages (which might be waived). That’s synonymous with a lessee’s termination of a lease when the obligations under the lease exceed the benefits. When that happens, and the lessee pays a cancellation fee to get out from underneath the lease, the lessee is generally allowed a deduction. The rationale for allowing a deduction is that the lessee does not receive a future benefit, as long as the lease cancellation payment is not integrated in some manner with the acquisition of another property right. If, however, the termination payment is part of a single overall plan involving the acquisition of an affirmative benefit, the taxpayer must capitalize the payment. See Priv. Ltr. Rul. 9607016 (Nov. 20, 1995). That would be the case, for instance, when a lessee terminates a lease by buying the leased property. I.R.C. §167(c)(2) bars an allocation of a portion of the cost to the leasehold interest. Thus, allocations to lease contracts by real estate purchasers of real estate are not effective. The taxpayer must allocate the entire adjusted basis to the underlying capital asset.
Sale Price Allocation To CRP Contract
The IRS has ruled that a taxpayer who sold the right to 90 percent of the revenue from three CRP contracts that had approximately 11 years remaining was required to report the lump sum payment as ordinary gross income in the year of receipt. C.C.A. 200519048 (Jan. 27, 2005). The taxpayer agreed to comply will all of the provisions of the CRP contract, with damage provisions applying if he failed to comply. The taxpayer’s return for the year of sale reported the entire amount received for the sale on Form 4835. On the following year’s return, the taxpayer included the annual CRP payment from the remaining 10 percent on Form 4835 and claimed a deduction for the part which sold the prior year. On the next year’s return, the taxpayer included the total CRP payment and did not offset it with the amount he received from the buyer. The taxpayer later filed amended returns to remove the amount reported as income on Form 4835 in the year of sale, and to remove the expense deduction that was claimed on the following year’s return. The taxpayer claimed that the lump-sum was not income in the year of sale because he did not have the unrestricted right to the funds (due to the damage clause applying in the event of noncompliance), and only held them as a conduit. The IRS disagreed, noting that the taxpayer had received the proceeds from the sale of the CRP contracts, with the risk of nonpayment by the USDA shifted to the purchaser. The IRS also stated that amounts received under a claim of right are includable in income, even though the taxpayer may have to repay some portion at a later date. In addition, the IRS noted that a lump sum payment for the right to future ordinary income generally results in ordinary income in the year of receipt. See, e.g., Cotlow v. Comr., 22 T.C. 1019 (1954), aff’d., 228 F.2d 186 (2nd Cir. 1955).
The acquiring farmer may pay the early termination costs. In such case, the payment should be considered part of the land, as an additional cost incurred to acquire full rights in the property (i.e., a payment made to eliminate an impediment to full use of the property).
Early Termination Payments
Generally. A lessor’s payment to the lessee to obtain cancelation of a lease that is not considered an amount paid to renew or renegotiate a lease is considered a capital expenditure subject to amortization by the lessor. Treas. Reg. §1.263(a)-4(d)(7). The amortization period depends on the intended use of the property subject to the canceled lease.
If the lessor pays a tenant for early termination to regain possession of the land, the termination costs should be capitalized and amortized over the lease’s remaining term. Rev. Rul. 71-283. However, if early termination costs are incurred solely to allow the sale of the farm, the costs should be added to the basis of the farmland and deducted as part of the sale.
As applied to CRP contracts. A landlord paying early CRP termination costs to enter into a new lease of farmland with another farmer will capitalize and amortize the costs over the remaining term of the CRP contract that is being terminated. That’s the case where a lease cancelation is not tied to substantial improvements that are to be made to the property. However, the IRS might claim that such costs should be amortized over the term of the new lease if the new lease is for a longer period that the remaining term of the CRP contract. However, the U.S. Court of Appeals for the Ninth Circuit has questioned this position, noting that the Tax Court decision seeming to bolster the IRS position relied on court cases that seemed to alternate between using the unexpired lease term versus the new lease term. Handlery Hotels, Inc. v. United States, 663 F.2d 892 (9th Cir. 1981). Thus, the general rule that lease cancelation costs should typically be written off over the unexpired term of the canceled lease.
The early disposition of a CRP contract carries with it some substantial consequences, both financial and tax. It’s important to understand what might happen if early termination is a possibility.
Monday, May 7, 2018
The popularity of e-filing taxes has now increased to the extent that more than 90 percent of all individual income tax returns are filed electronically. The vast majority of taxpayers that e-file find the process a simple and convenient way to file and, if a refund is due, a faster way to obtain it. But, is there any downside to e-filing? A recent federal case from California indicates that if a taxpayer isn’t diligent a big problem could arise.
The potential peril of e-filing – that’s the topic of today’s post.
