Monday, October 22, 2018
The purpose of the Clean Water Act (CWA) is to eliminate the discharge of pollutants into the nation's waters without a permit. The CWA recognizes two sources of pollution. Point source and nonpoint source pollution. Under the CWA, point source pollution is the concern of the federal government and it is the type of pollution that comes from a clearly discernable discharge point, such as a pipe, a ditch, or a concentrated animal feeding operation. Nonpoint source pollution, while not specifically defined under the CWA, is pollution that comes from a diffused point of discharge, such as fertilizer runoff from an open field. Control of nonpoint source pollution is to be handled by the states through enforcement of state water quality standards and area-wide waste management plans.
What if pollution enters CWA-regulated waters (“Waters of the United States”) through groundwater? Is groundwater a point source of pollution? If so, that has serious implications for agriculture. A recent federal appeals court opinion brings good news for agriculture. It also creates a split amongst the courts that the U.S. Supreme Court may be asked to resolve.
Groundwater and point-source pollution – that’s the topic of today’s post.
The CWA and “Point Source” Pollution
No one may discharge a “pollutant” from a point source into the “navigable waters of the United States” without a permit from the EPA. An NPDES permit is not required unless there is an “addition” of a pollutant to regulable waters. See e.g., Friends of the Everglades, et al. v. South Florida Water Management District, et al., 570 F.3d 1210 (11th Cir. 2009) reh’g., den., 605 F.3d 962 (11th Cir. 2010), cert. den., 131 S. Ct. 643 (2010).
The definition of “pollutant” has been construed broadly to include the tillage of soil which causes the soil to be “redeposited” into delineated wetlands constitutes the discharge of a “pollutant” into the navigable waters of the United States requiring an NPDES permit. See, Duarte Nursery, Inc. v. United States Army Corps of Engineers , No. 2:13-cv-02095-KJM-AC, 2016 U.S. Dist. LEXIS 76037 (E.D. Cal. Jun. 10, 2016). The court also determined that farming equipment, a tractor and ripper attachment constituted a point source pollutant under the CWA. The discharge was not exempt under the “established farming operation” exemption of 33 U.S.C. §1344(f)(1) because farming activities on the tract had not been established and on-going but had been grazed since 1988. As a result, the planting of wheat could not be considered a continuation of established and on-going farming activities. Id.
Under 1977 amendments to the CWA, irrigation return flows are not considered point sources. See, e.g., Pacific Coast Federation of Fishermen’s Associations, et al. v. Glaser, et al., No. CIV S-2:11-2980-KJM-CKD, 2013 U.S. Dist. LEXIS 132240 (E.D. Cal. Sept. 16, 2013). In Pacific Coast, the plaintiff directly challenged the exemption of tile drainage systems from CWA regulation via “return flows from irrigated water” on the basis that groundwater discharged from drainage tile systems is separate from any irrigation occurring on farms and is, therefore, not exempt. In dismissing the case, the court also noted that “return flows” narrows the type of water permissibly discharged from irrigated agriculture and covers discharges from irrigated agriculture that don’t contain additional discharges unrelated to crop production.
What About Groundwater?
The NPDES system only applies to discharges of pollutants into surface water. Discharges of pollutants into groundwater are not subject to the NPDES permit requirement even if the groundwater is hydrologically connected to surface water. Indeed, the legislative history of the CWA demonstrates that the Congress, did not intend that the CWA regulate hydrologically-connected groundwater. Groundwater regulation was to be left to the states as nonpoint source pollution. See, e.g., Umatilla Water Quality Protective Association v. Smith Frozen Foods, 962 F. Supp. 1312 (D. Or. 1997).
While it seems clear that the CWA was never intended to apply to pollution discharges into groundwater that eventually finds its way into a WOTUS, in recent years a split has developed between a few of the federal circuit courts of appeal. For example, in Upstate Forever, et al. v. Kinder Morgan Energy Partners, LP, et al., 887 F.3d 637 (4th Cir. 2018), the plaintiffs, a consortium of environmental and conservation groups, brought a citizen suit under the Clean Water Act (CWA) claiming that the defendant violated the CWA by discharging “pollutants” into the navigable waters of the United States without a required discharge permit via an underground ruptured gasoline pipeline owned by the defendant’s subsidiary. The plaintiff claimed that a discharge permit was needed because the CWA defines “point source pollutant” (which requires a discharge permit) as “any discernible, confined and discrete conveyance, included but not limited to any…well…from which pollutants are or may be discharged.”
The trial court dismissed the plaintiffs’ claim, but the appellate court held that a pollutant can first move through groundwater before reaching navigable waters and still constitute a “discharge of a pollutant” under the CWA that requires a federal discharge permit. The discharge need not be channeled by a point source until reaching navigable waters that are subject to the CWA. The appellate court did, however, point out that a discharge into groundwater does not always mean that a CWA discharge permit is required. A permit in such situations is only required if there is a direct hydrological connection between groundwater and navigable waters. In the present case, however, the appellate court noted that the pipeline rupture occurred within 1,000 feet of the navigable waters. The court noted that the defendant had not established any independent or contributing cause of pollution.
Similarly, in Hawai’i Wildlife Fund v. Cty. of Maui, 881 F.3d 754 (9th Cir. 2018), the defendant owned and operated four wells at the Lahaina Wastewater Reclamation Facility (LWRF), which is the principal municipal wastewater treatment plant for a city. Although constructed initially to serve as a backup disposal method for water reclamation, the wells became the defendant’s primary means of effluent disposal into groundwater and, ultimately, the Pacific Ocean. The LWRF received approximately 4 million gallons of sewage per day from a collection system serving approximately 40,000 people. That sewage was treated at LWRF and then either sold to customers for irrigation purposes or injected into the wells for disposal. The defendant injected approximately 3 to 5 million gallons of treated wastewater per day into the groundwater via its wells. The defendant conceded, and its expert, confirmed that wastewater injected into wells 1 and 2 enters the Pacific Ocean. In addition, in June 2013 the EPA, the Hawaii Department of Health, the U.S. Army Engineer Research and Development Center, and researchers from the University of Hawaii conducted a study on wells 2, 3 and 4. The study involved placing tracer dye into Wells 2, 3, and 4, and monitoring the submarine seeps off Kahekili Beach to see if and when the dye would appear in the Pacific Ocean. This study, known as the Tracer Dye Study, found that 64% of the treated wastewater from wells 3 and 4 discharged into the ocean.
The plaintiff sued, claiming that the defendant was in violation CWA by discharging pollutants into a WOTUS without a permit. The trial court agreed, holding that a permit was required for effluent discharges into navigable waters via groundwater. On appeal, the appellate court held that the wells were point sources that could be regulated through CWA permits despite the defendant’s claim that a permit was not required because the wells discharged only indirectly into the Pacific Ocean via groundwater. Specifically, the appellate court held that “a point source discharge to groundwater of “more than [a] de minimis” amount of pollutants that is “fairly traceable from the point source . . . such that the discharge is the functional equivalent of a discharge into a navigable water” is regulated under the CWA.”
A recent decision by the U.S. Circuit Court of Appeals for the Sixth Circuit, however, reached a different decision. In Tennessee Clean Water Network v. Tennessee Valley Authority, No. 17-6155, 2018 U.S. App. LEXIS 27237 (6th Cir. Sept. 24, 2018). The defendant, a utility that burns coal to produce energy, produces coal ash as a byproduct. The coal ash is discharged into man-made ponds. The plaintiffs, environmental activist groups, claimed that the chemicals from the coal ash in the ponds leaked into surrounding groundwater where it was then carried to a nearby lake that was subject to regulation under the Clean Water Act (CWA). The plaintiffs claimed that the contamination of the lake without a discharge permit violated the CWA and the Resource Conservation and Recovery Act (RCRA). The trial court had dismissed the RCRA claim but the appellate court reversed that determination and remanded the case on that issue.
On the CWA claim, the trial court ruled as a matter of law that the CWA applies to discharges of pollutants from a point source through hydrologically connected groundwater to navigable waters where the connection is "direct, immediate, and can generally be traced." The trial court held that the defendant’s facility was a point source because it "channel[s] the flow of pollutants . . . by forming a discrete, unlined concentration of coal ash," and that the Complex is also a point source because it is "a series of discernible, confined, and discrete ponds that receive wastewater, treat that wastewater, and ultimately convey it to the Cumberland River." The trial court also determined that the defendant’s facility and the ponds were hydrologically connected to the Cumberland River by groundwater. As for the defendant’s facility, the court held that "[f]aced with an impoundment that has leaked in the past and no evidence of any reason that it would have stopped leaking, the Court has no choice but to conclude that the [defendant’s facility] has continued to and will continue to leak coal ash waste into the Cumberland River, through rainwater vertically penetrating the Site, groundwater laterally penetrating the Site, or both." The trial court determined that the physical properties of the terrain made the area “prone to the continued development of ever newer sinkholes or other karst features." Thus, based on the contaminants flowing from the ponds, the court found defendant to be in violation of the CWA. The trial court also determined that the leakage was in violation of the defendant “removed-substances” and “sanitary-sewer” overflow provisions. The trial court ordered the defendant to "fully excavate" the coal ash in the ponds (13.8 million cubic yards in total) and relocate it to a lined facility.
On further review, the appellate court reversed. The appellate court held that the CWA does not apply to point source pollution that reaches surface water by means of groundwater movement. The appellate court rejected the plaintiffs’ assertion that mere groundwater is equivalent to a discernable point source through which pollutants travel to a CWA-regulated body of water. The appellate court noted that, to constitute a “conveyance” of groundwater governed by the CWA, the conveyance must be discernible, confined and discrete. While groundwater may constitute a conveyance, the appellate court reasoned that it is neither discernible, confined nor discrete. Rather, the court noted that groundwater is a “diffuse medium” that “seeps in all directions, guided only by the general pull of gravity. This it [groundwater] is neither confined nor discrete.” In addition, the appellate court noted that the CWA only regulates pollutants “…that are added to navigable waters from any point source.” In so holding, the court rejected the holdings in of the prior decisions of the Fourth and Ninth Circuits.
The Sixth Circuit’s decision is a breath of fresh air for agriculture. It is the state’s responsibility to regulate nonpoint source pollution. A hydrological connection was never intended to suffice for federal jurisdiction under the CWA, and the Sixth Circuit said that the other courts finding as such was “misguided.” The Sixth Circuit stated, “Reading the CWA to extend liability to groundwater pollution is not the best one.”
Groundwater is not a point source. The Sixth Circuit’s opinion has big implications for agricultural farming activities and will help keep the federal government out of the farm field in Kentucky, Michigan, Ohio and Tennessee. It’s also likely that the U.S. Supreme Court will be asked to clear up the split between the circuit courts. Stay tuned.
Thursday, October 18, 2018
For the Spring 2019 academic semester, Kansas State University will be offering my Agricultural Law and Economics course online. No matter where you are located, you can enroll in the course and participate in it as if you were present with the students in the on-campus classroom.
Details of next spring’s online Ag Law course – that’s the topic of today’s post.
The course provides a broad overview of many of the issues that a farmer, rancher, rural landowner, ag lender or other agribusiness will encounter on a daily basis. As a result, the course looks at contract issues for the purchase and sale of agricultural goods; the peril of oral contracts; the distinction between a lease and a contract (and why the distinction matters); and the key components of a farm lease, hunting lease, wind energy lease, oil and gas lease, and other types of common agricultural contractual matters. What are the rules surrounding ag goods purchased at auction?
Ag financing situations are also covered – what it takes to provide security to a lender when financing the purchase of personal property to be used in the farming business. In addition, the unique rules surrounding farm bankruptcy is covered, including the unique tax treatment provided to a farmer in Chapter 12 bankruptcy.
Of course, farm income tax is an important part of the course. Tax planning is perhaps the most important aspect of the farming business that every day decisions have an impact on and are influenced by. As readers of this blog know well, farm tax issues are numerous and special rules apply in many instances. The new tax law impacts many areas of farm income tax.
Real property legal issues are also prevalent and are addressed in the course. The key elements of an installment land contract are covered, as well as legal issues associated with farm leases. Various types of interests in real estate are explained – easements; licenses; profits, fee simples, remainders, etc. Like-kind exchange rules are also covered as are the special tax rules (at the state level) that apply to farm real estate. A big issue for some farmers and ranchers concerns abandoned railways, and those issues are covered in the course. What if an existing fence is not on the property line?
Farm estate and business planning is also a significant emphasis of the course. What’s the appropriate estate plan for a farm and ranch family? How should the farming business be structured? Should multiple entities be used? Why does it matter? These questions, and more, are addressed.
Agricultural cooperatives are important for the marketing of agricultural commodities. How a cooperative is structured and works and the special rules that apply are also discussed.
Because much agricultural property is out in the open, that means that personal liability rules come into play with respect to people that come onto the property or use farm property in the scope of their employment. What are the rules that apply in those situations? What about liability rules associated with genetically modified products? Ag chemicals also pose potential liability issues, as do improperly maintained fences? What about defective ag seed or purchased livestock that turns out to not live up to representations? These issues, and more, are covered in the scope of discussing civil liabilities.
Sometimes farmers and ranchers find themselves in violation of criminal laws. What are those common situations? What are the rules that apply? We will get into those issue too.
Water law is a very big issue, especially in the western two-thirds of the United States. We will survey the rules surrounding the allocation of surface water and ground water to agricultural operations.
Ag seems to always be in the midst of many environmental laws – the “Clean Water Rule” is just one of those that has been high-profile in recent years. We will talk about the environmental rules governing air, land, and water quality as they apply to farmers, ranchers and rural landowners.
Finally, we will address the federal (and state) administrative state and its rules that apply to farming operations. Not only will federal farm programs be addressed, but we will also look at other major federal regulations that apply to farmers and ranchers.
Further Information and How to Register
Information about the course is available here:
You can also find information about the text for the course at the following link (including the Table of Contents and the Index):
If you are an undergraduate student at an institution other than Kansas State, you should be able to enroll in this course and have it count as credit towards your degree at your institution. Consult with your academic advisor to see how Ag Law and Economics will transfer and align with your degree completion goals.
If you have questions, you can contact me directly, or submit your questions to the KSU Global Campus staff at the link provided above.
I hope to see you in January!
Checkout the postcard (401 KB PDF) containing more information about the course and instructor.
October 18, 2018 in Bankruptcy, Business Planning, Civil Liabilities, Contracts, Cooperatives, Criminal Liabilities, Environmental Law, Estate Planning, Income Tax, Insurance, Real Property, Regulatory Law, Secured Transactions, Water Law | Permalink | Comments (0)
Tuesday, October 16, 2018
In recent years, all states except California and Maryland have enacted Equine Activity Liability Acts designed to encourage the continued existence of equine-related activities, facilities and programs, and provide the equine industry limited protection against lawsuits. The laws vary from state-to-state, but generally require special language in written contracts and liability releases or waivers, require the posting of warning signs and attempt to educate the public about inherent risks in horse-related activities and immunities designed to limit liability. The basic idea of these laws is to provide a legal framework to incentivize horse-related activities by creating liability protection for horse owners and event operators.
Equine activity laws – that’s the topic of today’s post.
