Friday, August 17, 2018
An important concern for many farm and ranch families is how to keep the business in the family and operating as a viable economic enterprise into subsequent generations. Of course, economics and family relationships are very important to accomplishing this objective. So are various types of planning vehicles.
One of those vehicles that can work for some families is an intentionally defective grantor trust (IDGT). It allows the creator of the trust (grantor) to “freeze” the value of the transferred assets while simultaneously providing the grantor with a cash flow stream for a specified time-period. The “freeze” is achieved by capitalizing on the mismatch between interest rates used to value transfers and the actual anticipated performance of the transferred asset.
The use of an IDGT as part of a plan to transfer business assets from one generation to the next – that’s the topic of today’s post.
IDGT - Defined
An IDGT is a specially type of irrevocable grantor trust that is designed to avoid any retained interests or powers in the grantor that would result in the inclusion of the trust’s assets in the grantor’s gross estate upon the grantor’s death. For federal income tax purposes, the trust is designed as a grantor trust (as far as the grantor is concerned) under I.R.C. §671 for income tax purposes because of the powers the grantor retains. However, those retained powers do not cause the trust assets to be included in the grantor’s estate. The trust’s income, losses, deductions and credits are reported by the grantor on the grantor’s individual income tax return.
The trust is “defective” because the seller (grantor) and the trust are treated as the same taxpayer for income tax purposes. However, an IDGT is defective for income tax purposes only - the trust and transfers to the trust are respected (e.g., they are effective) for federal estate and gift tax purposes. The “defective” nature of the trust meant that the grantor does not have gain on the sale of the assets to the trust, is not taxed on the interest payments received from the trust, has no capital gain if the note payments (discussed below) are paid to the grantor in-kind and makes the trust an eligible S corporation shareholder. Rev. Rul. 85-13, 1985-1 C.B. 184; I.R.C. §1361(c)(2)(A)(i).
The IDGT Transaction
The IDGT technique involves the grantor selling highly-appreciating or high income-producing assets to the IDGT for fair market value in exchange for an installment note. The grantor makes an initial “seed” gift of at least 10 percent of the total transfer value to the trust so that the trust has sufficient capital to make its payments to the grantor. Typically, the IDGT transaction is structured so that a completed gift occurs for gift tax purposes, with no resulting income tax consequences. That also means, however, that the transfer is a completed gift and the trust will receive a carryover basis in the gifted assets.
The trust language is carefully drafted to provide the grantor with sufficient retained control over the trust to trigger the grantor trust rules for income tax purposes, but insufficient control to cause inclusion in the grantor’s estate. This is what makes the IDGT a popular estate planning technique for shifting large amounts of wealth to heirs and creating estate tax benefits because the value of the assets that the grantor transfers to the trust exceeds the value of the assets that are included in the grantor’s estate at death.
Interest on the installment note is set at the Applicable Federal Rate for the month of the transfer that represents the length of the note’s term. The installment note can call for interest-only payments for a period of time and a balloon payment at the end, or it may require interest and principal payments. Given the current low interest rates (but they have been rising), it is reasonable for the grantor to expect to receive a total return on the IDGT assets that exceeds the rate of interest. Indeed, if the income/growth rate on the assets sold to the IDGT is greater than the interest rate on the installment note taken back by the grantor, the “excess” growth/income is passed on to the trust beneficiaries free of any gift, estate and/or Generation Skipping Transfer Tax (GSTT).
The IDGT technique became popular after the IRS issued a favorable letter ruling in 1995 (Priv. Ltr. Rul. 9535026 (May 31, 29915)) that took the position that I.R.C. §2701 would not apply because a debt instrument is not an “applicable retained interest.” I.R.C. §2701 applies to transfers of interests in a corporation or a partnership to a family member if the transferor or family member holds and “applicable retained interest” in the entity immediately after the transfer. However, an “applicable retained interest” is not a creditor interest in bona fide debt. The IRS, in the same letter ruling also stated that a debt instrument is not a term interest, which meant that I.R.C. §2702 would not apply.
If the seller transfers a remainder interest in assets to a trust and retains a term equity interest in the income, I.R.C. §2702 applies which results in a taxable gift of the full value of the property sold. For instance, a sale in return for an interest only note with a balloon payment at the end of the term would result in a payment stream that would not be a qualified annuity interest because the last payment would represent an increase of more than 120 percent over the amount of the previous payments.
How It Works
If for example, a multi-dimensional farming operation is valued at $15 million and is transferred to a family limited partnership (FLP), a valuation discount for lack of marketability and/or minority interest might approximate 30 percent.
Note: A few months ago, the Treasury announced that it was not finalizing regulations that would tighten the ability to valuation discounts in such situations. So, a discount of 30-40 percent would be reasonable for such a transfer.
A 30 percent discount on a $15 million transfer would be $4.5 million. So, the transfer to the FLP would be valued at $11.5 million. Then an IDGT could be created and the $11.5 million FLP interest would be sold to the IDGT in exchange for a note with the installment payments to the grantor under the note being established based on the $11.5 million value rather than the $15 million value. This means that, in effect, $4.5 million has been transferred tax-free the transferors’ heirs.
The installment note can be structured in various ways, with the approach chosen generally tied to the cash flow that the assets generate that have been transferred to the IDGT. In addition, the income from the property contained in the IDGT is the grantor’s tax responsibility (with those taxes paid annually from a portion of the installment sale payments from the note), but it’s not a gift for estate and gift tax purposes. That means, then, that additional assets can be shifted to the IDGT which will further reduce the grantor’s taxable estate at death. The heirs benefit and the grantor gets a reduced taxable estate value. That could be a big issue if the current level of the federal estate tax exemption goes back down starting in 2026 (or sooner on account of a political change in philosophy).
When the grantor of the IDGT dies, the only item included in the grantor’s gross estate is the installment note. It is included at its fair market value. That means that the IDGT “froze” the value of the assets as of the sale date with any future appreciation in asset value occurring outside of the decedent’s estate.
Pros and Cons of IDGTs
As noted above, an IDGT has the effect of freezing the value of the appreciation on assets that are sold to it in the grantor’s estate at the interest rate on the installment note payable. Additionally, as previously noted, there are no capital gain taxes due on the installment note, and the income on the installment note is not taxable to the grantor. Because the grantor pays the income tax on the trust income, that has the effect of leaving more assets in the IDGT for the remainder beneficiaries. Likewise, valuation adjustments (discounts) increase the effectiveness of the sale for estate tax purposes.
On the downside, if the grantor dies during the term of the installment note, the note is included in the grantor’s estate. Also, there is no stepped-up basis in trust-owned assets upon the grantor’s death. Because trust income is taxable to the grantor during the grantor’s life, the grantor could experience a cash flow problem if the grantor does not earn sufficient income. In addition, there is possible gift and estate tax exposure if insufficient assets are used to fund the trust.
Proper Structuring of the Sale to the IDGT
Thee installment note must constitute bona fide debt. That is the key to the IDGT transaction from an income tax and estate planning or business succession standpoint. If the debt amounts to an equity interest, then I.R.C. §§2701-2702 apply and a large gift taxable gift could be created or the transferred assets will end up being included in the grantor’s estate. I.R.C. §2036 causes inclusion in the grantor’s estate of property the grantor transfers during life for less than adequate and full consideration if the grantor retained for life the possession or enjoyment of the transferred property or the right to the income from the property, or retained the right to designate the persons who shall possess or enjoy the property or the income from it. In the context of an IDGT, if the installment note represents bona fide debt, the grantor does not retain any interest in the property transferred to the IDGT and the transferred property is not included in the grantor’s estate at its date-of-death value.
All of the tax benefits of an IDGT turn on whether the installment note is bona fide debt. Thus, it is critical to structure the transaction properly to minimize the risk of the IRS taking the position that the note constitutes equity for gift or estate tax purposes. That can be accomplished by observing all formalities of a sale to an unrelated party, providing sufficient seed money, having the beneficiaries personally guarantee a small portion of the amount to be paid under the note, not tying the note payments to the return on the IDGT assets, actually following the scheduled note payments in terms of timing and amount, making the note payable from the trust corpus, not allowing the grantor control over the property sold to the IDGT, and keeping the term of the note relatively short. These are all indicia that the note represents bona fide debt.
Administrative Issues with IDGT’s
An IDGT is treated as a separate legal entity. Thus, a separate bank account is opened for the IDGT in order to receive the “seed” gift and annual cash inflows and outflows. An amortization schedule will need to be maintained between the IDGT and the grantor, as well as annual books and records of the trust.
Farmers and ranchers that intend to keep the farming or ranching business in the family for subsequent generations are searching for ways to accomplish that goal. The IDGT is one tool in the planner’s arsenal to accomplish that goal.
Wednesday, August 15, 2018
Earlier this year I did a blog post on some recent developments in crop insurance. Since that time, there have been more very significant developments involving crop insurance. As a result, another post on crop insurance is necessary.
More crop insurance recent developments – that’s the topic of today’s post.
Relying on Agent Representations
Bush v. AgSouth Farm Credit, No. A18A0339 2018, Ga. App. LEXIS 437 (Ga. Ct. App. Jun 27, 2018), the plaintiff owned a 280-acre soybean and wheat farm. The farm had been in his family for many years and operated as a dairy farm. In 2011, the plaintiff began planting wheat and soybean as commodity crops. At this point he took out several loans from the defendant in order to purchase farm machinery and equipment. After he obtained these loans, the defendant recommended that he get crop insurance in case of a weather-related crop loss. The plaintiff had heard about crop insurance and agreed that he needed it, but told the defendant that he knew nothing about crop insurance or anybody who “writes it.”
The defendant put the plaintiff in touch with an insurance agent who had been a licensed crop insurance agent with the defendant since 2000. The insurance agent told the plaintiff she sold crop insurance for “Diversified” (a company contracted with USDA to deliver the federal crop insurance program). At that time, the plaintiff told her where he obtained his grain and that he had never sold crops commercially before 2011, using it only as feed or seed to replant. The insurance agent handled all of the production history calculations, presumably from weight tickets he had provided to her. As a result of their meetings, the insurance agent procured crop insurance from Diversified for the plaintiff’s 2011 soybean crop and his 2012 wheat crop. The plaintiff had a continuous policy for wheat with an actual production history (APH) of 75 bushels per acre, which the insurance agent calculated based upon what the plaintiff told her that he produced for the four years prior to 2012.
The agent did not ask the plaintiff for documents supporting these amounts and explained that he was not required to submit such documentation with his insurance application, but she warned him that if he was ever audited he would have to document what was reported in the insurance application. The application requested 60 percent coverage, and the plaintiff testified that he left it up to the agent to decide the amount, but did not object to it when he signed the application. The plaintiff did not read the insurance application or the production and yield report on which the insurance agent calculated the APH, and he did not ask any questions about either document. For crop year 2012, the plaintiff planted over 600 acres of wheat and conducted his farming operations based on the agent’s representation that the wheat was insured at the coverage level stated in his policy. In July of 2013, he suffered a complete loss of his wheat crop due to excessive moisture.
The plaintiff called the insurance agent to report the loss, and Diversified sent an adjuster to examine the crop and calculate the loss. The plaintiff received approximately $102,986 from Diversified, which he then assigned to the defendant to pay down an existing loan. In July 2014 Diversified performed an audit of the plaintiff’s claim. Shortly thereafter, Diversified notified the plaintiff that a reduction in production and yields for specific units was applied resulting in an overpayment of $102,986 and demanded repayment. The plaintiff filed a complaint against the defendant and the insurance agent on May 9, 2016, alleging that the agent held herself out as a crop insurance expert and that he relied on that expertise and her representations to establish his farming plan. The plaintiff also claimed that the defendant, as the agent’s employer, was vicariously liable for her actions. The defendant moved for summary judgment, arguing that the plaintiff was obligated to read the policy and, if he had, he would have known that documentation was required to support the claimed APH.
The trial court granted the defendant’s motion for summary judgment and the plaintiff appealed. The appellate court determined that a jury could find that the plaintiff, a layperson, could not be expected to read the policy and determine what constituted a written verifiable record. The policy at issue referred to supporting “written verifiable records” and relied upon a reference to a federal regulation to define that term. Thus, the court held that it would not have been readily apparent to the plaintiff, on the face of the policy, that the weight tickets or other information he provided to the agent were not adequate to meet the definition of “written verifiable record.” Thus, the court held that even if the plaintiff had the read the policy from beginning to end, he would not have known that the calculation was not properly done in accordance with federal regulations because calculating the APH was up to the expert agent and governed by the rules set out in the Crop Insurance Handbook. As such, the appellate court held that the trial court erred in granting summary judgment to the defendant.
In Bottoms Farm Partnership v. Perdue, No. 17-2164, 2018 U.S. App. LEXIS 19609 (8th Cir. Jul. 17, 2018), the plaintiffs were entities engaged in rice farming. Their rice crops were insured under federally-reinsured multi-peril crop insurance policies purchased from Rural Crop Insurance Services (RCIS). The insurance policy was provided under the Federal Crop Insurance Act (FCIA), which is administered by the Federal Crop Insurance Corporation (FCIC) and the Risk Management Agency (RMA). After they purchased the insurance and planted the 2012 crop, their rice crops were damaged by excessive rainfall. They filed claims for indemnity with RCIS. RCIS denied the claims on the basis that the crops were not insurable under the policy because levees were not surveyed and constructed immediately after seeding the rice, and levee gates were not immediately installed and butted as required by a special provision in the policy. When their claims were denied, the plaintiffs sought arbitration with RCIS as required by the policy, which stated that: “In addition to the definition of Planted Acreage specified in section 1 of the Crop Provisions, the following must have occurred immediately following seeding. If these activities have not occurred, the acreage will be considered ‘acreage seeded in any other manner’ and will not be insurable: (1) levees are surveyed and constructed; (2) levee gates are installed and butted; and (3) the irrigation pump is operable, ready to be started in the event sufficient rainfall has not been received, and turned on to provide sufficient water for the purposes of germination or elimination of soil crusting.”
The FCIC agreed with RCIS that the Merriam-Webster dictionary defines "immediately" as "without any delay,” which means that the listed activities must occur right after planting has ended, weather permitting, without any delay. The plaintiffs requested a review of the FCIC's interpretation by the RMA, and the RMA affirmed. The National Appeals Division (NAD) concluded that RMA's written interpretation was not appealable and that the plaintiffs had exhausted their administrative remedies.
The trial court upheld the administrative determinations, as did the appellate court. The appellate court noted that the clear language of the FCIA indicated that the Congress intended the FCIC to have extensive and broad authority. Under the FCIA, judicial review is available but limited. Given the FCIA’s broad grant of authority to the FCIC, and the specific authority over the provisions of insurance and insurance contracts, the appellate court concluded that it must give substantial deference to the FCIC's interpretation of the special provision. In addition, the court determined that the FCIC's interpretation of the special provision was consistent with the plain reading of the policy, which indicated that the activities listed must "have occurred immediately following seeding" or the acreage would be considered to be uninsurable. The appellate court also determined that the FCIC's decision that the language provided a condition for insurability and was not subject to an analysis of good farming practices was not plainly erroneous. The appellate court, like the trial court found that the interpretation was not "'arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.
APH Yield Exclusion
Adkins v. Vilsack, No. 1:15-CV-169-C 2017 U.S. Dist. LEXIS 72790 (N. D. Tex. May 12, 2017), aff’d. sub. nom., Adkins v. Silverman, No. 17-10759, 2018 U.S. App. LEXIS 21961 (5th Cir. Aug. 7, 2018) involved a provision in the 2014 Farm Bill - Actual Production History (APH) Yield Exclusion. The APH Yield Exclusion allows eligible producers impacted by severe weather to receive a higher approved yield on their insurance policies through the federal crop insurance program. APH works by allowing a farmer to exclude yields in particularly bad years (e.g., those having a natural disaster or other extreme weather event) from their production history when calculating yields that are used to establish their crop insurance coverage. The level of crop insurance available to a farmer is based on the farmer’s average recent yields. Particularly low yields in a prior year would reduce the level of insurance coverage in future years but for the APH provision. Farmers are eligible for the APH exclusion when the county yield is at least 50 percent below the average of the immediately previous 10 consecutive crop years.
The APH provision was to become effective in the spring of 2015 for spring crops with a November 30, 2014 change date. Eligible crops include corn, soybeans, wheat, cotton, grain sorghum, rice, barley, canola, sunflowers, peanuts and popcorn. However, the USDA later decided to delay the APH Yield Exclusion for wheat for the 2015 crop year for winter wheat. The plaintiff challenged that decision as arbitrary, but the USDA’s National Appeals Division (NAD) upheld the decision. However, in late 2016 a U.S. Magistrate Judge recommended that the court reverse the USDA’s decision to delay implementation of the APH Yield Exclusion (i.e., “yield plug”) for winter wheat. The USDA appealed, but the trial court found that the NAD’s decision was erroneous because it failed to recognize the Farm Bill’s (7 U.S.C. §1508 (g)(4)(A)) effect on implementation for the 2015 winter wheat crop year. The court determined that Congress chose to leave the applicability provision in place thereby making it self-executing and immediate for the APH Yield Exclusion. In addition, the fact that Congress chose to include specific application/implementation language for other crops and yet stay silent as to winter wheat indicates a direct intention to allow the governing and existing statutory law to be applicable as to the implementation of the APH Yield Exclusion for the 2015 winter wheat crop. As a result, the court adopts the findings and conclusions of the Magistrate Judge. The USDA appealed, and the issue on appeal was “whether farmers were permitted to exclude the historical data for the 2015 crop year, even though the FCIC had not completed its data compilation.” The appellate court considered the “plain meaning” of the statute at issue in accordance with the standard set forth in Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984) and affirmed the trial court's decision.
Crop insurance is an important part of many farmer’s financial “toolbox.” It will likely also play a significant part of the next Farm Bill. But, as illustrated in today’s post (and the one earlier this year), numerous legal issues can arise.
Monday, August 13, 2018
As a result of the Tax Cuts and Jobs Act (TCJA), for tax years beginning after 2017 and before 2026, a non C corporate business owner as well as an owner of an interest in a pass-through entity is entitled to a deduction of 20% of the taxpayer’s share of qualified business income (QBI) associated with the conduct of a trade or business in the United States. I.R.C. 199A. The QBID replaces the DPAD, which applied for tax years beginning after 2004. The TCJA repealed the DPAD for tax years beginning after 2017.
The basic idea behind the provision was to provide a benefit to pass-through businesses and sole proprietorships that can’t take advantage of the lower 21 percent corporate tax rate under the TCJA that took effect for tax years beginning after 2017 (on a permanent basis). The QBID also applies to agricultural/horticultural cooperatives and their patrons.
Last week, the Treasury issued proposed regulations on the QBID except as applied to agricultural/horticultural cooperatives. That guidance is to come later this fall. The proposed regulations did not address how the QBID applies to cooper
The proposed regulations for the QBID – that the topic of today’s post.
