Monday, July 16, 2018
In recent years, the IRS has shown an increased focus on business activities that it believes are being engage in without an intent to make a profit. If that is the case, the “hobby loss” rules apply and limit deductions to the amount of income from the activity. But, engaging in an activity with a profit intent may not be enough to fully deduct losses from the activity. That’s particularly the case if the taxpayer hires a paid manager to run the operation. In that situation, the IRS may claim that the taxpayer is not materially participating in the activity under the passive loss rules. If the IRS prevails on that argument, loss deductions are severely limited, if not eliminated.
A recent Tax Court case involved both the hobby loss rules and the passive loss rules. While the ranching activity was deemed not to be a hobby, the court believed that the taxpayer was not materially participating in the activity.
Paid managers and the passive loss rules – that’s the focus of today’s post.
Passive Loss Rules
The passive loss rules, enacted in 1986, reduce the possibility of offsetting passive losses against active income. I.R.C. §469(a)(1). The rules apply to activities that involve the conduct of a trade or business (generally, any activity that is a trade or business for purposes of I.R.C. §162) where the taxpayer does not materially participate (under at least one of seven tests) in the activity on a basis which is regular, continuous and substantial. I.R.C. § 469(h)(1). Property held for rental usually is a passive activity, however, regardless of the extent of the owner's involvement in the management or operation of the property.
If the passive loss rules apply, deductions (losses) from passive trade or business activities, to the extent the deductions exceed income from all passive activities, may not be deducted against other income (non-passive activity gains). Losses (and credits) that a taxpayer cannot use because of the passive loss limitation rules are suspended and carry over indefinitely to be offset against future passive activity income from any source. I.R.C. §469(b). For farmers, the passive loss rules are likely to come into play in situations where the farmer is a passive investor in a separate business venture apart from the farming operation. In that case, as noted, the losses from the venture cannot be used to offset the income from the farming operation.
Facts. In Robison v. Comr., T.C. Memo. 2018-88, the petitioners, a married couple worked for a technology company in the San Francisco Bay. During the years in issue, 2010-2014, the husband’s salary ranged from $1.4 million to $10.5 million. He also was an Executive Vice President of Hewlett-Packard Co. In 1999, the petitioners bought a 410-acre tract in a remote area of southeastern Utah for $2,000,000. They later acquired additional land, bringing their total land holdings to over 500 acres. The property was in shambles and the petitioners spent large sums on infrastructure to refurbish it. The began a horse activity on the property which they continued until 2010. The activity never made money, with a large part of the losses (roughly $500,000 each year) attributable to depreciation, repairs due to vandalism, and infrastructure expense such as the building of an on-site cement factory). The petitioners did not live on the ranch. Instead, they traveled to the ranch anywhere from four to ten times annually, staying approximately 10 days each time. The petitioners drafted all employee contracts, and managed all aspects of the horse activity.
They deducted their losses from the activity annually. However, they were audited by the IRS in 2004 and 2008. Each of those audits concluded with an IRS determination that the petitioners were conducting a trade or business with profit intent (e.g., the activity was not a hobby). The IRS also indicated that the petitioners were materially participating for purposes of the passive loss rules. The petitioners did not maintain contemporaneous records of their time spent on ranch activities. However, for each of those audits, the petitioners prepared time logs based on their calendars and their historical knowledge of how long it took them to complete various tasks. The IRS deemed the petitioners’ approach to documenting and substantiating their time spent on various ranch activities as acceptable. That documentation showed that the petitioners were putting over 2,000 hours (combined) into the ranch activity annually. In one year alone, they devoted more than 200 hours dealing with the IRS audit.
In 2010, the petitioners shifted the ranch business activity from horses to cattle. The husband retired in 2012 and, upon retirement, devoted full-time to the ranching activity. The cattle operation was strictly grass-fed, with the cattle grazing upper-elevation Bureau of Land Management (BLM) land during the summer months. The petitioners negotiated the lease contracts with the BLM. They also hired a full-time ranch manager to manage the cattle. However, the petitioners managed the overall business of the ranch. From 2013-2015, the losses from the ranch declined each year.
The IRS initiated a third audit (all three audits involved different auditors) of the petitioners’ ranching activity, this time examining tax years 2010-2014. The IRS examined whether the activity constituted a hobby, but raised no questions during the audit concerning the petitioners’ material participation. The IRS spent three days at the ranch looking at all aspects of the ranching activity and examining each head of cattle. It also hired an “expert” to examine the cattle activity, and the expert produced a report simply concluding that the petitioners had too many expenses for the activity to be profitable. This time the IRS issued a statutory notice of deficiency (SNOD) denying deductions for losses associated with the ranching activity. The IRS claimed that the ranching activity was a “hobby,” and also raised the alternative argument that the petitioners failed to satisfy the material participation test of the passive loss rules.
The petitioners disagreed with the IRS’ assessment and filed a petition with the U.S. Tax Court. The IRS did not disclose to the petitioners whether the petitioners’ alleged lack of material participation was an issue until two days before trial. At the seven-hour trial, the court expressed no concern about any lack of profit motive on the petitioners’ part. The IRS’ trial brief focused solely on the hobby loss issue and did not address the material participation issue. In addition, the IRS did not raise the material participation issue at trial, and it was made clear to the court that the paid ranch manager was hired to manage the cattle, but that the overall business of the ranch was conducted by the petitioners. At the conclusion of the trial, the court requested that the parties file additional briefs on the material participation issue.
Tax Court’s opinion – hobby loss rules. Judge Cohen determined that the ranching activity was not a hobby based on the nine factors set forth in Treas. Reg. §1.183-2. One of the key factors in the petitioners’ favor was that they had hired a ranch manager and ranch hand to work the ranch and a veterinarian to assist with managing the effects of high altitude on cattle. This indicated that the activity was being conducted as a business with a profit intent. While they had many consecutive years of losses, didn’t have a written business plan and didn’t maintain records in a manner that aided in making business decisions, the court noted that they had made a significant effort to reduce expenses and make informed decisions to enhance the ranch’s profitability. Indeed, after ten years of horse activity, the petitioners changed the ranching activity to cattle grazing in an attempt to improve profitability. While the petitioners’ high income from non-ranching sources weighed against them, overall the court determined that the ranching activity was conducted with the requisite profit intent to not be a hobby.
Note: While the court’s opinion stated that the horse activity was changed to cattle in 2000, the record before the court indicated that the petitioners didn’t make that switch until 2010.
