Tuesday, July 25, 2017
For many people, the federal estate tax is not a concern. But, for a farming operation, other small business operation, and high-wealth individuals, it is. If a goal is transferring business interests and/or investment wealth to a successive generation, one aspect of the estate plan might involve the use of an Intentionally Defective Grantor Trust (IDGT). The IDGT allows the grantor to “freeze” the value of the transferred assets while simultaneously providing the grantor with a cash flow stream for a specified time period.
Today’s post looks at the use of the IDGT for transferring asset values from one generation to the next in a tax-efficient manner
What Is An IDGT?
An IDGT is a specially designed 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 to be a grantor trust under I.R.C. §671. That means that the grantor (or a third party) retains certain powers causing the trust to be treated as a grantor trust for income tax purposes. However, those retained powers do not cause the trust assets to be included in the grantor’s estate. Thus, a sale (or other transaction) between the trust and the grantor are not income tax events, and the trust’s income, losses, deductions and credits are reported by the grantor on the grantor’s individual income tax return.
This is what makes the trust “defective.” 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 for federal estate and gift tax purposes. The result is 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 are paid to the grantor in-kind, and the trust is an eligible S corporation shareholder. See, e.g., Rev. Rul. 85-13, 1985-1 C.B. 184; I.R.C. §1361(c)(2)(A).
How Does An IDGT Transaction Work?
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 should make 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. The IDGT transaction is structured so that a completed gift occurs for gift tax purposes, with no resulting income tax consequences. Because the transfer is a completed gift, the trust receives a carryover basis in the gifted assets.
The trust language should be 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. It’s 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. This is why an IDGT is generally viewed as an “estate freeze” technique.
What about the note? 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, 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 that took the position that I.R.C. §2701 would not apply because a debt instrument is not an applicable retained interest. Priv. Ltr. Rul. 9535026 (May 31, 1995). 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. For a good article on this point see Hatcher and Manigualt, “Using Beneficiary Guarantees in Defective Grantor Trusts,” 92 Journal of Taxation 152 (Mar. 2000).
Pros and Cons of IDGTs
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 low 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
A key point is that the installment note must constitute bona fide debt. That is the crucial aspect of 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. In Karmazin v. Comr., T.C. Docket No. 2127-03 (2003), the IRS took the position that I.R.C. §§2701 and 2702 applied to the sale of limited partnership interests to a trust which would cause them to have no value for federal gift tax purposes on the theory that the notes the grantor received were equity instead of debt. The case was settled before trial on terms favorable to the taxpayer with the parties agreeing that neither I.R.C. §2701 or I.R.C. §2702 applied. However, IRS resurrected the same arguments in Estate of Woelbing v. Comr., T.C. Docket No. 30261-13 (filed Dec. 26, 2013). The parties settled the case before trial with a stipulated decision entered on Mar. 25, 2016 that resulted in no additional gift or estate tax. The total amount of the gift tax, estate tax, and penalties at issue was $152 million.
Another concern is that 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. But, again, 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.
So, as you can imagine, 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. That means that a separate bank account must be opened for the IDGT so that it can receive the “seed” gift and annual cash inflows and outflows. The grantor’s Social Security number is used for the bank account. An amortization schedule will need to be maintained between the IDGT and the grantor, as well as annual books and records of the trust.
Structured properly an IDGT can be a useful tool in the estate planner’s arsenal for moving wealth from one generation to the next with minimal tax cost. That’s especially true for highly appreciating assets and family business assets. But, again, it is critical to get good legal and tax counsel before trying the IDGT strategy.
Friday, July 21, 2017
The issues associated with spray-drift of dicamba have generated numerous questions to me. I devoted a blog post to the issue last week. Since then I have received more calls and emails from farmers experiencing drift issues. One farmer raised an interesting question – does the drift of dicamba constitute a hazardous waste that is regulated under federal law? That’s an interesting question and the focus of today’s blog post.
Comprehensive Environmental Response Compensation & Liability Act (CERCLA)
Hazardous waste is regulated by the federal CERCLA. CERCLA became law in late 1980, set as a goal the initiation and establishment of a comprehensive response and financing mechanism to abate and control problems associated with abandoned and inactive hazardous waste disposal sites. In general, CERCLA was enacted as a response to several then high-profile hazardous waste trouble spots such as Love Canal in New York and the Valley of the Drums in Kentucky. While CERCLA focuses on hazardous waste sites, it can have significant ramifications for agricultural operations because the term “hazardous waste” has been defined to include most pesticides, fertilizers, and other chemicals commonly used on farms and ranches. See, e.g., 40 C.F.R. § 261. As such, CERCLA liability is a concern any time that agricultural land is purchased or leased.
CERCLA Components. There are four basic components to CERCLA. First, the statute sets up an information gathering and analysis system to allow state and federal governments to determine more accurately the danger level at various disposal sites and to develop cleanup priorities accordingly. 42 U.S.C. § 9604. The EPA is authorized to designate as hazardous any substance which, when released into the environment, may present a “substantial danger” to public health and welfare, or to the environment. The act requires notification of any release into the environment of these substances. The act requires owners and operators of hazardous waste storage, treatment, and disposal sites to provide EPA with notification of the volumes and composition of hazardous wastes that can be found at their facility, and of any known or possible releases. The EPA uses this information to develop a national priorities list (NPL) in order to prioritize hazardous waste sites from those most dangerous and in need of immediate cleanup to those least dangerous and not as urgently in need of cleanup.
With respect to releases of hazardous substances, CERCLA provides that any person in charge of a “facility” from which a hazardous substance has been released in a reportable quantity must immediately notify the National Response Center. 42 U.S.C. § 9603(a) (2008). Releases that exceed 100 pounds per day must be reported. A key question of major importance to agriculture is whether large-scale livestock/poultry confinement operations operated by individual growers pursuant to contractual arrangements with vertically integrated firms constitute a single “facility,” or whether each confinement structure on a farm is a separate facility. In Sierra Club, Inc. v. Tyson Foods, Inc., 299 F. Supp. 2d 693 (W.D. Ky. 2003), the court held that Tyson was an operator of the chicken farms at issue pursuant to the production contracts with growers and that an entire chicken farm site is a facility from which releases must be reported under CERCLA. In a later case, Sierra Club v. Seaboard Farms, Inc., 387 F.3d 1167 (10th Cir. 2004), the United States Court of Appeals for the Tenth Circuit ruled similarly that the term “facility,” as defined in CERCLA, meant any site or area where hazardous substances come to be located. As a result, a large-scale confinement hog operation was held to be subject to CERCLAs reporting requirements for ammonia emissions that exceeded the per-day limit for the operation as a whole, even though no single “facility” at the operation exceeded the limit. The rulings make it much more likely that large-scale confinement operations will be subject to the reporting requirements of CERCLA.
Second, CERCLA established two funds: (1) the hazardous substance response trust fund (“Superfund”) which is funded by taxes on crude oil and chemicals and finances the government's response costs and damage claims for injury to or destruction or loss of natural resources; and (2) the post-closure liability trust fund which is financed by taxes on hazardous wastes and out of which payments are made to cover the costs of response damages or other compensation for injury or loss to natural resources.
Third, CERCLA provides the federal government with authority to respond to emergencies involving hazardous substances and to clean up leaking disposal sites. The EPA is given authority to require parties responsible for contamination to clean up the contamination or reimburse EPA for the costs of remediation. If the liable or “potentially responsible party” cannot be found or cannot afford to pay, then EPA may use the Superfund to clean up the contamination.
Fourth, the statute holds persons responsible for releases of hazardous material liable for cleanup and restitution costs. Liability is strict, joint and several, and can be applied retroactively to those having no continuing control over the hazardous substance. However, liable parties at a multi-party Superfund site are not jointly and severally liable if a reasonable basis exists to apportion their liability. See, e.g., Burlington Northern and Santa Fe Railway Co., et al. v. United States et al., 129 S. Ct. 1870 (2009). But, state law still might provide for joint and several liability.
Elements of Liability. The government must establish four elements to prevail against a party under CERCLA. For example, the government must establish that the site in question is a covered facility subject to CERCLA regulation. The government must also establish that a release or threatened release of a hazardous substance has occurred which caused the U.S. to incur “response costs.” The government need not prove that a particular defendant’s waste caused the government to incur response costs. In addition, the defendant must be a “covered person” (also termed a “potentially responsible party”). If the four elements are proved, the defendant is strictly liable (absent a statutory defense).
Typically, the government has little trouble establishing the first three elements. Consequently, most CERCLA litigation concerns the issue of whether the defendant is a “covered person” as defined by CERCLA. A current owner or operator of a “covered facility” is a covered person. This includes such individuals as tenants, as well as bankers, insurers and other lenders that finance the purchase of the land, limited partners and stockholders, officers and employees, and may also include easement holders. Also deemed to be a “covered person” is any owner or operator of the site at the time of disposal, any person who arranged for disposal or treatment of hazardous substances at the site, and any person who transported hazardous substances to the site. Persons or entities serving as an executor, administrator, conservator or trustee whether serving as an individual or as a corporate fiduciary may also be deemed a “current owner or operator” and, as such, be a “covered person.” For example, in a 1994 case, the court held that a conservator or executor could be held liable as an owner under CERCLA by virtue of leasing a ranch. Castlerock Estates, Inc. v. Estate of Markham, 871 F. Supp. 360 (N.D. Calif. 1994). The environmental contamination at issue was caused by dipping cattle over a period of several years. The current owner of the ranch was obligated to pay the cleanup costs under CERCLA and sought to recover the cleanup costs from a bank that had acquired another bank that had served as conservator and executor for one of the owners of the ranch who had become disabled. While the court noted that bare legal title held by a conservator or executor was inadequate to make the conservator or executor liable for cleanup costs, the court noted that liability could attach if there were additional “indicia of ownership.” The court said that could come from leasing the ranch (which occurred for three years), the granting of additional powers to the fiduciary (which had occurred) or participation in the operation of the ranch. The court ultimately concluded that there was sufficient evidence to go to trial as to the fiduciary's liabilities. Consequently, fiduciaries of property in current use may want to consider executing an indemnity agreement with the operator concerning indemnification for liability arising from environmental problems caused by the operator's use.
Pesticide Exemption. There can be no recovery of response costs or damages under CERCLA from the application of a pesticide product registered under the Federal Insecticide, Fungicide, Rodenticide Act (FIFRA). This is known as the “pesticide exemption.” However, one federal court has construed the pesticide exemption narrowly to not apply to the application of pesticides to unauthorized crops and in a manner that caused off-site drift. See, e.g., United States v. Tropical Fruit, S.E., 96 F. Supp. 2d 71 (D. P.R. 2000). The court held that a farmer’s improper application of pesticides was inconsistent with the product label and rendered the farmer a potentially responsible party for an “escape” of a hazardous substance.
The dicamba drift matter is a big issue in certain parts of the country right now. The recent question concerning drift and hazardous waste is an interesting one. While CERCLA contains a “pesticide exemption” there is potential for CERCLA liability when it can be established that dicamba isn’t applied in accordance with label directions.
Wednesday, July 19, 2017
Many farmers and ranchers belong to one or more agricultural cooperatives, commonly referred to as co-ops. A co-op is a business entity that distributes its income to its members in accordance with a member's use of the co-op. Co-ops are designed to give farmers and ranchers the benefits of group action in the production and marketing of agricultural commodities, and in obtaining supplies and services.
A co-op is characterized by two levels of management – a board and a manager. The board of directors is the policymaking body and board members are elected from within the membership by members to represent them in overseeing the co-op's business affairs. The directors establish policy, report to members, give direction to the manager, and are accountable to the membership for their actions in conducting business affairs.
But, what are the responsibilities of the directors to the member-shareholders? That’s the focus of today’s post.
Co-op directors have the same fiduciary duties of obedience, loyalty and care that corporate directors have. Fiduciary duties are duties assigned to or incumbent upon someone who is a trustee or in a position of trust, such as a co-op director. The duty of obedience requires directors to comply with the provisions of the incorporating statute, articles of incorporation, bylaws, and all applicable local, state and federal laws. The duty of loyalty requires directors to act in good faith, and the duty of care requires directors to act with diligence, care and skill. Both the duty of loyalty and the duty of care are dependent upon the particular state's statutory or common law standard of director conduct.
Obedience to Articles of Incorporation, Bylaws, Statutes and Laws
Illegality. Directors engaging in an act, or permitting the co-op to engage in action, that violates the articles of incorporation, bylaws, state co-op statute, other state law, federal law, or public policy may incur liability for damages. Damages from such liability normally accrue only to the co-op. However, directors causing their co-op to engage in illegal actions may be personally liable for culpable mismanagement for violating their duty of care by failing to attend to co-op activities or neglecting their decisionmaking responsibilities.
Ultra Vires. Board of director actions that are not within the powers conferred by the co-op's articles or bylaws are “ultra vires.” When a director acts outside of the scope of authority as established in the co-op's articles, bylaws or applicable state statute to the injury of the co-op, the director may be liable to the co-op for the resulting damage. Directors may be liable for ultra vires acts both in jurisdictions that consider a co-op director to be a fiduciary or trustee and in jurisdictions that consider a co-op director to be an agent of the co-op. The non-timely return of member equities is a frequent subject for an allegation that the co-op has acted beyond the scope of its powers.
Fiduciary Duty of Obedience, Loyalty and Care
Co-op directors must discharge the duties of their respective positions in good faith. To satisfy the duty of obedience, a director must comply with the cooperative’s articles of formation, bylaws and all applicable local, state and federal laws. In general, good faith includes doing what is proper for the co-op, treating stockholders and patrons fairly, and protecting the shareholders’ investments in a diligent, careful and skillful manner. The duty of loyalty is the fiduciary duty that is most often litigated. The duty of loyalty requires directors to avoid conflicts of interest, not to take advantage of corporate opportunities for personal gain (such as self-dealing and insider trading), to treat the co-op and the shareholders fairly, and not to divulge privileged information.
Conflicts of Interest. A conflict of interest arises between a director and a co-op when a director has a material personal interest in a contract or transaction that either affects the co-op or includes the co-op as a party. In general, a director's duty of loyalty requires interested directors to disclose any conflict of interest between themselves and their co-op. Also, conflict issues may arise in situations involving capitalization of the cooperative, redemption rights of members and preferential treatment in insolvency. Major potential areas of conflict of interest include decisions involving director compensation, the payment of dividends, marketing and purchasing contracts, and whether a directorship position should also be taken with a second co-op or corporation.
Corporate Opportunities. A co-op director's duty of loyalty prevents a director from personally taking advantage of opportunities that would also be of value to the co-op unless the co-op chooses not to pursue the particular opportunity. This applies to business opportunities that the director learns about by reason of the director's position with the co-op. A director is liable if the director appropriated a business opportunity rightfully belonging to the co-op where there was also a violation of the director's fiduciary duty of loyalty in appropriating the opportunity.
Fairness. A director must act fairly when making decisions or taking actions that affect the competing interests of the co-op, its stockholders or patrons, or minority holders of co-op interests. Fairness may also involve the open and fair disclosure of information from both the co-op and its directors to the co-op and its directors, stockholders and patrons. In general, a co-op's bylaws are a contract between the members and the co-op which imposes on the board of directors an implied duty of good faith and fair dealing in its relationship with its members.
Co-op directors may breach their duty of fairness in providing for the payment of dividends to current members or in redeeming co-op equities of former members. But, this is largely a matter that is governed by state statute, and those statute vary widely on the manner in which retained equities must be returned to former members.
Where directors have the authority to either allocate net earnings as patronage refunds or pay dividends on preferred stock, the failure to pay dividends on stock could be unfair. The injustice arises because the preferred stockholder is not receiving any return on money invested in the co-op. Director discretion in the redemption of co-op retained equities also may be a breach of loyalty if the directors provide different treatment for different persons or classes of members or patrons. For example, some courts have ruled unfair a board of directors' refusal to redeem certificates when other certificates had been redeemed upon demand. See, e.g., Mitchellville Cooperative v. Indian Creek Corp., 469 N.W.2d 258 (Iowa 1991).
Confidentiality. The fiduciary relationship existing between a director and co-op includes the duty of confidentiality. This duty prohibits a director from disclosing privileged information. Lawsuits against directors for the breach of this duty are rare. The federal and state securities acts, with their strict provisions concerning the nondisclosure of certain information, constitute more demanding legislation which may affect the directors' duty of confidentiality.
Duty of Care
Co-op directors have a duty to act carefully in directing co-op affairs. In general, directors must use that degree of diligence, care and skill which an ordinarily prudent person would exercise under similar circumstances and in the same position. The facts and circumstances of each case determine how much care a director must use in fulfilling directorship responsibilities.