The QBI deduction (QBID) is subject to various limitations based on whether the entity is engaged manufacturing, producing, growing or extracting qualified property, or engaged in certain specified services (known as a specified service trade or business (SSSB)), or based on the amount of wages paid or “qualified property” (QP) that the business holds. These limitations apply once the taxpayer’s taxable income exceeds a threshold based on filing status. Once the applicable threshold is exceeded the business must clear a wages threshold or a wages and qualified property threshold.
Note: If the wages or wages/QP threshold isn’t satisfied for such higher-income businesses, the QBID could be diminished or eliminated.
What is the wage or wage/QP hurdle? For farmers and ranchers (and other taxpayers) with taxable income over $315,000 (MFJ) or $157,500 (other filing statuses), the QBID is capped at 50 percent of W-2 wages or 25 percent of W-2 wages associated with the business plus 2.5 percent of the “unadjusted basis immediately after acquisition” (UBIA) of all QP. But those limitations don’t apply if the applicable taxable income threshold is not met. In addition, the QBID is phased out once taxable income reaches $415,000 (MFJ) or $207,500 (all others).
On August 8, the Treasury issued proposed regulations on the QBID. Guidance was needed in many areas. For example, questions existed with respect to the treatment of rents; aggregation of multiple business activities; the impact on trusts; and the definition of a trade or business, among other issues. The proposed regulations answered some questions, left some unanswered and raised other questions.
Rental activities. One of the big issues for farmers and ranchers operating as sole proprietorships or as a pass-through entity is whether land rental income constitutes QBI. The proposed regulations do confirm that real estate leasing activities can qualify for the QBID without regard to whether the lessor participates significantly in the activity. That’s the case if the rental is between “commonly controlled” entities – defined as common ownership of 50 percent or more in each entity (e.g., between related parties). This part of the proposed regulations is generous to taxpayers, and will be useful for many rental activities. It’s also aided by the use of I.R.C. §162 for the definition of a “trade or business” as opposed to, for example, the passive loss rules of I.R.C. §469.
But, the proposed regulations may also mean that the income a landlord receives from leasing land to an unrelated party (or parties) under a cash lease or non-material participation share lease may not qualify for the QBID. If that latter situation is correct it could mean that the landlord must pay self-employment tax on the lease income associated with a lease to an unrelated party (or parties) to qualify the lease income for the QBID.
The proposed regulations use an example or a rental of bare land that doesn’t require any cost on the landlord’s part. This seems to imply that the rental of bare land to an unrelated third party qualifies as a trade or business. There is another example in the proposed regulations that also seems to support this conclusion. Apparently, this means that a landlord’s income from passive triple net leases (a lease where the lessee agrees to pay all real estate taxes, building insurance, and maintenance on the property in addition to any normal fees that are expected under the agreement) should qualify for the QBID. But, existing caselaw is generally not friendly to triple net leases being a business under I.R.C. §162. That means it may be crucial to be able to aggregate (group) those activities together.
Unfortunately, the existing caselaw doesn’t discuss the issue of ownership when it is through separate entities and, on this point, the Preamble to the proposed regulations creates confusion. The Preamble says that it's common for a taxpayer to conduct a trade or business through multiple entities for legal or other non-tax reasons, and also states that if the taxpayer meets the common ownership test that activity will be deemed to be a trade or business in accordance with I.R.C. §162. But, the Preamble also states that "in most cases, a trade or business cannot be conducted through more than one entity.” So, if a taxpayer has several rental activities that the taxpayer manages, does that mean that those separate rental activities can’t be aggregated (discussed below) unless each rental activity is a trade or business? If the Treasury is going to be making the trade or business determination on an entity-by-entity basis, triple net leases might be problematic.
Perhaps the final regulations will clarify whether rentals, regardless of the lease terms, will be treated as a trade or business (and can be aggregated).
Aggregation of activities. Farmers and ranchers often utilize more than a single entity for tax as well as estate and business planning reasons. The common technique is to place land into some form of non C corporate entity (or own it individually) and lease that land to the operating entity. For example, many large farming and ranching operations have been structured to have multiple limited liability companies (LLCs) with each LLC owning different tracts of land. These operations typically have an S corporation or some other type of business entity that owns the operating assets that are used in the farming operation. It appears that these entities can be grouped under the aggregation rule. For QBID purposes (specifically, for purposes of the wages and qualified property limitations) the proposed regulations allow an election to be made to aggregate (group) those separate entities. Thus, the rental income can be combined with the income from the farming/ranching operation for purposes of the QBID computation. Grouping allows wages and QP to also be aggregated and a single computation used for purposes of the QBID (eligibility and amount). In addition, taxpayers can allocate W2 wages to the appropriate entity that employs the employee under common law.
Note: The wages and QP from any trade or business that produces net negative QBI is not taken into account and is not carried over to a later year. The taxpayer has to offset the QBI attributable to each trade or business that produced net positive QBI.
Without aggregation, the taxpayer must compute W-2 wages for each trade or business, even if there is more than one within a single corporation or partnership. That means a taxpayer must find a way to allocate a single payroll across different lines.
To be able to aggregate businesses, they must meet several requirements, but the primary one is that the same person or group of persons must either directly or indirectly own 50 percent or more of each trade or business. For purposes of the 50 percent test, a family attribution rule applies that includes a spouse, children, grandchildren and parents of the taxpayer. However, siblings, uncles, and aunts, etc., are not within the family attribution rule. To illustrate the rule, for example, the parents and a child could own a majority interest in three separate businesses and all three of those businesses could be aggregated. But, the bar on siblings, etc., counting as "family" is a harsh rule for agricultural operations in particular. Perhaps the final regulations will modify the definition of "family."
Note: A ”group of persons” can consist of unrelated persons. It is important that the “group” meet the 50 percent test. It is immaterial that no person in the group meets the 50 percent test individually.
Common ownership is not all that is necessary to be able to group separate trade or business activities. The businesses to be grouped must provide goods or services that are the same or are customarily offered together; there must be significant centralized business elements; and the businesses must operate in coordination with or reliance upon one another. Meeting this three-part test should not be problematic for most farming/ranching operations, but there is enough "wiggle room" in those definitions for the IRS to create potential issues.
Once a taxpayer chooses to aggregate multiple businesses, the businesses must be aggregated for all subsequent tax years and must be consistently reported. The only exception is if there is a change in the facts and circumstances such that the aggregation no longer qualifies under the rules. So, disaggregation is generally not allowed, unless the facts and circumstances changes such that the aggregation rules no longer apply.
Losses. If a taxpayer’s business shows a loss for the tax year, the taxpayer cannot claim a QBID and the loss carries forward to the next tax year where it becomes a separate item of QBI. If the taxpayer has multiple businesses (such as a multiple entity farming operation, for example), the proposed regulations require a loss from one entity (or multiple entities) to be netted against the income from the other entity (or entities). If the taxpayer’s income is over the applicable threshold, the netting works in an interesting way. For example, if a farmer shows positive income on Schedule F and a Schedule C loss, the Schedule C loss will reduce the Schedule F income. The farmer’s QBID will be 20 percent of the resulting Schedule F income limited by the qualified wages, or qualified wages and the QP limitation. Of course, the farmer may be able to aggregate the Schedule F and Schedule C businesses and would want to do so if it would result in a greater QBID.
Note: A QBI loss must be taken and allocated against the other QBI income even if the loss entity is not aggregated. However, wages and QP are not aggregated.
If the taxpayer had a carryover loss from a pre-2018 tax year, that loss is not taken into account when computing income that qualifies for the QBID. This can be a big issue if a taxpayer had a passive loss in a prior year that is suspended. That's another taxpayer unfriendly aspect of the proposed regulations.
Trusts. For trusts and their beneficiaries, the QBID can apply if the $157,500 threshold is not exceeded irrespective of whether the trust pays qualified wages or has QP. But, that threshold appears to apply cumulatively to all trust income, including the trust income that is distributed to trust beneficiaries. In other words, the proposed regulations limit the effectiveness of utilizing trusts by including trust distributions in the trust’s taxable income for the year for purposes of the $157,500 limitation. Prop. Treas. Reg. §1.199A-6(d)(3)(iii). This is another taxpayer unfriendly aspect of the proposed regulations.
Based on the Treasury's position, it will likely be more beneficial for parents, for example, for estate planning purposes, to create multiple trusts for their children rather than a single trust that names each of them as beneficiaries. The separate trusts will be separately taxed. The use of trusts can be of particular use when the parents can't utilize the QBID due to the income limitation (in other words, their income exceeds $415,000). The trusts can be structured to qualify for the QBID, even though the parents would not be eligible for the QBID because of their high income. However, the proposed regulations state that, “Trusts formed or funded with a significant purpose of receiving a deduction under I.R.C. §199A will not be respected for purposes of I.R.C. §199A.” Again, that's a harsh, anti-taxpayer position that the proposed regulations take.
Under I.R.C. §643(f) the IRS can treat two or more trusts as a single trust if they are formed by substantially the same grantor and have substantially the same primary beneficiaries, and are formed for the principle purpose of avoiding income taxes. Does the statement in the proposed regulations referenced above mean that the Treasury is ignoring the three-part test of the statute? By itself, that would seem to be the case. However, near the end of the proposed regulations, there is a statement reciting the three-part test of I.R.C. §643(f). Prop. Treas. Reg. §1.643(f)-1). Hopefully, that means that any trust that has a reasonable estate/business planning purpose will be respected for QBID purposes, and that multiple trusts will not be aggregated that satisfy I.R.C. §643(f). Time will tell what the IRS position on this will be.
Unfortunately, the proposed regulations do not address how the QBID is to apply (or not apply) to charitable remainder trusts.
Here are a few other observations from the proposed regulations:
- Guaranteed payments in a partnership and reasonable compensation in an S corporation are not qualified wages for QBID purposes.
- Inherited property that the heir immediately places in service gets a fair market value as of date of death basis, but the proposed regulations don’t mention whether this resets the property’s depreciation period for QP purposes (as part of the 2.5 percent computation).
- For purposes of the QP computation, the 2.5 percent is multiplied by the depreciated basis of the asset on the day it is transferred to an S corporation, for example, but it’s holding period starts on the day it was first used for the business before it is transferred.
- A partnership’s I.R.C. §743(b) adjustment does not count for QP purposes. In other words, the adjustment does not add to UBIA. Thus, the inheritance of a fully depreciated building does not result in having any QP against which the 2.5 percent computation can be applied. That's a harsh rule from a taxpayer's standpoint.
- R.C. §1231 gains are not QBI. But, any portion of an I.R.C. §1231 gain that is taxed as ordinary income will qualify as QBI.
- Preferred allocations of partnership income will not qualify as QBI to the extent the allocation is for services. This forecloses a planning opportunity that could have been achieved by modifying a partnership agreement to provide for such allocations.
The proposed regulations are now subject to a 45-day comment period with a public hearing to occur in mid-October. The proposed rules do not have the force of law, but they can be relied on as guidance until final regulations are issued. From a practice standpoint, rely on the statutory language when it is more favorable to a client than the position the Treasury has taken in the proposed regulations.
Numerous questions remain and will need to be clarified in the final regulations. The Treasury will be hearing from the tax section of the American Bar Association, the American Institute of CPAs, other tax professionals and other interested parties. Hopefully, some of the taxpayer unfavorable positions taken in the proposed regulations can be softened a bit in the final regulations. In addition, it would be nice to get some guidance on how the rules will apply to cooperatives and their patrons.
Also, this post did not exhaust all of the issues addressed in the proposed regulations, just the one that are most likely to apply to farming and ranching businesses. For example, a separate dimension of the proposed regulations deals with “specialized service businesses.” That was not addressed.
Thursday, August 9, 2018
A tort is a civil (as opposed to a criminal) wrong or injury, other than breach of contract, for which a court will provide a remedy in the form of an action for damages. Tort law is based heavily upon state case law. That means that different legal rules apply in different jurisdictions. In addition, in all jurisdictions, tort law changes as new cases are decided.
Tort law is concerned with substandard behavior, and its objective is to establish the nature and extent of responsibility for the consequences of tortious (wrongful) conduct. Cases involving torts,
in an agricultural context, may involve such situations as employer/employee relationships, fence and boundary disputes, crop dusting and many other similar situations.
In today’s post, I take a look at several recent ag tort cases that provide a sampling of the tort situations that can happen on a farm or ranch.
In Halderson v. N. States Power Co., No. 2017AP2176, 2018 Wisc. App. LEXIS 645 (Wisc. Ct. App. July 24, 2018), the plaintiff’s dairy cows were experiencing health problems and the plaintiff contacted a veterinarian. In turn, the veterinarian suggested that the plaintiff contact an electrician that investigates stray voltage. The electrician found that the farm had stray voltage exceeding the defendant power company’s standards of one amp. The electrician suggested that the plaintiff request a neutral isolation from the defendant to separate the primary and secondary naturals, preventing any off-farm stray voltage from affecting the livestock. The defendant did so, and the cows’ health improved substantially. The plaintiff’s sued to recover economic losses to their dairy operation and, after a 12-day jury trial, the jury awarded the plaintiff $4.5 million dollars on the plaintiff’s negligence and nuisance claims. The jury also found that the defendant acted in a “… willful, wanton, or reckless manner…” thus activating treble damages under Wisconsin Code §196.64.
The plaintiff moved for judgment on the verdict. The defendant made numerous post-trial motions - renewing their motions to dismiss and for directed verdict. In addition, the defendant moved for a new trial based on a jury instruction and the plaintiff’s attorney failing to disclose that one of the juror’s uncles had been hired by the attorney as an expert witness on another stray voltage case. The trial court granted the defendant’s motion for directed verdict on the damages issue, stating that the evidence was insufficient to conclude that the defendant had acted in the manner that the jury found. However, the trial court affirmed the jury’s negligence findings and denied the motion for a new trial. The plaintiff appealed the directed verdict on the damages issue and the defendant cross-appealed the jury verdict on the negligence findings. The appellate court affirmed, and also noted that the defendant had failed to move for a mistrial on the conflict issue.
In Reasner v. Goldsmith, No. A17-1989, 2018 Minn. App. Unpub. LEXIS 578 (Minn. Ct. App. Jul. 9, 2018). The defendant’s cattle escaped their enclosure and were involved in an automobile accident. The defendant claimed that the cattle broke through a closed pasture gate. The defendant testified that the fences were checked weekly and that the cattle had been in that particular pasture for at least a week. In addition, the defendant testified that he had been working the field between the pasture and the road that day, and the cattle were in the pasture the whole time. After returning the cattle to the pasture the defendant fixed a few wires on the gate. The defendant also noted that the cattle were uneasy, like they had been “spooked.” No photos were taken of the broken gate before the fix. There was no dispute that the cattle came though the field from the pasture. The plaintiff claimed that the defendant came to him in the hospital and apologized for leaving the gate between the pasture and the field open. There was also a statement by a passenger in the plaintiff’s vehicle claiming that he saw the cattle in the field and not in the pasture the morning before the accident.
The trial court relied heavily on the defendant’s testimony, and granted summary judgment for the defendant. The court determined that the defendant neither allow the cattle to be on the road nor knew that they were on the road. Also, the court reasoned that it was unforeseeable to the defendant that the cattle would escape because of the weekly fence checks. Thus, the cattle were not running at-large and the defendant was not negligent in keeping the cattle fenced in. On appeal, the appellate court determined that there was an issue of genuine fact remaining with respect to where the cattle were before the accident and what was the cause of their escape. Thus, the trial court’s grant of summary judgment was reversed and the case remanded.
Statutory Protection for Horse-Related Injury
In James v. Young, No. 10-17-00346-CV, 2018 Tex. App. LEXIS 2406 (Tex. Ct. App. Apr. 4, 2018), the plaintiff, along with some others, offered to help at the defendant’s farm. An injury occurred to a child as a result of the defendant’s horses and the plaintiff sued, claiming negligent handling of horses. The defendant (in both the corporate capacity and individual capacity) moved for summary judgment based on no evidence, and the trial court granted the motion. The trial court granted the motions for summary judgment. The plaintiff did not appeal the grant of summary judgment for the defendant corporation, but did appeal the granting of summary judgment for the defendant individuals. The appellate court affirmed.
The plaintiff conceded that the Texas Equine Activity Limitation of Liability Act applied to the action. That Act protects owners of livestock and horses from liability from incidents stemming from the inherent risk of livestock and horses. However, the plaintiff claimed that the owner failed to make a reasonable effort to gauge the skill level of a participant to ensure safety – an exception to coverage under the Act. Since the no-evidence summary judgment motion is like a directed verdict, the burden is on the non-moving party to show genuine issue of material fact. The plaintiff never produced any evidence that the defendant failed to ask of the child’s riding ability or to prove that the lack of questioning lead to the accident directly. Thus, the appellate court affirmed the grants of summary judgment.
In Bryant v. Reams, Civil Action No. 16-cv-01638-NYW, 2018 U.S. Dist. LEXIS 99929 (D. Colo. Jun. 14, 2018), the plaintiff lost her arm when the car she was riding in collided with a dead cow on a public roadway in southwestern Colorado. She sued the defendant cow owner for negligence and the state (CO) Department of Transportation (CDOT) for failing to maintain fences along the state highway, seeking compensatory and punitive damages. The cow had been grazing with a herd of the defendant’s cattle on Bureau of Land Management (BLM) land, and the defendant alleged that the defendant did not have a license to graze cattle on BLM land but was doing so by virtue of a sublease from another rancher that did have a lease to graze cattle on the BLM land. The plaintiff claimed that the CDOT failed to maintain fences along the highway in a manner that was sufficient to bar cattle from wandering onto the road, and that the fence at issue had deteriorated and cattle had previously caused multiple accidents on the roadway. Both the CDOT and the defendant cow owner filed motions for summary judgment.
The trial court partially granted the cow owner’s motion by dismissing the claim for exemplary damages on the basis that the evidence clearly showed that the cow owner did not act in a willful and wanton manner toward the plaintiff because they never intentionally grazed cattle alongside the highway, but denied the motion with respect to negligence claim against the cow owner finding sufficient evidence regarding proximate causation to submit the issue to the jury. The trial court also denied the CDOT’s summary judgment motion on the plaintiff’s premises liability claim against the CDOT citing evidence showing that CDOT had been notified that the fence needed to be fixed.
Before the case went to trial, the CDOT and the plaintiff settled, but the other defendants moved to designate CDOT as a non-party at fault which would reduce the cow owner’s percentage of fault. At trial, the plaintiff claimed that the jury should be instructed that the CDOT could only be apportioned negligence if the CDOT had actual notice of a deficient fence. If that is true, the cow owner would have a greater percentage of fault leading to a larger damage award. The trial court held that the CDOT had an affirmative duty to maintain fences adjacent to state roads for the safety of motor vehicles irrespective of any actual notice that a fence is in need of repair. Bryant v. Reams, Civil Action No. 16-cv-01638-NYW, 2018 U.S. Dist. LEXIS 99929 (D. Colo. Jun. 14, 2018).