Tax Court’s opinion – passive loss rules. However, Judge Cohen determined that the petitioners had failed to satisfy the material participation test of the passive loss rule. The losses were, therefore, passive and only deductible in accordance with those rules. The court determined that only two of the seven tests for material participation were relevant – the 500-hour test (Treas. Reg. § 1.469-5T(a)(1)) and the facts and circumstances test (Treas. Reg. §1.469-5T(a)(7)). As for the 500-hour test, the court took issue with the manner in which the petitioners documented their time spent on the ranching activity. The court opined that the logs were merely estimates of time spent on ranch activities and were created in preparation for trial. The court made no mention of the fact that the IRS, on two prior audits, raised no issue with the manner in which the petitioners tracked their time spent on ranch activities and had not questioned the accuracy of the logs that were prepared based on the petitioners’ calendars during the third audit which led to the SNOD and eventual trial.
As for the facts and circumstances test, the court determined that the petitioners could not satisfy the test because of the presence of the paid ranch manager. The court made no distinction between the cattle grazing activity which the ranch manager was responsible for and the overall business operations for which the petitioners were responsible.
The regulations do not list the facts and circumstances considered relevant in the application of the test, but the legislative history behind the provision does provide some guidance. Essentially, the question is whether and how regularly the taxpayer participates in the activity. Staff of Joint Comm. on Taxation, 99th Cong., 2d Sess., General Explanation of the Tax Reform Act of 1986, at 238 (Comm. Print 1987) [hereinafter 1986 Act Bluebook]. A taxpayer that doesn’t live at the site of the activity can still satisfy the test. Id. While management activities can qualify as material participation, they are likely to be viewed skeptically because of the difficulty in verifying them. See, e.g., HR Rep. No. 841, 99th Cong., 2d Sess. II-148 (Conf. Rep. 1986); S. Rep. No. 313, 99th Cong., 2d Sess. 734 n.20 (1986); 1986 Act Bluebook, supra note 35, at 240. Merely “formal and nominal participation in management, in the absence of a genuine exercise of independent discretion and judgment is not material participation.” HR Rep. No. 841, 99th Cong., 2d Sess. II-148 (Conf. Rep. 1986); S. Rep. No. 313, 99th Cong., 2d Sess. 734 n.20 (1986). Thus, the decisions the taxpayer makes must be important to the business (and they must be continuous and substantial).
It is true that a taxpayer’s management activities are ignored if any person receives compensation for management services performed for the activity during the taxable year. Treas. Reg. §1.469-5T(b)(2)(ii)(A). Clearly, this exclusion applies where the “taxpayer has little or no knowledge or experience” in the business and “merely approves management decisions recommended by a paid advisor.” See Treas. Reg. §1.469-5T(k), Ex. 8. However, the regulation applies well beyond those situations. In addition, a taxpayer's management work is ignored if some other unpaid manager spends more time than the taxpayer on managing the activity. Treas. Reg. § 1.469-5T(b)(ii)(B). Thus, there is no attributions of the activities of employees and agents to the taxpayer for purposes of the passive loss rules, but hiring a paid manager does not destroy the taxpayer’s own record of involvement for the material participation purposes except for the facts and circumstances test. See, e.g., S. Rep. No. 313, 99th Cong., 2d Sess. 735 (1986)( “if the taxpayer’s own activities are sufficient, the fact that employees or contract services are utilized to perform daily functions in running the business does not prevent the taxpayer from qualifying as materially participating”).
Clearly, the petitioners’ type of involvement in the ranching activity was not that of an investor. However, equally clearly was that the petitioners’ method of recordkeeping was a big issue to the court (even though IRS was not concerned). The preparation of non-contemporaneous logs and those prepared from calendar entries has been a problem in other cases. See, e.g., Lee v. Comr., T.C. Memo. 2006-193; Fowler v. Comr., T.C. Memo. 2002-223; Shaw v. Comr., T.C. Memo. 2002-35. Without those logs being available to substantiate the petitioners’ hours, the petitioners were left with satisfying the material participation requirement under the facts and circumstances test. That’s where the presence of the paid manager proved fatal. Thus, the ranching activity was not a hobby, but it was passive.
Combining the passive loss rules with a hobby loss argument is not a new tactic for the IRS (it was recently utilized with respect to a Kansas ranch), but the Robison decision certainly indicates that it can be expected to be used more frequently. But, remember, the IRS, at no point in the audit or litigation in Robison pressed the material participation issue – it was simply stated as an alternative issue in the SNOD. It was Judge Cohen that sought additional briefing on the issue.
The result in Robison is that the losses will only be deductible to the extent of passive income from the activity. Otherwise, the losses remain suspended until the petitioners dispose of their entire interest in the activity in a fully taxable transaction to an unrelated party. I.R.C. §469(g). That’s exactly what is going to happen. The petitioners are tired of the constant battle with the IRS and will not appeal the Tax Court’s decision. The ranch is for sale.
Thursday, July 12, 2018
A partnership is an association of two or more persons to carry on as co-owners a business for profit. Uniform Partnership Act, § 6. Similarly, the regulations state that a business arrangement “may create a separate entity for federal tax purposes if the participants carry on a trade, business, financial operation, or venture and divide the profits therefrom.” 26 C.F.R. §301.7701-1(a)(2). If there is a written partnership agreement, that usually settles the question of whether the arrangement is a partnership. Unfortunately, relatively few farm or ranch partnerships are based upon a written partnership agreement or, as it is expressed in some cases, a set of articles of partnership.
Sometimes an interesting tax or other legal issue arises as to whether a particular organization is, in fact, a partnership. For example, sometimes taxpayers attempt to prove (or disprove) the existence of a partnership in order to split income and expense among several taxpayers in a more favorable manner (see, e.g., Holdner, et al. v. Comr., 483 Fed. Appx. 383 (9th Cir. 2012), aff’g., T.C. Memo. 2010-175) or establish separate ownership of interests for estate tax purposes. However, such a strategy is not always successful.
When is a partnership formed and why does it matter? That’s the topic of today post.
The Problems Of An Oral Arrangement
Because a partnership is an agreement between two or more individuals to carry on as co-owners a business for profit, a partnership generally exists when there is a sharing of net income and losses. See, e.g., In re Estate of Humphreys, No. E2009-00114-COA-R3-CV, 2009 Tenn. App. LEXIS 716 (Tenn. Ct. App. Oct. 28, 2009). The issue can often arise with oral farm leases. A crop-share lease shares gross income, but not net income because the tenant still has some unique deductions that are handled differently than the landlord's. For example, the landlord typically bears all of the expense for building maintenance and repair, but the tenant bears all the expense for machinery and labor. Thus, there is not a sharing of net income and the typical crop-share lease is, therefore, not a partnership. Likewise, a livestock share lease is usually not a partnership because both the landlord and the tenant will have unique expenses. But, if a livestock share lease or a crop-share lease exists for some time and the landlord and tenant start pulling out an increased amount of expenses and deducting them before dividing the remaining income, then the arrangement will move ever closer to partnership status. When the arrangement arrives at the point where there is a sharing of net income, a partnership exists. With a general partnership comes unlimited liability. Because of the fear of unlimited liability, landlords like to have written into crop-share and livestock-share leases a provision specifying that the arrangement is not to be construed as a partnership.