Attention to Co-op Matters. Directors must attend to co-op matters in a timely fashion. This duty requires directors to attend meetings, follow the articles and bylaws, be cognizant of the various laws affecting the co-op and comply with their provisions, appoint and supervise officers and employees, and perform any other matters that reasonably require the directors' attention. The main issue for consideration is the standard of attention required. Usually, this is determined by reference to a particular state's corporation laws.
Reliance on Officers and Employees. This duty concerns the ability of a director to rely on information, reports, statements or financial data prepared or presented by co-op officers or employees. Directors may not rely upon information from others unless the directors have first made a good faith inquiry into the accuracy and truthfulness of the information.
Delegation of Duties. The board of directors manages co-op affairs. Administrative functions are performed by the co-op's executives and managers. The board of directors should be able and willing to delegate duties to provide for the business operations of the co-op, but must have the authority to do so.
Decision Making—The Business Judgment Rule. The Business Judgment Rule is a defense that a director may assert against personal liability where the director has fulfilled the duty of care. If a board of directors decision proves to be unwise or unprofitable, the directors will not be personally liable unless the decision was not made on the basis of reasonable information or was made without any rational basis whatsoever. But, the rule does not protect the directors from liability for self-dealing, lack of knowledge and personal bias.
Common Law Liability
Fraud. Co-op members, or former members if the cause of action occurred during their membership, who are dissatisfied with the management of the co-op may institute an action against the co-op and its directors for fraud. For example, director action that conceals information that should be disclosed to co-op members constitutes fraud.
Conversion. Co-op directors may also be sued for conversion. Such examples may include approving chattel mortgages which result in the loss of members' property. The absence of director authorization or inaction involving a wrongful property transfer is a defense which may shield defendant directors from liability for conversion.
Tort. Corporate directors may also be sued in tort for personal injury or damages resulting from their negligent or intentional acts.
Corporate Waste. Co-op directors may also be sued for the waste of corporate assets. While courts generally do not interfere with directors' management of a co-op, one court stated that “directors will be held liable if they permit the funds of the corporation or the corporate property to be lost or wasted by their gross or culpable negligence.”
Nuisance. The directors of co-ops that create offensive odors, dust, noise or other pollution may be named in lawsuits brought by neighbors seeking to stop the offensive activity.
Co-ops play an important role in agriculture. Being a member of a co-op’s board is an important role, but along with it comes the responsibility to act in the best interest of co-op members.
Monday, July 17, 2017
One step in the estate planning process involves an examination of possible alternatives for disposing of property during life including a sale for cash, an installment sale, a private annuity or a part-gift, part-sale transaction. As for an installment sale, it can be used in an estate plan to “freeze” the value of an estate (typically that of a parent), and simultaneously shift future appreciation in asset value caused by inflation or improvements to the next generation successor-operator. Structured as an installment sale with an appropriate rate of interest, the transaction does not constitute a gift, and can provide a stream of income for the parents (as the sellers). In addition, if the value of the assets subject to the installment sale drop in value, the transaction can be renegotiated and the purchase price decreased while still maintaining installment sale tax treatment.
Transitioning the farm via an installment sale – that’s the topic of today’s post.
One way to facilitate the transfer of farm assets from one generation to the next is via the installment sale. Given that the current level of the present interest annual exclusion for gift tax purposes is $14,000, an installment sale transaction could be established whereby farm assets could be conveyed to a child, for example, for a $14,000 principal amount interest-bearing note, payable semi-annually. This provides an income stream to the parents and does not trigger any gift tax. That’s because installment sales are not within the scope of I.R.C. §2701. But, if the parents desire to make a gift to the child, they could forgive the payments as they become due. In that situation, it might be possible to discount the gift below the face value of the installment obligation. Also, if a gift is made within three years of death, any gift tax that the decedent (or the estate) pays on the gift is pulled back into the estate. I.R.C. §2035. In addition, in an estate, an installment obligation is income in respect of decedent (IRD). It is not an item of property. That means that there is no basis step-up in accordance with I.R.C. §1014 in the hands of the recipient of the obligation.
Of course, the IRS has its own view of the tax treatment of installment sales. It may assert that the entire value of the property involved in an installment sale is a gift. Indeed, in Rev. Rul. 77-299, 1977-2 C.B. 343, the IRS said that an installment sale of land to grandchildren where the annual payments were forgiven constituted a gift of the full amount of the land in the year the transaction was entered into. The IRS said that was the result because the grandparent had made been gifting property to his grandchildren in prior years and because they didn’t have any other source of income. The courts, however, don’t tend to agree with the IRS position. That’s especially true if the notes involved are legally enforceable, subject to sale to third parties or assignable, and the property involved is subject to foreclosure if the buyer defaults. See, e.g., Estate of Kelley v. Comr., 63 T.C. 321 (1974); Haygood v. Comr., 42 T.C. 936 (1964); Hudspeth v. Comr., 509 F.2d 1224 (9th Cir. 1975).
The IRS may also assert that a gift may occur on an installment sale of land if the interest rate is below a market rate of interest. The IRS, U.S. Tax Court, the Eighth and Tenth Circuit Courts of Appeals and the United States District Court for the Northern District of New York agree that the use of an interest rate in an installment sale other than the market rate of interest results in a gift of the present value of the difference in interest rates. See, e.g., Ltr. Rul. 8804002, Sept. 3, 1987; Frazee v. Comm’r, 98 T.C. 554 (1992); Krabbenhoft v. Comm’r, 939 F.2d 529 (8th Cir. 1991), cert. denied, 502 U.S. 1072 (1992); Schusterman v. Comm’r, 63 F.3d 986 (10th Cir. 1995), cert. denied, 116 S. Ct. 1823 (1996); Lundquist v. United States, 99-1 U.S. Tax Cas. (CCH) ¶60,336 (N.D. N.Y. 1999). The 7th Circuit Court of Appeals disagrees, however. Ballard v. Comm’r, 854 F.2d 185 (7th Cir. 1988). The U.S. Supreme Court has twice declined to resolve the conflicting views of the Circuit Courts of Appeal. Krabbenhoft v. Comm’r, 939 F.2d 529 (8th Cir. 1991), cert. denied, 502 U.S. 1072 (1992); Schusterman v. Comm’r, 63 F.3d 986 (10th Cir. 1995), cert. denied, 116 S. Ct. 1823 (1996).
The take home is that if the transaction is an arm’s length transaction where the parents are not legally obligated to forgive payments or make cash gifts to enable the buyer (child(ren)) to make the payments, then the installment sale should be respected and not gift in the year the transaction is entered into would result. This is particularly the case is the parents actually do receive payments in the early years of the installment sale and a market rate of interest is utilized.
Variation – The Sale-Leaseback
For parents that aren’t ready to retire from farming/ranching, a sale-leaseback transaction might be a consideration. Under this structure, the parents sell the property to the children and then lease it back. While this type of transaction would result in gain recognition to the parents, that gain could be at least partially offset by a deduction for rent. In addition, the rental payment that the parents make to the children will help the children make the payments. A bona fide sale-leaseback transaction will result in the children being able to deduct interest on the installment obligation to the extent the children use the rental payments they receive from the parents to repay the mortgage on the property purchased under the installment sale. There won’t be any interest deduction allowed for annual payments attributable to cash gifts. The sale-leaseback transaction works if ownership is completely transferred to the children and they have a non-contingent obligation to pay. See, e.g., Hudspeth v. Comr., 509 F.2d 1224 (9th Cir. 1975); Stiebling v. Comr., No. 95-70391, 1997 U.S. App. LEXIS 11447 (9th Cir. 1997).
Are There Any Related Party Concerns?
Of course, concerns about sales to related parties arise. That’s because when depreciable property is sold to a “related party” ordinary income is the result. I.R.C. §1239. In addition, the seller can’t use the installment method to report the income unless a principal purpose of the sale was something other than the avoidance of federal income tax. I.R.C. §453(g)(2); see, e.g., Priv. Ltr. Rul. 9926045 (Apr. 2, 1999). A “related party” is for this purpose is defined under I.R.C. §1239(b).
When a related party resells the property within two years of the original sale, gain is accelerated to the original seller. There are some exceptions to the two-year rule. See, e.g., I.R.C. §453(e)(6)). A primary one is that a disposition after the death of the seller or buyer to the original transaction is not treated as a second disposition. That’s probably also the case when there is a death of a joint tenant with respect to jointly owned property. But, any installment sale contract should contain language that bars any disposition by the buyer within two years of the original sale unless the original seller consents. The same can be said with respect to pledging the property. In that instance, the original buyer should continue to bear any risk of loss associated with the property.
There are various ways to transition the family farm/ranch. An outright gift or an outright sale are two options. Another one is the installment sale. An installment sale can provide a means to transfer the assets to the next generation in a tax efficient manner. But, as with any transaction, the details must be paid close attention to in order to achieve the desired tax (and legal) result. The drafting of the installment sale contract must be crafted with care. Of course, as with any complex legal transaction, competent legal (and tax) advice and counsel should be sought and obtained.
Thursday, July 13, 2017
The financial difficulties in agriculture have strained relationships between farmers and their creditors. Back in vogue are the Uniform Commercial Code (UCC) rules for the dispositions of collateral by a creditor when a debtor defaults. But, even when a creditor repossesses collateral and takes action to dispose of it, the debtor still has some rights. One of those rights involves the requirement that the disposition of the collateral be done in a reasonable manner
Commercially reasonable collateral sales – that’s the topic of today post.
Right and Duty to Dispose of Collateral
In General. Upon a debtor's default, a secured party can repossess the collateral and may sell (either by public or private sale), lease or otherwise dispose of the collateral either in its existing condition or following any commercially reasonable preparation or processing.
Two rules on timing of collateral sales apply:
- If the debtor has paid 60 percent of the cash price of a purchase money security interest (PMSI) in consumer goods, or 60 percent of the loan in the case of another security interest in consumer goods and has not signed, after default, a statement renouncing or modifying the debtor's right, a secured party who has taken possession of the collateral must dispose of the collateral within 90 days after possession or suffer liability to the debtor. A PMSI is involved in situations where the lender provides the financing.
- In all other situations, the secured creditor may, after repossessing the collateral, retain the collateral in full satisfaction of the debt unless the debtor objects within 21 days of receipt of notice of the creditor's intent to retain the collateral. If the creditor does retain the collateral, the security interest is discharged along with any liens that are subordinate to such interest. If the collateral is not worth the amount that is owed against it, the creditor is not entitled to the deficiency.
Commercial Reasonableness. If the creditor disposes of the collateral, every aspect of the secured party’s disposition of the collateral, including the method, manner, time, place and other terms must be commercially reasonable. If collateral is not disposed of in a commercially reasonably manner, the liability of a debtor or a secondary obligor for a deficiency may be limited. See, e.g., Ford Motor Credit Co. v. Henson, 34 S.W.3d 448 (Mo. Ct. App. 2001).
Unless the collateral is perishable or threatens to decline speedily in value or is of a type customarily sold on a recognized market, the creditor must give the debtor reasonable notification of the time and place of any public sale, private sale or other intended disposition of the collateral unless the debtor, after default, has signed a waiver of notification of sale. For example, in In re Krug, 189 B.R. 948 (Bankr. D. Kan. 1995), the creditor repossessed registered shorthorn cattle without giving the debtor notice, and placed them under care of other ranchers while seeking foreclosure. The court held that repossession was proper because the security agreement allowed lack of notice; the creditor gave the debtor time to cure the default and did not intend to harm the debtor; however, debtor allowed an offset for damage to the cattle and calves against the creditor's claim because the caretakers failed to properly feed the cattle and bred them improperly.
When Article 9 of the UCC was revised, those revisions did not change existing law with respect to the statutory language for the recognized market exception. See Revised UCC § 9-611(b)-(d). Local livestock auctions cannot qualify for the recognized market exception to the notification requirement because livestock sold at auction are not tangible items and bidders by bidding are individually negotiating the price for the particular livestock in the ring.
If the repossessed collateral fails to bring enough at sale to cover the creditor’s claim, the creditor may bring a legal action against the debtor for the amount of the deficiency. But, again, to recover the deficiency, the sale of the collateral must have been made in a commercially reasonable manner. For instance, in Dallas County Implement, Inc. v. Harding, 439 N.W.2d 220 (Iowa 1989), the sale of repossessed collateral was held to not be reasonable where collateral the collateral (farm equipment) was sold at a private sale without notice to the debtor. As a result, the creditor was not entitled to a deficiency judgment. However, some courts hold that failure to send notice to the debtor may not invalidate a sale of repossessed property if the collateral is sold at a recognized market or for fair market value. See, e.g., First National Bank v. Ruttle, 108 N.M. 657, 778 P.2d 434 (1989). Proof that a greater amount could have been obtained for the collateral by its disposition at a different time or in a different method is not alone sufficient to preclude the secured party from establishing that the disposition was commercially reasonable. But, a low sales price suggests the court should scrutinize carefully all the aspects of the disposition to insure each aspect was commercially reasonable.
Ultimately, the issue of whether the disposition of collateral was commercially reasonable is one of fact. Courts consider a number of factors to evaluate whether collateral was disposed of in a commercially reasonable manner. These factors include whether the secured party tried to obtain the best price possible, whether the sale was private or public, the condition of the collateral and any efforts made to enhance its condition, the advertising undertaken, the number of bids received and the method used in soliciting bids.
The secured party may buy repossessed collateral at a public sale and may also buy the collateral at a private sale if the goods are of a type customarily sold in a recognized market or of a type which is the subject of widely distributed standard price quotations.
Revised Article 9
As noted above, a few years ago the UCC was revised. Under the Revisions to Article 9, in non-consumer deficiency cases, the secured party need not prove compliance with the default provisions unless compliance is placed in issue. If compliance is placed in issue, the secured party has the burden to show compliance. If the creditor cannot prove compliance, the rule is that the failure will reduce the secured party’s deficiency to the extent that the failure to comply affected the price received for the goods at the foreclosure sale. Under the revisions, the value of the collateral is deemed to equal the unpaid debt and the noncomplying creditor is not entitled to a deficiency, unless the creditor seeking a deficiency proves by independent evidence that the price produced at sale was reasonable. Thus, the creditor must prove what the collateral would have been sold for at a commercially reasonable sale and that this amount is less than the unpaid debt.
While Revised Article 9 does not define “commercially reasonable,” UCC §9-611(c) provides that in a commercial transaction notice must be given to debtors, secondary obligors, any person who has given the foreclosing creditor notice of a claim, and any other secured party that holds a perfected security interest in the collateral. When consumer goods are involved, notice need only be given to debtors and secondary obligors.
Times of financial distress always strain relationships between debtors and creditors. That’s a tough situation in agricultural settings because of the typical close relationship that many farmers and ranchers have with their lenders. But, the law establishes many rules that must be followed in financial transactions – including rules that govern how collateral dispositions are handled. The rule of “commercial reasonableness” is one of those rules.
Tuesday, July 11, 2017
Spray-drift issues with respect to dicamba and the use of XtendiMax with VaporGrip (Monsanto) and Engenia (BASF) herbicides for use with Xtend Soybeans and Cotton are on the rise. Usage of dicamba has increased recently in an attempt to control weeds in fields planted with crops that are engineered to withstand it. But, Missouri (effective July 7) and Arkansas (as of June) have now taken action to ban dicamba products because of drift-related damage issues.
So, what factors help determine the proper application of dicamba? In addition, if drift occurs and damage crops in an adjacent field, how should the problem be addressed? Can the matter be settled privately by the parties involved? If not, what legal standard applies in resolving the matter – negligence or strict liability?
Issues associated with dicamba drift – that’s the focus of today’s post.
Uniqueness of Dicamba
In many instances, spray drift is a straightforward matter. The typical scenario involves either applying chemicals in conditions that are unfavorable (such as high wind), or a misapplication (such as not following recommended application instructions). But, dicamba is a unique product with its own unique application protocol.
I asked an expert on chemical applications to provide me with an assist on the issues associated with the application of dicamba. Jeff Haggerty of Heinen Bros. Ag near Seneca, KS, has many years in the agricultural chemical application business and provided some helpful comments to me, and the following bullet points summarize his thoughts on the matter:
- Dicamba is a very volatile chemical and is rarely sprayed in the summer months. This is because when the temperature reaches approximately 90 degrees Fahrenheit, dicamba will vaporize such that it can be carried by wind for several miles. This can occur even days after application.
- The typical causes of spray drift are application when winds are too strong, a temperature inversion (temperature not decreasing with atmospheric height) exists or there has been a misapplication of the chemical.
- For the new dicamba soybeans, chemical manufacturers reformulated the active ingredient to minimize the chance that it would move off-target due to it volatility.
- Studies have concluded that the new formulations are safe when applied properly, but if a user mixes-in unapproved chemicals, additives or fertilizer, the safe formulations revert to the base dicamba formulation with the attendant higher likelihood of off-target drift.
- Soybeans have an inherit low tolerance to dicamba. As low as 1/20,000 of an application rate can cause a reaction. A 1/1000 of rate can cause yield loss.