In Spottiswood v. United States, No. 17-cv-00209-MEJ, 2018 U.S. Dist. LEXIS 69064 (N.D. Cal. Apr 24, 2018), the plaintiff electronically filed a joint return for the 2012 tax year via TurboTax software on April 12, 2013. The return contained an erroneous Social Security number for a dependent. The same day, the IRS rejected the return because the Social Security number and last name did not match IRS records. Later that same day, TurboTax sent the plaintiff an email notifying him that the return had been rejected due to the mismatch of the name and Social Security number for the dependent.
The email notification of the rejected return is exactly how the system is supposed to work. However, the plaintiff failed to check his email account and, hence, did not learn of the e-file status of the return until about 18 months later. Consequently, the IRS assessed late payment and late filing penalties.
The plaintiff filed the 2012 return on January 7, 2015 and paid the $395,619 tax liability in full. On February 16, 2015, the IRS assessed a late filing penalty of $89,014.27 and a late payment penalty of $41,539.99 plus interest of $26,216.81 on the late payment. The plaintiff paid the interest, but not the penalties. On April 27, 2015, the plaintiff submitted a statement to the IRS noting that had he realized that the return had not been accepted he could have paper filed the return on a timely basis. The plaintiff also conceded that he didn’t read the “fine print” of the tax software agreement that “may have” notified him that he needed to log back in to ensure that the return was accepted. The plaintiff, in August of 2016, filed a request via Form 843 for abatement of the penalties for late filing and late payment, and lied that the 2012 return had been electronically filed via TurboTax without issue. The plaintiff filed suit challenging the assessment of the penalties.
At trial, the plaintiff conceded the late payment penalty (and associated interest) but challenged the other penalties and interest assessed. The plaintiff claimed that the document filed should have been accepted as a “return” and should not have been rejected. The plaintiff claimed that the return met all of the requirements of Beard v. Comr., 82 T.C. 766 (1984) because it was sufficient to calculate the tax liability; purported to be a return; was an honest and reasonable attempt to satisfy the requirements of the tax law; and was executed under the penalty of perjury. The plaintiff also pointed out that the IRS would have accepted the return had it been paper-filed, citing the Internal Revenue Manual (IRM).
Unfortunately for the plaintiff, the trial court determined that the plaintiff had not properly established a foundation for the IRM, and did not create a triable issue of fact as to whether the same mistake on a paper-filed return would have been accepted by the IRS. Accordingly, the court held that the return, as filed, did not allow the IRS to compute the plaintiff’s tax liability (without providing any explanation of how a Social Security number mismatch had anything to do with computing tax liability) and granted the government’s motion for summary judgment.
While e-filing a return can be a desirable method for filing a return it is imperative to ensure that the IRS has accepted the return. Any type of communication that doesn’t involve direct, face-to-face communication has its drawbacks. When a return is e-filed, it’s a must to make sure that the return has been accepted. Diligently checking for an email verification is absolutely essential. Not doing so could be quite costly.
Thursday, May 3, 2018
Tort cases involve personal injuries or property damage. Most tort cases are based in negligence which is a fault-based system. That means that for a person to be deemed legally negligent, certain conditions must exist. These conditions can be thought of as links in a chain. Each condition must be present before a finding of negligence can be obtained. What are those links? They are duty, breach, causation and damages. The defendant must have owed the plaintiff a duty to act in a certain way; that duty was breached; and the breach of the duty caused the plaintiff’s damages.
Perhaps the trickiest of the links is the causation link. The requirement that the breach of the duty owed to the plaintiff must be causally linked to the plaintiff’s damages is the last issue to resolve in many tort cases. Tied to the concept of causality is reasonable foreseeability. Was it or should it have been reasonably foreseeable to the defendant at the time the defendant did whatever it was that the defendant did, that the defendant’s conduct would result in harm to the plaintiff?
Reasonable foreseeability - that’s the focus of today’s post.
As noted above, the resulting harm to the plaintiff must have been a reasonably foreseeable result of the defendant's conduct at the time the conduct occurred. Reasonable foreseeability is the essence of causality (also known as proximate cause). For instance, in a Colorado case that was decided by the U.S. Court of Federal Claims, a farmer claimed personal injury caused by drinking water contaminated by U.S. Army operations. The court not only questioned the existence of the farmer's personal injuries but held that the farmer failed to prove by a preponderance of the evidence (the legal standard applicable in a civil tort case) that his personal injuries and the cattle deaths were caused by the contaminated groundwater. Land v. United States, 35 Fed. Cl. 345 (1996).