For federal tax purposes, the courts consider numerous factors to determine whether a particular business arrangement is a partnership: (1) the agreement of the parties and their conduct in executing its terms; (2) the contributions, if any, which each party has made to the venture; (3) the parties’ control over income and capital and the right of each to make withdrawals; (4) whether each party was a principal and coproprietor sharing a mutual proprietary interest in the net profits and having an obligation to share losses, or whether one party was the agent or employee of the other, receiving for his services contingent compensation in the form of a percentage of income; (5) whether business was conducted in the joint names of the parties; (6) whether the parties filed federal partnership returns or otherwise represented to the IRS or to persons with whom they dealt that there were joint venturers; (7) whether separate books of account were maintained for the venture; and (8) whether the parties exercised mutual control over and assumed mutual responsibilities for the enterprise. See, e.g., Luna v. Comr., 42 T.C. 1067 (1964). While of the circumstances of a particular arrangement or to be considered, the primary question “is whether the parties intended to, and did in fact, join together for the present conduct of an undertaking or enterprise.” Id. If a business arrangement is properly classified as a partnership for tax purposes, a partner is taxed only on the partner’s distributive share of the partnership’s income.
White v. Comr., T.C. Memo. 2018-102, involved the issue of whether an informal arrangement created a partnership for tax purposes. The petitioners, a married couple, joined forces with another couple to form a real estate business. They did not reduce the terms of their business relationship to writing. In 2011, one of two years under audit, the petitioners contributed over $200,000 to the business. The other couple didn’t contribute anything. The petitioners used their personal checking account for business banking during the initial months of the business. Later, business accounts were opened that inconsistently listed the type of entity the account was for and different officers listed for the business. The couples had different responsibilities in the business and, the business was operated very informally concerning financial activities. The petitioners controlled the business funds and also used business accounts to pay their personal expenses. They also used personal accounts to pay business expenses. No books or records were maintained to track the payments, and the petitioners also used business funds to pay personal expenses of the other couple. The petitioners acknowledged at trial that they did not agree to an equal division of business profits. When the petitioners’ financial situation became dire and they blurred the lines between business and personal accounts even further. Ultimately the business venture failed and the other couple agreed to buy the petitioners’ business interests.
Both couples reported business income on Schedule C for the tax years at issue. They didn’t file a partnership return – Form 1065. The returns were self-prepared and because the petitioners did not maintain books and records to substantiate the correctness of the income reported on the return, the IRS was authorized to reconstruct the petitioners’ income in any manner that clearly reflected income. The IRS did so using the “specific-item method.”
The petitioners claimed that their business with the other couple was a partnership for tax purposes and, as a result, the petitioners were taxable on only their distributive share of the partnership income. The court went through the eight factors for the existence of a partnership for tax purposes, and concluded the following: 1) there was no written agreement and no equal division of profits; 2) the petitioners were the only ones that capitalized the business – the other couple made no capital contributions, but did contribute services; 3) the petitioners had sole financial control of the business; 4) the evidence didn’t establish that the other couples’ role in the business was anything other than that of an independent contractor; 5) business bank accounts were all in the petitioners’ names – the other couple was not listed on any of the accounts; 6) a partnership return was never filed, and the petitioners characterized transfers from the other couple to the business as “loan repayments;” 7) no separate books and records were maintained; 8) the business was not conducted in the couples’ joint names, and there was not “mutual control” or “mutual responsibility” concerning the “partnership” business. Consequently, the court determined that the petitioners had unreported Schedule C gross receipts. They weren’t able to establish that they should be taxed only on their distributive share of partnership income.
The case is a reminder of what it takes to be treated as a partnership for tax purposes. In additions to tax, however, is the general partnership feature of unlimited liability, with liability being joint and several among partners. How you hold yourself out to the public is an important aspect of this. Do you refer to yourself as a “partner”? Do you have a partnership bank account? Does the farm pickup truck say “ABC Farm Partnership” on the side? If you don’t want to be determined to have partnership status, don’t do those things. If you want partnership tax treatment, bring your conduct within the eight factors – or execute a written partnership agreement and stick to it.
Tuesday, July 10, 2018
The Tax Cuts and Jobs Act made significant changes in the tax law. That’s an obvious conclusion. It also changed some of the rules associated with charitable giving, and other rules that have an impact are likely to impact a taxpayer’s decision to donate to charity. Because of these changes, some charities have expressed concerns about a potential decline in charitable giving overall.
Is a drop in overall charitable giving likely? If so, are there planning options that can be utilized to preserve charitable deductions for charitable gifts?
Post-2017 charitable giving. That’s the topic of today’s post.
For tax years beginning before 2018, taxpayers that itemized deductions (Schedule A) could deduct charitable donations of cash or property to qualifying organizations. That remains true for tax years beginning after 2017. However, the TCJA has made a couple of important changes. Pre-TCJA, most cash contributions were generally limited to 50 percent of the taxpayer’s “contribution base.” “Contribution base” is defined as the taxpayer’s adjusted gross income (AGI). For this purpose, AGI is computed without including any net operating loss carryback to the tax year. I.R.C. §170(b)(1)(H).
The 50 percent limit applies to donations of ordinary income property and cash to charitable organizations described in I.R.C. §170(b)(1)(A). Those charities include public charities, private foundations other than nonoperating private foundations, and certain governmental units. Donations of capital gain property to these entities are limited to 30 percent of the taxpayer’s contribution base. Donated capital gain property to these organizations that are for the purpose of allowing the charity to use the property is capped at 20 percent of the donor’s contribution base. Gifts to non-operating foundations are capped at 30 percent of the donor’s contribution base for gifts of ordinary income property and case. The cap is 20 percent for capital gain property gifted to a non-operating foundation.
Under the TCJA, effective for tax years beginning after 2017 and before 2026, the 50 percent limitation is increased to 60 percent. Thus, an individual taxpayer can deduct cash contributions up to 60% of contribution base for donations to I.R.C. §170(b)(1)(A) organizations. I.R.C. §170(b)(1)(G)(i). Any amount that is disallowed due to the limitation can be carried forward for five years. In addition, for taxpayers that have contributions of both cash and capital gain property in the same tax year, the cash contribution will reduce the amount of deduction for the donated capital gain property.