- The majority of crops damaged from vapor drift may not actually result in yield loss. That’s particularly the case if drift damage occurs before flowering. However, if the drift damage occurs post-flowering the likelihood of yield loss increases. Also, studies have shown that a slight rain event can stop the volatilizing of dicamba.
- The label is the law. This is particularly true with the new chemicals used on Xtend crops. The labels are very specific with respect to additives, nozzles, boom height, and wind speed and direction.
Damage Claims – Building a Case
Negligence. For a person to be deemed legally negligent, certain conditions must exist. These conditions can be thought of as links in a chain. Each condition must be present before a finding of negligence can be obtained. The first condition is that of a legal duty giving rise to a standard of care. To be liable for a negligent tort, the defendant's conduct must have fallen below that of a “reasonable and prudent person” under the circumstances. A reasonable and prudent person is what a jury has in mind when they measure an individual's conduct in retrospect - after the fact, when the case is in court. The conduct of a particular tortfeasor (the one causing the tort) who is not held out as a professional is compared with the mythical standard of conduct of the reasonable and prudent person in terms of judgment, knowledge, perception, experience, skill, physical, mental and emotional characteristics as well as age and sanity. For those held out as having the knowledge, skill, experience or education of a professional, the standard of care reflects those factors. For example, the standard applicable to a farmer applying chemicals to crops is what a reasonably prudent farmer would have done under the circumstances, not what a reasonably prudent person would do.
If a legal duty exists, it is necessary to determine whether the defendant's conduct fell short of the conduct of a “reasonable and prudent person (or professional) under the circumstances.” This is called a breach, and is the second element of a negligent tort case.
Once a legal duty and breach of that duty are shown to exist, a causal connection (the third element) must be established between the defendant's act and (the fourth element) the plaintiff's injuries (whether to person or property). In other words, the resulting harm to the plaintiff must have been a reasonably foreseeable result of the defendant's conduct at the time the conduct occurred. Reasonable foreseeability is the essence of causality (also known as proximate cause).
For a plaintiff to prevail in a negligence-type tort case, the plaintiff bears the burden of proof to all four elements by a preponderance of the evidence (just over 50 percent).
Typical drift case. In a straightforward drift case, the four elements are typically satisfied – the defendant misapplied the chemical or did so in high winds (breach of duty to apply chemicals in a reasonable manner in accordance with industry standards/requirements) resulting in damages to another party’s crops. In addition, the plaintiff is able to pin-down where the drift came from by weather reports for the day of application combined with talking with neighbors to determine the source of the drift (causation). In many of these situations, a solution is worked out privately between the parties. In other situations, the disaffected farmer could file a complaint with the state and the state would begin an investigation which could result in a damage award or litigation.
Generally, what are contributing factors to ag chemical drift? For starters, the liquid spray solution of all herbicides can physically drift off-target. This often occurs due to misapplication including such things as applying when wind speed exceeds the recommended velocity, improper spray pressure, and not setting the nozzle height at the proper level above the canopy of the intended plant target. Clearly, not shielding sprayers and aerial application can result in an increased chance of off-site drift. Also, the possibility of drift to an unintended field can be influenced by droplet size if the appropriate nozzle is not utilized.
Dicamba drift cases. As noted above, dicamba is a different product that is more volatile than other crop chemicals. That volatility, the increased likelihood of drift over a broader geographic area, and that dicamba drift damages can occur several days after application, makes it more difficult for a plaintiff to determine the source of the drift. Thus, the causation element of the plaintiff’s tort claim can be more difficult to establish with dicamba-related damage claims. In addition, soybeans are inherently sensitive to extremely low dicamba concentrations, thus elevating the potential for damages.
Clear patterns of injury indicate physical drift which could make the causation element easier to satisfy. Wind speed at time of application, sprayer speed, sprayer boom height above the plant canopy, nozzle height, tank cleaning, sprayer set-up and whether the application occurs at night rather in the daylight, are also factors that are within the applicator’s control. Failure to follow label directions, meet common industry standards or manufacturer guidance on any of those points could point toward the breach of a duty and could also weigh on the causation element of a tort claim.
Relatedly, another factor with dicamba, as noted above, is whether it was applied on a hot day. The chemistry of dicamba has a “vapor curve” that rises with the temperature. While I have not seen that vapor curve, it would be interesting to see whether that curve has a discernibly steeper slope at a particular temperature. If so, that would indicate the point at which dicamba becomes very volatile and should not be applied. Indeed, the Banvel (brand name of dicamba) label specifically states that the chemical is not to be applied “adjacent to sensitive crops when the temperature on the day of the application is expected to exceed 85 [degrees Fahrenheit] as drift is more likely to occur.” To the extent any particular defendant can establish that application occurred when temperature on the day of application was forecast to exceed 85 degrees, the duty and breach elements of the plaintiff’s tort claim would be easier to satisfy.
Dicamba manufacturers have protocols in place to aid in the safe application of the products. Thus, in quantifiable damage cases, it is likely that an application protocol was not followed. But, establishing that breach to the satisfaction of a jury could be steep uphill climb for a plaintiff. That’s particularly the case with dicamba given its heightened volatility. As previously noted, damages could be caused by physical drift, temperature, volatility or temperature inversions. Is a particular cause tied to the defendant’s breach of a duty owed to the plaintiff?
Strict liability. Most pesticide drift cases not involving aerially-applied chemicals are handled under the negligence standard. However, a strict liability approach is sometimes utilized for aerially applied chemicals. See, e.g., Langan v. Valicopters, Inc., 567 P.2d 218 (Wash. 1977); but see Mangrum v. Pique, et al., 359 Ark. 373, 198 S.W.3d 496 (2006)(the aerial application of chemicals commonly used in farming communities that are available for sale to the general public is not an ultrahazardous activity triggering application of strict liability). In such a situation, liability results from damages to others as a result of the chemicals. It makes no difference whether the applicator followed all applicable rules for applying the chemicals and did so without negligence. The strict liability rule is harsh, and is normally reserved for ultra-hazardous activities. Do the present issues associated with dicamba drift damages warrant the application of the strict liability rule? Only time will tell whether the theory is pled in a future case and whether the court would apply it.
The dicamba drift issue is an important one in agriculture at the present time with respect to soybean and cotton crops. While the new dicamba formulations will not eliminate the problem of physical drift, proper application procedures by following label directions can go a long way to minimizing it. Likewise, drift issues can also be minimized by communication among farmers that helps determine the planting location of particular crops, their relative sensitivities to dicamba and following acceptable setbacks. But, farmers that sustain damage should quantify the economic loss, and see whether it can be determined if the source of the loss arose from a causally-connected breach of a duty.
Friday, July 7, 2017
Wednesday’s post was the first of a two-part series on timber tax issues. In that post, I took a look at the tax issues facing timber farmers and investors. In Part Two today, I examine timber casualty loss issues and timber like-kind exchanges.
Defined. A deductible casualty loss is the complete or partial destruction of property resulting from an identifiable event of a sudden, unexpected or unusual nature. Thus, losses due to hurricanes, tornadoes, wild fires and similar natural disasters are deductible. However, timber losses due to disease or insect damage are generally not deductible because they are progressive in nature.
Calculating the loss. For deductible casualty losses (which are deducted from ordinary income), the loss is the lesser of the decrease in the fair market value of a “single identifiable property” (SIP) or the adjusted basis of the SIP, less any insurance proceeds, salvage value or other compensation received. In effect, the measure of the loss is the economic loss suffered limited by the basis.
For casualty loss deduction purposes, the SIP is any unit of property having an identifiable adjusted basis that can be identified in relation to the area impacted by the casualty. Thus, the allowable loss isn’t limited to merchantable units of timber totally destroyed. Instead, it is also allowed for trees that were damaged but not made worthless. Rev. Rul. 99-56, 1999-2 CB 676. The deductible loss is equal to the difference in fair market value of the SIP immediately before and after the casualty, limited by basis. Thus, in an IRS Field Service Advice from 2002, it was not correct for a taxpayer to deduct as a casualty loss the difference between the fair market value for the volume of timber from each type of affected tree before an ice storm and the reduced fair market value for the volume of timber remaining after a storm. F.S.A. 200229007 (Apr. 5, 2002).
Claiming the loss. A casualty loss is claimed in the year that the loss takes place. Also, deductible are costs incurred to substantiate the loss (such as appraisal or timber cruise). The loss is reported on Form 4684, Section B where it is then carried to Form 4797, Part II (an ordinary loss, which avoids the netting against §I.R.C. 1231 gains). For a casualty loss to timber held as an investment, the loss is reported on Form 1040, Schedule A. There is an exception for casualty losses that occur in Presidentially declared disaster areas. Those losses can be deducted on an original or amended return for the year immediately before the year the disaster took place.
Postponing the loss. If a gain results from a casualty loss due to proceeds from a salvage sale or other form of reimbursement that exceed the taxpayer’s adjusted income tax basis in the timber, the gain can be postponed if the taxpayer acquires replacement property within two years after the end of the first tax year in which the taxpayer realizes any portion of the gain. I.R.C. §1033.
Example: Boris owns 80 acres of timber with 1280 cords of pulpwood-sized timber. Boris’s basis in the timber is $10,000. A tornado damaged trees containing 300 cords of wood such that they will have to be removed. The tornado damage reduced the fair market value of the timber by $2,000. Boris found a buyer willing to pay $4,000 for the damaged timber. Boris calculates his casualty loss deduction as follows:
Step 1: Adjusted basis in the tract: $10,000
Step 2: Difference in fair market value before and after the casualty: $10,000 - $8,000 = $2,000
Step 3: Smaller of Steps 1 and 2: $2,000
Adjusted basis in timber after the casualty: $10,000 - $2,000 = $8,000 ($6.25/cord)
Boris has gain on sale of the damaged timber of $2,125: ($4,000 – ($6.25 x 300)). The $2,125 gain recognition can be postponed if Boris purchases qualified replacement property within two years.
Losses for investors. The above discussion on losses was restricted to timber farmers. For investors, the loss is a non-business casualty loss. For property held for nonbusiness use, the first $100 of casualty or theft loss attributable to each item is not deductible. The deduction is also limited to the excess of aggregate losses over 10 percent of AGI, except for victims of certain hurricanes. Nonbusiness losses are deductible only to the extent total nonbusiness casualty losses exceed 10 percent of the taxpayer’s AGI. However, each casualty loss of nonbusiness property is deductible only to the extent the loss exceeds $100.
Personal casualty gains and losses (from nonbusiness property) are netted against each other. If the losses exceed the gains, all gains and losses are ordinary. Losses to the extent of gains are allowed in full. Losses in excess of gains are subject to the 10 percent AGI floor. All personal casualty losses are subject to the $100 floor before netting. If the personal gains for any taxable year exceed the personal casualty losses for the year, all gains and losses are treated as capital gains and losses.
Like-Kind Exchange of Timber and Timberland
Under the like-kind exchange rules of IRC §1031, a broad definition of “like-kind” for purposes of real estate exchanges is utilized. For instance, undeveloped real estate can be exchange for developed real estate. The “class” and “type” requirements that apply to tangible personal property do not apply with respect to real estate exchanges. However, the real estate needs to be held for investment or used in the taxpayer’s trade or business, and not held for sale. Thus, real estate can be exchanged for real estate as long as the traded properties are held for either a business or investment purpose.
Whether land has timber on it or not is immaterial for purposes of a like-kind exchange with other real estate. See Rev. Rul. 72-515, 1972-2 C.B. 466; Rev. Rul. 76-253, 1976-2 C.B. 51 and Rev. Rul. 78-163, 1978-1 C.B. 257. Thus, an exchange of real estate for standing timber or right to cut standing timber can qualify as a like-kind exchange. To qualify, an interest in standing timber must be treated as real property under state law. In many states, growing timber is considered part of the land. See, e.g., Hutchins v. King, 68 U.S. 53 (1863); Laird v. United States, 115 F. Supp. 931 (W.D. Wis. 1953).
The quantity, quality, age and/or species of timber may relate to grade or quality of timberland, but has no impact on whether timberland is like-kind to other real estate, whether or not the replacement land is timberland. See Priv. Ltr. Rul. 200541037; Ltr. Rul. 8621012.
For like-kind exchanges involving timberland, a key case is Oregon Lumber Co. v. Comr., 20 T.C. 192 (1953). Under the facts of the case, a timber harvesting company exchanged timberland with the U.S. government for the right to cut certain timber marked for cutting on other timberland owned by the U.S. The exchange agreement contained a provision obligating the exchanger to cut certain timber marked for cutting within a certain time period. The Tax Court held that the conveyance was not like-kind because Oregon law treated the right to cut timber as a right to acquire goods only (personal property), and under the exchange agreement, the exchanger acquired the right and obligation to cut timber marked for cutting that was limited in duration.
So, state law may dictate that a right to cut timber on someone else’s land is not like-kind to timberland. Relatedly, the IRS has considered whether an exchange of standing timber and cut timber located on 60 acres owned by the exchanger for a fee interest in three parcels of timberland qualified as like-kind exchange. The IRS determined that it did not. Tech. Adv. Memo. 9525002 (Feb. 23, 1995). The relinquished property was conveyed by a “timber deed” of all standing and cut timber located on 60 acres that would be removed within a specified period with any remaining timber reverted to the exchanger and constituted personal property. The two-year contract period amounted to a de facto restriction on the number of trees that could be removed. Thus, the duration of interests was dissimilar.
The key points on exchanges can be summarized as follows:
- Know state law;
- Based on state law, is the timber right being conveyed limited in duration or is it perpetual (e.g., fee simple)?
- Under state law, are rights to cut timber in the nature of a service contract as opposed to a property right?
- Are the rights to harvest timber conveyed by deed? Are they conveyed by bill of sale? Are they conveyed by a license?
- Does the conveyance instrument contain any obligation to cut and remove timber?
For rights to harvest timber conveyed by license, the Tax Court issued a key decision in 1994. In Smalley, the issue was whether the taxpayer had constructive receipt of a payment for purposes of the installment sale rules. The taxpayer sold “the exclusive license and right to cut all merchantable pine and hardwood timber suitable for poles, saw timber, or pulpwood” on 95 acres of land. Under the contract terms, the buyer paid the purchase price to an escrow agent so that the taxpayer could complete a deferred exchange. The court held that if the taxpayer had a bona fide right to complete a like-kind exchange, then the taxpayer did not have constructive receipt of the payment to an escrow agent even if he did not acquire like-kind property within the replacement period. The court did not provide any analysis of whether like-kind property was involved, but did state that it was reasonable for taxpayer to believe that proposed transaction would qualify as a like-kind exchange. State law (GA) specified that standing timber that the buyer severs constitutes a transfer of real property.
Timber casualty loss and like-kind exchange tax issues are important to timber producers and investors. This post and the previous one provide an overview of the basic issues.
Wednesday, July 5, 2017
Another aspect of agricultural taxation involves the timber industry. Most of the time we tend to think of tax issues for grain farmers, but there are also tax issues for producers that raise fruits and vegetables. In addition, livestock producers have some tax issues that are unique to them. But, there are certain areas of the country where the timber industry is significant, with taxpayers involved in the industry having unique tax issues of their own.
In the first of two blog posts involving timber tax issues, today’s post looks at the tax issues for timber producers and timber investors.
Timber Sellers in the Trade or Business of Timber Farming
A timber seller is either an investor or is engaged in the timber business. For an investor, resulting gain or loss is capital in nature. However, if the seller is in the trade or business of timber farming, the tax treatment of the sale depends on the amount of timber sold and how the taxpayer chooses to treat the sale.
For taxpayers that are engaged in the trade of business of timber farming, the income resulting from the sale of cut timber, whether cut personally or cut via contract by another party, the income on sale is ordinary gain or loss unless the taxpayer elects to treat the cutting as a sale under I.R.C. §631(a). That’s because the sales are generally treated as occurring in the ordinary course of the taxpayer’s business. If the election is made, the difference between the standing timber’s fair market value (as of the first day of the tax year) and basis is I.R.C. §1231 gain or loss that is netted with other I.R.C. §1231 gains or losses for the year. The difference between the net proceeds and the standing timber’s fair market value is ordinary in nature. Form T is required; this form tracks the taxpayer’s depletion in the timber.
To qualify for the election, standing timber must be cut by the owner or someone who has held a contract right to cut the timber for more than a year. The holding period must include the first day of the tax year in which timber is cut. The election statement must be attached to the return and the gain or loss is reported as of the first day of the tax year on Form 4797 and on Schedule F
If the taxpayer sells standing timber, the gain or loss is I.R.C. §1231 gain or loss (reported on Form 4797 along with a subtraction for the costs of sale and basis in the timber) that is netted with taxpayer’s other I.R.C. §1231 gains or losses for the year. I.R.C. §631(b). Net proceeds from annual sales of timber products (e.g., firewood, pine straw) and from sale of timber products after cutting (e.g., tree stumps) is ordinary income or loss.