Proximate cause can also be an issue (apart from negligence) with respect to coverage for an insured-against loss. In a Nebraska case, the court dealt with the proximate cause issue in determining whether an insurance policy on livestock covered damages resulting from an infectious disease transmitted by a tornado. The policy covered damage caused by windstorm, but not specifically cover damage caused by infectious disease. The court held that the proximate cause of the damage to the hogs at issue was the windstorm – without the windstorm, the hogs would not have been infected by the disease. Griess & Sons v. Farm Bureau Insurance Co., 247 Neb. 526, 528 N.W.2d 329 (1995).
The Palsgraf Case
Some things are reasonably foreseeable and other things are not; and an individual will be held liable for harm that is reasonably foreseeable or reasonably expected to result from the defendant's actions. For example, in one case a landowner was not liable for the death of a motorist that was stuck by a falling tree because eve thought the tree leaned over the road, there was no visible decay present and the landowner had no notice of a dangerous condition. Wade v. Howard., 499 S.E.2d 652 (Ga. Ct. App. 1998). This just reinforces the notion that there must be a causal connection - a causal linkage - between the defendant's action and the plaintiff's harm. On the other hand, a superseding cause is an intervening force that relieves an actor from liability for harm that the actor’s negligence was a substantial factor in producing. Thus, negligence that is too remote from the subsequent injury bars liability.”
Foreseeability may also be an issue with respect to the plaintiff. The famous case of Palsgraf v. Long Island Railroad Co., 248 N.Y. 339, 162 N.E. 99 (1928), is an example of an injury which was caused by an unbroken chain of events. The plaintiff was standing on a platform of the defendant's railroad after buying a ticket to ride one of the defendant’s trains. As the court described the facts: “[A] train stopped at the station, bound for another place. Two men ran forward to catch it. One of the men reached the platform of the car without mishap, though the train was already moving. The other man, carrying a package, jumped aboard the car, but seemed unsteady as if about to fall. A guard on the car, who had held the door open, reached forward to help him in, and another guard on the platform pushed him from behind. In this act, the package was dislodged, and fell upon the rails. It was a package of small size, about fifteen inches long, and was covered by a newspaper. In fact it contained fireworks, but there was nothing in its appearance to give notice of its contents. The fireworks when they fell exploded. The shock of the explosion threw down some scales at the other end of the platform many feet away. The scales struck the plaintiff, causing injuries for which she sues.”
Based on those facts, the court ruled that it was not foreseeable to a reasonable and prudent person that the actions which triggered the chain of events could ultimately cause injury to the plaintiff. The railroad was not legally responsible for the plaintiff’s injuries. For a modern version of Palsgraf, see Zokhrabov v. Park 963 N.E.2d 1035 (Ill. Ct. App. 2011).
Application to Agricultural Activities
It is possible that a negligent tort claim could be brought against a farmer that plants genetically modified (GM) crops if the crops cross-pollinate and contaminate a neighbor’s conventional crop. For the neighbor to prevail in court, the neighbor would have to prove that the farmer had a duty to prevent contamination, that the duty was breached (e.g., failure to select seed properly, adhere to specified buffer zones, or follow growing and harvesting procedures), and that the breach of the duty caused the neighbor’s damages, which were a reasonably foreseeable result of the farmer’s conduct. But is there a duty on the part of the farmer planting GM crops to prevent contamination when it is the convention crops that are the rarity? I don’t know the answer to that one. To date, no appellate-level court has rendered a published opinion in a negligence tort case involving genetically modified crops on that specific set of facts that I am aware of.
As noted above, the foreseeability of harm is generally a major factor that is considered in determining the existence of a duty. However, the Restatement (Third) of Torts states that the foreseeability of physical injury to a third party is not to be considered in determining whether there exists a duty to exercise reasonable care. That’s an interesting take, and at least one court has adopted the Restatement approach in holding that a landowner has a duty to exercise reasonable care to keep their premises in a manner that would not create hazards on adjoining roadways. See, e.g., Thompson v. Kaczinski, et al., 774 N.W.2d 829 (Iowa 2009), vac’g, 760 N.W.2d 211 (Iowa Ct. App. 2008). If that is the case, then there is a duty to maintain a premises. That would be of particular importance to a rural landowner.
Tuesday, May 1, 2018
Occasionally, farmers and ranchers are required to defend their livestock from harm caused by trespassing dogs. Many states have adopted statutes that permit dogs to be killed if they are caught in the act of harming domesticated animals. However, it is critical to follow the specifics of the applicable state statute allowing the killing of trespassing dogs. Failure to do so can result in a criminal charge of cruelty to animals.
Today’s post examines the issue of killing trespassing dogs.
Sample State Statutes
Here’s a sample of state “dog-kill” statutes:
Illinois (Illinois Comp. Stat. Ann. Chapter 510, Section 5, Subsection 18): “Any owner seeing his or her livestock, poultry, or equidae being injured, wounded, or killed by a dog, not accompanied by or not under the supervision of its owner, may kill such dog.”
