Tuesday, January 23, 2018
Farmers, ranchers and rural landowners frequently deal with many types of legal issues. Two of those sometimes involve the rules surrounding partition of farmland and adverse possession. These are two issues that heavily depend on state law and, as a result, the same set of facts can produce a different depending on the particular state.
In today’s post I take a look at a couple of recent cases that have again highlighted the importance of these issues.
Unfortunately, an all too common problem in estate planning for farm families is that farmland is left to multiple children equally as co-owners at the death of the surviving parent. That can create problems, particularly if there is at least one child that wants to continue farming the land and siblings that don’t. The sibling (or siblings) that don’t want to farm will often want to “cash out” their inheritance. Can the farmland be split-out between the siblings? That’s often difficult to accomplish, as a recent case illustrates.
In Wihlm v. Campbell, No. 15-0011 (Iowa Sup. Ct. Jan. 12, 2018), vac’g., 886 N.W.2d 617 (Iowa Ct. App. 2016), three siblings inherited approximately 300 acres of farmland as tenants in common when their father died. The land was divided into several parcels and two of the siblings brought partition actions seeking to have the properties sold and the proceeds divided. The other sibling (the defendant) wanted an in-kind division with respect to her share of about 79 acres and the homestead. The trial court ordered the entire property sold with the proceeds divided equally. The defendant appealed. An appraiser had testified at trial that if the property were sold at auction he would recommend selling it in separate parcels to bring a higher total selling price. The appraiser also testified that the tract that the defendant sought would be worth approximately one-third of the total value of the 300-acre tract. He also testified that an in-kind division would be fair and equitable. Another appraiser testified that it would be better to sell the entire tract together, but still another appraiser testified that more money could be realized on sale if separate tracts were sold.
The appellate court noted that the trial court had concluded that the defendant had failed to prove that the division of the properties in kind was equitable and practicable based on the testimony of two of the appraisers. But, the appellate court disagreed, noting that an appraisal is much more certain than speculation and that, in this case, the appraiser’s opinion was well supported. Accordingly, the court held that the defendant had proved that the division of the property was equitable and practicable. The court remanded the case for an in-kind partition of the property that the defendant requested, and for partition by sale of the balance with the proceeds split by the other siblings.
On further review, the Iowa Supreme Court vacated the court of appeals’ opinion on the basis that the defendant failed to meet her burden to prove that the partition in-kind was equitable and practicable. The Supreme Court gave no analysis for its opinion other than noting a 1968 Iowa Supreme Court opinion that stated the rule pertaining to partition of real estate “is unequivocal in favoring partition by sale and in placing upon the objecting party the burden to show why this should not be done in the particular case.” The Court followed that view in Newhall v. Roll, 888 N.W.2d 636 (Iowa 2016). Apparently, the conflicting testimony of the appraisers was insufficient to allow the defendant to prove that the division of the properties in-kind would be equitable and practicable.
Another topic that often arises in rural settings involves adverse possession. Adverse possession can involve boundary issues as well as access to property. But, again, the rules surrounding this issue are highly dependent on state law concerning the elements that must be establish to prove adverse possession. A recent case illustrates how the adverse possession rules work in Texas. Adverse possession gets particularly “messy” when mineral rights are also involved.
The facts of Hardaway v. Lou Eda Korth Stubbs Nixon, No. 04-16-00252-CV, 2017 Tex. App. LEXIS 10957 (Tex. Ct. App. Nov. 22, 2017) date back over 100 years. In the late 1800s, the Eckford’s owned, among other property, a 147.5-acre tract in Karnes County, Texas as community property. Mrs. Eckford was appointed as guardian of the community estate in 1893. Mr. Eckford died intestate on November 10, 1896. Under the laws of intestacy, one-half of the real property, which was community property, passed to Mrs. Eckford, and the other half of the real property passed to the couple’s nine surviving children. Mrs. Eckford conveyed portions of the property throughout her life, including a conveyance to the defendant’s predecessor in interest. When Mrs. Eckford died in 1928, her court appointed administrator advised the trial court that “all of the real estate” belonging to the estate should be sold to pay claims and expenses. Ultimately, in 1939, the administrator purported to sell all of the property once owed by the Eckfords as community property, including the 147.5 acres to the defendant’s predecessors.
The defendant’s parents entered into a mineral lease with Texas Oil & Gas Corp. in 1978 leasing the mineral rights in the entire 147.5 acres. At some point before 2012, Burlington Resources Oil & Gas Company and East 17th Resources, LLC (BRO&G) discovered information that led them to believe that the heirs of the Eckford’s owned an unleased one-half interest in the 147.5-acre tract that the defendant possessed. BRO&G believed that the defendant and the Eckford’s heirs were cotenants with regard to the 147.5 acres. As a result, BRO&G sought out and entered into mineral leases with numerous Eckford heirs. In 2012, because some of the numerous Eckford heirs could not be located, BRO&G instigated a receivership proceeding. The defendant intervened in the receivership action alleging sole ownership of the entire 147.5-acre tract. Ultimately, the defendant filed a motion for partial summary judgment in which he alleged full ownership of the property as a matter of law.
The trial court granted summary judgment in the defendant’s favor with regard to ownership of the property based only on constructive ouster and subsequent adverse possession. The Eckford heirs appealed. The appellate court held that a party claiming adverse possession as to a cotenant must not only prove his possession was adverse, but must also prove some sort of ouster. In addition, Texas law requires a summary judgment movant to do more than assert and prove “long-continued” possession under a claim of ownership and nonassertion of a claim by the titleholder to prove constructive ousters as a matter of law.
The appellate court determined that the only ground for summary judgment as to constructive ouster set forth in the defendant’s motion is long-continued possession coupled with absence of a claim by the Eckford heirs. The court determined that this neither asserted or established that they took “unequivocal, unmistakable, and hostile acts.” Therefore, the defendant failed to prove constructive ouster as a matter of law on the sole ground asserted in their motion. Accordingly, the appellate court reversed the trial court’s grant of summary judgment and remanded the matter to the trial court.
There are many cases involving these two issues, and the cases mentioned above are just a very small sample that illustrate an aspect of the real estate-related issues that rural landowners face. The cases also point out that a good lawyer well versed in these type of issues is good to have in tow.
Friday, January 19, 2018
Normally, the computation of a tax deduction for a gift to charity is simple – it’s the fair market value of the donated property limited by basis. That’s why, for example raised grain gifted to charity by a farmer doesn’t generate an income tax deduction. The farmer that gifts the grain doesn’t have a basis in the grain. But, special rules apply to a trust from which property is gifted to charity.
Today’s post looks at the issue of the tax deduction for property gifted to charity from a trust. Those special rules came up in a recent case involving a multi-million-dollar gift.
Rule Applicable to Trusts
I.R.C. §642(c)(1) says that a trust can claim a deduction in computing its taxable income for any amount of gross income, without limitation, that under the terms of the governing instrument is, during the tax year, paid for a charitable purpose. Note the requirement of “gross income.” A trust only gets a charitable deduction if the source of the contribution is gross income. That means that tracing the contribution is required to determine its source. See, e.g., Van Buren v. Comr., 89 T.C. 1101 (1987); Rev. Rul. 2003-123, 2003-150 I.R.B. 1200. Does the tracing have to be to the trust’s gross income earned in years before the year of the contribution? Or, does the trust just have to show that the charitable contribution was made out of gross income received by the trust in the year the contribution was made? According to the U.S. Supreme Court, the trustee does not have to prove that the charitable gift was made from the current year’s income, just that the gift was made out of trust income. Old Colony Trust Company v. Comr., 301 U.S. 379 (1937).
But, does trust income include unrealized gains on appreciated property donated to charity? That’s an interesting question that was answered by a recent federal appellate court.
A recent case involving a charitable donation by a trust raised the issue of the amount of the claimed deduction. Is it the fair market value of the property or is it the basis of the donated property if that amount is less than the fair market value? Under the facts of Green v. United States, 144 F. Supp. 3d 1254 (W.D. Okla. 2015), the settlors created a dynasty trust in 1993 with terms authorizing the trustee to make charitable distributions out of the trust's gross income at the trustee's discretion. The trust wholly owned a single-member LLC and in 2004, the LLC donated properties that it had purchased to three charities. Each property had a fair market value that exceeded basis. The LLC received the funds to buy the properties from a limited partnership's distribution to the trust in which the trust was a 99 percent limited partner. The limited partnership owned and operated most of the Hobby-Lobby stores in the United States.
The IRS initially claimed that the trust could not take a charitable deduction, but then decided that a deduction could be claimed if it were limited to the trust's basis in each property. The trust claimed a charitable deduction in excess of $20 million on Form 1041 for 2004, and later filed an amended Form 1041 increasing the claimed charitable deduction to just shy of $30 million, and seeking a tax refund of over $3 million. The IRS denied the refund, claiming that the charitable deduction was limited to cost basis. The trust paid the deficiency and sued for a refund.
On the trust's motion for summary judgment, the parties agreed that the donated properties were acquired by the trust with funds coming from gross income from a pre-2004 tax year. Thus, according to the trust, I.R.C. Sec. 642(c)(1) allowed the charitable deduction to be computed based on the donated property's fair market value. The court agreed, noting that I.R.C. § 642(c)(1) allowed a deduction without limitation contrary to the basis limitation contained in I.R.C. §170, and that charitable deduction provisions are to be construed liberally in the taxpayer's favor.
The trial court noted that the donated properties were all acquired with distributions from the limited partnership to the trust, and each distribution was part of the LLC's gross income for the year of distribution. Thus, the donated properties were clearly bought with funds traceable to the trust's gross income and were donated under the terms of the trust. The court noted that the IRS admitted that there was no caselaw or other substantial authority that supported the government's position. The court granted summary judgment for the trust.
On appeal, the U.S. Court of Appeals for the Tenth Circuit reversed. Green v. United States, No. 16-6371, 2018 U.S. App. LEXIS 885 (10th Cir. Jan. 12, 2018). The appellate court noted that the parties agreed that the trust had acquired the donated properties with gross income and that the charitable donation was made out of gross income. However, the IRS claimed that only the basis of the properties was traceable to an amount paid out of gross income. It was that amount of gross income, according to the IRS, that was utilized to acquire each property. The appellate court agreed. There was no realization of gross income on the appreciation of the properties because the underlying properties had not been sold. So, because the trust had not sold or exchanged the properties, the gains tied to the increases in market value were not subject to tax. The appellate court reasoned that if the deduction of I.R.C. §642(c)(1) extended to unrealized gains, that would not be consistent with how the tax Code treats gross income. The appellate court tossed the “ball” back to the Congress to make it clear that the deduction under I.R.C. §642(c)(1) extends to unrealized gains associated with real property originally purchased with gross income
The charitable donation rules associated with trusts are complicated. The income tax deduction is tied to the trust’s gross income. Now we have greater certainty that the deduction is limited to realized gains, not unrealized gains. Maybe the Congress will clarify that unrealized gains should count in the computation. But, then again, maybe not.
Wednesday, January 17, 2018
Much of the focus on the new tax law (TCJA) has been on its impact on the rate changes for individuals along with the increase in the standard deduction, and the lower tax rate for C corporations. Also receiving a great deal of attention has been the qualified business income (QBI) deduction of new I.R.C. §199A.
But, what about the impact of the changes set forth in the TCJA on estate planning? That’s the focus of today’s post.
Estate Planning Implications
Existing planning concepts reinforced. The TCJA reinforces what the last major tax act (the American Taxpayer Relief Act (ATRA) of 2012) put in motion – an emphasis on income tax basis planning, and the elimination of any concern about the federal estate tax for the vast majority of estates. Indeed, the Joint Committee on Taxation (JCT) estimates that in 2018 the federal estate tax will impact only 1,800 estates. Given an approximate 2.6 million deaths in the U.S. every year, the federal estate tax will now impact about one in every 1,400 estates. Because of this minimal impact, estate planning will rarely involve estate tax planning, but it will involve income tax basis planning. In other words, the basic idea is to ensure that property is included in a decedent’s estate at death for tax purposes so that a “stepped-up” basis at death is achieved (via I.R.C. §1014).
Increase in the exemption. Why did the JCT estimate that so few estates will be impacted by the federal estate tax in 2018? It’s because the TCJA substantially increases the value of assets that can be included in a decedent’s estate without any federal estate tax applying – doubling the exempt amount from what it would have been in 2018 without the change in the law ($5.6 million) to $11.2 million per decedent. That amount can be transferred tax-free during life via gift or at death through an estate. In addition, for gifts, the present interest annual exclusion is set at $15,000 per donee. That means that a person can make cumulative gifts of up to $15,000 per donee in 2018 without any gift tax consequences (and no gift tax return filing requirement) and without using up any of the $11.2 million applicable exclusion that offsets taxable gifts – it will be fully retained to offset taxable estate value at death. In addition, the $15,000 amount can be doubled by spouses via a special election. But, if the $15,000 (or $30,000) amount is exceeded, Form 709 must be filed by April 15 of the year following the year of the gift.
Marital deduction and portability. For large estates that exceed the applicable exclusion amount of $11.2 million, the tax rate is 40 percent. The TCJA didn’t change the estate tax rate. Another aspect of estate tax/planning that didn’t change involves the marital deduction. For spouses that are U.S. citizens, the TCJA retains the unlimited deduction from federal estate and gift tax that delays the imposition of estate tax on assets one spouse inherits from a prior deceased spouse until the death of the surviving spouse. Thus, assets can be gifted to a spouse with no tax complications at the death of the first spouse, and the first spouse can simply leave everything to a surviving spouse without any tax effect until the surviving spouse dies. This, of course, may not be a very good overall estate plan depending on the value of the assets transferred to the surviving spouse.
The “portability” concept of prior law was retained. That means that a surviving spouse can carry over any unused exemption of the surviving spouse’s “last deceased spouse” (a phrase that has meaning if the surviving spouse remarries). Portability allows married couples to transfer up to $22.4 million without any federal transfer tax consequences, and without any need to have complicated estate planning documents drafted to achieve the no-tax result. But, portability is not “automatic.” The estate executor must “elect” portability by filing a federal estate tax return (Form 706) within nine months of death (unless a six-month extension is granted). That requirement applies even if the estate is beneath the applicable exclusion amount such that no tax is due.
Remember the “Alamo” – state transfer taxes. A minority of states (presently 17 of them) tax transfers at death, either via an estate tax or an inheritance tax. The number of states that do is dwindling - two more states repealed their estate tax as of the beginning of 2018. A key point to remember is that in the states where an estate tax is retained, the exemption is often much less than the federal exemption. Only three states that retain an estate tax tie the state exemption to the federal amount. This all means that for persons in these states, taxes at death are a real possibility. This point must be remembered by persons in these states – CT, HI, IL, IA, KY, ME, MD, MA, MN, NE, NJ, NY, OR, PA, RI, VT, WA and the District of Columbia.
Generation-skipping transfer tax. The TCJA does retain the generation-skipping transfer (GSTT) tax. Thus, for assets transferred to certain individuals more than a generation younger than the decedent (that’s an oversimplification of the rule), the “generation-skipping” transfer tax (GSTT) applies. The GSTT is an addition to the federal estate or gift tax, but it does come with an exemption of $11.2 million (for 2018) for GSTT transfers made either during life (via gift) or at death. Above that exemption, a 40 percent tax rate applies. Portability does not apply to the GSTT.
Income tax basis. As noted above, the TCJA retains the rule that for income tax purposes, the cost basis of inherited assets gets adjusted to the fair market value on the date of the owner’s death. This is commonly referred to as “stepped-up” basis, but that may not always be the case. Sometimes, basis can go down. When “stepped-up” basis applies, the rule works to significantly limit (or eliminate) capital gains tax upon subsequent sale of the asset by the heir(s). This can be a very important rule for ag estates where the heirs desire to sell the inherited assets. Ag estates are commonly comprised of low-basis assets. So, while the federal estate tax won’t impact very many ag estates, the basis issue is important to just about all of them. That’s why, as mentioned above, the basic estate plan for most estates is to cause inclusion of the property in the estate at death. Achieving that basis increase is essential.
Estate planning still remains important. While the federal estate tax is not a concern for most people, there are still other aspects of estate planning that must be addressed. This includes having a basic will prepared and a financial power of attorney as well as a health care power of attorney. In certain situations, it may also include a pre-marital/post-marital agreement. If a family business is involved, then succession planning must be incorporated into the overall estate plan. That could mean, in many situations, a well-drafted buy-sell agreement. In addition, a major concern for some people involves planning for long-term health care.
Also, it’s a good idea to always revisit your estate plan whenever there is a change in the law to make sure that the drafting language used in key documents (e.g., a will or a trust) doesn’t result in any unintended consequences.
Oh…remember that the changes in the federal estate tax contained in the TCJA mentioned above are only temporary. If nothing changes as we go forward, the law reverts to what the law was in 2017 starting in 2026. That means the exemption goes back down to the 2017 level, adjusted for inflation. That also means estate planning is still on the table. The federal estate tax hasn’t been killed, just temporarily buried a bit deeper.
Monday, January 15, 2018
If tax simplicity was the goal of the recently enacted “Tax Cuts and Jobs Act” (not the official title), it’s hard to claim that the goal was met, at least as to the entirety of the bill. Perhaps a number of the individual income tax provisions were streamlined by virtue of the elimination of some itemized deductions and the near doubling of the standard deduction. Likewise, the corporate tax rate structure was simplified by moving to a single 21 percent rate. But that single lower rate doesn’t necessarily mean that there will be a stampede to form C corporations or convert existing businesses to C corporate status. There are other issues that work against converting a business to the C corporate form.
For sole proprietorships and pass-through businesses, a new deduction makes tax planning and preparation more complex - much more complex. Today’s post takes a brief look at this new deduction – a 20 percent deduction for qualified business income (QBI) that is available to businesses other than C corporations. There are many issues associated with the QBI, and those issues will be left for future posts. But, a couple of implications are addressed in this post.
The QBI Deduction
The complexity of the QBI deduction Code section (I.R.C. §199A) is difficult to overstate. The new QBI provision is 23 pages in length, at least when counting pages of the text of the provision in the final bill version that the President signed. If my count is correct, there are over 20 definitions in §199A, more than two dozen cross references to other parts of the Code, and just as many cross-references to other parts of §199A. The QBI deduction computation contains several formulas with “lesser than” or “greater than” language, and some of the computations are embedded inside each other. In addition, those computations involve addition, subtraction and multiplication (remember the ordering rules from grade school math class?). The QBI deduction also includes exemption amounts, formulas that phase-out those exemptions, and an international tax provision that applies to domestic pass-through entities.
The basics. The genesis for the §199A deduction dates at least to 2009. Before he became House Majority Leader in 2011, Rep. Eric Cantor, proposed a 20 percent deduction for small businesses. That proposal came up again a couple of times in later years, but nothing was formally introduced until the tax legislative discussions started to take shape in the summer of 2016, and the legislative process unfolded in 2017. The 20 percent deduction found its life in newly created I.R.C. §199A as part of the recently enacted tax bill.
Like the original proposal years ago, the QBI deduction is a deduction against business income for non-C corporations that aren’t specified service businesses. Some of the other basic points about the QBI deduction include: 1) for income above a threshold a W-2 wage limitation applies; 2) the deduction is claimed at the partner or shareholder level; 3) trusts and estates are eligible, as are agricultural and horticultural cooperatives; 4) the deduction applies only for income tax purposes, and is determined without regard to alternative minimum tax (AMT) adjustments; and 5) the accuracy-related penalty for substantial understatement of tax for a tax return claiming the QBI deduction applies if the understatement if five percent, rather than the normal 10 percent.
The formulas. The QBI deduction equals the sum of the lesser of the “combined qualified business income” of the taxpayer, or 20 percent of the excess of taxable income over the sum of any net capital gains and qualified cooperative dividends, plus the lesser of 20 percent of qualified cooperative dividends or taxable income less net capital gain. What is “combined qualified business income”? It’s not really income. Instead, it’s a deduction. It’s 20 percent of the taxpayer’s “qualified business income” from each of the taxpayer’s qualified trade or business; limited to the greater of 50 percent of W-2 wages with respect to the business or 25 percent of the W-2 wages with respect to the business, plus 2.5 percent of the unadjusted basis (immediately after acquisition of all qualified property). Plus, 20 percent of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership income.
Definitions. As noted the definition of terms for purpose of the deduction are many. “Qualified property” is defined as tangible property that is subject to I.R.C. §167 depreciation. Likewise, “qualified business income” is the taxpayer’s ordinary income (less ordinary deductions) from the taxpayer’s non-C corporate business. Not included are any wages earned as an employee. Thus, for independent contractors, self-employment income is QBI that is potentially eligible for the 20 percent deduction. Conversely, for employees, wages earned are not eligible for the 20 percent deduction. Also, the definition of QBI does not include short or long-term capital gain or loss, dividend income or interest income. In addition, QBI does not include any wages or guaranteed payments received from a flow-through business, and any income that is not “effectively connected with the conduct of a U.S. trade or business.”
QBI might also include rental income. Clearly, the QBI must be earned in a “qualified trade or business.” But, what definition is going to be used to determine “trade or business”? My guess is it will be the I.R.C. §162 definition. If so, certain rental activities may not meet the definition, such as a triple-net lease where the owner has practically no regular involvement. Also, not satisfying the test would be cash rentals and non-material participation crop-share or livestock-share leases.
As noted above, the formula applies a W-2 wage limitation to pass-through businesses and sole proprietorships. However, the limitation does not apply to taxpayers below $315,000 (MFJ) – half of that for all other filers. Once taxable income exceeds the threshold, the W-2 limitations are phased-in over the next $100,000 of taxable income (MFJ) - $50,000 for all other taxpayers. But, what are W-2 wages? They must be wages subject to withholding. So, by definition, that excludes payments a business makes to an independent contractor, management fees that are paid, ag wages paid in-kind and wages paid to children under age 18 by parents. In addition, the wages must be paid for amounts that are properly allocable to producing QBI.
Net Operating Losses. As for net operating losses (NOLs), if a taxpayer claims the QBI deduction in the same year as an NOL, the deduction does not add to the NOL.
Agricultural and horticultural cooperatives. One issue that Senators Thune (R-SD) and Hoeven (R-ND) (among others) are presently working on is a technical correction that would balance out how the QBI deduction works with respect to agricultural products sold to a cooperative by a patron and those sold to a non-cooperative. A cooperative is eligible for the QBI deduction in accordance with a formula (of course). That is not in controversy. A cooperative’s deduction is 20 percent of the cooperative’s excess gross income over qualified cooperative dividends, or the greater of 50 percent of the cooperative’s W-2 wages, or the sum of 25 percent of the cooperative’s W-2 wages relating to the cooperative’s business plus 2.5 percent of the unadjusted basis immediately after acquisition of the cooperative’s qualified property. The deduction is then limited to the cooperative’s taxable income for the tax year.
What is controversial is that the QBI deduction is essentially 20 percent of taxable income (less capital gains) in the hands of a taxpayer that is a patron of a cooperative that sells to the cooperative. For a taxpayer in the 35 percent bracket, the deduction would reduce the effective rate by seven percentage points. However, for a taxpayer that doesn’t sell the ag products to a cooperative (say, for example) to a private elevator, the deduction is 20 percent of net farm income. That will often result in a lower deduction, but whether a sale should be made to a cooperative or a non-cooperative will depend on various economic factors as well as the tax factors.
The discrepancy could cause some farm landlords to switch from a cash lease to a crop-share lease if doing so will allow the landlord to claim the QBI deduction. Sales to a non-cooperative require that the taxpayer be engaged in a “trade or business” to qualify for the deduction. That means that a cash rent landlord will not qualify for the deduction. On the other hand, sales to a cooperative do not require the existence of a trade or business. Thus, the tenant under a cash lease gets the entire deduction. The landlord under a crop-share lease would be entitled to the landlord’s share.
Form 4797 and the QBI Deduction
Even though the new tax bill bars personal property trades, farmers will undoubtedly continue “trading” equipment. The “trade-in” value will be listed as the “selling price” of the “traded” equipment. A key question is whether the gain reported on Form 4797 will be QBI. As noted, the QBI deduction does not apply to capital gain income. I.R.C. §199A refers to “capital gain.” It does not refer to “gain on capital assets.” Thus, income taxed as “capital gain,” even though it is from an I.R.C. §1231 asset, is included in the definition of “capital gain” that is not eligible for the QBI deduction.
Form 4797 separates out the I.R.C. §1231 gain, the ordinary income and the gain attributable to recapture from sales or exchanges of business property. Specifically, Form 4797 Part I property is includible as LTCG property (taxed at a favorable rate), and is not QBI. Form 4797 Part II property is not considered STCG property, which is specifically excluded from the calculation. Gain or loss reported on Part II is QBI. The same is true for income reported on Part III of Form 4797.
The Form 4797 issue is not restricted just to personal property trades. It will also arise, for example, with respect to dairy operations. Dairies that are not C corporations, can be eligible for the QBI deduction. However, without careful planning, the deduction could be of limited value. Dairies typically have two sources of income – Schedule F income from milk sales (which is likely minimal due to offsetting expenses); and Form 4797 where sales of culled dairy cows are reported. The gain attributable to the dairy cow sales is not eligible for the QBI deduction.
I will get into more of the QBI-related issues at the law school’s January 24 seminar/webinar. Our first one on January 10 sold-out, and available spots for the January 24 event are filling up fast. Information on registration is available here: http://washburnlaw.edu/employers/cle/taxlandscape2.html.