Investors as Timber Sellers
For investors, lump-sum sales of standing timber are treated as a capital gain or loss under I.R.C. §1231. For land that is inherited with standing timber, the holding period is deemed to be long-term irrespective of how long either the taxpayer or the decedent held the land. I.R.C. §1223(9). The timber’s basis is its fair market value as of the date of the decedent’s death (or I.R.C.§2032 date).
The tax treatment of timber-related expenses depends on the type of expense and the tax status of the timber activity. I.R.C. §263A(c)(5) provides exception from uniform capitalization rules for timber and ornamental trees, other than Christmas trees (an evergreen tree that is more than six years old when it is severed from its roots).
Management and operating expenses. Ordinary and necessary expenses associated with the daily operation and management of timber property are currently deductible in accordance with IRC §162, even if no income is produced from the property, if the timber activity is engaged in for profit and the expenses are directly related to the property’s income potential. If the timberland is investment property, management and operating expenses are deductible in accordance with I.R.C. §212.
Expenses that are associated with the sale or other disposition of timber are deducted from the sale proceeds.
Carrying charges. Carrying charges (taxes, interest and other expenses that are related to the development and operation of timber properties) may be treated as deductible expenses or, by election, may be capitalized. Investors can also make the election. The election is made by attaching a statement to the original return for the tax year for which the election is desired to apply. The statement should explain that the taxpayer is electing to capitalize carrying charges and include sufficient information with respect to the activity that the charges relate to. If carrying charges are not deducted in a particular year, it is not assumed that an election to capitalize the costs has been made.
If the election to capitalize is made, the carrying charges are allocated to the capital accounts to which the charges apply. Non-commercial thinning and timber stand improvement costs are allocated in full to the timber accounts associated with the timber involved.
Holding costs. Annual property taxes, mortgage interest, insurance premiums and similar costs can be expensed or capitalized as the taxpayer chooses during any year in which timberland is “unimproved and unproductive.” Unimproved real property is generally defined as land without buildings, structures or any other improvements that contribute significantly to its value. Timberland is unproductive in any year in which it produces no income from any source (such as hunting lease income, timber sales, or sale of forest products from cut timber). The election to capitalize carrying charges characterized as holding costs cannot be made in any year that the taxpayer receives income from the timberland.
Development costs. Expenses for developing real property (such as non-commercial thinning and timber stand improvements) constitute carrying charges and must be treated consistently from year-to-year. It is immaterial whether the property is improved or unimproved, productive or unproductive.
Management costs. Management costs are deductible by individual taxpayers who hold timber activities as an investment as a miscellaneous itemized deduction on Schedule A. Property taxes (and other taxes attributable to timber operations) are deductible by investors as an itemized deduction (not subject to 2% of AGI floor). The interest deduction is limited to investment income. Fertilizer expenses are deductible under I.R.C. §194.
Reforestation expenses. Under I.R.C. §194(b), qualifying taxpayers can deduct up to $10,000 of reforestation expenses annually per individual tract of timberland. But, each reforestation project must be separately tracked and be shown on Form T. Cost–share payments may be available for expenses associated with reforestation activities. Cost-share expenses are excludible in accordance with a formula set forth in I.R.C. §126. But, unless a taxpayer is in a high tax bracket, the taxpayer may be better off to include cost-share expenses in income so as to claim the reforestation deduction (or amortization deduction) on total qualified reforestation expenses.
Non-deductible expenses. Non-deductible expenses for “qualified timber property” can be amortized over 84 months using the half-year convention. I.R.C.§194(a). For this purpose, “qualified timber property” is a woodlot or other site located in the U.S. that will contain trees in significant commercial quantities and is held by the taxpayer for the planting, cultivating, caring for and cutting of trees for sale or use in the commercial production of timber products. “Commercial production” means that the timber is grown for eventual sale to commercial timber processors or for use in the taxpayer’s trade or business. In addition, the tract (whether owned or leased) being reforested must be at least one acre in size, and the tract must contain sufficient trees to be adequately stocked for purposes of commercial timber production. Thus, trees grown for personal use do not qualify. The same is true for Christmas trees irrespective of whether the trees are grown for personal use or for commercial purposes.
Timber tax issues are, obviously, very important to timber producers. In Part Two on Friday, I will examine timber-related casualty loss issues and like-kind exchanges involving timber.
Monday, July 3, 2017
A taxpayer that manufactures, produces, grows or extracts property in the U.S. that is held primarily for sale, lease or rental in the ordinary course of the taxpayer’s trade or business by or to an Interest Charge Domestic International Sale Corporation (IC-DISC) for direct use, consumption or disposition outside the U.S., and not more than 50 percent of the fair market value of the property is attributable to articles imported into the U.S. can get some favorable tax breaks.
The IC-DISC concept may not be that well known, but it can be utilized by agricultural businesses. It’s also a topic that Paul Neiffer and I will cover at our two-day summer ag tax/estate and business planning conference in Sheridan, Wyoming (and online) next week. http://washburnlaw.edu/employers/cle/farmandranchincometax.html
An IC-DISC has as its statutory basis I.R.C. §§991-997. It is a corporate entity (not an S corporation) that is separate from the producer, manufacturer, reseller or exporter. To meet the statutory definition of an IC-DISC, it must have 95 percent or more of its gross receipts consist of qualified export receipts, and the adjusted basis of the qualified export assets of the IC-DISC at the close of the tax year equals or exceeds 95 percent of the sum of the adjusted basis of all of the IC-DISC assets at the close of the tax year. Also, the IC-DISC cannot have more than a single class of stock and the par (stated value) of the outstanding stock must be at least $2,500 on each day of the tax year. In addition, the corporation must make an election to be treated as an IC-DISC for the tax year. I.R.C. §992(a)(1).
As such, it is exempt from federal income tax under I.R.C. §991, and any dividends (actual and deemed) paid-out are qualified dividends that are taxed at the more favorable long-term capital gain rate by converting ordinary income from sales to foreign unrelated parties. I.R.C. §995(b)(1).
“Destination test.” As noted above, the property at issue must be held for sale, lease or rental in the ordinary course of the taxpayer’s trade or business for direct use, consumption or disposition outside of the U.S. This is known as the “destination test.” This test is satisfied if the IC-DISC delivers property to a carrier or a party that forwards freight for foreign delivery. It doesn’t matter when title passes or who the purchaser is or whether the property (goods) will be used or resold. The test is also met if the IC-DISC sells the property to an unrelated party for U.S. delivery with no additional sale, use assembly or processing in the U.S. and the property is delivered outside the U.S. within a year after the IC-DISC’s sale. Likewise, the “destination test” is satisfied if the sale of the property is to an unrelated IC-DISC for the same purpose of direct use, consumption or disposition outside the U.S.
The “destination test,” at least in the realm of agricultural products, has been made easier to satisfy with the advent of rules that require food tracing. This is particularly the case with fruits and vegetables. Growers can trace their products to grocery stores and other end-use foreign destinations. The same is true for grain producers that deliver crops to export elevators. They will likely be able to get the necessary documents showing the precise export location of their grain products.
Once an IC-DISC is set-up (by competent legal and tax counsel), the producer, manufacturer, reseller or exporter can pay the IC-DISC a commission that is tax deductible. This is the most common way that the IC-DISC earns income. The commission is tied to the producer’s (or manufacturer or reseller or exporter) foreign sales or foreign taxable income for the tax year. It is that commission that then can be distributed (after the tax year) to the IC-DISC shareholders as qualified dividends at qualified long-term capital gain rates.
There is a safe harbor for the commission which is the greater of four percent of the qualified export receipts on reselling the property, or 50 percent of the combined taxable income from the export sales. For instance, assume that a Kansas what farmer (sole proprietor) sells wheat to an export elevator for $2 million. The elevator is able to document that all of the wheat was exported. The farmer pays four percent of $2 million ($80,000) to the IC-DISC, and claims a deduction of that amount on Schedule F. The IC-DISC has income of $80,000 (less any expenses incurred). If that income is distributed to the farmer, it takes the form of a qualified dividend which will be taxed at long-term capital gain rates.
What’s the benefit to the farmer? It's in the form of a reduction in self-employment taxable income, and the replacement (to an extent) of ordinary income with qualified dividend income.
There’s also a benefit if the farmer operates in the C corporate form. In that case, the commission that is paid to the IC-DISC reduces C corporate taxable income. As a result, if the IC-DISC shareholders are individuals, there is only a single layer of tax. In addition, as noted, the IC-DISC ordinary income is converted to qualified dividends and taxed at long-term capital gain rates.
Instead of paying tax currently in the form of a qualified dividend, the IC-DISC can also provide income deferral. Deferral is achieved by having each IC-DISC shareholder pay interest in an amount tied to the deferred tax liability associated with the IC-DISC times the base period T-bill rate. Each shareholder does their own computation. Thus, the ultimate tax liability of a shareholder will be determined by that particular shareholder’s marginal tax rate.
The IC-DISC may be unheard of by many farmers and practitioners. However, it can play a role in the overall income tax and estate planning process. As part of an estate plan, if the IC-DISC shareholders are the younger members of the family, value can be transferred to them without triggering federal transfer taxes. In addition, the IC-DISC shareholders don’t have to be involved in the farm business – they don’t have to be engaged in manufacturing, production growing, exporting or reselling. Thus, off-farm heirs can be set-up as IC-DISC shareholders and receive at least a portion of their anticipated inheritance in that manner without being engaged in the farming operation. That will please the on-farm heirs (and, likely, the parents).
The IC-DISC can also reduce tax liability to an extent that exceeds its cost of formation, operation and administration. But, as is the case with any tax tool, all applicable Code requirements must be satisfied, and competent professional help should be utilized in setting up the IC-DISC structure.
Thursday, June 29, 2017
Farm and ranch clients face many income tax issues that require special attention and planning. Likewise, they also encounter many estate and business planning opportunities that they can either take advantage of miss out on. For those representing farm and ranch clients, professional training in these issues is an important part of proper client representation. Our upcoming summer conference in the Bighorn Mountains of Sheridan, Wyoming on July 13-14, will dig into these issues and provide an opportunity for professional development. My teaching partner for the two days is Paul Neiffer of CliftonLarsonAllen.
Day 1 – Farm Income Tax
On Day 1, Paul and I will dig into numerous farm income tax topics. I will begin the day with an update of key developments in farm taxation. Before lunch, we will address various depreciation issues, farm income averaging and financial distress tax issues along with tax-deferral opportunities. In the afternoon, cash accounting issues for farmers, an update on the repair/capitalization regulations and a number of other specific farm income tax issues are on the agenda.
Day 2 – Farm Estate and Business Planning
On Day 2, we get into key estate and business planning issues for farmers and ranchers including how to maintain a stepped-up basis, planning strategies, the use of charitable trusts and FSA planning issues and opportunities. We will also get into other topics related to farm/ranch estate and business planning.
In-Person or Webinar
If you can’t attend the event in-person, the conference will also be webcast live. For in-person attendees, you can enjoy the beautiful Bighorn Mountains nearby with numerous outdoor opportunities. Also, the Sheridan Rodeo will be going on while we are there.
Here’s the link to the conference brochure: http://washburnlaw.edu/employers/cle/farmandranchincometax.html
We hope to see you in Sheridan in two weeks. There’s a week left for early registration. After that, the registration rates increase.
Tuesday, June 27, 2017
The power to “take” private property for public use (or for a public purpose) without the owner's consent is an inherent power of the federal and state government. However, the United States Constitution limits the government's eminent domain power by requiring federal and state governments to pay for what is “taken.” The Fifth Amendment states in part “...nor shall private property be taken for public use without just compensation.” The clause has two prohibitions: (1) all takings must be for public use, and (2) even takings that are for public use must be accompanied by compensation.
Whether a taking has occurred is not an issue when the government physically takes the property, with the only issue being whether the taking is compensable and the amount of compensation due to the landowner. However, for non-physical takings, the issue is murkier. At what point does government regulation of private property amount to a compensable taking? The Supreme Court has addressed this issue on numerous occasions, and most recently dealt with a key issue that is the starting point in these matters – how to define the actual property that the landowner claims that the government has taken. This definitional issue is important to landowners because the way a tract is defined can either restrict the government’s regulation of the tract or expand it.
Regulatory (Non-Physical) Takings
A non-physical taking may involve the governmental condemnation of air space rights, water rights, subjacent or lateral support rights, or the regulation of property use through environmental restrictions. How is the existence of a regulatory taking determined? There are several approaches that the Supreme Court has utilized.
Multi-factor balancing test. In a key case decided in 1978, the U.S. Supreme Court set forth a multi-factored balancing test for determining when governmental regulation of private property effects a taking requiring compensation. In Penn Central Transportation Co. et al. v. New York City, 438 U.S. 104 (1978), the Court held that a landowner cannot establish a “taking” simply by being denied the ability to exploit a property interest believed to be available for development. Instead, the Court ruled that in deciding whether particular governmental action effects a taking, the character, nature and extent of the interference with property rights as a whole are the proper focus rather than discrete segments of the owner’s property rights. In 2005, the Court confirmed the multi-factor test and noted that the touchstone for deciding when a regulation is a taking is whether the restriction on property usage is functionally equivalent to a physical taking of the property. Lingle, et al. v. Chevron U.S.A., Inc., 544 U.S. 528 (2005).
Total regulatory taking. In Lucas v. South Carolina Coastal Council, 505 U.S. 1003 (1992), the landowner purchased two residential lots with an intent to build single-family homes. Two years later, the state legislature passed a law prohibiting the erection of any permanent habitable structures on the Lucas property. The law's purpose was to prevent beachfront erosion and to protect the property as a storm barrier, a plant and wildlife habitat, a tourist attraction, and a “natural health environment” which aided the physical and mental well-being of South Carolina's citizens. The law effectively rendered the Lucas property valueless. Lucas sued the Coastal Council claiming that, although the act may be a valid exercise of the state's police power, it deprived him of the use of his property and thus, resulted in a taking without just compensation. The Coastal Council argued that the state had the authority to prevent harmful uses of land without having to compensate the owner for the restriction.
The Supreme Court ruled for Lucas and opined that the state's interest in the regulation was irrelevant since the trial court determined that Lucas was deprived of any economically viable alternative use of his land. The Lucas case has two important implications for environmental regulation of agricultural activities. First, the Lucas court focused solely on the economic viability of the land and made no recognition of potential noneconomic objectives of land ownership. However, in the agricultural sector land ownership is typically associated with many noneconomic objectives and serves important sociological and psychological functions. Under the Lucas approach, these noneconomic objectives are not recognized. Second, under the Lucas rationale, environmental regulations do not invoke automatic compensation unless the regulations deprive the property owner of all beneficial use.
Under the Lucas approach, an important legal issue is whether compensation is required when the landowner has economic use remaining on other portions of the property that are not subject to regulation.
Unconstitutional conditions. In Nollan v. California Coastal Commission,483 U.S. 825 (1987), the plaintiff owned a small, dilapidated beach house and wanted to tear it down and replace it with a larger home. However, the defendant was concerned about preserving the public's viewing access over the plaintiff's land from the public highway to the waterfront. Rather than preventing the construction outright, the defendant conditioned the plaintiff's right to build on the land upon the plaintiff giving the defendant a permanent, lateral beachfront easement over the plaintiff's land for the benefit of the public. Thus, the issue was whether the state could force the plaintiffs to choose between their construction permit and their lateral easement. The Court, held that this particular bargain was impermissible because the condition imposed (surrender of the easement) lacked a “nexus” with, or was unrelated to the legitimate interest used by the state to justify its actions - preserving the view. The Court later ruled similarly in Dolan v. Tigard, 512 U.S. 374 (1994). These cases hold that the government may not require a person to give up the constitutional right to receive just compensation when property is taken for a public use in exchange for a discretionary benefit that has little or no relationship to the property. The rule of the cases does not apply to situations involving impact fees and other permit conditions that do not involve physical invasions, but it would apply to monetary exactions where none of the plaintiff’s property is actually taken. See, e.g., Koontz v. St. Johns River Water Management District, 133 S. Ct. 2586 (2013).
Defining The Property At Issue
An important first question in non-physical takings cases is the definition of the boundaries of the subject property. How the property is defined will often determine whether a taking has occurred. For instance, if the government designates a portion of a farm field as a wetland that can no longer be farmed without civil and criminal penalties applying, is the property interest at issue that is subject to a takings analysis the wetland or the entire field? If it is defined as the wetland, then the regulatory designation would result in a severe burden on the landowner with a high likelihood that a compensable taking has occurred. If it is the entire field, then the overall burden on the landowner is much less.