Example: Tammy has a contribution base of $75,000 for 2018. She donates $10,000 of cash to various I.R.C. §170(b)(1)(A) organizations. The 60 percent limitation would limit her cash contributions for 2018 to $45,000. Tammy also donated her 1969 John Deere 4020 tractor to an I.R.C. §170(b)(1)(A) organization in 2018. The tractor was valued at $32,500. Her limitation on donated capital gain property for 2018 is $22,500 (30 percent of $75,000). However, the $22,500 is reduced by her $10,000 cash contribution. Thus, her limit in 2018 for capital gain donations (30 percent property) is $12,500. Tammy will be able to deduct $12.500 of the tractor’s value in 2018 and carry forward the balance of the donated value ($20,000).
The increase from 50 percent to 60 percent on the AGI maximum deduction amount is certainly good news for taxpayers with charitable inclinations. In addition, the TCJA eliminates the “Pease limitation” (I.R.C. §68) through 2025. That rule phased-out itemized deductions at particular income levels. These two TCJA changes could, by themselves, trigger a significant increase in charitable giving – particularly by higher income taxpayers. However, the TCJA made other changes that could have an offsetting effect.
Other TCJA Changes That Could Impact Giving
The TCJA significantly increases the standard deduction – to $12,000 for single filers and $24,000 for married filing jointly taxpayers. Also, many expenses that were deductible for tax years beginning before 2018 are either non-deductible or are limited. For example, the deduction for state and local taxes associated with non-business property is limited to $10,000. The increase in the standard deduction coupled with the elimination/limitation of various deductions will have an impact on giving, particularly by taxpayers that make relatively smaller gifts. That’s because the TCJA has made it more difficult for Schedule A deductions to exceed the standard deduction. More taxpayers are likely to simply claim the standard deduction rather than file Schedule A. Without filing Schedule A to itemize deductions, there is no deduction for charitable gifts.
Normally, a tax deduction cannot be taken for a donation to a qualified charity when there is a quid pro quo. However, for tax years beginning before 2018, a taxpayer could deduct 80 percent of charitable contributions made to an institution of higher learning for the right to buy tickets or seating at an athletic event. However, the TCJA changed this rule. For tax years beginning after 2017, the 80 percent rule is eliminated.
The TCJA also increased the federal unified credit for estate and gift tax purposes such that, beginning in 2018, federal estate tax doesn’t apply until a decedent’s taxable estate value exceeds $11.18 million. That’s practically twice the amount that it was for 2017. It’s likely that this significant increase will dampen charitable bequests. Presently, about 8 percent of charitable giving derives from bequests.
Will these changes be enough to cause taxpayers to curb charitable giving? To the extent a taxpayer donates to charity based on getting a tax break, that could be the case to the extent the TCJA changes reduce the deduction associated with charitable gifts. Many charities are concerned. Historically, taxpayers that itemize deductions are more likely to give to charity than are non-itemizers. Similarly, non-itemizers make up a relatively small percentage of total charitable giving. One estimate is that, for tax years beginning after 2017, less than five percent of taxpayers will itemize by filing Schedule A. The Indiana University School of Philanthropy and Independent Sector has estimated that the TCJA changes will reduce overall charitable giving by 1.7 percent to 4.6 percent. Those percentages convert to an annual reduction in giving between $4.9 billion and $13.1 billion.
Are there options to plan around the TCJA impacts on charitable giving? There might be, at least for some taxpayers. One approach is for a taxpayer to aggregate charitable gifts – make them in one year but not the following year, etc., so that there is a larger amount gifted in any particular year. This technique is designed to get the level of itemized deductions to an amount that is greater than the standard deduction for the years of the gifts.
If “gift stacking” won’t work for a taxpayer, other techniques may include gifting to private foundations, using charitable trusts or a donor advised fund. A donor advised fund allows a donor to make a charitable contribution, get an immediate tax deduction and then recommend grants from the fund to qualified charities. Of course, these various donation vehicles come with their own limitations on deductions and how they can operate. Likewise, there is no “one size fits all” when it comes to putting together a charitable giving plan. Some techniques just simply won’t work unless large gifts are made.
The TCJA made significant changes to the rules surrounding charitable giving. For many taxpayers, planning steps need to be taken to alter existing approaches to account for the new rules. Make sure to get good tax advice for your own situation. Also, when it comes to charitable giving, make sure to keep good records to substantiate your gifts. The IRS looks at the substantiation issue very closely.
Friday, July 6, 2018
Owner-lessors and operator-lessees of oil and gas interests can claim depletion associated with the production of oil and gas. Although conceptually similar to depreciation, the depletion deduction differs in significant ways from depreciation. The depletion deduction is based on the depletion of the mineral resource, whereas depreciation is based on the exhaustion of an asset that is used in the taxpayer’s trade or business.
The depletion deduction associated with oil and gas interests – that’s the topic of today’s post.
Requirements for the Deduction
To claim a depletion deduction, the taxpayer must have an economic interest in the mineral property, and the legal right to the income from the oil and gas extraction. Treas Reg. §1.611-1(b). If these two requirements are met, the deduction is allowed upon the sale of the oil and gas when income is reported. For the owner-lessor, the deduction can offset royalty payments but not bonus lease payments (because the deduction is allowed only when oil or gas is actually sold and income is reportable). For the operator-lessee, the depletable cost is the total amount paid to the lessor (the lease bonus) and other costs that are not currently deducted such as exploration and development costs as well as intangible drilling costs.
Conceptually, the taxpayer is entitled to a deduction against the revenue received as the income tax basis in the mineral property is depleted. For the owner-lessor, a cost basis in the minerals must have been established at the time basis in the taxpayer’s property (surface and mineral estate) was established. This may have occurred as part of an estate tax valuation in which the minerals and surface were separately valued or upon allocation of the purchase price at the time of acquisition. For the operator- lessee, the operator’s historical investment cost is the key.
When a lease of minerals is involved, the depletion deduction must be equitably apportioned between the lessor and the lessee. IRC §611(b). If a life estate is involved (the property is held by one person for life with the remainder to another person), the deduction is allowed to the life tenant but not the remainderman. For property held in a trust, the deduction is apportioned between the income beneficiaries and the trustee in accordance with the terms of the trust. If the trust instrument does not contain such provisions, the deduction is apportioned on the basis of the trust income allocable to each. For a decedent’s estate, the deduction is apportioned between the estate and the heirs on the basis of the estate income allocable to each.
There are two methods available for computing the depletion deduction: the cost depletion method and the percentage depletion method. A comparison should be made of the two methods and the one that provides the greater deduction should be used.