State Law Variations
The typical statute covers an “equine activity sponsor,” “equine professional,” or other person (such as an employer in an employment setting involving livestock) and specifies that such "covered" person can only be sued in tort for damages related to the knowing provision of faulty tack, failure to determine the plaintiff’s ability to safely manage a horse, or failure to post warning signs concerning dangerous latent conditions. See, e.g., Baker v. Shields, 767 N.W.2d 404 (Iowa 2009); Pinto v. Revere Saugus Riding Academy, No. 08-P-318, 2009 Mass. App. LEXIS 746 (Mass. Ct. App. Jun. 8, 2009). For example, in Germer v. Churchill Downs Management, No. 3D14-2695, 2016 Fla. App. LEXIS 13398 (Fla. Ct. Ap. Sept. 7, 2016), state law “immunized” (among other things) an equine activity sponsor from liability to a “participant” from the inherent risks of equine activities. The plaintiff, a former jockey visited a race course that the defendant managed. It was a spur-of-the-moment decision, but he was required to get a guest pass to enter the stables. He was injured by a horse in the stables and the court upheld the immunity provisions of the statute on the basis that the requirement to get a guest pass before entering the stables was sufficient protocol to amount to “organization” which made the plaintiff’s visit to the stables “an organized activity” under the statute.
While many state equine activity laws require the postage of warning signs and liability waivers, not every state does. For example, the statutes in CT, HI, ID, MT, NH, ND, UT, WA and WY require neither signage nor particular contract language.
Recovery for damages resulting from inherent risks associated with horses is barred, and some state statutes require the plaintiff to establish that the defendant’s conduct constituted “gross negligence,” “willful and wanton misconduct,” or “intentional wrongdoing.” For example, in Snider v. Fort Madison Rodeo Corp., No. 1-669/00-2065, 2002 Iowa App. LEXIS 327 (Iowa Ct. App. Feb. 20, 2002), the plaintiff sued a parade sponsor and a pony owner for injuries sustained in crossing the street during a parade. The court determined that the omission of a lead rope was not reckless conduct and that the plaintiff assumed the risk of crossing the street during the parade. Similarly, in Markowitz v. Bainbridge Equestrian Center, Inc., No. 2006-P-0016, 2007 Ohio App. LEXIS 1411 (Ohio Ct. App. Mar. 30, 2007), the court held that there was no evidence present that the plaintiff’s injuries sustained in the fall from a horse was a result of the defendant’s willful or wanton conduct or reckless indifference. In addition, the signed liability release form complied with statutory requirements. However, in Teles v. Big Rock Stables, L.P., 419 F. Supp. 2d 1003 (E.D. Tenn. 2006), the provision of a saddle with stirrups that could not be shortened enough to reach plaintiff’s feet which then caused the plaintiff to fall from a horse raised jury question as to whether faulty tack provided, whether the fall was the result of the inherent risk of horseback riding, and whether the defendant’s conduct was willful or grossly negligent and, thus, not covered by the signed liability release form.
What constitutes an “inherent risk” from horse riding is a fact issue in many states due to the lack of any precise definition of “inherent risk” in the particular state statute. For example, under the Texas Equine Activity Liability Act, the phrase “inherent risk of equine activity” refers to risks associated with the activity rather than simply those risks associated with innate animal behavior. See, e.g., Loftin v. Lee, No. 09-0313, 2011 Tex. LEXIS 326 (Tex. Sup. Ct. Apr. 29, 2011). The Ohio equine activities immunity statute has been held to bar recovery for an injury incurred while assisting an employer unload a horse from a trailer during a day off, because the person deliberately exposed themselves to an inherent risk associated with horses and viewed the activity as a spectator. Smith v. Landfair, No. 2011-1708, 2012 Ohio LEXIS 3095 (Ohio Sup. Ct. Dec. 6, 2012). Also, in Einhorn v. Johnson, et al., No. 50A03-1303-CT-93, 2013 Ind. App. LEXIS 495 (Ind. Ct. App. Oct. 10, 2013), the Indiana Equine Activity Act barred a negligence action after a volunteer at a county fair was injured by a horse. The plaintiff’s injuries were determined to result from the inherent risk of equine activities. Likewise, in Holcomb v. Long, No. A14A0815, 2014 Ga. App. LEXIS 726 (Ga. Ct. App. Nov. 10, 2014), the Georgia Equine Activities Act barred recovery for injuries sustained as a result of slipping saddle during horseback ride; slipping saddle inherent risk of horseback riding. See also, Fishman v. GRBR, Inc., No. DA 17-0214, 2017 Mont. LEXIS 602 (Mont. Sup. Ct. Oct. 5, 2017).
In Franciosa v. Hidden Pond Farm, Inc., No. 2017-0153 2018 N.H. LEXIS 174 (N. H. Sup. Ct. Sept. 21, 2018), the plaintiff was severely injured in a horseback riding accident. At the time of the accident, she was thirteen years old, had been riding horses for eight years, and had been taking weekly riding lessons from the defendant, an expert equestrian, for almost two years. Approximately once each seek, the plaintiff went for a “free ride”—a ride that did not involve a lesson. On those occasions the defendant was not always present, and no one was assigned to supervise the plaintiff. The day before the accident the plaintiff texted the defendant to arrange a lesson for the following day. The defendant texted the plaintiff that, although she would not be present at the farm on the following day, the plaintiff had permission to take a free ride on a horse that the plaintiff had ridden without incident on at least two occasions.
The next day after riding the horse for about 30 minutes the plaintiff fell to the ground as she tried to dismount and was seriously injured when the horse subsequently stepped on her. The plaintiff sued, and the defendant moved for summary judgment on the basis that the equine immunity provisions set forth N.H. Rev. Stat. §508:19 barred the plaintiff’s negligence claim. The plaintiff then filed a cross-motion for partial summary judgment, arguing that the plaintiff’s injuries were not caused by an “inherent risk” of horseback riding and, therefore, the defendant was not immune from liability. Alternatively, the plaintiff argued that even if the statute applied, a jury trial was necessary to resolve issues of material fact regarding the statutory exceptions in N.H. Rev. Stat. §508:19. The trial court entered summary judgment for the defendant, denied the plaintiff’s cross motion, and also denied the plaintiff’s motion for reconsideration.
On further review, the appellate court held that the statute clearly operated “to shield persons involved in an equine activity from liability for negligence claims related to a participant’s injuries resulting from the inherent risks of equine circumstances.” The appellate court also determined that it didn’t have to decide whether the defendant’s physical absence and inability to supervise the plaintiff at the time of the accident placed the accident outside of the risks inherent in equine activities, because under RSA 508:19, I(f)(5) a failure to take “corrective measures” was relevant only when the participant was negligent and that negligence can be reasonably foreseen, which was not present in the case. The court also determined that there was no evidence to support the plaintiff’s argument that the defendant’s failure to supervise the plaintiff amounted to willful or wanton disregard for the plaintiff’s safety. Consequently, the appellate court held that the trial court did not err in holding that the defendant was entitled to immunity under N.H. Rev. Stat. §508:19. As such, the decisions of the trial court were affirmed.
State Equine Activity Liability laws are designed to provide liability protection for injuries arising from horse-related activities. If you have horses or are involved in horse-related activities, it might be a good idea to determine what rules your particular state has.
Friday, October 12, 2018
Interest in the corporate form of farm or ranch organization has varied over the years. That interest has generally peaked when corporate rates are lower compared to rates applicable to individuals and pass-through entities. In the 1970s, many farming operations were incorporated for succession planning reasons. But, with the Tax Cuts and Jobs Act (TCJA) establishing a flat C corporate rate of 21 percent effective for tax years beginning after 2017, some taxpayers may be enticed to structure their business in the C corporate form.
Is the C corporation a good business format for a farming operation? As with many tax planning considerations, numerous factors must be accounted for. Farming C corporations post-TCJA – that’s the topic of today’s post.
For tax years beginning before 2018, corporations paid tax on income at progressive marginal rates, with the first $50,000 of taxable income taxed at 15 percent. Dividends paid by a corporation (if any) to its shareholders were (and still are) generally taxed to the shareholder at a 15 percent or 20 percent rate. That combined 30 percent rate (15 percent on corporate income and 15 percent rate on the dividend) was less than the 39.6 rate which was the highest marginal rate for individuals. Thus, if a farm corporation’s income could be kept at approximately $50,000 of taxable income a year, tax savings could be achieved in the corporate structure. The tax planning for many farming C corporations was designed to accomplish that objective.
For tax years beginning after 2017, however, the C corporate rate is a flat 21 percent and no domestic production deduction of nine percent (I.R.C. §199) is available. In addition, for tax years beginning after 2017, a C corporation cannot claim the 20 percent deduction for qualified business income. I.R.C. §199A. This all means that for many farming corporations, the effective tax rate in 2018 could be at least 40 percent higher than it was in 2017 (at least through 2025).
But, it is also true that many farm C corporations were established as means of providing tax-deductible meals and lodging to the owners on a tax-free (to the owners) basis. That can still be done post-2017, except that the deduction for the cost of meals is only 50 percent rather than being fully deductible.
In general, firms turn to the corporation because they are seeking a collection of advantages they cannot achieve with a partnership, joint venture, limited partnership or limited liability company. For instance, the corporation provides a means for simplified internal accounting, extension of the planning horizon and a way to keep the business together beyond the present generation. Also, if plans are not made for continuity of the farm or ranch business, there is a tendency for individuals, over time, to focus less on the future. This causes decision making to be less than optimal. The corporation, as an entity of perpetual existence, helps to extend the planning horizon over which decisions are made which may result in a more rational set of economic decisions.
The corporation also tends to smooth the family farm cycle and make it possible for the continuation of the operation into subsequent generations with greater efficiency. Empirical studies in several states reveal that four major factors account for most of the decisions to incorporate in those states. These factors are: (1) ease of transferring interests in property by transferring shares of stock to accomplish specific estate planning objectives; (2) possibilities for planning management and ownership succession to make continuation of the business easier after death of the original owners; (3) avoidance of full owner liability for obligations of the business through shareholder limited liability; and (4) opportunities for income tax saving.
Thus, there still exist significant non-tax reasons to form a farming C corporation. However, it may not be the best entity structure for federal farm program payment limitation purposes. If a C corporation (or any other entity that limits liability) is the farming entity, the Farm Service Agency will limit the eligibility for payment limitations to the entity itself. Then, the owners of that entity will have to split the amount of government payments attributable to the one “person” determination between themselves. If a pass-through entity were utilized that did not limit owner liability at the entity level, then each owner (member) of the entity would be entitled to its own payment limit.
Anti-Corporate Farming Laws
When it comes to agricultural law and agricultural taxation, special rules apply in many situations. One of those special situations involves farming corporations. Historically, the first significant wave of interest in the corporate form for farm and ranch businesses dates back to the 1920s at a time when change was occurring very rapidly in the agricultural industry. The prevailing belief at the time was that the mechanization of agriculture was going to produce a few large “factories in the field.” This widespread belief produced a wave of state legislation, much of it still in existence today, limiting the use of the farm or ranch corporation. Kansas was the first state to legislate anti-corporate farming restrictions. Other states, primarily in the Midwest and the Great Plains, followed suit. Restrictions were enacted (in addition to Kansas) in North Dakota, Oklahoma, Minnesota, South Dakota, Missouri, Wisconsin, Nebraska and Iowa. Other restrictions were enacted in Colorado, Texas, West Virginia and South Carolina. In many of these states, the restrictions remain on the books (albeit modified in some states).
Recent case. The North Dakota anti-corporate farming restriction bars corporations, other than family farming corporations, from owning farm land and engaging in farming or agriculture. The specific statutory language states: “All corporations and limited liability companies, except as otherwise provided in this chapter, are prohibited from owning or leasing land used for farming or ranching and from engaging in the business of farming or ranching. A corporation or a limited liability company may be a partner in a partnership that is in the business of farming or ranching only if that corporation or limited liability company complies with this chapter.” However, by virtue of a 1981 amendment, the statute also states: “This chapter does not prohibit a domestic corporation or a domestic limited liability company from owning real estate and engaging in the business of farming or ranching, if the corporation meets all the requirements of chapter 10-19.1 or the limited liability company meets all the requirements of chapter 10-32.1 which are not inconsistent with this chapter.” This amended language became known as the “family farm exception” because it requires shareholders to have a close family relation who is actively engaged in the operation. Historically, the state attorney general and secretary of state have interpreted the “family farming” exception as a way to allow out-of-state family farming corporations to own farm land and conduct agricultural operations in North Dakota. However, in North Dakota Farm Bureau, Inc. v. Stenehjem, No. 1:16-cv-137, 2018 U.S. Dist. LEXIS 161572 (D. N.D. Sep. 21, 2018), the plaintiff, North Dakota’s largest farm group along with other family farming corporations challenged the law as written on the basis that the law violated the “Dormant Commerce Clause” as discriminating against interstate commerce. The court agreed, enjoining the State from enforcing the family farm exception against out-of-state corporations that otherwise meet the statutory requirements (which the State didn’t do anyway).
The C corporation remains a viable entity structure for the farm or ranch business. While some of the tax advantage has been reduced, other factors indicate that the C corporation still has its place. In any event, wise tax and legal counsel should be consulted to determine the right approach for any particular situation
Wednesday, October 10, 2018
The changes made by the Tax Cuts and Jobs Act (TCJA) for tax years beginning after 2017 could have a significant impact on charitable giving. Because of changes made by the TCJA, it is now less likely that any particular taxpayer will itemize deductions. Without itemizing, the tax benefit of making charitable deductions will not be realized. This has raised concerns by many charities.
Are there any tax planning strategies that can be utilized to still get the tax benefit from charitable deductions? There might be. One of those strategies is the donor-advised fund.
Using a donor-advised fund for charitable giving post-TCJA – that’s the topic of today’s post.
A taxpayer gets the tax benefit of charitable deductions by claiming them on Schedule A and itemizing deductions. However, the TCJA eliminates (through 2025) the combined personal exemption and standard deduction and replaces them with a higher standard deduction ($12,000 for a single filer; $24,000 for a couple filing as married filing jointly). The TCJA also either limits (e.g., $10,000 limit on state and local taxes) or eliminates other itemized deductions. As a result, it is now less likely that a taxpayer will have Schedule A deductions that exceed the $12,000 or $24,000 amount. Without itemizing, the tax benefit of charitable deductions is lost. This is likely to be particularly the case for lower and middle-income taxpayers.
One strategy to restore the tax benefit of charitable giving is to bundle two years (or more) of gifts into a single tax year. Doing so can cause the total amount of itemized deductions to exceed the standard deduction threshold. Of course, this strategy results in the donor’s charities receiving a nothing in one year (or multiple years) until the donation year occurs.
A better approach than simple bundling (or bunching) of gifts might be to contribute assets to a donor-advised fund. It’s a concept similar to that of bundling, but by means of a vehicle that provides structure to the bundling concept, with greater tax advantages. A donor-advised fund is viewed as a rather simple charitable giving tool that is versatile and affordable. What it involves is the contribution of property to a separate fund that a public charity maintains. That public charity is called the “sponsoring organization.” The donor retains advisory input with respect to the distribution or investment of the amounts held in the fund. The sponsoring organization, however, owns and controls the property contributed to the fund, and is free to accept or reject the donor’s advice.
While the concept of a donor-advised fund has been around for over 80 years, donor-advised funds really weren’t that visible until the 1980s. Today, they account for approximately 4-5 percent of charitable giving in the United States. Estimates are that over $150 billion has been accumulated in donor advised funds over the years. Because of their flexibility, ease in creating, and the ability of donors to select from pre-approved investments, donor advised funds outnumber other type of charitable giving vehicles, including the combined value included in charitable remainder trusts, charitable remainder annuity trusts, charitable lead trusts, pooled income funds and private foundations.