On June 23, the Court decided Murr v. Wisconsin, No. 15-214, 2017 U.S. LEXIS 4046 (U.S. Sup. Ct. Jun. 23, 2017). In Murr, siblings owned two adjacent parcels of waterfront property. A zoning regulation that became effective in 1976, long before the siblings came into ownership of the tracts, designated the tracts as “substandard” – neither tract could be developed individually. But, a grandfather clause in the zoning law said that the tracts could be separately developed if they were owned by different owners and not owned (under a merger clause) in common by a group of owners (such as the siblings). The merger provision also prevented the siblings from selling one of the tracts without selling the other tract. That was the problem. They wanted to sell one of the tracts, and sued for a regulatory taking. The state trial court granted summary judgment to the state on the basis that the siblings still had options available for the use and enjoyment of their property and had not been deprived of all economic value of their property. Indeed, they could either develop or sell the two lots together. The court looked at the subject property as one single lot rather than two separate lots. The case was affirmed on appeal with the appellate court noting that the siblings bought the second tract a year after the first tract and being charged with the knowledge of the merger clause in the zoning law. The state (WI) Supreme Court denied review.
The U.S. Supreme Court affirmed in a 5-3 opinion authored by Justice Kennedy. The Court reasoned that the definition of the subject property, just like the takings analysis itself, is determined by a multi-factor analysis. That multi-factor test, according to Justice Kennedy, involves state law (including lot lines), reasonable expectations about ownership of the subject property, the land’s physical characteristics and the prospective value of the land with attention paid to the effect of the burdened land on the value of other holdings. As applied in Murr, the Court determined that the two tracts should be treated as a single tract for purposes of the takings analysis. That was primarily because state law treated the parcels as one as a result of the merger provision, the two tracts were contiguous, and the fact that they were oddly shaped with rough terrain and bordered a river made land-use regulations foreseeable.
The Court determined that a taking had not occurred. The dissent was critical of the new test for determining what constitutes the subject property in a takings case, arguing that the test was “stacked” in the government’s favor.
The definition of property for purposes of takings analysis is the key starting point in non-physical takings cases. In addition, for rural landowners, “property” may also include more than just the surface estate. See, e.g., The Edwards Aquifer Authority, et al. v. Day, et al., 369 S.W.3d 814 (Tex. Sup. Ct. 2012). How do the “Kennedy Conditions” apply in situations where the surface estate is regulated, but the sub-surface estate is not (or vice versa)? In one case, the plaintiffs owned oil and gas rights in west central Michigan. In 1987, the director of the State Department of Natural Resources prohibited exploration for or development of oil and gas on the bulk of the plaintiff's property. The state appellate court focused solely on the landowner's use of the mineral interests involved to hold that the plaintiff's property had been taken. Even though a non-mineral interest land use possibility remained, the court held that the landowners were denied all economically viable use of the mineral interest. The court found it immaterial that all but one of the plaintiffs had extensive landholdings outside of the protected area. Miller Brothers v. Michigan Department of Natural Resources, 203 Mich. App. 674, 513 N.W.2d 217 (1994)
The new test of Murr will make regulatory takings cases more complex and legal outcomes more unpredictable. The “Kennedy Conditions” could work in favor of a landowner, but are more likely to do just the opposite. It was also Justice Kennedy’s concurring opinion in Rapanos, et ux., et al. v. United States Army Corps of Engineers, 126 S. Ct. 2208 (2006) that has created tremendous confusion for the lower courts and injected a high degree of uncertainty into the law with respect to the federal government’s jurisdiction over isolated wetlands under the Clean Water Act.
Kennedy’s opinion in Murr again appears to be judicial micro-management, making meaningful the comment of Justice Thomas in the dissent about the need to take a “fresh look” at takings cases and whether the Court’s current analytical approach squares with the Constitution’s “original public meaning.”
Friday, June 23, 2017
Many farmers sell their products through a marketing cooperative of which they are likely to be a member. As a member, they have stock ownership in the cooperative, and typically must buy the right to market certain units of production from their farming business. Along with that right also comes (in most instances) a requirement that the farmer deliver those units of production on an annual basis.
In these situations, the cooperative will annually pay its members a “value-added” which represents the excess amount the cooperative received for a commodity from members over what it paid for the commodity. That raises tax issues associated with how the farmer should report the payment? Is it subject to self-employment tax? What if the grain delivered to the cooperative came from a landlord’s share of the crop under a lease?
The tax issues associated with value-added payments from a cooperative. That’s today’s topic.
The Self-Employment Tax Issue
In recent years, the self- employment tax issue has arisen with respect to payments received by individuals from closed cooperatives, such as local ethanol-production plants. In the typical scenario, an individual subscribes to ownership units that require the individual either to deliver bushels of grain grown on the individual’s farm or to purchase an equivalent amount for delivery to the cooperative. At the end of the production year, the individual receives a “value-added payment” for a share of the cooperative’s profit.
Clearly, the value-added payment is ordinary income to the recipient, but the question remains as to whether the payment is also subject to self-employment tax. In addition to income tax, a tax of 15.3 percent is imposed on the self-employment income of every individual. Self-employment income is defined as “net earnings from self-employment.” The term “net earnings from self-employment” is defined as gross income derived by an individual from a trade or business that the individual conducts. I.R.C. §1402. In general, income derived from real estate rents (and personal property leased with real estate) is not subject to self-employment tax unless the arrangement involves an agreement between a landowner or tenant and another party providing for the production of an agricultural commodity and the landowner or tenant materially participates. I.R.C. §§1402(a)(1) and 1402(a)(1)(A). For rental situations not involving the production of agricultural commodities where the taxpayer materially participates, rental income is subject to self-employment tax if the operation constitutes a trade or business “carried on by such individual.” Similarly, an individual rendering services is subject to self-employment tax if the activity rises to the level of a trade or business. In general, to be subject to self-employment tax, an activity must be engaged in on a substantial basis with continuity and regularity.
In 1996, the IRS ruled that the value-added payments represented a part of the recipient’s farming business and were, therefore, subject to self-employment tax. Tech. Adv. Memo. 9652007 (Aug. 30, 1996). Under the facts of the ruling, the taxpayer was a grain grower that was obligated to deliver stated quantities of grain to the cooperative for processing three times annually. The farmer could satisfy the obligation by delivering grain grown on the farm, by delivering “pooled” grain maintained by the cooperative, or by delivering grain purchased from other growers. For the most part, the taxpayer satisfied his obligation by delivering grain grown by others. Grain that was grown on the farm was primarily used as livestock feed. Indeed, the taxpayer stated that “except for one year, all of the raised grain was fed to the taxpayer’s livestock and he had not raised sufficient amounts of grain to provide a full year’s supply of grain for the livestock. Consequently, the farmer purchased grain from other local farmers to feed the livestock. While the farmer indicated that he joined the cooperative as an investor with the intent of purchasing the grain that he would need to deliver to the cooperative rather than producing it on his own farm, the IRS determined that the value-added payments to the farmer were subject to self-employment tax because he remained an active farmer.
In Hansen v. Commissioner, T.C. Sum. Op. 1998-91, the taxpayer had retired from active farming in 1990. In 1993 (the year at issue), the taxpayer received $12,052 in value-added payments. The taxpayer reported the payments as farm rental income, not subject to self-employment taxes, on Form 4835 attached to the taxpayer’s 1993 return. The IRS determined that the value-added payments constituted Schedule F farm income and thereby subjected the payments to self-employment tax. While the taxpayer maintained that the value-added payments were not subject to self-employment tax because the taxpayer did not personally participate in the trade or business of growing corn or processing corn during 1993, the IRS argued that the cooperative’s corn processing activity was attributable to the taxpayer for the purpose of determining whether the taxpayer was engaged in a trade or business.
The Tax Court disagreed with the IRS’s position, noting instead that the taxpayer’s relationship with the cooperative ceased to be a principal-agent relationship as of the date the taxpayer retired from the trade or business of growing corn. In addition, the Tax Court concluded that the cooperative’s activity was not attributable to the taxpayer as a member of a partnership because a cooperative is an incorporated organization which is not considered a partnership. In April, 1999, the Chief Counsel of IRS announced a change in litigating position concerning value-added payments and self-employment tax, conceding to the Tax Court’s decision in Hansen. IRS Notice (36)000-3, Apr. 21, 1999.
In Bot v. Comm’r., 118 T.C. 138 (2002), aff’d, 353 F.3d 595 (8th Cir. 2003), a retired farmer and his wife (who were members of a value-added cooperative which also required the delivery of corn) were operating under a crop-share lease with their sons as tenants. The court held that the value-added payments the farmer and his wife received from the cooperative were subject to self-employment tax. The court noted that Hansen could not be cited as precedent and held that the taxpayers were engaged in the trade or business of producing, marketing and selling corn and corn products in relationship with the cooperative. The court determined that, inasmuch as the value-added payments were directly related to the volume of corn delivered to the cooperative, the value-added payments had a direct nexus to their trade or business and must be included in self-employment income. The court reached its conclusion in light of the involvement by the taxpayers in the operation and the involvement of their sons. However, since 1974, imputation of activities by an agent to a principal as a property owner under a lease (and involving the production of agricultural or horticultural commodities) has been barred for purposes of self-employment tax liability. In the case, the only apparent business relationship of the taxpayers and their sons was through the crop-share lease. On that basis, the court’s opinion is inconsistent with the statute. But, even without imputing the sons’ activities, the taxpayers might have been sufficiently involved in the business for self-employment tax to apply. See also Fultz v. Comm’r, T.C. Memo. 2005-45 and Fultz v. Comm’r, T.C. Memo. 2005-46 in which the Tax Court followed its earlier opinion in Bot.
Thus, for individuals who are members of cooperatives that require the members to buy equity shares and to deliver an amount of grain based on the number of equity shares purchased, any payment received by the member for the value added to the grain during processing is subject to self-employment tax if the member is an active farmer. The value-added payment received as a patronage distribution would be reported on lines 3a and 3b of Schedule F (Form 1040). It is ordinary income subject to self-employment tax. The same reporting result is reached if the farmer is a landlord under a material participation crop-share lease who satisfies the delivery obligation out of grain produced under the lease.
For members of such cooperatives that serve as landlords pursuant to a cash lease where the cash rent is reported on Schedule E, or a non-material participation crop share or livestock lease with minimal involvement by the landlord (where the rent is reported on Form 4835), the value-added payments should not be subject to self-employment tax. If a member is retired at the time the member subscribes to ownership units in the cooperative and satisfies the member’s obligation to the cooperative solely with pooled grain, the value-added payments represent investment income and are not subject to self-employment tax. However, Bot makes it clear that retired members of value-added cooperatives need to watch their involvement under the arrangement with the cooperative if self-employment tax is to be avoided. To avoid a CP-2000 Notice from the IRS in this situation, the distribution could be reported on Schedule F so that the IRS computer gets a match, and then an offsetting deduction could be taken.
The self-employment tax issue reaches many areas for agricultural producers. Cooperative value-added payments creates a self-employment tax issue for farmers, but the basic principles still apply.
Wednesday, June 21, 2017
One issue that I occasionally receive questions on concerns liability for animal disease. The questions can take several forms, including diseased animals of the owner as well as another person’s diseased animals that cause an infection.
Given that animal disease can result in significant economic loss, the liability question is an important one. Today’s post takes a brief look at the issue.
Trespassing or Straying Animals
If an owner of diseased animals knows of an infection and knows that it would be communicated to other animals if contracted, some states hold the owner liable for damages caused by transmission of the disease. Knowledge that the animals were infected is typically an essential element. Once the animals' owner has knowledge of the disease, the owner is under a duty to take reasonable steps to ensure that the animals do not come into contact with healthy, uninfected livestock of anyone else. Knowledge that the animals were infected is typically an essential element. Several states, by statute, require restraint of animals that are known to have an infectious or contagious disease from running at large or coming into contact with other animals. These statutes have been enacted by the major livestock producing states.
The injured party may be barred from recovering damages if the complaining party is contributorily negligent. Knowledge that animals running at large were infected coupled with the complainant's failure to attempt to prevent the infected animal from coming in contact with the complainant's own animals may preclude recovery. Moreover, allowing infected animals to remain on the complaining party's premises after being aware of their diseased condition may be a bar to damages.
Landlord's Duty Regarding Diseased Premises
Sometimes questions arise concerning a landlord's liability for diseased or contaminated premises when a tenant brings healthy animals to the premises. In most jurisdictions, the liability of the landlord depends largely upon the landlord's deceit to the tenant concerning the past presence of disease on the premises. Thus, if a tenant has healthy animals and brings those animals onto the landlord's diseased or contaminated premises and the animals become diseased themselves, it will be difficult for the tenant to recover against the landlord. Failure to disclose the diseased condition of the leased premises is usually not a basis for action. Instead, actual deceit is required. Therefore, if the tenant fails to ask whether the premises are disease or contamination free, the landlord is under no duty to disclose that fact to the tenant. However, if the tenant asks and the landlord responds less than fully or less than truthfully, actual deceit may be present and provide the tenant a basis for recovery. See, e.g., Wilcox v. Cappel, No. A-95-798, 1996 Neb. App. LEXIS 243 (Neb. Ct. App. Dec. 3, 1996).
For farm tenants that claim that the landlord’s premises caused damage to the tenant’s animals, the law is fairly clear. As a prerequisite for recovering damages against a landlord arising from defects in the leased premises, the tenant should make a thorough inspection of the property and ask questions. It is also a really good idea to reduce the lease agreement to writing and include in the lease a provision that specifies which party is liable for damages resulting from disease or contamination.
Disposal of Animal Carcasses
All states have statutory requirements that must be satisfied in order to properly dispose of a dead animal. In most states, disposal must occur within 24 hours after death. By statute, states typically acknowledge that disposal may be by burying, burning or feeding the carcass to other livestock. The option of feeding the carcass to other livestock is typically only available if the animal did not die of a contagious disease. Disposal is also usually available to a licensed rendering company. The typical state statute requires direct delivery to the point of disposal with an exception often made for stops to load additional carcasses. Vehicles used to transport the carcass of an animal typically must be lined or other measures taken to prevent any leakage of liquid, and must be disinfected after each transport.
Most states prohibit certain methods of dead animal disposal. For instance, placing the carcass of dead animal in a water course or roadway is a misdemeanor in many states. Similarly, knowingly allowing a carcass to remain in such an area is also typically a misdemeanor. But, in most jurisdictions, cattle and horse carcasses may be moved from one farm to another if they are not diseased.
Animal diseases are a natural aspect of livestock production activities. Knowing the liability issues that might arise is an important aspect of livestock risk management.
Monday, June 19, 2017
The like-kind exchange rules of I.R.C. §1031 have restrictions that can apply when related parties are involved. One of those restrictions is a two-year rule. The rule applies when related parties engage in an exchange, and results in the tax-deferred benefit of the transaction being lost if the property exchanged of is disposed of within two years.
So, who are “related parties” for purposes of the two-year rule? Can the related party rules create an issue with an estate plan? For instance, if an estate plan for a married couple establishes a trust for the surviving spouse with the surviving spouse receiving the income from trust property for life and the remainder passing to the children, will the children be able to exchange their interests so that at least one child can receive money for their interest without triggering immediate gain?
Today’s post takes a look at the related party rules in the context of like-kind exchanges and the potential impact on traditional estate plans.
Related Party Rules
General rule. Under I.R.C. §1031(a)(1), no gain or loss is recognized on the exchange of property that is held for productive use in a trade or business or for investment if the property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment. If the exchange occurs between “related parties,” a two-year rule applies. I.R.C. §1031(f)(1)(C). Under that rule, non-recognition treatment is lost if the related party with which like-kind property is exchanged disposes of the property within two years of the exchange. I.R.C. §1031(f)(1)(A)-(C). The two-year holding period starts running on the date of the transfer or conveyance of the last property involved in the exchange.
Exceptions. There are exceptions to the two-year rule for: (1) transfers that occur after the taxpayer’s death or the related party’s death; (2) transfers that occur due to an involuntary conversion, and; (3) transfers that do not involve tax avoidance as the purpose of the transfer. I.R.C. §1031(f)(2). There is also a “suspension” provision in I.R.C. §1031(g). Under that provision, the two-year holding period is suspended if either the taxpayer’s or the related party’s risk of loss is substantially decreased (due to an option, put, short sale or other transaction). Once the risk of loss ceases, the two-year period continues from the point where it stopped.
Definition of “related parties.” I.R.C. §1031(f)(3) defines “related party” by routing the answer through I.R.C. §§267(b) or 707(b)(1). Under those provisions, related persons to the taxpayer are:
- Brothers and sisters (whether whole or half-blood)
- The taxpayer’s spouse, ancestors, lineal descendants
- Certain types of entity relationships – a corporation, limited liability company or partnership and a person that owns (directly or indirectly) more than 50 percent of the stock, membership interests or partnership interests or more that 50 percent of the capital interests or profits interests, and two partnerships in which the same persons owns (directly or indirectly) more than 50 percent of the capital or profits interests
- Two entities in which the same individuals own directly or indirectly more than 50 percent of each entity
- An estate in which the taxpayer is either the executor or beneficiary of the estate
- A trust in which the taxpayer is the fiduciary and the related party is a beneficiary either of that trust or a related trust or a fiduciary of a related trust
Related parties, however, do not include step-parents, uncles, aunts, in-laws, cousins, nephews, nieces and ex-spouses.