By the time we get to January 24, there may be additional developments concerning the QBI deduction, especially with respect to its application to cooperatives and patrons. In addition, Paul Neiffer and I will delve deeply into these issues at our summer seminar in Shippensburg, PA on June 7-8. Plan now to attend. Be watching http://washburnlaw.edu/practicalexperience/agriculturallaw/waltr/index.html for information concerning the seminar in the next few days. If you would like to be put on a list to be notified of the June seminar, please send an email to email@example.com.
Thursday, January 11, 2018
The Fourth Amendment protects against illegal searches and seizures. In general, government officials must secure a search warrant based on probable cause before searching an area unless the owner gives consent. However, the Fourth Amendment’s protection accorded to “persons, houses, papers and effects,” does not extend to all open areas contiguous to a person’s home, but rather only to the home itself and its surrounding curtilage. Curtilage is generally defined as the land immediately surrounding an individual’s home or dwelling, including any closely associated buildings and structures, but not any “open fields” or buildings or structures that contain separate activities conducted by others. For example, in United States v. Ritchie, 312 Fed. Appx. 885 (9th Cir. 2009), the court held that a trailer used occasionally as a place to sleep while performing farm chores did not constitute a “home” for purposes of establishing a Fourth Amendment protection in the curtilage of the home.
The scope and extent of curtilage is an important issue to farming and ranching operations – much of the business occurs in the “open.” Are those areas subject to warrantless searches? It’s an issue that comes up more than one might think, particularly with respect to possible environmental crimes.
Curtilage and Agriculture
Multi-factor test. The extent of the curtilage is defined with reference to the proximity to the home of the area claimed to be curtilage, whether the area is included within an enclosure surrounding the home, the nature of the uses to which the area is put, and the steps taken by the resident to protect the area from observation by passersby. These are known as the “Dunn factors” based on United States v. Dunn, 480 U.S. 294 (1987). One key case applying the factors was United States v. Gilman, No. 06-00198 SOM, 2007 U.S. Dist. LEXIS 32524 (D. Haw. May 2, 2007), aff’d, sub nom., United States v. Terragna, 390 Fed. Appx. 631 (9th Cir. 2010), cert. den., Terragna v. United States, 562 U.S. 1191 (2011). In this case, which turned the typical curtilage analysis on its head, the court held that all evidence that was seized from a shed was to be suppressed because the shed was not within the curtilage of the residence for which a search warrant had been issued. The court reasoned that the home and shed were not enclosed by a fence or natural boundary, and there was no evidence that the shed was used for illegal activities. In addition, the court noted that the defendant took no steps to prevent the observation of the shed from passersby.
Another instructive case applying the Dunn factors is Wilson v. Florida, 952 So. 2d 564 (Fla. Ct. App. 2007). In that case, a warrantless search was allowed of a greenhouse that was not within the curtilage of the defendant’s home. The greenhouse was used to manufacture controlled substances. It was not locked and was made of semitransparent materials. The court determined that there was no reasonable expectation of privacy with respect to the greenhouse to which the protection against an illegal search and seizure extended.
The “open fields doctrine.” Obviously, a great deal of farming and ranching activities occurs in the “open” and the courts have held that, under the “open fields doctrine,” that government officials can make warrantless searches of such areas. Here’s a sample of some of the more prominent cases involving the doctrine:
- In United States v. Kirkwood, No. CR11-5488RBL, 2012 U.S. Dist. LEXIS 65214 (W.D. Wash. May 9, 2012), an open clearing near a rural home that separated the home and outbuildings from a wooded area functioned as curtilage. The court determined that the area was suitable for activities associated with the home and the use of the area associated with the home.
- In Westfall v. State, 10 S.W.3d 85 (Tex. Ct. App. 1999), a sheriff entered a pasture without a warrant. The sheriff seized cattle and charged the owner with cruelty to animals. The warrantless search was challenged, but was upheld under the open fields doctrine.
- In Trimble v. State, 842 N.E.2d 798 (Ind. 2006), the court upheld a conviction for cruelty to a dog even though the police did not have a search warrant to search the defendant’s home. While the dog house was within the curtilage of the home, the court determined that the defendant had no expectation of privacy because the dog was visible from the route any visitors to the property would be expected to use.
- In Hill v. Commonwealth, 47 Va. App. 442, 624 S.E.2d 666 (2006), the court upheld convictions for violations of the Virginia Food Act even though an administrative inspection of the defendant’s goat cheese manufacturing facility was conducted without a search warrant. The court determined that the state had a significant interest in protecting public health and that even though the facility was located within the curtilage of the defendant’s home, it was subject to search because it was functioning as commercial property.
- In United States v. Boyster, 436 F.3d 986 (8th Cir. 2006), open fields were found not to be within the curtilage of the defendant’s home. The fields were within the plain view of an aerial flyover and were 100 yards from the defendant’s residence and not enclosed by a fence and no other precautions had been taken to keep the growing marijuana from being visible by others. Thus, the fields were not protected by the Fourth Amendment.
- In State v. Nance, 149 N.C. App. 734, 562 S.E.2d 557 (N.C. Ct. App. 2002), a warrantless search was upheld under the open fields doctrine, where the animals observed were in plain view from the nearby road. However, the court noted that the seizure of items in plain view may require a warrant absent exigent circumstances.
The scope of curtilage in an ag setting was recently before another court – this time the Ohio Court of Appeals. In State v. Powell, No. 27580, 2017 Ohio App. LEXIS 5096 (Ohio Ct. App. Nov. 22, 2017), the defendant was charged with seven counts of cruelty to animals. A humane agent for the local Humane Society testified that she was constantly getting complaints, both from the public, next door neighbors, news and also from the County Sherriff’s Office regarding the defendant’s horse not being fed and a pig being stuck. The agent testified that she responded to the area based upon only seeing two of the three horses she knew were normally on the property. The agent also testified that she heard the pigs squealing and followed the sound of animal distress, a sound which she recognized through her experiences as a humane agent. She stated that she first observed the pigs on January 3, 2017. At this time, they were standing in “liquid mud” and she smelled “fecal and urine ammonia” coming from the pen. Fecal and urine ammonia is toxic to pigs. She further stated that pigs were at risk of hypothermia due to the cold weather. The agent spoke with the defendants concerning the condition of the pig pen and the fact that it needed to be remedied along with the pigs’ food and water. The humane agent stated that she and the defendants agreed on a timetable for these items to be remedied. The defendants stated that they would work on it through the week remedy the situation in a timely manner, and that the pigs would be provided food and water. The humane agent testified that when she returned to the property the next day, the pigs were in the same condition and the weather was getting colder. Finally, on her third trip to the property, the humane agent stated the pigs lacked food and fresh water, and that they were “actively freezing to death.” The outside temperature had fallen to six degrees, according to the humane agent. The humane agent arranged for the removal of the pigs from the property on January 7, 2017 at around 12:30am.
The defendant filed a motion to suppress the evidence obtained by the humane agent as the result of an illegal warrantless search of the curtilage surrounding their home. The trial court sustained the defendant’s motion to suppress and the state appealed. On appeal, the appellate court reversed. The appellate court noted that while curtilage is considered to be part of a defendant’s home and, as such, is entitled to Fourth Amendment protection, the agent’s testimony revealed that the home on the property was uninhabitable due to a collapsed roof and no windows. In addition, the evidence showed that the pig pen was 100 yards from the vacant home, and the pig pen was not in an enclosure surrounding the vacant home. There also was no evidence that steps had been taken to protect the area from observation from the adjacent lane, such as the erection of a privacy fence, locked gates or “No Trespassing” signs. Thus, the court concluded that the pig pen was not within the defendant’s residence or its curtilage, and that the defendant’s observation of the pigs was not a “search” for purposes of the Fourth Amendment. Accordingly, the trial court’s judgment was reversed and the matter remanded for further proceedings.
Warrantless searches can be an important issue for farmers and ranchers, particularly with respect to the possibility of inadvertent violations of the criminal provisions of environmental laws. It’s helpful to know when a search warrant is required.
Tuesday, January 9, 2018
In response to attempts by activist groups opposed to animal agriculture, legislatures in several states have enacted laws designed to protect specified livestock facilities from certain types of interference. Some of the laws have been challenged on free speech and equal protection grounds with a few courts issuing opinions that have largely found the laws constitutional suspect. However, last week’s opinion by the U.S. Court of Appeals for the Ninth Circuit construing the Idaho provision provides a roadmap for lawmakers to follow when crafting similar statutes to protect livestock facilities that will survive constitutional scrutiny.
I asked my research assistant, Washburn law student Melissa Miller, to dig into the Ninth Circuit’s opinion for me so that I could wrap her insight from that case into a broader piece for today’s post. Today’s post includes some of her thoughts.
General Statutory Construct
The basic idea of state legislatures that have attempted to provide a level of protection to livestock facilities is to bar access to an animal production facility under false pretenses. At their core, the laws attempt to prohibit a person having the intent to harm a livestock production facility from gaining access to the facility (such as via employment) to then commit illegal acts on the premises. See, e.g., Iowa Code §717A.3A. (a legal challenge to the Iowa law was filed in late 2017). Laws that bar lying and trespass coupled with the intent to do physical harm to an animal production facility likely are not constitutionally deficient. Laws that go beyond those confines may be.
Recent Court Opinions
Recently, a challenge to the North Carolina statutory provision was dismissed for lack of standing. The plaintiffs in the case, numerous animal rights activist groups, brought a pre-enforcement challenge to the North Carolina Property Protection Act (Act). The Act creates a civil cause of action for a North Carolina employer against an employee who “captures or removes” documents from the employer’s premises or records images or sound on the employer’s premises and uses the documents or recordings to breach the employee’s duty of loyalty to the employer. The plaintiffs claimed that the Act unconstitutionally stifled their ability to investigate North Carolina employers for illegal or unethical conduct and restricted the flow of information those investigations provide. The court dismissed the case for lack of standing. People for the Ethical Treatment of Animals v. Stein, 259 F. Supp. 3d 369 (M.D. N.C. 2017).
The Utah law, however, was deemed unconstitutional. At issue was Utah Code §76-6-112 (Act) which criminalizes the entering of a private agricultural livestock facility under false pretenses or via trespass to photograph, audiotape or videotape practices inside the facility. Anti-livestock activist groups sued on behalf of the citizen-activist claiming that the Act amounted to an unconstitutional restriction on speech in violation of the First Amendment. While the state claimed that lying, which the statute regulates, is not protected free speech, the court determined that only lying that causes “legally cognizable harm” falls outside First Amendment protection. The state also argued that the act of recording is not speech that is protected by the First Amendment. However, the court determined that the act of recording is protectable First Amendment speech. The court also concluded that the fact that the speech occurred on a private agricultural facility did not render it outside First Amendment protection. The court determined that both the lying and the recording provisions of the Act were content-based provisions subject to strict scrutiny. To survive strict scrutiny the state had to demonstrate that the restriction furthered a compelling state interest. The court determined that “the state has provided no evidence that animal and employee safety were the actual reasons for enacting the Act, nor that animal and employee safety are endangered by those targeted by the Act, nor that the Act would actually do anything to remedy those dangers to the extent that they exist.” For those reasons, the court determined that the Act was unconstitutional. Animal Legal Defense Fund v. Herbert, 263 F. Supp. 3d 1193 (D. Utah 2017).
A Wyoming law experienced a similar fate. In 2015, two new Wyoming laws went into effect that imposed civil and criminal liability upon any person who "[c]rosses private land to access adjacent or proximate land where he collects resource data." Wyo. Stat. §§6-3-414(c); 40-27-101(c). The appellate court, reversing the trial court, determined that because of the broad definitions provided in the statutes, the phrase "collects resource data" included numerous activities on public lands (such as writing notes on habitat conditions, photographing wildlife, or taking water samples), so long as an individual also records the location from which the data was collected. Accordingly, the court held that the statutes regulated protected speech in spite of the fact that they also governed access to private property. While trespassing is not protected by the First Amendment, the court determined that the statutes targeted the “creation” of speech by penalizing the collection of resource data. Western Watersheds Project v. Michael, 869 F.3d 1189 (10th Cir. 2017), rev’g., 196 F. Supp. 3d 1231 (D. Wyo. 2016).
The Idaho Statute and the Courts
In 2012, an animal rights activist went undercover to get a job at an Idaho dairy farm then secretly filmed ongoing animal abuse there. The video was then given to Mercy for Animals, an animal rights group, that publicly released portions of the video, drawing national attention. The dairy farm owner responded to the video by firing the employees who were caught on camera, instituting operational protocols, and conducting an animal welfare audit at the farm. Following the release of the video, the Idaho Legislature responded by enacting the Interference with Agricultural Production Law, Idaho Code § 18-7042. The legislation broadly criminalizes making misrepresentations to access an agricultural production facility as well as making audio and video recordings of the facility without the owner’s consent. Specifically, Idaho Code Sec. 18-7042(1)(d)) criminalizes "interference with agricultural production" when a person knowingly enters an ag production facility without permission or without a court order or without otherwise having the right to do so by statute (in other words, the person is on the premises illegally), and makes a video or audio recording of how the ag operation is conducted.
In March of 2014, The Animal League Defense Fund (ALDF) sued challenging the constitutionality of the law. The complaint alleged that the purpose and effect of the statute “are to stifle political debate about modern agriculture by criminalizing all employment-based undercover investigations and criminalizing investigative journalism, whistleblowing by employees, or other expository efforts that entail images or sounds” in violation of the First and Fourteenth Amendments. The district court determined that four subsections of the statute—§18-7042(1)(a)-(d)—were unconstitutional on First Amendment and Equal Protection Grounds.
On appeal, the Ninth Circuit partially reversed parts of the trial court’s ruling, thereby upholding parts of the law. Animal Legal Defense Fund v. Wasden, No. 15-35960, 2018 U.S. App. LEXIS 241 (9th Cir. Jan. 4, 2018). The appellate court analyzed the statute, subsection-by-subsection.
Subsection (a). Subsection (a) criminalizes entry into an agricultural production facility “by force, threat, misrepresentation or trespass.” The ALDF challenged only the misrepresentation prong of this subsection as unconstitutional and the appellate court agreed that it was unconstitutional, affirming the trial court. The appellate court determined that, unlike lying to obtain records or gain employment (which are associated with a material benefit to the speaker), lying to gain entry merely allowed the speaker to cross the threshold of another’s property, including property that is generally open to the public. Thus, the appellate court determined that the provision was overbroad and could potentially criminalize behavior that, by itself, was innocent, and was targeted at speech and investigative journalists. The court stated that it saw no reason why the state could not narrow the subsection by requiring specific intent or by limiting criminal liability to statements that cause particular harm. The court also held that an easy solution to the First Amendment issue would be to simply strike the word “misrepresentation.”
Subsection (b). Subsection (b) criminalizes obtaining records of an agricultural production facility by misrepresentation. Unlike the trial court, the appellate court upheld this subsection on the basis that it protects against a legally cognizable harm associated with a false statement. The court determined that unlike false statements made to enter property, false statements made to actually acquire agricultural production facility records inflict a property harm upon the owner, and may also bestow a material gain on the acquirer.
Subsection (c). The appellate court also reversed the trial court’s finding of unconstitutionality with respect to subsection (c). This subsection criminalizes knowingly obtaining employment with an agricultural production facility by misrepresentation with the intent to cause economic or other injury to the facility’s operations, property or personnel. The appellate court determined that subsection (c) properly followed U.S. Supreme Court guidance as to what constitutes a lie made for material gain. This was particularly the case, the appellate court noted, because subsection (c) limits criminal liability to only those who gain employment by misrepresentation and who have the intent to cause economic or other injury which further limits the scope of the subsection.
Subsection (d). This subsection bars a person from entering a private agricultural production facility and, without express consent from the facility owner, making audio or video recordings of the “conduct of an agricultural production facility’s operations.” The appellate court determined that because the recording process is itself expressive and is inextricably intertwined with the resulting recording, the creation of audiovisual recordings is speech entitled to First Amendment protection as purely expressive activity. In addition, the appellate court concluded that the subsection was both under-inclusive and over-inclusive. It was under-inclusive by prohibiting audio or video recordings but saying nothing about photographs. It was over-inclusive and suppressed more speech than necessary to further Idaho’s stated goals of protecting property and privacy. Accordingly, the appellate court agreed with the trial court that subsection (d) was unconstitutionally defective.
The Ninth Circuit’s opinion provides a roadmap for state lawmakers to follow to provide at least a minimal level of protection to animal production facilities from those that would intend to do them economic harm. Barring entry to a facility by force, threat or trespass is allowed. Likewise, the acquisition of economic data by misrepresentation can be prohibited. Similarly, criminalizing the obtaining of employment by false pretenses coupled with the intent to cause harm to the animal production facility is not constitutionally deficient. However, provisions that criminalize audiovisual recordings likely will not stand. That conclusion shouldn’t trouble animal production facilities – if they are operating properly there is nothing to hide.
Friday, January 5, 2018
This week we are looking at the biggest developments in agricultural law and taxation for 2017. On Monday, I discussed those developments that were important but just not quite significant enough based on their national significance to make the top ten. On Wednesday I addressed developments 10 through 6. Today I discuss the top five developments of 2017 – the really big ones. These are the developments that I deem to be of the highest importance on a national scale to agricultural producers, agribusiness and rural landowners in general.
Today’s blog post – the top five developments in agricultural law and taxation in 2017.
- 5 – Federal Implied Reserved Water Rights Doctrine Applies to Groundwater. Water issues are big in the West, and the Federal Government owns about 28 percent of the land area of the United States, with approximately 50 percent of that amount concentrated in 11 Western states (excluding Alaska). Across the West, most water rights are granted under and governed by state law. Federal law touching on water rights has generally deferred to state law for over 140 years, and the federal government waives its sovereign immunity from state court proceedings involving water rights. However, the U.S. Supreme Court has long recognized that Native American tribes can be entitled to water rights under federal law, rights that supersede many of these state rights. These federal implied rights are based upon the belief that the United States, when establishing Indian reservations, “intended to deal fairly with the Indians by reserving for them the waters without which their lands would have been useless.” But, the federal government’s water rights are not limited to its trustee capacity for Native American Tribes, but also apply to national monuments, national forests, and other public lands. In 2017, the U.S. Court of Appeals for the Ninth Circuit became the first federal appellate case to reach a decision on this issue, and its reasoning follows multiple state court decisions across the West. The court first held that the United States clearly intended to reserve water under federal law when it created the Tribe’s reservation. The court noted that the underlying purpose of the reservation was to establish a tribal homeland supporting an agrarian society. That purpose would be entirely defeated, the court reasoned, without sufficient water supplies held under federal law. Thus, the Tribe was entitled to a reserved water right for the Agua Caliente Reservation. Next, the Ninth Circuit held that the Tribe’s reserved water right extended to groundwater. It was necessary for the Tribe to access groundwater in the Coachella Valley Basin because surface supplies were clearly inadequate—a reservation without an adequate supply of surface water must be able to access groundwater as well. Thus, the court held that the reservation and establishment of the Agua Caliente Reservation carried with it an implied federal reserved right to use water from the aquifer. The court also determined that the Tribe’s implied reserved water rights pre-empted state water rights, and the Tribe’s lack of groundwater pumping did not defeat those rights, because they are immune from abandonment. The court also determined that the proper inquiry was whether water was envisioned as necessary for the reservation’s purpose at the time the reservation was created. Thus, the Ninth Circuit held, the issue of the Tribe’s state law-based water rights did not affect the existence of its federal implied reserved water right. That right, the court held, always applies as a matter of federal pre-emption, regardless of how a state allocates groundwater rights. The court’s opinion is significant because groundwater has become the dominant supply of water across the West. The decision also has important implications for California, the number one agricultural state in the nation (in terms of cash receipts), which enacted the Sustainable Groundwater Management Act (SGMA) in 2014. Because the Ninth Circuit’s decision establishes strong (and largely non-negotiable) rights for tribes within California’s groundwater basins, it complicates the formidable task of achieving sustainable groundwater management. Across the West, the other implications of the decision likely depend upon what remains of basin-wide adjudications of water rights.
Note: On November 27, 2017, the U.S. Supreme Court denied certiorari in the first phase of the case, allowing the Ninth Circuit’s holding to stand. Coachella Valley Water District v. Agua Caliente Band of Cahuilla Indians, No. 17-40, Vide No. 17-42, 2017 U.S. LEXIS 7044 (U.S. Sup. Ct. Nov. 27, 2017).
- 4 - EPA Rule Exempting Farms From Air Release Reporting Vacated.Under the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA) and the Emergency Planning and Community Right-to-Know Act (EPCRA), the federal government is to be notified when large quantities of hazardous materials are released into the environment. Once notified, the Environmental Protection Agency (EPA) has discretion to take remedial actions or order further monitoring or investigation of the situation. In 2008, the EPA issued a final regulation exempting large (commercial) farms (those that emit more than 100 pounds total of hydrogen sulfide or ammonia daily) from the CERCLA reporting/notification requirement for air releases from animal waste (by issuing an annual report of “continuous releases”) on the basis that a federal response would most often be impractical and unlikely. However, the EPA retained the reporting/notification requirement for Confined Animal Feeding Operations (CAFOs) under EPCRAs public disclosure rule. Indeed, in early 2009, EPA, pursuant to the EPCRA, issued a final regulation regarding the reporting of emissions from confined AFO’s – termed a “CAFO.” The rule applies to facilities that confine more than 1,000 beef cattle, 700 mature dairy cows, 1,000 veal calves, 2,500 swine (each weighing 55 pounds or more), 10,000 swine (each weighing less than 55 pounds), 500 horses and 10,000 sheep. The rule requires these facilities to report ammonia and hydrogen sulfide emissions to state and local emergency response officials if the facility emits 100 pounds or more of either substance during a 24-hour period. Various environmental activist groups challenged the exemption in the final regulation on the basis that the EPA acted outside of its delegated authority to create the exemption. Agricultural groups claimed that the carve-out for CAFOs was also impermissible. The environmental groups claimed that emissions of ammonia and hydrogen sulfide (both hazardous substances under CERCLA) should be reported as part of furthering the overall regulatory objective. The court noted that there was no clear way to best measure the release of ammonia and hydrogen sulfide, but noted that continuous releases are subject to annual notice requirements. The court held that the EPA’s final regulation should be vacated as an unreasonable interpretation of the de minimis exception in the statute. As such, the challenge brought by the agriculture groups to the CAFO carve-out was mooted and dismissed. Later, the court, granted a motion filed by the EPA and ag groups to delay the removal of the exemption until November 14, 2017. The EPA’s interim guidance on the new reporting requirements was issued on October 26, 2017, but the EPA again motioned for an extension of time to fully implement the regulations. The court granted the motion on November 22, 2017, staying the implementation of the new reporting regulations until January 22, 2018. The reporting requirement will have direct application to larger livestock operations with air emissions that house beef cattle, dairy cattle, horses, hogs and poultry. It is estimated that approximately 60,000 to 100,000 livestock and poultry operations will be subject to the reporting requirement. The reporting level would be reached by a facility with approximately 330-head (for a confinement facility) according to a calculator used by the University of Nebraska-Lincoln which is based on emissions produced by the commingling of solid manure and urine. The underlying action is Waterkeeper Alliance, et al. v. Environmental Protection Agency, 853 F.3d 527 (D.C. Cir. 2017).
- 3 – Clean Water Act “WOTUS” Developments. In 2015, the Environmental Protection Agency (EPA) and the U.S. Army Corps of Engineers (COE) finalized a regulation (known as the “Clean Water Rule”) concerning “waters of the United States” (WOTUS) which expanded the parameters of waters (streams, rivers, ponds, ditches, puddles and other water bodies) that are subject to federal jurisdiction and regulation. The final regulation became effective in the late summer of 2015, but a federal court stayed its implementation later that year in October. In early 2016, the U.S. Court of Appeals for the Sixth Circuit held that federal law placed jurisdiction with the federal appellate courts rather than the federal district courts concerning any challenges to the WOTUS rule. In January of 2017, the U.S. Supreme Court agreed to review the Sixth Circuit’s decision. National Association of Manufacturers v. Department of Defense, et al., 137 S. Ct. 811 (2017). About a month later, President Trump issued an Executive Order directing the EPA and the COE to revisit the Clean Water Rule and change their interpretation of waters subject to federal jurisdiction such that it only applied to waters that were truly navigable – the approach taken by Justice Scalia in Rapanos v. United States, 547 U.S. 715 (2006). The EPA and Corps later indicated they would follow the President’s suggested approach, and would push the effective date of the revised Clean Water Rule to two years after its finalization and publication.