Mechanics. The structure of the transaction involves the taxpayer making an irrevocable contribution of personal assets to a donor-advised fund account. The contribution is tax deductible. Thus, the donor gets a tax deduction in the year of the contribution to the fund, and the funds can be distributed to charities over multiple years.
The donor also selects the fund advisors (and any successors) as well as the charitable beneficiaries (such as a public charity or community foundation). The amount in the fund account is invested and any fund earnings grow tax-free. The donor also retains the ability to recommend gifts from the account to qualified charities along with the fund advisors. The donor cannot, however, have the power to select distributes or decide the timing or amounts of distributions from the fund. The donor serves in a mere advisory role as to selecting distributees, and the timing and amount of distributions. If the donor retains control over the assets or the income the transaction could end up in the crosshairs of the IRS, with the fund’s tax-exempt status denied. See, I.R. News Release 2006-25, Feb. 7, 2006; New Dynamics Foundation v. United States, 70 Fed. Cl. 782 (2006).
No time limitations apply concerning when the fund assets must be distributed, but the timing of distributions is discretionary with the donor and the fund advisors.
When highly appreciated assets are donated to a donor advised fund, the donor’s overall tax liability can be reduced, capital gain tax eliminated, and a charity can benefit from a relatively larger donation. For taxpayer’s that are retiring, or have a high-income year, a donor advised fund might be a particularly good tax strategy. In addition, a donor advised fund can be of greater benefit because the TCJA increases the income-based percentage limit on charitable donations from 50 percent of adjusted gross income (AGI) to 60 percent of AGI for cash charitable contributions to qualified charities made in any tax year beginning after 2017 and before 2026. The percentage is 30 percent of AGI for gifts of appreciated securities, mutual funds, real estate and other assets. Any excess contributed amount of cash may be carried forward for five years. I.R.C. §170(b)(1)(G)(ii).
Donor-advised funds are not cost-free. It is common for a fund to charge an administrative fee in the range of 1 percent annually. That’s in addition to any fees that might apply to assets (such as mutual funds) that are contributed to the donor advised fund. Also, the fund might charge a fee for every charitable donation made from the fund. That’s likely to be the case for foreign charities.
In addition, as noted above, the donor can only recommend the charities to be benefited by gifts from the fund. For example, in 2011 the Nevada Supreme Court addressed the issue of what rights a donor to a donor advised fund has in recommending gifts from the fund. In Styles v. Friends of Fiji, No. 51642, 2011 Nev. Unpub. LEXIS 1128 (Nev. Sup. Ct. Feb. 8, 2011), the sponsoring charity of the donor-advised fund used the funds in a manner other than what the donor recommended by completely ignoring the donor’s wishes. The court found that to be a breach of the duty of good faith and fair dealing by the fund advisors. But, the court determined that the donor didn’t have a remedy because he had lost control over his contributed assets and funds based on the agreement he had signed at the time of the contribution to the donor-advised fund. As a result, the directors of the organization that sponsored the donor-advised fund could use the funds in any manner that they wished. That included paying themselves substantial compensation, paying legal fees to battle the donor in court, and sponsoring celebrity golf tournaments.
Also, an excise tax on the sponsoring organization applies if the sponsoring organization makes certain distributions from the fund that don’t satisfy a defined charitable purpose. I.R.C. §4966. Likewise, an excise tax applies on certain distributions from a fund that provide more than an incidental benefit to a donor, a donor-advisor, or related persons. I.R.C. §4967.
The TCJA changes the landscape (at least temporarily) for charitable giving for many taxpayers. To get the maximum tax benefit from charitable gifts, many taxpayers may need to utilize other strategies. One of those might include the use of the donor-advised fund. If structured properly, the donor-advised fund can be a good tool. However, there are potential downsides. In any event, competent tax counsel should be sought to assist in the proper structuring of the transaction.
Monday, October 8, 2018
The Tax Cuts and Jobs Act (TCJA) has made estate planning much easier for most farm and ranch families. Much easier, that is, with respect to avoiding the federal estate tax. Indeed, under the TCJA, the exemption equivalent of the unified credit is set at $11.18 million per decedent for deaths in 2018, and an unlimited marital deduction and the ability to “port” over the unused exclusion (if any) at the death of the first spouse to the surviving spouse, very few estates will incur federal estate tax. Indeed, according to the IRS, there were fewer than 6,000 estates that incurred federal estate tax in 2017 (out of 2.7 million decedent’s estates). In 2017, the exemption was only $5.49 million. For 2018, the IRS projects that there will be slightly over 300 taxable estates.
The TCJA also retains the basis “step-up” rule. That means that property that is included in the decedent’s estate at death for tax purposes gets an income tax basis in the hands of the recipient equal to the property’s fair market value as of the date of death. I.R.C. §1014.
But, with the slim chance that federal estate tax will apply, should estate planning be ignored? What are the basic estate planning strategies for 2018 and for the life of the TCJA (presently, through 2025)?
Married Couples (and Singles) With Wealth Less Than $11.18 Million.
Most people will be in this “zone.” For these individuals, the possibility and fear of estate tax is largely irrelevant. But, there is a continual need for the guidance of estate planners. The estate planning focus for these individuals should be on basic estate planning matters. Those basic matters include income tax basis planning – utilizing strategies to cause inclusion of property in the taxable estate so as to get a basis “step-up” at death.
Existing plans should also focus on avoiding common errors and look to modify outdated language in existing wills and trusts. For example, many estate plans utilize "formula clause" language. That language divides assets upon the death of the first spouse (regardless of whether it is the husband or the wife) between a "credit shelter trust," which utilizes the remaining federal estate tax exemption amount, and a "marital trust," which qualifies for the (unlimited) federal estate tax marital deduction. The intended result of the language is to cause that trust’s value to be taxed in the first spouse’s estate where it will be covered by the exemption, and create a life estate in the credit shelter trust property for the surviving spouse that will “bypass” the surviving spouse’s estate upon death. As for the martial trust assets, tax on those assets is postponed (if it is taxed at all) until the surviving spouse dies.
But, here’s the rub. As noted above, the TCJA’s increase in the exemption could cause an existing formula clause to “overfund” the credit shelter trust with up to the full federal exemption amount of $11.18 million. This formula could potentially result in a smaller bequest for the benefit of the surviving spouse to the marital trust than was intended, or even no bequest for the surviving spouse at all. It all depends on the value of assets that the couple holds. The point is that couples should review any existing formula clauses in their current estate plans to ensure they are still appropriate given the increase in the federal exemption amount. It may be necessary to have an existing will or trust redrafted to account for the change in the law and utilize language that allows for flexibility in planning.
In addition, for some people, divorce planning/protection is necessary. Also, a determination will need to be made as to whether asset control is necessary as well as creditor protection. Likewise, a consideration may need to be made of the income tax benefits of family entities to shift income (subject to family partnership rules of I.R.C. §704(e)) and qualifying deductions to the entity. The entity may have been created for estate and gift tax discount purposes, but now could provide income tax benefits. In any event, family entities (such as family limited partnerships (FLPs) and limited liability companies (LLCs)) will continue to be valuable estate planning tools for many clients in this wealth range.
Most persons in this zone will likely fare better by not making gifts, and retaining the ability to achieve a basis step-up at death for the heirs. That means income tax basis planning is far more important for most people. Also, consideration should be made to determine whether insurance is still necessary to fund any potential estate tax liability It also may be possible to recast insurance to fund state death taxes (presently, 12 states retain an estate tax and six states have an inheritance tax (one state (Maryland) has both)) and serve investment and retirement needs, minimize current income taxes, and otherwise provide liquidity at death.
Other estate planning points for moderate wealth individuals include:
- For life insurance, it’s probably not a good idea to cancel the polity before having that move professionally evaluated. That’s particularly the case for trust-owned life insurance. For pension-owned life insurance, for those persons that are safely below the exemption, adverse tax consequences can likely be avoided.
- Evaluate irrevocable trusts and consider the possibility of “decanting.” I did a blog post on decanting earlier this summer.
- For durable powers of attorney, examine the document to see whether there are caps on gifted amounts (the annual exclusion is now $15,000) and make sure to not have inflation adjusting references to the annual exclusion.
- For qualified personal residence trusts (QPRTs) that were created when the estate tax exemption was $2 million, the conventional advice was to deed the house from the QPRT to the children or a remainder trust (which might have been a grantor trust), with a written lease agreement in favor of the parent/donor who would continue to live in the house. Now, it may be desired to have the home included in the estate for basis step-up purposes and the elimination of gain on sale.
- While FLPs and LLCs may have been created to deal with an estate tax value-inclusion issue, it may not be wise to simply dismantle them because estate tax is no longer a problem for the client. Indeed, it may be a good idea to actually cause inclusion of the FLP interest in the estate. This can be accomplished by revising the partnership or operating agreement and having a parent document control over the FLP. Then, an I.R.C. §754 election can be made which can allow the heirs to get a basis step-up.
Other Planning Issues
While income tax basis planning (using techniques to cause inclusion of asset value in the estate at death) is now of primary importance for most people, asset protection may also be a major concern. Pre-nuptial agreements have become more common in recent decades, and marital trusts are also used to ultimately pass assets to the heirs of the first spouse to die (who may not be the surviving spouse’s heirs) at the death of the surviving spouse. A “beneficiary-controlled” trust has also become a popular estate planning tool. This allows assets to pass to the beneficiary in trust rather than outright. The beneficiary can have a limited withdrawal right over principal and direct the disposition of the assets at death while simultaneously achieving creditor protection. In some states, such as Nebraska, the beneficiary can be the sole trustee without impairing creditor protection.
Powers of attorney for both financial and health care remain a crucial part of any estate plan. For a farm family, the financial power should be in addition to the FSA Form 211, and give the designated agent the authority to deal with any financial-related matter that the principal otherwise could.
While estate planning has been made easier by the TCJA, that doesn’t mean that it is no longer necessary. Reviewing existing plans with an estate planning professional is important. Also, the TCJA is only temporary. The estate and gift tax provisions expire at the end of 2025. When that happens, the exemption reverts to what it was under prior law and then is adjusted for inflation. For deaths in 2026, the federal estate and gift tax exemption is estimated to be somewhere between $6.5 and $7.5 million dollars. While those numbers are still high enough to cover the vast majority of people, they are a far cry from the present $11.18 million amount. One thing is for sure – a great deal of wealth is going to transfer in the coming decades. One estimate I have seen is that approximately $30 trillion in asset value will transfer over the next 30-40 years. That’s about a trillion per year over that time-frame. A chunk of that will involve farm and ranch real estate, livestock, equipment and other personal property.
Is your plan up-to-date?
Thursday, October 4, 2018
The Tax Cuts and Jobs Act (TCJA) added a new section to the Internal Revenue Code (Code) to provide temporary deferral from gross income of capital gains incurred on the sale or exchange of an investment in a Qualified Opportunity Fund. I.R.C. §1400Z-2, as added by TCJA §13823. A Qualified opportunity fund is part of an “Opportunity Zone” - essentially an economically distressed area where long-term investments by a taxpayer in a Qualified Opportunity Fund are incentivized by the deferral of capital gain taxes. It is not necessary that the investor actually live in the opportunity zone. It’s only required that the taxpayer invest in a Qualified Opportunity Fund.
Farmers and ranchers can qualify to take their capital gains and invest them in a Qualified Opportunity Fund (an investment vehicle that is organized as a corporation or a partnership that holds at least 90 percent of its assets in Qualified Opportunity Zone property) that, in turn, invests in a Qualified Opportunity Zone property So, this new TCJA provision could be of particular interest to farmers and ranchers that have large gains that they are looking to defer capital gain taxes on.
The tax implications of Qualified Opportunity Zone investments – that’s the topic of today’s post.
As noted, I.R.C. §1400Z-2 provides for the temporary deferral of inclusion in gross income for capital gains reinvested in a Qualified Opportunity Fund and the permanent exclusion of capital gains from the sale or exchange of an investment in the Qualified Opportunity Fund. I.R.C. §1400Z-2. The fund must be located in a Qualified Opportunity Zone, which is a “designated low-income community population census tract.” The number of designated tracts in any particular State cannot exceed 25 percent of the number of population census tracts in that State that are “low income communities.” A Qualified Opportunity Zone remains in effect for ten calendar years after the date of the designation. I.R.C. §1400Z-1.
A taxpayer that incurs a capital gain but who reinvests it in a Qualified Opportunity Fund that is located in a Qualified Opportunity Zone obtains temporary deferral of that gain (both short-term or long-term). The maximum amount of the deferred gain equals the amount invested in the Qualified Opportunity Fund by the taxpayer during the 180-day period beginning on the date of sale of the asset to which the deferral pertains. Excess capital gains are included in the taxpayer’s gross income. The unrealized gain can then be realized on a tax-deferred basis until at least December 31, 2026. In addition, the taxpayer receives a 10 percent stepped-up basis on the deferred capital gains (10 percent of the amount of the deferred gain) if the investment in the Qualified Investment Fund are held for at least five years, and 15 percent if it is held for at least seven years. Once the investment has been held for 10 years, the tax on the gain is eliminated.
The deferred gain can be elected to be permanently excluded upon the sale or exchange of the investment in a Qualified Opportunity Fund that the taxpayer has held for at least 10 years. What the election does is cause the taxpayer’s income tax basis in the investment to be the fair market value of the investment as of the date of the sale or exchange. In addition, any loss on the investment can be recognized. I.R.C. §1400Z-2.
In Revenue Procedure 2018-16, the IRS announced the designation of Qualified Opportunity Zones in 18 states. In addition, a safe harbor was provided for applying the 25 percent limitation to the number of population census tracts in a State that can be designated as a Qualified Opportunity Zone. Rev. Proc. 2018-16, I.R.B. 2018-9. The IRS noted that a State Governor can nominate a census tract for designation as a Qualified Opportunity Zone by notifying the IRS in writing of the nomination. The IRS then will certify the nomination and designate the tract as a Qualified Opportunity Zone beyond the end of the “consideration period.” I.R.C. §1400Z-1(b).
Earlier this year, the IRS approved submissions for areas in Arizona, California, Colorado, Georgia, Idaho, Kentucky, Michigan, Mississippi, Nebraska, New Jersey, Oklahoma, South Carolina, South Dakota, Vermont and Wisconsin.
In Notice 2018-48, the IRS listed all of the designated Qualified Opportunity Zones. Presently, every state has submitted to the Treasury Department its list of proposed Opportunity Zones. Notice 2018-48, I.R.B. 2018-28.
What About I.R.C. §1031?
The TCJA eliminated (on a permanent basis) the tax-deferred exchange provision under I.R.C. §1031 for exchanges of personal property. Real estate exchanges remain eligible for I.R.C. §1031 treatment. So, how does this new TCJA provision compare with I.R.C. §1031?
- Unlike a real estate trade under I.R.C. §1031, a taxpayer’s investment in a Qualified Opportunity Fund only requires that the capital gains portion from the sale of property be reinvested. An I.R.C. §1031 transaction requires that the entire sale proceeds be reinvested.
- In addition, the investment in a Qualified Opportunity Fund does not have to involve like-kind property, and the investment property can be real or personal.
- The replacement property need not be identified (as it does in an I.R.C. §1031 transaction).
- The 180-day rule applies in both situations. In other words, the closing on the “replacement property” must occur within 180 days with respect to a Qualified Opportunity Zone as well as with respect to an I.R.C. §1031 exchange.