Related Party Scenarios
It is possible for a taxpayer to relinquish property to a related party and acquire like-kind replacement property from a non-related party without violating the I.R.C. §1031 exchange related party rules. The related parties must each hold their respective properties for a minimum of two years. The deferral rules also apply when property is acquired from a related party and the related party then completes a separate tax-deferred exchange transaction using the sales proceeds from the sale of the related party's property that was received in the initial exchange.
Related party transactions will also be respected if a “basis swap” is not involved. See, e.g., Priv. Ltr. Rul. 200810016 (Dec. 6, 2007).
The exchange of interests in real estate among related parties can also qualify under the rules. In Rev. Rul. 73-476,9 IRS ruled that exchanges of undivided interests in multiple parcels of real estate for 100 percent ownership of one or more parcels of the same real estate qualify as valid like-kind exchanges. In addition, IRS has also ruled that an exchange of partial interests in two parcels of property between related persons, followed by the sale of one of the parcels to an unrelated party within two years, qualified for non-recognition of gain. Priv. Ltr. Rul. 200730002 (April 26, 2007).
Estate Planning Implications
The related party rules can apply after the implementation of common estate plans. For example, assume that Jimmy owns farmland that he transfers to a trust for his wife, Beulah. The trust terms specify that if Beulah survives Jimmy, she is to receive the income from the farmland for life with the farmland passing upon her death to their three children equally. Beulah survives Jimmy, and on her subsequent death the farmland is transferred to the children with each child owning an undivided one-third interest in the farmland as tenants in common. Each of the children then deeds their respective undivided interests to their own grantor trust. One child farms his undivided one-third interest that is held in his trust, and also serves as a co-trustee of his trust. One child dies, and her undivided one-third interest remained in her trust with the trust income payable to her surviving spouse for life and the remainder interest passing to her children (nieces and nephews of her siblings). The third child continues to hold his undivided one-third interest in trust and farms with it.
Thus, after the one child’s death, the ownership of the farmland is as follows: (1) a one-third undivided interest by a farming child held via his trust; (2) a one-third undivided interest held in trust by another farming child; and (3) a one-third undivided interest in trust split equally among the children of the deceased child subject to a life income interest in that child’s surviving spouse. The co-trustees of this last trust were the deceased child’s surviving spouse and their two children. They have no care for the farmland, and would like to liquidate their one-third ownership interest in the farmland. The two sons of Jimmy and Beulah wish to continue farming the land that they hold in their trusts.
After visiting with their legal and tax counsel to determine a way to allow the two sons to continue farming and allow their niece and nephew to liquidate their interest, and do so in a tax efficient manner, a solution is proposed. The solution is to have the three trusts exchange each of their undivided one-third interests in the farmland for 100 percent fee simple (outright ownership) interests in the same farmland. The exchange will be based on surveys and appraisals that will result in a three-way split of equal value. There will be no liabilities assumed, and none of the trusts will receive money or other property in the exchange. The exchange will be straight-up. The only difference among the trusts is that the one-third farmland interest in the deceased daughter’s trust will have a higher income tax basis because of her death and the resulting step-up in basis to fair market value at that time. After the exchange, the daughter’s trust will sell its parcel to a third party for cash, and the two sons of Jimmy and Beulah will continue to farm their tracts.
The IRS has blessed this type of a scenario. In PLRs 200919027 (Feb. 3, 2009) and 200920032 (Feb. 3, 2009), the IRS said that the related party rule of I.R.C. §1031(f) didn’t apply and the gain from the sale by the niece and nephew of their parcel within two years of the exchange was deferrable. The two sons were not related parties to their sister’s trust or its trustees (her surviving spouse and children). The related party rule would apply, however, if either of the two brothers would sell their respective tracts within two years of the initial exchange.
The related party rules are important provisions in like-kind exchange transactions. With respect to real estate swaps, proper estate planning techniques can be utilized to achieve the desired result. The use of a like-kind exchange in a situation such as that presented above is a much better solution than a partition and sale of the property. It’s one way to get cash into the hands of a non-farm heir without disrupting the farming operation, and doing so on a tax-deferred basis.
Thursday, June 15, 2017
Tuesday’s post started the discussion of how farm program payment limitation rules can impact the estate and business planning for a farmer. That post discussed the basics of the provisions under the 2014 Farm Bill, and discussed PLC and ARC, the overall payment limit, the AGI limitation and the attribution rule.
Today, we dig deeper and examine the “active personal management” rule, recordkeeping requirements and how the rules impact the planning process.
Keep in mind, this is an overview of a very technical subject. Make sure to find counsel that deals with farm programs so that you can properly integrate payment limitation planning into the overall estate and business plan. I am often asked for recommendations of practitioners that have a good grasp of the payment limitation rule that can work with their tax counsel to put an effective plan together. One person I would suggest that may also know others that I am not aware of is Bill Bridgforth in Pine Bluff, Arkansas. He's a good friend that is easy to work with and has a great deal of experience with the payment limitation rules.
Active Personal Management
Three-part test for "active engagement." Under 7 C.F.R. Part 1400, a person must be “actively engaged” in farming to receive farm program payments. To satisfy the “actively engaged in farming” test, three conditions must be met. First, the individual's or entity's share of profits or losses from the farming operation must be commensurate with the individual's or entity's contribution to the operation. Second, the individual's or entity's contributions must be “at risk.” Third, an individual must make a significant contribution of land, capital or equipment, and active personal labor or active personal management.
What is "management“? Active personal management” is defined as significant contributions of management activities that are performed on a regular, continuous and substantial basis to the farming operation – basically the I.R.C. §1402 test for self-employment tax purposes. In addition, the management activities must represent at least 25 percent of the total management time that is necessary for the success of the farming operation on an annual basis, or represent at least 500 hours of specific management activities annually. That is a more defined test for active management than was contained under the previous Farm Bill, which required that the management be “critical to the overall profitability of the farming operation.”
How many "person" determinations can be achieved? The rules also restrict the number of persons that may qualify for payment by making a significant contribution of active personal management. For this purpose, the limit is one person unless the farming operation is large or complex. A "large" farming operation is one that has crops on more than 2,500 acres (planted or prevented from being planted). If the acreage limitation is satisfied, an additional person may qualify upon making a significant contribution of active personal management. If the farming operation satisfies another test of being “complex,” an additional payment limit may be available. This all means that, for large and complex, farming operations, a total of three payment limits may be obtained. Who decides whether a farming operation is "complex"? That determination is made by the State FSA Committee. These rules establish a more restrictive test than was in place before the 2014 Farm Bill became effective. The prior rules did not limit the number of persons that could qualify for farm program payments via the significant contribution of active personal management route. Now, the maximum potential limit is three.
Special rules. Special rules apply to tenant-operated farms and family-owned operations with multiple owners. In some situations, a person meeting specified requirements is considered to be actively engaged in farming in any event. For example, a crop-share or livestock-share landlord who provides capital, equipment or land as well as personal labor, or active personal management meets the test. But, neither a cash rent landlord nor a crop share landlord is actively engaged in farming if the rent amount is guaranteed. Also, if one spouse meets the active engagement test, the other spouse is deemed to meet the test.
Exemption for family operations. The active personal management test applies to non-family general partnerships and joint operations that seek to qualify more than one farm manager based solely on providing management or a combination of management and labor (another rule). However, it does not apply to farming operations where all of the partners, stockholders or persons with an ownership interest in the farming operation (or any entity that is a member of the farming operation) are “family members.” For this purpose, “family member” means a person to whom another member in the farming operation is related as a lineal ancestor, lineal descendant, sibling, spouse or otherwise by marriage. Legally adopted children and step-children count as “family members.”
The rule also doesn’t come into play where only one person attempts to qualify under the rule or when combined with a contribution of labor. The rule also doesn't apply to farming operations that are operated by individuals or entities other than general partnerships or joint ventures.
When multiple payments are sought for a farming operation under the active management rule, the operation must maintain contemporaneous records or logs for all persons that make any contribution of management. Those records must include, at a minimum, the location where the management activity was performed, and the amount of time put into the activity and its duration. In addition, every legal entity that receives farm program payments must report to the local FSA committee the name and social security number of each person who owns, either directly or indirectly, any interest in the entity. Also, the entity must inform its members of the payment limitation rules.
The FSA Handbook (5-PL, Amendment 3) specifies that the farming operation must maintain contemporaneous records or logs for all persons that make management contributions. The records must provide: (1) the location (either on-site or remote) where the management activity was performed; (2) the time spent on the activity and the timeframe in which it occurred; and (3) a description of the activity. FSA Handbook, Paragraph 222A. It is important that the records be maintained and be timely made available to the FSA for their review upon request. FSA Handbook, Paragraph 222B. Fortunately, the FSA provides a Form (CCC-902 MR) to track and maintain all of the necessary information. Note that these are the present references to the applicable FSA Handbook Paragraphs and Form. Those paragraph references and Form number can change. FSA modifies its handbook frequently and Forms are modified and numbers often are changed. Practitioners and their farm clients must be diligent in monitoring the changes.
Two things happen if the necessary records aren’t maintained – (1) the person’s contribution of active personal management for payment eligibility purposes will be disregarded; and (2) the person’s payment eligibility status will be re-determined for that particular program year.
The “substantive change” rule. In general, any structural change of the farming or ranching business that increases the number of payment limits must be bona fida and substantive and not a “scheme or device.” See, e.g., Val Farms v. Espy, 29 F.3d 1570 (10th Cir. 1994). In addition, reliance on the advice of local or state USDA officials concerning the payment limitation rules is at the farmer or rancher's own risk. But, the substantive change rule does not apply to spouses. Thus, for example, a spouse of a partner that is providing active management to a farm partnership can be added to the partnership and automatically qualify as a partnership member for FSA purposes. However, a “substantive change occurs when a “family member” is added to a partnership unless the family member also provides management or labor.
"Scheme or device." The USDA is adept at alleging that a farming operation has engaged in a "scheme or device" that have the purpose or effect of evading the payment limitation rules. But, this potential problem can be avoided if multiple payments are not sought, such as by having one manager for each entity engaged in farming. Of course, this is not a concern if all of the members of a multi-person partnership are family members. If non-family members are part of the farming operation, perhaps they can farm individually or with other non-family members that can provide labor to the farming business. That might be a safe approach.
"Combination" rule. There is also a “combination” rule that can apply when the farming business is restructured. If the rule applies, it will result in the denial of separate “person” status to “persons” who would otherwise be eligible for a separate limit.
Entity type based on size. From an FSA entity planning standpoint, the type of entity structure utilized to maximize payment limits will depend on the size/income of the operation.
For smaller producers, entity choice for FSA purposes is largely irrelevant. Given that the limitation is $125,000 and that payments are made either based on price or revenue (according to various formulas), current economic conditions in agriculture indicate that most Midwestern farms would have to farm somewhere between 3,000 and 4,000 acres before the $125,000 payment limit would be reached. Thus, for smaller producers, the payment limit is not likely to apply and the manner in which the farming business is structured is not a factor.
For larger operations, the general partnership or joint venture form is likely to be ideal for FSA purposes. If creditor protection or limited liability is desired, the partnership could be made up of single-member LLCs. For further tax benefits, the general partnership’s partners could consist of manager-manager LLCs with bifurcated interests.
Farm program payment limitation planning is a complicated mix of regulatory and administrative rules and tax/entity planning. It’s not an area that a producer should engage in without counsel if maximizing payments in conjunction with an estate/business plan is the goal. Unfortunately, only a few practitioners are adept at navigating both the tax planning rules and the FSA regulatory web.
Tuesday, June 13, 2017
A unique aspect of estate planning for farmers and ranchers is the need to incorporate (for many of these clients) farm program payment limitation planning into the mix. The way the farming or ranching business is structured can impact eligibility for farm program benefits.
So, what are the essential farm program rules that impact the planning/structuring process? That’s our focus this week. Today is part one of the two-part series
2014 Farm Bill
Primary programs. Under the 2014 Farm Bill, the total amount of payments received, directly and indirectly, by a person or legal entity (except joint ventures or general partnerships) for Price Loss Coverage (PLC) Agricultural Risk Coverage (ARC), marketing loan gains, and loan deficiency payments (other than for peanuts), may not exceed $125,000 per crop year. A person or legal entity that receives payments for peanuts has a separate $125,000 payment limitation ($250,000 for married persons). Cotton transition payments are limited to $40,000 per year. For the livestock disaster programs, a total $125,000 annual limitation applies for payments under the Livestock Indemnity Program, the Livestock Forage Program, and the Emergency Assistance for Livestock, Honey Bees and Farm-Raised Fish program. A separate $125,000 annual limitation applies to payments under the Tree Assistance Program.
Beginning in 2014, farmers were given a one-time opportunity to elect PLC or ARC for the 2014-2018 crop years. If an election was not made, PLC applied beginning in 2015 with no payment available for 2014. If ARC was elected, all producers with respect to a farm had to sign the election form. If PLC was elected, the owners of the farm had an option to update their yields to 90 percent of their average yields from 2008-2012. All farm owners also could elect to reallocate their base acres based on the actual plantings for 2009-2012.
PLC and ARC. The PLC option works in tandem with a crop insurance Supplemental Coverage Option (SCO). It is a risk management tool that is designed to address significant, multiple-year price declines. It compliments crop insurance, which is not designed to cover multiple-year price declines. A farmer that chooses the PLC option will receive a payment (consistent with payment limitations) when the effective price of a covered commodity is less than the target (“reference”) price for that commodity established in the statute (e.g., the target price for corn is $3.70/bu). The effective price is the higher of the mid-season price or the national average loan rate for the covered commodity. Thus, the PLC payment rate is the reference price less the effective price, and the PLC payment amount is the payment rate times the payment acres. Putting it another way, the PLC payment is equal to 85 percent of the base acres of the covered commodity times the difference between the target price and the effective price times the program payment yield for the covered commodity. SCO provides additional county-level insurance coverage not to exceed the difference between 86 percent and the coverage level in the individual insurance policy. Because SCO is a form of crop insurance, payment limits do not apply. But, a farmer selecting the PLC option must pay an additional premium for SCO coverage (but, the cost of the additional premium is 65 percent taxpayer subsidized).
ARC is a risk management tool that addresses revenue losses. Under the ARC, payments are issued when the actual county crop revenue of a covered commodity is less than the ARC county guarantee for the covered commodity and are based on county data, not farm data. A producer electing ARC must unanimously select whether to receive county-wide coverage on a commodity-by-commodity basis or choose individual coverage that applies to all of the commodities on the farm. Payment acres are 85 percent of base acres for county coverage, and 65 percent for individual farm coverage. Under ARC, a producer must incur at least a 14 percent loss (defined as 86 percent of benchmark revenue) for coverage to kick-in. The ARC county guarantee equals 86 percent of the previous five-year average national farm price, excluding the years with the highest and lowest price (the ARC guarantee price), times the five-year average county yield, excluding the years with the highest and lowest yield (the ARC county guarantee yield). This guarantee revenue is based on five-year Olympic production and average crop price excluding the high and low years. Both the guarantee and actual revenue are computed using base acres, not planted acres. The payment is equal to 85 percent of the base acres (this is for county-elected ARC) of the covered commodity times the difference between the county guarantee and the actual county crop revenue for the covered commodity, not to exceed 10 percent of the benchmark county revenue (the ARC guarantee price times the ARC county guarantee yield). In other words, if revenue is less than 76 percent of the previous five-year average national farm price, then the maximum 10 percent of benchmark revenue is paid, subject to the payment limit of $125,000 per person.
For 2014 and 2015 crops, ARC was more likely to result in a payment to a producer because of the higher Olympic average. But, it is now less likely to make a payment in for 2016-2018 crops due to low crop prices. If prices remain low, PLC will result in a payment. The choice for any given producer will be different (there is no “one size fits all” with respect to the election) and ARC may be desired with respect to one crop and PLC may be best for another crop, for example. In general, the bigger margin between expected prices and reference prices, the more likely it is that a producer would choose ARC. However, the ARC and PLC was an irrevocable election and whatever the producer elected in 2014 will apply through the 2018 crop year. The only way to make a new election is by having acres come out of CRP that are then put back into production.
Payments for PLC and ARC are issued after the end of the respective crop year, but not before Oct. 1. Thus, the 2016 crop payment will not be made until after October 1, 2017. That means that no payments will be received in 2016, other than for ACRE or other related payments that are normally paid after the crop year. In 2017, producers enrolled in the PLC who also participate in the federal crop insurance program may choose whether to purchase SCO.