Wind Energy Company Creates Nuisance and Must Pay
In re Wisconsin Power and Light, Co., No. ET-6657/WS-08-573, Minn. Pub. Util. Commission (June 5, 2018) illustrates the problems that a commercial wind energy operation can present for nearby landowners. On October 20, 2009, the Minnesota Public Utilities Commission issued a large wind energy conversion system site permit to Wisconsin Power and Light Company (WPL) for the approximately 200-megawatt first phase of the Bent Tree Wind Project, located in Freeborn County, Minnesota. The project commenced commercial operation in February 2011. On August 24, 2016, the Commission issued an order requiring noise monitoring and a noise study at the project site. During the period of September 2016 through February 2018 several landowners in the vicinity filed over 20 letters regarding the health effects that they claim were caused by the project.
On September 28, 2017, the Department of Commerce Energy Environmental Review Analysis Unit (EERA) filed a post-construction noise assessment report for the project, identifying 10 hours of non-compliance with Minnesota Pollution Control Agency (MPCA) ambient noise standards during the two-week monitoring period. On February 7, 2018, EERA filed a phase-two post construction noise assessment report concluding that certain project turbines are a significant contributor to the exceedances of MPCA ambient noise standards at certain wind speeds. On February 8, 2018, WPL filed a letter informing the Commission that it would respond to the Phase 2 report at a later date and would immediately curtail three turbines that are part of the project, two of which were identified in the phase 2 report. On February 20, 2018, the landowners filed a Motion for Order to Show Cause and for Hearing, requesting that the Commission issue and Order to Show Cause why the site permit for the project should not be revoked, and requested a contested-case hearing on the matter. On April 19, 2018 WPL filed with the Commission a Notice of Confidential Settlement Agreement and Joint Recommendation and Request, under which WPL entered into a confidential settlement with each landowner, by which the parties agree to the terms of sale of their properties to WPL, execution of easements on the property, and release of all the landowners’ claims against WPL. The agreement also outlined the terms by which the agreement would be executed.
The finality of the agreement was conditioned upon the Commission making specific findings on which the parties and the Department agreed. These findings include, among others: dismissal of the landowners’ February 2018 motion and all other noise-related complaints filed in this matter; termination of the required curtailment of turbines; transfer of possession of each property to WPL; and a requirement that compliance filing be filed with commission. The Commission determined that resolving the dispute and the terms of the agreement were in the public interest and would result in a reasonable and prudent resolution of the issues raised in the landowner’s complaints. Therefore, the Commission approved the agreement with the additional requirement that upon the sale of either of the landowners’ property, WPL shall file with the Commission notification of the sale and indicate whether the property will be used as a residence. If the property is intended to be used as a residence after sale or upon lease, the permittee shall file with the Commission: notification of sale or lease; documentation of present compliance with noise standards of turbines; documentation of any written notice to the potential residence of past noise studies alleging noise standards exceedances, and if applicable, allegations of present noise standards exceedances related to the property; and any mitigation plans or other relevant information.
Tort situations can arise in a myriad of ways for farmers, ranchers and rural landowners. Think you might need an attorney sometime in the future that is well trained in these unique tort scenarios? That’s what we’re doing at Washburn Law School.
Tuesday, August 7, 2018
The “Water of the United States” (WOTUS) rule has caused a considerable amount of controversy in agriculture for many years. In 2006, the U.S. Supreme Court had a chance to add clarity to the matter, but managed to “muddy the waters” instead – rendering a split 4-1-4 decision. In subsequent years, the Environmental Protection Agency (EPA) attempted to exploit that lack of clarity by expanding the regulatory definition of a WOTUS.
The WOTUS issue is a very important issue for agricultural and rural landowners, and the U.S. Supreme Court is being asked to hear another case involving the issue at the present time.
So, what is the present status of the WOTUS matter? There have been many twists and turns in recent years Today’s post sorts out the significant recent developments
The WOTUS rule recent developments – that’s the topic of today’s post.
The Clean Water Act makes illegal the discharging of dredge or fill material into the “navigable waters of the United States” without first obtaining a permit from the Secretary of the Army acting through the Corps of Engineers (COE). In March of 2014, the EPA and the COE released a proposed rule defining “waters of the United States” (WOTUS) in a manner that would significantly expand the agencies’ regulatory jurisdiction under the CWA. Under the proposed rule, the CWA would apply to all waters which have been or ever could be used in interstate commerce as well as all interstate waters and wetlands. In addition, the proposed WOTUS rule specifies that the agencies’ jurisdiction would apply to all “tributaries” of interstate waters and all waters and wetlands “adjacent” to such interstate waters. The agencies also asserted in the proposed rule that their jurisdiction applies to all waters or wetlands with a “significant nexus” to interstate waters.
Under the proposed rule, “tributaries” is broadly defined to include natural or man-made waters, wetlands, lakes, ponds, canals, streams and ditches if they contribute flow directly or indirectly to interstate waters irrespective of whether these waterways continuously exist or have any nexus to traditional “waters of the United States.” The proposed rule defines “adjacent” expansively to include “bordering, contiguous or neighboring waters.” Thus, all waters and wetlands within the same riparian area of flood plain of interstate waters would be “adjacent” waters subject to CWA regulation. “Similarly situated” waters are evaluated as a “single landscape unit” allowing the agencies to regulate an entire watershed if one body of water within it has a “significant nexus” to interstate waters. The proposed rule became effective as a final rule on August 28, 2015 in 37 states.
In a recent case, Georgia v. Pruitt, No. 2:15-cv-79, 2018 U.S. Dist. LEXIS 97223 (S.D. Ga. Jun. 8, 2018), the plaintiffs claimed that the WOTUS rule, implemented in 2015, violates the Clean Water Act, the Administrative Procedure Act, the Commerce Clause of the Constitution, and the Tenth Amendment. The plaintiffs sought an injunction preventing the rule from being implemented in 11 states pending a full hearing on the merits. To receive the injunction, the plaintiffs had to prove that they would (1) likely succeed on the merits; (2) be irreparably harmed; (3) sustain more potential injury than the defendant would be harmed; and (4) establish that the injunction is not contrary to the public interest. The court determined that the plaintiffs had met the standards for all four requirements. As for success on the merits, the court determined that the WOTUS rule would not likely be upheld under the U.S. Supreme Court standard set forth in Rapanos v. United States, 547 U.S. 715 (2006), and was random and impulsive. The court also determined that the irreparable harm standard had been satisfied given the increase in federal jurisdiction of “wetlands” under the rule which overstepped states’ rights and had the potential to impose substantial monetary harm on affected landowners. As for the balancing of the equities, the court determined that the loss of state rights and the increased potential for monetary damages outweighed the harm to the government in complying with an injunction. The court also reasoned that entering an injunction would not violate public policy because the WOTUS rule may be an be an unenforceable rule as inconsistent with prior court rulings concerning the scope of the government’s jurisdiction over wetlands. Accordingly, the court entered a preliminary injunction.
The court’s order of preliminary injunction prevented the WOTUS rule from being implemented in 11 states – Alabama, Florida, Georgia, Indiana, Kansas, Kentucky, North Carolina, South Carolina, Utah, West Virginia and Wisconsin. A prior decision by the North Dakota federal district court had blocked the rule from taking effect in 13 states – AK, AZ, AR, CO, ID, MO, MT, NE, NV, NM, ND, SD and WY. North Dakota v. United States Environmental Protection Agency, No. 3:15-cv-59 (D. N.D. May 24, 2016).
The Sixth Circuit Litigation and the Jurisdiction Issue
On October 9, 2015, the U.S. Court of Appeals for the Sixth Circuit issued a nationwide injunction barring the rule from being enforced anywhere in the U.S. Ohio, et al. v. United States Army Corps of Engineers, et al., 803 F.3d 804 (6th Cir. 2015). Over 20 lawsuits had been filed at the federal district court level. On February 22, 2016, the U.S. Court of Appeals for the Sixth Circuit ruled that it had jurisdiction to hear the challenges to the final rule, siding with the EPA and the U.S. Army Corps of Engineers that the CWA gives the circuit courts exclusive jurisdiction on the matter. The court determined that the final rule is a limitation on the manner in which the EPA regulates pollutant discharges under CWA Sec. 509(b)(1)(E), the provision addressing the issuance of denial of CWA permits (codified at 33 U.S.C. §1369(b)(1)(E)). That statute, the court reasoned, has been expansively interpreted by numerous courts and the practical application of the final rule, the court noted, is that it impacts permitting requirements. As such, the court had jurisdiction to hear the dispute. The court also cited the Sixth Circuit’s own precedent on the matter in National Cotton Council of America v. United States Environmental Protection Agency, 553 F.3d 927 (6th Cir. 2009) for supporting its holding that it had jurisdiction to decide the dispute. Murray Energy Corp. v. United States, Department of Defense, No. 15-3751, 2016 U.S. App. LEXIS 3031 (6th Cir Feb. 22, 2016).
In January of 2017, the U.S. Supreme Court agreed to review the Sixth Circuit’s decision. National Association of Manufacturers v. Department of Defense, et al., 137 S. Ct. 811 (2017). About a month later, President Trump issued an Executive Order directing the EPA and the COE to revisit the Clean Water Rule and change their interpretation of waters subject to federal jurisdiction such that it only applied to waters that were truly navigable – the approach taken by Justice Scalia in Rapanos v. United States, 547 U.S. 715 (2006). The EPA and Corps later indicated they would follow the President’s suggested approach, and would push the effective date of the revised Clean Water Rule to two years after its finalization and publication in the Federal Register. In November of 2017, the EPA issued a proposed rule delaying the effective date of the WOTUS rule until 2020.
In January of 2018, the U.S. Supreme Court ruled unanimously that jurisdiction over challenges to the WOTUS rule was in the federal district courts, reversing the Sixth Circuit’s opinion. National Association of Manufacturer’s v. Department of Defense, No. 16-299, 2018 U.S. LEXIS 761 (U.S. Sup. Ct. Jan. 22, 2018). The Court determined that the plain language of the Clean Water Act (CWA) gives authority over CWA challenges to the federal district courts, with seven exceptions none of which applied to the WOTUS rule. In particular, the WOTUS rule neither established an “effluent limitation” nor resulted in the issuance of a permit denial. While the Court noted that it would be more efficient to have the appellate courts hear challenges to the rule, the court held that the statute would have to be rewritten to achieve that result. Consequently, the Supreme Court remanded the case to the Sixth Circuit, with instructions to dismiss all of the WOTUS petitioners currently before the court. Once the case was dismissed, the nationwide stay of the WOTUS rule that the court entered in 2015 was removed, and the injunction against the implementation of the WOTUS rule entered by the North Dakota court was reinstated in those 13 states. Thus, given the June 2018 by the Georgia court, an injunction is presently in place in 24 states against the implementation of the rule. Another case against the WOTUS rule is currently pending in a Texas federal court.
2018 Notice of Proposed Rulemaking
Most recently, as directed by President Trump, the (COE) and the EPA issued a supplemental notice of proposed rulemaking. The proposed rule seeks to “clarify, supplement and seek additional comment on” the 2017 congressional attempt to repeal the 2015 WOTUS rule. If the rule is repealed, the prior regulations defining a WOTUS will become the law again. The agencies are seeking additional comments on the proposed rulemaking via the supplemental notice. The comment period is open through August 13, 2018. Comments can be submitted by accessing the page at the following link: https://www.regulations.gov/docket?D=EPA-HQ-OW-2017-0203. COE/EPA, “Waters of the United States"– Reinstatement of Preexisting Rules, No. EPA-HQ-OW-2017-0203 (Jul. 12, 2018).
For those interested in the WOTUS issue, it may certainly be worthwhile to submit a comment to the EPA by the August 13 deadline. We will have to wait and see what happens to the definition of a WOTUS over the coming months. It’s a big issue for agriculture.
Friday, August 3, 2018
The Tax Cuts and Jobs Act (TCJA) increased the maximum amount a taxpayer may expense under IRC §179 to $1 million. The TCJA also increased the phase-out threshold amount to $2.5 million for tax years beginning after 2017. The $1 million and $2.5 million amounts are indexed for inflation for tax years beginning after 2018.
Is property held in trust eligible to be expensed under I.R.C. §179? That’s a big issue for farm and ranch families (and others). Trusts are a popular part of many estate and business plans, and if property contained in them is not eligible for I.R.C. §179 their use could be costly from an income tax standpoint.
Trusts and eligibility for I.R.C. §179 - that’s the topic of today’s post.
Does the Type of Trust Matter?
I.R.C. §179(d)(4) states that an estate or trust is not eligible for I.R.C. §179. That broad language seems to be all inclusive – all types of trusts and in addition to estates are included. If that is true, that has serious implications for estate planning for farmers and ranchers (and others). Revocable living trusts are a popular estate planning tool in many estate planning situations, regardless of whether there is potential for federal estate tax. If property contained in a revocable trust (e.g., a “grantor” trust) is not eligible for I.R.C. §179, that can be a significant enough income tax difference that would mean that the estate plan should be changed to not utilize a revocable trust.
Grantor trusts. A grantor trust is a trust in which the grantor, the creator of the trust, retains one or more powers over the trust. Because of this retained power, the trust's income is taxable to the grantor. From a tax standpoint, the grantor is treated as the owner of the trust with the result that all items of income, loss, deduction and credit flowing through to the grantor during the period for which the grantor is treated as the owner of the trust. I.R.C. §671; Treas. Reg. § 1.671-3(a)(1); Rev. Rul. 57-390, 1957-2 C.B. 326. Another way of stating the matter is that a grantor trust is a disregarded entity for federal income tax purposes. C.C.A. 201343021 (Jun. 17, 2013). Effectively, the grantor simply treats the trust property as their own.
This is the longstanding position of the IRS. In Rev. Rul 85-13, 1985-1 C.B. 184, the IRS ruled that a grantor of a trust where the grantor retains dominion and control resulted in the grantor being treated as the trust owner. In other words, a grantor is treated as the owner of trust assets for federal income tax purposes to the extent the grantor is treated as the owner of any portion of the trust under I.R.C. §§671-677. In the ruling, the IRS determined that a transfer of trust assets to the grantor in exchange for the grantor's unsecured promissory note did not constitute a sale for federal income tax purposes. The facts of the ruling are essentially the same as those at issue in Rothstein v. United States, 735 F.2d 704 (2d Cir. 1984). In Rothstein, while the court found the trust at issue to be a grantor trust, the court concluded that the trust was separate from the taxpayer. But, in the 1985 ruling based on the same facts, the IRS stated that it would not follow Rothstein and reasserted its position that a taxpayer is deemed to own the assets contained in a grantor trust for federal tax purposes.
Thus, there is substantial authority for the position that property contained in a grantor trust, such as a revocable living trust, is eligible for expense method depreciation under I.R.C. §179. The grantor is the same thing for tax purposes as the grantor trust.
Irrevocable trusts. An irrevocable trust can't be modified or terminated without the beneficiary's permission. The grantor, having transferred assets into the trust, effectively removes all rights of ownership to the assets and control over the trust assets. This is the opposite of a revocable trust, which allows the grantor to modify the trust. That means that an irrevocable trust is a different entity from the taxpayer and the property contained in the trust is not eligible for expense method depreciation under I.R.C. §179 pursuant to I.R.C. §179(d)(4), unless the grantor retains some degree of power over trust income or assets. For instance, a common situation when an irrevocable trust will be treated by the IRS as a grantor trust is when the grantor retains a five percent or larger reversionary interest in the trust property. The same result occurs when the grantor retains any significant level of administrative control over the trust such as discretionary authority to distribute trust property to the grantor or the power to borrow money from the trust without paying a market rate of interest.
Pass-Through Entities and Irrevocable Trusts
The 20 percent deduction for qualified business income under I.R.C. §199A in effect for tax years beginning after 2017 and before 2026 for taxpayers with business income that are not C corporations, may spark increased interest in pass-through entities. With respect to a pass-through entity, though, questions concerning the use of I.R.C. §179 arise when an irrevocable trust has an ownership interest in the entity. Under Treas. Reg. § 1.179-1(f)(3), a trust that is a partner or S corporation shareholder is barred from deducting its allocable share of the I.R.C. §179 depreciation that is elected at the entity level. The pass-through entity’s basis in the I.R.C. §179 property is not reduced to reflect any portion of the I.R.C. §179 expense that is allocable to the trust or estate. Consequently, the entity claims a regular depreciation deduction under I.R.C. §168 with respect to any depreciable basis that results from the inability of a non-grantor irrevocable trust or the estate to claim its allocable portion of the I.R.C. §179 depreciation. Id. The irrevocable trust or estate does not benefit from the entity’s I.R.C. §179 election.
A revocable living trust, as a grantor trust, can claim I.R.C. §179 depreciation. Thus, that common estate planning vehicle won’t present an income tax planning disadvantage by taking I.R.C. §179 depreciation off of the table. However, when an irrevocable trust is involved, the result is different, unless the trust contains language that gives the grantor sufficient control over trust income or assets. Business property that is contained in an irrevocable trust is generally not eligible for I.R.C. §179 depreciation. But, trust language may change that general result. In addition, if a pass-through entity claims I.R.C. §179 depreciation, none of that depreciation flows to the irrevocable trust (or estate). That means that the entity will need to make special basis adjustments so that the deduction (or a portion thereof) is not wasted. Likewise, the depreciation should be “separately stated items” on the K-1 whenever an irrevocable trust or an estate owns an interest in the entity. Likewise, existing partnership agreements may need to be modified so that I.R.C. §179 deductions are allocated to non-trust partners and other expenses to owners of interests that are irrevocable trusts and estates.
This potential difference in tax treatment between revocable grantor trusts and irrevocable trusts should be considered as part of the overall tax planning and estate/business planning process.
Wednesday, August 1, 2018
Naming one person to receive the income and/or use of property until death and naming another person to receive ultimate ownership of the property is done for various reasons. One primary reason is to allow one person (or persons) to have the use of property during life and then have someone else own the property after the life estate expires. Life estate/remainder arrangements are also used for estate tax planning purposes. In that instance, the intent of the person creating the life estate/remainder arrangement is to effectively use the estate tax exemptions of both the husband and wife.
The life estate/remainder arrangement also raises some tax issues. One of those issues concerns the income tax basis of the property that is the subject of the arrangement. The cost basis of inherited property is almost always the fair market value of the property as of the testator's date of death. However, what is the income tax basis of property when the various rights to the property are not owned by the same people?
Income tax basis issues associated with property subject to a life estate/remainder arrangement. That’s the subject of today’s post.
The general rule is that property is valued in a decedent’s gross estate at its fair market value as of the date of the decedent’s death. I.R.C. §1014. It is that fair market value that determines the basis of the property in the hands of the recipient of the property. That’s fairly simple to understand when the decedent owns the entire property interest at death. However, that’s not the case with property that is held under a life estate/remainder arrangement. In that situation, the remainder holder does not benefit from the property until the life tenant dies. That complicates the income tax basis computation.