- Also, with respect to an investment in a Qualified Opportunity Zone, a partnership interest is allowed. That’s not the case with an I.R.C. §1031 exchange. The same can be said for stock in a corporation.
- The gain is deferred permanently (excluded from income) if the property is held in a Qualified Opportunity Fund for at least 10 years. With an I.R.C. §1031 exchange, the gain is deferred until the replacement property is sold, unless the gain is deferred in another like-kind exchange (or the taxpayer dies).
- With an investment in a Qualified Opportunity Zone, the sale of the invested property cannot be to a related party. Related party sales are not barred for like-kind exchange property where gain is deferred under I.R.C. §1031, but a two-year rule applies – the property must be held for at least two years after the exchange if a related party is involved.
Assume that Bob owns Blackacre that with a current fair market value of $1,000,000. Bob’s income tax basis in Blackacre is $500,000. Bob sold Blackacre for $1,000,000 on October 1, 2018, resulting in a realized gain of $500,000. Bob has until March 1, 2019 (180 days after the sale date) to invest the sale proceeds in a Qualified Opportunity Fund equal to the amount of gain that he elects to defer.
Now assume that Bob elects to defer the full amount of the realized gain and invests the $500,000 in a Qualified Opportunity Fund in a timely manner. Further assume that Bob sells his investment in the Fund on March 1, 2024, for $600,000. Bob could exclude the lesser of the amount of gain previously excluded ($500,000) or $600,000 (the fair market value of the investment on the sale date). From that $500,000 amount is subtracted Bob’s basis in the Fund investment (initial basis in Fund investment ($0), increased by the amount of the original gain previously recognized ($0)). Thus, Bob’s basis in the Fund’s investment is zero.
Note: Because Bob held the investment for at least five years, his basis is increased by 10 percent of the deferred gain or $50,000 ($500,000 x .10). Had Bob held the investment for at least seven years, he would have qualified for an additional five percent basis adjustment.
Bob’s recognized gain in 2024 associated with the prior deferral would be $450,000 ($500,000 less the $50,000). In 2024, Bob would also recognize a $100,000 gain associated with the sale of his Fund investment. Thus, Bob’s total recognized gain in 2024 is $550,000. If Bob were to hold the investment in the Fund for at least 10 years, he could exclude all of the gain associated with the investment. However, the 10-year holding period has no impact on the taxability of Bob’s original deferred gain. That gain cannot be deferred beyond 2026.
The Opportunity Zone provision of the TCJA is particularly tailored to a taxpayer that has an asset (or assets) with inherent large built-in gain. In other words, the provision may be particularly attractive to a taxpayer with a low income tax basis in the property and the property has appreciated greatly in value. There is a great deal of farm and ranch land that falls into that category. In addition, many opportunity zones are located in rural areas and farmland and timberland investments tend to be long-term. It’s these long-term investments that can be a prime candidate for using this new tax provision.
Tuesday, October 2, 2018
Many farmers and ranchers are reaching retirement age for Social Security benefit purposes. That raises numerous questions involving such things as benefits, earnings, what counts as “wages” and the cash renting of farmland. These are all important questions for farmers and ranchers to have answers to so that appropriate planning can be engaged in and expectations realized.
Social Security benefit planning – that’s the topic of today’s post.
For 2009-2020, the full retirement age for persons born in 1943-1954 is 66. Under present rules, in 2027, the full retirement age will be 67.
During the calendar year in which an individual reaches age 66, an earnings limit applies for the months before the individual reaches full retirement age. For example, for an individual that turns age 66 during 2018, there is a monthly earnings limit of $3,780 ($45,360 ¸ 12 months) for the months before full retirement age is reached. Excess earnings for this period result in a $1 reduction in benefits for each $3 of excess earnings received before attaining the age of 66 years. But, for a person that hasn’t reached full retirement age, benefits are reduced by $1 for every $2 of earnings over the annual limit of $17,040 for 2018. For those drawing benefits after reaching full retirement age, there is no limit on earnings – benefits are not reduced.
An individual can receive full Social Security benefits if they aren’t drawn until full retirement age is achieved. Another way to state it is that if an individual delays taking social security benefits until reaching full retirement age, the individual receives additional benefits for each year of postponement until reaching age 70. The rate of increase is a fraction of one percent per month. In essence, the impact of drawing Social Security benefits before reaching full retirement age is that such a person must live longer to equalize the amount of benefits received over their lifetime compared to waiting until full retirement age to begin drawing benefits.
Taxability of Benefits
About 20 million people each year, some that are undoubtedly farmers and ranchers, pay tax on their Social Security benefits. These people are commonly in the 62-70 age range. Taxing Social Security benefits seems harsh, inasmuch as the person has already paid income tax and Social Security payroll taxes on the earnings that generated the benefits. But, not every dollar of benefits is taxed. What matters is a person’s total income from non-Social Security sources such as wages and salaries, investment income (and capital gains on those investments) and pension income. To that amount is added one-half of the person’s Social Security income. The total amount then is measured against a limit. For example, a person that files as married-filing-jointly (MFJ) will subject 50 percent of their Social Security benefits to tax if the total amount exceeds $32,000 for 2018 (it’s $25,000 for a single filer). The 50 percent changes to 85 percent once the total amount exceeds $44,000 (MFJ) or $34,000 (single) for 2018. Those are the maximum percentages in theory. In reality, however, there is a complex formula that often results in less Social Security benefits being taxed than that maximum percentage. To boil it down, the formula often results in about 20 percent of Social Security benefits being taxed once the total amount threshold is exceeded.
Some farmers receive wages in-kind rather that in cash. In-kind wages such as crops or livestock, count toward the earnings limitations test. The earnings limit test includes all earnings, not just those that are subject to Social Security (FICA/Medicare) tax. But, employer-provided health insurance benefits are not considered to be “earnings” for purposes of the earnings limitation test. They are not taxed as wages. I.R.C. §3121; SSA Program Operations Manual System, §§RS 01402.040; 01402,048.
Federal farm program payments that a farmer receives are not deemed to be “earnings” when calculating each calendar year's earnings limitation. SSA Program Operations Manual System §RS 02505.115. That is the case except for the initial year of Social Security benefit application. In that initial year, all FSA program payments are counted along with other earned income and earnings for purposes of the annual earnings limitation test.
For farmers that cash rent farm ground to their employer, the cash rental income that the farmer receives will likely be treated as “earnings” even though the farmer is getting a wage from the employer. This is particularly the case if the farmer is farming the ground on the employer’s behalf. The result would be a “doubling-up” of the wage income and the cash rent income for purposes of the age 62-66 earnings test.
For a farmer that is drawing Social Security benefits, whether retired or not, Conservation Reserve Program Payments received are not subject to Social Security tax. I.R.C. §1402(a)(1).
Social Security benefit planning is an item that is often overlooked by farmers and ranchers. However, it is useful to know how such planning may fit into the overall retirement plan of a farmer or rancher. It is just one piece of the retirement, succession, estate plan that should be considered in terms of how it fits in with other strategies. While a farmer or rancher may never actually “retire,” there is a benefit to properly timing the drawing of Social Security benefits. In addition, as noted above, there are some special situations that a farmer or rancher should be aware of.
The Social Security Administration website (ssa.gov) has some useful online calculators that can aid in estimating retirement benefits. It may be worth checking out.
Friday, September 28, 2018
I just finished a series of tax seminars in various states. The attendees were engaged in the discussions and had great questions. It’s always good to interact with practitioners and listen to what they are dealing with and what the current audit issues are with respect to farm and ranch clients. I have four events remaining before I start the fall tour of tax school beginning in late October.
In today’s post, I list the tax seminars upcoming this fall.
Kansas Tax Schools
Here’s the 2018 list of fall tax schools of Kansas State University. I teach on the second day at each location. The first day at the Garden City, Colby and Hays are taught by Paul Neiffer and Andy Morehead. The schools at Wichita and Salina are taught on Day 1 by Andy Morehead and Bill Parrish. The schools at Topeka, Overland Park and Pittsburg are taught on Day 1 by Bill Parrish and Felecia Dixson. The Kansas Department of Revenue makes a presentation on Day 1 at each location.
Here’s the list of tax schools in Kansas:
- 70th Annual Kansas Income Tax Institute
10/30-31/2018: Clarion Inn (Garden City, Kansas)
- 70th Annual Kansas Income Tax Institute
10/31-11/1/2018: Comfort Inn and Convention Center (Colby, Kansas)
- 70th Annual Kansas Income Tax Institute
11/1-2/2018: Fort Hays State University Memorial Union Ballroom (Hays, Kansas)
- 70th Annual Kansas Income Tax Institute
11/5-6/2018: Ramada Convention Center (Topeka, Kansas)
- 70th Annual Kansas Income Tax Institute
11/12-13/2018: Sedgwick County Extension Office (Wichita, Kansas)
- 70th Annual Kansas Income Tax Institute
11/13-14/2018: Tony's Pizza Events Center (formerly Bicentennial Center) (Salina, Kansas)
- 70th Annual Kansas Income Tax Institute
11/19-20/2018: DoubleTree by Hilton (Overland Park, Kansas)
- 70th Annual Kansas Income Tax Institute
12/12-13/2018: Pittsburg State University Overman Student Center (Pittsburg, Kansas)
Registration for the KSU tax schools is available here: https://www.agmanager.info/events/kansas-income-tax-institute. The Pittsburg school is also available online. In addition, Prof. Lori McMillan, my colleague at Washburn Law School, will join me in presenting a two-hour tax ethics seminar/webinar on December 14.
North Dakota Tax Schools
I will also be speaking on the second day at two tax schools in North Dakota. Here’s the list of the North Dakota tax schools:
- North Dakota Tax Practitioners' Institute
11/27-28/2018: Ramkota (Bismarck, North Dakota)
- North Dakota Tax Practitioners' Institute
11/29-30/2018: Holiday Inn (Fargo, North Dakota)
Registration information for the North Dakota schools is available here:
On November 8 and 9, Paul Neiffer and I will be doing a two-day tax school in Sioux Falls, SD for the American Society of Tax Professionals. I will also provide an ethics session after Day 1.
Here are the details for the Sioux Falls seminar:
- 11/8-11/9/2018: American Society of Tax Professionals, Ramada Inn & Suites (Sioux Falls, South Dakota) (8am – 4:30 p.m., contact: 1-877-674-1996).
The 2018 Bloethe Tax School in Des Moines, Iowa is set for December 5-7. I will kick-off that event on December 5 with a 4-hour afternoon seminar on the new tax law. Here are the registration details for the school:
I hope to see you at one of the schools this fall. There is certainly a great deal to talk about at these events. The new law is keeping all of us busy.
Wednesday, September 26, 2018
As a result of the Tax Cuts and Jobs Act (TCJA), the exemption equivalent of the unified credit for federal estate and gift tax purposes is presently $11.18 million. That’s the amount for decedent’s dying in 2018 and gifts made in 2018. There is also a present interest annual exclusion that covers the first $15,000 of gifts made to a donee in 2018. In other words, the first $15,000 is not subject to gift tax and then additional amounts gifted to that donee by the donor start using the donor’s unified credit applicable exclusion amount. In addition, the TCJA retained the unlimited marital deduction and income tax basis “step-up.”
The amount of the exemption means that very few people will encounter issues with federal estate or gift tax. Indeed, for the vast majority of people, estate planning involves income tax basis planning rather than planning to avoid estate or gift tax. Some states tax estates at death and one state retains a gift tax, and in these states the exemption is often much lower than the federal exemption. So, for individuals in these states estate and gift tax planning can remain important for state tax purposes.
What is much more important for most people, however, is income tax basis planning. That’s because property that is included in a decedent’s estate at death receives an income tax basis equal to the property’s fair market value as of the date of death. I.R.C. §1014. As a result of this rule, much of estate planning involves techniques to cause inclusion of property in a decedent’s estate at death. Even though the property will be subjected to federal estate tax, the value will be excluded from tax by virtue of the credit.
A great deal of property (such as farmland and personal residences) is owned in joint tenancy at death. How much of jointly held property is included in a joint tenant’s estate at death? That is a very important issue in the present estate planning environment. Specifically, what is the rule involving spousal joint tenancies?
The income tax basis rules at death for spousal joint tenancies – that’s the topic of today’s post.
A distinguishing characteristic of joint tenancy is the right of survivorship. That means that the surviving joint tenant or tenants become the full owners of the jointly held property upon the death of a fellow joint tenant regardless of the terms of the deceased joint tenant’s will. It’s important to note that upon a conveyance of real property, transfer to two or more persons generally creates a tenancy in common unless it is clear in the deed or other conveyancing document that a joint tenancy is intended. For example, if Blackacre is conveyed to “Michael and Kelsey, husband and wife,” Michael and Kelsey own Blackacre as tenants in common. To own Blackacre as joint tenants, Blackacre needed to be conveyed to them as required by state law. The typical language for creating a joint tenancy is to “Michael and Kelsey, husband and wife, as joint tenants with right of survivorship and not as tenants in common.”
Estate Tax Treatment. For joint tenancies involving persons other than husbands and wives, property is taxed in the estate of the first to die except to the extent the surviving owner(s) prove contribution for its acquisition. I.R.C. § 2040(a). This is the “consideration furnished” rule. While property held jointly may not be included in the “probate estate” for probate purposes, the value of that property is potentially subjected to federal estate tax and state inheritance or state estate tax to the extent the decedent provided the consideration for its acquisition. As a result, property could be taxed fully at the death of the first joint tenant to die (if that person provided funds for acquisition) and again at the death of the survivor. Whatever portion is taxed in the estate of the first to die also receives a new income tax basis based on the fair market value of that portion at the date of death.
Consider the following example (from my text, Principles of Agricultural Law):
Bob and Bessie Black, brother and sister, purchased a 1,000-acre Montana ranch in 1970 for $1,000,000. Bob provided $750,000 of the purchase price and Bessie the remaining $250,000. At all times since 1960, they have owned the ranch in joint tenancy with right of survivorship. Bob died in 2011 when the ranch had a fair market value of $2,500,000. Seventy-five percent of the date of death value, $1,875,000 will be included in Bob’s estate.
Bessie, as the surviving joint tenant will now own the entire ranch. Her income tax basis in the ranch upon Bob’s death is computed as follows:
$1,875,000 (Value included in Bob’s estate)
+ 250,000 (Bessie’s contribution toward purchase price)
Thus, if Bessie were to sell the ranch soon after Bob’s death for $2,500,000, she would incur a federal capital gain tax of $75,000, computed as follows:
$2,500,000 (Sale price)
- 2,125,000 (Bessie’s income tax basis)
$375,000 Taxable gain
x.20 (Capital gain tax rate)
For joint tenancies involving only a husband and wife, the property is treated at the first death as belonging 50 percent to each spouse for federal estate tax purposes. I.R.C. § 2040(b). This is known as the “fractional share” rule. Thus, only one-half of the value is taxed at the death of the first spouse to die and only one-half receives a new income tax basis.