In addition, there were several important WOTUS cases decided/finalized in 2017:
- COE jurisdictional determination is final agency action; no WOTUS present. The plaintiff, a peat moss mining company, sought the approval of the Corps of Engineers (COE) to harvest a swamp (wetland) for peat moss to use in landscaping projects. The COE issued a jurisdictional determination that the swamp was a wetland subject to the permit requirements of the Clean Water Act (CWA). The plaintiff sought to challenge the COE determination, but the trial court ruled for the COE, holding that the plaintiff had three options: (1) abandon the project; (2) seek a federal permit costing over $270,000; or (3) proceed with the project and risk fines of up to $75,000 daily and/or criminal sanctions including imprisonment. On further review, the U.S. Supreme Court unanimously reversed, holding that COE Jurisdictional Determinations constitute final agency actions that are immediately appealable in court. The court noted that to hold elsewise would allow the COE to effectively kill the project without any determination of whether it's position as to jurisdiction over the wetland at issue was correct. Not only did the jurisdictional determination constitute final agency action under the Administrative Procedure Act, the court held that it also determined rights or obligations from which legal consequences would flow. That made the determination judicially reviewable. United States Army Corps of Engineers v. Hawkes Company, No. 15-290, 136 S. Ct. 1807 (2016). On remand, the trial court granted summary judgment for the plaintiff on the grounds that the plaintiff’s property did not constitute “waters of the United States” that the defendant had jurisdiction over. The court determined that the government did not establish a “significant nexus” under the Rapanos standard between the plaintiff’s property and the Red River 93 miles away that the defendant claimed were connected via ditches and seasonal tributaries. The court also determined that the Jurisdictional Determination was not based on the “significant nexus” standard of Rapanos and was arbitrary and capricious. The court entered an injunction that ordered the defendant to not assert jurisdiction over the plaintiff’s property. In doing so, the court determined that the defendant had an adequate chance to develop a record which negated a remand back to the defendant to address the evidentiary inadequacies. Hawkes Co., Inc., et al. v. United States Army Corps of Engineers, No. 13-107 ADM/TNL, 2017 U.S. Dist. LEXIS 10680 (D. Min. Jan. 24, 2017).
- Prior Converted Cropland Exception to CWA Jurisdiction Inapplicable.The plaintiff, a developer, obtained title to a 100-acre tract on the southeast side of Chicago metro area in 1995. The defendant claimed federal jurisdiction over water on a portion of the property on the basis that the “wetland” drained via a storm sewer pipe to a creek that was a tributary to a river that was a navigable water of the U.S. After exhausting administrative appeals, the court upheld the defendant’s nexus determination because it sufficiently documented a physical, chemical and biological impact of the navigable river. The court also determined that the prior converted cropland exemption did not apply because farming activities had been abandoned for at least five years and wetland characteristics returned. The court noted that the defendant and the EPA had jointly adopted a rule in 1993 adopting the NRCS exemption for prior converted cropland. The court also that prior caselaw had held that the CWA’s exemption of “prior converted croplands” included the abandonment provision, and that it would apply the same rationale in this case. The court noted that the specific 13-acre parcel at issue in the case had not been farmed since 1996, and that conversion to a non-ag use did not remove the abandonment provision. The plaintiff also claimed that the wetlands at issue were “artificial” wetlands (created by adjacent development) under 7 C.F.R. §12.2(a) that were not subject to the defendant’s jurisdiction. However, the court noted that the defendant never adopted the “artificial wetland” exemption of the NRCS and, therefore, such a classification was inapplicable. The court granted the defendant’s cross motion for summary judgment. Orchard Hill Building Co. v. United States Army Corps of Engineers, No. 15-cv-06344, 2017 U.S. Dist. LEXIS 151673 (N.D. Ill. Sept. 19, 2017).
- Conviction Upheld for Clean Water Act Violations.The defendant, a disabled Vietnam Navy veteran, was charged with multiple counts of criminal violations of the (CWA) by virtue of the unauthorized knowing discharge of “pollutants” into the “waters of the United States” (WOTUS) (in violation of 33 U.S.C. §1251-1388) and depredation of U.S. property (18 U.S.C. §1361). The defendant was indicted for building illegal ponds (nine in total) in an existing stream on two parcels - one federal and one private (which the defendant did not own). The defendant did the work due to multiple fires in the area that had recently occurred and to create stock water ponds for his animals. The government claimed that the ponds resulted in the discharge of dredged and fill material into a tributary stream and adjacent wetlands and damaged both properties, even though there was no tributary from the ponds. Dredged material from the ponds had been used to create the berms and had been placed in and around the streams and wetlands. The trial court determined that the stream at issue was a WOTUS on the basis that the stream headwater and wetland complex provided critical support to trout in downstream rivers and fisheries, including the Boulder and Jefferson Rivers (60 miles away) – navigable waters of the U.S. The trial court jury, after a second trial and the introduction by the government of evidence that it allegedly manufactured, found the defendant guilty of two counts of illegal discharge of pollutants into WOTUS without a federal permit and one count of injury or depredation of U.S. property. On appeal, the appellate court affirmed. The appellate court held that U.S. Supreme Court Justice Kennedy’s opinion in Rapanos v. United States, 547 U.S. 715 (2006) was controlling and that the trial court jury instructions based on Justice Kennedy’s “significant nexus test contained in his opinion in Rapanos were proper. The appellate court also held that the definition of WOTUS was not too vague to be enforced. Thus, there was no due process violation. The defendant had fair warning that his conduct was criminal. United States v. Robertson, 875 F.3d 1281 (9th Cir. 2017).
- 2 – Rental and Employment Agreements Appropriately Structured; No Self-Employment Tax on Rental Income.The petitioners, a married couple, operated a farm in Texas. In late 1999, they built the first of eight poultry houses to raise broilers under a production contract with a large poultry integrator. The petitioners formed an S corporation in 2004, and set up oral employment agreements with the S corporation based on an appraisal for the farm which guided them as to the cost of their labor and management services. They also pegged their salaries at levels consistent with other growers. The wife provided bookkeeping services and the husband provided labor and management. In 2005, they assigned the balance of their contract to the S corporation. Thus, the corporation became the "grower" under the contract. In 2005, the petitioners entered into a lease agreement with the S corporation. Under the agreement, the petitioners rented their farm to the S corporation, under which the S corporation would pay rent of $1.3 million to the petitioners over a five-year period. The court noted that the rent amount was consistent with other growers under contract with the integrator. The petitioners reported rental income of $259,000 and $271,000 for 2008 and 2009 respectively, and the IRS determined that the amounts were subject to self-employment tax because the petitioners were engaged in an "arrangement" that required their material participation in the production of agricultural commodities on their farm. The Tax Court, in an opinion by Judge Paris, noted that the IRS agreed that the facts of the case were on all fours with McNamara v. Comr., T.C. Memo. 1999-333 where the Tax Court determined that the rental arrangement and the wife's employment were to be combined, which meant that the rental income was subject to self-employment tax. However, the Tax Court's decision in that case was reversed by the Eighth Circuit on appeal. McNamara v. Comr., 236 F.3d 410 (8th Cir. 2000). Judge Paris, in the current case, determined that the Eighth Circuit's rationale in McNamara was persuasive and that the "derived under an arrangement" language in I.R.C. §1402(a)(1) meant that a nexus had to be present between the rents the petitioners received and the "arrangement" that required their material participation. In other words, there must be a tie between the real property lease agreement and the employment agreement. The court noted the petitioners received rent payments that were consistent with the integrator's other growers for the use of similar premises. That fact was sufficient to establish that the rental agreement stood on its own as an appropriate measure as a return on the petitioners' investment in their facilities. Similarly, the employment agreement was appropriately structured as a part of the petitioners' conduct of a legitimate business. Importantly, the court noted that the IRS failed to brief the nexus issue, relying solely on its non-acquiescence to McNamara (A.O.D. 2003-003, I.R.B. 2003-42 (Oct. 22, 2003)) and relying on the court to broadly interpret "arrangement" to include all contracts related to the S corporation. The Tax Court refused to do so and, accordingly, the court held that the petitioner's rental income was not subject to self-employment tax. Martin v. Comr., 149 T.C. No. 12 (2017).
- No 1 – The Tax Bill ("To provide for Reconciliation Pursuant to Titles II and V of the Concurrent Resolution on the Budget for Fiscal Year 2018"). The most significant development of 2017 with the widest impact on agricultural producers, agribusinesses and rural landowners is unquestionably the tax bill enacted into law on December 22, 2017. The new law establishes new tax brackets, essentially doubles the standard deduction, eliminates many itemized deductions, modifies many cost-recovery provisions and changes the corporate tax rate to a flat rate of 21 percent. The legislation also creates a new 20 percent deduction for qualified business income from a pass-through entity. Prior law was also modified concerning cash accounting, the tax rate applicable to commodity gifts made to a non-charitable donee above certain levels of unearned income, the rules surrounding net operating losses, interest deductibility, elimination of the corporate alternative minimum tax (AMT) and modification of the individual AMT, the child tax credit and various international tax provisions. The new law will create many planning questions and opportunities with the structure of perhaps many farm operations being modified to take advantage of the new provisions.
2017 was another active year on the agricultural law and taxation front. It was also the first year in many years where some rather significant federal regulations as applies to agriculture were either rolled back or eliminated. 2018 will be another very busy year. That is certainly to be the case especially on the tax side of things.
Wednesday, January 3, 2018
This week we are looking at the biggest developments in agricultural law and taxation for 2017. On Monday, I discussed those developments that were important but just not quite significant enough based on their national significance to make the top ten. Today I start a two-day series on the top ten developments of 2017 with a discussion of developments 10 through six. On Friday, developments five through one will be covered. To make my list, the development from the courts, IRS and federal agencies must have a major impact nationally on agricultural producers, agribusiness and rural landowners in general.
Without further delay, here we go - the top developments for 2017 (numbers 10 through six).
- 10 – South Dakota Enacts Unconstitutional Tax Legislation. In 2017, the South Dakota Supreme Court gave the South Dakota legislature and Governor what it wanted – a ruling that a recently enacted South Dakota law was unconstitutional. South Dakota’s thirst for additional revenue led it to enact a law imposing sales tax on businesses that have no physical presence in the state. That’s something that the U.S. Supreme Court first said 50 years ago that a state cannot do. Accordingly, the South Dakota Supreme Court struck the law down as an unconstitutional violation of the Commerce Clause. The legislature deliberately enacted the law so that it would be challenged as unconstitutional in order to set up a case in hopes that the U.S. Supreme Court would review it and reverse its longstanding position on the issue. See, e.g., National Bellas Hess, Inc. v. Illinois Department of Revenue, 386 U.S. 753 (1967) and Quill Corporation v. North Dakota, 504 U.S. 298 (1992). If that happens, or the Congress takes action to allow states to impose sales (and/or use) tax on businesses with no physical presence in the state, the impact would be largely borne by small businesses, including home-based business and small agricultural businesses all across the country. It would also raise serious questions about how strong the principle of federalism remains. State v. Wayfair, Inc., et al., 901 N.W.2d 754 (S.D. Sup. Ct. 2017), pet. for cert. filed, Oct. 2, 2017.
- 9 - Amendment to Bankruptcy Law Gives Expands Non-Priority Treatment of Governmental Claims. H.R. 2266, signed into law on October 26, 2017, contains the Family Farmer Bankruptcy Act (Act). The Act adds 11 U.S.C. §1232 which specifies that, “Any unsecured claim of a governmental unit against the debtor or the estate that arises before the filing of the petition, or that arises after the filing of the petition and before the debtor's discharge under section 1228, as a result of the sale, transfer, exchange, or other disposition of any property used in the debtor's farming operation”… is to be treated as an unsecured claim that arises before the bankruptcy petition was filed that is not entitled to priority under 11 U.S.C. §507 and is deemed to be provided for under a plan, and discharged in accordance with 11 U.S.C. §1228. The provision amends 11 U.S.C. §1222(a)(2)(A) to effectively override Hall v. United States, 132 Sup. Ct. 1882 (2012) where the U.S. Supreme Court held that tax triggered by the post-petition sale of farm assets was not discharged under 11 U.S.C. §1222(a)(2)(A). The Court held that because a Chapter 12 bankruptcy estate cannot incur taxes by virtue of 11 U.S.C. §1399, taxes were not “incurred by the estate” under 11 U.S.C. §503(b) which barred post-petition taxes from being treated as non-priority. The provision is effective for all pending Chapter 12 cases with unconfirmed plans and all new Chapter 12 cases as of October 26, 2017. H.R. 2266, Division B, Sec. 1005, signed into law on October 26, 2017.
- 8 – “Hobby Loss” Tax Developments. 2017 saw two significant developments concerning farm and ranching activities that the IRS believes are not conducting with a business purpose and are, thus, subject to the limitation on deductibility of losses. Early in 2017, the IRS issued interim guidance on a pilot program for Schedule F expenses for small business/self-employed taxpayer examinations. It set the program to begin on April 1, 2017 and run for one year. The focus will be on “hobby” farmers, and will involve the examination of 50 tax returns from tax year 2015. The program could be an indication that the IRS is looking to increase the audit rate of returns with a Schedule F, and it may be more likely to impact the relatively smaller farming operations. The interim guidance points out that the IRS believes that compliance issues may exist with respect to the deduction of expenses on the wrong form, or expenses that actually belonged to another taxpayer, or that should be subject to the hobby loss rules of I.R.C. §183. Indeed, the IRS notes that a filter for the project will be designed to identify those taxpayers who have W-2s with large income and who also file a Schedule F “and may not have time to farm.” In addition, the guidance informs IRS personnel that the examined returns could have start-up costs or be a hobby activity which would lead to non-deductible losses. The interim guidance also directs examiners to look for deductions that “appear to be excessive for the income reported.” The implication is that such expenses won’t be deemed to be ordinary and necessary business expenses. How that might impact the practice of pre-paying farm expenses remains to be seen. The guidance also instructs examiners to pick through gas, oil, fuel, repairs, etc., to determine the “business and non-business parts” of the expense without any mention of the $2,500 safe harbor of the repair regulations. The interim guidance would appear to be targeted toward taxpayers that either farm or crop share some acres where the income ends up on Schedule F, but where other non-farm sources of income predominate (e.g., W-2 income, income from leases for hunting, bed and breakfast, conservation reserve program payments, organic farming, etc.). In those situations, it is likely that the Schedule F expenses will exceed the Schedule F income. That’s particularly the case when depreciation is claimed on items associated with the “farm” - a small tractor, all-terrain vehicle, pickup truck, etc. That’s the typical hobby loss scenario that IRS is apparently looking for.
The second development on the hobby loss issue was a Tax Court opinion issued by Judge Paris in late 2017. The case involved a diversified ranching operation that, for the tax years at issue, had about $15 million in losses and gross income of $7 million. For those years, the petitioner’s primary expense was depreciation. The IRS claimed that the ranching activity was not engaged in for profit and the expenses were deductible only to the extent of income. The Tax Court determined that all of the petitioner’s activities were economically intertwined and constituted a single ranching activity. On the profit issue, the court determined that none of the factors in the Treasury Regulations §1.183-2(b) favored the IRS. Accordingly, the petitioner’s ranching activity was held to be conducted for-profit and the losses were fully deductible. The court specifically rejected the IRS argument that a profit motive could not be present when millions of dollars of losses were generated. That’s a very important holding for agriculture. Depreciation is often the largest deduction on a farm or ranch operation’s return. Welch, et al. v. Comr., T.C. Memo. 2017-229.
- 7 - Beneficial Use Doctrine Established Water Right That Feds Had Taken. In late 2017, the U.S. Court of Federal Claims issued a very significant opinion involving vested water rights in the Western United States. The court ruled that the federal government had taken the vested water rights of the plaintiff, a New Mexico cattle ranching operation, which required compensation under the Fifth Amendment. The court determined that the plaintiff had property rights by virtue of having “made continuous beneficial use of stock water sources” predating federal ownership. Those water rights pre-dated 1905, and the U.S. Forest Service (USFS) had allowed that usage from 1910 to 1989. The court also agreed with the plaintiff’s claim the water was “physically taken” when the United States Forest Service (USFS) blocked the plaintiff’s livestock from accessing the water that had long been used by the plaintiff and its predecessors to graze cattle so as to preserve endangered species.
More specifically, the plaintiff held all “cattle, water rights, range rights, access rights, and range improvements on the base property, as well as the appurtenant federally-administered grazing allotment known as the Sacramento Allotment” in New Mexico. The plaintiff obtained a permit in 1989 from the USFS to graze cattle on an allotment of USFS land which allowed for the grazing of 553 cows for a 10-year period. At the time the permit was obtained, certain areas of the allotment were fenced off, but the USFS allowed the plaintiff’s cattle access to water inside the fenced areas. However, in 1996, the USFS notified the plaintiff that cattle were not permitted to graze inside the fenced areas, but then later allowed temporary grazing due to existing drought conditions. In 1998, the USFS barred the plaintiff from grazing cattle inside the fenced areas, but then reissued the permit in 1999 allowing 553 cattle to graze the allotment for 10 years subject to cancellation or modification as necessary. The permit also stated that “livestock use” was not permitted inside the fenced area. In 2001, the USFS denied the plaintiff’s request to pipe water from the fenced area for cattle watering and, in 2002, the USFS ordered the plaintiff to remove cattle that were grazing within the fenced area. Again in 2006, the plaintiff sought to pipe water from a part of the fenced area, but was denied. A U.S. Fish and Wildlife Service Biological Opinion in 2004 recommended the permanent exclusion of livestock from the allotment, and the plaintiff sued for a taking of its water rights which required just compensation. While the parties were able to identify and develop some alternative sources of water, that did not solve the plaintiff’s water claims and the plaintiff sued.
The court determined that the plaintiff’s claim was not barred by the six-year statute of limitations because the plaintiff’s claim accrued in 1998 when the USFS took the first “official” action barring the grazing of cattle in the fenced area. The court also determined that under state (NM) law, the right to the beneficial use of water is a property interest that is a distinct and severable interest from the right to use land, with the extent of the right dependent on the beneficial use. The court held that the “federal appropriation of water does not, per se constitute a taking….Instead, a plaintiff must show that any water taken could have been put to beneficial use.” The court noted that NM law recognizes two types of appropriative water rights – common law rights in existence through 1907 and those based on state statutory law from 1907 forward. The plaintiff provided a Declaration of Ownership that had been filed with the New Mexico State Engineer between 1999 and 2003 for each of the areas that had been fenced-in. Those Declarations allow a holder of a pre-1907 water right to specify the use to which the water is applied, the date of first appropriation and where the water is located. Once certified, the Declaration of Ownership is prima facie evidence of ownership. The court also noted that witnesses testified that before 1907, the plaintiff’s predecessor’s in interest grazed cattle on the allotment and made beneficial use of the water in the fenced areas. Thus, the court held that the plaintiff had carried its burden to establish a vested water right. The plaintiff’s livestock watering also constituted a “diversion” required by state law. Thus, the USFS action constituted a taking of the plaintiff’s water right. Importantly, the court noted that a permanent physical occupation does not require in every instance that the occupation be exclusive, or continuous and uninterrupted. The key, the court noted, was that the effects of the government’s action was so complete to deprive the plaintiff of all or most of its interest. The court directed the parties to try to determine whether alternative water sources could be made available to the plaintiff to allow the ranching operation to continue on a viable basis. If not, the court will later determine the value of the water rights taken for just compensation purposes. Sacramento Grazing Association v. United States, No. 04-786 L. 2017 U.S. Claims LEXIS 1381 (Fed. Cl. Nov. 3, 2017).
- 6 – Department of Labor Overtime Rules Struck Down. In 2017, a federal court in Texas invalidated particular Department of Labor (DOL) rules under the Fair Labor Standards Act (FLSA). The invalidation will have a significant impact on agricultural employers. The FLSA exempts certain agricultural employers and employees from its rules. However, one aspect of the FLSA that does apply to agriculture are the wage requirements of the law, both in terms of the minimum wage that must be paid to ag employment and overtime wages. But, an exemption denies persons employed in agriculture the benefit of mandatory overtime payment. 29 U.S.C. § 213(b)(12). The agricultural exemption is broad, defining “agriculture” to include “farming in all its branches [including] the raising of livestock, bees, fur-bearing animals, or poultry,…and the production, cultivation, growing, and harvesting of...horticultural commodities and any practices performed by a farmer or on a farm as an incident to or in conjunction with farming operations.” In addition, exempt are “executive” workers whose primary duties are supervisory and the worker supervises 2 or more employees. Also exempt are workers that fall in the “administrative” category who provide non-manual work related to the management of the business, and workers defined as “professional” whose job is education-based and requires advanced knowledge. Many larger farming and ranching operations have employees that will fit in at least one of these three categories. For ag employees that are exempt from the overtime wage payment rate because they occupy an “executive” position, they must be paid a minimum amount of wages per week.
Until December 1, 2016, the minimum amount was $455/week ($23,660 annually). Under the Obama Administration’s DOL proposal, however, the minimum weekly amount was to increase to $913 ($47,476 annually). Thus, an exempt “executive” employee that is paid a weekly wage exceeding $913 is not entitled to be paid for any hours worked exceeding 40 in a week. But, if the $913 weekly amount was not met, then the employee would generally be entitled to overtime pay for the hours exceeding 40 in a week. Thus, the proposal would require farm businesses to track hours for those employees it historically has not tracked hours for – executive employees such as managers and those performing administrative tasks. But, remember, if the employee is an agricultural worker performing agricultural work, the employee need not be paid for the hours in excess of 40 in a week at the overtime rate. The proposal also imposes harsh penalties for noncompliance. Before the new rules went into effect, many states and private businesses sued to block them. The various lawsuits were consolidated into a single case, and in November of 2016, the court issued a temporary nationwide injunction blocking enforcement of the overtime regulations. Nevada v. United States Department of Labor, 218 F. Supp. 3d 520 (E.D. Tex. 2016).
On Aug. 31, 2017, the court entered summary judgment for the plaintiffs in the case thereby invalidating the regulations. In its ruling, the court focused on the congressional intent behind the overtime exemptions for “white-collar” workers as well as the authority of the DOL to define and implement those exemptions. The court also concluded that the DOL did not have any authority to categorically exclude workers who perform exempt duties based on salary level alone, which is what the court said that the DOL rules did. The court noted that the rules more than doubled the required salary threshold and, as a result, “would essentially make an employee’s duties, functions, or tasks irrelevant if the employee’s salary falls below the new minimum salary level.” The court went on to state that the overtime rules make “overtime status depend predominantly on a minimum salary level, thereby supplanting an analysis of an employee’s job duties.” The court noted that his was contrary to the clear intent of the Congress and, as a result, the rules were invalid. The court’s ruling invalidating the overtime rules is an important victory for many agricultural (and other) businesses. It alleviates an increased burden to maintain records for employees in executive positions (e.g., managers and administrators), and the associated penalties for non-compliance. The case is Nevada v. United States Department of Labor, No. 4:16-cv-731, 2017 U.S. Dist. LEXIS 140522 (E.D. Tex. Aug. 31, 2017).
Those are the "bottom five" of the "top 10" developments of 2017. On Friday I will reveal what I believe to be the top five developments.
Monday, January 1, 2018
This week I will be writing about what I view as the most significant developments in agricultural law and agricultural taxation during 2017. There were many important happenings in the courts, the IRS and with administrative agencies that have an impact on farm and ranch operations, rural landowners and agribusinesses. What I am writing about this week are those developments that will have the biggest impact nationally. Certainly, there were significant state developments, but they typically will not have the national impact of those that result from federal courts, the IRS and federal agencies.
It's tough to get it down to the ten biggest developments of the year, and I do spend considerable time sorting through the cases and rulings get to the final cut. Today’s post examines those developments that I felt were close to the top ten, but didn’t quite make the list. Later this week we will look at those that I feel were worthy of the top ten. Again, the measuring stick is the impact that the development has on the U.S. ag sector as a whole.
Almost, But Not Quite
Those developments that were the last ones on the chopping block before the final “top ten” are always the most difficult to determine. But, as I see it, here they are (in no particular order):
- Withdrawal of Proposed I.R.C. §2704 Regulations. In the fall of 2016, the Treasury Department issued proposed regulations (REG-16113-02) involving valuation issues under I.R.C. §2704. The proposed regulations would have established serious limitations on the ability to establish valuation discounts (e.g., minority interest and lack of marketability) for estate, gift and generation-skipping transfer tax purposes via estate and business planning techniques. In early December of 2016, a public hearing was held concerning the proposed regulations. However, the proposed regulations were not finalized before President Trump took office. In early October of 2017, the Treasury Department announced that it was pulling several tax regulations identified as burdensome under President Trump’s Executive Order 13789, including the proposed I.R.C. §2704 regulations. Second Report to the President on Identifying and Reducing Tax Regulatory Burdens (Oct. 4, 2017).
Note: While it is possible that the regulations could be reintroduced in the future with revisions, it is not likely that the present version will ultimately be finalized under the current Administration.
- IRS Says There Is No Exception From Filing a Partnership Return. The IRS Chief Counsel’s Office, in response to a question raised by an IRS Senior Technician Reviewer, has stated that Rev. Prov. 84-35, 1984-2 C.B. 488, does not provide an automatic exemption from the requirement to file Form 1065 (U.S. Return of Partnership Income) for partnerships with 10 or fewer partners. Instead, the IRS noted that such partnerships can be deemed to meet a reasonable cause test and are not liable for the I.R.C. §6698 penalty. IRS explained that I.R.C. §6031 requires partnerships to file Form 1065 each tax year and that failing to file is subject to penalties under I.R.C. §6698 unless the failure to file if due to reasonable cause. Neither I.R.C. §6031 nor I.R.C. §6698 contain an automatic exception to the general filing requirement of I.R.C. §6031(a) for a partnership as defined in I.R.C. §761(a). IRS noted that it cannot determine whether a partnership meets the reasonable cause criteria or qualifies for relief under Rev. Proc. 84-35 unless the partnership files Form 1065 or some other document. Reasonable cause under Rev. Proc. 84-35 is determined on a case-by-case basis and I.R.M. Section 126.96.36.199.3.1 sets forth the procedures for applying the guidance of Rev. Proc. 84-35. C.C.A. 201733013 (Jul. 12, 2017); see also Roger A. McEowen, The Small Partnership 'Exception,' Tax Notes, April 17, 2017, pp. 357-361.