From a practical/procedural standpoint, because a payment (if any) will not be issued until at or near the end of the producer’s marketing year, lenders could have a more difficult time determining a producer’s cash flow for crop loans.
Monetary limit. As previously noted, the Farm Bill established a payment limit of $125,000 per person or legal entity (excluding general partnerships and joint ventures). This is the general rule. Peanut growers are allowed an additional $125,000 payment limitation, and the spouse of a farmer is entitled to an additional $125,000 payment limit if the spouse is enrolled at the local Farm Service Agency (FSA) office. The limit applies to all PLC, ARC, marketing loan gains, and loan deficiency payments.
The payment limit is applied at both the entity level (for entities that limit liability) and then the individual level (up to four levels of ownership). Thus, general partnerships and joint ventures have no payment limits. Instead, the payment limit is calculated at the individual level. However, an entity that limits the liability of its shareholders/members is limited to one payment limitation. That means that the single payment limit is then split equally between the shareholders/members.
AGI limitation. To be eligible for a payment limit, an adjusted gross income (AGI) limitation must not be exceeded. That limitation is $900,000, and applies to commodity programs, conservation programs and disaster programs. The AGI limitation is an average of the three prior years, with a one-year delay. In other words, farm program payments received in 2017 are based off of the average of AGI for 2013, 2014 and 2015. While FSA had not treated the I.R.C. §179 deduction as allowed against AGI for S corporations and LLC’s taxed as partnerships, but did allow it for C corporations and individuals, beginning with 2017 crop year the deduction will be allowed against AGI for all entities.
The AGI limitation, which does not apply for crop insurance purposes, applies to both the entity and the owners of the entity, as illustrated in the following example:
Example. Assume that FarmCo receives $100,000 of farm program payments in 2015. FarmCo’s AGI is $850,000. Thus, FarmCo is entitled to a full payment limitation. But, if one of FarmCo’s owners has AGI that exceeds the $900,000 threshold, a portion of FarmCo’s payment limit will be disallowed in proportion to that shareholder’s percentage ownership. So, if the shareholder with income exceeding the $900,000 threshold owns 25 percent of FarmCo, FarmCo’s $100,000 of farm program payment benefits will be reduced by $25,000.
Attribution Rule. Under a rule of direct attribution, individuals and entities are credited with both the amount of payments received directly and also the amount received indirectly by holding an interest in an entity receiving payment. In general, payments to a legal entity are attributed to the persons who have a direct or indirect interest in the legal entity. But, payments made to a joint venture or general partnership are determined by multiplying the maximum payment amount by the number of persons and entities holding ownership interests in the joint venture or general partnership. That means that joint ventures and partnerships are not subject to the attribution rules.
Program payments to legal entities are tracked through four levels of ownership. If another legal entity owns any part of the ownership interest at the fourth level, then the payments to the entity receiving payments will be reduced by the amount of the indirect interest. Thus, the entity has a limitation, and then each member has a limitation. The measuring date for purposes of direct attribution is June 1.
As applied to marketing cooperatives, the attribution rules apply to the producers as persons, and not to the cooperative association of producers. Also, children under age 18 are treated the same as the parents. It is also assumed that if one parent has filled their payment limit, payments made to a child could be attributed to the parent that has not filled their payment limit. For payments made to a revocable trust, they are attributed to the trust’s grantor. As applied to irrevocable trusts and estates, the Ag Secretary is directed to administer the rules so as to ensure "equitable treatment" of the beneficiaries.
In the next post, I will take a look at the payment limitation rules. That will include a discussion of the “active personal management” test, recordkeeping requirements and entity planning implications. Farm program payment limitation planning certainly complicates estate and business planning for farmers.
Friday, June 9, 2017
When financial and economic conditions sour, one of the issues that can come up concerns the ability to collect on debts. Agriculture has been through some difficult times for the past few years, and the occurrence of bad debts has been on the rise. Ag retail businesses are experiencing tougher credit relations with farm clients.
What does it take to be able to deduct a bad debt? Is there a difference in the tax of a business bad debt or a non-business bad debt? What if a parent guarantees the debt of a child? How do bad debts get reported? Today’s post examines the basic rules that come into play when dealing with a creditor that doesn’t pay.
Elements Necessary For Deductibility
Debtor-creditor relationship. An income tax deduction is allowed for debts which become worthless within the taxable year. For a bad debt to be deductible, there must be a debtor-creditor relationship involving a legal obligation to pay a fixed sum of money. See, e.g., Meier v. Comm’r, T.C. Memo. 2003-94. A bad debt deduction may be claimed only if there is an actual loss of money or the taxpayer has reported the amount as income. It can’t be claimed if the taxpayer doesn’t have any records or activity to establish that the money transferred created an enforceable loan to her son entered into for profit. That’s a key point with many farming operations and loans between family members. See, e.g., Vaughters v. Comr., T.C. Memo. 1988-276. It’s critical to properly document the arrangement.
A debt may be totally or partially worthless. A debt is a totally worthless bad debt if the taxpayer is unable to collect what is still owed even though some of the debt had been collected in the past. The amount remaining to be paid is eligible for a bad debt deduction. Factors indicating total worthlessness include the debtor being in a serious financial position, insolvency, lack of assets, ill health, or bankruptcy.
Establishing worthlessness. To be deductible, the debt must be proved to be worthless with reasonable steps taken to collect the debt. Bankruptcy is generally good evidence that at least part of the debt is worthless, but the debtor’s technical insolvency may not be. The debtor’s technical insolvency is not enough to conclude that a debt is worthless. O’Neal Feeder Supply, Inc., v. United States, No. 2:96 CV 0514, 2017 U.S. Dist. LEXIS 1085 (W.D. La. 2000). But, it is not necessary to resort to legal action if it can be shown that a judgment would not be collectible.
Claiming a Bad Debt Deduction
A deduction may only be claimed in the year a debt becomes worthless – when there is no longer any change it will be paid. It is not necessary to wait until the debt is due to determine its worthlessness. But, if a taxpayer recovers a bad debt or part of a bad debt that was allowed as a deduction in a prior year, it is includible in gross income in the year of recovery. The amount of the deduction is the taxpayer’s adjusted basis in the debt.
Business and Nonbusiness Bad Debts
Bad debts may be business bad debts or nonbusiness bad debts, except that corporations have only business bad debts. Business bad debts are deducted directly from gross income while a nonbusiness bad debt of a non-corporate taxpayer is reported as a short-term capital loss when it becomes totally worthless.
A business bad debt relates to operating a trade or business and is mainly the result of credit sales to customers or loans to suppliers, clients, employers or distributors. A bad debt deduction may be taken for accounts and notes receivable only if the amount had been included in gross income for the current or prior taxable year. While this largely limits bad debt deductions to accrual-basis taxpayers, a business bad debt deduction for a cash basis taxpayer is possible. For example, a business loan may go sour and the obligation may become worthless. A business bad debt is one that is incurred in the taxpayer's trade or business. In money lending situations, the business of the taxpayer must be lending money.
Nonbusiness bad debts are bad debts not acquired or created in the course of operating the taxpayer's a trade or business, or a debt the loss from the worthlessness of which is not incurred in the taxpayer's trade or business. Thus, a noncorporate taxpayer's bad debts may be either business or nonbusiness bad debts. To be deductible, nonbusiness bad debts must be totally worthless; partially worthless nonbusiness bad debts are not deductible. Nonbusiness bad debts are deductible only as short-term capital losses and are reported on Schedule D, Form 1040. That means that they are not as valuable as business bad debts.
If payment of another's debt is guaranteed, a bad debt deduction may be claimed by the guarantor if payment is made under the guarantee. To qualify for a deduction, these guarantees must meet one of two conditions - (1) the guarantee must have been entered into for profit with the guarantor receiving something in return; or (2) the guarantee must be related to the taxpayer's trade, business or employment. In many instances, these requirements can be very difficult to satisfy. For example, most guarantees are entered into as an accommodation. In addition, the amount that the guarantor receives in return must be a reasonable amount under the circumstances.
With respect to the requirement that the guarantee be related to the taxpayer's trade, business or employment, the IRS particularly scrutinizes intra-family arrangements and generally holds that for parents guaranteeing a child's debt, the parent is not in the trade or business of guaranteeing loans. Instead, the parent typically is in the trade or business of farming or some other enterprise. In one Tax Court case, for example, the court held that a father's guarantee of his sons' bad debts was not a business bad debt. The father was receiving rent from his sons, and argued that the rental amounts represented a receipt of consideration. The father also argued that the guarantee was given in the ordinary course of business. The Tax Court disagreed on both counts. See, e.g., Lair v. Comr., 95 T.C. 484 (1990).
The loss associated with a guarantee may be either from a business or be a nonbusiness bad debt depending upon the facts of the situation. To qualify as a business bad debt, the taxpayer must show that the reason for guaranteeing the debt was closely related to the taxpayer's trade or business. If the reason for making the guarantee was to protect the taxpayer's investment but not as part of the taxpayer's trade or business, a guarantee may give rise to a nonbusiness bad debt. Guarantees made as a favor to friends where the taxpayer received nothing in return do not give rise to a deduction.
Related Issues With Guarantees
Because a guarantor is only secondarily liable and becomes liable only on the principal's default and notice, a release of the guarantor before becoming primarily liable does not appear to involve discharge of indebtedness income. In the event a guarantor has become primarily liable, release of the guarantor would seem to produce the possibility of discharge of indebtedness income.
Likewise, a deduction may be available for interest paid by a guarantor after the primary obligor is discharged in bankruptcy.
Reporting Bad Debts
A bad debt deduction must be explained on the income tax return with a statement attached that shows a description of the debt, the name of the debtor, the business or family relationship between the creditor and debtor, if any, the date the debt became due, efforts made to collect the debt and basis upon which the decision was made that the debt was worthless. For business bad debts, the amount claimed as a deduction should be reported on Form 1120 or 1120-S in the case of a corporation.
The amount of deduction attributable to a business bad debt should be reported on Form 1065 for partnerships and Form 1040 for bad debts incurred in relation to a trade or business as an employee. The amount claimed as a deduction for a business bad debt for individuals carrying on the business of farming as a sole proprietor are reported on Schedule F of Form 1040. For individuals carrying on a trade or business other than farming as a sole proprietor, business bad debts are reported on Schedule C of Form 1040.
Nonbusiness bad debts for individuals are deducted on Form 8949 as a short-term capital loss. with various notations. A separate line should be used for each bad debt. In addition, a nonbusiness bad debt, to generate a deduction, requires a separate detailed statement attached to the return.
Nonbusiness bad debts for partnerships are entered on Schedule D, Form 1065 in the same manner as above shown for Schedule D, 1040, for individuals.
Tough times create financial issues, and associated tax issues. But, if the rules are followed, the tax Code can help soften the blow of uncollectable debts by allowing a deduction.
Wednesday, June 7, 2017
In early 2014, the 2014 Farm Bill passed the Congress and was signed into law. The legislation contains a projected $956 billion in spending over the next 10 years (much of which is attributable to spending on Food Stamps and related programs) which is approximately 50 percent more than the 2008 Farm Bill. The Farm Bill also contained numerous other provisions such as repealing direct payments immediately, repealing seven other current commodity programs and making adjustments to payment limitations, program eligibility rules and the income limitation rule.
The Farm Bill also removed both the farm and non-farm AGI limitations of the 2008 Farm Bill and replaces them with a $900,000 AGI limitation applicable to any individual or entity. The $900,000 AGI limitation applies to both commodity and conservation programs. While the Farm Service Agency initially did not take into account any I.R.C. §179 deduction for an S corporation or a partnership, but did for a C corporation or an individual, their position has now changed so that issue is no longer on the table
However, the Farm Bill did not include a provision that was contained in the initial House version that would have barred a state, absent legitimate public safety concerns, from enacting legislation designed to regulate the production of out-of-state agricultural goods and livestock that are sold in that state.
So, can a state regulate the manner in which agricultural goods are produced in another state? That’s the focus of today’s post.
The House Farm Bill provision was in response to a 2008 California (CA) ballot initiative (Proposition 2) that required all California egg producers to produce eggs from laying hens in cages that allowed the hens to “lie down, stand up, fully extend its limbs, and turn around freely.” Because of the additional cost placed on CA egg producers which made their eggs non-competitive with eggs produced in other states not subject to such restrictions, CA passed a law in 2010 (A.B. 1437) making it a crime to sell shelled eggs in CA (regardless of whether the eggs were produced in CA) that came from a laying hen that was confined in a cage not allowing the hen to “lie down, stand up, fully extend its limbs, and turn around freely.” The law was purportedly based on consumer health concerns, but it had the effect of regulating egg production in all states. The law applied to the sale of eggs for human consumption in CA occurring on or after January 1, 2015.
Legal challenge. In 2014, the Missouri (MO) Attorney General (and officials from other states) sued CA officials over the law. They sought declaratory and injunctive relief, costs and fees, associated with blocking enforcement of the CA law. The claim was that the law would increase size of egg-laying hen enclosures and decrease flock densities for egg producers in other states desiring to sell eggs in CA. The lead plaintiff (MO) noted that CA consumers bought one-third of all eggs produced in MO in 2013 and that the CA requirement would substantially increase the cost of MO egg production if egg producers continue to sell eggs in CA, which will also make eggs too expensive to sell in other states. The plaintiff also noted that if MO producers choose to not participate in CA market, other markets will have surplus eggs and egg prices will fall which could force some producers out of business; suit claims that CA provision was an unconstitutional violation of the Commerce Clause by "conditioning the flow of goods across its state lines on the method of their production." In the alternative, the suit alleged federal preemption via 21 U.S.C. Sec. 1052(b) – the Federal Egg Products Inspection Act.
The trial court held that the plaintiff lacked standing for failure to articulate an interest separate and apart from the interests of private parties, and that the claim involving the egg price-effect on consumers was remote and speculative. Missouri v. Harris, No. 2:14-cv-00341-KJM-KJN, 2014 U.S. Dist. LEXIS 76305 (E.D. Ca. Jun. 2, 2014). The trial court also determined that the CA law was not discriminatory. On further review, the appellate court affirmed, but remanded for dismissal without prejudice. Missouri v. Harris, 842 F.3d 658 (9th Cir. 2016). Last week, the U.S. Supreme Court declined to hear the case. Missouri v. Becerra, No. 16-1015, 2017 U.S. LEXIS 3405 (U.S. Sup. Ct. May 30, 2017).
Legal ‘standing.” There is no doubt that “Parens patriae” standing (a federal court doctrine) is difficult to obtain in a case asserting economic loss. The states have to show injury to the citizens of their respective states as a whole, rather than injury to a small group of their citizens (egg producers and egg consumers). While the states did claim that their residents would be paying higher prices for eggs, the trial court and the appellate court both determined that the claim was speculative at this stage of the litigation. Certainly, any time a regulation is imposed that requires a change in production activities (here, requiring the replacement of “battery” cages with alternative structures that meet the CA specifications) higher costs will be imposed on egg producers. To the extent those costs can be passed-on to egg consumers, they will. The more market power any individual egg producer has will determine how much, if any, of that cost gets passed-on.
Related to the egg production matter were developments involving animal rights groups and foie gras, a delicacy that is a product of enlarged livers of ducks and geese that have been force-fed corn. While a federal court, in 2013, refused the groups’ attempt to force USDA to regulate the delicacy as an adulterated food product, the Ninth Circuit upheld a CA ban on foie gras. In 2014, the U.S. Supreme Court declined to hear the case, leaving the CA ban in place. Association Des Eleveurs De Canards Et D’Oies Du Quebec, et al. v. Harris, 729 F.3d 937 (9th Cir. 2013), cert. den., 135 S. Ct. 398 (2014). Importantly, the California ban only applies to products produced by force feeding a bird to enlarge its liver. It does not ban the sale of duck breasts, down jackets, or other non-liver products from force-fed birds.
After the Ninth Circuit upheld the CA ban, the plaintiffs amended their complaint to include a challenge to the ban on preemption grounds. In early 2015, the district court struck down the CA law on the basis that the CA ban was preempted by the Poultry Products Inspection Act, the federal law that regulates the sale and distribution of poultry products. The court pointed out that the plaintiffs had suffered economic injury. Association Des Eleveurs De Canards Et D'oies Du Quebec, et al. v. Harris, No. 2:12-cv-5735-SVW-RZ (C.D. Cal. Jan. 7, 2015).
Egg Law Litigation Current Status.
Presently no court has decided the merits of the case. But, if standing can be established, do the states challenging the CA law have a legitimate claim? The Ninth Circuit’s dismissal of the case was “without prejudice.” Koster v. Harris, 847 F.3d 646 (9th Cir. 2017). That means that if standing can eventually be established, the case can be brought again.