Special rule. In 1992, the Sixth Circuit Court of Appeals applied the consideration furnished rule to a husband-wife joint tenancy in farmland with the result that the entire value of the jointly-held property was included in the gross estate of the husband, the first spouse to die. Gallenstein v. United States, 975 F.2d 286 (6th Cir. 1992). The full value was subject to federal estate tax but was covered by the 100 percent federal estate tax marital deduction, eliminating federal estate tax. In addition, the entire property received a new income tax basis which was the objective of the surviving spouse. The court reached this result because of statutory changes to the applicable Internal Revenue Code sections that were made in the late 1970s. To take advantage of those changes, the court determined, it was critical that the jointly held property at issue was acquired before 1977. Under the facts of the case, the farmland was purchased in 1955 for $38,500 exclusively with the husband’s funds. The surviving wife sold the farmland in 1988 for $3,663,650 after her husband’s death in late 1987. The entire gain on sale was eliminated because of the full basis step-up.
In 1996 and 1997, the federal district court for Maryland reached a similar conclusion. Anderson v. United States, 96-2 U.S. Tax Cas. (CCH) ¶60,235 (D. Md. 1996); Wilburn v. United States, 97-2 U.S. Tax Cas. (CCH) ¶50,881 (D. Md. 1997). Also, in 1997, the Fourth Circuit Court of Appeals followed the Sixth Circuit’s 1992 decision as did a federal district court in Florida. Patten v. United States, 116 F.3d 1029 (4th Cir. 1997), aff’g, 96-1 U.S. Tax Cas. (CCH) ¶ 60,231 (W.D. Va. 1996); Baszto v. United States, 98-1 U.S.Tax Cas. (CCH) ¶60,305 (M.D. Fla. 1997).
In 1998, the Tax Court agreed with the prior federal court opinions. Under the Tax Court’s reasoning, the fractional share rule cannot be applied to joint interests created before 1977. Hahn v. Comm’r, 110 T.C. No. 14 (1998). This is a key point. If the jointly held assets had declined in value, such that death of the first spouse would result in a lower basis, the fractional share rule would result in a more advantageous result for the survivor in the event of sale if the survivor could not prove contribution at the death of the first to die. In late 2001, the IRS acquiesced in the Tax Court’s opinion.
So what does all of this mean? It means that for pre-1977 marital joint tenancies where one spouse provided all of the funds to acquire the property and that spouse dies, the full value of the property will be included in the decedent’s gross estate. The value of the property will be subject to estate tax, but with an exemption of $11.18 million and the marital deduction, it’s not likely that federal estate tax would be due. In addition, and perhaps more importantly, the surviving spouse receives an income tax basis equal to the date of death value. That could be dramatically higher than the original cost basis. If the surviving spouse sells the property, capital gain could be potentially eliminated.
In agriculture, many situations still remain involved pre-1977 marital joint tenancies. Be on the look-out for this planning opportunity. It’s a “biggie” in the present era of a large federal estate tax unified credit exemption for federal estate (and gift) tax purposes.
Monday, September 24, 2018
The Tax Cuts and Jobs Act (TCJA) significantly increased the federal estate and gift tax exemption to $11.18 million for deaths in or gifts made in 2018. That effectively makes federal estate and gift tax a non-issue for practically all farming and ranching operations, with or without planning. However, business succession planning remains as important as ever. Last month, I wrote about one possible strategy, the intentionally defective grantor trust. Today, I discuss another possible succession planning concept – the grantor-retained annuity trust (GRAT). It’s another technique that can allow the grantor to “freeze” the value of the transferred assets while simultaneously providing the grantor with a cash flow stream for a specified time-period.
Transferring interests in a farming business (and other investment wealth) to successive generations by virtue of a GRAT – that’s the topic of today’s post.
GRAT - Defined
A GRAT is an irrevocable trust to which assets (those that are likely to appreciate in value (such as real estate) at a rate exceeding the rate applied to the annual annuity payment the GRAT will make) are transferred and the grantor receives the right to a fixed annuity payment for a term of years, with the remainder beneficiaries receiving any remaining assets at the end of the GRAT term. The fixed payment is typically a percentage of the asset’s initial fair market value computed so as to not trigger gift tax. The term of the annuity is fixed in the instrument and is either tied to the annuitant’s life, a specified term of years or a term that is the shorter of the two. The annuity payment can be structured to remain the same each year or it can increase up to 120 percent annually. However, once the annuity is established, additional property cannot be added to the GRAT.
A GRAT can accomplish two important estate planning objectives. The GRAT technique “freezes” the value of the senior family member’s highly appreciated assets at today’s value, and it provides the senior family member with an annuity payment for a term of years. Thus, the GRAT can deliver benefits without potential transfer tax disadvantages. Clearly, the lower the interest rate, the more attractive a GRAT is.
A GRAT must make at least one annuity payment every 12-month period that is paid to an annuitant from either the GRAT’s income or principal. There is a 105-day window within which the GRAT can satisfy the annual annuity payment requirement. The window runs from the GRAT creation date, which is based on state law. Notes cannot be used to fund annuity payments, and the trustee cannot prepay the annuity amount or make payments to any person other than the annuitant during the qualified interest term.
A GRAT is subject to a fixed amount requirement that takes the form of either a fixed dollar amount or a fixed percentage of the initial fair market value of the property transferred to the trust. There is also a formula adjustment requirement that is tied to the fixed value of the trust assets as finally determined for gift tax purposes. The provision must require adjustment of the annuity amount.
From a financial accounting standpoint, the GRAT is a separate legal entity. The GRAT’s bank account is established using the grantor’s social security number as the I.D. number. Annual accounting is required, including a balance sheet and an income statement.
Tax Consequences of Creating, Funding, Administering and Terminating a GRAT
For income tax purposes, the GRAT is treated as a grantor trust because, by definition, the retained interest exceeds five percent of the value of the trust at the time the trust is created. I.R.C. §673. Thus, there is no gain or loss to the grantor on the transfer of property to the GRAT in exchange for the annuity. There can be issues, however, if there is debt on the property transferred to the GRAT that exceeds the property’s basis. Also, when a partnership interest is contributed there can be an issue with partnership “negative basis” (i.e., the partner’s share of partnership liabilities exceeds the partner’s share of the tax basis in the partnership assets).
Because the trust is a grantor trust, the grantor is taxed on trust income, including interest, dividends, rents and royalties, as well as pass-through income from business entity ownership. The grantor also can claim the GRAT’s deductions. However, the grantor is not taxed on annuity payments, and transactions between the GRAT and the grantor are ignored for income tax purposes. A significant tax benefit of a GRAT is that the sale of the asset between the grantor and the GRAT does not trigger any taxable gain or loss. The transaction is treated as a tax-free installment sale of the asset. Also, the GRAT is permitted to hold “S” corporation stock as the trust is a permitted S corporation shareholder, and the GRAT assets grow without the burden of income taxes.
For gift tax purposes, the value of the gift equals the value of the property transferred to the GRAT less the value of the grantor’s retained annuity interest. In essence, the transferred assets are treated as a gift of the present value of the remainder interest in the property. That allows asset appreciation to be shifted (net of the assumed interest rate that is used to compute present value) from the grantor’s generation to the next generation.
If the GRAT underperforms (i.e., the GRAT assets fail to appreciate at a higher rate than the interest rate of the annuity payment), the GRAT can sell its assets back to the grantor with no income tax consequences (assuming the GRAT is a wholly-owned grantor trust. Rev. Rul. 85-13, 1985-1 C.B. 184. Then, the repurchased property can be placed in a new GRAT with a lower annuity payment. The original GRAT would then pay out its remaining cash and collapse.
It is possible to “zero-out” the gift value so there is no taxable gift. An interest rate formula determined by I.R.C. §7520 is used to calculate the value of the remainder interest. If the income and appreciation of the trust assets exceed the I.R.C. §7520 rate, assets remain at the end of the GRAT term that will pass to the GRAT beneficiaries. The basic idea is to transfer wealth to the subsequent generation with little or no gift tax consequences.
The grantor’s payment of taxes is not treated as a gift to the trust remainder beneficiaries. Rev. Rul. 2004-64, 2004-27 I.R.B. 7. Also, if the trustee reimburses (or has the power to reimburse) the grantor for the grantor’s payment of income tax, the reimbursement (or the discretion to reimburse) does not cause inclusion of the trust assets in the grantor’s estate. But, it’s important that the trustee is an independent trustee.
Death of Grantor During GRAT Term
If the grantor dies before the end of the GRAT term, a portion (or all) of the GRAT is included in the grantor’s gross estate. The amount included in the grantor’s estate is the lesser of the fair market value of the GRAT’s assets as of the grantor’s date of death or the amount of principal needed to pay the GRAT annuity into perpetuity (which is determined by dividing the GRAT annuity by the I.R.C. §7520 rate in effect during the month of the grantor’s death). Rev. Rul. 82-105, 1982-1 C.B. 133.
Example: Bubba died in June 2018 with $700,000 of assets held in a 10-year GRAT. At the time the GRAT was created in June of 2010 with a contribution of $1.5 million, the annuity was calculated to be $183,098.70 per year (based on an interest rate of 3.8 percent and a zeroed-out gift). The amount included in Bubba’s gross estate would be the lesser of $700,000 (the FMV of the GRAT assets at the time of death) or $5,385,255.88 (the value of the GRAT annuity paid into perpetuity ($183,098.70/.034)). Thus, the amount included in Bubba’s estate would be $700,000.
To minimize the risk of assets being included in the grantor’s estate, shorter GRAT terms are generally selected for older individuals. There is no restriction in the law as to how long a GRAT term must be. For example, Kerr v. Comr., 113 T.C. 449 (1999), aff’d., 292 F.3d 490 (5th Cir. 2002) involved a GRAT with a term of 366 days, and there is no indication in the court’s opinion that the term was challenged. In Priv. Ltr. Rul. 9239015 (Jun. 25, 1992), the IRS blessed a GRAT with a two-year term. See also Walton v. Comr., 115 T.C. 589 (2000).
GRAT Advantages and Disadvantages
To summarize the above discussion the following is a brief listing of advantages and disadvantages of a GRAT.
Advantages: 1) there is a reduced gift tax cost as compared to a direct gift; 2) the GRAT receives grantor trust status; 3) the grantor can borrow funds from the GRAT and the GRAT can borrow money from third parties (however, the grantor must report as income the amount borrowed - Tech. Adv. Memo. 200010010 (Nov. 23, 1999)); and 4) the GRAT term can safely be as short as two years.
Disadvantages: 1) upon formation, some of the grantor’s applicable exclusion might be utilized; 2) the grantor must survive the GRAT term to avoid having any part of the GRAT assets being included in the grantor’s gross estate; 3) notes or other forms of indebtedness cannot be used to satisfy the required annuity payments; and 4) grantor continues to pay income taxes on all of the GRAT’s income that is earned during the GRAT term.
The GRAT is another way to pass interests in the farming or ranching operation to the next generation. While it’s not a technique for everyone, it can be helpful for those with substantial estates. Also, keep in mind that the present level of the federal estate and gift tax exclusion amount of $11.18 million is scheduled to “sunset” after 2025. After that, under present law, the exclusion will drop to $5 million with an inflation adjustment. Also, if the political landscape changes to a significant enough degree the exemption could fall sooner and to a greater degree.
Thursday, September 20, 2018
Land ownership includes two separate estates in land – the surface estate and the mineral estate. The mineral estate can be severed from the surface estate with the result that ownership of the separate estates is in different parties. In some states, the mineral estate is dominant. That means that the mineral estate owner can freely use the surface estate to the extent reasonably necessary for the exploration, development and production of the minerals beneath the surface.
The “accommodation doctrine” is a court-made doctrine relating to the mineral owner's right to use the surface estate to drill for and produce minerals. ... The doctrine requires a balancing of the interests of the surface and mineral owner. How that balancing works was at issue in a recent case.
The accommodation doctrine – that’s the topic of today’s post.
The Accommodation Doctrine
If the owner of the mineral estate has only a single method for developing the minerals, many courts will allow that method to be utilized without consideration of its impact on the activities of the surface estate owner. See., e.g., Merriman v. XTO Energy, Inc., 407 S.W.3d 244 (Tex. 2013). But, under the accommodation doctrine, if alternative means of development are reasonably available that would not disrupt existing activities on the surface those alternative means must be utilized. For example, in Getty Oil co. v. Jones, 470 S.W.2d 618 (Tex. 1971), a surface estate owner claimed that the mineral estate owner did not accommodate existing surface use.
To prevail on that claim, the Texas Supreme Court, determined that the surface owner must prove that the mineral estate owner’s use precluded or substantially impaired the existing surface use, that the surface estate owner had no reasonable alternative method for continuing the existing surface use, and that the mineral estate owner has reasonable development alternatives that would not disrupt the surface use. A question left unanswered in the 1971 decision was whether the accommodation doctrine applied beyond subsurface mineral use to the exercise of groundwater rights. But, in 2016, the court said that the doctrine said the doctrine applied to groundwater. Coyote Lake Ranch, LLC v. City of Lubbock, No. 14-0572, 2016 Tex. LEXIS 415 (Tex. Sup. Ct. May 27, 2016).
Harrison v. Rosetta Res. Operating, LP, No. 08-15-00318-CV 2018 Tex. App. LEXIS 6208 (Tex Ct. App. Aug. 8, 2018), involved a water-use dispute between an oil and gas lessee and the surface owner. The plaintiff owned the surface of a 320-acre tract. The surface estate had been severed from the mineral estate, with the minerals being owned by the State of Texas. In October 2009, the plaintiff executed an oil and gas lease on behalf of the State with Eagle Oil & Gas Co. Eagle began its drilling operations, but before completing its first well it assigned the lease to Comstock Oil & Gas, L.P., subject to an agreement to indemnify Eagle against claims arising from its operations to that point. Within a few months, the plaintiff and several other plaintiffs sued Eagle for negligently destroying the plaintiff’s irrigation ditch as well as damage resulting from road construction, among other claims. Comstock defended Eagle in the lawsuit and settled a few months later. According to the settlement agreement, Comstock would make repairs to a water well on the plaintiff’s land and purchase 120,000 barrels of water from the plaintiff at a rate of fifty cents per barrel. A plastic-lined “frac pit” was also built on the property to store water produced from the well, although the pit was not a requirement of the settlement agreement. Comstock complied with the agreement and purchased the required amounts of water from the plaintiff at the agreed price. Comstock completed two oil wells on the property that year and began constructing a third well the following year. Before completing the third well, however, Comstock assigned the least to Rosetta Resources Operating, LP, the defendant in this case, who continued construction of the third well and began construction of several more. Unlike Comstock, the defendant did not purchase its water from the plaintiff, choosing instead to pump in water from an adjacent property, a neighbor of the plaintiff.
After learning that the defendant was importing his neighbor’s water, the plaintiff filed suit in his individual capacity and as trustee against the defendant for breach of contract, claiming an employee of the defendant had orally agreed to continue the same arrangement the plaintiff had enjoyed with Comstock. He also sought to permanently enjoin the defendant from using his neighbor’s water and sought cancellation of the State’s oil and gas lease. The defendant filed three motions for summary judgment that collectively challenged all of the plaintiff’s claims. In response, the plaintiff filed an amended petition asserting that the defendant had violated the “accommodation doctrine” by not purchasing his water, thus rendering his well and frac pit useless and unnecessarily causing damage to his property. The trial court granted the defendant’s motions for summary judgment in their entirety. The plaintiff appealed.