Uniform basis. The general idea of uniform basis is that the cost basis of inherited property should equal the value used for estate tax purposes. The new cost basis after death is usually referred to as the “stepped-up” basis, although the new basis can be lower than the original cost. As noted above, it’s tied to the property’s fair market value as of the date of death for purposes of inclusion in the decedent’s estate. The regulations state that the basis of property acquired from a decedent is uniform in the hands of every person having an interest in the property. Treas. Reg. §1.1014-4. As explained in the regulations, under the laws governing transfers from decedents, all ownership interests relate to the death of the decedent, whether the interests are vested or contingent. That means that there is a common acquisition date and a common basis for life tenants and remainder holders.
The uniform basis rule is easy to implement after the death of the life tenant, as shown in the following example.
Example. Boris leaves his entire estate to his son, Rocky, as a remainder holder. However, all income from the estate is payable to his wife, Natasha, until her death. The value of the property is $200,000 at the time of his death.
Natasha collects the income from the inherited property for 20 years. When she dies, the appreciated value of the property is $500,000.
When Natasha dies, Rocky becomes the sole owner of both the property and the future income. However, because Rocky's ownership of the property is based initially on his father's death, Rocky's basis is $200,000 - the value at the time his father died.
The result of the example makes sense when you consider that the value of the life estate interest is excluded from Natasha’s estate. Because it was excluded from her estate, there is not basis step-up in Rocky’s hands – the person who receives the right to the income after Natasha dies.
If the inherited property is subject to depreciation, the holder of the life interest is allowed to claim the depreciation expense attributable to the entire inherited basis of the depreciable property.
Sale of the Life Estate Interest
The basis rules change dramatically for the holder of a life estate interest if the rights to the income are sold without the remainder interest being sold as part of the same transaction. If the life interest is sold separately, the seller's basis for tax purposes is $0. I.R.C. 1001(e). The buyer of the life interest can amortize the cost of the purchase over the life expectancy of the seller.
Example. Bill leaves a life interest in stock to his neighbor, Dale, and a remainder interest to another neighbor, Bobbi. The value of the stock for estate tax purposes is $5,000 at the time Bill dies. Dale immediately sells his life interest to LuAnn for $100.
Dale's cost basis in his life interest is $0. Dale reports the gain of $100 on Schedule D, Capital Gains and Losses, as a long-term capital gain. I.R.C. §1223(10). This transaction has no effect on the uniform basis. The cost basis allocable to Bobbi's remainder interest will continue to increase each year as the life interest's value decreases. Treas Reg. §1-1014. LuAnn is entitled to subtract a portion of the $100 she paid Dale each year against her dividend income. The subtraction is based upon Dale's life expectancy at the time of the sale. Treas. Reg. 1.1014-5(c).
Technically, there is no authority directing LuAnn where.to include this subtraction on her return. The conservative approach is to include it in investment expense on Schedule A, Itemized Deductions. An aggressive approach is to treat it in the same way as premiums paid for bonds, which is as a subtraction on Schedule B, Interest and Ordinary Dividends.
Death of the Remainder Holder
If the holder of the remainder interest dies before the holder of the life interest, the uniform basis is not adjusted and the life tenant's basis is still calculated as explained previously.
However, the value of the remainder interest is included in the estate of the remainder holder. The regulations, therefore, allow the beneficiary of the remainder holder's estate to adjust the basis for a portion of the value that is included in the estate.
This basis adjustment is calculated by subtracting the portion of the uniform basis allocable to the decedent immediately prior to death from the value of the remainder interest included in the estate.
Example. Marge died in 2006. In her will, she left Bart, her son, a life estate interest in their family home. She left Lisa, her daughter, the remainder interest. In 2010, Lisa died. In Lisa's will, Maggie, her sister, is the sole heir. Bart is still alive.
The fair market value of the house in 2006 when Marge died was $100,000. At the time of Lisa's death, her share in the uniform basis was $15,000, based on Bart's life expectancy and the fair market value. The value of the home in 2010 when Lisa died was $200,000. The value of the remainder interest included in Lisa's estate was $30,000.
Maggie's basis adjustment in the inherited house is shown below:
Value of the house included in Lisa's estate
Less: Lisa's portion of the uniform basis at her death
Maggie's basis adjustment in the house
When the beneficiary to the remainder interest sells the property, the basis is calculated using the beneficiary's current portion of the uniform basis at the time of the sale plus the adjustment.
Most people have a pretty good understanding that the income tax basis of property received from a decedent that was included in that decedent’s estate is the fair market value of the property as of the date of the decedent’s death. But, the basis issue becomes more complex when the property at issue is part of a life estate/remainder arrangement. It’s a common estate planning technique, so the issue often arises. Hopefully, today’s post helped sort it out.
Monday, July 30, 2018
Last week, House Ways and Means Committee Chairman Kevin Brady released the committee’s working outline for a tax legislative proposal that they are presently working on with hopes of passage later this summer or fall. It appears to be a framework at this time, with not much substantive Code structure attached to it. But, the framework is something to go on in anticipating what might be a forthcoming legislative proposal. In any event, it’s worth noting what has been released so that feedback from tax professionals can be provided to tax staffers as the drafting process proceeds.
A tax proposal following-up on the Tax Cuts and Jobs Act – that’s the topic of today’s post.
The framework puts the tax proposals into three separate categories: 1) individual and small business tax cuts; 2) promotion of individual savings; and 3) promotion of business innovation.
Individual and small business. The effort seems to be with respect to the first category to make most of the TCJA provisions that apply to individuals and small business permanent. Under the TCJA, many provisions are set to expire at the end of 2025. Remember, however, tax provisions are only “permanent” if they don’t contain a statutory sunset date and the Congress doesn’t otherwise change the law.
Savings. The second area of focus, promoting individual savings, contains several proposals designed not only to spur individual savings, but also incentivize the use of workplace retirement plans. One proposal that is outlined would establish a “Universal Savings Account.” The description of the account is that it would be a “fully flexible savings tool for families.” At this time, however, there are no details as to how the account would be established or function.
While the TCJA did expand the potential use and application of funds contained in a “529” education account, the proposal would attempt to expand further the use of such funds by allowing them (on a tax-favored basis) to be used to pay for apprenticeship fees to learn a trade, cover home schooling expenses and be applied to pay-off student debt.
This prong of the proposal would also allow money to be withdrawn without penalty from existing retirement accounts to pay for childbirth or adoption costs. In addition, amounts withdrawn for such purposes could be paid back at a later time.
Innovation. The third prong of the proposal focuses on spurring small business entrepreneurship and innovation. To accomplish this objective, the proposal would allow qualified small businesses to write off a greater amount of initial start-up costs than is permitted under present law. There is no specification as to the additional amount, nor is there any “meat” to the comment in the proposal that new tax provisions would be used to “remove barriers to growth.”
In recent years, tax legislation (or most legislation, for that matter) passes the House and then goes to the Senate to either die or not get acted upon – largely because of the 60-vote requirement to pass tax legislation in the Senate without the reconciliation process. That same process could also be true for this proposal. A likely scenario is that the House passes a tax bill, but the Senate fails to take action before the end of the year (or takes action at the last minute in December). For this reason, it looks as if (at least right now) the House will introduce its tax proposals in three separate bills – one for each of the prongs mentioned above. It is believed that such a strategy will assist in the process of getting the necessary 60 votes by tailoring each proposal to specific provisions. But, then there is always the politics of the situation. The Senate majority leader could call for a vote before the fall congressional election. Or, on the other hand, the vote could be put off until after the election on anticipation that the Republican majority in the Senate will widen.
While some in the Congress could balk at what is likely to be budget scoring that will say that additional tax cuts will widen the deficit, that may be counterbalanced by those wanting deeper cuts and pointing to the strength of the overall economy. In addition, I am already hearing talk from some tax staffers that there could be an attempt to tweak the TCJA by repealing the tax on private college endowments, modifying the new qualified business income deduction of I.R.C. §199A and indexing capital gains. The I.R.C. §199A issue is an interesting one. There are many unanswered question concerning it and the first set of regulations involving the new deduction have yet to be released. Also, politicians from high tax states may push for a full reinstatement of the state and local tax deduction.
Another possibility is that any new tax legislation will contain technical corrections to TCJA provisions. That is probably a slim possibility, however, until after the midterm election. That means that technical corrections, if any, won’t be until later in November or December. Of course, those are needed now (actually they were needed months ago) as are regulations and forms so that tax pros can give advice to clients and take appropriate planning steps.
As for health care, on July 25, the U.S. House passed two health care reform bills which would do numerous things but, in particular, expand access to tax-preferred health savings accounts (HSAs). As usual, it remains to be seen whether the Senate will even take up either or both of the bills.
The first of the two bills, H.R. 6311, would allow individuals to bypass the Obamacare restriction on using premium tax credits to buy catastrophic health care plans and would broaden eligibility for contributions to an HSA. Specifically, the bill would raise the contribution limit to $6,650 for individuals and $13,000 for families. That’s the combination of the annual limit for out-of-pocket and deductible expenses for 2018. The bill would also permit HSA funds to pay for qualified medical expenses at the start of coverage of the high deductible health policy (HDHP) if the HSA has been opened within 60 days of the HDHP start date. The bill would also suspend until 2022 Obamacare’s annual fee on health insurers.
The other bill concerning health care that was passed on July 25 is H.R. 6199. This legislation repeals the portions of Obamacare that limit payments for medications from HSAs, medical savings accounts, health FSAs, and health reimbursement arrangements to only prescription drugs or insulin. As a result, distributions from such accounts can be made without penalty for over-the-counter medications and products. The bill would also allow persons with health insurance that qualifies as HSA family coverage to contribute to an HSA if their spouse is enrolled in a medical FSA. It would also allow an HDHP to annually cover up to $250 (self) and $500 (family) of non-preventative services (e.g., chronic care) that may not be covered until after the deductible is reached.
Tax policy will remain a key topic over the weeks leading up to the midterm election. Whether any legislation is enacted remains to be seen. Certainly, technical corrections are needed to deal with certain aspects of the TCJA. From there, additional legislation is an add-on. In any event, certainty in tax policy will not likely be part of the future for some time. All of this makes providing tax advice to clients difficult.
Thursday, July 26, 2018
Financial distress in the farm sector continues to be a real problem. Low prices in recent years has added to the problem, as have increased debt levels as a result of financed asset purchases during the economic upswing in the ag economy in earlier years. As an example, the level of working capital in the farm sector has fallen sharply since 2012. Working capital for the farm sector as a whole (current assets less current liabilities) is at its lowest level in 10 years, presently at 36 percent of its 2012 peak. In the past year alone, working capital dropped by 18 percent. It has also declined precipitously as a percentage of gross revenue. This means that many farmers have a diminished ability to reinvest in their farming operations. It also means that there is an increased likelihood that a farmer may experience the repossession of farm personal property and real estate. When that happens, the sellers of the assets that repossess have tax consequences to worry about.
Sometimes a Chapter 12 bankruptcy might be filed – and those filings are up in parts of the Midwest and the Great Plains. Other times, farmland might be repossessed.
Tax issues upon repossession of farmland – that’s the topic of today’s post.
Repossession of Farmland
Special exception. A special exception exists under I.R.C. § 1038 that is very favorable to sellers repossessing land under an installment sale – the seller need not recognize gain or loss upon the repossession in either full or partial satisfaction of the debt. It doesn’t matter what method of accounting the seller used in reporting gain or loss from the sale or whether at the time of reacquisition the property has increased or decreased in value since the time of the original sale. However, the rules do not apply if the disposition constitutes a tax-free exchange of the property, and a special problem can be created if related parties are involved. See I.R.C. §453B(f)(2). In addition, for the special rules to apply, the debt must be secured by the real property.
When real property is repossessed, whether the repossession is voluntary or involuntary, the amount of gain recognized is the lesser of - (1) the amount of cash and the fair market value of other property received before the reacquisition (but only to the extent such money and other property exceeds the amount of gain reported before the reacquisition); or (2) the amount of gain realized on the original sale (adjusted sales price less adjusted income tax basis) in excess of the gain previously recognized before the reacquisition and the money or other property transferred by the seller in connection with the reacquisition.
Handling interest. Amounts of interest received, stated or unstated, are excluded from the computation of gain. Because the provision is applicable only when the seller reacquires the property to satisfy the purchaser's debt, it is generally inapplicable where the seller repurchases the property by paying the buyer an extra sum in addition to cancelling the debt. However, if the parties are related, the seller (according to the statute) must report interest debt that is canceled as ordinary income. I.R.C. §453B(f)(2). But, a question exists as to whether that provision applies in financial distress situations.
The rules generally are applicable, however, if the seller reacquires the property when the purchaser has defaulted or when default is imminent even if the seller pays additional amounts.
Debt secured by the real property. The provisions on repossession of real property do not apply except where the indebtedness was secured by the real property. Therefore, reconveyance of property by the obligor under a private annuity to the annuitant would appear not to come within the rules.
Character of gain. The character of the gain from reacquisition is determined by the character of the gain from the original sale. For an original sale reported on the installment method, the character of the reacquisition gain is determined as though there had been a disposition of the installment obligation. If the sale was reported on the deferred payment method, and there was voluntary repossession of the property, the seller reports the gain as ordinary income. If the debts satisfied were securities issued by a corporation, government or political subdivision, the gain would be capital gain.
Basis issues. Once the seller has reacquired the property, it is important to determine the seller's basis in the reacquired property. The adjusted income tax basis for the property in the hands of the reacquiring seller is the sum of three amounts - (1) the adjusted income tax basis to the seller of the indebtedness, determined as of the date of reacquisition; (2) the taxable gain resulting from reacquisition; and (3) the money and other property (at fair market value) paid by the seller as reacquisition costs.
The holding period of the reacquired property, for purposes of subsequent disposition, includes the holding period during which the seller held the property before the original sale plus the period after reacquisition. However, the holding period does not include the time between the original sale and the date of reacquisition.
Is the personal residence involved? The provisions on reacquisition of property generally apply to residences or the residence part of the transaction. However, the repossession rules do not apply if - (1) an election is in effect for an exclusion on the residence (I.R.C. §121) and; (2) the property is resold within one year after the date of reacquisition. See, e.g., Debough v. Comm’r, 142 T.C. No. 297 (2014), aff’d, 799 F.3d 1210 (8th Cir. 2015). If those conditions are met, the resale is essentially disregarded and the resale is considered to constitute a sale of the property as of the original sale. In general, the resale is treated as having occurred on the date of the original sale. An adjustment is made to the sales price of the old residence and the basis of the new residence. If not resold within one year, gain is recognized under the rules for repossession of real property. An exclusion election is considered to be in effect if an election has been made and not revoked as of the last day for making such an election. The exclusion can, therefore, be made after reacquisition. An election can be made at any time within three years after the due date of the return.
No bad debt deduction is permitted for a worthless or a partially worthless debt secured by a reacquired personal residence, and the income tax basis of any debt not discharged by repossession is zero. Losses are not deductible on sale or repossession of a personal residence. When gain is not deferred or excluded, the repossession of a personal residence is treated under the general rule as a repossession of real property. Adjustment is made to the income tax basis of the reacquired residence.
Special situations. In 1969, the IRS ruled that the special provisions on income tax treatment of reacquisition of property did not apply to reacquisition by the estate of a deceased taxpayer. Rev. Rul. 69-83, 1969-1 C.B. 202. A decedent's estate was not permitted to succeed to the income treatment that would have been accorded a reacquisition by the decedent. However, the Installment Sales Revision Act of 1980 changed that result. The provision is effective for “acquisitions of real property by the taxpayer” after October 19, 1980. Presumably, that means acquisitions by the estate or beneficiary. Under the 1980 amendments, the estate or beneficiary of a deceased seller is entitled to the same nonrecognition treatment upon the acquisition of real property in partial or full satisfaction of secured purchase money debt as the deceased seller would have been. The income tax basis of the property acquired is the same as if the original seller had reacquired the property except that the basis is increased by the amount of the deduction for federal estate tax which would have been allowable had the repossession been taxable.
The IRS ruled in 1986 that the nonrecognition provision on repossessions of land does not apply to a former shareholder of a corporation who receives an installment obligation from the corporation in a liquidation when that shareholder, upon default by the buyer, subsequently receives the real property used to secure the obligation. Rev. Rul. 86-120, 1986-2 C.B. 145.
Tax planning is important for farmers that are in financial distress and for creditors of those farmers. As usual, having good tax counsel at the ready is critical. Tax issues can become complex quickly.
Tuesday, July 24, 2018
For many people, the most important estate planning document is the will (or trust) that disposes of property at the time of death. Assets that pass by will are subject to probate and are known as “probate assets.” But, a decedent’s estate may also have “non-probate assets.” Those are assets that are not subject to the probate court’s jurisdiction and pass by a contractual beneficiary designation. These contractual arrangements include life insurance, pensions, IRAs and annuities.
For married couples, one spouse typically names the other spouse as the beneficiary of these non-probate assets. But, what if one spouse names the other as the beneficiary of a non-probate contractual arrangement and divorce occurs and the beneficiary designation is not changed? Does the beneficiary-spouse remain the beneficiary, or is that designation automatically revoked? Can the law automatically remove the former spouse as beneficiary? How does the Constitution’s Contracts Clause factor into this?
That’s the topic of today’s post – beneficiary changes upon divorce.
The Contracts Clause
Article I, Section 10, Clause 1 of the U.S. Constitution specifies that a state cannot enact legislation that disrupts contractual arrangements. That provision says that, “[n]o state shall…pass any…Law impairing the Obligation of Contracts.” Thus, while citizens have the right to enter into contracts that don’t violate “public policy,” the government cannot impair otherwise permissible contracts. But, what does that mean? Does it mean that a state can enact a law that changes the contractual beneficiary designation on a life insurance policy, for example? The issue recently came up in a case that made it all of the to the U.S. Supreme Court.
In Sveen v. Melin, 138 S. Ct. 1815 (2018), a couple married in 1997. In 1998, the husband bought a life insurance policy that named his wife as the primary beneficiary and his two children from a prior marriage as the contingent beneficiaries. In 2002, a new Minnesota law took effect providing that “the dissolution or annulment of a marriage revokes any revocable…beneficiary designation…made by an individual to the individual’s former spouse.” Minn. Stat. §524.2-804, subd.1. Thus, divorce automatically revokes the designation of a spouse as the beneficiary. That would cause the insurance proceeds to go to the contingent beneficiary or the policyholder’s estate upon death of the policyholder. If the policyholder does not want this result, the former spouse can be named as beneficiary (again). In 2007, the couple divorced and the former husband died in 2011 without changing the beneficiary designation. The deceased ex-husband’s children claimed that they were the beneficiaries of the life insurance proceeds. But, the surviving ex-spouse claimed that she was the beneficiary because the law did not exist at the time the policy was purchased and she was named the primary beneficiary. Her core argument was that the retroactive application of the law violated the Contracts Clause.