Indiana (Indiana Code §15-20-2-2): “A person who observes a dog in the act of killing or injuring livestock may kill the dog if the person has the consent of the person in possession of the real estate on which the dog is found.”
Iowa (Iowa Code §351.26-.28): “It shall be lawful for any person, and the duty of all peace officers within their respective jurisdictions unless such jurisdiction shall have otherwise provided for the seizure and impoundment of dogs, to kill any dog for which a rabies vaccination tag is required, when the dog is not wearing a collar with rabies vaccination tag attached. It shall be lawful for any person to kill a dog, wearing a collar with a rabies vaccination tag attached, when the dog is caught in the act of chasing, maiming, or killing any domestic animal or fowl, or when such dog is attacking or attempting to bite a person. The owner of a dog shall be liable to an injured party for all damages done by the dog, when the dog is caught in the action of worrying, maiming, or killing a domestic animal.”
Kansas (Kansas Stat. Ann. §47-646): “It shall be lawful for any person at any time to kill any dog which may be found injuring or attempting to injure any livestock as defined in K.S.A. 47-1001, and amendments thereto.” The term “livestock” is defined in K.S.A. §47-1001 as meaning and including, “cattle, bison, swine, sheep, goats, horses, mules, domesticated deer, camelids, domestic poultry, domestic waterfowl, all creatures of the ratite family that are not indigenous to this state, including, but not limited to, ostriches, emus and rheas, and any other animal as deemed necessary by the [animal health commissioner of the department of agriculture] established through rules and regulations.”
Nebraska (Neb. Rev. Stat. §54-604): “Any person [,firm or corporation] shall have the right to kill any dog found [killing, wounding, injuring, worrying, or chasing any person or persons or any sheep or other domestic animals belonging to such person, firm, or corporation] doing any damage …to any sheep or domestic animal, or if he shall have just and reasonable ground to believe that such dog has been killing, wounding, chasing or worrying such sheep or animal; and no action shall be maintained for such killing.”
As can be noted from the above-cited state statutes, they all require certain conditions to be satisfied before a trespassing dog can be killed without legal ramifications. Essentially, the statutes require that the dog be “caught in the act” of doing some specified act to covered livestock. The statutory definitions of the acts described are important, as is the definition of the livestock that are covered. That makes it critical to preserve evidence showing that the statutory requirements have been met. For example, in Grabenstein v. Sunsted, 237 Mont. 254, 772 P.2d 865 (1989), a farmer shot a neighbor’s dog that had broken into the farmer’s chicken coop and had killed all but one of the chickens when the farmer found him in the pen trying to kill that chicken and shot him. The Court held that the farmer had a common law right to kill the dog in such a situation and that the later enactment of the dog-kill statute had not removed that right. It was of no importance that the dog was of much more value at the time it was shot than was the sole remaining chicken.
Failure to maintain strict compliance with a particular state’s dog-kill statute could result in the person killing the dog being convicted of cruelty to animals. Indeed, the Oregon cruelty to animal statute has been upheld against a constitutional challenge that it was vague and overbroad. State v. Thomas, 63 P.3d 1242 (Or. Ct. App. 2003). The court held that the Tenth Amendment does not prohibit the authority of states to regulate the conduct of its citizens. As a result, the statute under which the defendant was charged with first degree animal abuse for shooting neighbor’s dog was constitutional as not prohibited by Tenth Amendment. Also, in State v. Walter, 266 Mont. 429, 880 P.2d 1346 (1994), the Montana Supreme Court held that the defendant was properly found guilty by the trial court of the misdemeanor of cruelty to animals. The court determined that there was sufficient evidence that the defendant did not shoot the dog while it was in the act of doing any of the statutorily enumerated things that would give the defendant the right to shoot the dog. Also, in Propes v. Griffith, 25 S.W.3d 544 (Mo. Ct. App. 2000) the court held the defendant liable for actual and punitive damages for killing dogs that the defendant claimed were harming his sheep. The court determined there was insufficient evidence presented that the dogs were “killing, wounding or chasing” the sheep as required by state law.
Most dog-kill statutes are only designed to protect livestock-type animals. For example, dogs are not “livestock” for purposes of the typical state statute. See, e.g., People v. Bugaiski, 224 Mich. App. 241, 568 N.W.2d 391 (1997). In addition, deer are usually not defined as “livestock.” Thus, there is no statutory protection for shooting a dog while in the act of attacking deer. See, e.g., Bueckner v. Hamel, 886 S.W.2d 368 (Tex. App. 1994). Similarly, the usually is no statutory protection under a “dog-kill” statute for the killing a dog while in the act of attacking a household pet, such as a kitten. See, e.g., McKinney v. Robbins, 319 Ark. 596, 892 S.W.2d 502 (1995).