State Regulation of Interstate Commerce - U.S. Supreme Court Precedent
The U.S. Supreme Court has long held that one state cannot regulate economic conduct in another state in a manner that is clearly excessive in relation to the benefits to the regulating state, even if the law is facially neutral. See, e.g., Bibb v. Navajo Freight Lines, Inc., 359 U.S. 520 (1959). In Bibb, various interstate motor carriers challenged an Illinois statute that required the use of certain type of mud-flap on trucks and trailers that operated on Illinois highways. They claimed that the statute violated the Constitution’s Commerce Clause because it placed an “undue” burden on them that outweighed any safety benefit the state might receive in return. In essence, the statute required that the mud-flap had to contour with the rear wheels, with the inside surface “being relatively parallel to the top 90 degrees of the rear 180 degrees of the whole surface.” In addition, the mud-flap surface had to extend down to within 10 inches of the ground on a fully-loaded truck. Furthermore, the mud-flap had to be wide enough to cover the width of the tire, be installed within six inches from the tire surface on a loaded truck and have a flange on its outer edge that did not exceed two inches. Basically, these detailed requirements made conventional mud-flaps that were legal in at least 45 states at the time illegal in Illinois.
The trial court held that the Illinois statute “unduly and unreasonably burdened and obstructed interstate commerce” in violation of the Commerce Clause and enjoined the state from enforcing it. On direct appeal to the U.S. Supreme Court, the Court unanimously affirmed. While safety measures carry a “strong presumption of validity” the Court determined that the enhanced safety resulting from the statutory requirement did not outweigh the national interest in “keeping interstate commerce free from interferences that seriously impede it.”
So how does Bibb apply to the CA egg law? If standing is ever established (and the proper plaintiff may, indeed, be actual egg producers rather than respective states), the burden will be on the plaintiff(s) to show that the CA law imposes an undue and unreasonable burden on interstate commerce in relation to the benefit that CA derives on behalf of its citizens (e.g., health and safety). Thus, the citizens of CA can, via their elected representatives, determine the law and regulations for the economic activity of other states to an extent. The limits of that extent have not yet been established in the egg case, but it seems that the egg case is a clearer illustration of a state trying to regulate economic activity in other states instead of protecting the health and/or safety of its own citizens than the state statute involved in Bibb.
Monday, June 5, 2017
Generally, an exchange of property for other property is treated as a sale. However, no gain or loss is recognized if property held for productive use in a trade or business or for investment is exchanged for property of a like-kind to be held either for productive use in a business or for investment. I.R.C. §1031. The new property is treated as a continuation of the original property. That means that neither gain nor loss is recognized until (if ever) the replacement property is sold. Gain, however, is recognized to the extent of any boot or unlike property received in the exchange.
Like-kind exchanges are very popular in agriculture. Whether the transaction involves a trade of real estate or equipment, ag producers find tax-deferred exchanges to be a useful tax planning tool. Today’s post looks at just a few of the aspects of like-kind exchanges.
What is “Like-Kind”?
Personal property. With respect to the trade of tangible personal property, such as farm machinery, the Treasury Regulations determine if property is like-kind by reference to being within the same product class. Also, property is of a like-kind to property that is of the same nature or character. Like-kind property does not necessarily have to be of the same grade or quality. In addition, for intangible assets, the determination of like-kind must be made on an asset-by-asset basis. Thus, a like-kind trade can involve a bull for a bull, a combine for a combine, but not a combine for a sports car or a farm or ranch for publicly traded stock.
Real estate. With respect to real estate, a much broader definition of like-kind applies. Virtually any real estate used for business or investment can be exchanged for any other real estate if the exchanger continues to use the replacement property for business or investment. Thus, agricultural real estate may be traded for residential real estate. However, if bare farmland is traded for farmland with depreciable structures on it, tax issues can arise. Many farm depreciable buildings and structures are “I.R.C. §1245 property.” For example, commodity storage facilities and single-purpose agricultural structures are I.R.C. §1245 property, as are irrigation systems, drainage tile, and other improvements to farm real estate. If property with an I.R.C. §1245 depreciation recapture attribute is disposed of in an I.R.C. §1031 exchange, the I.R.C. §1245 depreciation recapture must be recognized to the extent that the replacement property has insufficient I.R.C. §1245 property. IRS Form 8824 provides a location for reporting the I.R.C. §1245 depreciation recapture if non-I.R.C. §1245 property is received in exchange.
A leasehold interest can be exchanged for fee interests if the leasehold interest has at least 30 years to run at the time the exchange is entered into. Treas. Reg. §1.1031(a)-1(c). Case law also indicates that, at the time the transaction is entered into, the lease must have at least 30 years remaining. See, e.g., VIP Industries Inc. & Subsidiaries v. Comm’r, T.C. Memo. 2013-357.
Water rights that are limited in duration are not considered like-kind to a fee interest in land, (Wiechens v. United States, 228 F. Supp. 2d 1080 (D. Ariz. 2002)), but if the water rights are limited only as to annual use the IRS has ruled that they are of sufficient like-kind to a fee interest in land to qualify the transaction for like-kind exchange treatment. Priv. Ltr. Rul. 200404044 (Oct. 23, 2003).
The “Holding” Requirement
The statute is silent about how long the relinquished and replacement properties must be held. Thus, the key is the taxpayer’s intent in holding the exchange properties. However, the IRS has ruled that if the taxpayer acquires the relinquished property immediately before the exchange, or disposes of the replacement property immediately after the exchange, the holding requirement of I.R.C. §1031(a) is not met. See, e.g., Rev. Rul. 75-291, 1975-2 C.B. 332; Rev. Rul. 77-297, 1977-2 C.B. 304; Rev. Rul. 84-121, 1984-2 C.B. 168.
The courts tend to consider whether the relinquished property was held for investment or for use in a business, and whether the replacement property was held for investment or for use in a business. See, e.g., Bolker v. Comr., 760 F.2d 1039 (9th Cir. 1985). Clearly, acquiring property in an exchange which is then immediately fixed-up and sold, does not meet the test of having been held for investment or for use in a trade or business. Similarly, based on the facts of the case, IRS may argue that the transaction really involved the intent to make a gift and that the property was not held for investment or for use in a trade or business. See, e.g., Wagensen v. Comr., 74 T.C. 653 (1980); Click v. Comr., 78 T.C. 225 (1982). In any event, the taxpayer bears the burden to prove the requisite intent. See, e.g., Land Dynamics v. Comr., T.C. Memo. 1978-259.
For exchanges between related parties, if property that was part of the exchange is disposed of within two years of the last transfer that was part of the exchange, the tax deferral is eliminated. In addition, I.R.C. §1031(f)(4) provides that the like-kind exchange rules do not apply to any exchange that is part of a transaction or series of transactions structured to avoid the related party prohibition. The IRS has ruled that taxpayer who transfers relinquished property to a qualified intermediary in an I.R.C. §1031 exchange for replacement property formerly owned by a related party does not qualify for non-recognition treatment. Rev. Rul. 2002-83, IRB No. 2002-49 (intermediary used to circumvent the related party prohibition). The IRS has also disallowed tax-deferred treatment where a taxpayer attempted several related party exchanges, moving low basis property in exchange for the high basis property of a related party, before the sale of the low basis property. Priv. Ltr. Rul. 200126007 (Mar. 22, 2001). However, the IRS has allowed tax-deferred treatment where the related party exchange preceded the sale to a third party by more than the two-year statutory minimum. Field Service Advice 200137003 (Sept. 17, 2001).
What About Debt?
The IRS has prescribed rules that govern the handling of debt in a like-kind exchange. Treas. Reg. §1.1031(d)-(2). Gain recognized on a like-kind exchange with debt is the greater of the excess value of the relinquished property over the value of the acquired property, or the excess of the equity in the relinquished property over the equity in the acquired property (this excess equal to the cash received in the exchange). Thus, if the value of the acquired property equals or exceeds the value of the relinquished property and the equity in the acquired property equals or exceeds the equity in the relinquished property, no gain is recognized on the exchange.
These are just a few of the points concerning like-kind exchanges that seem to generate a lot of questions. These transactions are popular in agriculture. But, anytime a tax-deferred exchange is desired, competent tax and legal advice is a must.
Thursday, June 1, 2017
For farmers on the cash method of accounting, certain types of financing arrangements may create questions concerning when inputs are considered paid and, hence, qualify for a deduction. Similarly, for livestock growers and feeders, letters of credit and advance payments for management services are common but can raise similar deductibility issues.
For a cash basis farmer, inputs are deducted in the year that they are paid for. In pre-payment situations, as long as the rules for pre-paying inputs are followed, there shouldn’t be an issue with achieving the up-front deduction. See Rev. Rul. 79-229, 1979-2 C.B. 210. But, what if the inputs are financed via a promissory note or a letter of credit? Can a deduction be taken when the agreement is entered into? What if the inputs are financed by a lender that is a subsidiary of the input supplier? Relatedly, when can a deduction be claimed for financed improvements of depreciable property? What about financing arrangements for feeding cattle? What about buying a farm with a depreciable structure on it?
There are a lot of arrangements out there. It can get messy in a hurry. Today’ post takes a look at these issues.
Payment Via Promissory Note and/or Letter of Credit
The purchase of depreciable property on credit generally allows the buyer to receive an income tax basis for the purchase price cost of the property – including any liability assumed. But, there can be situations where payment in accordance with a promissory note, even if secured by collateral, may not result in a deduction. See Rev. Rul. 77-257, 1977-2 C.B. 174; Helvering v. Price, 309 U.S. 409 (1940). The same could be true if payment is secured by a letter of credit.
In livestock feeding situations, letters of credit and advance payments for management services are common. For example, in Chapman v. United States, 527 F. Supp. 1053 (D. Minn. 1981), a farmer entered into a purchase agreement for $30,000 worth of cattle feed. The farmer paid one-half of the total amount in cash in 1973 and the remaining $15,000 was due and payable when each cattle lot was sold and was subtracted from cattle sale proceeds before any remaining balance was disbursed to the farmer. To insure payment if the cattle sale proceeds didn’t cover the amount owed the seller of the feed, the farmer gave the seller a promissory note for $15,000 and a secured letter of credit for the same amount. The farmer deducted the entire $30,000 in 1973 and recognized income of $15,000 in 1974 when the letter of credit expired. The court held that the letter of credit was synonymous with a promissory note secured by collateral, and denied the $15,000 deduction in 1973 that was attributable to the note.
In Bandes, et al. v. Comr., T.C. Memo. 1982-355, two taxpayers got into the cattle feeding business by contracting with a cattle company in Guymon, Oklahoma, to act as their agent and advisor for the purchase, feeding and sale of 1200 head of livestock. The taxpayers agreed to share expenses and proceeds equally, and the contract with the cattle company appointed the cattle company as agent to select feedlots, negotiate and execute feeding contracts, and oversee the buying, managing and selling of the cattle. The cattle company was also authorized to negotiate and contract for the delivery of the cattle by the end of 1972. The cattle company would receive $8 per head for its management services and the taxpayers paid the fee on December 12, 1972 ($4,800 for each taxpayer). The cattle company arranged for a line of credit to each taxpayer for 180 days from a bank set at a maximum of $210,000 per taxpayer at eight percent interest. In the summer of 1973, the line of credit was renewed for another 180 days at 9 percent interest. Security for the loan was the feed and livestock, and the taxpayers were not personally liable for any advances under the line of credit. The advances from the bank paid a portion of the purchase price of the cattle and feedyard charges, and were repaid (except for interest which was paid in advance by the taxpayers) out of cattle sale proceeds. In addition, advances were only made after each taxpayer had a net equity in the cattle of $90 per head. Thus, on December 15, 1972, each taxpayer opened an account with the bank and deposited $54,000 ($90 x 600 head).
On December 22, 1972, the cattle company purchased $96,000 worth of feed on each taxpayer’s behalf. In early 1973, the cattle company bought 1,200 head of cattle for $411,352 that were then shipped to a feedyard. During the remainder of 1973 the 1,153 surviving cattle were sold for $578,476. Also in 1973, the unused feed was sold for $3,424.
Both taxpayers were on the cash method and each of them deducted the $4,800 management fee on their respective 1972 returns along with a $48,000 deduction for cattle feed. The IRS disallowed the deduction for the cattle feed in accordance with Rev. Rul. 79-229, but the court allowed the deduction on the basis that the taxpayers had a legitimate business purposes (locking in price) and that the payment was not a deposit and did not materially distort income. As for the management fee, the court allowed one-half of the fee to be deducted in 1972 and the other half in 1973, absent evidence as to the value of the services that the cattle company performed.
As for monthly maintenance fees paid under an agreement involving the purchase of cattle, the IRS has said that those fees are not deductible for the period before purchase of the cattle. Rev. Rul. 84-35, 1984-1 C.B. 31. Where an advance payment was made for management services for the current year and the succeeding year, the Tax Court has allocated the fee between the two years and allowed a deduction for the amount related to the current year. Bandes v. Comr., T.C. Memo. 1982-355.
Financing Input Costs
In Rev. Rul. 77-257, 1977-2 C.B. 174, a limited partnership, was engaged in acquiring and holding land for investment and for farming. The limited partnership was on the cash method of accounting. A partnership was involved in management of farm properties. The two entities were not related and had no common owners. In the year in question, the limited partnership purchased farmland from the partnership and then entered into a management agreement with the partnership whereby the partnership was to provide development services on the farmland produced by the limited partnership. The management expenses were billed monthly to a partnership account, and were paid by checks drawn on another partnership bank account. At the end of the development period, the limited partnership gave the partnership a note for the account receivable on the partnership account’s books. The IRS cited Helvering v. Price, 309 U.S. 409 (1940) where the U.S. Supreme Court said that the issuance of a note by a cash method taxpayer, without any disbursement of cash or property with a cash value, does not give rise to a deduction. But, the IRS also stated that “the actual payment of an expense with funds borrowed from a third party does give rise to a current deduction.”
Vendor-financed inputs. That last portion of Rev. Rul. 77-257, where the IRS said that actual payment of an expense with borrowed funds from a third party, opens the door to allow costs paid by vendor financing to be deductible. Sometimes a farmer buys inputs that are financed by a lending subsidiary of the input supplier. In many of these situations, the interest rate is set low to enhance sales. But, the key is whether the lender that finances the input purchase is really independent from the vendor. Rev. Rul. 77-257 says that when the funds are borrowed from a “third party,” a deduction for expenses incurred can be taken in the year the funds are loaned. But what if the lender is wholly-owned subsidiary of the vendor? In that situation is the lender really a “third party” lender?
Another issue can be created when the input financing by a wholly-owned subsidiary of the vendor occurs without the farmer writing out a check. Does that give rise to deductibility? What if the financing is provided by a different legal entity within the vendor’s business group? It that really third-party financing if the financing company is wholly-owned by the vendor? It gets a little blurry, doesn’t it? All of this presents farmers with a challenge to identify the true nature of all parties that are involved in a transaction.
Financed improvements to depreciable property. Improvements to property which are financed by a promissory note or other obligation do not add to basis until the obligation is paid. This is different than paying for the cost using borrowed funds, which doesn’t raise a concern. Without a basis increase, there can be no depreciation deduction. In Owen v. United States, 34 F. Supp. 2d 1071 (W.D. Tenn. 1999), the taxpayers financed improvements to office condominiums by promissory notes issued to an entity that the taxpayers owned and controlled. The taxpayers did not make any payment on the notes before selling the improved property. The taxpayers argued that the issuance of the notes for payment of the improvements increased their basis in the property, but the court distinguished the case (which involved a subsequent adjustment to basis) from those situations involving the taxpayer’s initial cost basis in property. The court noted that cash-basis taxpayers do not recognize income or expenses until cash is actually received or paid. Thus, the issuance of a promissory note as payment for benefits received was not a cash payment that allowed the taxpayers to take a current-year deduction. It also did not increase the basis in the condominiums by the cost of the improvements. The result was that no depreciation deductions would be allowed.
The Owen decision raises some interesting questions (which the court did not address), including how a taxpayer handles the sale of property purchased and financed by the taxpayer and subsequently sold while the taxpayer remained personally liable on the note. For instance, assume that a farmer buys farmland with a building on it for cash. The farmer financed improvements to the building, and then later sold the entire property while principal amounts were still outstanding on the note. How does the farmer compute gain on the sale? Does he count the amount financed as basis, or only add to basis any amount that has been paid on the note’s principal? Or, does the farmer report more gain (because of no basis increase attributable to the amount financed) and then reduce the gain as payments are made on the note’s principal? In the latter situation, the farmer would have to file an amended return for the year of sale each year that a principal payment is made. If he doesn’t get the note paid off soon enough, he could end up with closed tax years that can’t be amended. That would mean he would have gain recognition with no basis offset and the responsibility to still make principal payments.
You have heard it said many times that “cash is king.” That’s true not only from a debt standpoint. The tax issues associated with transactions can get complex fast when structured financing deals take place.