The U.S. Court of Appeals for the Eighth Circuit agreed with the surviving ex-spouse (Metro Life Insurance Co. v. Melin, 853 F.3d 410 (8th Cir. 2017), but the U.S. Supreme Court reversed. The Supreme Court noted that the Contracts Clause did not establish a complete prohibition against states from enacting laws that impacted pre-existing contracts. The Court noted that a two-step test existed form determining the constitutionality of such a law. Step one involves the question of whether the law “operated as a substantial impairment of a contractual relationship” based on the extent to which the law undermined the parties’ bargain, interfered with the parties’ reasonable expectations, and barred the parties from safeguarding their rights. If a contractual impairment is determined under step one, then the second step examines the means and ends of the legislation to determine whether the state law advances a significant and legitimate public purpose.
In Sveen, the Court held that the law did not substantially impair pre-existing contractual arrangements. The Court reasoned that the law was designed to reflect a policyholder’s intent based on an assumption that an ex-spouse would not be the desired primary beneficiary. In addition, the Court stated that an insured cannot reasonably rely on a beneficiary designation staying in place after a divorce – noting that divorce courts have wide discretion to divide property, including the revocation of spousal beneficiary designations in life insurance policies (or mandating that they remain). Accordingly, the Court concluded that a policyholder had no reliance interest in the policy in the event of divorce, and could undo the impact of the law by again naming the (now) ex-spouse as the primary beneficiary. The decedent’s children were held to be the primary beneficiaries of the policy.
Kansas, like other states, has an automatic revocation provision for wills upon divorce. Kan. Stat. Ann. §59-610. For non-probate assets with a beneficiary designation, in divorce actions judges are to include changes in beneficiary status as part of the property division between the spouses and note any change in the divorce decree. Kan. Stat. Ann. §2-2602(d). The policyholder remains responsible for actually changing the beneficiary designation. Id.
The Court’s conclusion expands the reach of the government into private contractual arrangements. It also assumes that all divorces are acrimonious and that a divorced policyholder would never want to benefit a former spouse. That's simply not true. What's more is that the Court upheld the Minnesota law even though it retroactively applied in the case at bar. If a statute that changes (rewrites) the primary beneficiary designation of a contract on a retroactive basis doesn’t substantially impair that contract, I don’t know what does. Judge Gorsuch seems to agree with that last point in his dissent.
How does your state law treat the issue?
Friday, July 20, 2018
Many states criminalize the intentional killing, injuring, maiming, torturing or mutilating of any animal. In some states, simply abandoning or leaving an animal in any place without making provisions for its proper care or having physical custody of an animal and failing to provide food, potable water, protection from the elements, opportunity for exercise and other care, as is needed for the health or well-being of the animal is criminal.
But, what must the state prove to make a cruelty to animals charge stick? That issue came up in a recent case and is the topic of today’s post.
Typically, the state must prove that the defendant acted with depraved intent. Cruelty to animals is typically classified as a misdemeanor carrying a penalty of up to six months in jail and/or a fine of up to $2,000. Most states do not classify as cruelty to animals accepted veterinary practices and bona fide experiments carried on by commonly recognized research facilities. In many of the western states, rodeo practices accepted by the Rodeo Cowboy's Association are statutorily determined not to constitute cruelty to animals as well as the humane killing of an animal which is diseased or disabled beyond recovery for any useful purpose or for population control by the animal's owner. Normal or accepted practices of animal husbandry do not constitute cruelty to animals with respect to farm animals, and killing an animal that is found injuring or posing a threat to another person, farm animal or property is also permitted.
In Cadwell v. State, No. 06-17-00227-CR 2018 Tex. App. LEXIS 4545 (Tex. Ct. App. Jun. 21, 2018), the defendant and his estranged wife were involved in divorce proceedings and during that time various horses belonging to them that had been ordered into the defendant’s custody lost weight, reportedly due to inadequate nutrition. The defendant’s estranged wife as well as two other investigators and animal control officers all testified that the horses were in very bad condition with ribs showing and cracked and had split hooves due to malnutrition. The investigator testified that the horses were kept in an enclosure that had “virtually no grass,” and that grass that was present was too short for them to eat. All the bushes and shrubs had been picked clean. The water troughs within that enclosure were empty and had only leaves and debris in them or had been overturned. A stock tank or pond had water, but it was filled with debris and was stagnant. In addition, there was no evidence of hay found in the horses’ enclosure. The state’s expert witness was a veterinarian with 11 years’ experience. She explained that there is a body scoring scale from one (extremely emaciated) to nine or ten (being extremely obese). In addition, she explained that the acceptable range for a horse is four to six. A horse that is scored under four is in a condition that needs to be addressed. A horse scored at three on this scale is considered thin, while a score of two would indicated that a horse is badly emaciated but standing, while a one indicates extreme emaciation, not able to stand, and not considered savable. She testified that when she saw them the majority of the horses were scored at a three. She also testified that she was surprised with the relatively low parasite presence in most of them and concluded that the most likely reason for the horses’ thinness was that they were not being fed properly.
Ultimately, the defendant was convicted of cruelty to livestock animals and sentenced to 180 days in jail (which was changed to 24 months on the condition that the defendant serve 30 days in jail). The defendant appealed on the basis that there the state failed to prove that he had the criminal intent (mens rea) to harm the animals. The appellate court determined that evidence could lead a rational jury to find beyond a reasonable doubt that the defendant was intentional or knowing in not providing one or more of the horses in his care enough nutrition.
The defendant also claimed that by inserting “by neglect” in the information and the jury charge, the State and the trial court, improperly instructed the jury and improperly lowered the mens rea requirement from intentionally or knowingly to a lower level of mens rea. However, the appellate court determined that the phrase “by neglect” charges the defendant with cruelty to animals by the manner and means of failure to act or of behavior that was not attentive to the needs of the horses, not with negligently doing so, especially given that the mens rea was specified in both the information and in the jury charge as intentional or knowing. Thus, the appellate court held that because the use of the phrase “by neglect” set out the manner and means of committing the offense and because the information and the jury charge clearly set out the required mens rea of intentional or knowing behavior by the defendant, the use of the phrase did not improperly reduce the State’s burden to prove the defendant’s willful or knowing mens rea.
Generally accepted farming practices do not constitute animal cruelty. Generally, providing adequate food and shelter is required, but some states have little to no shelter requirements in certain situations and with respect to certain types of livestock. The statutory rules vary from state to state.
Wednesday, July 18, 2018
Next month, Washburn Law School and Kansas State University (KSU) will team up for its annual symposium on agricultural law and the business of agriculture. The event will be held in Manhattan at the Kansas Farm Bureau headquarters. The symposium will be the first day of three days of continuing education on matters involving agricultural law and economics. The other two days will be the annual Risk and Profit Conference conducted by the KSU Department of Agricultural Economics. That event will be on the KSU campus in Manhattan. The three days provide an excellent opportunity for lawyers, CPAs, farmers and ranchers, agribusiness professionals and rural landowners to obtain continuing education on matters regarding agricultural law and economics.
This year’s symposium on August 15 will feature discussion and analysis of the new tax law, the Tax Cuts and Jobs Act, and its impact on individuals and businesses engaged in agriculture; farm and ranch financial distress legal issues and the procedures involved in resolving debtor/creditor disputes, including the use of mediation and Chapter 12 bankruptcy; farm policy issues at the state and federal level (including a discussion of the status of the 2018 Farm Bill); the leasing of water rights; an update on significant legal (and tax) developments in agricultural law (both federal and state); and an hour of ethics that will test participant’s negotiation skills.
The symposium can also be attended online. For a complete description of the sessions and how to register for either in-person or online attendance, click here: http://washburnlaw.edu/practicalexperience/agriculturallaw/waltr/continuingeducation/businessofagriculture/index.html
Risk and Profit Conference
On August 16 and 17, the KSU Department of Agricultural Economics will conduct its annual Risk and Profit campus. The event will be held at the alumni center on the KSU campus, and will involve a day and a half of discussion of various topics related to the economics of the business of agriculture. One of the keynote speakers at the conference will be Ambassador Richard T. Crowder, an ag negotiator on a worldwide basis. The conference includes 22 breakout sessions on a wide range of topics, including two separate breakout sessions that I will be doing with Mark Dikeman of the KSU Farm Management Association on the new tax law. For a complete run down of the conference, click here: https://www.agmanager.info/risk-and-profit-conference
The two and one-half days of instruction is an opportunity is a great chance to gain insight into making your ag-related business more profitable from various aspects – legal, tax and economic. If you are a producer, agribusiness professional, or a professional in a service business (lawyer; tax professional; financial planner; or other related service business) you won’t want to miss these events in Manhattan. See you there, or online for Day 1.
July 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)
Monday, July 16, 2018
In recent years, the IRS has shown an increased focus on business activities that it believes are being engaged in without an intent to make a profit. If that is the case, the “hobby loss” rules apply and limit deductions to the amount of income from the activity. But, engaging in an activity with a profit intent may not be enough to fully deduct losses from the activity. That’s particularly the case if the taxpayer hires a paid manager to run the operation. In that situation, the IRS may claim that the taxpayer is not materially participating in the activity under the passive loss rules. If the IRS prevails on that argument, loss deductions are severely limited, if not eliminated.
A recent Tax Court case involved both the hobby loss rules and the passive loss rules. While the ranching activity was deemed not to be a hobby, the court believed that the taxpayer was not materially participating in the activity.
Paid managers and the passive loss rules – that’s the focus of today’s post.
Passive Loss Rules
The passive loss rules, enacted in 1986, reduce the possibility of offsetting passive losses against active income. I.R.C. §469(a)(1). The rules apply to activities that involve the conduct of a trade or business (generally, any activity that is a trade or business for purposes of I.R.C. §162) where the taxpayer does not materially participate (under at least one of seven tests) in the activity on a basis which is regular, continuous and substantial. I.R.C. § 469(h)(1). Property held for rental usually is a passive activity, however, regardless of the extent of the owner's involvement in the management or operation of the property.
If the passive loss rules apply, deductions (losses) from passive trade or business activities, to the extent the deductions exceed income from all passive activities, may not be deducted against other income (non-passive activity gains). Losses (and credits) that a taxpayer cannot use because of the passive loss limitation rules are suspended and carry over indefinitely to be offset against future passive activity income from any source. I.R.C. §469(b). For farmers, the passive loss rules are likely to come into play in situations where the farmer is a passive investor in a separate business venture apart from the farming operation. In that case, as noted, the losses from the venture cannot be used to offset the income from the farming operation.
Facts. In Robison v. Comr., T.C. Memo. 2018-88, the petitioners were a married couple who lived in the San Francisco Bay area. The husband worked in the technology sector, and during the years in issue (2010-2014) the husband’s salary ranged from $1.4 million to $10.5 million. In 1999, the petitioners bought a 410-acre tract in a remote area of southeastern Utah for $2,000,000. They later acquired additional land, bringing their total land holdings to over 500 acres. The wife sold her physical therapy practice to focus her time on the administrative side of their new ranching activity.
The property was in shambles and the petitioners spent large sums on infrastructure to refurbish it. The began a horse activity on the property which they continued until 2010. The activity never made money, with a large part of the losses (roughly $500,000 each year) attributable to depreciation, repairs due to vandalism, and infrastructure expense such as the building of a woodshop and cement factory as the property’s remote location made repair work and build-out necessary to conduct on-site. The petitioners did not live on the ranch. Instead, they traveled to the ranch anywhere from four to ten times annually, staying approximately 10 days each time. The petitioners drafted all employee contracts, and managed all aspects of the horse activity.
They deducted their losses from the activity annually, and presumably because of the continued claimed losses, they were audited by the IRS in 2004 and 2008. Each of those audits concluded with an IRS determination that the petitioners were conducting a trade or business with profit intent (e.g., the activity was not a hobby). The IRS also determined that the petitioners were materially participating for purposes of the passive loss rules. The petitioners did not maintain contemporaneous records of their time spent on ranch activities. However, for each of those audits, the petitioners prepared time logs based on their calendars and their historical knowledge of how long it took them to complete various tasks. The IRS deemed the petitioners’ approach to documenting and substantiating their time spent on various ranch activities as acceptable. That documentation showed that the petitioners were putting over 2,000 hours (combined) into the ranch activity annually. In one year alone, they devoted more than 200 hours dealing with the IRS audit.
In 2010, the petitioners shifted the ranch business activity from horses to cattle. The husband retired in 2012 and, upon retirement, the couple moved to Park City, Utah, with the husband devoting full-time to the ranching activity along with his wife. The cattle operation was strictly grass-fed, with the cattle grazing upper-elevation Bureau of Land Management (BLM) land during the summer months. The petitioners negotiated the lease contracts with the BLM. They also hired a full-time ranch manager to manage the cattle. However, the petitioners managed the overall business of the ranch. From 2013-2015, the losses from the ranch declined each year.
The IRS initiated a third audit (all three audits involved different auditors) of the petitioners’ ranching activity, this time examining tax years 2010-2014. The IRS examined whether the activity constituted a hobby, but raised no questions during the audit concerning the petitioners’ material participation. The IRS hired an expert who spent three days at the ranch looking at all aspects of the ranching activity and examining each head of cattle. The expert produced a report simply concluding that the petitioners had too many expenses for the activity to be profitable. This time the IRS issued a statutory notice of deficiency (SNOD) denying deductions for losses associated with the ranching activity. The IRS claimed that the ranching activity was a “hobby,” and also raised the alternative argument that the petitioners failed to satisfy the material participation test of the passive loss rules.
The petitioners disagreed with the IRS’ assessment and filed a petition with the U.S. Tax Court. The IRS did not disclose to the petitioners whether the petitioners’ alleged lack of material participation was an issue until two days before trial. At the seven-hour trial, the court expressed no concern about any lack of profit motive on the petitioners’ part. The IRS’ trial brief focused solely on the hobby loss issue and did not address the material participation issue. In addition, the IRS did not raise the material participation issue at trial, and it was made clear to the court that the paid ranch manager was hired to manage the cattle, but that the overall business of the ranch was conducted by the petitioners. At the conclusion of the trial, the court requested that the parties file additional briefs on the material participation issue.
Tax Court’s opinion – hobby loss rules. Judge Cohen determined that the ranching activity was not a hobby based on the nine factors set forth in Treas. Reg. §1.183-2. One of the key factors in the petitioners’ favor was that they had hired a ranch manager and ranch hand to work the ranch and a veterinarian to assist with managing the effects of high altitude on cattle. This indicated that the activity was being conducted as a business with a profit intent. They had many consecutive years of losses, didn’t have a written business plan and didn’t maintain records in a manner that aided in making business decisions. However, the court noted that they had made a significant effort to reduce expenses and make informed decisions to enhance the ranch’s profitability. Indeed, after ten years of horse activity, the petitioners changed the ranching activity to cattle grazing in an attempt to improve profitability. While the petitioners’ high income from non-ranching sources weighed against them, overall the court determined that the ranching activity was conducted with the requisite profit intent to not be a hobby.
Note: While the court’s opinion stated that the horse activity was changed to cattle in 2000, the record before the court indicated that the petitioners didn’t make that switch until 2010.
Tax Court’s opinion – passive loss rules. However, Judge Cohen determined that the petitioners had failed to satisfy the material participation test of the passive loss rule. The losses were, therefore, passive and only deductible in accordance with those rules. The court determined that only two of the seven tests for material participation were relevant – the 500-hour test (Treas. Reg. § 1.469-5T(a)(1)) and the facts and circumstances test (Treas. Reg. §1.469-5T(a)(7)). As for the 500-hour test, the court took issue with the manner in which the petitioners documented their time spent on the ranching activity. The court opined that the logs were merely estimates of time spent on ranch activities and were created in preparation for trial. The court made no mention of the fact that the IRS, on two prior audits, raised no issue with the manner in which the petitioners tracked their time spent on ranch activities and had not questioned the accuracy of the logs that were prepared based on the petitioners’ calendars during the third audit which led to the SNOD and eventual trial.
As for the facts and circumstances test, the court determined that the petitioners could not satisfy the test because of the presence of the paid ranch manager. The court made no distinction between the cattle grazing activity which the ranch manager was responsible for and the overall business operations for which the petitioners were responsible. Indeed, on the material participation issue, due to the presence of the ranch manager, all of the personal actions and involvement of the petitioners on which the court based its determination of their profit motive were dismissed as “investor” hours.
The regulations do not list the facts and circumstances considered relevant in the application of the test, but the legislative history behind the provision does provide some guidance. Essentially, the question is whether and how regularly the taxpayer participates in the activity. Staff of Joint Comm. on Taxation, 99th Cong., 2d Sess., General Explanation of the Tax Reform Act of 1986, at 238 (Comm. Print 1987) [hereinafter 1986 Act Bluebook]. A taxpayer that doesn’t live at the site of the activity can still satisfy the test. Id. While management activities can qualify as material participation, they are likely to be viewed skeptically because of the difficulty in verifying them. See, e.g., HR Rep. No. 841, 99th Cong., 2d Sess. II-148 (Conf. Rep. 1986); S. Rep. No. 313, 99th Cong., 2d Sess. 734 n.20 (1986); 1986 Act Bluebook, supra note 35, at 240. Merely “formal and nominal participation in management, in the absence of a genuine exercise of independent discretion and judgment is not material participation.” HR Rep. No. 841, 99th Cong., 2d Sess. II-148 (Conf. Rep. 1986); S. Rep. No. 313, 99th Cong., 2d Sess. 734 n.20 (1986). Thus, the decisions the taxpayer makes must be important to the business (and they must be continuous and substantial).
It is true that a taxpayer’s management activities are ignored if any person receives compensation for management services performed for the activity during the taxable year. Treas. Reg. §1.469-5T(b)(2)(ii)(A). Clearly, this exclusion applies where the “taxpayer has little or no knowledge or experience” in the business and “merely approves management decisions recommended by a paid advisor.” See Treas. Reg. §1.469-5T(k), Ex. 8. However, the regulation applies well beyond those situations. In addition, a taxpayer's management work is ignored if some other unpaid manager spends more time than the taxpayer on managing the activity. Treas. Reg. § 1.469-5T(b)(ii)(B). Thus, there is no attributions of the activities of employees and agents to the taxpayer for purposes of the passive loss rules, but hiring a paid manager does not destroy the taxpayer’s own record of involvement for the material participation purposes except for the facts and circumstances test. See, e.g., S. Rep. No. 313, 99th Cong., 2d Sess. 735 (1986)( “if the taxpayer’s own activities are sufficient, the fact that employees or contract services are utilized to perform daily functions in running the business does not prevent the taxpayer from qualifying as materially participating”).
Clearly, the petitioners’ type of involvement in the ranching activity was not that of an investor. However, equally clearly was that the petitioners’ method of recordkeeping was a big issue to the court (even though IRS was not concerned). The preparation of non-contemporaneous logs and those prepared from calendar entries has been a problem in other cases. See, e.g., Lee v. Comr., T.C. Memo. 2006-193; Fowler v. Comr., T.C. Memo. 2002-223; Shaw v. Comr., T.C. Memo. 2002-35. Without those logs being available to substantiate the petitioners’ hours, the petitioners were left with satisfying the material participation requirement under the facts and circumstances test. That’s where the presence of the paid manager proved fatal. Thus, the ranching activity was not a hobby, but it was passive.