Cost depletion. For the owner-lessor, the cost depletion method is a units-of-production approach that is associated with the owner’s basis in the property. Cost depletion, like depreciation, cannot exceed the taxpayer’s basis in the property. The basis includes the value of the land and any associated capital assets (e.g., timber, equipment, buildings, and oil and gas reserves). See I.R.C. §612. Basis also includes any other expenses that were incurred in acquiring the land (e.g., attorney fees, surveys, etc.). Basis is tied to the manner in which a property is acquired. For example, mineral property can be acquired via purchase (purchase price basis), inheritance (basis equals the property’s FMV at the time of the decedent’s death) or gift (carryover basis from the donor). Basis is allocated among the various capital assets and is determined after accounting for the following items:
- Amounts recovered through depreciation deductions, deferred expenses, and deductions other than depletions;
- The residual value of land and improvements at the end of operations; and
- The cost or value of land acquired for purposes other than mineral production
Under the cost depletion approach, the taxpayer must know the total recoverable mineral units in the property’s natural deposit and the number of mineral units sold during the tax year. The total recoverable units is the sum of the number of mineral units remaining at the end of the year plus the number of mineral units sold during the tax year. The landowner must estimate or determine the recoverable units of mineral product using the current industry method and the most accurate and reliable information available. A safe harbor can be elected to determine the recoverable units. Rev. Proc. 2004-19, 2004-10 IRB 563. The mechanics of the computation are contained in Treas. Reg. §1.611-2.
The number of mineral units sold during the tax year depends on the accounting method that the taxpayer uses (i.e., cash or accrual). Many taxpayers, particularly landowners, are likely to be on the cash method. Thus, for these taxpayers, the units sold during the year are the units for which payment was received. Under the cost depletion approach, an estimated cost per unit of the mineral resource is computed annually by dividing the unrecoverable depletable cost at the end of the year by the estimated remaining recoverable units at the beginning of the year. The cost per unit is then multiplied by the number of units sold during the year.
Let’s look at an example:
Billie Jo’s father died in 2014. His will devised a 640-acre tract of land to Billie Jo. The value of the tract as reported on Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, for estate tax purposes was $6.4 million. Of that amount, $1 million was allocated to the mineral rights in the tract.
In 2018, a well drilled on the property produced 300,000 barrels of oil. Geological and engineering studies determined that the deposit contained 2 million barrels of usable crude oil. In 2018, the 300,000 barrels produced were sold. Billie Jo’s cost depletion deduction for 2018 is $150,000 and is calculated as follows.
Unrecoverable depletable cost at the end of the year × Number of units Estimated remaining recoverable units at the beginning of the year sold during the year
$1,000,000 /$2,000,000 × 300,000 = $150,000
Billie Jo deducts the $150,000 on her 2018 Schedule E. Billie Jo’s adjusted basis in the mineral deposit for 2019 that is eligible for cost depletion is $850,000 ($1 million − $150,000).
Also, consider this example:
Acme Drilling Corporation paid Bubba $300,000 to acquire all of the oil rights associated with Bubba’s land. The $300,000 was Acme’s only depletable cost. Geological and engineering studies estimated that the deposit contains 800,000 barrels of usable crude oil.
In 2018, 200,000 barrels of oil were produced and 180,000 were sold. Acme’s cost depletion deduction for 2015 is $67,500 and is calculated as follows.
Unrecoverable depletable cost at the end of the year x Number of units
Estimated remaining recoverable units at the beginning of the year sold during the year
$300,000 /$800,000 × 180,000 = $67,500
Percentage depletion. As noted previously, the amount allowed as a depletion deduction is the
greater of cost or percentage depletion computed for each property (as defined in I.R.C. §614(a) for the tax year. See IRC §§613 and 613A and Treas. Reg. §1.611-1(a).
Landowners without an established cost basis may be able to claim percentage depletion (discussed later). It is common for a landowner to not allocate any part of the property’s basis to the oil and gas reserves. Thus, percentage depletion may be the only depletion method available.
Under the percentage depletion method, the taxpayer (owner-lessor or a producer that is not a retailer or refiner) uses a percentage of gross income from the property, which is limited to the lesser of the following:
- 15% of the gross income from the oil/gas property (for an operator-lessee, this is defined as gross income from the property less expenses attributable to the property other than depletion and the production deduction, but including an allocation of general )
- 65% of the taxable income from all I.R.C. §613A(d).
For percentage depletion purposes, total taxable income is a function of gross income. Gross income from the property includes, among other things, the amount received from the sale of the oil or gas in the immediate vicinity of the well. Treas. Reg. §1.613-3. Gross income does not include lease bonuses, advance royalties, or other amounts payable without regard to production from the property. I.R.C. §613A(d)(5).
Any amount not deductible due to the 65% limitation can be carried over to the following year, subject to the same limitation. Any amount carried over is added to the depletion allowance before any limits are applied for the carryover year. I.R.C. §613A and the underlying regulations set forth a detailed multi-step process that is utilized to compute percentage depletion allowed to independent producers and royalty owners.
A production limit also applies. For partnerships, all depletion is computed at the partner level and not by the partnership. Prop. Treas. Reg. §1.613A-3(e). The partnership must allocate the adjusted basis of its oil and gas properties to its partners in accordance with each partner’s interest in capital or income.
Consider the following example:
In 2018, Rusty received $50,000 of royalty income from a well on his farm. His taxable income from all sources in 2018 is $432,000. Of that amount, $300,000 is income from crops and livestock. He has $82,000 of income from other sources.
Rusty computes his percentage depletion deduction by multiplying his $50,000 gross income from the oil/gas property by 15%, which is $7,500. His taxable income from all sources is $432,000, and 65% of that amount is $280,800. Thus, Rusty’s depletion deduction is the lesser of $7,500 or $280,800. Rusty can claim the $7,500 deduction on line 18 (depreciation expense or depletion) of his 2018 Schedule E.
Oil and gas taxation is complex. But, the Code does provide some beneficial rules to offset the cost of production. That’s true for other lines of businesses also. The cost of production associated with business property typically generates a tax write-off. When it comes to oil and gas, the rules may be more difficult. If you have these issues, it will pay to hire tax counsel that is well versed in the tax rules associated with oil and gas.
Monday, July 2, 2018
Over two thousand years ago, the Roman philosopher Cicero coined a phrase for opinions not supported by facts. “Ipse dixit” is Latin for “he said it himself.” It’s an assertion without proof, with the person (or entity) making the assertion claiming that a matter is because the party making the assertion said it is.
In a recent case involving wetlands, the court determined that the U.S. Army Corps of Engineers (Corps) claimed jurisdiction over “wetlands” without any supporting evidence. It was a wetland because the Corps said it was a wetland – an “ipse dixit” determination. The court set the Corps’ determination aside.