Trespassing dogs can be a big problem for farmers and ranchers. When they are shot in the act of damaging livestock as defined by the applicable state statute, they can be shot without repercussion. However, of course, the dog owner will likely not be happy and neighborly relationships can be damaged. As always, its good to have a conversation with neighbors about dogs and livestock so that potential problems can be minimized. For many farmers and ranchers, the “shoot, shovel and shut-up” approach may seem like the best and most practical approach. But, it can lead to problems – both interpersonal and legal.
Friday, April 27, 2018
When a farmer sells an harvested crop, the tax rules surrounding the reporting of the income from the sale are fairly well understood. But, what happens when a farmer dies during the growing season? The tax issues are more complicated with the tax treatment of the sale tied to the status of the decedent at the time of death – whether the decedent was a farmer or a landlord. If the decedent was a landlord, the type of lease matters.
The tax rules involving the post-death sale of crops and livestock – that’s the focus of today’s post.
For income tax purposes, the basis of property in the hands of the decedent’s heir or the person otherwise acquiring the property from a decedent is the property’s FMV as of the date of the decedent’s death. I.R.C. §1014(a)(1). But, there is an exception to this general rule. Income in respect of decedent (IRD) property does not receive any step-up in basis. I.R.C. §691. IRD is taxable income the taxpayer earned before death that is received after death. IRD is not included on the decedent’s final income tax return because the taxpayer was not eligible to collect the income before death.
In Estate of Peterson v. Comm’r, 667 F.2d 675 (8th Cir. 1981), the Tax Court set forth four requirements for determining whether post-death sales proceeds are IRD.
- The decedent entered into a legal agreement regarding the subject matter of the sale.
- The decedent performed the substantive acts required as preconditions to the sale (i.e., the subject matter of the sale was in a deliverable state on the date of the decedent’s death).
- No economically material contingencies that might have disrupted the sale existed at the time of death.
- The decedent would have eventually received (actually or constructively) the sale proceeds if he had lived.
The case involved the sale of calves by a decedent’s estate. Two-thirds of the calves were deliverable on the date of the decedent’s death. The other third were too young to be weaned as of the decedent’s death and the decedent’s estate had to feed and raise the calves until they were old enough to be delivered. The court held that the proceeds were not IRD because a significant number of the calves were not in a deliverable state as of the date of the decedent’s death. In addition, the estate’s activities with respect to the calves were substantial and essential. The Tax Court held that all four requirements had to be satisfied for the income to be IRD, and the second requirement was not satisfied.
Farmer or Landlord?
Classifying income as IRD depends on the status of the decedent at the time of death. The following two questions are relevant.
- Was the decedent an operating farmer or a farm landlord at the time of death? If the decedent was a farm landlord, the type of lease matters.
- If the decedent was a farm landlord, was the decedent a materially participating landlord or a non-materially participating landlord?
For operating farmers (including materially participating farm landlords), unsold livestock, growing crops, and grain inventories are not IRD. Rev. Rul. 58-436, 1958-2 CB 366. See also Estate of Burnett v. Comm’r, 2 TC 897 (1943). The rule is the same if the decedent was a landlord under a material participation lease. These assets are included in the decedent’s gross estate and receive a new basis equal to their FMV as of the decedent’s date of death under IRC §1014. No allocation is made between the decedent’s estate and the decedent’s final income tax return. Treas. Reg. §20.2031-1(b).
From an income tax perspective, all of the growing costs incurred by the farmer before death are deducted on the decedent's income tax return. At the time of death, the FMV of the growing crop established in accordance with a formula is treated as inventory and deducted as sold. The remaining costs incurred after death are also deducted by the decedent's estate. In many cases, it may be possible to achieve close to a double deduction.
If a cash-basis landlord rents out land under a non-material participation lease, the landlord normally includes the rent in income when the crop share is reduced to cash or a cash equivalent, not when the crop share is first delivered to the landlord. In this situation, a portion of the growing crops or crop shares or livestock that are sold post-death are IRD and a portion are post-death ordinary income to the landlord’s estate. That is the result if the crop share is received by the landlord before death but is not reduced to cash until after death. It is also the result if the decedent had the right to receive the crop share, and the share is delivered to the landlord’s estate and then reduced to cash. In essence, for a decedent on the cash method, an allocation is made with the portion of the proceeds allocable to the pre-death period (in both situations) being IRD in accordance with a formula set forth in Rev. Rul. 64-289, 1964-2 CB 173 (1964). That formula splits out the IRD and estate income based on the number of days in the rental period before and after death with the IRD portion being attributable to the days before death. If the decedent dies after the crop share is sold (but before the end of the rental period), the proceeds would have been reported on the decedent’s final return. No prorations would have been required. If the decedent’s crop share is held until death, when the heirs sell the crop share, the proceeds are allocated between IRD and ordinary income of the decedent’s estate under the formula.