- “Qualified Farmer” Definition Not Satisfied; 100 Percent Deductibility of Conservation Easement Not Allowed. A “qualified farmer” can receive a 100 percent deduction for the contribution of a permanent easement to a qualified organization in accordance with I.R.C. §170(b)(1)(E). However, to be a “qualified farmer,” the taxpayer must have gross income from the trade or business of farming that exceeds 50 percent of total gross income for the tax year. In a 2017, the U.S. Tax Court decided a case where the petitioners claimed that the proceeds from the sale of the property and the proceeds from the sale of the development rights constituted income from the trade or business of farming that got them over the 50 percent threshold. The IRS disagreed, and limited the charitable deduction to 50 percent of each petitioner’s contribution base with respect to the conservation easement. The court agreed with the IRS. The court noted that the income from the sale of the conservation easement and the sale of the land did not meet the definition of income from farming as set forth in I.R.C. §2032A(e)(5) by virtue of I.R.C. §170(b)(1)(E)(v). The court noted that the statute was clear and that neither income from the sale of land nor income from the sale of development rights was included in the list of income from farming. While the court pointed out that there was no question that the petitioners were farmers and continued to be after the conveyance of the easement, they were not “qualified farmers” for purposes of I.R.C. §170(b)(1)(E)(iv)(I). Rutkoske v. Comr., 149 T.C. No. 6 (2017).
- Corporate-Provided Meals In Leased Facility Fully Deductible. While the facts of the case have nothing to do with agriculture, the issues involved are the same ones that the IRS has been aggressively auditing with respect to farming and ranching operations – namely, that the 100 percent deduction for meals provided to corporate employees for the employer’s convenience cannot be achieved if the premises where the meals are provided is not corporate-owned. In a case involving an NHL hockey team, the corporate owner contracted with visiting city hotels where the players stayed while on road trips to provide the players and team personnel pre-game meals. The petitioner deducted the full cost of the meals, and the IRS limited the deduction in accordance with the 50 percent limitation of I.R.C. §274(n)(1). The court noted that the 50 percent limitation is inapplicable if the meals qualify as a de minimis fringe benefit and are provided in a nondiscriminatory manner. The court determined that the nondiscriminatory requirement was satisfied because all of the staff that traveled with the team were entitled to use the meal rooms. The court also determined that the de minimis rule was satisfied if the eating facility (meal rooms) was owned or leased by the petitioner, operated by the petitioner, located on or near the petitioner’s business premises, and the meals were furnished during or immediately before or after the workday. In addition, the court determined that the rules can be satisfied via contract with a third party to operate an eating facility for the petitioner’s employees. As for the business purpose requirement, the court noted that the hotels where the team stayed at while traveling for road games constituted a significant portion of the employees’ responsibilities and where the team conducted a significant portion of its business. Thus, the cost of the meals qualified as a fully deductible de minimis fringe benefit. Jacobs v. Comr., 148 T.C. No. 24 (2017).
Note: The petitioner’s victory in the case was short-lived. The tax bill enacted into law on December 22, 2017, changes the provision allowing 100 percent deductibility of employer-provided meals to 50 percent effective Jan. 1, 2018, through 2025. After 2025, no deduction is allowed.
- Settlement Reached In EPA Data-Gathering CAFO Case. In 2008, the Government Accounting Office (GAO) issued a report stating that the Environmental Protection Agency (EPA) had inconsistent and inaccurate information about confined animal feeding operations (CAFOs), and recommended that EPA compile a national inventory of CAFO’s with NPDES permits. Also, as a result of a settlement reached with environmental activist groups, the EPA agreed to propose a rule requiring all CAFOs to submit information to the EPA as to whether an operation had an NPDES permit. The information required to be submitted had to provide contact information of the owner, the location of the CAFO production area, and whether a permit had been applied for. Upon objection by industry groups, the proposed rule was withdrawn and EPA decided to collect the information from federal, state and local government sources. Subsequent litigation determined that farm groups had standing to challenge the EPA’s conduct and that the EPA action had made it much easier for activist groups to identify and target particular confined animal feeding operations (CAFOs). On March 27, 2017, the court approved a settlement agreement ending the litigation between the parties. Under the terms of the settlement, only the city, county, zip code and permit status of an operation will be released. EPA is also required to conduct training on FOIA, personal information and the Privacy Act. The underlying case is American Farm Bureau Federation v. United States Environmental Protection Agency, 836 F.3d 963 (8th Cir. 2016).
- Developments Involving State Trespass Laws Designed to Protect Livestock Facilities.
- Challenge to North Carolina law dismissed for lack of standing. The plaintiffs, numerous animal rights activist groups, brought a pre-enforcement challenge to the North Carolina Property Protection Act (Act). The Act creates a civil cause of action for a NC employer against an employee who “captures or removes” documents from the employer’s premises or records images or sound on the employer’s premises and uses the documents or recordings to breach the employee’s duty of loyalty to the employer. The plaintiffs claimed that the Act stifled their ability to investigate NC employers for illegal or unethical conduct and restricted the flow of information those investigations provide in violation of the First and Fourteenth Amendments of the U.S. Constitution and various provisions of the NC Constitution. The court dismissed the case for lack of standing. People for the Ethical Treatment of Animals v. Stein, 259 F. Supp. 3d 369 (M.D. N.C. 2017).
- Utah law deemed unconstitutional. Utah law (Code §76-6-112) (hereinafter Act) criminalizes entering private agricultural livestock facilities under false pretenses or via trespass to photograph, audiotape or videotape practices inside the facility. Anti-livestock activist groups sued on behalf of the citizen-activist claiming that the Act amounted to an unconstitutional restriction on speech in violation of the First Amendment. While the state claimed that lying, which the statute regulates, is not protected free speech, the court determined that only lying that causes “legally cognizable harm” falls outside First Amendment protection. The state also argued that the act of recording is not speech that is protected by the First Amendment. However, the court determined that the act of recording is protectable First Amendment speech. The court also concluded that the fact that the speech occurred on a private agricultural facility did not render it outside First Amendment protection. The court determined that both the lying and the recording provisions of the Act were content-based provisions subject to strict scrutiny. To survive strict scrutiny the state had to demonstrate that the restriction furthered a compelling state interest. The court determined that “the state has provided no evidence that animal and employee safety were the actual reasons for enacting the Act, nor that animal and employee safety are endangered by those targeted by the Act, nor that the Act would actually do anything to remedy those dangers to the extent that they exist”. For those reasons, the court determined that the act was unconstitutional. Animal Legal Defense Fund v. Herbert, 263 F. Supp. 3d 1193 (D. Utah 2017).
- Wyoming law struck down. In 2015, two new Wyoming laws went into effect that imposed civil and criminal liability upon any person who "[c]rosses private land to access adjacent or proximate land where he collects resource data." Wyo. Stat. §§6-3-414(c); 40-27-101(c). The appellate court, reversing the trial court, determined that because of the broad definitions provided in the statutes, the phrase "collects resource data" includes numerous activities on public lands (such as writing notes on habitat conditions, photographing wildlife, or taking water samples), so long as an individual also records the location from which the data was collected. Accordingly, the court held that the statutes regulated protected speech under the First Amendment in spite of the fact that they also governed access to private property. While trespassing is not protected by the First Amendment, the court determined that the statutes targeted the “creation” of speech by penalizing the collection or resource data. Western Watersheds Project v. Michael, 869 F.3d 1189 (10th Cir. 2017), rev’g., 196 F. Supp. 3d 1231 (D. Wyo. 2016).
- Challenge to North Carolina law dismissed for lack of standing. The plaintiffs, numerous animal rights activist groups, brought a pre-enforcement challenge to the North Carolina Property Protection Act (Act). The Act creates a civil cause of action for a NC employer against an employee who “captures or removes” documents from the employer’s premises or records images or sound on the employer’s premises and uses the documents or recordings to breach the employee’s duty of loyalty to the employer. The plaintiffs claimed that the Act stifled their ability to investigate NC employers for illegal or unethical conduct and restricted the flow of information those investigations provide in violation of the First and Fourteenth Amendments of the U.S. Constitution and various provisions of the NC Constitution. The court dismissed the case for lack of standing. People for the Ethical Treatment of Animals v. Stein, 259 F. Supp. 3d 369 (M.D. N.C. 2017).
- GIPSA Interim Final Rule on Marketing of Livestock and Poultry Delayed and Withdrawn.In the fall of 2016, the USDA sent to the Office of Management and Budget (OMB) interim final rules that provide the agency’s interpretation of certain aspects of the Packers and Stockyards Act (PSA) involving the buying and selling of livestock and poultry. The interim final rules concern Section 202 of the PSA (7 U.S.C. §§ 192 (a) and (e)) which makes it unlawful for any packer who inspects livestock, meat products or livestock products to engage in or use any unfair, unjustly discriminatory or deceptive practice or device, or engage in any course of business or do any act for the purpose or with the effect of manipulating or controlling prices or creating a monopoly in the buying, selling or dealing any article in restraint of commerce. The “effect” language of the statute would seem to eliminate any requirement that the producer show that the packer acted with the intent to control or manipulate prices. However, the federal courts have largely interpreted the provision to require a plaintiff to show an anti-competitive effect in order to have an actionable claim. Under the proposed regulations, "likelihood of competitive injury" is defined as "a reasonable basis to believe that a competitive injury is likely to occur in the market channel or marketplace.” It includes, but is not limited to, situations in which a packer, swine contractor, or live poultry dealer raises rivals' costs, improperly forecloses competition in a large share of the market through exclusive dealing, restrains competition, or represents a misuse of market power to distort competition among other packers, swine contractors, or live poultry dealers. It also includes situations “in which a packer, swine contractor, or live poultry dealer wrongfully depresses prices paid to a producer or grower below market value, or impairs a producer's or grower's ability to compete with other producers or growers or to impair a producer's or grower's ability to receive the reasonably expected full economic value from a transaction in the market channel or marketplace." According to the proposed regulations, a “competitive injury” under the PSA occurs when conduct distorts competition in the market channel or marketplace. The scope of PSA §202(a) and (b) is stated to depend on the nature and circumstances of the challenged conduct. The proposed regulations specifically note that a finding that a challenged act or practice adversely affects or is likely to affect competition is not necessary in all cases. The proposed regulations also note that a PSA violation can occur without a finding of harm or likely harm to competition, but as noted above, that is contrary to numerous court opinions that have decided the issue. On April 11, 2017, the USDA announced that it was delaying the effective date of the interim final rule for 180 days, until October 19, 2017. However, on October 18, 2017, GIPSA officially withdrew the proposed rule. Related to, but not part of, the GIPSA Interim Final Rule, a poultry grower ranking system proposed rule was not formally withdrawn.
- Syngenta Settlement. In late 2017, Syngenta publicly announced that it was settling farmers’ claims surrounding the alleged early release of Viptera and Duracade genetically modified corn. While there are numerous cases and aspects of the litigation involving Syngenta, the settlement involves what is known as the “MIR 162 Corn Litigation” and a Minnesota state court class action. The public announcement of the settlement indicated that Syngenta would pay $1.5 billion.
- IRS To Finalize Regulations on the Tax Status of LLC and LLP Members. In its 2017-2018 Priority Guidance Plan, the IRS states that it plans to finalize regulations under I.R.C. §469(h)(2) – the passive loss rules that were initially proposes in 2011. That provision creates a per se rule of non-material participation for limited partner interests in a limited partnership unless the Treasury specifies differently in regulations. Those regulations were initially issued in temporary form and became proposed regulations in 2011. Is the IRS preparing to take a move to finalize regulations taking the position that they the Tax Court refused to sanction? Only time will tell, but the issue is important for LLC and LLP members. The issue boils down to the particular provisions of a state’s LLC statute and whether there are sufficient factors under the state statute that distinguish an LLC from a limited partnership. That will be the case until IRS issues regulations dealing specifically with LLCs and similar entities. The proposed definition would make it easier for LLC members and some limited partners to satisfy the material participation requirements for passive loss purposes, consistent with the court opinions that IRS has recently lost on the issue. Specifically, the proposed regulations require that two conditions have to be satisfied for an individual to be classified as a limited partner under I.R.C. §469(h)(2): (1) the entity must be classified as a partnership for federal income tax purposes; and (2) the holder of the interest must not have management rights at any time during the entity’s tax year under local law and the entity’s governing agreement. Thus, LLC members of member-managed LLCs would be able to use all seven of the material participation tests, as would limited partners that have at least some rights to participate in managerial control or management of a partnership.
- Fourth Circuit Develops New Test for Joint Employment Under the FLSA. The Fair Labor Standards Act of 1938 (FLSA) (29 U.S.C. §§ 201 et seq.) as originally enacted, was intended to raise the wages and shorten the working hours of the nation's workers. The FLSA is very complex, and not all of it is pertinent to agriculture and agricultural processing, but the aspect of it that concerns “joint employment” is of major relevance to agriculture. Most courts that have considered the issue have utilized an “economic realities” or “control” test to determine if one company’s workers are attributable to another employer for purposes of the FLSA. But, in a 2017 case, the U.S. Court of Appeals for the Fourth Circuit, created a new test for joint employment under the FLSA that appears to expand the definition of “joint employment” and may create a split of authority in the Circuit Courts of Appeal on the issue. The court held that the test under the FLSA for joint employment involved two steps. The first step involved a determination as to whether two or more persons or entities share or agree to allocate responsibility for, whether formally or informally, directly or indirectly, the essential terms and conditions of a worker’s employment. The second step involves a determination of whether the combined influence of the parties over the essential terms and conditions of the employment made the worker an employee rather than an independent contractor. If, under this standard, the multiple employers were not completely disassociated, a joint employment situation existed. The court also said that it was immaterial that the subcontractor and general contractor engaged in a traditional business relationship. In other words, the fact that general contractors and subcontractor typically structure their business relationship in this manner didn’t matter. The Salinas court then went on to reason that separate employment exists only where the employers are “acting entirely independent of each other and are completely disassociated with respect to” the employees. The court’s “complete disassociation” test appears that it could result in a greater likelihood that joint employment will result in the FLSA context than would be the case under the “economic realities” or “control” test. While the control issue is part of the “complete disassociation” test, joint determination in hiring or firing, the duration of the relationship between the employers, where the work is performed and responsibility over work functions are key factors that are also to be considered. Salinas v. Commercial Interiors, Inc., 848 F.3d 125 (4th Cir. 2017), rev’g, No. JFM-12-1973, 2014 U.S. Dist. LEXIS 160956 (D. Md. Nov. 17, 2014).
- Electronic Logs For Truckers. On December 18, 2017, the U.S. Department of Transportation (USDOT) Final Rule on Electronic Logging Devices (ELD) and Hours of Service (HOS) was set to go into effect. 80 Fed. Reg. 78292 (Dec.16, 2015). The final rule, which was issued in late 2015, could have a significant impact on the livestock industry and livestock haulers. The new rule will require truck drivers to use electronic logging devices instead of paper logs to track their driving hours starting December 18. The devices connect to the vehicle's engine and automatically record driving hours. The Obama Administration pushed for the change to electronic logs purportedly out of safety concerns. The Trump Administration has instructed the FMCSA (and state law enforcement officials) to delay the December 18 enforcement of the final rule by delaying out-of-service orders for ELD violations until April 1, 2018, and not count ELD violations against a carrier’s Compliance, Accountability, Safety Score. Thus, from December 18, 2017 to April 1, 2018, any truck drivers who are caught without an electronic logging device will be cited and allowed to continue driving, as long as they are in compliance with hours-of-service rules. In addition, the FMCSA has granted a 90-day waiver for all vehicles carrying agricultural commodities. Other general exceptions to the final rule exist for vehicles built before 2000, vehicles that operate under the farm exemption (a “MAP 21” covered farm vehicle; 49 C.F.R. §395.1(s)), drivers coming within the 100/150 air-mile radius short haul log exemption (49 CFR §395.1(k)), and drivers who maintain HOS logs for no more than eight days during any 30-day period. One rule that is of particular concern is an HOS requirement that restricts drive time to 11 hours. This rule change occurred in 2003 and restricts truck drivers to 11 hours of driving within a 14-hour period. Ten hours of rest is required. That is a tough rule as applied to long-haul cattle transports. Unloading and reloading cattle can be detrimental to the health of livestock.
- Dicamba Spray-Drift Issues. 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 were on the rise in 2017. , 2017Usage 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 2017) took action to ban dicamba products because of drift-related damage issues. In addition, numerous lawsuits have been filed by farmers against Monsanto, BASF and/or DuPont alleging that companies violated the law by releasing their genetically modified seeds without an accompanying herbicide and that the companies could have reasonably foreseen that seed purchasers would illegally apply off-label, older dicamba formulations, resulting in drift damage. Other lawsuits involve claims that the new herbicide products are unreasonably dangerous and have caused harm even when applicators followed all instructions provided by law. In December of 2017, the Arkansas Plant Board voted to not recommend imposing a cut-off date of April 15 for dicamba applications. Further consideration of the issue will occur in early 2018.
Friday, December 22, 2017
Big Development for Water in the West - Federal Implied Reserved Water Rights Doctrine Applies to Groundwater
Water issues are big in the West. Couple that fact with the fact that the Federal Government owns about 28 percent of the land area of the United States, with approximately 50 percent of that amount is concentrated in 11 Western states (excluding Alaska). Recently, a federal appeals court held that that the federal implied reserved water rights doctrine categorically extends to groundwater. The court’s decision could have significant implications for the usage of water in the West – a very big issue for affected farmers and ranchers. It could also have an impact on water policy.
For today’s blog post, I asked Washburn Law School’s water law expert, Prof. Burke Griggs, to take a look at the recent case and project the important implications for agriculture and Western water policy in general. Here’s what Burke had to say:
Western Water Rights
Across the West, most water rights are granted under and governed by state law. Federal law touching on water rights has generally deferred to state law, most prominently in legislation such as the General Mining Law of 1872, the Desert Land Act of 1877, and the Reclamation Act of 1902. Since Winters v. United States, 207 U.S. 564 (1908), however, the Supreme Court has recognized that Native American tribes can be entitled to water rights under federal law, rights that supersede many of these state rights. Specifically, when the United States withdraws land from the public domain and reserves it for a particular federal purpose—as for a reservation intended to be the permanent home for a Native American tribe—then the federal government has impliedly reserved sufficient unappropriated water supplies required to effect the purpose of the reservation. These federal implied rights are based upon the belief that the United States, when establishing Indian reservations, “intended to deal fairly with the Indians by reserving for them the waters without which their lands would have been useless.” Arizona v. California, 373 U.S. 546, 600 (1963).
The Winters doctrine thus reserves water to the extent it is necessary to accomplish the purpose of the reservation, and it only reserves water if it is appurtenant, or connected to, the land that has been withdrawn and reserved. Once established, however, Winters rights vest on the date of the reservation, and are thus superior to the rights of future appropriators; and unlike most state-law granted water rights, they are also immune from abandonment. Because most western states follow the prior appropriation doctrine—first in time, first in right—Winters inserted a substantial exception into the operation of their water rights systems. This was due both to the seniority of tribal rights (which antedate most state law water rights, since most Indian reservations were established in the nineteenth century) and the size of the rights (which are large, because they must be sufficient to satisfy irrigation rights - the usual, agrarian purpose of the reservations). For example, the Winters right of the Kickapoo Tribe in Kansas dates from 1834—twenty years before Kansas became a territory pursuant to the Kansas-Nebraska Act of 1854, and twenty-seven years before it became a State.
Since the 1970’s, many western tribes have obtained recognition of their Winters rights, primarily through state law water-rights adjudications. The United States holds substantial water rights across the West, not only in its trustee capacity for Native American Tribes, but also for national monuments, national forests, and other public lands. But because the United States generally enjoys sovereign immunity from state court proceedings, Congress enacted the McCarran Amendment, 43 U.S.C. § 666, which waives that sovereign immunity so that the United States must participate in such state court adjudications. Because, pursuant to Winters, tribes frequently hold some of the most senior and largest water rights in the basins at issue, the extent of their Winters rights has figured prominently in these adjudications. In addition, because groundwater has become a major source of supply for irrigators and other water users across the West since Winters, these state-court adjudications have been forced to address the issue of whether Winters rights extended to groundwater.
For the most part, state courts have held that Winters rights do extend to groundwater. See, e.g., In re Gen. Adjudication of All Rights to Use Water in Gila River Sys. & Source, 989 P.2d 739 (Ariz. 1999). The logic behind such an extension should be uncontroversial, at least from a hydrological standpoint; surface and groundwater supplies are connected to one another. As the Arizona Supreme Court wrote in the Gila case, “some [Indian] reservations lack perennial streams and depend for present and future survival substantially or entirely upon pumping of underground water. We find it no more thinkable in the latter circumstance than in the former that the United States reserved land for habitation without reserving the water necessary to sustain life.” Id. at 746. State courts and federal district courts deciding the issue of whether Winters rights extend to groundwater have mostly held in the affirmative, or have refused to exclude groundwater from the scope of Winters. See, e.g., Tweedy v. Texas Co., 286 F. Supp. 383 (D. Mont. 1968) and Confederated Salish and Kootenai Tribes v. Stults, 59 P. 3d 1093 (Mont. 2002); see also United States v. Washington Dep’t of Ecology, 375 F. Supp. 2d 1050 (W.D. Wash. 2005). Wyoming has held otherwise. See In re the General Adjudication of All Rights to Use Water in the Big Horn River System, 753 P.2d 76 (Wyo. 1988), aff’d by an equally divided Court, Wyoming v. United States, 492 U.S. 406 (1989).
In Agua Caliente Band of Cahuilla Indians v. Coachella Valley Water District, 849 F.3d 1262 (9th Cir. 2017), the court held that the federal implied reserved water rights doctrine, first established in Winters, categorically extends to groundwater. The case is notable as the first federal appellate case to reach a decision on this issue, and its reasoning follows multiple state court decisions across the West. On November 27, 2017, the U.S. Supreme Court denied certiorari in the first phase of the case, allowing the Ninth Circuits holding to stand. Coachella Valley Water District v. Agua Caliente Band of Cahuilla Indians, No. 17-40, Vide No. 17-42, 2017 U.S. LEXIS 7044 (U.S. Sup. Ct. Nov. 27, 2017).
Background. The case arose as a declaratory judgment action (where the court determines the rights of the parties without ordering any action be taken or that damages be awarded) brought by the Agua Caliente Band of Cahuilla Indians (“Tribe”), seeking a declaration that the Tribe was entitled to federal water rights that supersede state law—including rights to groundwater that lie beneath the tribe’s reservation. The most important of these rights, as noted above, is the federal implied reserved water right first established in Winters.
The Agua Caliente case was brought outside of the context of a state-court adjudication. Indeed, in many respects, the case does not present the usual facts of a reserved water rights claim. The Tribe’s reservation in the Coachella Valley of California dates to 1876-77, and consists of approximately 31,000 acres interspersed in a checkerboard pattern amid several cities within Riverside County, including Palm Springs, Cathedral City, and Rancho Mirage. By placing the Tribe on the reservation, the United States sought to protect the Tribe and, in the words of the Commissioner of Indian Affairs in 1877, secure them “permanent homes, with land and water enough.” Unfortunately, the Coachella Valley receives less than six inches of precipitation annually, and the Whitewater River System—the only supply of surface water in the area— can only provide between 4,000 and 9,000 acre-feet of water every year, most of which flows during the winter months. Therefore, almost all of the water in the valley comes from the underlying aquifer—the Coachella Valley Groundwater Basin (“Basin,”) which supports nine cities, 400,000 people, and 66,000 acres of farmland. Given the size of this cumulative demand, it is no surprise that pumping vastly exceeds recharge in the basin by 240,000 acre-feet per year. By 2010, the aquifer had become over-drafted by 5.5 million acre-feet. The Tribe, however, does not pump groundwater from its reservation lands. Rather, it obtains most of its water supplies by purchasing groundwater from the defendant water agencies—the Coachella Valley Water District and the Desert Water Agency (“water agencies”). (The Tribe also holds a small surface-water right from the Whitewater River, pursuant to a 1938 state court decree.)
Trial court. Alarmed by the state of groundwater overdraft in the Basin, the Tribe brought its suit against the water agencies in 2013, seeking a declaration that the Tribe had Winters rights extending to the groundwater supplies in the Basin. In 2014, the United States, acting in its trustee capacity for the Tribe, successfully intervened in the case, and also alleged that the Tribe enjoyed Winters rights. In 2015, the district court held that the reserved rights doctrine applies to groundwater, and that the United States had reserved appurtenant groundwater for the Tribe when it established the Tribe’s reservation in the Coachella Valley. The water agencies perfected an interlocutory appeal whereby the appellate court (the U.S. Court of Appeals for the Ninth Circuit) would rule on the issue of Winters rights before the trial concluded.