This isn’t the first time this has happened. In 1998, the USDA/NRCS did the same thing in a Nebraska case involving ditch maintenance of a hay meadow caught up in the Swampbuster regulations.
“Ipse dixit” determinations involving wetlands – that’s today’s blog post topic.
Farmed Wetlands and Swampbuster
The conservation-compliance provisions of the 1985 Farm Bill introduced the concept of “Swampbuster.” In 1986, the interim rules for Swampbuster were published in the Federal Register and evidenced general compliance with congressional intent and made no mention of “farmed wetland.” However, the final rules published in 1987 introduced the concept of “farmed wetland,” defining a farmed wetland as playa, potholes, and other seasonally flooded wetlands that were manipulated before December 23, 1985, but still exhibited wetland characteristics. Drains affecting these areas can be maintained, but the scope and effect of the original drainage system cannot be exceeded. 7 C.F.R. § 12.33(b). The USDA/NRCS has interpreted this as meaning that farmed wetland can be used as it was before December 23, 1985 (National Food Security Act Manual (NFSAM) § 514.23), and a hydrologic manipulation can be maintained to the same “scope and effect” as before December 23, 1985. Id. § 515.10(a). In particular, the government has interpreted the “scope and effect” regulation such that the depth or scope of drainage ditches, culverts or other drainage devices be preserved at their December 23, 1985, level regardless of the effect any post-December 23, 1985, drainage work actually had on the land involved.
Nebraska case. However, in 1999, the Eighth Circuit Court of Appeals invalidated the government’s interpretation of the “scope and effect” regulation. The court held that a proper interpretation should focus on the status quo of the manipulated wetlands rather than the drainage device utilized in post-December 23, 1985, drainage activities. Barthel v. United States Department of Agriculture, 181 F.3d 934 (8th Cir. 1999).
In Barthel, to determine the original scope and effect of the manipulation, the USDA focused solely on the depth of the ditch that drained the hay meadow at issue. In essence, the USDA interpreted the manipulation to be the ditch. The USDA pointed out that the level of the culvert (that drained the ditch beneath a road) on or before December 23, 1985, was eighteen inches higher than at the time of the litigation. The USDA took the position that the culvert could only be placed at that higher level. At that level, the meadow would not drain and the plaintiff’s land was flooded.
The USDA/NRCS claimed it had the authority to “determine the scope and effect of [the] original manipulation” by selecting “any pre-December 23, 1985, manipulation ‘which can be determined by reliable evidence.’” Thus, if the agency had reliable evidence about the ditch level in 1965, then the Barthels would be stuck with those findings, even if in 1983 (still before the effective date of the Act), more far reaching modifications were made. The appellate court disagreed, noting that it was presented with a factual setting that was cyclical. The court noted that the record showed that the ditch was continually silted-in by natural conditions and animal traffic and must be periodically cleaned out. The court then stated that if it accepted “the government’s argument, the USDA could select a level for the original manipulation, either intentionally or unintentionally, which is at the end of the natural cycle - just before the periodic clean-up. This would essentially redefine the cycle. Thus, in the government’s view, if partial flooding occurred just before the clean-up, the flood level would be the best the Barthels could expect for use of their land. An ipse dixit determination like this would drastically reduce the use of the land and even leave it underwater - reviving a wetland [citation omitted]. This interpretation conflicts with the Act considered as a whole.”
Wetland and the Clean Water Act
In 1993, the COE and EPA adopted new regulations clarifying the application of the permit requirement of §404 of the CWA to land designated as wetland. Section 404 of the CWA makes illegal the discharging of dredge or fill material into the “navigable waters of the United States” (WOTUS) without obtaining a permit from the Secretary of the Army acting through the Corps. The regulations specifically exempt prior converted wetlands from the definition of “navigable waters” for CWA purposes. 58 Fed. Reg. 45,008-48,083 (1993); 33 C.F.R. §328.3(a)(8). Thus, prior converted cropland is not subject to the permit requirements of § 404 of the CWA. Indeed, the Corps stated clearly that the only method for prior converted cropland to return to the Corps’ jurisdiction under the regulation was for the cropland to be “abandoned” – cropland production ceases with the land reverting to a wetland.
In early 2009, the Corps prepared an Issue Paper announcing for the first time that prior converted cropland that is shifted to non-agricultural use becomes subject to regulation by the Corps. See Issue Paper Regarding "Normal Circumstances" (ECF No. 18-22). The paper was the Corps’ response to five pending applications for jurisdictional determinations involving the transformation of prior converted cropland to limestone quarries. The paper concluded that the transformation would be considered an "atypical situation" within the meaning of the Corps’ Wetlands Manual and, thus, subject to regulation. The paper further found that active management, such as continuous pumping to keep out wetland conditions, was not a "normal condition" within the meaning of 33 C.F.R. § 328.3(b). However, no APA notice-and-comment period occurred (as required by the Administrative Procedure Act (APA) – Pub. L. 79-404, 69 Stat. 237, enacted Jun. 11, 1946)) before the Corps issued the memorandum. Even so, the Corps implemented and enforced the rules nationwide. The rules were challenged and in New Hope Power Company, et al. v. United States Army Corps of Engineers, 746 F. Supp.2d 1272 (S.D. Fla. Sept. 2010), the court held that the Corps had improperly extended its jurisdiction over the prior converted croplands that were converted to non-agricultural use and where dry lands were maintained using continuous pumping. Under the Corp’s new rule, wetland determinations were being made based on what a property’s characteristic would be if pumping ceased. The court noted that the rules effectively changed the regulatory definition of prior converted cropland without the new definition being subjected to notice and comment requirements. Accordingly, the court invalidated the Corp’s new rule.
Illinois case. In Orchard Hill Building Co. v. United States Army Corps of Engineers, No. 15-cv-06344, 2017 U.S. Dist. LEXIS 151673 (N.D. Ill. Sept. 19, 2017), the plaintiff was a developer that obtained title to a 100-acre tract on the southeast side of Chicago metro area in 1995. The local town then passed a zoning ordinance allowing development of the property. The tract was divided into three sections - 25 acres were to be developed into 168 townhomes; 61 acres to be developed into 169 single-family homes; and 14 acres in between the other acreages to function as a stormwater detention area. The townhomes and water detention area was to be developed first and then the single-family housing. Construction of the townhomes began in 1996, and the single-family housing development was about to begin when the defendant designated about 13 acres of the undeveloped property as “wetlands” and asserted regulatory jurisdiction under the CWA.