IRD results from crop share rents of a non-materially participating landlord that are fed to livestock before the landlord’s death if the animals are also owned on shares. If the decedent utilized the livestock as a separate operation from the lease, the in-kind crop share rents (e.g., hay, grain) are treated as any other asset in the farming operation — included in the decedent’s gross estate and entitled to a date-of-death FMV basis.
Crop share rents fed to livestock after the landlord’s death are treated as a sale at the time of feeding with an offsetting deduction. Rev. Rul. 75-11, 1975-1 CB 27.
Character of Gain
Sale of grain. Grain that is raised by a farmer and held for sale or for feeding to livestock is inventory in the hands of the farmer. Upon the subsequent sale of the grain, the proceeds are treated as ordinary income for income tax purposes. I.R.C. §§61(a)(2), 63(b). However, when a farmer dies and the estate sells grain inventory within six months after death, the income from the sale is treated as long-term capital gain if the basis in the crops was determined under the IRC §1014 date-of-death FMV rule. I.R.C. §1223(9). However, ordinary income treatment occurs in the crop was raised on land that is leased to a tenant. See, e.g., Bidart Brothers v. U.S., 262 F.2d 607 (9th Cir. 1959).
If the decedent operated the farming business in a partnership or corporation and the entity is liquidated upon the decedent’s death, the grain that is distributed from the entity may be converted from inventory to a capital asset. See, e.g., Greenspon v. Comm’r, 229 F.2d 947 (8th Cir. 1956). However, to get capital asset status in the hands of a partner or shareholder, the partner or shareholder cannot use the grain as inventory in a trade or business. Baker v. Comm’r, 248 F.2d 893 (5th Cir. 1957). That status is most likely to be achieved, therefore, when the partner or shareholder does not continue in a farming business after the entity’s liquidation.
The sale of crops and livestock post-death are governed by specific tax rules. Because death often occurs during a growing period, it’s important to know these unique rules.
Wednesday, April 25, 2018
Cash method farm proprietors have had several situations where gifts of farm commodities to family members are advantageous. The commodity gifts can be used to shift income to minor children to take advantage of their lower tax rates. Likewise, they could be used to assist with a child’s college costs or made to a child in return for the child support the donor-parents.
How should commodity gift transactions be structured? What are the tax consequences? What is the impact of the Tax Cuts and Jobs Act (TCJA) on commodity gifts to children.
Ag commodity gifts to children. That’s the topic of today’s post.
Tax Consequences to the Donor.
Avoid income and self-employment tax. A donor does not recognize income upon a gift of unsold grain inventory. Rev. Rul. 55-138, 1955-1 C.B. 223; Rev. Rul. 55-531, 1955-2 C.B. 520. Instead, a gift of unsold raised farm commodities represents a transfer of an asset (i.e., inventory) rather than an assignment of income. Estate of Farrier v. Comr., 15 T.C. 277 (1950); SoRelle v. Comr., 22 T.C. 459 (1954); Romine v. Comr., 25 T.C. 859 (1956). That means that the farmer, as the donor, sidesteps the income tax on commodities that are transferred by gift to another taxpayer. Further, self-employment tax is also eliminated on the commodities. That’s because excludable gross income is not considered in determining self-employment income. Treas. Reg. 1.1402(a)-2(a). This is particularly beneficial for donor-parents that have income under the Social Security wage base threshold.
Prior year’s crop. The gifted commodities should have been raised or produced in a prior tax year. If this is not the case, the IRS takes the position that a farmer is not 100 percent in the business of raising agricultural commodities for profit and will require that a pro rata share of the expenses of raising the gifted commodity will not be deductible on the farmer’s tax return. According to the IRS, if a current year’s crop is gifted, the donor’s opening inventory must be reduced for any costs or undeducted expenses relating to the transferred property. Rev. Rul. 55-138, 1955-1, C.B. 223. That means that the donor cannot deduct current year costs applicable to the commodity. See also Rev. Rul. 55-531, 1955-2 C.B. 522. However, costs deducted on prior returns are allowed. Thus, a farmer reporting on a calendar year basis under the cash method is allowed full deductibility of expenses if a gift of raised commodity is not made until the tax year after harvest (i.e., the grain which is the subject of the gift was raised in a year prior to the gift, and all associated expenses would have been deducted in the prior year).
Tax consequences to the Donee.
The donor's tax basis in the commodity carries over to the donee. I.R.C. §1015(a). Thus, in the case of raised commodities given in the year after harvest by a cash method producer, the donee receives the donor’s zero basis. Conversely, an accrual method farmer will have an income tax basis in raised commodities. If this tax basis approaches the market value of the commodity, there will be little income shifting accomplished from a gift.