Combining the passive loss rules with a hobby loss argument is not a new tactic for the IRS (it was recently utilized with respect to a Kansas ranch), but the Robison decision certainly indicates that it can be expected to be used more frequently. But, remember, the IRS, at no point in the audit or litigation in Robison pressed the material participation issue – it was simply stated as an alternative issue in the SNOD. It was Judge Cohen that sought additional briefing on the issue.
The result in Robison is that the losses will only be deductible to the extent of passive income from the activity. Otherwise, the losses remain suspended until the petitioners dispose of their entire interest in the activity in a fully taxable transaction to an unrelated party. I.R.C. §469(g). That’s exactly what is going to happen. The petitioners are tired of the constant battle with the IRS and will not appeal the Tax Court’s decision. The ranch is for sale.
Thursday, July 12, 2018
A partnership is an association of two or more persons to carry on as co-owners a business for profit. Uniform Partnership Act, § 6. Similarly, the regulations state that a business arrangement “may create a separate entity for federal tax purposes if the participants carry on a trade, business, financial operation, or venture and divide the profits therefrom.” 26 C.F.R. §301.7701-1(a)(2). If there is a written partnership agreement, that usually settles the question of whether the arrangement is a partnership. Unfortunately, relatively few farm or ranch partnerships are based upon a written partnership agreement or, as it is expressed in some cases, a set of articles of partnership.
Sometimes an interesting tax or other legal issue arises as to whether a particular organization is, in fact, a partnership. For example, sometimes taxpayers attempt to prove (or disprove) the existence of a partnership in order to split income and expense among several taxpayers in a more favorable manner (see, e.g., Holdner, et al. v. Comr., 483 Fed. Appx. 383 (9th Cir. 2012), aff’g., T.C. Memo. 2010-175) or establish separate ownership of interests for estate tax purposes. However, such a strategy is not always successful.
When is a partnership formed and why does it matter? That’s the topic of today post.
The Problems Of An Oral Arrangement
Because a partnership is an agreement between two or more individuals to carry on as co-owners a business for profit, a partnership generally exists when there is a sharing of net income and losses. See, e.g., In re Estate of Humphreys, No. E2009-00114-COA-R3-CV, 2009 Tenn. App. LEXIS 716 (Tenn. Ct. App. Oct. 28, 2009). The issue can often arise with oral farm leases. A crop-share lease shares gross income, but not net income because the tenant still has some unique deductions that are handled differently than the landlord's. For example, the landlord typically bears all of the expense for building maintenance and repair, but the tenant bears all the expense for machinery and labor. Thus, there is not a sharing of net income and the typical crop-share lease is, therefore, not a partnership. Likewise, a livestock share lease is usually not a partnership because both the landlord and the tenant will have unique expenses. But, if a livestock share lease or a crop-share lease exists for some time and the landlord and tenant start pulling out an increased amount of expenses and deducting them before dividing the remaining income, then the arrangement will move ever closer to partnership status. When the arrangement arrives at the point where there is a sharing of net income, a partnership exists. With a general partnership comes unlimited liability. Because of the fear of unlimited liability, landlords like to have written into crop-share and livestock-share leases a provision specifying that the arrangement is not to be construed as a partnership.
For federal tax purposes, the courts consider numerous factors to determine whether a particular business arrangement is a partnership: (1) the agreement of the parties and their conduct in executing its terms; (2) the contributions, if any, which each party has made to the venture; (3) the parties’ control over income and capital and the right of each to make withdrawals; (4) whether each party was a principal and coproprietor sharing a mutual proprietary interest in the net profits and having an obligation to share losses, or whether one party was the agent or employee of the other, receiving for his services contingent compensation in the form of a percentage of income; (5) whether business was conducted in the joint names of the parties; (6) whether the parties filed federal partnership returns or otherwise represented to the IRS or to persons with whom they dealt that there were joint venturers; (7) whether separate books of account were maintained for the venture; and (8) whether the parties exercised mutual control over and assumed mutual responsibilities for the enterprise. See, e.g., Luna v. Comr., 42 T.C. 1067 (1964). While of the circumstances of a particular arrangement or to be considered, the primary question “is whether the parties intended to, and did in fact, join together for the present conduct of an undertaking or enterprise.” Id. If a business arrangement is properly classified as a partnership for tax purposes, a partner is taxed only on the partner’s distributive share of the partnership’s income.
White v. Comr., T.C. Memo. 2018-102, involved the issue of whether an informal arrangement created a partnership for tax purposes. The petitioners, a married couple, joined forces with another couple to form a real estate business. They did not reduce the terms of their business relationship to writing. In 2011, one of two years under audit, the petitioners contributed over $200,000 to the business. The other couple didn’t contribute anything. The petitioners used their personal checking account for business banking during the initial months of the business. Later, business accounts were opened that inconsistently listed the type of entity the account was for and different officers listed for the business. The couples had different responsibilities in the business and, the business was operated very informally concerning financial activities. The petitioners controlled the business funds and also used business accounts to pay their personal expenses. They also used personal accounts to pay business expenses. No books or records were maintained to track the payments, and the petitioners also used business funds to pay personal expenses of the other couple. The petitioners acknowledged at trial that they did not agree to an equal division of business profits. When the petitioners’ financial situation became dire and they blurred the lines between business and personal accounts even further. Ultimately the business venture failed and the other couple agreed to buy the petitioners’ business interests.
Both couples reported business income on Schedule C for the tax years at issue. They didn’t file a partnership return – Form 1065. The returns were self-prepared and because the petitioners did not maintain books and records to substantiate the correctness of the income reported on the return, the IRS was authorized to reconstruct the petitioners’ income in any manner that clearly reflected income. The IRS did so using the “specific-item method.”
The petitioners claimed that their business with the other couple was a partnership for tax purposes and, as a result, the petitioners were taxable on only their distributive share of the partnership income. The court went through the eight factors for the existence of a partnership for tax purposes, and concluded the following: 1) there was no written agreement and no equal division of profits; 2) the petitioners were the only ones that capitalized the business – the other couple made no capital contributions, but did contribute services; 3) the petitioners had sole financial control of the business; 4) the evidence didn’t establish that the other couples’ role in the business was anything other than that of an independent contractor; 5) business bank accounts were all in the petitioners’ names – the other couple was not listed on any of the accounts; 6) a partnership return was never filed, and the petitioners characterized transfers from the other couple to the business as “loan repayments;” 7) no separate books and records were maintained; 8) the business was not conducted in the couples’ joint names, and there was not “mutual control” or “mutual responsibility” concerning the “partnership” business. Consequently, the court determined that the petitioners had unreported Schedule C gross receipts. They weren’t able to establish that they should be taxed only on their distributive share of partnership income.
The case is a reminder of what it takes to be treated as a partnership for tax purposes. In additions to tax, however, is the general partnership feature of unlimited liability, with liability being joint and several among partners. How you hold yourself out to the public is an important aspect of this. Do you refer to yourself as a “partner”? Do you have a partnership bank account? Does the farm pickup truck say “ABC Farm Partnership” on the side? If you don’t want to be determined to have partnership status, don’t do those things. If you want partnership tax treatment, bring your conduct within the eight factors – or execute a written partnership agreement and stick to it.
Tuesday, July 10, 2018
The Tax Cuts and Jobs Act made significant changes in the tax law. That’s an obvious conclusion. It also changed some of the rules associated with charitable giving, and other rules that have an impact are likely to impact a taxpayer’s decision to donate to charity. Because of these changes, some charities have expressed concerns about a potential decline in charitable giving overall.
Is a drop in overall charitable giving likely? If so, are there planning options that can be utilized to preserve charitable deductions for charitable gifts?
Post-2017 charitable giving. That’s the topic of today’s post.
For tax years beginning before 2018, taxpayers that itemized deductions (Schedule A) could deduct charitable donations of cash or property to qualifying organizations. That remains true for tax years beginning after 2017. However, the TCJA has made a couple of important changes. Pre-TCJA, most cash contributions were generally limited to 50 percent of the taxpayer’s “contribution base.” “Contribution base” is defined as the taxpayer’s adjusted gross income (AGI). For this purpose, AGI is computed without including any net operating loss carryback to the tax year. I.R.C. §170(b)(1)(H).
The 50 percent limit applies to donations of ordinary income property and cash to charitable organizations described in I.R.C. §170(b)(1)(A). Those charities include public charities, private foundations other than nonoperating private foundations, and certain governmental units. Donations of capital gain property to these entities are limited to 30 percent of the taxpayer’s contribution base. Donated capital gain property to these organizations that are for the purpose of allowing the charity to use the property is capped at 20 percent of the donor’s contribution base. Gifts to non-operating foundations are capped at 30 percent of the donor’s contribution base for gifts of ordinary income property and case. The cap is 20 percent for capital gain property gifted to a non-operating foundation.
Under the TCJA, effective for tax years beginning after 2017 and before 2026, the 50 percent limitation is increased to 60 percent. Thus, an individual taxpayer can deduct cash contributions up to 60% of contribution base for donations to I.R.C. §170(b)(1)(A) organizations. I.R.C. §170(b)(1)(G)(i). Any amount that is disallowed due to the limitation can be carried forward for five years. In addition, for taxpayers that have contributions of both cash and capital gain property in the same tax year, the cash contribution will reduce the amount of deduction for the donated capital gain property.
Example: Tammy has a contribution base of $75,000 for 2018. She donates $10,000 of cash to various I.R.C. §170(b)(1)(A) organizations. The 60 percent limitation would limit her cash contributions for 2018 to $45,000. Tammy also donated her 1969 John Deere 4020 tractor to an I.R.C. §170(b)(1)(A) organization in 2018. The tractor was valued at $32,500. Her limitation on donated capital gain property for 2018 is $22,500 (30 percent of $75,000). However, the $22,500 is reduced by her $10,000 cash contribution. Thus, her limit in 2018 for capital gain donations (30 percent property) is $12,500. Tammy will be able to deduct $12.500 of the tractor’s value in 2018 and carry forward the balance of the donated value ($20,000).
The increase from 50 percent to 60 percent on the AGI maximum deduction amount is certainly good news for taxpayers with charitable inclinations. In addition, the TCJA eliminates the “Pease limitation” (I.R.C. §68) through 2025. That rule phased-out itemized deductions at particular income levels. These two TCJA changes could, by themselves, trigger a significant increase in charitable giving – particularly by higher income taxpayers. However, the TCJA made other changes that could have an offsetting effect.
Other TCJA Changes That Could Impact Giving
The TCJA significantly increases the standard deduction – to $12,000 for single filers and $24,000 for married filing jointly taxpayers. Also, many expenses that were deductible for tax years beginning before 2018 are either non-deductible or are limited. For example, the deduction for state and local taxes associated with non-business property is limited to $10,000. The increase in the standard deduction coupled with the elimination/limitation of various deductions will have an impact on giving, particularly by taxpayers that make relatively smaller gifts. That’s because the TCJA has made it more difficult for Schedule A deductions to exceed the standard deduction. More taxpayers are likely to simply claim the standard deduction rather than file Schedule A. Without filing Schedule A to itemize deductions, there is no deduction for charitable gifts.
Normally, a tax deduction cannot be taken for a donation to a qualified charity when there is a quid pro quo. However, for tax years beginning before 2018, a taxpayer could deduct 80 percent of charitable contributions made to an institution of higher learning for the right to buy tickets or seating at an athletic event. However, the TCJA changed this rule. For tax years beginning after 2017, the 80 percent rule is eliminated.
The TCJA also increased the federal unified credit for estate and gift tax purposes such that, beginning in 2018, federal estate tax doesn’t apply until a decedent’s taxable estate value exceeds $11.18 million. That’s practically twice the amount that it was for 2017. It’s likely that this significant increase will dampen charitable bequests. Presently, about 8 percent of charitable giving derives from bequests.
Will these changes be enough to cause taxpayers to curb charitable giving? To the extent a taxpayer donates to charity based on getting a tax break, that could be the case to the extent the TCJA changes reduce the deduction associated with charitable gifts. Many charities are concerned. Historically, taxpayers that itemize deductions are more likely to give to charity than are non-itemizers. Similarly, non-itemizers make up a relatively small percentage of total charitable giving. One estimate is that, for tax years beginning after 2017, less than five percent of taxpayers will itemize by filing Schedule A. The Indiana University School of Philanthropy and Independent Sector has estimated that the TCJA changes will reduce overall charitable giving by 1.7 percent to 4.6 percent. Those percentages convert to an annual reduction in giving between $4.9 billion and $13.1 billion.
Are there options to plan around the TCJA impacts on charitable giving? There might be, at least for some taxpayers. One approach is for a taxpayer to aggregate charitable gifts – make them in one year but not the following year, etc., so that there is a larger amount gifted in any particular year. This technique is designed to get the level of itemized deductions to an amount that is greater than the standard deduction for the years of the gifts.
If “gift stacking” won’t work for a taxpayer, other techniques may include gifting to private foundations, using charitable trusts or a donor advised fund. A donor advised fund allows a donor to make a charitable contribution, get an immediate tax deduction and then recommend grants from the fund to qualified charities. Of course, these various donation vehicles come with their own limitations on deductions and how they can operate. Likewise, there is no “one size fits all” when it comes to putting together a charitable giving plan. Some techniques just simply won’t work unless large gifts are made.
The TCJA made significant changes to the rules surrounding charitable giving. For many taxpayers, planning steps need to be taken to alter existing approaches to account for the new rules. Make sure to get good tax advice for your own situation. Also, when it comes to charitable giving, make sure to keep good records to substantiate your gifts. The IRS looks at the substantiation issue very closely.
Friday, July 6, 2018
Owner-lessors and operator-lessees of oil and gas interests can claim depletion associated with the production of oil and gas. Although conceptually similar to depreciation, the depletion deduction differs in significant ways from depreciation. The depletion deduction is based on the depletion of the mineral resource, whereas depreciation is based on the exhaustion of an asset that is used in the taxpayer’s trade or business.
The depletion deduction associated with oil and gas interests – that’s the topic of today’s post.
Requirements for the Deduction
To claim a depletion deduction, the taxpayer must have an economic interest in the mineral property, and the legal right to the income from the oil and gas extraction. Treas Reg. §1.611-1(b). If these two requirements are met, the deduction is allowed upon the sale of the oil and gas when income is reported. For the owner-lessor, the deduction can offset royalty payments but not bonus lease payments (because the deduction is allowed only when oil or gas is actually sold and income is reportable). For the operator-lessee, the depletable cost is the total amount paid to the lessor (the lease bonus) and other costs that are not currently deducted such as exploration and development costs as well as intangible drilling costs.
Conceptually, the taxpayer is entitled to a deduction against the revenue received as the income tax basis in the mineral property is depleted. For the owner-lessor, a cost basis in the minerals must have been established at the time basis in the taxpayer’s property (surface and mineral estate) was established. This may have occurred as part of an estate tax valuation in which the minerals and surface were separately valued or upon allocation of the purchase price at the time of acquisition. For the operator- lessee, the operator’s historical investment cost is the key.
When a lease of minerals is involved, the depletion deduction must be equitably apportioned between the lessor and the lessee. IRC §611(b). If a life estate is involved (the property is held by one person for life with the remainder to another person), the deduction is allowed to the life tenant but not the remainderman. For property held in a trust, the deduction is apportioned between the income beneficiaries and the trustee in accordance with the terms of the trust. If the trust instrument does not contain such provisions, the deduction is apportioned on the basis of the trust income allocable to each. For a decedent’s estate, the deduction is apportioned between the estate and the heirs on the basis of the estate income allocable to each.
There are two methods available for computing the depletion deduction: the cost depletion method and the percentage depletion method. A comparison should be made of the two methods and the one that provides the greater deduction should be used.
Cost depletion. For the owner-lessor, the cost depletion method is a units-of-production approach that is associated with the owner’s basis in the property. Cost depletion, like depreciation, cannot exceed the taxpayer’s basis in the property. The basis includes the value of the land and any associated capital assets (e.g., timber, equipment, buildings, and oil and gas reserves). See I.R.C. §612. Basis also includes any other expenses that were incurred in acquiring the land (e.g., attorney fees, surveys, etc.). Basis is tied to the manner in which a property is acquired. For example, mineral property can be acquired via purchase (purchase price basis), inheritance (basis equals the property’s FMV at the time of the decedent’s death) or gift (carryover basis from the donor). Basis is allocated among the various capital assets and is determined after accounting for the following items:
- Amounts recovered through depreciation deductions, deferred expenses, and deductions other than depletions;
- The residual value of land and improvements at the end of operations; and
- The cost or value of land acquired for purposes other than mineral production
Under the cost depletion approach, the taxpayer must know the total recoverable mineral units in the property’s natural deposit and the number of mineral units sold during the tax year. The total recoverable units is the sum of the number of mineral units remaining at the end of the year plus the number of mineral units sold during the tax year. The landowner must estimate or determine the recoverable units of mineral product using the current industry method and the most accurate and reliable information available. A safe harbor can be elected to determine the recoverable units. Rev. Proc. 2004-19, 2004-10 IRB 563. The mechanics of the computation are contained in Treas. Reg. §1.611-2.
The number of mineral units sold during the tax year depends on the accounting method that the taxpayer uses (i.e., cash or accrual). Many taxpayers, particularly landowners, are likely to be on the cash method. Thus, for these taxpayers, the units sold during the year are the units for which payment was received. Under the cost depletion approach, an estimated cost per unit of the mineral resource is computed annually by dividing the unrecoverable depletable cost at the end of the year by the estimated remaining recoverable units at the beginning of the year. The cost per unit is then multiplied by the number of units sold during the year.
Let’s look at an example:
Billie Jo’s father died in 2014. His will devised a 640-acre tract of land to Billie Jo. The value of the tract as reported on Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, for estate tax purposes was $6.4 million. Of that amount, $1 million was allocated to the mineral rights in the tract.
In 2018, a well drilled on the property produced 300,000 barrels of oil. Geological and engineering studies determined that the deposit contained 2 million barrels of usable crude oil. In 2018, the 300,000 barrels produced were sold. Billie Jo’s cost depletion deduction for 2018 is $150,000 and is calculated as follows.
Unrecoverable depletable cost at the end of the year × Number of units Estimated remaining recoverable units at the beginning of the year sold during the year
$1,000,000 /$2,000,000 × 300,000 = $150,000
Billie Jo deducts the $150,000 on her 2018 Schedule E. Billie Jo’s adjusted basis in the mineral deposit for 2019 that is eligible for cost depletion is $850,000 ($1 million − $150,000).
Also, consider this example:
Acme Drilling Corporation paid Bubba $300,000 to acquire all of the oil rights associated with Bubba’s land. The $300,000 was Acme’s only depletable cost. Geological and engineering studies estimated that the deposit contains 800,000 barrels of usable crude oil.
In 2018, 200,000 barrels of oil were produced and 180,000 were sold. Acme’s cost depletion deduction for 2015 is $67,500 and is calculated as follows.