The appellate court determined that the plaintiff’s accommodation doctrine arguments appeared to rest on his proposition that because a frac pit was built on his land for use by the former lessee, it unified the use of the land with the oil and gas operations, and when the defendant chose not buy his water it substantially interfered with his existing use of the land as a source of water for drilling operations. Thus, the substantial interference complained of was that the frac pit was no longer profitable because the defendant is not using it to supply water for its operations. The appellate court held that categorizing a refusal to buy goods produced from the land as interference with the land for purposes of the accommodation doctrine would stretch the doctrine beyond recognition. Therefore, because the defendant’s use did not impair the plaintiff’s existing surface use in any way, except in the sense that not buying the water had precluded the plaintiff from realizing potential revenue from selling its water to the defendant, the inconvenience to the surface estate was not evidence that the owner had no reasonable alternative to maintain the existing use. Lastly, the court determined that if it were to hold for the plaintiff on these facts they would, in effect, be holding that all mineral lessees must use and purchase water from the surface owner under the accommodation doctrine if his water is available for use. Accordingly, the appellate court affirmed.
The accommodation doctrine is not designed to substitute for common sense reasonableness when the dominant estate owner has two clear options for doing something that involve the same cost. If one option is more disruptive to the surface owner, inherent limits of reasonable use dictate use of the less disruptive option. The recent Texas case is just another illustration of how courts wrestle with the application of the doctrine.
Tuesday, September 18, 2018
When farmland is purchased, depreciation can be claimed on depreciable assets associated with the farmland starting with the first tax year in which possession of the land is taken. The amount claimed is tied to the portion of the total cost of the farmland that can be allocated to any depreciable asset, such as fencing, field drainage tile, grain storage facilities, farm buildings, and irrigation equipment, just to name a few of the more common depreciable items.
In certain parts of the Midwest, above average soil fertility is also eligible for expense deductions. The concept is known as “residual soil fertility” and it can be available to farmland buyers that didn’t farm the acquired property within the immediately prior crop year.
Deductions associated with residual soil fertility, that’s the topic of today’s post.
I.R.C. §180 allows a taxpayer engaged in the trade or business of farming to annually elect (by deducting the expense on the return) the cost of fertilizer, lime, potash, or other materials which enrich, neutralize or condition land used in farming. If these fertilization costs are not expensed, they are required to be capitalized with expense deductions being amortized over a presumed useful life (similar to field drainage tile and/or fencing). This means that residual soil fertility is a capital asset in the hands of an operating farmer, crop-share landlord or cash rent landlord when farmland is acquired, with the cost amortized over the useful life of the asset. That useful life is typically three to four years. The general 15-year amortization rules don’t apply. Instead, the IRS position is that fertilizer costs should be amortized based on the percentage of use or benefit each year. That likely means that straight-line amortization probably does not apply. An agronomist or other soil scientist may be able to provide sufficient information so that the property annual expense allocation can be determined See, e.g., IRS Pub. 225, Chapter 4.
For farmland inherited from a decedent, the date of the decedent’s death is the measurement date for determining whether residual soil fertility exists. If it does, the cost can be amortized by the decedent’s estate and/or the beneficiaries of the estate that receive the farmland.
In 1995, the IRS published a Market Segment Specialization Program (MSSP) addressing residual soil fertility. IRS MSSP, Guideline on Grain Farmers (Training 3149-133, Jul. 1995). In the MSSP, the IRS notes that a deduction for residual fertilizer supply will be denied unless the taxpayer can establish (1) beneficial ownership of the residual fertilizer supply; (2) the presence and extent of the residual fertilizer; and (3) that the residual fertilizer supply is actually being exhausted. In addition, the MSSP instructs IRS examining agents to make sure that the values assigned to depreciable farm assets is reasonable. See also, Tech. Adv. Memo. 9211007 (Dec. 3, 1991).
So, how can a taxpayer establish the presence and extent of residual fertilizer supply and that it is actually being exhausted? For starters, if farmland has an actual excess soil fertility base it will normally bring a price premium upon sale. That’s the same rationale that applies when farmland with good fences, field drainage tile and grain storage facilities is purchased – a price premium applies to factor in the existence of those assets. As for residual fertilizer supply, the excess amount can be measured by grid sampling. A buyer can anticipate that grid sampling will cost of approximately $4-$8 per acre. Agronomists and agricultural soil testing labs follow certain guidelines and procedures that they use to determine average (base) soil fertility for various soil types. Once grid soil samples are obtained, the fertility levels of those samples are compared to the base fertility guideline levels for particular soil types to establish the amount of “excess” fertility on a tract of acquired farm real estate.
The key is to obtain data for the established base soil fertility for the type of soil on the purchased farmland from comparable tracts and comparable soil types. By establishing the base soil fertility, the actual sampling on the purchased property will reveal whether excess residual fertilizer is present. That soil sampling should occur on or before the buyer takes possession of the farmland. For farmland that is inherited, the sampling should occur before the buyer applies any new fertilization.
While the IRS does not require it, perhaps the best way to document the deduction for excess soil fertility is to provide for the allocation of value to the amount of above average soil fertility in the purchase contract for the farmland. In addition, a written summary of how the computation was made and the time period over which it would deplete due to crop production should be obtained from the agronomist or other expert involved. This will be beneficial for establishing the proper amortization period for the excess soil fertility, and will provide substantiation of the deduction upon any subsequent IRS (or state) audit. Depending on the soil type involved, the deduction could range from $50 per acre to over $700 per acre.
When farmland is acquired, an allocation of value can be made to depreciable items. In certain parts of the country, a depreciable item might be residual fertilizer supply. If it can be established with appropriate data, a tax benefit is available. It’s important, however, to follow the IRS guidelines. Also, in some states, following the IRS guidance on deducting excess soil fertility may not be good enough. Yes, Minnesota, I am talking about you.
Friday, September 14, 2018
A great deal of farm personal property is out in the open. From time to time, machinery and equipment may sit outside, and farm tools and supplies may also be out in the open. Of course, grazing livestock may be outside along with other farm property. Farm real estate may contain farm ponds, stock water tanks and other potential hazards. All of this raises concerns about public access to the premises and possible theft of property and potential liability issues. Similarly, livestock confinement operations have their own unique concerns about who has access to the property.
Does the posting of the property as “No Trespassing” have any legal consequence? It might. That’s the topic of today’s post.
Benefits of Posting
Criminal trespass. One potential benefit of posting property “No Trespassing” is that, in some states, what is otherwise a civil trespass can be converted to a criminal trespass. A criminal trespass gets the state involved in prosecuting the trespasser, and it might be viewed as having a greater disincentive to trespass than would a civil trespass. A civil trespass is prosecuted by the landowner personally against the alleged trespasser.
Search warrant. Another possible benefit of posting property “No Trespassing” is that it may cause a search warrant to be obtained before the property can be search for potential criminal conduct. Under the Fourth Amendment to the Constitution, unreasonable searches and seizures are prohibited absent a search warrant that is judicially-approved and supported by probable cause.
The search warrant issue and the posting of “No Trespassing” signs was the subject of a recent case from Vermont. In State v. Dupuis, 2018 VT 86 (Vt. Sup. Ct. 2018), a fish and game warden entered the defendant’s property via an adjoining property. The warden found a blind with a salt block and apples nearby. A rather precarious path through tough timber was used by the warden to avoid detection. The defendant was charged with baiting and taking big game by illegal means. At trial, the defendant and many others testified that there are “no trespassing” and “keep out” signs all around the property and on the gate to the public road. The warden stated that he did not see any of these signs. The defendant motioned to exclude the evidence because the warden never obtained a search warrant. The defendant claimed that he had a reasonable expectation of privacy throughout his property particularly because of the “No Trespassing” signs.
The trial court reasoned that the warden’s access to the property was abnormal and did not diminish the defendant’s intent to exclude people from coming onto the property. The trial court granted the defendant’s motion to suppress evidence obtained by the warden during the warrantless search. On appeal, the state Supreme Court affirmed. The State claimed that the defendant did not properly exclude the public and, therefore, did not have an expectation of privacy relating to the regulation of hunting. However, the Supreme Court held that when a landowner objectively demonstrates an intent to maintain privacy of open fields, a search warrant is required. Game wardens must obtain a search warrant, the court determined, whenever a warden seeks to enter property and gather evidence. The defendant’s posting of “No Trespassing” signs created an expectation of privacy. Accordingly, the evidenced obtained in the warrantless search was properly suppressed.
The Vermont case points out that posting property as “No Trespassing” can, indeed, have its benefits. Also, it’s important to check state law requirements for the type, size, placement and content of signs. State rules vary and they must be complied with to properly post your property. Just another thing to think about in the world of agricultural law.
Wednesday, September 12, 2018
The vast majority of agricultural businesses depend on financing to buy crop inputs, machinery, equipment, livestock and land. For financed purchased items other than land, the lender will obtain in interest in collateral to secure the loan. That is done by the parties executing a security agreement and the lender filing a financing statement as a public record of the transaction. Often the lender will also obtain an interest in the “proceeds” of the collateral. A state’s version of Article 9 of the Uniform Commercial Code governs the matter.
But, just what are “proceeds” of crops and livestock? It’s an interesting question that sometimes arises in ag financing situations? It’s the topic of today’s post.
“Proceeds” – The Basics
The security interest created by a security agreement is a relatively durable lien. The collateral may change form as the production process unfolds. Fertilizer and seed become growing crops, animals are fattened and sold, and equipment is replaced. The lien follows the changing collateral and, in the end, may attach to the proceeds from the sales of products (at least up to ten days after the debtor receives the proceeds). In other words, a security interest in proceeds is automatically perfected if the interest in the original collateral was perfected. However, a security interest in proceeds ceases to be automatically perfected ten days after the debtor receives the proceeds.
Proceeds are generally defined as whatever is received upon the sale, trade-in or other disposition of the collateral covered by the security agreement. Revised UCC § 9-102(a)(64)(A). “Proceeds” also includes whatever is distributed or collected on account of collateral. That does not necessarily require a disposition. See, e.g., Western Farm Service v. Olsen, 90 P.3d 1053 (Wash. 2004), rev’g, 59 P.3d 93 (Wash. Ct. App. 2003). But, “proceeds” does not include a deposit account unless monies from the disposition of collateral are deposited into the account. See, e.g., Community Trust Bank v. First National Bank, 924 So. 2d 488 (La. Ct. App. 2006).
“Proceeds” in Ag Settings
In agricultural settings, “proceeds” of crops or livestock can take several forms. These can include federal farm program deficiency payments, storage payments, diversion payments, disaster relief payments, insurance payments for destroyed crops, Conservation Reserve Program payments and dairy herd termination program payments, among other things. This is significant in agriculture because of the magnitude of the payments. In fact, in debt enforcement or liquidation settings, the federal payments are often the primary or only form of money remaining for creditors to reach.
Crops fed to livestock. If both a farmer's crops and livestock are items of collateral for the same lender, the lender does not usually object to use of the crops as feed. The lender's filed financing statement describing the crop and animals would give sufficient notice of the continuing lien and preserve an interest in the disappearing feed. However, where one lender has a lien on the crops that are fed and another has a lien on the animals that eat the crops as feed, a so-called “split line” of credit, the outcome is not completely clear. If rules as to commingling apply, a perfected security interest in the feed which loses its identity by becoming part of the animal ranks equally with other perfected security interests in the animals according to the ratio that the cost of the assets to which each interest originally attached bears to the total cost of the resulting animal. However, the Nebraska Supreme Court determined in a 1988 decision that the commingling of feed rule does not apply to feed where there is no evidence that the feed was fed to livestock. Beatrice National Bank v. Southeast Nebraska Cooperative, 230 Neb. 671, 432 N.W.2d 842 (1988). But, when feed that is collateral for one lender is fed to livestock that is collateral for another lender, the courts are split on the outcome. In a Colorado case, the court held that the feeding of grain to cattle that was pledged as collateral under a security agreement terminated the creditor's security interest in the grain. First National Bank of Brush v. Bostron 39 Colo. App. 107, 564 P.2d 964 (1977). But, in a later Wisconsin decision where the debtor raised cattle that were owned by third party investors, the court determined that the creditor's security interest in the crops that were fed to the cattle continued in cattle proceeds under either Article 9 or because the feeding was considered to be a sale of the crops to the investors. In re Pelton 171 B.R. 641 (Bankr. W.D. Wis. 1994)
“Proceeds” and bankruptcy. The “identifiable proceeds” problem may also be a concern to a creditor in the event the debtor files bankruptcy. In Pitcock v. First Bank of Muleshoe, 208 B.R. 862 (Bankr. N.D. Tex. 1997), the debtor borrowed money from a bank to plant crops and granted the bank a security interest in all crops and equipment. The debtor grew crops, but instead of harvesting the crops and selling the grain, the debtor pastured cattle “on the gain” on leased land. The debtor received a rental payment based upon the amount of weight the cattle gained from consuming the crops that served as collateral for the loan from the creditor. The debtor received the rent checks and used all of the proceeds for business and living expenses. Shortly after the loan became due, the debtor filed bankruptcy and the creditor filed a claim for the unpaid loan. The creditor argued that its security agreement extended to the pasture rents. The court held, however, that because the crops were not in existence when the debtor filed bankruptcy, no collateral remained to secure the bank's loan. As such, the bank's claim was unsecured.
What about milk? A recent case dealt with the issue of the rights to the sale proceeds of milk. In, In re Velde, No. 18-11651-A-11 2018 Bankr. LEXIS 2621 (Bankr. E.D. Cal. Aug. 23, 2018), the plaintiff owned three dairies including one that delivered the milk it produced to a processor, Columbia River Processing. The plaintiff gave multiple creditors a consensual lien against the milk-delivering dairy’s, crops, milk, milk checks, equipment and other personal property at a time when the aggregate amount due the creditors was about $78 million. Custom Feed Services, LLC; Western Ag Improvements, Inc.; Cold Springs Veterinary Services, Inc.; and Scott Harvesting, LLC (collectively known as ASL holders) provided goods and/or services to the plaintiff’s milk-delivering dairy. The plaintiff then filed Chapter 11 bankruptcy.
Each of the ASL creditors claimed a non-possessory chattel lien under Oregon Rev. Stat. § 87.226, encumbering the dairy’s crops and livestock, as well as the sale proceeds of the sales of the crops and livestock. The amount due ASL Holders on the date of bankruptcy filing was almost $1.1 million. The ASL Holders served notice of their liens on Columbia River. Columbia River owed the dairy approximately $1.2 million for milk delivered to it. Uncertain as to whether the plaintiff, the Consensual Lienholders or the ASL Holders were entitled to those funds, Columbia River Processing impounded and held the milk proceeds. The plaintiff sued the Consensual Lienholders and the ASL Holders to determine the nature, extent and validity of the agricultural service liens.
Oregon's non-possessory lien statutes specifies that persons who provide services and suppliers who provide materials a lien against chattels improved by the services and materials. Agricultural Services Liens extend to crops and animals, their "proceeds," and, in limited instances, to the offspring of those animals. The court determined that the text and context of the statute revealed a legislative intent that the agricultural services lien reach only crops and animals, the proceeds of crops or animals generated by their sale or similar disposition and, in limited instances, the products of crops or animals, unborn regency of animals that are in utero on the date a notice of lien is filed and, in the case of stud or artificial insemination services, offspring. The court also pointed out that in common parlance, “milk” is neither a product nor a proceed, and §87.226 narrowly tailored the circumstances in which agricultural service liens attach to products (i.e., unborn progeny and offspring of stud/artificial insemination services). Because this was not one of those circumstances, the court held that “proceeds” did not attach to milk, or the funds generated by its sale, produced by a cow encumbered by an Agricultural Service Lien. As such, the milk held by Columbia River was not subject to the lien of ASL lienholders.