Ninth Circuit. Given the diversity of state court decisions concerning whether Winters rights extend to groundwater, and the lack of a federal appellate decision on the issue, the appeal provided the first opportunity for a federal appeals court to rule on the issue. In a straightforward decision, the Ninth Circuit upheld the trial court’s decision extending Winters rights to groundwater. The court based its decision on three related holdings. First, it held that the United States clearly intended to reserve water under federal law when it created the Tribe’s reservation. The appellant water agencies argued that Winters and its progeny should not apply in this case, because the Tribe has been able to satisfy its water needs by purchase from them. Thus, according to the water agencies, the Tribe should be treated as any other private water user obtaining its water rights under state law. The Ninth Circuit disagreed, noting that the underlying purpose of the reservation was to establish a tribal homeland supporting an agrarian society. That purpose would be entirely defeated, the court reasoned, without sufficient water supplies held under federal law. Thus, the Tribe was entitled to a reserved water right for the Agua Caliente Reservation.
Next, the Ninth Circuit held that the Tribe’s Winters right extended to groundwater. In so holding, the court cited the Arizona Supreme Court’s holding in the Gila River case. It was necessary for the Tribe to access groundwater in the Coachella Valley Basin because surface supplies were clearly inadequate—a reservation without an adequate supply of surface water must be able to access groundwater as well. Thus, the court held that the reservation and establishment of the Agua Caliente Reservation carried with it an implied federal reserved right to use water from the aquifer.
Neither of the Ninth Circuit’s first two holdings seems controversial, given the logic and the scope of Winters and its progeny. However, the third and final holding addressed a more complicated issue: how the Tribe’s Winters right exists in relation to water rights recognized under California state water law. California (like Nebraska and Arizona, to name two) follows the reasonable use/correlative rights doctrine for groundwater. At the Ninth Circuit, the water agencies argued that the Tribe’s state law water rights rendered its claim for Winters rights unnecessary. Their argument was layered: 1) because the Tribe enjoys correlative water rights under California law; and 2) because the Tribe has not drilled for water under the Agua Caliente Reservation; and 3) because the Tribe held some (but not sufficient) surface water rights under state law pursuant to the 1938 state court adjudication of the Whitewater River, then the Tribe, according to the water agencies, did not need a federal reserved right to prevent the purposes of the reservation from being entirely defeated. The Ninth Circuit rebuffed the agencies’ argument. It determined that 1) the Tribe’s Winters rights pre-empted state water rights; 2) the Tribe’s lack of groundwater pumping did not defeat those Winters rights, because they are immune from abandonment; and 3) the proper inquiry was not one of current necessity, but whether water was envisioned as necessary for the reservation’s purpose at the time the reservation was created. Thus, the Ninth Circuit held, the issue of the Tribe’s state law-based water rights did not affect the existence of its Winters water right. In sum, the Ninth Circuit’s analysis produced a categorical holding: Winters always applies as a matter of federal pre-emption, regardless of how a state allocates groundwater rights.
Supreme Court Review?
The Ninth Circuit’s decision provoked substantial amicus participation on appeal to the Supreme Court. States as legally diverse as Minnesota and Nevada, as well as property-rights advocacy groups such as the Pacific Legal Foundation, submitted amicus briefs. Both the appellants and the amici supporting them made two general arguments in opposition to the Ninth Circuit’s holding: 1) that Winters should be limited to surface water supplies governed by state-law prior appropriation regimes (such as Montana, where Winters originated); and 2) that the Ninth Circuit’s holding will interfere with and even take long-established groundwater rights secured under state law. The Supreme Court’s denial of certiorari, like all of its denials, did not give its reasons.
The arguments involved Agua are important arguments to make, especially as groundwater has become the dominant supply of water across the West. However, the logic of Winters presents formidable obstacles to limiting its scope to surface water supplies only—especially in the Coachella Valley and other desert basins which lack substantial surface water supplies. The Court’s denial of certiorari has allowed the Ninth Circuit’s decision to stand.
The Ninth Circuit’s decision also has important implications for California, which enacted the Sustainable Groundwater Management Act (SGMA) in 2014, an ambitious act that requires local “groundwater sustainability agencies” to establish sustainable groundwater management plans during the next decade or so. Because the Ninth Circuit’s decision establishes strong (and largely non-negotiable) rights for tribes within California’s groundwater basins, it probably complicates the already formidable task of achieving the necessary goal of groundwater management at the level of sustainability.
Across the West, the other implications of the decision likely depend upon what remains the primary vehicle through which tribal rights are clearly established: basin-wide adjudications of water rights undertaken in state courts pursuant to the McCarran Amendment.
P.S. Absent anything of major significance in the ag law and tax world next week, this is the final post of 2017. However, that doesn’t mean that I will be sitting idly by. I will be continuing to prep two courses for the spring semester – one for the law school and one for Kansas State University. I will also be updating my treatise for the changes triggered by the new tax law and other relevant developments, and preparing materials for the Jan. 10 seminar/webinar on the new tax law. In addition, travel begins on Jan. 4 as I head for engagements in Illinois and Tennessee before the Jan. 10 event. Radio and TV interviews also continue as usual next week. The next post is scheduled for January 1 and will be Part 1 of the top ten ag law and tax developments of 2017.
To all of my readers, have a wonderful Christmas with your families! See you on January 1.
Thursday, December 21, 2017
As I mentioned at tax seminars this fall, the tax bill that the Congress was considering and will soon be signed into law (probably on Dec. 22, 2018) did not address the provisions that expired at the end of 2016. Those provisions needed separate legislation to be in play for 2017. Well, on December 20, Senator Hatch (R-UT) introduced S. 2256 into the Senate. It's the (seemingly) annual extenders bill.
For many of the readers of this blog, here are some of the most relevant provisions that the bill would renew for 2017:
- Credit for certain nonbusiness energy property
- Credit for residential energy property (as modified)
- Qualified fuel cell motor vehicle credit
- Alternative fuel vehicle refueling property credit
- Credit for 2-wheeled plug-in electric vehicles
- Second generation biofuel producer credit under
- Credits for biodiesel fuel, biodiesel used to produce a qualified mixture, small agri-biodiesel producers, renewable diesel fuel and renewable diesel used to produce a qualified mixture
- Credit for construction of new energy efficient homes
- Credit for geothermal heat pump property, small wind property, and combined heat and power property
- 3-year depreciation for race horses two years old or younger.
- 7-year recovery period for motorsports entertainment complexes.
- Accelerated depreciation for business property on an Indian reservation.
- Special depreciation allowance for second generation biofuel plan property.
- Exclusion for discharge of indebtedness (within a limit) on a principal residence.
- Treatment of mortgage insurance premiums as deductible qualified residence interest.
- Deduction for qualified tuition and related expens
- Deduction allowable with respect to income attributable to domestic production activities in Puerto Rico.
- The alternative 23.8 percent maximum tax rate for qualified timber gains of C corporations.
- Energy efficient commercial buildings deduction.
Late Year-End Planning
Much of the year-end planning deals with shifting income to next year to take advantage of lower rates and accelerating itemized deductions to this year. However, there are some other planning opportunities that can perhaps be taken advantage of over the next few days. Here are some thoughts – again each taxpayer’s situation will be different and this is not an exhaustive list of every possible opportunity.
- Wait until next year to convert a regular IRA to a Roth IRA.
- If a Roth IRA was converted to a regular IRA earlier this year, complete a recharacterization by December 31, 2017.
- Don’t bill clients until late next week or in early January to ensure that the income won’t be received until 2018 (cash basis businesses).
- For accrual businesses, take a break and complete jobs next year (not a problem for construction businesses).
- Hold-off on having debt cancelled until next year.
- As I mentioned on Monday’s post, pay the last installment of 2017 estimated taxes this month and pay 2017 real property taxes that are due next year by then end of this year.
- Pay some of next years anticipated charitable contributions and tithe and offerings this year to the extent cash flow will allow. For famers, consider additional grain gifts to charity this year.
- For taxpayers working out arrangements with creditors, delay any debt reduction until next year.
- See if medical expenses might be incurred in 2017 that will help clear the 7.5 percent of AGI floor for 2017 (maybe a year-end visit to the optometrist or dentist or getting that physical next week (after Christmas is always a great time for that) is in order instead of waiting until January). In addition, for businesses, if health insurance premiums would normally be paid in January, pay them this month.
- For taxpayers thinking about exercising an incentive stock option, it may be a good idea to wait until 2018 if alternative minimum tax might be an issue. The AMT exemption is higher next year.
- Do a like-kind exchange of qualified personal property this year. But, even if it’s not done this year, it really is of little concern because 100 percent expensing is the rule next year. Will the particular state couple? That’s always a question to ask.
- For businesses, have business meetings with clients next week to be able to write-off half of the cost of food and beverages. Do it next month and none of it is deductible.
- For taxpayers other than those on active military duty, incur moving expenses by year-end.
- Pay employee business expenses this year that would otherwise be paid in 2018.
- Birth a child (or twins or triplets, etc.) before the stroke of midnight on Dec. 31.
- Make a substantial gift to Washburn Law School's Rural Law Program before January 31.
January 10 Seminar/Webinar
On January 10 I will be joined by Prof. Lori McMillan of Washburn Law School in presenting a 2-hour seminar/webinar on the new law. This seminar is for everyone to learn how the new tax law will impact individual taxpayers and businesses. Should a business be reorganized? What about existing estate plans? How does the new pass-through tax system apply? What are the special rules for farmer and their businesses? What about cooperatives? What are the nuts and bolts of the new law?
You can register for the event here: https://www.agmanager.info/present-tax-landscape-implications-individuals-businesses-investors-and-others
The fun is just beginning. It’s beginning to look a lot like Taxmas!!
Wednesday, December 20, 2017
Under current law, a business has options concerning where it can file bankruptcy. Those places include the state in which the business is organized, the location where the business has significant business assets or conducts business, or (in certain situations) where the parent company or affiliate has filed bankruptcy. That can create a tough situation for a farmer that has a claim against the bankrupt company if they have to travel far from their farming operation to participate in the bankruptcy. An example of this was the VeraSun bankruptcy that impacted farmers across parts of the Midwest and the Great Plains a few years ago.
Now, according to Bloomberg News and the Wall Street Journal, it looks like legislation will be introduced into the Congress that would change where a bankrupt company can file bankruptcy. See, e.g., https://www.wsj.com/articles/lawmakers-to-propose-making-bankrupt-companies-file-for-protection-close-to-home-1513644954?reflink=djemBankruptcyPro&tpl=db; This is known as “venue” and the bill is known as the “Bankruptcy Venue Reform Act of 2017.” If introduced this week, the bill may be tucked into the Omnibus spending bill that the Congress will vote on late this week. It’s a big deal for farmers, employees, retirees of bankrupt debtors (and other creditors).
Bankruptcy venue reform – today’s blog post topic.
Why Tightening Venue Matters
Several prominent bankruptcy cases filed in recent years illustrate why modifying existing venue rules matters.
VeraSun Energy Corporation (VeraSun). In early November 2008, Sioux Falls-based VeraSun and twenty-four of its subsidiaries filed for Chapter 11 bankruptcy protection to enhance liquidity while it reorganized. VeraSun got in financial trouble when it bought corn contracts at a high price and then corn prices dropped by about 50 percent before the specified delivery date in the contracts. VeraSun had failed to protect itself on the board of trade. That big price drop caused VeraSun to lose hundreds of millions of dollars. Of course, VeraSun was using the contract to hedge against corn prices going up and the farmer sellers were using them to hedge against a price decline. The corn farmers guessed right and the contracts worked to their advantage. However, VeraSun’s bankruptcy meant that VeraSun could force farmer sellers to hold their grain in a dropping market since it was not required to assume or reject the contracts until its plan of reorganization was to be heard several months down the line. If the contracting farmer sold his corn to minimize his loss, and the price of corn increased so that it made economic sense for VeraSun to enforce the purchase contract, the farmer would be forced to make up the difference. Many farmers sought to have the bankruptcy court force VeraSun to make decisions regarding assuming or rejecting the out-of-the money corn contracts quickly, so they would not be faced with a problem if the market rebounded. The bankruptcy court in Delaware was not willing to force VeraSun to act on a plant-by-plant basis, opting instead to allow each individual farmer to hire counsel in Delaware to press his case involving his contracts. This was cost prohibitive. There were over 6,000 midwestern farmers affected by this bankruptcy.
Later in the case, lawyers from Delaware and New York sent threatening letters to the farmers who had been paid for their corn promptly in accordance with state grain elevator laws demanding that they repay all sums they had been paid within 90 days of the case filing claiming that they were preferential transfers. The farmers organized, and defensive letters were sent back to the threatening lawyers who then opted to not file the threatened preference lawsuits. If the case had been filed in the Midwest, it would have been more likely that lawyers familiar with agricultural law would not have sent the preference demand letters because they would have known the prompt payment requirements of state grain elevator laws and would have recognized that these payments were in the ordinary course of business of both VeraSun and the farmers it paid.
In addition, farmers who were unpaid when the bankruptcy was filed became creditors in the VeraSun bankruptcy and had to file claims and participate in the bankruptcy process to have any hope of getting paid. Those farmers were scattered across the Midwest and Great Plains where Verasun had ethanol and biodiesel plants. None of them were located in Delaware, where VeraSun filed its bankruptcy petition.
Why did Verasun file bankruptcy in Delaware when it didn’t have any ethanol plants located in Delaware and wasn’t headquarted there? Because the an affiliated company organized in Delaware filed Chapter 11 filed bankruptcy in Delaware. Because of that, all of the affiliated companies could also file in Delaware under the applicable venue rule of the Bankruptcy Code. That meant that farmers with claims against VeraSun had to participate in Delaware bankruptcy proceedings rather than in the jurisdiction where the contracts were to be performed. That’s a frustrating, and expensive, proposition for farmers. Ultimately, VeraSun ended up selling seven of the plants to Valero Energy Corporation, and the rest to other companies in 2009.
A short video about the VeraSun bankruptcy effects on farmers, as told by an Iowa farmer, can be found at: https://www.youtube.com/watch?v=7GdifLvuRdw
Peregrine Financial Group, Inc. (PFG). PFG was an Iowa-based financial firm that was shut down in 2012 after it was put under investigation for a $200 million shortfall in customer funds. PFG’s Peregrine’s chief executive office was arrested and charged with making false statements to the Commodity Futures Trading Commission (CFTC). At the time of PFG filed Chapter 7 it had over $500 million in assets and over $100 million in liabilities. PFG filed bankruptcy in Illinois even though it was headquartered in Iowa. Similar to the VeraSun bankruptcy, many Midwest farmers were impacted by PFG’s bankruptcy.
Solyndra, LLC. The solar-panel maker Soyndra, LLC, filed Chapter 11 in 2011 in Delaware. Solyndra had received $535 million in federal financing (under the Obama Administration’s “stimulus” program) and a $25.1 million tax break from the State of California. Upon filing, the California-based company suspended its manufacturing operations and laid-off approximately 1,100 employees triggering both Federal and California Worker Adjustment and Retraining Notification Act issues. The employees affected by the mass layoffs resided in California. By filing in Delaware, Solyndra made it more expensive and burdensome for the laid-off employees to pursue their claims. The result for the employees was an out-of-court settlement of only $3.5 million (less 33% for their attorneys' contingent fee) on their claim of $15 million. One can only imagine the result if the case had been filed in California and the employees had easy access to the court deciding their fates.
Winn-Dixie Stores, Inc. (WD). WD was a supermarket chain headquartered in Florida. In April 2004, Winn-Dixie announced the closure of 156 stores, including all 111 stores located in the Midwest. On early 2005, WD filed Chapter 11 bankruptcy. To establish venue in technical compliance with the statute, the WD formed a new entity in New York shortly before the Chapter 11 filing and admitted it did so to establish venue. The bankruptcy court stated that the current statute contains a loophole allowing companies to file in venues that are not proper even if they have literally complied with the statute. The court transferred the case to Florida, with the judge stating, “…simply because I don’t believe it just to exploit the loophole in the statute to obtain venue here.” In re Winn-Dixie Stores, Inc., Case No. 05-11063 (RDD) (Bankr. S.D.N.Y. April 12, 2005) Hearing Transcript at 167.
In re Houghton Mifflin-Harcourt Publishing Co. (HM). HM was a publishing company that filed its case in the Southern District of New York in 2012. The United States Trustee filed a Motion to Change Venue. Unlike the court in WD that transferred venue, the bankruptcy court in HM found there was no statutory basis for venue in the Southern District of New York, but chose to defer transfer of venue until after confirmation of the plan. The court even chided the United States Trustee for filing the Motion to Change Venue. In re Houghton Mifflin Harcourt Publishing Co., Case No. 12‐12171 (RFG), Decision on U.S. Trustee Motion to Transfer Venue of these Cases, (June 22, 2012, Bankr. SDNY).
Boston Herald. Last week, provided another example of forum shopping at the expense of retirees, employees and the local community. The Boston Herald (Herald), a local Boston, MA, newspaper announced plans to sell the newspaper to GateHouse Media after filing Chapter 11 bankruptcy in Delaware. The only connection that the Herald has to Delaware is that its holding company is incorporated in Delaware. Eighteen of its 30 largest creditors reside in Massachusetts or New Hampshire and most are individual retirees.
Changing Venue as an Option?
The WD bankruptcy judge’s transfer of the case is a rarity. Very few cases are ever transferred. Indeed, some venue-change proceedings have turned into costly extended proceedings with evidentiary trials and extensive briefing. For instance, the Patriot Coal Corporation (a St. Louis-based spin-off of Peabody Energy Corporation) filed Chapter 11 bankruptcy in 2015. On a motion to transfer venue from the Southern District of New York, the bankruptcy court took four months to issue a 61-page decision based on facts that were largely uncontested and involved the manipulation of current venue law. Venue was determined to be in the Southern District of New York. Based on a review of the interim fee applications filed in the Patriot Coal case, it can be estimated that the debtor spent approximately $2 million and the creditors spent an additional $1 million to litigate the venue challenge. The court’s opinion “demonstrates the near impossibility of having venue transferred away from New York.” See Bill Rochelle, Patriot Shows Futility of Moving Cases from NY, Bloomberg (11/29/12).
In In re Enron Corp., 274 B.R. 327 (Bankr. S.D. N.Y. 2002), the court stressed the importance of case administration, and noted the “learning curve” the court acquired in the first month of the case in denying a motion to change venue filed shortly after the filing of the case. Enron and other cases such as In re Jitney Jungle, Case No. 99‐3602 (Bankr. D. Del.) and the WD case mentioned above demonstrate that by the time courts consider venue transfer motions, most of the important first day or “second day” motions relating to debtor-in-possession financing, sale procedures, break-up fees and the like would have already been entered and have become final. The reorganization case would have progressed forward so far and taken such a direction that it bears the indelible imprint of the first court. Such was the case with Jitney Jungle. By the time this case was transferred to New Orleans there was little that the New Orleans bankruptcy judge said that he could do because of the actions taken or orders previously entered in Delaware. Similarly, in Winn-Dixie, by the time the Florida judge received the case, so much of substance had already been ordered in the case that there was little the Florida judge could do but administer the orders of the prior judge.
Bankruptcy Venue Reform Act of 2017
The goal of the legislation is to drastically reduce the ability of companies to forum shop bankruptcies by denying access to justice for creditors of companies that choose to file their bankruptcies primarily in the Southern District of New York and Delaware. The legislation does this will by eliminating place of incorporation as a proper venue as well as eliminating the affiliate rule allowing the companies to file a Delaware affiliate first in Delaware, then file the rest of the cases in Delaware. Under the bill, venue is appropriate only in the district court for the district where an individual debtor is domiciled, resides, or where their principal assets have been located for the 180-day period immediately preceding the bankruptcy petition, or for a longer portion of the 180-day period than the domicile, residence or principal asset were located anywhere else. The same 180-day rule applies to a business debtor, but in terms of the debtor’s principal place of business rather than residence or domicile.
Venue is also proper in jurisdictions where there is already a pending bankruptcy case concerning an affiliate that directly or indirectly owns, controls, is the general partner, or holds 50 percent or more of the outstanding voting securities, of the person or entity that is the subject of the later-filed case if the pending case was properly filed in that district. The bill also says that changes of ownership or control of a person or entity or assets or principal place of business within a year before bankruptcy filing that is done with the purpose of establishing venue are to be ignored. A court could still transfer a case in the interest of justice or for the convenience of the parties.
Currently, bankruptcies can be filed in several places, including the state of organization of the company, the district where a company has significant business assets or conducts business, or in the district where a parent or an affiliate has filed bankruptcy. The proposed legislation will make it difficult for bankruptcies to be filed remotely from the company’s assets or headquarters. The idea is to increase fair access to justice for the parties affected by a bankruptcy. The bill is a big deal for bankruptcy reform and fairness to creditors. While similar legislation was introduced in 2011, it was opposed by the Obama Administration. Individuals and businesses interested in the matter should contract their Congressional Representatives and Senators immediately and request Senators to Co-sponsor the bill and ask their Representatives to support it.
Monday, December 18, 2017
The Congress appears to finally be on the brink of a major overhaul of the Tax Code this week. The stated goal is to get a bill to the President’s desk before Christmas. Prior blog posts have highlighted both the House-passed version (http://lawprofessors.typepad.com/agriculturallaw/2017/11/comparison-of-the-house-and-senate-tax-bills-implications-for-agriculture.html) and the Senate-passed version (http://lawprofessors.typepad.com/agriculturallaw/2017/12/senate-clears-tax-bill-on-to-conference-committee.html). The Conference Committee produced a bill based largely on provisions drawn from both bills and produced a result for the two bodies to consider.
Today’s post takes a look at the major provisions on the Conference Committee bill that will be voted on this week. On January 10, 2018, Prof. Lori McMillan and I will conduct a two-hour seminar/webinar on the new law (assuming that the bill passes this week, as expected). If there is no new law by Jan. 10, we will update practitioners on the status of the law for 2017 and going forward. Registration for those attending in person and online is available here: https://www.agmanager.info/present-tax-landscape-implications-individuals-businesses-investors-and-others.
Now, a look at the major provisions in the Conference Committee bill.
Note: This is my attempt to understand the statutory language as it modifies current law. The text of the language is nearly 500 pages, with many interrelated provisions. Any mistakes in interpreting that language are my own.
Income tax rates. The conference agreement temporarily replaces the existing rate structure with a new rate structure for 2018-2025. Seven rate brackets are provided from 10 percent to 37 percent. The benefit of the 12 percent bracket is not phased-out for taxpayers with adjusted gross income in excess of $1,000,000 ($1,200,000 in the case of married taxpayers filing jointly). Also, the conference bill generally retains present-law maximum rates on net capital gains and qualified dividends.
Standard deduction. Starting for tax year 2018, through tax years beginning before 2026, the basic standard deduction is increased for all individuals. It will be $24,000 for MFJ, $18,000 for HOH and $12,000 for all other individuals. The amount of the standard deduction is indexed for inflation using the C-CPI-U for taxable years beginning after December 31, 2018. The additional standard deduction for the elderly and the blind remains unchanged.
Inflation adjustments. For tax years beginning after 2018, the basic standard deduction and the marginal tax brackets are indexed for inflation utilizing the chained CPI-U.
Personal exemptions. Effective for tax years beginning after 2017, the deduction for personal exemptions is suspended through 2025. The suspension does not apply to taxable years beginning after December 31, 2025.
Repeal of overall limitation on itemized deductions. The bill repeals the overall limitation on itemized deductions. The provision is effective for taxable years beginning after December 31, 2017 and before 2026.
Commodity gifts. Under current rules, a parent can gift grain to a child and eliminate the self-employment tax on the gifted grain and, under the “kiddie-tax” rules, the tax rate of the child is generally the parent’s rate. However, under the bill, in most situations, the tax rate of the child will be the tax rates applicable to estates and trusts. Thus, once the child has $12,500 of unearned income, the tax rate applicable to the child will be 37 percent on all excess amounts. This provision is applicable for tax years 2018 through 2025.
Family and individual tax credits. Effective for tax years beginning after 2017 through 2025 child tax credit is temporarily increased to $2,000 per qualifying child (one that hasn’t attained age 17 during the tax year), with up to $1,400 (indexed to the next lowest multiple of $100) of the credit refundable. In addition, the bill provides for a $500 nonrefundable credit for qualifying dependents other than qualifying children. In order to receive the child tax credit (i.e., both the refundable and non-refundable portion), a taxpayer must include a Social Security number (that is issued before the due date for the filing of the return for the tax year at issue) for each qualifying child for whom the credit is claimed on the tax return. If a taxpayer can’t claim the child tax credit for an otherwise qualifying child because the child didn’t have a Social Security number, the $500 nonrefundable credit can still be claimed. The credit is phased out for MFJ taxpayers with AGI exceeding $400,000 (not indexed for inflation).
Home mortgage interest. For taxable years beginning after December 31, 2017, and before January 1, 2026, a taxpayer may deduct interest paid on up to $750,000 (MFJ) of acquisition indebtedness, unless the debt is incurred before December 15, 2017, in which case the limit is $1,000,000. For taxable years beginning after December 31, 2025, a taxpayer may treat up to $1,000,000 (MFJ) of indebtedness as acquisition indebtedness, regardless of when the indebtedness was incurred. The additional deduction for interest attributable to home equity debt is suspended for tax years beginning after 2017 and before 2026.
Deduction for State and local taxes. For tax years beginning after 2017, for individuals, State, local, and foreign property taxes and State and local sales taxes are allowed as a deduction only when paid or accrued in carrying on a trade or business, or an activity that produces income. Thus, only those deductions for State, local, and foreign property taxes, and sales taxes, that are presently deductible in computing income on an individual’s Schedule C, Schedule E, or Schedule F are allowed. However, an itemized deduction of up to $10,000 may be taken for the aggregate of state and local real property taxes not paid or accrued in carrying on a trade or business or an income-producing activity, plus either state and local income tax or sales tax. It is also not possible to claim an itemized deduction in 2017 for a pre-payment of income tax for a future tax year in order to avoid the dollar limitation applicable for tax years after 2017.