The defendant claimed jurisdiction on the basis that the “wetland” drained via a storm sewer pipe to a creek that was a tributary to a river that was a navigable water of the U.S. The plaintiff administratively appealed the defendant’s jurisdictional determination to the Division Engineer who agreed that the District Engineer failed to properly interpret and apply applicable the U.S. Supreme Court decision in Rapanos v. United States, 547 U.S. 715 (2006), which created a significant nexus test. On reconsideration, the District Engineer issued a second approved jurisdictional determination in 2010 concluding that the tract had a significant nexus to the navigable river. The plaintiff appealed, but the Division Engineer dismissed the appeal as being without merit. In 2011, the plaintiff sought reconsideration of the defendant’s appeal decision because of a 1993 prior converted cropland designation that excluded a part of the 100-acres from CWA jurisdiction. Upon reconsideration, the District Engineer issued a third jurisdictional determination in 2012 affirming its prior determination noting that farming activities had ceased by the fall of 1996 and wetland conditions had returned. The plaintiff appealed on the basis that the “significant nexus” determination was not supported by evidence. The Division Engineer agreed and remanded the matter to the District Engineer for supportive documentation and to follow the defendant’s 2008 administrative guidance. The District Engineer issued a new jurisdictional determination with supportive evidence, including an 11-page document that had previously not been in the administrative record. This determination, issued in 2013, constituted a final agency determination, from which the plaintiff sought judicial review.
In court, the plaintiff claimed that the defendant didn’t follow its own regulations, disregarded the instructions of the Division Engineer, and violated the Administrative Procedures Act (APA) by supplementing the record with the 11-page document. However, the trial court judge (an Obama appointee) noted that existing regulations allowed the Division Engineer, on remand, to instruct the District Engineer to supplement the administrative record on remand and that the limitation on supplementing the administrative record only applied to the Division Engineer. The trial court also determined that the supplemental information did not violate the Division Engineer’s remand order, and that the supplemental information had been properly included in the administrative record and was part of the basis for the 2013 reviewable final agency determination. The trial court also upheld the defendant’s nexus determination because it sufficiently documented a physical, chemical and biological impact of the navigable river. In addition, the trial court determined that the prior converted cropland exemption did not apply because farming activities had been abandoned for at least five years and wetland characteristics returned.
On appeal, in Orchard Hill Building Co. v. United States Army Corps of Engineers, No. 17-3403, 2018 U.S. App. LEXIS 17608 (7th Cir. Jun. 27, 2018), the appellate court three-judge panel in a unanimous opinion (the author of the opinion is a Trump appointee and another judge is also a Trump appointee; the third panel member is a Ford appointee) first noted that the Corps concluded that the tract was a WOTUS based on the 11-page document both “alone and in combination with other wetlands in the area.” However, the appellate court held that this conclusion lacked substantial evidence. Simply stating that wetlands filter out pollutants and that the tract has a “discrete and confined intermittent flow” to a creek that flowed to a WOTUS which gave the tract the ability to pass pollutants along was mere speculation that didn’t support a significant nexus with a navigable water. The appellate court also that the Corps also determined that the development of the tract would result in a floodwater rise of a fraction of one percent. On this point, the court stated, “If the Corps thinks that trivial number significant, it needs to give some explanation as to why.” The appellate court found similarly with respect to the potential increase on downstream nitrogen. The Corps provided no reasoning for its conclusion.
The appellate court also noted that the Corps referenced the National Wetland Inventory for a listing of all of the wetlands in the area that were in proximity to the creek that flowed into a navigable waterway. But, again, the appellate court scolded the Corps for making a bald assertion that the wetlands in the watershed were adjacent to the same tributary without any supporting evidence. The Corps claimed it didn’t have to show or explain how each wetland was adjacent to the creek, but the appellate court stated that constituted jurisdictional overreach. Importantly, the court stated that, “the significant nexus test has limits: the Corps can consider the effects of in-question wetlands only with the effects of lands that are similarly situated. To do as the Corps did on this record – to consider the estimated effects of a wide swath of land that dwarfs the in-question wetlands, without first showing or explaining how the land is in fact similarly situated – is to disregard the test’s limits…. By contrast, the Corps’ similarly-situated finding here, lacking as it does record support or explanation, is little more than administrative ipse dixit.”
Consequently, the appellate court vacated the trial court’s grant of summary judgment to the Corps and remanded with instructions to remand to the Corps for reconsideration of its jurisdiction over the tract.
Two ipse dixit determinations by federal agencies against landowners. In each situation, the appellate court found that the government had abused its discretion. The cases point out that maybe there is some hope that the courts will hold government agencies to the requirement that they must support their determinations with solid proof. They can’t just say that it is so because they say it is.
Thursday, June 28, 2018
The needs and capabilities of a farming or ranching business (or any business for that matter) need to be integrated with business and estate plans, and the retirement needs, of each of the owners. A buy-sell agreement is a frequently used mechanism for dealing with these issues. For many small businesses, a well-drafted buy-sell agreement is perhaps just as important as a will or trust. It can be the key to passing on the business to the next generation successfully. For most farming and ranching operations, succession planning is now more important than estate tax planning. That makes a good buy-sell agreement an important document.
Buy-sell agreements – the basics of what they are and how they work, that’s the topic of today’s post.
A buy-sell agreement is typically a separate document, although some (or all) of its provisions may be incorporated in its bylaws, the partnership agreement, the LLC operating agreement and, on occasion, in an employment agreement with owner-employees. Major reasons for having a buy-sell agreement include: establishing continuity of business ownership; providing a market for otherwise illiquid closely held shares; establishing a funding source and a mechanism for share purchase; establishing certainty as to the value of the shares for estate purposes; and providing restrictions on operational matters, e.g. voting control and protection of S corporation status.
Establishment of Estate Tax Value
While very few farming and ranching operations (and small businesses in general) are subject to the federal estate tax because of the current level of the exemption, some are. For those that are, in addition to providing a market for closely held shares at a determinable price, the buy-sell agreement can serve as a mechanism for establishing the value of the interest for estate tax purposes – or otherwise establish value of the decedent’s interest at death.
There are six basic requirements for a buy-sell agreement to establish value of a deceased owner’s interest: (1) the interest must be subject to an option to purchase that is a binding obligation on the estate; (2) the purchase price must be established with certainty; (3) the interest must not be subject to lifetime transfers that could defeat the obligation to purchase; (4) there must be a “ bona fide business arrangement”; (5) the agreement cannot be a device to transfer at lower than fair market value; and (5) the agreement must be comparable to similar arrangements between persons in an arms-length transaction.
The estate must be obligated to sell; however, there is no requirement for the purchaser to buy. However, there is often an additional provision in such agreements to provide that if adequate funding is available, the survivors are obligated to purchase in order to provide estate liquidity, and often to protect the deceased shareholder’s family from the vagaries of the ongoing business.