Assuming that the donee has not materially participated in the production of the commodity, the income from the sale of the commodity by the donee is treated as unearned income that is not subject to self-employment tax. Even though the raised farm commodity was inventory in the hands of the farmer-donor, the asset will typically not have inventory status in the hands of the done. That means the sale transaction is treated as the sale of a capital asset that is reported on Schedule D.
The holding period of an asset in the hands of a donee refers back to the holding period of the donor. I.R.C. §1223(2). So, if the donee holds the commodity for more than a year after the harvest date, the donee has long-term capital gain or loss.
Gifts of Livestock?
A donee who receives raised animals and takes responsibility for the care and feeding of these animals after the date of gift may face the risk of materially participating in the raising of the animals, and thus be subject to self-employment tax. To help avoid that result, physical segregation of the livestock at the time of gift is helpful, and any post-gift maintenance expenses for the animals should be paid by the donees. See, e.g., Smith v. Comr., T.C. Memo. 1967-229; Alexander v. Comr., 194 F.2d 921 (5th Cir. 1952); Jones Livestock Feeding Co., T.C. Memo. 1967-57; Urbanovsky v. Comr., T.C. Memo. 1965-276.
Structuring the Transaction
Cash-method farm proprietors intending to gift raised commodities to a child or other non-charitable donee should structure the transaction in two distinct steps. First, the donor makes a gift of unsold inventory, using prior year crop or commodity, and documents the transfer of the title/ownership in the commodity as transferred to the donee. Second, the donee independently and at a later date accomplishes a sale of the commodity, recognizing income because of the zero basis in the commodity. The income is reported typically as a short-term capital gain. The donee, as the owner of the sold commodity, must retain full ownership and control of the sale proceeds from the commodity. Make sure that the transaction is not a loan.
“Kiddie Tax” Complications
Unearned income of a dependent child includes items such as interest, dividends and rents, as well as income recognized from the sale of raised grain received as a gift and not as compensation for services. The “Kiddie Tax” has a small inflation-indexed exemption. I.R.C. §1(g). For dependent children who sell commodities received as a gift and are subject to the” Kiddie Tax,” a standard deduction offsets the first $1,000 of unearned income (2017 amount). Then the next $1,000 of unearned income is subject to tax at the child’s single tax rate of 10 percent. That means that the child’s unearned income in excess of $2,100 is taxed at the parents’ top tax rate.
The Kiddie Tax applies to a child who has not attained age 18 before the close of the year. It also applies to a child who has not attained the age of 19 as of the close of the year or is at least age 19 and under 24 at the close of the year and is a full-time student at an educational organization during at least five months of the year and the child’s earned income didn’t exceed one-half of the child’s own support for the year (excluding scholarships).
TCJA modification. As noted above, under pre-TCJA law, the child who receives a commodity gift and then sells the commodity usually pays income taxes based on the parent’s tax rates (there is a smaller amount taxed at lower rates) on unearned income. Earned income, such as wages, is always taxed at the child’s tax rates. But, under the TCJA for tax years beginning after 2017, the child’s tax rates on unearned income are the same as the tax rates (and brackets) for estates and trusts. That means that once the child’s unearned income reaches $12,500, the applicable tax rate is 37 percent on all unearned income above that amount. This will make it much costlier for farm families to gift grain to their children or grandchildren and receive any tax savings.
Gifting commodities to a family member can produce significant tax savings for the donor, and also provide assistance to the donee. That was much more likely to be the result pre-2018. The TCJA removes much of the tax benefit of commodity gifting to children. In any event, however, the commodity gifting transactions must be structured properly to achieve the intended tax benefits.
Monday, April 23, 2018
The Tax Cuts and Jobs Act (TCJA) constituted a major overhaul of the tax Code for both individuals and businesses. In previous posts, I have examined some of those provisions. In particular, I have taken a look at the new I.R.C. §199A and its impact on agricultural producers and cooperatives. Recently the IRS Commissioner told the Senate Finance Committee that it would take “years” to finish writing all of the rules needed to clarify the many TCJA provisions and provide the interpretation of the IRS. But, recently the IRS did clarify how “alimony trusts” are to work for divorces entered into before 2019.
The alimony tax rules and “alimony trusts”, that’s the focus of today’s blog post.