Personal casualty and theft losses. Beginning in 2018, and lasting through 2025, a taxpayer may claim a personal casualty loss (subject to certain limitations) only if the loss was attributable to a disaster declared by the President.
Deduction of charitable donations. For tax years beginning after 2017, the bill increases the percentage limit for contributions of cash to public charities from the current 50 percent of the taxpayer’s contribution base to 60 percent. Effective for tax years beginning after 2016, the bill eliminates the possibility that a charity can substantiate a contribution of a donor via the charity’s return.
Repeal of certain miscellaneous itemized deductions subject to the two-percent floor. Effective for tax years beginning after 2017 and before 2026, the bill suspends all miscellaneous itemized deductions that are subject to the two-percent floor under present law.
Medical expenses. For taxable years beginning after December 31, 2016 and ending before January 1, 2019, the threshold for deducting medical expenses returns to 7.5 percent for all taxpayers. It had been increased by Obamacare to 10 percent, thus making it more difficult for taxpayers to deduct medical expenses. For 2017 and 2018, the threshold applies for purposes of the AMT in addition to the regular tax.
Alimony. The bill specifies that alimony and separate maintenance payments are not deductible by the payor spouse, and are not income to the recipient. Income used for alimony payments is taxed at the rates applicable to the payor spouse rather than the recipient spouse. The treatment of child support is not changed. The provision is effective for any divorce or separation instrument executed after December 31, 2018, or for any divorce or separation instrument executed on or before December 31, 2018, and modified after that date, if the modification expressly provides that the amendments of the bill apply to such modification.
Moving Expenses. The bill, effective for tax years beginning after 2017 and before 2026, generally suspends the deduction for moving expenses and repeals the exclusion for qualified moving expense reimbursement except for members of the military on active duty.
Alternative Minimum Tax (AMT). Under the bill, the individual AMT exemption amount and phase-out threshold are both increased for tax years beginning after 2017 and before 2026. The exemption goes to $109,400 (MFJ) and the phase-out begins at $1,000,000 (MFJ).
Treatment of business income of individuals. For tax years beginning after 2017 and before 2026, an individual business owner (other than the owner of a personal service business with income of $315,000 (MFJ) and above for the tax year) as well as an owner of an interest in a pass-through entity is entitled to a deduction of 20 percent of the individual’s share of qualified business income (QBI). QBI is the net amount of income, gain, deduction and loss attributable to the business less net long-term capital gains. However, the deduction comes with a limitation. The limitation (computed on a business-by-business basis) is the greater of (a) 50 percent of the W-2 wages paid with respect to the qualified trade or business, or (b) the sum of 25 of percent of the W-2 wages with respect to the qualified trade or business plus 2.5 percent of the unadjusted basis, immediately after acquisition, of all qualified property. But, the wage limitation does not apply if the business owner's income is less than $315,000 (MFJ). As noted, the ability of a personal service business to claim the deduction is phased-out once taxable income reaches $315,000 (MFJ). The phase-out range is $100,000 (MFJ).
The 20-percent deduction is not allowed in computing adjusted gross income. It’s allowed as a deduction reducing taxable income. Thus, for example, the provision does not affect limitations based on adjusted gross income. However, the deduction is available to both nonitemizers and itemizers. The QBI deduction is allowed when computing AMT. Thus, it does reduce AMTI.
Corporate tax. A flat 21 percent tax corporate rate applies, effective for tax years beginning after 2017.
Corporate AMT. The AMT is repealed for tax years beginning after 2017. For corporations, the AMT credits offsets regular tax liability and is refundable for tax years beginning after 2017 and before 2022 in an amount equal to 50 percent (except it is 100 percent for tax years beginning in 2021) of the excess minimum tax credit for the tax year over the amount of the credit allowable for the year against regular tax liability. Thus, the full amount of the minimum tax credit will be allowed in taxable years beginning before 2022.
Cooperatives. An agricultural or horticultural cooperative engaged in the MPGE (manufacturing, production, growth or extraction) of an agricultural or horticultural product, the marketing of such a product that a patron has conducted MPGE on, or the provision of supplies or services to farmers is entitled to a deduction (computed separately from the patron with no pass-through to the patron) equal to the lesser of (a) 20 percent of the cooperative’s taxable income (gross income less qualified cooperative dividends) for the taxable year or (b) the greater of 50 percent of the W-2 wages paid by the cooperative with respect to its trade or business, or the sum of 25 percent of the W-2 wages of the cooperative with respect to its trade or business plus 2.5 percent of the unadjusted basis immediately after acquisition of qualified property of the cooperative. The deduction can't exceed the cooperative's taxable income for the year.
In addition, for tax years beginning after 2017, trusts and estates are eligible for the 20-percent deduction. Rules similar to the rules under current I.R.C. §199 apply for apportioning between fiduciaries and beneficiaries any W-2 wages and unadjusted basis of qualified property under the limitation based on W-2 wages and capital.
Loss limitation for non-corporate taxpayers. For taxable years beginning after December 31, 2017 and before January 1, 2026, excess business losses of a taxpayer other than a corporation are not allowed for the taxable year. The excess losses are carried forward and treated as part of the taxpayer’s net operating loss (“NOL”) carryforward in subsequent taxable years. NOL carryovers generally are allowed for a taxable year up to the lesser of the carryover amount or 80 percent of taxable income determined without regard to the deduction for NOLs. A two-year carryback rule applies for NOLs arising from a farming business. The carryback is to each of the two taxable years preceding the taxable year of the loss.
An excess business loss for the taxable year is the excess of aggregate deductions of the taxpayer attributable to trades or businesses of the taxpayer (determined without regard to the limitation of the provision), over the sum of aggregate gross income or gain of the taxpayer plus a threshold amount.
The threshold amount for a taxable year is $500,000 (net) on a joint return. The threshold amount is indexed for inflation. In the case of a partnership or S corporation, the provision applies at the partner or shareholder level. Each partner’s distributive share and each S corporation shareholder’s pro rata share of items of income, gain, deduction, or loss of the partnership or S corporation are taken into account in applying the limitation under the provision for the taxable year of the partner or S corporation shareholder.
Business interest. For tax years beginning after 2017, deductible business interest (interest paid or accrued on debt allocable to the trade or business, including investment interest) is limited to business income plus 30 percent of the taxpayer’s adjusted taxable income (taxable income computed without business interest expense, business interest income, NOLs, the 20 percent QBI deduction, and other adjustments as provided in forthcoming regulations) for the tax year that is not less than zero. The deductible amount is determined at the tax-filer level except for pass-through entities where it is made at the entity level. Any disallowed amount is treated as paid or accrued in the succeeding tax year. However, businesses entitled to use cash accounting (as noted below) are not subject to the limitation, but large cash accounting businesses such as personal service businesses are limited in the deductibility of business interest. Special rules apply to excess business interest of partnerships.
An electing farm business (as defined by I.R.C. §263A(e)(4) and including an agricultural or horticultural cooperative) that is barred from using cash accounting can make an irrevocable election to not be subject to the limitation on the deductibility of interest. In return, such farm businesses (not farm landlords) must use alternative depreciation on farm property with a recovery period of 10 years or more. However, the election out will likely result in the inability to qualify otherwise eligible assets for bonus depreciation (in accordance with I.R.C. §263A). In addition, a farm business that elects out of the limitation on deducting interest must use ADS to depreciate any property with a recovery period of 10 years or more. This provision is also effective for tax years beginning after 2017.
Cash accounting. Cash accounting is available for taxpayers with annual average gross receipts that do not exceed $25 million for the three prior taxable year periods (the “$25 million gross receipts test”). The $25 million amount is indexed for inflation for taxable years beginning after 2018. The provision expands the ability of farming C corporations (and farming partnerships with a C corporation partner) that may use the cash method to include any farming C corporation (or farming partnership with a C corporation partner) that meets the $25 million gross receipts test. The provision retains the exceptions from the required use of the accrual method for qualified personal service corporations and taxpayers other than C corporations. Thus, qualified personal service corporations, partnerships without C corporation partners, S corporations, and other passthrough entities are allowed to use the cash method without regard to whether they meet the $25 million gross receipts test, so long as the use of the cash method clearly reflects income. In addition, the provision also exempts certain taxpayers from the requirement to keep inventories, and from the uniform capitalization rules. In the case of a sole proprietorship, the $25 million gross receipts test is applied as if the sole proprietorship is a corporation or partnership. In the case of a sole proprietorship, the $25 million gross receipts test is applied as if the sole proprietorship is a corporation or partnership.
Business-provided meals. Beginning in 2018, the current 100 percent deduction for amounts incurred and paid for the provision of food and beverage associated with operating a business drops to 50 percent. The provision applies to amounts incurred and paid after December 31, 2017 and until December 31, 2025, that are associated with providing food and beverages to employees through an eating facility that meets requirements for de minimis fringes and are for the convenience of the employer. After 2025, the amount goes to zero. Thus, the provision allowing a deduction for meals provided to employees for the convenience of the employer is repealed for amounts paid or incurred after 2025.
Partnership losses. When determining a partner’s distributive share of any partnership loss, the partner takes into account the distributive share of the partnership’s charitable contributions and taxes, except that if the fair market value of a charitable contribution exceeds the contributed property’s adjusted basis, the partner is not to take into account the partner’s distributive share of the charitable contribution as to the excess. The result of this provision is that basis is not decreased by the excess fair market value over basis. The provision applies to partnership taxable years beginning after 2017.
Expensing. The bill allows for full expensing of assets presently eligible for “bonus” depreciation under I.R.C. §168(k) for property place in service after September 27, 2017 through December 31, 2022 (see below). After 2022, the provision is phased-out by 20 percentage points every year thereafter with a complete phaseout for property placed in service beginning in 2027. The same rules apply to plants bearing fruits and nuts.
Expense method depreciation. The maximum amount a taxpayer may expense under I.R.C. §179 to $1,000,000, and increases the phase-out threshold amount to $2,500,000 for tax years beginning after 2017. The $1,000,000 and $2,500,000 amounts are indexed for inflation for tax years after 2018. In addition, some additional types of property are specified to qualify for I.R.C. §179, including qualified real property.
Bonus depreciation. First-year “bonus” depreciation is extended through 2026 at 100 percent for property acquired and placed in service after September 27, 2017, and before 2023. The 100-percent allowance is phased down by 20 percent per calendar year for property placed in service, and specified plants planted or grafted, in taxable years beginning after 2022. It is not required that the original use of the qualified property commence with the taxpayer. Thus, bonus applies to new and used property. A transition rule provides that, for a taxpayer’s first taxable year ending after September 27, 2017, the taxpayer may elect to apply a 50 percent allowance instead of the 100 percent allowance.
Luxury autos. For passenger automobiles placed in service after December 31, 2017, for tax years ending after 2017, and for which bonus depreciation is not claimed, the maximum amount of allowable depreciation is $10,000 for the year in which the vehicle is placed in service, $16,000 for the second year, $9,600 for the third year, and $5,760 for the fourth and later years in the recovery period. The limitations are indexed for inflation for passenger automobiles placed in service after 2018. The provision removes computer or peripheral equipment from the definition of listed property. Such property is therefore not subject to the heightened substantiation requirements that apply to listed property.
Farm property. The bill shortens the depreciable recovery period from seven to five years for any machinery or equipment (other than any grain bin, cotton ginning asset, fence, or other land improvement) used in a farming business, the original use of which commences with the taxpayer and is placed in service after December 31, 2017. The provision also repeals the required use of the 150-percent declining balance method for property used in a farming business (i.e., for 3-, 5-, 7-, and 10-year property). The 150 percent declining balance method will continue to apply to any 15-year or 20-year property used in the farming business to which the straight-line method does not apply, or to property for which the taxpayer elects the use of the 150-percent declining balance method. For these purposes, the term “farming business” means a farming business as defined in I.R.C. § 263A(e)(4).
Depreciation of real property. Unlike the prior versions, the conference committee bill maintains the present law general MACRS recovery periods of 39 and 27.5 years for nonresidential real and residential rental property, respectively. In addition, the conference agreement provides a general 15-year MACRS recovery period (20-years for ADS) for qualified improvement property (limited to straight-line depreciation).
Education saving plans. For distributions made after 2017, the bill allows I.R.C. §529 plans to distribute up to $10,000 in expenses for tuition incurred during the taxable year in connection with the enrollment or attendance of the designated beneficiary at a public, private or religious elementary or secondary school on a per-student basis.
Student loan debt. The bill modifies the exclusion of student loan discharges from gross income, by including within the exclusion certain discharges on account of death or disability. The provision is effective for discharges after 2017 and before 2026.
Rollovers between Qualified Tuition Programs and Qualified ABLE programs. Amounts from an I.R.C. §529 plan account can be rolled over to an ABLE account without penalty, provided that the ABLE account is owned by the designated beneficiary of that I.R.C. §529 account, or a member of the designated beneficiary's family. The rolled-over amounts count towards the overall limitation on amounts that can be contributed to an ABLE account within a taxable year, with any excess includible in the gross income of the distribute. The provision is effective for distributions after date of enactment through 2025
ABLE accounts. Effective for tax years beginning after the date of enactment, the contribution limit to an ABLE account is increased with respect to contributions made by the designated ABLE account beneficiary. The provision does not apply to tax years beginning after 2025.
Qualified retirement plan distributions. For tax years beginning in 2016 and 2017, a special provision is included that waives the 10 percent early withdrawal penalty for distributions from a qualified retirement plan in the event of a qualified disaster in 2016, up to $100,000.
Recharacterization of IRA contributions. For tax years beginning after 2017, the current rule that allows a contribution to one type of IRA to be recharacterized as a contribution to the other type of IRA does not apply to a conversion contribution to a Roth IRA. Thus, recharacterization cannot be used to unwind a Roth conversion. However, recharacterization is still permitted with respect to other contributions.
Estate and gift tax. Effective for estates of decedent’s dying and gifts made after 2017 and before 2026, the bill doubles the existing amount of the estate and gift tax (coupled) exemption for estates of decedents dying and gifts made after December 31, 2017, and before January 1, 2026. Thus, for 2018, it will be $11.2 million per person.
Obamacare. For months beginning after 2018, the bill eliminates the “Roberts tax” that is imposed on a taxpayer that fails to acquire government-mandate health insurance (known as “minimum essential coverage”).
Like-kind exchanges. For exchanges completed after 2017, the bill modifies the provision providing for nonrecognition of gain in the case of like-kind exchanges by limiting its application to real property that is not held primarily for sale.
Domestic Production Activities Deduction (DPAD). The bill repeals the deduction for income attributable to domestic production activities, effective for non-corporate taxpayers, ag and horticultural cooperatives, and corporations for tax years beginning after 2017.
The following provisions in the current Tax Code remain unchanged:
- Credit for the elderly and permanently disabled
- Credit for plug-in electric drive motor vehicles
- The American Opportunity Tax Credit
- The Lifetime Learning Credit
- Deduction for student loan interest
- Deduction for qualified tuition and related expenses
- Exclusion for qualified tuition reductions
- Exclusion for interest on United States savings bonds used for higher education expenses
- Exclusion for educational assistance programs
- Deduction and exclusions for contributions to medical savings accounts
- Deduction for certain expenses of school teachers
- Employer-provided housing
- Gain on sale of principal residence
- Exclusion for dependent care assistance programs
- Exclusion for adoption assistance programs
- Minimum age for allowable in-service distributions from an IRA
- Rules governing hardship distributions from an IRA
- Employer-provided child care credit
- Credit for portion of employer social security taxes paid with respect to employee tips
- Credit for electricity produced from certain renewable resources
- Energy investment tax credit
- Extension and phaseout of residential energy efficient property credit
- Credit for producing oil and gas from marginal wells
- Cost basis of specified securities determined without regard to identification
The conference committee bill is a fairly good blend of the House and Senate bills. Whether the bill will benefit a particular taxpayer is highly dependent on the taxpayer’s facts. But, clearly, many taxpayers and businesses will benefit. Personally, if the bill passes the House and Senate and becomes law, I will be making 2018 charitable contributions before the end of 2017, pre-paying the last quarter of 2017 estimated taxes that would normally be paid in January of 2018 and pre-paying the last half of the 2017 real property taxes that aren’t due until sometime in 2018. That technique will likely then be employed on an every-other-year basis.
What’s your strategy? Attend (either in-person or online) on January 10 and learn what the planning options are. Here's the registration link for the event that is co-sponsored by the Kansas Society of CPAs and the Iowa State Bar Association: http://washburnlaw.edu/employers/cle/taxlandscape.html. See you then.
Thursday, December 14, 2017
Many people have gotten involved in the current Bitcoin “craze.” But, just what is Bitcoin, and what are the tax implications of Bitcoin transactions? The IRS is interested in making sure that all Bitcoin transactions are fully reported and the tax paid. It is also certain that underreporting is occurring. A recent case makes that last point clear.
Today’s blog post looks at the Bitcoin phenomenon, and the interest of the IRS in making sure that Bitcoin transactions are reported properly.
What is Bitcoin?
Bitcoin, is a digitalized currency (a type of cryptocurrency) that serves as a worldwide payment system. A bitcoin is not a tangible item of property, it’s just a balance that is maintained on a public ledger in the digital cloud along with all Bitcoin transactions as a decentralized digital currency. The Bitcoin network operates as “peer-to-peer” with transactions occurring directly between users. That means that the transactions are anonymous, but can be verified by network “nodes” and are recorded in a “blockchain” ledger.
A bitcoin results from a “mining” process and can be exchanged for other currencies as well as products and even services. A Bitcoin balance is maintained by the use of “public” and “private” “keys.” These keys are simply long strings of numbers and letters linked through the mathematical algorithm that was used to create them. The public key (comparable to a bank account number) is the public address to which others may send bitcoins. The private key (comparable to an ATM PIN) is meant to be a guarded secret, and is only used to authorize Bitcoin transmissions.
In addition, a bitcoin is not issued by a bank or government and has no intrinsic value by itself. A bitcoin is not legal tender. But, in spite of all of this, Bitcoin is popular and other digital currencies (known as “Altcoin”) have developed. Data exists showing that, as of early 2015, there were more than 100,000 merchants and vendors that accepted bitcoin as payment. There are millions of users, and the amount presently in circulation is estimated to exceed $7 billion.
Bitcoin can be an effective way of transferring money, but that is different from being a sound investment because of its lack of intrinsic value. It is highly volatile, and since its emergence in 2009, Bitcoin has gone through numerous cycles of spikes and valleys in value. It is much more volatile as gold or the U.S. dollar. These significant swings in value can produce big “winners” when the pendulum swings upward, but big “losers” are also produced when the pendulum swings wildly the other way.
Reporting Cash Transactions
What does the Code say about reporting Bitcoin transactions? If bitcoin is cash, I.R.C. §6050I requires a person engaged in a trade or business to report via Form 8300 a transaction in which more than $10,000 in cash is received. Reporting is also required if more than $10,000 in cash is received during any 12-month period in two or more related transactions. But, is bitcoin cash? Not according to the IRS. In March of 2014, the IRS stated that all virtual currencies, including bitcoins, would be taxed as property rather than currency. IRS Notice 2014-21, 2014-16 I.RB. 938. Thus, gains or losses from bitcoins held as capital will be realized as capital gains or losses, while bitcoins held as inventory will incur ordinary gains or losses.
In United States v. Coinbase, Inc., No. 17-cv-01431-JSC, 2017 U.S. Dist. LEXIS 196306 (N.D. Cal. Nov. 28, 2017), the IRS served a summons on the defendant, a virtual currency exchange, seeking records of the defendant’s customers for multiple years. The defendant (America’s largest platform for exchanging bitcoin into U.S. dollars) didn’t comply with the request, and the IRS sued to enforce the summons in accordance with I.R.C. §§7402(b) and 7604(a). The IRS later narrowed the scope of the summons so that it applied to fewer of the defendant’s account holders. Nevertheless, the summons still applied to more than 10,000 account holders.
The reason for the summons, of course, was because the IRS believes that many taxpayers engaged in Bitcoin transactions are not properly reporting the resulting gain or loss, or are not reporting anything at all. In its petition to enforce the summons, the IRS provided data showing that approximately 84 percent of taxpayers file returns electronically and that capital gain or loss for property transactions (such as Bitcoin) is reported on Form 8949 that is attached to Schedule D (Form 1040). The IRS noted that Form 8949 includes a space where the taxpayer is to report the type of property sold. The IRS also noted that its analysis of its data showed that only 800-900 taxpayers electronically filed a Form 8949 that included a property description that is “likely related to bitcoin” in each of the years at issue – 2013-2015.
When the IRS narrowed its summons, it sought information of the defendant’s account holders having accounts “with at least the equivalent of $20,000 in any one transaction type (buy, sell, send, or receive) in any one year during the 2013-2015 period.” That excluded the defendant’s customers who only bought and held bitcoin during 2013-2015 or for which the defendant filed Forms 1099-K during that same timeframe. The narrowed summons still applied to 14,355 of the defendant’s account holders and 8.9 million transactions. For those accounts, the IRS wanted registration records for each account, the name, address, tax identification number, date of birth, account opening records, copies of passport or driver’s license, all bitcoin wallet addresses, and all public keys for all accounts. The IRS also wanted the records of “Know-Your-Customer” diligence, as well as agreements or instructions granting a third-party access, control or transaction approval authority. The IRS also sought all information that would identify transactions, their balances and how they were conducted, and any correspondence that the defendant had with the user or any third party with account access. The IRS was also after all periodic statements of account or invoices.
The defendant still refused to comply with the summons, narrowed as it was. However, as time went on, the parties started negotiating. But, they couldn’t come to an agreement and the defendant claimed it was too difficult to comply with the summons. The IRS pressed on in court.
The issue before the court was the reasonableness of the IRS narrowed summons. The court noted that it was reasonable to the extent it sought information that would aid the IRS in closing the reporting gap between the number of the defendant’s virtual currency users and bitcoin users that reported gains or losses to the IRS during the 2013-2015 time period. In other words, the difference between the defendant’s 5.9 million customers, six billion transactions, and only 800-900 e-filed returns with a property description related to bitcoin. That created, the court noted, an inference that more of the defendant’s customers were trading bitcoin than were reporting gains on their returns. The court determined, based on this data, that the IRS had met the standard of making a minimal showing of meeting the good faith requirement for issuing a summons. In addition, the court rebuffed the defendant’s arguments that the IRS expert was not qualified to testify on the matter. After all, the court pointed out, he was the senior manager on the IRS virtual currency investigation team and personally supervised the analyst who performed the search that generated the data to support the summons. Neither the statute nor applicable caselaw required the IRS to do anything more for the summons request to be granted. In addition, the defendant’s claim that their customers filed paper returns in a greater proportion that the general population was unfounded. In addition, the court held that the narrowing of the summons was not arbitrary, but was based on information gleaned from the defendant during negotiations over the summons request. Importantly, the court held that the IRS summons request involved compliance and not general research into bitcoin data. So, the court approved the narrowed summons request and determined that the IRS had not abused the process or showed a lack of good faith. However, the court determined that certain documents were not required to be provided to the IRS. Those included the defendant’s records of “Know-Your-Customer” diligence; agreements or instructions granting a third-party access, control or transaction approval authority; and correspondence between the defendant and the user or any third party with access to the account with transaction activity.
Bitcoin seems to be all the rage. The current speculative bubble will burst at some point, but then another bubble is likely to pop back up. Clearly, the IRS is aware of the virtual currency world and is quite interested in making sure that gains (and losses) are reported properly. In addition, they are interested in assessing penalties for not filing appropriate information returns. The penalty is assessed on each instance of a failure to file the appropriate return. If the failure to file the required information return is determined to be an intentional disregard of the requirement, the penalty (for the years at issue in the case) is $250 per return with no maximum total limit. That could be a huge sum for the defendant, and it’s probably what the IRS is actually after. They simply don’t have the resources to go after very many individual taxpayers that aren’t reporting Bitcoin gains. But, they will certainly make a show of a few of the more prominent individual taxpayers.
In any event, practitioners would be wise to ask clients about any virtual currency transactions, make sure Form 1099-K is filed when required, and maintain good records.
Tuesday, December 12, 2017
There are several provisions in federal law that regulate the transport of livestock, other animals, poultry, fish, and insects. Those rules generally concern animal health and safety, and driver safety. The rules also apply to the transport of agricultural livestock. However, in some instances, exceptions exist that apply to agriculture.
On December 18, 2017, the U.S. Department of Transportation (USDOT) Final Rule on Electronic Logging Devices (ELD) and Hours of Service (HOS) is set to go into effect. 80 Fed. Reg. 78292 (Dec.16, 2015). The final rule, which was issued in late 2015, could have a significant impact on the livestock industry and livestock haulers. The new rule will require truck drivers to use electronic logging devices instead of paper logs to track their driving hours starting December 18. The devices connect to the vehicle's engine and automatically record driving hours.
The Obama Administration pushed for the change to electronic logs purportedly out of safety concerns. But, what will be the impact of the new final rule on the livestock industry? The federal government has a long history of regulating the transport of livestock in interstate commerce. Today’s post examines provides a brief history of the federal regulation of transporting animals in interstate commerce and the implications for agriculture of finalizing the USDOT ELD and HOS rule.