What are proceeds of crops and livestock? It depends! Ag financing situations can get complex quickly. This is certainly another one of those situations where a good ag lawyer comes in very handy. Farming and ranching is complex in many respects, not the least of which is agricultural financing.
Monday, September 10, 2018
Partition and sale of land is a legal remedy available if co-owners of land cannot agree on whether to buy out one or more of the co-owners or sell the property and split the proceeds. It is often the result of a poorly planned farm or ranch estate where the last of the parents to die leaves the farm or ranch land equally to all of the kids and not all of them want to farm or they simply can’t get along. Because they each own an undivided interest in the entire property, they each have the right of partition and sell to parcel out their interest. But, that rarely is the result because they aren’t able to establish that the tract can be split exactly equally between them in terms of soil type and slope, productivity, timber, road access, water, etc. So, a court will order the entire property sold and the proceeds of sale split equally.
The court-ordered sale is most likely an unhappy result, and it can be avoided with appropriate planning in advance. But, what tax consequences result from a partition and resulting sale? That’s the focus of today’s post.
A partition of property involving related parties comes within the exception to the “related party” rule under the like-kind exchange provision. This occurs in situations where the IRS is satisfied that avoidance of federal income tax is not a principal purpose of the transaction. Therefore, transactions involving an exchange of undivided interests in different properties that result in each taxpayer holding either the entire interest in a single property or a larger undivided interest in any of the properties come within the exception to the related party rule. But, as noted, this is only true when avoidance of federal income tax is not a principal purpose of the transaction.
As for the income tax consequences on the sale of property in a partition proceeding to one of two co-owners, such a sale does not trigger gain for the purchasing co-owner as to that co-owner’s interest in the property.
Is a Partition an Exchange?
If the transaction is not an “exchange,” it does not need to be reported to the IRS, and the related party rules are not involved. If the property that is “exchanged” is dissimilar, then the matter is different. Gain or loss is realized (and recognized) from the conversion of property into cash, or from the exchange of property for other property differing materially either in kind or extent. Treas. Reg. §1.1001-1(a). In the partition setting, that would mean that items of significance include whether debt is involved, whether the tracts are contiguous, and the extent to which they differ.
IRS ruling. In 1954, the IRS ruled that the conversion of a joint tenancy in capital stock of a corporation into tenancy in common ownership (to eliminate the survivorship feature) was a non-taxable transaction for federal income tax purposes. Rev. Rul. 56-437, 1956-2 C.B. 301. Arguably, however, the ruling addressed a transaction distinguishable from a partition of property insomuch as the taxpayers in the ruling owned an undivided interest in the stock before conversion to tenancy in common and owned the same undivided interest after conversion.
Partition as a Severance
A partition transaction, by parties of jointly owned property, is not a sale or exchange or other disposition. It is merely a severance of joint ownership. For example, assume that three brothers each hold an undivided interest as tenants-in-common in three separate tracts of land. None of the tracts are subject to mortgages. They agree to partition the ownership interests, with each brother exchanging his undivided interest in the three separate parcels for a 100 percent ownership of one parcel. None of them assume any liabilities of any of the others or receive money or other property as a result of the exchange. Each continues to hold the single parcel for business or investment purposes. As a result, any gain or loss realized on the partition is not recognized and is, therefore, not includible in gross income. Rev. Rul. 73-476, 1973-2 C.B. 301. However, in a subsequent letter ruling issued almost 20 years later, the IRS stated that the 1973 Revenue Ruling on this set of facts held that gain or loss is “realized” on a partition. It did not address explicitly the question of whether the gain or loss was “recognized” although the conclusion was that the gain was not reportable as income. Priv. Ltr. Rul. 200303023 (Oct. 1, 2002).
To change the facts a bit, assume that two unrelated widows each own an undivided one-half interest in two separate tracts of farmland. They transfer their interests such that each of them now becomes the sole owner of a separate parcel. Widow A’s tract is subject to a mortgage and she receives a promissory note from Widow B of one-half the amount of the outstanding mortgage. Based on these facts, it appears that Widow A must recognize gain to the extent of the FMV of the note she received in the transaction because the note is considered unlike property. Rev. Rul. 79-44, 1979-2 C.B. 265.
Based on the rulings, while they are not entirely consistent, gain or loss on a partition is not recognized (although it may be realized) unless a debt security is received, or property is received that differs materially in kind or extent from the partitioned property. The key issue in partition actions then is a factual one. Does the property received in the partition differ “materially in kind or extent” from the partitioned property or is debt involved?
It may also be important whether the partition involves a single contiguous tract of land or multiple contiguous tracts of land. However, in two other private rulings, the taxpayer owned a one-third interest in a single parcel of property with two siblings as tenants-in-common. Priv. Ltr. Ruls. 200411022 (Dec. 10, 2003) and 200411023 (Dec. 10, 2003). The parties agreed to partition the property into three separate, equal-valued parcels with each person owning one parcel in fee. The property was not subject to any indebtedness. The IRS ruled that the partition of common interests in a single property into fee interests in separate portions of the property did not cause realization of taxable gain or deductible loss. Rev. Rul. 56-437, 1956-2 C.B. 507.
So, is there any difference taxwise between a partition with undivided interests that are transformed into the same degree of ownership in a different parcel and an ordinary partition of jointly owned property? Apparently, the IRS doesn’t think so. In one IRS ruling, the taxpayers proposed to divide real property into two parcels by partition, and the IRS ruled that gain or loss would not be recognized. Ltr. Rul. 9327069, February 12, 1993. Likewise, in another ruling, a partition of contiguous properties was not considered to be a sale or exchange. Ltr. Rul. 9633028 (May 20, 1996). The tracts were treated as one parcel.
The partition of the ownership interests of co-owners holding undivided interests in real estate is often an unfortunate aspect of poor planning in farm and ranch estates. That problem can be solved with appropriate planning. The tax consequences of a partition don’t appear to present a problem if the partition amounts to simply a rearrangement of ownership interests among the co-owners.
Thursday, September 6, 2018
One of the reasons for the formation of a corporation is to achieve liability protection. Liability of corporate shareholders is limited to the extent of their individual investment in the corporation. In a farm and ranch setting, while a corporation may not actually be utilized as the operating entity, it is commonly used to hold operating assets as a means of shielding the shareholders from personal liability against creditor claims arising from operations.
But, creditor protection is not absolute. In certain circumstances the corporate “veil” can be “pierced” with the result that a shareholder can be held personally liable for corporate liabilities.
Corporate veil-piercing – that’s the topic of today’s post.
Factors for “Piercing”
Corporate “veil piercing” is generally a matter of state law. A state’s corporate code sets forth the rules for properly forming a corporation and the ongoing conduct of the corporate business. It is critical for a corporation and its shareholders to follow those rules. For instance, shareholder limited liability can be lost if the corporation is not validly organized in accordance with state law. In addition, to maintain limited liability the corporation must comply with certain corporate formalities such as conducting an annual meeting, filing an annual report with a designated state office, and electing directors and officers. If these corporate formalities are not complied with, limited liability for shareholders is sacrificed.
Also, a reasonable amount of equity or risk capital must be committed to the corporation. Shareholder limited liability is lost if the corporation is inadequately capitalized. Courts will “pierce the corporate veil” unless a reasonable amount of equity capital is committed to the business to serve as a cushion to absorb the liability shocks of the business. See, e.g., Dewitt Truck Brokers v. W. Ray Flemming Fruit Co., 540 F.2d 681 (4th Cir. 1976).
Illustrative Cases on Veil Piercing
The following cases are a small sample that show the various ways in which corporate veil piercing can arise:
- In Juniper Investment Co v. United States, 338 F2d 356 (Cl. Ct. 1964), a personal holding company’s separate existence was disregarded because it acted as the alter ego of the shareholders.
- Listing corporate assets as those of the shareholder on the shareholder’s personal loan application resulted in the court finding that the corporation was merely created for the taxpayer to avoid tax and was not a separate entity from the shareholder in Wenz v. Comr., T.C. Memo. 1995-277.
- In Foxworthy, Inc. v. Comr., T.C. Memo. 2009-203, the court held that the corporation at issue was the taxpayer’s alter ego that couldn’t be disregarded for tax purposes. The court pointed out that the taxpayer was neither an owner, director or corporate employee. Even so, the taxpayer had complete control over the corporation and used the corporation to buy the taxpayer’s personal resident and maintain it. The court noted that the corporation had no real business purposes and was used in an attempt to convert personal living expenses into deductible business expenses.
- Veil piercing was the result where a corporation’s funds and a shareholder’s funds were comingled and the shareholder controlled and managed the corporation’s accounts as his own. Pollack v. Comr., T.C. Memo. 1982-638.
- In Pappas v. Comr., T.C. Memo. 2002-127, the corporate veil was pierced because there was no real distinction between the taxpayer and the corporation. The taxpayer used corporate funds for personal expenses, the corporation didn’t file federal or state tax returns. In addition, corporate formalities were ignored, and the corporation did not have a separate office apart from the taxpayer’s home address. Also, the taxpayer was the only corporate employee and corporate records were not maintained.
In Woodruff Construction, L.L.C. v. Clark, No. 17-1422, 2018 Iowa App. LEXIS 765 (Iowa Ct. App. Aug. 15, 2018), the defendant formed a corporation and filed articles of incorporation in 1997. The corporation was reincorporated in 2001 after an administrative dissolution. The corporation was engaged in the business of biosolids management. The defendant was the sole owner and director of the corporation along with being the corporation’s secretary and treasurer. The plaintiff contracted with a small town to be the general contractor during the construction of a wastewater treatment facility for the town. In early 2010, the plaintiff contracted with the defendant for lagoon sludge removal. The defendant began work, but then ceased work after determining that project would cost more to complete that what the contract was bid for.
In 2012, the plaintiff sued for breach of contract and obtained a judgment of $410,066.83 plus interest in 2014. The corporation failed to pay the judgment and the plaintiff sued in 2015 to pierce the corporate veil and recover the judgment personally from the defendant. The trial court refused to pierce the corporate veil and also denied a request to impose a constructive trust and equitable lien on the corporate assets. The plaintiff appealed the denial of piercing the corporate veil.
The appellate court determined that the plaintiff had failed to establish that the corporation was undercapitalized – it had assets and was profitable. The plaintiff also did not show that the corporation was undercapitalized at the time it entered into the contract with the plaintiff. There also was no evidence showing that the corporation changed the nature of its work or engaged in an inadequately-capitalized expansion of the business. It was also unclear, the appellate court noted, that the capital transfers from the corporation to the defendant rendered the initial adequate capitalization irrelevant. Thus, the plaintiff failed to establish that the corporation was undercapitalized to an extent that merited piercing the corporate veil.
However, the appellate court noted that the evidence illustrated that the defendant commingled personal funds with corporate funds. The defendant used corporate funds for personal purposes, and also failed to maintain separate books and records that sufficiently distinguished them from the defendant personally. In addition, the appellate court noted that the corporation did not follow corporate formalities. The corporation had been dissolved administratively by the Secretary of State in 1998 due to the failure to file a biennial report, but the corporation continued operations during the time it was dissolved as if the corporation were active. When the new corporation began in 2001, no bylaws, corporate minute book or shareholder ledger were produced. In addition, the new corporation (operating under the same name as the old corporation) was administratively dissolved three times for failure to submit the biennial report (the corporation used the statutory procedure to apply for reinstatement each time). The appellate court determined that the corporation was not considered by the defendant to be a separate entity from himself. Accordingly, the appellate court reversed the trial court and allowed the corporate veil to be pierced and the defendant to be held personally responsible for the judgment.
To obtain creditor protection that the limited liability feature of a corporation can provide, it’s critical to follow corporate formalities and respect the corporation as an entity distinct from the shareholder. Failure to do so can result in personal liability for corporate debts and obligations. With machinery, equipment, livestock and unique features on farm and ranch land, achieving liability protection for farmers and ranchers is a big deal. Respecting the corporate entity is key to achieving that protection. Good legal counsel can make sure these requirements are satisfied.
Tuesday, September 4, 2018
On occasion I get a question about whether it is permissible to pick up roadkill. Often, the question is in relation to big game such as deer or bear or moose. But, other times the question may involve various types of furbearing animals such as coyotes, racoons or badgers. I don’t get too many roadkill questions involving small game. That’s probably because when small game is killed on the road, it is either not wanted or the party hitting it simply assumes that there is no question that it can be possessed.
There are many collisions involving wildlife and automobiles every year. One estimate by a major insurance company projects that one out of every 169 motorists in the U.S. will hit a deer during 2018. That’s a projected increase of three percent over 2017, with an estimated 1.3 million deer being hit.
If a wild animal is hit by a vehicle, the meat from the animal is the same as that from animal meat obtained by hunting – assuming that the animal is not diseased. So, in that instance, harvesting roadkill is a way to get free food – either for personal consumption or to donate to charity.
What are the rules and regulations governing roadkill? That’s the topic of today’s post.
Many states have rules on the books concerning roadkill. Often, the approach is for the state statutes and the regulatory body (often the state Department of Game and Fish (or something comparable)) to distinguish between "big game," "furbearing animals" and "small game." This appears to be the approach of Kansas and a few other states. Often a salvage tag (e.g., “permit”) is needed to pick up big game and turkey roadkill. This is the approach utilized in Iowa and some other states. If a salvage tag is possessed, a hunting license is not required. For furbearing animals such as opossums and coyotes that are roadkill, the typical state approach is that these animals can only be possessed during the furbearing season with a valid fur harvester license. As for small game, the typical state approach is that these roadkill animals can be possessed with a valid hunting license in-season. But variations exist from state-to-state.
An approach of several states is to allow the collection of roadkill with a valid permit. That appears to be the approach in Colorado, Georgia, Idaho, Illinois, Indiana, Maryland, New Hampshire, North Dakota, New York, Ohio, Pennsylvania and Tennessee. Other states require the party hitting wildlife and collecting the roadkill to report the incident and collection within 24 hours. Other states may limit roadkill harvesting to licensed fur dealers. In these states (and some others), the general public doesn’t have a right to collect roadkill. In Texas, roadkill-eating is not allowed (although a legislative attempt to remove the ban was attempted in 2014). South Dakota has legislatively attempted to make roadkill public property. Wyoming requires a tag be received from the game warden for possessing big game roadkill. Oregon allows drivers to get permits to recover, possess, use or transport roadkill.
Other states (such as Alabama) may limit roadkill harvesting to non-protected animals and game animals, and then only during open season. The Alaska approach is to only allow roadkill to be distributed via volunteer organizations. A special rule for black bear roadkill exists in Georgia. Illinois, in certain situations requires licenses and a habitat stamp. Massachusetts requires that roadkill be submitted for state inspection, and New Jersey limits salvaging roadkill to deer for persons with a proper permit.
In all states, federally-protected species cannot be possessed. If a question exists about the protected status of roadkill, the safest approach is to leave it alone. Criminal penalties can apply for mere possession of federally protected animals and birds. Similarly, if a vehicle does significant enough damage to wildlife that the animal’s carcass cannot be properly identified to determine if the season is open for that particular animal (in those states that tie roadkill possession to doing so in-season) the recommended conduct is to not possess the roadkill.