Unrecoverable depletable cost at the end of the year x Number of units
Estimated remaining recoverable units at the beginning of the year sold during the year
$300,000 /$800,000 × 180,000 = $67,500
Percentage depletion. As noted previously, the amount allowed as a depletion deduction is the
greater of cost or percentage depletion computed for each property (as defined in I.R.C. §614(a) for the tax year. See IRC §§613 and 613A and Treas. Reg. §1.611-1(a).
Landowners without an established cost basis may be able to claim percentage depletion (discussed later). It is common for a landowner to not allocate any part of the property’s basis to the oil and gas reserves. Thus, percentage depletion may be the only depletion method available.
Under the percentage depletion method, the taxpayer (owner-lessor or a producer that is not a retailer or refiner) uses a percentage of gross income from the property, which is limited to the lesser of the following:
- 15% of the gross income from the oil/gas property (for an operator-lessee, this is defined as gross income from the property less expenses attributable to the property other than depletion and the production deduction, but including an allocation of general )
- 65% of the taxable income from all I.R.C. §613A(d).
For percentage depletion purposes, total taxable income is a function of gross income. Gross income from the property includes, among other things, the amount received from the sale of the oil or gas in the immediate vicinity of the well. Treas. Reg. §1.613-3. Gross income does not include lease bonuses, advance royalties, or other amounts payable without regard to production from the property. I.R.C. §613A(d)(5).
Any amount not deductible due to the 65% limitation can be carried over to the following year, subject to the same limitation. Any amount carried over is added to the depletion allowance before any limits are applied for the carryover year. I.R.C. §613A and the underlying regulations set forth a detailed multi-step process that is utilized to compute percentage depletion allowed to independent producers and royalty owners.
A production limit also applies. For partnerships, all depletion is computed at the partner level and not by the partnership. Prop. Treas. Reg. §1.613A-3(e). The partnership must allocate the adjusted basis of its oil and gas properties to its partners in accordance with each partner’s interest in capital or income.
Consider the following example:
In 2018, Rusty received $50,000 of royalty income from a well on his farm. His taxable income from all sources in 2018 is $432,000. Of that amount, $300,000 is income from crops and livestock. He has $82,000 of income from other sources.
Rusty computes his percentage depletion deduction by multiplying his $50,000 gross income from the oil/gas property by 15%, which is $7,500. His taxable income from all sources is $432,000, and 65% of that amount is $280,800. Thus, Rusty’s depletion deduction is the lesser of $7,500 or $280,800. Rusty can claim the $7,500 deduction on line 18 (depreciation expense or depletion) of his 2018 Schedule E.
Oil and gas taxation is complex. But, the Code does provide some beneficial rules to offset the cost of production. That’s true for other lines of businesses also. The cost of production associated with business property typically generates a tax write-off. When it comes to oil and gas, the rules may be more difficult. If you have these issues, it will pay to hire tax counsel that is well versed in the tax rules associated with oil and gas.
Monday, July 2, 2018
Over two thousand years ago, the Roman philosopher Cicero coined a phrase for opinions not supported by facts. “Ipse dixit” is Latin for “he said it himself.” It’s an assertion without proof, with the person (or entity) making the assertion claiming that a matter is because the party making the assertion said it is.
In a recent case involving wetlands, the court determined that the U.S. Army Corps of Engineers (Corps) claimed jurisdiction over “wetlands” without any supporting evidence. It was a wetland because the Corps said it was a wetland – an “ipse dixit” determination. The court set the Corps’ determination aside.
This isn’t the first time this has happened. In 1998, the USDA/NRCS did the same thing in a Nebraska case involving ditch maintenance of a hay meadow caught up in the Swampbuster regulations.
“Ipse dixit” determinations involving wetlands – that’s today’s blog post topic.
Farmed Wetlands and Swampbuster
The conservation-compliance provisions of the 1985 Farm Bill introduced the concept of “Swampbuster.” In 1986, the interim rules for Swampbuster were published in the Federal Register and evidenced general compliance with congressional intent and made no mention of “farmed wetland.” However, the final rules published in 1987 introduced the concept of “farmed wetland,” defining a farmed wetland as playa, potholes, and other seasonally flooded wetlands that were manipulated before December 23, 1985, but still exhibited wetland characteristics. Drains affecting these areas can be maintained, but the scope and effect of the original drainage system cannot be exceeded. 7 C.F.R. § 12.33(b). The USDA/NRCS has interpreted this as meaning that farmed wetland can be used as it was before December 23, 1985 (National Food Security Act Manual (NFSAM) § 514.23), and a hydrologic manipulation can be maintained to the same “scope and effect” as before December 23, 1985. Id. § 515.10(a). In particular, the government has interpreted the “scope and effect” regulation such that the depth or scope of drainage ditches, culverts or other drainage devices be preserved at their December 23, 1985, level regardless of the effect any post-December 23, 1985, drainage work actually had on the land involved.
Nebraska case. However, in 1999, the Eighth Circuit Court of Appeals invalidated the government’s interpretation of the “scope and effect” regulation. The court held that a proper interpretation should focus on the status quo of the manipulated wetlands rather than the drainage device utilized in post-December 23, 1985, drainage activities. Barthel v. United States Department of Agriculture, 181 F.3d 934 (8th Cir. 1999).
In Barthel, to determine the original scope and effect of the manipulation, the USDA focused solely on the depth of the ditch that drained the hay meadow at issue. In essence, the USDA interpreted the manipulation to be the ditch. The USDA pointed out that the level of the culvert (that drained the ditch beneath a road) on or before December 23, 1985, was eighteen inches higher than at the time of the litigation. The USDA took the position that the culvert could only be placed at that higher level. At that level, the meadow would not drain and the plaintiff’s land was flooded.
The USDA/NRCS claimed it had the authority to “determine the scope and effect of [the] original manipulation” by selecting “any pre-December 23, 1985, manipulation ‘which can be determined by reliable evidence.’” Thus, if the agency had reliable evidence about the ditch level in 1965, then the Barthels would be stuck with those findings, even if in 1983 (still before the effective date of the Act), more far reaching modifications were made. The appellate court disagreed, noting that it was presented with a factual setting that was cyclical. The court noted that the record showed that the ditch was continually silted-in by natural conditions and animal traffic and must be periodically cleaned out. The court then stated that if it accepted “the government’s argument, the USDA could select a level for the original manipulation, either intentionally or unintentionally, which is at the end of the natural cycle - just before the periodic clean-up. This would essentially redefine the cycle. Thus, in the government’s view, if partial flooding occurred just before the clean-up, the flood level would be the best the Barthels could expect for use of their land. An ipse dixit determination like this would drastically reduce the use of the land and even leave it underwater - reviving a wetland [citation omitted]. This interpretation conflicts with the Act considered as a whole.”
Wetland and the Clean Water Act
In 1993, the COE and EPA adopted new regulations clarifying the application of the permit requirement of §404 of the CWA to land designated as wetland. Section 404 of the CWA makes illegal the discharging of dredge or fill material into the “navigable waters of the United States” (WOTUS) without obtaining a permit from the Secretary of the Army acting through the Corps. The regulations specifically exempt prior converted wetlands from the definition of “navigable waters” for CWA purposes. 58 Fed. Reg. 45,008-48,083 (1993); 33 C.F.R. §328.3(a)(8). Thus, prior converted cropland is not subject to the permit requirements of § 404 of the CWA. Indeed, the Corps stated clearly that the only method for prior converted cropland to return to the Corps’ jurisdiction under the regulation was for the cropland to be “abandoned” – cropland production ceases with the land reverting to a wetland.
In early 2009, the Corps prepared an Issue Paper announcing for the first time that prior converted cropland that is shifted to non-agricultural use becomes subject to regulation by the Corps. See Issue Paper Regarding "Normal Circumstances" (ECF No. 18-22). The paper was the Corps’ response to five pending applications for jurisdictional determinations involving the transformation of prior converted cropland to limestone quarries. The paper concluded that the transformation would be considered an "atypical situation" within the meaning of the Corps’ Wetlands Manual and, thus, subject to regulation. The paper further found that active management, such as continuous pumping to keep out wetland conditions, was not a "normal condition" within the meaning of 33 C.F.R. § 328.3(b). However, no APA notice-and-comment period occurred (as required by the Administrative Procedure Act (APA) – Pub. L. 79-404, 69 Stat. 237, enacted Jun. 11, 1946)) before the Corps issued the memorandum. Even so, the Corps implemented and enforced the rules nationwide. The rules were challenged and in New Hope Power Company, et al. v. United States Army Corps of Engineers, 746 F. Supp.2d 1272 (S.D. Fla. Sept. 2010), the court held that the Corps had improperly extended its jurisdiction over the prior converted croplands that were converted to non-agricultural use and where dry lands were maintained using continuous pumping. Under the Corp’s new rule, wetland determinations were being made based on what a property’s characteristic would be if pumping ceased. The court noted that the rules effectively changed the regulatory definition of prior converted cropland without the new definition being subjected to notice and comment requirements. Accordingly, the court invalidated the Corp’s new rule.
Illinois case. In Orchard Hill Building Co. v. United States Army Corps of Engineers, No. 15-cv-06344, 2017 U.S. Dist. LEXIS 151673 (N.D. Ill. Sept. 19, 2017), the plaintiff was a developer that obtained title to a 100-acre tract on the southeast side of Chicago metro area in 1995. The local town then passed a zoning ordinance allowing development of the property. The tract was divided into three sections - 25 acres were to be developed into 168 townhomes; 61 acres to be developed into 169 single-family homes; and 14 acres in between the other acreages to function as a stormwater detention area. The townhomes and water detention area was to be developed first and then the single-family housing. Construction of the townhomes began in 1996, and the single-family housing development was about to begin when the defendant designated about 13 acres of the undeveloped property as “wetlands” and asserted regulatory jurisdiction under the CWA.
The defendant claimed jurisdiction on the basis that the “wetland” drained via a storm sewer pipe to a creek that was a tributary to a river that was a navigable water of the U.S. The plaintiff administratively appealed the defendant’s jurisdictional determination to the Division Engineer who agreed that the District Engineer failed to properly interpret and apply applicable the U.S. Supreme Court decision in Rapanos v. United States, 547 U.S. 715 (2006), which created a significant nexus test. On reconsideration, the District Engineer issued a second approved jurisdictional determination in 2010 concluding that the tract had a significant nexus to the navigable river. The plaintiff appealed, but the Division Engineer dismissed the appeal as being without merit. In 2011, the plaintiff sought reconsideration of the defendant’s appeal decision because of a 1993 prior converted cropland designation that excluded a part of the 100-acres from CWA jurisdiction. Upon reconsideration, the District Engineer issued a third jurisdictional determination in 2012 affirming its prior determination noting that farming activities had ceased by the fall of 1996 and wetland conditions had returned. The plaintiff appealed on the basis that the “significant nexus” determination was not supported by evidence. The Division Engineer agreed and remanded the matter to the District Engineer for supportive documentation and to follow the defendant’s 2008 administrative guidance. The District Engineer issued a new jurisdictional determination with supportive evidence, including an 11-page document that had previously not been in the administrative record. This determination, issued in 2013, constituted a final agency determination, from which the plaintiff sought judicial review.
In court, the plaintiff claimed that the defendant didn’t follow its own regulations, disregarded the instructions of the Division Engineer, and violated the Administrative Procedures Act (APA) by supplementing the record with the 11-page document. However, the trial court judge (an Obama appointee) noted that existing regulations allowed the Division Engineer, on remand, to instruct the District Engineer to supplement the administrative record on remand and that the limitation on supplementing the administrative record only applied to the Division Engineer. The trial court also determined that the supplemental information did not violate the Division Engineer’s remand order, and that the supplemental information had been properly included in the administrative record and was part of the basis for the 2013 reviewable final agency determination. The trial court also upheld the defendant’s nexus determination because it sufficiently documented a physical, chemical and biological impact of the navigable river. In addition, the trial court determined that the prior converted cropland exemption did not apply because farming activities had been abandoned for at least five years and wetland characteristics returned.
On appeal, in Orchard Hill Building Co. v. United States Army Corps of Engineers, No. 17-3403, 2018 U.S. App. LEXIS 17608 (7th Cir. Jun. 27, 2018), the appellate court three-judge panel in a unanimous opinion (the author of the opinion is a Trump appointee and another judge is also a Trump appointee; the third panel member is a Ford appointee) first noted that the Corps concluded that the tract was a WOTUS based on the 11-page document both “alone and in combination with other wetlands in the area.” However, the appellate court held that this conclusion lacked substantial evidence. Simply stating that wetlands filter out pollutants and that the tract has a “discrete and confined intermittent flow” to a creek that flowed to a WOTUS which gave the tract the ability to pass pollutants along was mere speculation that didn’t support a significant nexus with a navigable water. The appellate court also that the Corps also determined that the development of the tract would result in a floodwater rise of a fraction of one percent. On this point, the court stated, “If the Corps thinks that trivial number significant, it needs to give some explanation as to why.” The appellate court found similarly with respect to the potential increase on downstream nitrogen. The Corps provided no reasoning for its conclusion.
The appellate court also noted that the Corps referenced the National Wetland Inventory for a listing of all of the wetlands in the area that were in proximity to the creek that flowed into a navigable waterway. But, again, the appellate court scolded the Corps for making a bald assertion that the wetlands in the watershed were adjacent to the same tributary without any supporting evidence. The Corps claimed it didn’t have to show or explain how each wetland was adjacent to the creek, but the appellate court stated that constituted jurisdictional overreach. Importantly, the court stated that, “the significant nexus test has limits: the Corps can consider the effects of in-question wetlands only with the effects of lands that are similarly situated. To do as the Corps did on this record – to consider the estimated effects of a wide swath of land that dwarfs the in-question wetlands, without first showing or explaining how the land is in fact similarly situated – is to disregard the test’s limits…. By contrast, the Corps’ similarly-situated finding here, lacking as it does record support or explanation, is little more than administrative ipse dixit.”
Consequently, the appellate court vacated the trial court’s grant of summary judgment to the Corps and remanded with instructions to remand to the Corps for reconsideration of its jurisdiction over the tract.
Two ipse dixit determinations by federal agencies against landowners. In each situation, the appellate court found that the government had abused its discretion. The cases point out that maybe there is some hope that the courts will hold government agencies to the requirement that they must support their determinations with solid proof. They can’t just say that it is so because they say it is.
Thursday, June 28, 2018
The needs and capabilities of a farming or ranching business (or any business for that matter) need to be integrated with business and estate plans, and the retirement needs, of each of the owners. A buy-sell agreement is a frequently used mechanism for dealing with these issues. For many small businesses, a well-drafted buy-sell agreement is perhaps just as important as a will or trust. It can be the key to passing on the business to the next generation successfully. For most farming and ranching operations, succession planning is now more important than estate tax planning. That makes a good buy-sell agreement an important document.
Buy-sell agreements – the basics of what they are and how they work, that’s the topic of today’s post.
A buy-sell agreement is typically a separate document, although some (or all) of its provisions may be incorporated in its bylaws, the partnership agreement, the LLC operating agreement and, on occasion, in an employment agreement with owner-employees. Major reasons for having a buy-sell agreement include: establishing continuity of business ownership; providing a market for otherwise illiquid closely held shares; establishing a funding source and a mechanism for share purchase; establishing certainty as to the value of the shares for estate purposes; and providing restrictions on operational matters, e.g. voting control and protection of S corporation status.
Establishment of Estate Tax Value
While very few farming and ranching operations (and small businesses in general) are subject to the federal estate tax because of the current level of the exemption, some are. For those that are, in addition to providing a market for closely held shares at a determinable price, the buy-sell agreement can serve as a mechanism for establishing the value of the interest for estate tax purposes – or otherwise establish value of the decedent’s interest at death.
There are six basic requirements for a buy-sell agreement to establish value of a deceased owner’s interest: (1) the interest must be subject to an option to purchase that is a binding obligation on the estate; (2) the purchase price must be established with certainty; (3) the interest must not be subject to lifetime transfers that could defeat the obligation to purchase; (4) there must be a “ bona fide business arrangement”; (5) the agreement cannot be a device to transfer at lower than fair market value; and (5) the agreement must be comparable to similar arrangements between persons in an arms-length transaction.
The estate must be obligated to sell; however, there is no requirement for the purchaser to buy. However, there is often an additional provision in such agreements to provide that if adequate funding is available, the survivors are obligated to purchase in order to provide estate liquidity, and often to protect the deceased shareholder’s family from the vagaries of the ongoing business.
To establish the purchase price with certainty an appropriate valuation method must be established. An independent party valuation will not only satisfy the requirements of § 2703 but also provide an estimate of the potential funding obligation and the liquidity expectations of the seller/estate. See Rev Rul. 59-60 as amplified by Rev. Rul. 83-120,1983-2 CB 170.
A key point is that, to be effective in establishing a value for estate tax purposes, the buy-sell agreement must provide that the corporation or shareholders are either obligated or have an option to purchase the shares of a holder who desires to sell within his lifetime, at the same price and on the same terms as provided for upon the death of the shareholder. A right of first refusal will not accomplish the same objective and will potentially contravene the requirements of I.R.C. §2031. From the selling shareholder’s viewpoint, either an option or right of first refusal may not be acceptable because of their failure to guarantee a market for the shares.
The long-established position of the IRS is that, “It is always necessary to consider the relationship of the parties, the relative number of shares held by the decedent, and other material facts to determine whether the agreement represents a bona fide business arrangement or a device to pass the decedent’s shares to the natural objects of his bounty for less than an adequate and full consideration in money or money’s worth”. Rev.Rul 59-60, 1959-1 CB 137. See also Estate of True v. Comr., T.C. Memo 2001-167(2001), aff’d 390 F. 3d 1210 (2004), and Estate of Blount v. Comr., T.C. Memo 2004-116(2004).
Valuation methods. There are several general valuation methods for buy-sell agreements.
One method is the fixed value method. Under this method, the value of the interest being valued doesn’t change. It is not used much, and would not meet most IRS requirements under IRC §2703(b) and the regulations.
Another approach is one that uses an appraisal to value the underlying business interest. This method is also rarely used for operating businesses, but may be appropriate for certain types of business such as real estate. If this method is used it is often a triple appraisal approach, where the purchaser and estate each appoint an appraiser who appoints a third if the first two cannot agree. A drawback is that the valuation is left until the triggering event (death, disability, etc.), leaving the owners with little guidance for the necessary funding decisions.
The formula method uses book value from the financial statements of the business to value the interest. That is relatively easy to determine, but it will result in a significant deviation from fair market value unless adjusted for such matters as the company’s accounting method, differences between book and fair market value for real estate, equipment, other tangible assets and intangible assets. Other adjustments may include accounts receivable to reflect collectability, and an examination of the adequacy of reserve accounts.
Another formula method is one based on earnings which are then capitalized to arrive at a proper value. The selection of an appropriate capitalization rate is an important determination, and it must be recognized that a rate appropriate at the time of the agreement may not be appropriate later due to a change in business or the economic environment.
Agreed value is another frequently used method of valuation, usually combined with periodic adjustments by the parties. This is often coupled with a back-up valuation method to take effect within a certain period of time if a value has not been adopted.