Animal Welfare Act
As originally enacted in 1966, the Animal Welfare Act (7 U.S.C. §§ 2131 et seq.) addressed the problem of an increase in the theft of pets and their sale for research. The legislation was subsequently expanded to cover the mistreatment of animals in transportation and animal fighting ventures by any live bird, dog or other mammal except man. The rules do not bar hunting with animals.
The major provisions of the legislation include licensing of those who handle pets, those who handle animals who might be used for research and ultimate dealers, exhibitors and auction operators. The purchase of dogs and cats for research purposes is prohibited except from authorized operators. The Act covers warm blooded animals used for research and experimentation. Humane standards are imposed for the handling, care and transportation of animals covered by the Act. Health certificates are required. A five-day waiting period applies before dogs and cats can be sold by dealers and exhibitors. Animals must be marked or otherwise identified.
”28 Hour Law”
The precursor to the present “28 Hour Law” was passed in 1873 to prevent cruelty to animals in interstate commerce by common carrier. The Act was repealed in 1906 and replaced with the “28 Hour Law.” 15 U.S.C. § 1825(a).
The Act, sometimes referred to as the “Food and Rest Law,” prohibits some carriers from transporting animals beyond certain time limits. For example, common carriers engaged in interstate commerce must unload animals for rest, water and feeding into properly equipped pens every 28 hours for at least five consecutive hours. The Act applies to cattle, sheep, swine and other animals. The original application of the law was with respect to trains, but the USDA revised existing regulations in 2006 to also apply to trucks. However, the Act does not apply to the transport of animals by airplane. Thus, the Act applies to transport by rail, boat or truck.
Upon request, the 28-hour time limit may be extended to 36 hours. Similarly, if the time period was exceeded because the unloading of animals was prevented “by storm or other accidental or unavoidable causes which cannot be anticipated or avoided by the exercise of due diligence and foresight,” the 28-hour time limit does not apply.
A special rule exists for sheep. Sheep do not have to be unloaded when the 28-hour time period expires at night. In that event, the sheep can be continued for 36 hours without written consent. A similar exception applicable to all animals is that no unloading is required if the animals have proper food, water, space and an opportunity to rest. However, that is not usually the case with railroads and with other kinds of carriers.
Monitoring Driver Hours – The FMCSA Final Rule
In the 1930s, the federal government established hours of service (HOS) rules for truck drivers. Under the rules, truckers are required to maintain logbooks to record on-duty as well as off-duty hours. It’s those rules that are set to change. As noted above, the Federal Motor Carrier Safety Administration (FMCSA) issued a final rule in 2015 requiring most motor carriers and interstate truck drivers to start using electronic logs to ensure drivers are complying with hours-of-service rules. 80 Fed. Reg. 78292 (Dec.16, 2015). The final rule is set to go into effect on December 18, 2017. It is estimated that the new rule will apply to more than three million truckers. Presently, there are more than 200 ELDs that are self-certified and have been registered with the USDOT.
The FMCSA claims that the goal of the ELD mandate is to make roadways safer by providing the government with a greater ability to more closely track driver hours. For fiscal year 2017, the FMCSA notes an increase of over 11 percent in citations for falsifying driver logs and a 14.8 percent increase in the number of truck drivers put out of service for falsifying logs. During that same timeframe, false log violations accounted for 16.2 percent of the 186,596 out-of-service orders issued to truck drivers. The FMCSA asserts that these statistics are justification for the ELD and HOS final rule.
The Owner-Operator Independent Drivers Association (OOIDA) challenged the final rule based on a violation of privacy rights (Fourth Amendment), but the U.S. Court of Appeals for the Seventh Circuit rejected the argument. Owner-Operator Independent Drivers Association, Inc., et al. v. United States Department of Transportation, et al., 840 F.3d 879 (7th Cir. 2016), cert. den., 137 S. Ct. 2246 (2017). The court determined that the ELD mandate constituted a reasonable administrative inspection under the Fourth Amendment involving a pervasively regulated industry, and was not arbitrary or capricious. The U.S. Supreme Court declined to hear the case, and a subsequent effort to override or delay the ELD rule legislatively failed.
The Trump Administration has instructed the FMCSA (and state law enforcement officials) to delay the December 18 enforcement of the final rule by delaying out-of-service orders for ELD violations until April 1, 2018, and not count ELD violations against a carrier’s Compliance, Accountability, Safety Score. Thus, from December 18, 2017 to April 1, 2018, any truck drivers who are caught without an electronic logging device will be cited and allowed to continue driving, as long as they are in compliance with hours-of-service rules.
Impact on agriculture. The agricultural industry has raised concern over how the ELD rule will impact its stakeholders. Data indicate that the livestock sector has consistently been one of the safest of the commercial hauling sectors. The Large Truck Crash Causation Study, conducted by the Federal Motor Carrier Safety Administration (FMCSA) and the National Highway Traffic Safety Institute, showed that of 1,123 accidents involving trucks hauling cargo, only five involved the transportation of livestock. Another report, the Transportation Institute’s Trucks Involved in Fatal Accidents Fact-book 2005, shows that livestock transporters accounted for just 0.7 percent of fatal accidents.
Exceptions. There are numerous exceptions to the ELD final rule. While the mandate is set to go into effect December 18, 2017, the FMCSA has granted a 90-day waiver for all vehicles carrying agricultural commodities. Other general exceptions to the final rule exist for vehicles built before 2000, vehicles that operate under the farm exemption (a “MAP 21” covered farm vehicle; 49 C.F.R. §395.1(s)), drivers coming within the 100/150 air-mile radius short haul log exemption (49 CFR §395.1(k)), and drivers who maintain HOS logs for no more than eight days during any 30-day period.
Several ag groups have also petitioned the FMCSA for a limited exemption from ELDs for agricultural trucks. There still remains a chance (slim as it may be) that an exemption for ag could be slipped into the tax bill that House and Senate conferees are presently marking up, or in an appropriations bill to continue the funding of the federal government.
One rule that is of particular concern is an HOS requirement that restricts drive time to 11 hours. This rule change occurred in 2003 and restricts truck drivers to 11 hours of driving within a 14-hour period. Ten hours of rest is required. That is a tough rule as applied to long-haul cattle transports. Unloading and reloading cattle can be detrimental to the health of livestock. An exemption from that restriction seems to be in order.
The federal government has long been involved in the regulation of the interstate transport of livestock and drivers. The FMCSA final rule is generally opposed by the transportation industry as well as the ag industry. Fortunately, some exemptions exist to relieve the burden on livestock transporters. Nevertheless, the finalization of the rule and eventual implementation merits attention.
Friday, December 8, 2017
Rural landowners can have various opportunities to earn income from their land that is in addition to income from crop and/or livestock production. For some landowners, that might include the possibility of leasing some of the property for oil and gas production. But, what should be considered before entering into a lease? This past May, David Pierce, Burke Griggs, Shawn Leisinger and I took our Rural Law Program to Dodge City, KS for a presentation. David Pierce made a presentation on oil and gas leases, and I took some notes of his discussion for future use on the blog.
Today’s post takes a brief look at what Prof. Pierce highlighted as some of the basic issues to be think about before entering into an oil and gas lease. Any lack of clarity in the commentary below is mine.
Doing nothing. It’s important to remember that when a landowner is approached about entering into an oil and gas lease that an acceptable strategy is to do nothing. There is no obligation to lease in a state (such as Kansas) that doesn’t have a compulsory “pooling” statute. But, while there is no obligation to lease, if the land is not owned outright by one person any cotenant has the power to develop, and authorize others to develop, without the consent of other cotenants. If that happens, there is then a duty to account to other cotenants for their share of the net proceeds (production revenue minus all reasonable costs of drilling, completing, and operating the well). Similarly, if one cotenant seeks to develop the minerals, that could give rise to another cotenant seeking a partition.
Similarly, when parents leave a tract of land to multiple children, and the parents don’t hold the leasing rights for the benefit of others that may create a duty to lease. The children end up with undivided interests in the entire tract. This means that the children receive all of the surface rights associated with the tract plus an undivided percentage interest in the oil and gas rights, plus the right to execute oil and gas leases for all of the undivided interests in their tract. That last point is key. Each child will end up with the right to enter into any lease covering the oil and gas rights held collectively by all of the siblings.
A related issue to that of a cotenant developing the property without the consent of other cotenants is that, for a proposed horizontal well, a lessee might seek to use another provision in state law to consolidate nonconsenting parties. This can happen if a state has a compulsory unitization statute. Kansas has such a statute, but it has never been tested in court. On the other hand, Ohio has used its compulsory unitization statute to combine the acreage necessary to conduct horizontal drilling into a shale formation.
Doing nothing presently. Another viable strategy is that the landowner may simply not enter into an oil and gas lease at the present time. Perhaps the up-front bonus money is not enough to allow the landowner to hire an attorney that is well-versed in oil and gas law for representation in the negotiation process. In any event, with this approach the landowner could gain strength in any future negotiation process.
Other Questions to Ask
Its also important for a landowner to understand who they are dealing with. Is it the developer or an intermediary? If the landowner is dealing with an intermediary, the intermediary will be looking to sell the lease and probably receive an overriding royalty in the lease. That’s an important point. The profit the intermediary retains upon selling the lease could have been the landowner’s if the deal is struck directly with the developer.
Also, it’s a good idea for a landowner to determine what the party seeking the oil and gas lease is planning for the landowner’s property and the nearby area. When is drilling to begin? Is there a formation that they are trying to develop? Have wells already been drilled in that area? Have wells been drilled elsewhere? Have other local landowners already executed leases and, if so, how many acres are under lease? What is being paid to other landowners in terms of a bonus and royalty rate? Can the landowner get the best deal that is offered? Will the developer match the best deal another developer offers? What can be learned about the company that is investing in the development of the land that will be leased?
Standard Lease Form?
One basic principle of oil and gas development is that there is not standard form for an oil and gas lease. See, e.g., Kansas Natural Gas Co. v. Board of Commissioners of Neosho County, 89 P.750, 751 (Kan. 1907). Thus, all of the terms of an oil and gas lease are negotiable. But, an oil and gas lease should address three general topics: 1) the rights granted by the lease; 2) the duration of those granted rights; and 3) the amount of compensation that the lessor will receive during the lease term.
While the terms of an oil and gas lease are negotiable, a party to the lease will not be satisfied with the contractual arrangement unless certain key points are achieved. The lessee (developer) wants exclusive development rights and associated use rights that are broad enough to allow the lessee to develop. In addition, the lessee must have adequate time to conduct the operations required to extend the lease. Also, the lessee must ensure that the leased land can be developed under existing law regulating oil and gas operations. From an economic standpoint, once the lessee commits funds to develop the lease, the lessee needs to be able to maintain the lease in effect as necessary to fully enjoy the benefits of its investment. In that same vein, the anticipated economic returns must be adequate to justify the risks involved.
From the lessor’s standpoint, it is important to receive an adequate financial incentive to part with the oil and gas and related surface rights. The lessee also wants continuing control over the surface estate prior before electing to make use of the surface to develop the leased land. Likewise, the lesssor wants continuing control over all other mineral and related rights not encompassed by the rights granted to the lessee. The lessor wants the ability to easily determine when the lease terminates in whole or in part, and the ability to easily determine the royalty due. It’s also important the lessor gets an assurance that as development progresses the impacted surface will be timely and properly reclaimed so it can be devoted to other uses. Similarly, the lessor wants the assurance that any disputes will be determined locally where the land is located, and that the lessor is able to access local courts to address disputes.
The Bonus and Obligation to Lease
Some of the most important details of the oil and gas lease transaction are not reflected anywhere in the oil and gas lease. Usually the lease contains a recitation similar to the following:
“Lessor, in consideration of one Dollars ($ 1.00 ) in hand paid, receipt of which is here acknowledged . . . .”. As that recitation indicates, the lease is presented as a unilateral grant by the lessor, and the lease is typically signed only by the lessor.
As for what makes the agreement binding on the parties, a conveyancing analysis is used to bind the lessee applying the requirements of delivery and acceptance. Likewise, some lessees still use a sight draft to create a situation where the parties may, or may not, be bound pending the lessee’s review and approval of the lessor’s title. The sight draft can create problems if it is not clear whether a contract to lease, with performance conditions, has been created or whether no obligation exists because the lessee is not bound in any way. This creates opportunities for the lessor in a rising leasing market and opportunities for the lessee in a declining leasing market. Thus, it is best to avoid the situation by nailing down the moment when the parties become bound. Perhaps the best approach is for a landowner to remain unbound, and free to deal with anyone, up until the landowner has the bonus money in hand. This places the urgency on the lessee to close the deal quickly.
These are some basic initial considerations for a landowner to work through before entering into an oil and gas lease so that the best negotiated deal can be struck. Useful information for those thinking about getting into an oil and gas lease.
Wednesday, December 6, 2017
For Chapter 7 and 11 filers, there is a possibility that taxes could be dischargeable in bankruptcy. That’s because under those bankruptcy code provisions, a new tax entity is created at the time of bankruptcy filing. That’s not the case for individuals that file Chapter 12 (farm) bankruptcy or 13 and for partnerships and corporations under all bankruptcy chapters. In those situations, the debtor continues to be responsible for the income tax consequences of business operations and disposition of the debtor's property. Thus, payment of all the tax triggered in bankruptcy is the responsibility of the debtor. The only exception is that Chapter 12 filers can take advantage of a special rule that makes the taxes a non-priority claim.
A new Tax Court case involving a Chapter 7 filer, illustrates how timing the bankruptcy filing is important for purposes of being able to discharge taxes in a Chapter 7.
Taxes discharged in bankruptcy, that’s the focus of today’s post.
The Bankruptcy Estate as New Taxpayer
The creation of the bankruptcy estate as a new taxpayer, separate from the debtor, highlights the five categories of taxes in a Chapter 7 or 11 case.
- Category 1 taxes are taxes where the tax return was due more than three years before filing. These taxes are dischargeable unless the debtor failed to file a return or filed a fraudulent return.
- Category 2 taxes are the taxes due within the last three years. These taxes are not dischargeable but are entitled to an eighth priority claim in the bankruptcy estate, ahead of the unsecured creditors.
- Category 3 taxes are the taxes for the portion of the year of bankruptcy filing up to the day before the day of bankruptcy filing. If the debtor's year is closed as of the date of filing, the taxes for the first year, while not dischargeable, are also entitled to an eighth priority claim in the bankruptcy estate. If the debtor's year is not closed, the entire amount of taxes for the year of filing are the debtor's responsibility.
- Category 4 taxes are the taxes triggered on or after the date of filing and are the responsibility of the bankruptcy estate. Taxes due are paid by the bankruptcy estate as an administrative expense. If the taxes exceed the available funds, the tax obligation remains against the bankruptcy estate but does not return to the debtor.
- Category 5 taxes are for the portion of the year beginning with the date of bankruptcy filing (or for the entire year if the debtor's year is not closed) and are the responsibility of the debtor.
The Election To Close the Debtor’s Tax Year
In general, the bankrupt debtor’s tax year does not change upon the filing of bankruptcy. But, debtors having non-exempt assets may elect to end the debtor’s tax year as of the day before the filing.
Making the election creates two short tax years for the debtor. The first short year ends the day before bankruptcy filing and the second year begins with the bankruptcy filing date and ends on the bankrupt’s normal year-end date. If the election is not made, the debtor remains individually liable for income taxes for the year of filing. But, if the election is made, the debtor’s income tax liability for the first short year is treated as a priority claim against the bankruptcy estate, and can be collected from the estate if there are sufficient assets to pay off the estate’s debts. If there are not sufficient assets to pay the income tax, the remaining tax liability is not dischargeable, and the tax can be collected from the debtor at a later time. The income tax owed by the bankrupt for the years ending after the filing is paid by the bankrupt and not by the bankruptcy estate. Thus, closing the bankrupt’s tax year can be particularly advantageous if the bankrupt has substantial income in the period before the bankruptcy filing. Conversely, if a net operating loss, unused credits or excess deductions are projected for the first short year, an election should not be made in the interest of preserving the loss for application against the debtor’s income from the rest of the taxable year. Even if the debtor projects a net operating loss, has unused credits or anticipates excess deductions, the debtor may want to close the tax year as of the day before bankruptcy filing if the debtor will not likely be able to use the amounts, the items could be used by the bankruptcy estate as a carryback to earlier years of the debtor (or as a carryforward) and, the debtor would likely benefit later from the bankruptcy estate’s use of the loss, deduction or credits.
But, in any event, if the debtor does not act to end the tax year, none of the debtor’s income tax liability for the year of bankruptcy filing can be collected from the bankruptcy estate. Likewise, if the short year is not elected, the tax attributes (including the basis of the debtor’s property) pass to the bankruptcy estate as of the beginning of the debtor’s tax year. Therefore, for example, no depreciation may be claimed by the debtor for the period before bankruptcy filing. That could be a significant issue for many agricultural debtors.
Consider the following example:
Sam Tiller, a cash method taxpayer, on January 26, 2016, bought and placed in service in his farming business, a new combine that cost $402,000. Sam is planning on electing to claim $102,000 of expense method depreciation on the combine and an additional $150,000 (50 percent of the remaining depreciable balance) of first-year bonus depreciation as well as regular depreciation on the combine for 2016. However, during 2016, Sam’s financial condition worsened severely due to a combination of market and weather conditions. As a result, Sam filed Chapter 7 bankruptcy on December 5, 2016.
If Sam does not elect to close the tax year, the tax attributes (including the basis of his property) will pass to the bankruptcy estate as of the beginning of Sam’s tax year (January 1, 2016). Therefore, Sam would not be able to claim any of the depreciation for the period before he filed bankruptcy (January 1, 2016, through December 4, 2016).
Recent Tax Court Case
In Ashmore v. Comr., T.C. Memo. 2017-233, the petitioner claimed that his 2009 tax liability, the return for which was due on April 15, 2010, was discharged in bankruptcy. He filed Chapter 7 on April 8, 2013. That assertion challenged whether the collection action of the IRS was appropriate. As indicated above, the Tax Court noted that taxes are not dischargeable in a Chapter 7 bankruptcy if they become due within three years before the date the bankruptcy was filed. Because the petitioner filed bankruptcy a week too soon, the Tax Court held that his 2009 taxes were dischargeable and could be collected. As a result, the IRS settlement officer did not abuse discretion in sustaining the IRS levy. In addition, the Tax Court, held that the IRS did not abuse the bankruptcy automatic stay provision that otherwise operates to bar creditor actions to collect on debts that arose before the bankruptcy petition was filed.
The Tax Court’s conclusion in Ashmore is not surprising. The three-year rule has long been a part of the bankruptcy code. Indeed, in In re Reine, 301 B.R. 556 (Bankr. W.D. Mo. 2003), the debtor filed the Chapter 7 bankruptcy petition more than three years after filing the tax return, but within three years of due date of return. The court held that the debtor’s tax debt was not dischargeable.
Monday, December 4, 2017
My post of November 20, 2017, compared the House and Senate proposed tax bills. At that time the House had passed its bill, but the Senate was still working its way through a different piece of tax legislation. Now, with numerous last-minute amendments, the Senate has approved (51-49) a tax bill that sets the stage for the Conference Committee to work out the differences and produce a final bill for the President’s signature. In reality, the final Senate version is not much different from the version I wrote about on November 20, but there were some last-minute amendments (primarily offered as revenue-related provisions) that were included in the bill that make the final version a bit different.
Or is there a process that will short-circuit working out the differences between the two bills?
Today’s post examines the final version of the Senate bill as approved on December 2, 2017. The reader can refer to my November 20 post for a look at the House bill. That post is accessible here: http://lawprofessors.typepad.com/agriculturallaw/2017/11/comparison-of-the-house-and-senate-tax-bills-implications-for-agriculture.html
For readers interested in learning more and getting continuing education in the process, on Dec. 14 I will be covering the tax rules that are in place at that time at a live seminar from Pittsburg State University. That seminar will also be live simulcast over the web. You can register for that seminar/webinar here: https://www.agmanager.info/events/kansas-income-tax-institute On January 10, 2018, I will be conducting a seminar/webinar on the new tax law (if we have one) which will include insight into planning issues related to the changes in the Code. Prof. Lori McMillan of Washburn Law will be on the program with me. That seminar/webinar will be live from the law school in Topeka, Kansas. The event is sponsored by Washburn University School of Law and the Kansas State University Department of Ag Econ and the Kansas Society of CPAs. Be watching this blog and my website – www.washburnlaw.edu/waltr for further information about registration.
Now, the key provisions in the Senate tax bill – The Tax Cuts and Jobs Act.
Major Individual Income Tax Provisions
Rate brackets. The Senate bill retains the existing structure of seven brackets, but changes the bracket margins and rates. For 2017, the percentage rates are 10, 15 (up to $77,400 mfj), 25, 28, 33, 35 and 39.6 percent. Under the Senate bill, for tax years 2018 through 2025, the rates would be 10, 12, 22, 24, 32, 35 and 38.5 percent. The compressed bracket rates remain for estates and trusts, with the top rate of 38.5 percent applying at income above $12,500. The brackets would be adjusted for inflation for tax years beginning after 2018.
Standard deduction/personal exemption. The Senate bill also nearly doubles the standard deduction by taking it to $24,000 for a married couple filing jointly. Along with this, the bill eliminates the personal exemption (presently $4,050) that a taxpayer can claim for themselves, spouse and dependents, but retains the additional standard deduction for the aged or blind. Thus, a taxpayer would itemize deductions only if itemized deductions exceed the standard deduction.
Note: The reduction in marginal rates (depending on a taxpayer’s income level) increases the after-tax cost of charitable donations which, for some taxpayers, will reduce the incentive to make charitable donations. When this is combined with elimination of many itemized deductions and the near doubling of the standard exemption, the impact on charitable giving is magnified. Presently, it is estimated that over 80 percent of total charitable giving is from taxpayers that itemize deductions, with this group giving approximately $240 billion annually. A negative impact on charitable would also likely result from the elimination or a reduction in the impact of the federal estate tax on high wealth taxpayers. For some taxpayers, making extra charitable donations by the end of 2017 may be a good tax planning move.
Itemized deductions. For tax years beginning after 2017 and before 2026, the Senate bill eliminates the allowance of miscellaneous itemized deductions that, in the aggregate, exceed two percent of the taxpayer’s AGI. In addition, the overall limitation on itemized deductions does not apply to tax years beginning after 2017 and before 2025.
Other deductions. The bill eliminates most deductions, including the deduction for state and local taxes. However, the bill was amended at the last minute to allow an itemized deduction of up to $10,000 in property taxes. Other deduction provisions include:
- Mortgage interest deduction is allowed up to $1 million, but interest on home equity loans would not be deductible for tax years beginning after December 31, 2017 and before January 1, 2026.
- The existing $250 deduction for certain expenses of schoolteachers is increased to $500 for tax years beginning after 2017 and before 2026.
- In addition, the bill allows all taxpayers an itemized deduction for medical (and dental) expenses exceeding 7.5 percent of a taxpayer’s AGI for tax years beginning after 2016 and ending before 2019. The bill also applies the 7.5 percent threshold for tax years 2013 through 2016 for a taxpayer (or spouse) that has attained age 65 by the end of the tax year.
- As for charitable contributions, the total amount that can be deducted in a tax year beginning after 2017 and before 2026 is limited to 60 percent (up from 50 percent) of the taxpayer’s contribution base. A five-year carryover applies to amounts not deductible due to the percentage limitation.
- The existing deduction for qualified moving expenses is suspended for tax years 2018 through 2025, except such expenses incurred by active duty members of the military that move pursuant to a military order and the move is incident to a permanent change of station. R.C. §217 is similarly conformed.
Exclusion of gain on sale of personal residence. The Senate bill increases the time that a taxpayer must own and use a home as their principal residence to be able to exclude a portion (or all) of the gain on sale. Under the modified provision, for a taxpayer to exclude up to $500,000 of gain (MFJ) on sale or exchange of the residence, the taxpayer must own the residence and use it as the taxpayer’s principal residence for five-out-of-eight years. The provision applies for sales or exchanges occurring after 2017 and before 2026. However, the five-out-of-eight-year rule does not apply to any sale or exchange for which there was a written binding contract in effect before 2018.
Credits. The Senate bill doubles the child tax credit, setting it at $2,000 per child under age 18 (rather than the current under age 17 limit) through 2024. The $2,000 amount of the credit reverts to $1,000 after 2025. In addition, the enhanced amount of the credit is not refundable. Thus, for lower income families that don’t have a filing requirement (which is more likely to be the case with the doubling of the standard deduction), the enhanced child tax credit will be of no effect. Also, the credit doesn’t begin to phase-out until AGI reaches $500,000 (MFJ).
Taxpayers with dependents that don’t qualify for the child tax credit but do meet certain requirements are eligible for an additional $500 (nonrefundable) credit for each such dependent.
Casualty and theft losses. For tax years beginning after 2017 and before 2026, personal casualty and theft losses are only deductible to the extent they are attributable to a Presidentially-declared disaster. However, this rule does not apply to any net operating loss carried over to a tax year beginning after 2017 and before 2026 from a tax year beginning before 2018.
Alternative Minimum Tax (AMT). The Senate bill retains the AMT. For tax years beginning after 2017 and before 2026, the exemption (MFJ) is increased to $109,400 (from $78,750) and to $70,300 from $50,600 (single).