Tax treatment of alimony. For divorce agreements entered into before 2019, “alimony or separate maintenance payment” is taxable to the recipient and deductible to the payor. I.R.C. §71. What is an alimony or separate maintenance payment? It’s any payment received by or on behalf of a spouse (or former spouse) of the payor under a divorce or separate maintenance agreement that meets certain basic requirements: 1) the payment is made in cash (checks and money orders) pursuant to a decree, court order or written agreement; 2) the payment is not designated as a payment which is excludible from the gross income of the payee and non-deductible by the payor; 3) for spouses legally separated under a decree of divorce or separate maintenance, the spouses are not members of the same household at the time payment is made; 4) the payor has no liability to continue to make any payment after the payee’s death and the divorce or separation instrument states that there is no such liability. I.R.C. §71(b)(1). It’s also possible that a settlement requiring or allowing the paying spouse to make payments directly to third parties for the benefit of the other spouse (such as for medical treatment, life insurance premiums or mortgage payments, for example) can result in the payments being treated as alimony as long as they do not benefit the paying spouse or property owned by the paying spouse.
It is possible, however, to specify in a separation agreement or divorce decree that such payments escape taxation in the hands of the recipient (and not give rise to a deduction in the hands of the payor-spouse). Conversely, child support and property settlements are tax neutral – neither party pays tax nor gets a deduction. I.R.C. §71(c).
Another rule specifies that if the payor owes both alimony and child support, but pays less than the total amount owed, the payments apply first to child support and then to alimony. If the separation agreement does not specify separate alimony and child support payments, general “family support” payments are treated as child support for tax purposes, unless the alimony qualifications are met.
Planning point. This tax treatment raises an interesting planning point. In general, when the higher income spouse makes payments to the lower-income spouse, the payments should be structured as alimony because the deduction can be available to the spouse in the higher tax bracket and, concomitantly, the income will be taxable to the spouse in the lower tax bracket. If the spouse making payments is not in the higher income tax bracket (perhaps because of high levels of tax-exempt income such as disability payments), it makes more sense to structure the payments as child support or as a property settlement, or simply specify in the agreement that the alimony is not taxable to the recipient.
What about trusts? During marriage, one spouse may have created an irrevocable trust for the benefit of the other spouse. In that situation, I.R.C. §672(e)(1)(A) makes the trust a “grantor” trust with the result that the income of the trust is taxed to the spouse that created the trust. If the couple later divorces, the trust remains. It’s an irrevocable trust. The divorce doesn’t change the nature or tax status of the trust – the spouse (now ex-spouse) that created the trust must continue to pay tax on trust income. That’s probably both an unexpected and unhappy result for the spouse that created the trust. That’s why (at least through 2018) I.R.C. §682(a) provides that the spouse that didn’t create the trust is taxed on the trust income, except for capital gain. Capital gain income remains taxable to the spouse that created the trust. In essence, then, the “payee” spouse is considered to be the trust beneficiary. I.R.C. §682(b).
Reversing tax treatment of alimony. Under the TCJA, for agreements entered into after 2018, alimony and separate maintenance payments are not deductible by the payor- spouse, and they are not included in the recipient-spouse’s income. Title I, Subtitle A, Part V, Sec. 11051. This modification conforms alimony tax provisions to the U.S. Supreme Court’s opinion in Gould v. Gould, 245 U.S. 151 (1917). In that case, the Court held that alimony payments are not income to the recipient.
Under the TCJA, income that is used for alimony payments is taxed at the rates applicable to the payor spouse rather than the recipient spouse. The treatment of child support remains unchanged.
Impact on “alimony trusts.” However, the TCJA also struck I.R.C. §682 from the Code as applied to any divorce or separation instrument executed after 2018, and any divorce or separation agreement executed before the end of 2018 that is modified after 2018 if the modification provides that the TCJA amendments are to apply to the modification.
With the coming repeal of I.R.C. §682, what will happen to “alimony trusts” that were created before the repeal? IRS has now answered that question. According to IRS Notice 2018-37, IRB 2018-18, regulations will be issued stating that I.R.C. §682 will continue to apply to these trusts. That means that the “beneficiary” spouse will continue to be taxed on the trust income. But, the IRS points out that this tax treatment only applies to couples divorced (or legally separated) under a divorce or separation agreement executed on or before December 31, 2018. The only exception is if such an agreement is modified after that date and the modification says that the TCJA provisions are to apply to the modification.
What happens to “alimony trusts” executed after 2018? The spouse that creates the trust will be taxed on the trust income under the “grantor trust” rules. That’s because I.R.C. §672(e)(1) will continue to apply. Some taxpayers finding themselves in this position may want to terminate grantor trust treatment in the event of divorce. A qualified terminable interest property (QTIP) trust may be desired. Another approach may be to have a provision drafted into the language of the trust that says that the spouse creating the trust will be reimbursed for any tax obligation post-divorce attributable to the trust.
The IRS is requesting comments be submitted by July 11, 2018.
The TCJA changed many tax Code provisions. The alimony rules are only a small sample of what was changed. If you haven’t done so already, find a good tax practitioner and get to know them well. Tax planning for 2018 and beyond has already begun.