Another commonly used provision is one that requires any outside purchaser of the business to adopt the buy-sell agreement. In the case of a limited liability company, the requirement may be to adopt the operating agreement before becoming a member. Either of these provisions serves to protect the remaining owners.
Who Will Be the Buyer?
When setting up a buy-sell agreement for your farm/ranch (or other) business, an important decision at the beginning is to determine who will be the purchaser. Not only is establishing a purchase price important, but determining how the purchase price will be paid is also important. This is a function of the type of buy-sell agreement that is utilized. With a “redemption’ type agreement, the corporation is the buyer. With a “cross-purchase” agreement, the other shareholders are the buyers. A buy-sell agreement can also be a combination of a redemption and cross-purchase agreement.
Since life insurance on the lives of the shareholders is often used to partially or fully fund a buy-sell agreement, the availability and affordability of insurance, the number of policies needed, and the source of funds to pay the premiums will often dictate the type of agreement selected. The amount will depend upon the valuation of the company, the limits on corporate or shareholder finances to pay the premiums, and the extent to which both the shareholders and the seller are willing to assume an unfunded liability if the buy-sell is not fully funded by insurance. Multiple policies may be required for a cross-purchase agreement unless a partnership can be utilized to hold the insurance (e.g. if three shareholders, there would be six separate policies; if four shareholders, twelve policies) so that beyond a few shareholders may make this approach impractical. However, a single policy on each shareholder would suffice when funding a corporate redemption. Another possible solution is a buy-out insurance trust which owns the policies.
If the farming business owns the policy, the business can borrow against any cash value if needed. If no trust or partnership is used, a cross-purchase agreement leaves the payment of premiums in the control of the individual shareholder, and potentially subjects any cash value to creditor claims. This factor alone may determine which form of agreement is most desirable.
If there is a disparity in ownership shares (and there often is), a minority shareholder may be required to fund the much higher interest of the majority shareholder(s) in a cross-purchase agreement. In a corporate redemption, however, the funding of the purchase, either from insurance or other corporate assets, is being born by the shareholders in proportion to their relative stock interests.
While life insurance will often solve the funding problem for purchasing a deceased shareholders stock, and disability insurance is available for permanent disability, insurance proceeds are generally not available in lifetime purchase situations. Thus, the funding capability of the parties is critical since there may not be an alternative funding method available that will satisfy all parties. However, in many situations non-insurance methods of funding coupled with installment payments of the purchase price will meet most of the major needs of the parties.
Today’s post was only a surface-level discussion on buy sell agreements. A good buy-sell agreement is an essential part of transitioning a business to the next generation of owners. But, it is complex and a great deal of thought must be given to the proper crafting of the agreement. Of course, there are associated tax considerations which were not covered in this post. In addition, there are numerous financial and personal factors that also come into play. Likewise, significant thought must be given to the events that can trigger the operation of the agreement.
Like other estate planning documents, a buy-sell agreement should be reviewed regularly even in the absence of any potentially triggering event, and particularly when there is any change in the business structure or ownership.
Tuesday, June 26, 2018
Last week, the U.S. Supreme Court, in South Dakota v. Wayfair, Inc., No. 17-494, 2018 U.S. LEXIS 3835 (U.S. Sup. Ct. Jun. 21, 2018), handed South Dakota a narrow 5-4 win in its quest to collect taxes from online sales. The Court held that the Constitution’s Commerce Clause did not bar South Dakota from statutorily requiring remote sellers without a physical presence in the state to collect and remit sales tax on goods and services that are sold to buyers for delivery inside the state of South Dakota. In so doing, the Court overruled 50 years of Court precedent on the issue.
Other states will certainly take note of the Court’s decision, and some (such as Iowa) were banking on the Court ruling in the manner that it did and passed legislation similar to the South Dakota legislation that will take effect in the future. But, as I wrote last fall, a victory for South Dakota could do damage to the Commerce Clause and the concept of due process and contemporary commerce.
An update on state taxation of internet sales, the possible implications of the Court’s recent decision and what the impact could be on small businesses – that’s the focus of today’s post.
In 1967, the U.S. Supreme Court determined that the Commerce Clause grants “exclusive authority [to] Congress to regulate trade between the States” in holding that Illinois could not subject a mail order seller located in Missouri to use tax where the seller had no physical presence in Illinois. National Bellas Hess, Inc. v. Illinois Department of Revenue, 386 U.S. 753 (1967). In holding the law unconstitutional, the Court reasoned that subjecting the seller’s interstate business to local “variations in rates of tax…and record-keeping requirements” would violate the purpose of the Commerce Clause “to ensure a national economy free from…unjustifiable local entanglements.”
Twenty-five years later, the Court reaffirmed the limitations of the Commerce Clause on state regulatory authority in Quill Corporation v. North Dakota, 504, U.S. 298 (1992). In Quill, the Court held that a mail order house with no physical presence in North Dakota was not subject to North Dakota use tax for “property purchased for storage, use, or consumption within the State.” The Court followed closely its holding in National Bellas Hess, Inc. because doing so “encourage[d] settled expectations and …foster[ed] investment by businesses and individuals.” As applied to internet sales, Quill (which predated the internet) does not exempt all internet sales from state sales taxes – just sales by sellers who don’t have a physical presence in a particular state. National retailers have a presence in many states.
More recently, in 2015, the Court examined a Colorado “tattletale” law that required out-of-state sellers with no physical presence in the state “to notify…customers of their use tax liability and to report” sales information back to Colorado. Direct Marketing Association v. Brohl, 135 S. Ct. 1124 (2013). The trial court enjoined enforcement of the law on Commerce Clause grounds. On appeal, the Tenth Circuit held that it couldn’t hear the challenge to the law because the Tax Injunction Act (28 U.S.C. §1341) divested it of jurisdiction and the matter belonged in state court and, ultimately, the U.S. Supreme Court. The Tenth Circuit remanded the case for dismissal of the Commerce Clause claims and dissolution of the permanent injunction. The U.S. Supreme Court reversed and remanded the decision of the Tenth Circuit on the jurisdiction issue and, on remand, the Tenth Circuit, invalidated the Colorado law on Commerce Clause grounds. Direct Marketing Association v. Brohl, 814 F.3d 1129 (10th Cir. 2016).
In the U.S. Supreme Court’s reversal and remand of the Tenth Circuit’s decision in Direct Marketing Association, Justice Kennedy wrote a concurring opinion that essentially invited the legal system to find an appropriate case that would allow the Court to reexamine the Quill and National Bellas Hess holdings. Hence, the South Dakota legislation.
South Dakota Legislation and Litigation
S.B. 106 was introduced in the 2016 legislative session of the South Dakota legislature. It requires the collection of sales taxes from certain remote sellers – those with “gross revenue” from sales in South Dakota of over $100,000 per calendar year or with 200 or more “separate transactions” in the state within the same timeframe. Interestingly, S.B. 106 authorized the state to bring a declaratory judgment action in circuit court against any person believed to be subject to the law. The law also authorized a motion to dismiss or a motion for summary judgment in the court action, and provided that the filing of such an action “operates as an injunction during the pendency of the” suit that would bar South Dakota from enforcing the law.
S.B. 106 was signed into law on March 22, 2016, and the state Department of Revenue soon thereafter began issuing notices to sellers that it thought were in violation of the law. Several out-of-state sellers that received notices did not register for sale tax licenses as the law required. Consequently, the state brought a declaratory judgment action against the sellers in circuit court, and sought a judicial declaration that the S.B. 106 requirements were valid and applied to the sellers. The state also sought an order enjoining enforcement of S.B. 106 while the action was pending in court, and an injunction that required the sellers to register for licenses to collect and remit sales tax.
The sellers tried to remove the case to federal court based on federal question jurisdiction, but the federal court rejected that approach and remanded the case to the South Dakota Supreme Court. South Dakota v. Wayfair, Inc., 229 F. Supp. 3d 1026 (D. S.D. Jan. 17, 2017). On remand, the South Dakota Supreme Court invalidated S.B. 106 on Commerce Clause based on the U.S. Supreme Court precedent referenced above. State v. Wayfair, Inc., et al., 901 N.W.2d 754 (S.D. 2017). The state of South Dakota announced shortly after the South Dakota Supreme Court’s decision that it would file a petition for certiorari with the U.S. Supreme Court by mid-October. They did, the U.S. Supreme Court granted the petition and heard the case which lead to last week’s opinion.
U.S. Supreme Court Decision
Article I, Section 8 of the U.S. Constitution says that, “The Congress shall have the power...to regulate commerce…among the several states…”. That was the key point of the Court’s 1967 Bellas Hess, Inc. decision. As noted above, in that case the Court stated that the Commerce Clause grants “exclusive authority [to] Congress to regulate trade between the States.” Apparently, that is not the case anymore, at least according to the majority in Wayfair – Justices Kennedy, Thomas, Ginsburg, Alito and Gorsuch. Under the new interpretation of the Commerce Clause, states can impose sale tax obligations on businesses that have no physical presence in the state. But is that completely true? Can the Court’s opinion be construed as giving the states a “blank check” to tax out-of-state businesses? Maybe not.
In Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977), the Court ruled that a state tax would be upheld if it applied to an activity having a substantial nexus with the state; was fairly apportioned; did not discriminate against interstate commerce; and, was fairly related to the services that the state provided. Later, in the Quill case, the Court determined that a physical presence in the taxing jurisdiction was what satisfied the Brady “substantial nexus” requirement.
In Wayfair, the Court determined that a “substantial nexus” could be present without the party subjected to tax having a physical presence in the taxing jurisdiction. But, the key point is that the “substantial nexus” test of Brady remains. Likewise, the other three requirements of Brady remain – fair apportionment; no discrimination against interstate commerce, and; fairly related to services that the state provides. In other words, taxing a business without a physical presence in the state cannot unduly burden interstate commerce. The Wayfair majority determined that the South Dakota law satisfied these tests because of the way it was structured – limited application (based on transactions or dollars of sales); not retroactive; the state was a member of the Streamlined Sales and Use Tax Agreement; the sellers at issue were national businesses with a large online presence; and South Dakota provided tax software to ease the administrative burden.
The dissent in Wayfair, authored by Chief Justice Roberts, noted that there was no need for the Court to overturn Quill. The Chief Justice noted that, “E-commerce has grown into a significant and vibrant part of our national economy against the backdrop of established rules, including the physical-presence rule. Any alteration to those rules with the potential to disrupt the development of such a critical segment of the economy should be undertaken by Congress.” That’s precisely the point of the Commerce Clause, and Chief Justice Roberts pointed it out – the Court had no business wading into this issue. In fact, several members of the Congress filed briefs with the Court in the case to inform the Court that various pieces of legislation were pending that would address the issue.
The question then is what, if any, type of a state taxing regime imposed on out-of-state sellers would be determined to violate the Commerce Clause post-Wayfair. Of course, the answer to that question won’t be known until a state attempts more aggressive taxation on out-of-state sellers than did South Dakota, but a few observations can be made. Presently, 23 states are “full members” of the Streamlined Sales and Use Tax Agreement. For those states, the Wayfair majority seemed to believe that had the effect of minimizing the impact on interstate commerce. Also, it would appear that any state legislation would have to have exceptions for small businesses with low volume transactions and sales revenue. Whether a series LLC (in some states such as Iowa) or subsidiaries of a business could be created, each with sales below the applicable threshold, remains to be seen.
Now, it appears that state legislatures crafting tax statutes need not give much, if any, thought to the reason for the tax or who the parties subject to the tax might be. The only consideration appears to be the relative burden of the tax. With Wayfair, states have gained more power – the power to tax people and businesses for whom the state provides no services and who cannot vote the people out of office that created the tax. That would not appear to square with traditional concepts of due process.
The whole notion of a state taxing a business that has no physical presence in the state is incompatible with the principles of federalism that bar states from taxing (whether income, property or sales tax, for instance) non-resident individuals or businesses (with a few, minor exceptions). As noted earlier, a state that imposes such a taxing regime would be able to generate revenue from taxpayers who use none of the services provided by the taxing jurisdiction.
Post Wayfair, where will the line be drawn? Wayfair involved state sales tax. Will states attempt to go after a portion of business income of the out-of-state business via income tax? That seems plausible. However, the Interstate Income Act of 1959 (15 U.S.C. §381-384), requires that a business (or individual – the business form does not matter because corporations have long held personhood status under the Constitution (see, Bank of the United States v. Deveaux, 9 U.S. 61 (1809); Burwell v. Hobby Lobby Stores, Inc., 134 S. Ct. 2751 (2014)) have some sort of connection with a state before its income can be taxed (at least with respect to the solicitation of orders for tangible personal property). Is that legislation now unconstitutional too? Or, is there a distinction remaining between taxing receipts as opposed to income?
Only time will tell.
Friday, June 22, 2018
When land is sold, is the gain on sale taxed as capital gain (preferential rate) or as ordinary income? As with most answers to tax questions, the answer is that “it depends.” Most of the time, when a farmer or ranchers sells land, the gain will be a capital gain. But, there can be situations where the gain will be ordinary in nature – particularly when farmland is subdivided or sold off in smaller tracts. That’s a technique, by the way of some farm real estate sellers, especially in the eastern third of the United States. Does selling the land in smaller tracts, or subdividing it create ordinary gain rather than capital gain?
A recent case illustrated the issue of what a capital asset is and the safe harbor that can apply when land is sold that has been subdivided or sold off in smaller tracts.
The character of gain on sale of land and a possible “safe harbor” – that’s the topic of today’s post.
What Is A Capital Asset?
I.R.C.§1221(a) broadly defines the term “capital asset” as all property held by the taxpayer. Eight exceptions from that broad definition are provided. The first exception, I.R.C. §1221(a)(1), states that property that is either inventory or like inventory cannot qualify as a “capital asset.” In particular, I.R.C. §1221(a)(1) says a capital asset does not include “property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.” Whether a landowner is holding land primarily for sale to customers depends on the facts. As the U.S. Circuit Court of Appeals for the Tenth Circuit put in in the classic case of Mauldin v. Commissioner, 195 F.2d 714 (10th Cir. 1952), “There is no fixed formula or rule of thumb for determining whether property sold by the taxpayer was held by him primarily for sale to customers in the ordinary course of his trade or business. Each case must, in the last analysis, rest upon its own facts.” The Fifth Circuit has said essentially the same thing in Suburban Realty Co., v. United States, 615 F.2d 171 (5th Cir. 1980).
Subdividing Real Estate
When property is subdivided and then sold, the IRS may assert that the property was being held for sale to customers in the ordinary course of the taxpayer’s trade or business. If that argument holds, the gain will generate ordinary income rather than capital gain. However, there is a Code provision that can come into play. I.R.C. §1237 provides (at least) a partial safe harbor that allows a taxpayer “who is not otherwise a dealer”… to dispose of a tract of real property, held for investment purposes, by subdividing it without necessarily being treated as a real estate dealer.” If the provision applies, the taxpayer is not treated as a “dealer” just simply because the property was subdivided in an attempt to sell all or a part of it. But, the safe harbor only applies if there is a question of whether capital gain treatment applies. If capital gain treatment undoubtedly applies, I.R.C. §1237 does not apply. See, e.g., Gordy v. Comr., 36 T.C. 855 (1961).
What is a “dealer”? It’s not just subdividing land that can cause a taxpayer to be a “dealer” in real estate with gains on sale taxes as ordinary income. That’s the result if the taxpayer is engaged in the business of selling real estate; holds property for the purpose of selling it and has sold other parcels of land from the property over a period of years; or the gain is realized from a sale in the ordinary operation of the taxpayer’s business. In addition, it’s possible that a real estate dealer may be classified as an investor with respect to some properties sold and capital gains treatment on investment properties. But, as to other tracts, the dealer could be determined to be in the business of selling real estate with the sale proceeds taxed as ordinary income. See, e.g., Murray v. Comr., 370 F.2d 568 (4th Cir. 1967).
The “Safe Harbor”
I.R.C. §1237 specifies that gain from the sale or exchange of up to five lots sold from a tract of land can be eligible for capital gain treatment. Sale or exchange of additional lots will result in some ordinary income. To qualify for the safe harbor, both the taxpayer and the property must meet the requirements of I.R.C. §1237 and make an election to have the safe harbor apply. For the taxpayer to qualify for the election, the taxpayer cannot be a C corporation. Presumably, an LLC taxed as a partnership would qualify. For property to qualify, it must have not previously been held by the taxpayer primarily for sale to customers in the ordinary course of business; in the year of sale, the taxpayer must not hold other real estate for sale as ordinary income property; no substantial improvement that considerably enhances the property value has been made to the property (see I.R.C. §1237(b(3); Treas. Reg. §1.1237-1(c)); and the taxpayer must have held the property for at least five years. I.R.C. §1237(a).
If the requirements are satisfied, the taxpayer can elect to have the safe harbor apply by submitting a plat of the subdivision, listing all of the improvements and providing an election statement with the return for the year in which the lots covered by the election were sold.
In Sugar Land Ranch Development, LLC v. Comr., T.C. Memo. 2018-21, the taxpayers formed a partnership in 1998 to buy and develop land outside of Houston for the purpose of turning that land into housing developments and commercial developments. The partnership acquired various parcels of land totaling about 950 acres. The land had been a former oil field and so over the years the partnership cleaned up the land, built a levee, and entered into a development contract with the city of Sugar Land, Texas to set up the rules for developing the lots. All of this sounds like the characteristics of a “developer” doesn’t it?
By 2008, the partnership had done a lot of work developing the land. But, then the downturn in the real estate market hit and the partnership stopped doing any more work. It wasn’t until 2012 that the partnership sold any significant part of the land. In that year it sold two parcels (about 530 acres) to a homebuilding company. The homebuilding company paid a lump sum for each parcel, and also agreed to make future payments relating to the expected development. A flat fee was paid for each plat recorded, and the homebuilding company paid two percent of the final sales price of each house developed on one of the parcels.
The partners entered into a “Unanimous Consent” dated December 16, 2008, declaring that the partnership would no longer attempt to develop the land but would instead hold the land until the real estate market recovered enough to sell at a profit.
The partnership reported an $11 million gain from the sale of one parcel and a $1.6 million loss on the other parcel. It took the position that the land sold was a “capital asset” and so the gains and losses were capital gains and losses. The IRS disagreed. After all, it pointed out that the partnership acquired the property to develop it and merely delayed doing so because of the economic downturn.
Ultimately, the Tax Court agreed that the partnership had successfully changed its operations after 2008 from “developer” to “investor” such that the land it sold in 2012 was a capital asset and the gain was a capital gain. That made a big bottom-line tax difference.
The partnership in Sugar Land Ranch Development, LLC never actually subdivided the property at issue into separate lots, and the IRS still claimed it was acquired and held for development purposes. While capital gain classification is based on a facts and circumstances test, subdividing land for sale doesn’t necessarily mean that it’s no longer a capital asset. That’s the point of I.R.C. §1237 and the safe harbor. In addition, the facts can cause the reason for holding property to change over time. That, in turn, can change the tax result.