Estate tax. The Senate bill doubles the base amount of the applicable exclusion to $10 million, with the exclusion remaining adjusted for inflation for decedents dying and gifts made in 2018 through 2025. Thus, the applicable exclusion will be $11.2 million per person in 2018. Stepped-up basis is retained, as is the gift tax and the existing rules for portability of the unused exclusion at the death of the first spouse.
Commodity gifts. Under current rules, a parent can gift grain to a child and eliminate the self-employment tax on the gifted grain and, under the “kiddie-tax” rules, the tax rate of the child is generally the parent’s rate. However, under the Senate bill, in most situations, the tax rate of the child will be the tax rates applicable to estates and trusts. Thus, once the child has $12,500 of unearned income, the tax rate applicable to the child will be 38.5 percent on all excess amounts. This provision is applicable for tax years 2018 through 2025.
Like-kind exchanges. The Senate bill eliminates like-kind exchanges for personal property exchanges, but retains the existing rules for real property exchanges. An interest in a partnership that has elected to be excluded from subchapter K is treated as an interest in each of the partnership’s assets and not as an interest in the partnership.
Fringe benefits. The Senate bill leaves unchanged the taxation to the individual taxpayer with respect to fringe benefits.
Obamacare. The Senate bill repeals the “Roberts Tax” by eliminating the mandate that a taxpayer acquire government-approved health insurance.
Corporate rate. The Senate bill repeals the existing rate structure for C corporations and replaces it with a flat 20 percent rate for tax years beginning after 2018. Thus, the 15 percent bracket on the first $50,000 of corporate income is eliminated. This amounts to a tax increase (as compared to current law through 2018) for corporations with $75,000 of taxable income and less. For example, under current law the tax owed on $75,000 of corporate taxable income is $13,750 while the tax liability under the new law would be $15,000.
AMT. The corporate AMT is retained at a 20 percent rate with an exemption of $40,000.
Pass-through entities. The Senate bill establishes a deduction to be applied against the lesser of a pass-through entity owner’s qualified business income (limited to 50 percent of W-2 wages subject to FICA) or 23 percent of the owner’s taxable income less net capital gain for the tax year. Qualified business income does not include any amount of reasonable compensation the owner receives from the pass-through entity, and also does not include the amount of any guaranteed payment. Those amounts are not entitled to the deduction and are taxed at ordinary income rates. To prevent a pass-through owner from recharacterizing wage income as the owner’s share of business profit, the deduction is limited to one-half of the Form W-2 wages paid by the pass-through entity or the entity’s share of the pass-through income passed through to the owner. However, this limitation only applies if the owner’s taxable income exceeds $500,000 (mfj). The taxable income limit is adjusted for inflation for tax years beginning after 2018.
Note: An owner of a pass-through service business is eligible for the deduction if taxable income is under $500,000 (mfj). However, the deduction is not available on the first $500,000 if the provision has been fully phased-out. Also, when determining alternative minimum taxable income, “qualified business income” is determined without regard to any adjustments under I.R.C. §§56-59.
Cooperatives. An agricultural or horticultural cooperative that is subject to part I of Subchapter T and is engaged in manufacturing, growing, producing or extracting any agricultural or horticultural product, or is engaged in the marketing of agricultural or horticultural products that its patrons have manufactured, produced, grown or extracted, or provides supplies to farmers or other similar cooperatives, can claim a deduction equal to the lesser of 23 percent of the cooperative’s taxable income for the tax year or 50 percent of the cooperative’s W-2 wages related to the cooperative’s trade or business. This provision, however is only available for tax years beginning after 2018 and before 2026.
Cost recovery. The Senate bill allows for full expensing of assets presently eligible for “bonus” depreciation under I.R.C. §168(k) for property place in service after September 27, 2017 through December 31, 2022. After 2022, the provision is phased-out by 20 percentage points every year thereafter with a complete phaseout for property placed in service beginning in 2027. The same rules apply to plants bearing fruits and nuts. The bill also increases the maximum base amount deductible under I.R.C. §179 to $1,000,000 and the beginning of the phase-out to $2,500,000 of qualified property placed in service. Both amounts remain subject to inflation adjustments. In addition, qualified property for purposes of I.R.C. §179 includes I.R.C. §1245 property or, by election, certain qualified real property.
“Luxury” automobiles. Under §280F, passenger automobiles, trucks and vans are subject to special annual depreciation limits, known as luxury auto limits. Under the Senate bill, the first-year depreciation for certain automobiles is increased to $10,000, with subsequent years set at $16,000, $9,600, and then $5,760. Computer equipment is removed from the definition of “listed” property.
Farm property. The five-year MACRS rule that was in effect for machinery and equipment used in a farming business and placed in service in 2009 is restored for such property placed in service after 2017. In addition, the use of the 150 percent declining balance method for farm property is repealed for such property placed in service after 2017 in tax years ending after 2017. Thus, farm property, except for farm buildings and land improvements, will be eligible for the 200 percent declining balance method.
Real estate. The bill changes the applicable depreciable recovery period for residential rental property from 27.5 years to 25 years, and changes the applicable depreciable recovery period for nonresidential real property from 39 years to 25 years. Eliminated from the category of “15-year property” are qualified leasehold improvement property, qualified restaurant property and qualified retail improvement property.
Loss limitation. For tax years beginning after 2017 and before 2026, the excess farm loss rule of I.R.C. §461(j) will not apply. In essence, that rule limits the deductibility of farm losses exceeding the greater of $300,000 for a farmer that receives a Commodity Credit Corporation loan. However, the Senate bill includes an overall $500,000 limit on the deductibility of losses from all businesses of the taxpayer.
Cash accounting. For tax years beginning after 2017, a corporation or partnership with average gross receipts for the three taxable years ending with the taxable year preceding the taxable year not exceeding $15 million can use the cash method of accounting (the present limit is $1 million). For family corporations, the limit is $25 million. The $15 million limit applies to farming corporations, except that family farm corporations have a $25 million limit. Both the $15 million and $25 million amounts are adjusted for inflation for tax years beginning after 2018. There remains no limit for S corporations.
Inventories. Small businesses using cash accounting that are not required to use inventories when accounting for income can treat the inventories as a non-incidental material or supply (or whatever categorization the taxpayer uses for their books and records) for tax years beginning after 2017. The “small business” for this purpose is one allowed to use the cash method of accounting under the provision noted above.
Business interest. For tax years beginning after 2017, deductible business interest is limited to business income plus 30 percent of the taxpayer’s adjusted taxable income for the tax year that is not less than zero. Any disallowed amount is treated as paid or accrued in the succeeding tax year. However, businesses entitled to use cash accounting are not subject to the limitation, but large cash accounting businesses such as personal service businesses are limited in the deductibility of business interest. Special rules apply to excess business interest of partnerships.
An electing farm business (as defined by I.R.C. §263A(e)(4)) is not subject to the limitation on the deductibility of interest deduction. In return, such farm businesses that elect out of the interest deductibility limitation must use alternative depreciation on farm property with a recovery period of 10 years or more. However, the election out will likely result in the inability to qualify otherwise eligible assets for bonus depreciation (in accordance with I.R.C. §263A).
Net operating losses (NOLs). For tax years beginning after 2017, the Senate bill limits net operating losses to the lesser of the aggregate of the NOL carryovers to the tax year plus the NOL carryback to the tax year, or 90 percent of taxable income computed without regard to the NOL allowed for the tax year. The 90 percent amount drops to 80 percent for tax years beginning after 2022. For tax years ending after 2017, NOL carrybacks are disallowed, but an NOL can be carried forward indefinitely. A two-year carryback is allowed for farming NOLs with an election available forgo the two-year carryback.
Fringe benefits. The Senate bill reduces or eliminates the deduction for entertainment expenses presently allowed under I.R.C. §274(a)(1)(A). The 50 percent expense deduction for entertainment expenses is limited to 50 percent of food and beverage expenses. The deduction for corporate-provided meals is limited to 50 percent of such qualified meals. The existing deduction for qualified transportation fringe benefits is eliminated. Expenses associated with the operation of an employer-provided eating facility are disallowed as are associated expenses for food and beverages. All of these provisions are effective for amounts paid or incurred after 2017, except for the provision governing employer-provided meals. That provision is eliminated for amounts paid or incurred after 2025.
Domestic Production Activities Deduction (DPAD). The Senate bill repeals the DPAD for any taxpayer other than a C corporation for tax years beginning after 2017. Thus, the DPAD is eliminated for agricultural and horticultural cooperatives for tax years beginning after 2017. For C corporations, the DPAD is eliminated effective for tax years beginning after 2018.
Family and medical leave. The Senate bill creates a credit for an eligible employer a paid family medical leave credit in an amount equal to 12.5 percent of normal hourly wages paid to a qualifying employee during any period in which the qualifying employee is on family and medical leave (not to exceed 12 weeks). The credit is increased by .25 percentage points for each percentage point by which the rate of payment exceeds 50 percent. Any leave paid by a State or local government or required by State or local law is not taken into account in determining the amount of paid family and medical leave that the employer provides. In other words, if a state or locality mandates a level of family or medical leave, there is no credit.
Partnership losses. When determining a partner’s distributive share of any partnership loss, the partner takes into account the distributive share of the partnership’s charitable contributions and taxes, except that if the fair market value of a charitable contribution exceeds the contributed property’s adjusted basis, the partner is not to take into account the partner’s distributive share of the charitable contribution as to the excess. The result of this provision is that basis is not decreased by the excess fair market value over basis. The provision applies to partnership taxable years beginning after 2017.
- The Senate bill expands the qualifying beneficiaries of an electing small business trust, effective January 1, 2018.
- Effective for distributions after the date of enactment, the Senate bill amends I.R.C. §1371 concerning cash distributions after the post-termination transition period when an S corporation converts to a C corporation.
- For tax years beginning after 2017, the Senate bill imposes a tax on excess tax-exempt organization executive compensation.
- For tax years beginning after 2017, Roth IRA contributions would not be able to be recharacterized as traditional IRA contributions.
- For organizations with multiple unrelated trades or businesses, unrelated business taxable income is computed separately for each trade or business activity. Except for a carryover provision, the new rule applies to tax years beginning after 2017.
- The deduction for amounts paid in exchange for college event seating rights is repealed effective for contributions made in tax years beginning after 2017.
- The provision that waives the substantiation requirement for charitable gifts of $250 or more if the donee organization files a return that contains the necessary written acknowledgement substantiation concerning the gift, is eliminated for contributions made in tax years beginning after 2016.
- The current system for the taxation of capital gains remains unchanged.
- Farm income averaging remains unchanged.
- The prohibition on the production of oil and gas from a portion of the Artic National Wildlife Refuge is removed, presumably upon enactment.
Both the House and Senate will now vote to advance their respective bills to the conference committee that will be assembled. While the bills are different, there are many similarities. One possibility is that the House conferees will simply adopt the Senate bill. If that is done, the Senate bill will then be presented to the President for signature.
My view is that the individual provisions will be beneficial to many taxpayers. But, taxpayers residing in states with an income tax that would normally itemize deductions under current law will not likely see a rate reduction, unless their taxable income is between $480,000 and $1 million, and they can no longer be able to deduct state income tax or sales tax. But, as always, the specific taxpayer’s situation will determine how beneficial, if at all, the new tax system will be. On the corporate side, the new changes do pose additional complexity.
It is still possible that the wheels come off of the House and Senate proposals and a bill is not able to be presented to the President this year. However, it no longer looks like that will be the case.
Thursday, November 30, 2017
In 1930, the Congress enacted the Perishable Agricultural Commodities Act (PACA) to address unfair and fraudulent practices in the marketing of perishable agricultural commodities in interstate and foreign commerce. 7 U.S.C. §§ 499a et seq. A provision in the PACA requires a covered “dealer” to “promptly pay” for the purchase of perishable agricultural commodities. One way that the PACA ensures prompt payment is via the creation of a PACA trust to hold the proceeds of the sale of perishable commodities for the for the benefit of the unpaid seller until full payment is made. 7 U.S.C. § 499e(c)(2).
This PACA trust provision was added in 1984 to address the problem of buyers filing bankruptcy after purchasing perishable commodities, but before full payment was made. Basically, once an unpaid seller learns that a buyer has become insolvent, a PACA trust is created and the PACA trust funds (amounts owed to the seller) are escrowed for pro rata distribution to the PACA trust beneficiary or beneficiaries. The point is that the assets in a PACA trust are excluded from the bankruptcy estate of a bankrupt buyer.
A recent case involved an interesting question - whether the PACA trust bars a bankruptcy debtor-in-possession (DIP), from using the cash collateral of the PACA trust in the continued operation of the DIP’s business. Is the status of the perishable commodity seller as a PACA trust beneficiary sufficient, by itself, to bar the DIP’s use of the cash collateral?
The rights of a DIP to use cash collateral of a PACA trust, that’s the topic of today’s post.
Chapter 11 and the DIP
A DIP is a party (individual or corporation) that has filed a Chapter 11 (reorganization) bankruptcy petition. While creditors of the DIP have liens in the DIP’s property, the DIP remains in control of the property and continues to operate the underlying business. The DIP essentially continues to operate the business in a fiduciary capacity for the creditors’ best interest. Thus, ordinary business operations are permissible, but the DIP has to get court approval for actions that are beyond the scope of normal business practices.
Recent Bankruptcy Case
In a recent Chapter 11 bankruptcy case, In re Cherry Growers, Inc., No. 17-04127-swd, 2017 Bankr. LEXIS 3838 (W.D. Mich. Nov. 1, 2017), the debtor, as a Chapter 11 DIP, filed a motion for an order authorizing its use of cash collateral. A bank, the DIP’s principal secured creditor, supported the motion. However, a claimant asserting PACA rights opposed the motion because, in its view, such an order would violate the claimant’s PACA trust rights as well as the rights of others as beneficiaries of the PACA trust.
As mentioned above, the PACA creates a statutory trust to protect growers of perishable agricultural products against the risk of non-payment by buyers and others. A PACA claimant, as a seller of eligible produce, has a trust claim against the qualifying inventory and proceeds that is superior to the claims and liens of the buyer’s creditors with no regard to whether the creditors are secured or unsecured and without regard to the priority level of the claim. Under the facts of the case, the claimant held an equitable interest in the bankruptcy estate with respect to its $337,159.18 PACA claim, and the question before the court was whether that equitable interest was sufficient to deny the debtor’s requested (and otherwise consensual) use of its secured lender’s cash collateral, especially where a sufficient equity cushion existed to adequately protect the PACA claimant’s claim.
The court held an interim hearing on the motion at which it took testimony, granted interim relief and scheduled a final hearing. At the final hearing PACA claimant argued that its PACA claim reached all of the DIP’s property, at least if the DIP could not prove otherwise. The claimant asserted that its status as PACA trust beneficiary was sufficient to bar a debtor from utilizing the cash collateral. The claimant also argued that in the absence of proof the contrary from the DIP, all income derived during the case from any of the property in the DIP’s possession, would constitute proceeds of the PACA trust, and that the DIP could not use any of the property because it belonged to the PACA claimant and not the bankruptcy estate.
The court did note the power of the PACA trust. Specifically, the court pointed out that, under PACA, growers and suppliers of perishable agricultural products who have properly preserved their rights under the statute are entitled to the benefit of a broad and powerful “floating trust” in their buyer’s qualifying inventory and proceeds thereof. These trust claims are to be paid first from trust assets, even prior to any claims or interests of secured creditors in such property. Furthermore, the court noted that the commingling of trust assets is specifically contemplated under the federal regulations implementing PACA. As the court recognized, PACA is “designed to promote priority payment to the PACA claimant.”
However, the court held that to conclude that the subject matter of the PACA trust is excluded from the bankruptcy estate overstated the case holdings that the PACA claimant cited. Instead, the court determined that the PACA expressly contemplates the commingling of trust and non-trust property, the creation of a “floating trust,” and the continued operation of the PACA trustee. Thus, within the context of a Chapter 11 bankruptcy, the DIP presumptively continues operating its business in accord with applicable non-bankruptcy law. In turn, the court reasoned, this meant that it made sense to think in terms of permitting the DIP to use its buildings and equipment to conduct its business as it had done for years, along with the cash and cash equivalents derived from that use, even though they may be impressed to some extent with a statutory trust, as long as the DIP provides adequate protection of the PACA claimant’s interest in the estate property. In addition, because the value of the property of the estate that the PACA claimant believed to be impressed with the PACA trust far exceeded the claimant’s claim, the court concluded that the DIP had met its burden of showing that the claimant would be adequately protected. Therefore, the court granted the DIP’s motion authorizing the use of the cash collateral in the property in which the PACA claimant had an equitable interest, in accordance with 11 U.S.C. §363 “as long as the DIP provides adequate protection of [the PACA claimant’s] interests in the estate property.” Because the DIP’s property that the PACA claimant alleged was subject to the PACA trust was much greater than the PACA claimant’s $337,159.18 claim, the court found that the PACA claimant’s interests were adequately protected.
The court also disagreed with the PACA claimant’s assertion that the DIP bore the burden of proof that the property that the DIP wanted to utilize in its business operations were not property of the PACA trust. Instead, the court determined that the PACA claimant had to first prove that the claimant had an interest in the DIP’s property. After that, the DIP had to establish that adequate protection was provided to the PACA claimant. In so holding, the court distinguished a contested matter under 11 U.S.C. §363 from that involving a battle of competing property interests.
What’s the “take-home” from the court’s decision? Certainly, PACA claimants have substantial rights. But, there are limits on those rights. In addition, according to the court, a PACA claimant’s equitable interests in the PACA trust are not bankruptcy estate property, but the assets themselves are under 11 U.S.C. §541. The case could also indicate that DIPs may have more leverage with creditors in getting authority to use cash collateral to conduct continuing business operations.
Tuesday, November 28, 2017
Sometimes farmers and ranchers operate in the partnership form without any formal documentation of their business association. Other times, there is a formalized agreement that really isn’t paid much attention to. But, the details of partnership law and the associated tax rules can produce some surprises if those details are not properly understood.
Today’s post takes a look at some key tax features, and surprises, surrounding the partnership form of doing business.
A major tax consideration for farmers and ranchers (and others) when deciding the appropriate form of business structure is self-employment tax. This year, the tax rate is 15.3 percent on the first $127,200 of an individual’s self-employment income. The rate then goes to 2.9 percent up to self-employment income of $250,000 (for a married person that files jointly). Then, thanks to the health care law, the rate jumps another 31 percent to 3.8 percent on any additional amount of self-employment income. For the 3.8 percent amount, the combined earned income of spouses is measured against the $250,000 threshold.
But, self-employment tax is treated differently in a partnership – at least for limited partners. A limited partner, under the tax law, is treated like an owner of an S corporation. A limited partner’s compensation income is subject to self-employment tax, but the limited partner’s share of partnership income is not net earnings from self-employment. Accordingly, it is not subject to self-employment tax. For a limited liability company (LLC) that is treated as a partnership for tax purposes, the self-employment tax burden depends on the structure of the LLC and whether it is member-managed or manager-managed. In other posts, I have written on that structure and the associated self-employment tax issues. Basically, however, if a member does not have management authority under the agreement, the member is viewed under the tax law as a limited partner.
Recent cases. A couple of recent cases illustrate the self-employment tax treatment of members of partnerships. In Hardy v. Comr., T.C. Memo. 2017-17, the petitioner was a plastic surgeon who purchased a 12 percent manager interest in an LLC that operated a facility in which the plaintiff could conduct surgeries when necessary. The petitioner also conducted surgeries in his own office separate from the LLC facility, and owned a separate company run by his wife for his surgical practice. The court did not allow the IRS to group the two activities together based on the weight of the evidence that supported treating the two activities as separate economic units. The petitioner did not have any management responsibilities in the LLC, did not share building space, employees, billing functions or accounting services with the LLC. In addition, the petitioner’s income from the LLC was not linked to his medical practice. Thus, by looking to the petitioner’s actual conduct, the Tax Court determined that the petitioner was a limited partner in the LLC for self-employment tax purposes even though the petitioner held a manager interest in the LLC. Hardy v. Comr., T.C. Memo. 2017-17. For reasons further explained below, one should not rely on the Hardy case to avoid self-employment tax if the person may exercise management authority.
By comparison, consider Methvin v Comr., 653 Fed. Appx. 616 (10th Cir. Jun. 24, 2016), aff’g., T.C. Memo. 2015-81. In this case, the petitioner was a CEO of a computer company, and didn’t have any specialized knowledge or expertise in oil and gas ventures. In the 1970s, he acquired working interests in several oil and gas ventures of about 2-3 percent each. The ventures were not part of any business organization, but were established by a purchase and operating agreement with the actual operator of the interests. The operator managed the interests and allocated to the petitioner the income and expense from the petitioner's interests. The petitioner had no right to be involved in the daily management or operation of the ventures. Under the agreement, the owners of the interests elected to be excluded from Subchapter K via I.R.C. §761(a).
For the year at issue, the petitioner's interests generated almost $11,000 of revenue and approximately $4,000 of expenses. The operator classified the revenues as non-employee compensation and issued the petitioner a Form 1099-Misc. (as non-employee compensation). No Schedule K-1 was issued and no Form 1065 was filed. The petitioner reported the net income as "other income" on line 21 of Form 1040 where it was not subject to self-employment tax. The petitioner believed that his working interests were investments and that he was not involved in the investment activity to an extent that the income from the activity constituted a trade or business income. He also believed that he was not a partner because of the election under I.R.C. §761(a), so his distributive share was not subject to self-employment tax.
The IRS agreed with the petitioner’s position in prior years, but chose not to for 2011, the year in issue. The IRS claimed that the income was partnership income that was subject to self-employment tax. The Tax Court agreed with the IRS because a joint venture had been created with the working interest owners (of which the petitioner was one) and the operator. Thus, the petitioner's income was partnership income under the broad definition of a partnership in I.R.C. I.R.C. §7701(a)(2). Importantly, the trade or business was conducted, the court determined, by agents of the petitioner, and simply electing out of Subchapter K did not change the nature of the entity from a partnership. Also, the fact that IRS had conceded the issue in prior years did not bar the IRS from changing its mind and prevailing on the issue for the year at issue.
On appeal, the Tenth Circuit affirmed, noting that the petitioner did not hold a limited partner interest which would not be subject to self-employment tax pursuant to I.R.C. §1402(a)(13). The Tenth Circuit also noted that the fact that the IRS had conceded the self-employment tax issue in prior years did not preclude the IRS from pursuing the issue in a subsequent tax year.
The outcome of the case is not surprising. In the oil and gas realm, operating agreements often create a joint venture between the owners of the working interests (who are otherwise passive) and the operator. That will make the income for the working interest owners self-employment taxable, and an election out of Subchapter K won’t change that result. That’s particularly the case if the court finds an agency relationship to be present, as it did in the present case. And, IRS gets a pass for inconsistency. At least the investor’s income would not be subject to the 3.8 percent Net Investment Income Tax imposed by the health care law (I.R.C. §1411).
As for the IRS, its position on the matter was most recently announced in a Chief Counsel Advice in 2014. C.C.A. 201436049 (May 20, 2014). Citing I.R.C. §1402(a)(13), the IRS noted that a limited partner is not subject to self-employment tax on the limited partner’s share of partnership income, but an active owner is.
The cases point out several things of importance. First, even though a taxpayer may not be personally active in the management of a partnership that is carrying on a trade or business that generates self-employment income, the taxpayer can still be subject to self-employment tax on the taxpayer’s share of partnership income if the partnership business is carried out on the partner’s behalf by an agent (or employee). In addition to Methvin, the Tax Court decided similarly in a 1988 case. Cokes v. Comr., 91 T.C. 222 (1998). It doesn’t matter how large or small the taxpayer’s interest in the partnership is.
The second point is that an election out of Subchapter K (the partnership tax section of the Code) has no impact on the nature of the entity for self-employment tax purposes. That’s fundamental partnership tax law dating at least back to the Tax Court’s 1998 decision. The real question is whether the entity satisfies the definitional test set forth in I.R.C. §7701(a)(2). Likewise, a partnership’s existence turns on the parties’ intent. That’s a factual determination and numerous considerations are important to answering that question. See Luna v. Comr., 42 T.C. 1067 (1964). So, even if a taxpayer doesn’t participate in the partnership’s business activities, it may not matter from a self-employment tax standpoint. That’s why the Congress included a special “carve-out” for limited partners in I.R.C. §1402(a)(13). A taxpayer classified as a general partner (or one with a manager interest) can’t use the special provision. Viewed in this light, the Tax Court’s Hardy decision would appear incorrect. But, there were other unique issues in Hardy that may have influenced the court’s conclusion on the self-employment tax issue.
The third point is that the IRS can change its administrative position on an issue. It need not be “fair” as it applies the tax rules to a taxpayer’s situation. The simple fact is that an IRS concession of an issue for a taxpayer in one tax year does not mean it must concede the issue in other years. See, e.g., Burlington Northern Railroad Co. v. Comr., 82 T.C. 143 (1984). The same can be said for taxpayers. The American Institute of Certified Public Accountants has Statements on Standards for Tax Services. One of those Standards, No. 5, allows a CPA to argue a position that is contrary to one that the client has conceded in prior tax years.
Clarity on the type of partnership and the type of interest is important. A well-drafter partnership agreement can go a long way to ensuring that the desired tax result is achieved. Operating under an informal arrangement and/or not fully understanding the meaning of the type of ownership interest held from a tax standpoint can result in an unexpected tax result.