In the states that have considered roadkill legislation in recent years, proponents often claim that allowing licensed hunters to take (subject to legal limits) a fur-bearing animal from the roadside would be a cost-saving measure for the state. The logic is that fewer state employees would be required to clean-up dead animal carcasses. Opponents of roadkill bills tend to focus their arguments on safety-related concerns – that having persons stopped alongside the roadway to collect dead animals would constitute a safety hazard for other drivers. That’s an interesting argument inasmuch as those making this claim would also appear to be asserting that a dead animal on a roadway at night is not a safety hazard. Others simply appear to argue that collecting roadkill for human consumption is disgusting.
There is significant variation among state approaches with respect to possession of roadkill. That means that for persons interested in picking up roadkill, researching applicable state law and governing regulations in advance would be a good idea. For roadkill that is gleaned from a roadway that is used for human consumption, care should be taken in preparation and cooking. The present younger generation typically doesn’t have much experience dining on racoon (they tend to be greasy), opossum shanks and gravy, as well as squirrel. But, prepared properly, some view them as a delicacy.
To date, the USDA hasn’t issued guidelines on the proper preparation of roadkill or where roadkill fits in its food pyramid (that was revised in recent years). That’s sounds like a good project for some USDA Undersecretary for Food Safety to occupy their time with.
Friday, August 31, 2018
Economic and financial conditions remain tough in much of agriculture. Bankruptcy filings have seen an increase, and that includes the number of Chapter 12 filings. In a Chapter 12 the debtor must file a reorganization plan under which the debtor proposes a plan for paying off creditors. Plan payments generally must pass through the hands of the bankruptcy trustee. The trustee is compensated out of a portion of the plan payments.
But, what if a debtor proposes to make payments directly to the creditors? Doing so would bypass the trustee, and would also bypass the trustee’s fee. It would also mean that all of the payments made under the bankruptcy plan would go to the creditors instead of some of it syphoned off to pay the trustee.
That’s the focus of today’s post – whether a debtor in reorganization bankruptcy can make direct payments to creditors under the debtor’s reorganization plan.
The Reorganization Plan
A Chapter 12 debtor has an exclusive 90-day period after filing for Chapter 12 bankruptcy to file a plan for reorganization unless the court grants an extension. A court may grant additional time only if circumstances are present for which the debtor should not fairly be held accountable. 11 U.S.C. §1221. See e.g., In re Davis, No. CC-16-1390-KuLTa, 2017 Bankr. LEXIS 2169 (B.A.P. 9th Cir. Aug. 2, 2017). If the court determines that the debtor will be unable to make all payments as required by the plan, the court may require the debtor to modify the plan, convert the case to a Chapter 7, or request the court to dismiss the case. In other words, the plan must be feasible. It must also be proposed in good faith. Good faith can be viewed as practically synonymous the requirement that the plan be feasible. See, e.g., In re Lockard, 234 B.R. 484 (Bankr. W.D. Mo. 1999).
The Bankruptcy Trustee
Duties. A trustee is appointed in every Chapter 12 case. A Chapter 12 trustee’s duties are similar to those under Chapter 13. Specifically, a trustee under Chapter 12, is directed to:
* be accountable for all property received;
* ensure that the debtor performs in accordance with intention;
* object to the allowance of claims which would be improper;
* if advisable, oppose the discharge of the debtor;
* furnish requested information to a party in interest unless the court orders otherwise;
* make a final report;
* for cause and upon request, investigate the financial affairs of the debtor, the
operation of the debtor’s business and the desirability of the continuance of the business;
* participate in hearings concerning the value of property of the bankruptcy estate; and
* ensure that the debtor commences making timely payments required by confirmed plan.
In specifying the duties of trustees, Chapter 12 modifies the duty applicable to trustees under other chapters of the Bankruptcy Code to “investigate the financial affairs of the debtor.” Chapter 12 authorizes an investigative role for trustees, as noted above, “for cause and on request of a party in interest....” Thus, it would appear, in a routine case where there is no fraud, dishonesty, incompetence or gross mismanagement, the debtor should be allowed to reorganize without significant interference from the trustee.
Compensation. The compensation of trustees is not to exceed 10 percent of payments made under the debtor’s plan for the first $450,000 of payments. The fee is then not to exceed three percent of aggregate plan payments above that amount. 28 U.S.C. §586(e)(1). The trustee collects the fee from payments received under the plan. 28 U.S.C. § 586(e)(2). That’s an important point - the fee is based on all payments the debtor makes under the plan to the trustee rather than on amounts the trustee disperses to creditors. See, e.g., Pelofsky v. Wallace, 102 F.3d 350 (8th Cir. 1996).
Except as provided in the plan or in order confirming the plan, it is the trustee that is to make payments to creditors under the plan. Courts have generally recognized that payments on fully secured claims that the bankruptcy plan does not modify can be paid directly to the creditor, as can claims not impaired by the plan. However, for claims that are impaired, courts are divided as to whether a court may approve direct payments to creditors.
The issue of who actually disburses the debtor’s payments is important to the trustee because, as noted above, the trustee is entitled to a statutory commission only on funds actually received from the debtor pursuant to the reorganization plan. But, the bankruptcy code does not prevent a debtor from making payments directly to creditors.
So, how does a court decide whether a debtor can make payments directly to creditors and bypass the trustee (and the trustee fee)? Historically, the courts have utilized three approaches for deciding whether a debtor can make direct payment under a Chapter 12 reorganization plan (and thereby bypass the trustee fee). One approach utilizes a blanket rule barring the direct payment of impaired secured creditors. See, e.g., In re Fulkrod, 973 F.2d 801 (9th Cir. 1992). Another approach is, essentially, the direct opposite. Under this approach, debtors can pay secured creditors directly, regardless of their impaired status. See, e.g., In re Wagner, 36 F.3d 723 (8th Cir. 1994). But, the majority approach is to weigh a number of factors in the balance on a case-by-case basis to determine whether direct payments can be made. See, e.g., In re Beard, 45 F.3d 113 (6th Cir. 1995)
The issue came up again in a recent case.
In In re Speir, No. 16-11947-JDW, 2018 Bankr. LEXIS 2359 (Bankr. N.D. Miss. Aug. 8, 2018), the debtor filed Chapter 12 in mid-2016 and a reorganization plan later that year. The plan called for direct payments to the secured creditors but payments to the unsecured creditors would be made to the trustee for distribution. The trustee objected, but the court upheld the direct payments except as applied to one secured creditor based on the application of a 13-factor test. Those factors are:
- The debtor’s past history;
- The debtor’s business acumen;
- Whether the debtor has complied post-filing statutory and court-imposed duties;
- Whether the debtor is acting in good-faith;
- The debtor’s ability to achieve meaningful reorganization absent direct payments;
- How the reorganization plan treats each creditor to which a direct payment is proposed to be made;
- The consent, or non-consent, of the affected creditor to the proposed plan treatment;
- How sophisticated a creditor is, and whether the creditor has the ability and incentive, to monitor compliance;
- The ability of the trustee and the court to monitor future direct payments;
- The potential burden on the trustee;
- The possible effect on the trustee’s salary or funding of the U.S. Trustee system;
- The potential for abuse of the bankruptcy system; and
- The existence of other unique or special circumstances
In balancing the factors, the In re Speir court noted that each factor may be considered, but it is not necessary that equal weight be given to each factor or even to different claims in the same case. Ultimately, what the analysis came down to in In re Speir was a weighing of the necessary compensation for the Trustee against a feasible plan for the debtor. The court noted that the debtor had used the bankruptcy process to substantially modify one secured creditor’s claim and, as a result, had to pay that creditor’s claim through the Trustee. The other secured creditors, the court noted, remained mostly unaffected by the debtor’s bankruptcy and could be paid directly.
While times remain tough in agriculture for some ag producers, Chapter 12 bankruptcy was created specifically to assist farm debtors in distress. The ability to pay creditors directly and bypass the Trustee (and the Trustee’s fee) might be possible. For those in Chapter 12, the issue should be evaluated.
Wednesday, August 29, 2018
In late 2016, I blogged on the issue of what ag employers need to do to verify employment and provided a survey of the primary employment laws and their application to agricultural employers. The issue has increased in importance recently, so it’s a good time to brush the dust off that blog post and update it.
Verifying the legal status of ag employees – that’s the topic of today’s post.
Ag Employment Data
Most estimates peg the total number of persons working on farms and ranches in the United States at approximately 3 million. Hired farm workers make up approximately one-third of that total. Of that number, about half are full-time workers, and about twenty-five percent are ag service workers that are contract hires. A slight majority of the hires work in crop agriculture with the balance working in the livestock industry. Two states – California and Texas account for more than a third of all farmworkers. According to the USDA data, 59 percent of farm laborers and supervisors are U.S. citizens (compared to 91 percent for all U.S. workers). The data also show that about 70 percent of hired crop farmworkers were born in Mexico.
According to the National Agricultural Worker Survey (NAWS), approximately 48 percent of farmworkers lack work authorization. However, this estimate may be low due to a variety of factors. But, this number is likely low because a worker not in the country legally may not complete the survey or may complete it untruthfully. Due to this, estimates assert that at least 70 percent of the ag workforce is not working in the United States legally. Over 90 percent of the ag immigrant labor comes from Mexico.
This presents a very real problem for ag employers.
In late 2016, the U.S. Citizenship and Immigration Service (USCIS) updated Form I-9 and the related instructions. Beginning on January 22, 2017, the update Form I-9 became mandatory for employers to use when hiring persons.
The Form is used for verifying the identity and employment authorization of individuals hired for employment in the U.S. All U.S. employers must ensure proper completion of Form I-9 for each individual they hire for employment in the U.S., whether the employment involves citizens or noncitizens. While agriculture is often exempt from or treated differently in many situations, that is not the case with respect to Form I-9. There is no exception based on the size of the farming operation or for farming businesses where a majority of the interests are held by related persons.
Form I-9 applies to employment situations. It doesn’t apply to situations where a farmer hires custom work or other work to be done on an independent contractor basis. Whether a situation involves the hiring of an employee or an independent contractor basically comes down to the issue of control over the work. If the farmer controls the means and method of the work, then it’s likely to be an employment situation that will trigger the use of Form I-9.
Completing the form. Both employees and employers (or an employer’s authorized representative) must complete the form within three days of the hire. On the form, an employee must attest to their employment authorization. The employee must also present his or her employer with acceptable documents evidencing identity and employment authorization. The employer must examine the employment eligibility and all identity documents an employee presents to determine whether the documents reasonably appear to be genuine and relate to the employee. The employer must also record the document information on the Form I-9. The list of acceptable documents can be found on page three of Form I-9. Employers must retain Form I-9 for a designated period and make it available for inspection by authorized government officers.
The form itself is comprised of three sections.
- Section 1 is for the reporting of employee information and attesting to that information. The employee has to attest that they are a citizen, a noncitizen national of the U.S., a lawful permanent resident or an alien that is authorized to work until the time specified in the document. If the employee is an alien that is authorized to work, they must provide their alien registration number/USCIS number or their Form I-94 admission number, or their foreign passport number and list the country of issuance. The employee must sign the form and date it. Likewise, the employer must also sign and date the form and provide their address. The employee selects the appropriate Citizenship/Immigration status in this section. Also, the new Form I-9 contains a box where the employee indicates if they did not use a translator or preparer in completing Section 1.
- Section 2 is a certification of the employer’s review and verification of the documents of the new hire. On the new form, there is a “Citizenship/Immigration Status” field where the employer is to select (or write) the number that corresponds with the Citizenship/Immigration status that the employee selected in Section 1.
- Section 3 pertains to reverifications and rehires. This section lists the acceptable documents that employees can select from to establish their identity and their employment authorization.
The form is to be completed in English, unless it involves and employer and employees that are in Puerto Rico.
Filing the form. The I-9 doesn’t get filed with any government agency. It doesn’t get filed with the USCIS or the U.S. Immigration and Customs Enforcement (ICE). Instead the employer simply keeps the completed Form I-9 on file for each person on their payroll who is required to complete the form. An employer has to retain Form I-9 for three years after the date of hire or for one year after employment is terminated, whichever is later. It must also be made available for inspection by authorized U.S. Government officials from the Department of Homeland Security, Department of Labor, or Department of Justice.
The form can be completed via computer, but it is not an electronic Form I-9 that is subject to the electronic Form I-9 storage regulations. Instead, Form I-9 is to be printed, signed and stored as a hard copy. If it is completed on a computer, the new form has new drop-down screens, field checks and instructions that are easily accessible.
Penalties. In 2016, the U.S. Department of Justice increased the penalties that can be imposed on employers that hire illegal immigrants. The minimum penalty for a first offense is now $539 (up from $375) and the maximum penalty is $4,313 (up from $3,200). These new amounts are effective August 1, 2016. The minimum penalty for failing to comply with the Form I-9 employment verification requirements is $216 for each form (first offense) and the maximum penalty is $2,156 per form. There are also other penalties that can apply, and the failure to complete the Form I-9 paperwork properly and completely can lead to multiple fines getting stacked together. For example, in 2015, an employer was ordered to pay a fine of over $600,000 for more than 800 Form I-9 violations. The fines were primarily the result of the failure of the employer to sign Section 2 of Form I-9. That’s the section, as noted above, where the employer certifies within three days of a hire that the employer has reviewed the verification and employment authorization documents of a new hire. The penalties arose from the hire of union employees who worked for the employer on a project-by-project basis during the term of a collective bargaining agreement. The workers were not terminated when they completed a project and remained “on-call.” The employer didn’t complete a separate Form I-9 apart from what the union provided and didn’t sign Section 2 of the union form.
Mistakes. So, with the possibility for penalties for improper completion of Form I-9, what are the biggest potential areas of pitfalls? Some basic ones come to mind – incorrect dates, missing signatures, transposed numbers and not checking boxes properly. Also, the correct document codes have to be recorded for each identification method. An employer should also make sure to ask for only those documents that are necessary to identify the employee. Not too many or too few. Requesting too many can lead to a charge of discrimination; too few can trigger a violation for an incomplete form.
Other mistakes can include failure to comply with the three-day rule, failure to re-verify and get updated documents from employees. Also, it is a good idea to get rid of outdated forms. Any outdated forms that exist can lead to penalties if discovered in an audit.
E-Verify is a web-based system operated by the Department of Homeland Security (DHS). The system allows an employer to confirm the eligibility of an employee to work in the United States. E-Verify involves an electronic match of identity and employment eligibility of new hires. The system matches the Form I-9 information against the records of the Social Security Administration and the Department of Homeland Security.
The E-Verify system is not mandatory (except for federal contractors, vendors and agencies). However, employers use it to make sure that a new hire is in compliance with federal law. It is a no-charge system. More than 600,000 employers used the E-Verify system in 2016.
States can mandate the use of E-Verify. While federal law generally pre-empts most state authority on immigration, it does not do so with respect to licensing and similar laws. Indeed, a challenge to the Arizona law requiring a business to use E-Verify or lose its state business license upon hiring a worker not in the United States legally failed when the U.S. Supreme Court held that federal law did not pre-empt the Arizona law. United States Chamber of Commerce v. Whiting, 563 U.S. 582 (U.S. 2011). Iowa, for example, has made numerous attempts to pass legislation requiring employers to utilize the E-Verify system with no success. The Iowa legislation, most recently S.F. 412 introduced during the 2018 legislative session, was modeled after the Arizona legislation.
The proper documentation of employees is critically important. There are indications that the federal government is now looking more closely at employer hiring practices. That makes compliance with Form I-9 requirements even more important. In addition, it makes sense for an ag employer to utilize the E-Verify system. Failure to do so could result in really bad consequences for the business.