To establish the purchase price with certainty an appropriate valuation method must be established. An independent party valuation will not only satisfy the requirements of § 2703 but also provide an estimate of the potential funding obligation and the liquidity expectations of the seller/estate. See Rev Rul. 59-60 as amplified by Rev. Rul. 83-120,1983-2 CB 170.
A key point is that, to be effective in establishing a value for estate tax purposes, the buy-sell agreement must provide that the corporation or shareholders are either obligated or have an option to purchase the shares of a holder who desires to sell within his lifetime, at the same price and on the same terms as provided for upon the death of the shareholder. A right of first refusal will not accomplish the same objective and will potentially contravene the requirements of I.R.C. §2031. From the selling shareholder’s viewpoint, either an option or right of first refusal may not be acceptable because of their failure to guarantee a market for the shares.
The long-established position of the IRS is that, “It is always necessary to consider the relationship of the parties, the relative number of shares held by the decedent, and other material facts to determine whether the agreement represents a bona fide business arrangement or a device to pass the decedent’s shares to the natural objects of his bounty for less than an adequate and full consideration in money or money’s worth”. Rev.Rul 59-60, 1959-1 CB 137. See also Estate of True v. Comr., T.C. Memo 2001-167(2001), aff’d 390 F. 3d 1210 (2004), and Estate of Blount v. Comr., T.C. Memo 2004-116(2004).
Valuation methods. There are several general valuation methods for buy-sell agreements.
One method is the fixed value method. Under this method, the value of the interest being valued doesn’t change. It is not used much, and would not meet most IRS requirements under IRC §2703(b) and the regulations.
Another approach is one that uses an appraisal to value the underlying business interest. This method is also rarely used for operating businesses, but may be appropriate for certain types of business such as real estate. If this method is used it is often a triple appraisal approach, where the purchaser and estate each appoint an appraiser who appoints a third if the first two cannot agree. A drawback is that the valuation is left until the triggering event (death, disability, etc.), leaving the owners with little guidance for the necessary funding decisions.
The formula method uses book value from the financial statements of the business to value the interest. That is relatively easy to determine, but it will result in a significant deviation from fair market value unless adjusted for such matters as the company’s accounting method, differences between book and fair market value for real estate, equipment, other tangible assets and intangible assets. Other adjustments may include accounts receivable to reflect collectability, and an examination of the adequacy of reserve accounts.
Another formula method is one based on earnings which are then capitalized to arrive at a proper value. The selection of an appropriate capitalization rate is an important determination, and it must be recognized that a rate appropriate at the time of the agreement may not be appropriate later due to a change in business or the economic environment.
Agreed value is another frequently used method of valuation, usually combined with periodic adjustments by the parties. This is often coupled with a back-up valuation method to take effect within a certain period of time if a value has not been adopted.
Another commonly used provision is one that requires any outside purchaser of the business to adopt the buy-sell agreement. In the case of a limited liability company, the requirement may be to adopt the operating agreement before becoming a member. Either of these provisions serves to protect the remaining owners.
Who Will Be the Buyer?
When setting up a buy-sell agreement for your farm/ranch (or other) business, an important decision at the beginning is to determine who will be the purchaser. Not only is establishing a purchase price important, but determining how the purchase price will be paid is also important. This is a function of the type of buy-sell agreement that is utilized. With a “redemption’ type agreement, the corporation is the buyer. With a “cross-purchase” agreement, the other shareholders are the buyers. A buy-sell agreement can also be a combination of a redemption and cross-purchase agreement.
Since life insurance on the lives of the shareholders is often used to partially or fully fund a buy-sell agreement, the availability and affordability of insurance, the number of policies needed, and the source of funds to pay the premiums will often dictate the type of agreement selected. The amount will depend upon the valuation of the company, the limits on corporate or shareholder finances to pay the premiums, and the extent to which both the shareholders and the seller are willing to assume an unfunded liability if the buy-sell is not fully funded by insurance. Multiple policies may be required for a cross-purchase agreement unless a partnership can be utilized to hold the insurance (e.g. if three shareholders, there would be six separate policies; if four shareholders, twelve policies) so that beyond a few shareholders may make this approach impractical. However, a single policy on each shareholder would suffice when funding a corporate redemption. Another possible solution is a buy-out insurance trust which owns the policies.
If the farming business owns the policy, the business can borrow against any cash value if needed. If no trust or partnership is used, a cross-purchase agreement leaves the payment of premiums in the control of the individual shareholder, and potentially subjects any cash value to creditor claims. This factor alone may determine which form of agreement is most desirable.
If there is a disparity in ownership shares (and there often is), a minority shareholder may be required to fund the much higher interest of the majority shareholder(s) in a cross-purchase agreement. In a corporate redemption, however, the funding of the purchase, either from insurance or other corporate assets, is being born by the shareholders in proportion to their relative stock interests.
While life insurance will often solve the funding problem for purchasing a deceased shareholders stock, and disability insurance is available for permanent disability, insurance proceeds are generally not available in lifetime purchase situations. Thus, the funding capability of the parties is critical since there may not be an alternative funding method available that will satisfy all parties. However, in many situations non-insurance methods of funding coupled with installment payments of the purchase price will meet most of the major needs of the parties.
Today’s post was only a surface-level discussion on buy sell agreements. A good buy-sell agreement is an essential part of transitioning a business to the next generation of owners. But, it is complex and a great deal of thought must be given to the proper crafting of the agreement. Of course, there are associated tax considerations which were not covered in this post. In addition, there are numerous financial and personal factors that also come into play. Likewise, significant thought must be given to the events that can trigger the operation of the agreement.
Like other estate planning documents, a buy-sell agreement should be reviewed regularly even in the absence of any potentially triggering event, and particularly when there is any change in the business structure or ownership.
Tuesday, June 26, 2018
Last week, the U.S. Supreme Court, in South Dakota v. Wayfair, Inc., No. 17-494, 2018 U.S. LEXIS 3835 (U.S. Sup. Ct. Jun. 21, 2018), handed South Dakota a narrow 5-4 win in its quest to collect taxes from online sales. The Court held that the Constitution’s Commerce Clause did not bar South Dakota from statutorily requiring remote sellers without a physical presence in the state to collect and remit sales tax on goods and services that are sold to buyers for delivery inside the state of South Dakota. In so doing, the Court overruled 50 years of Court precedent on the issue.
Other states will certainly take note of the Court’s decision, and some (such as Iowa) were banking on the Court ruling in the manner that it did and passed legislation similar to the South Dakota legislation that will take effect in the future. But, as I wrote last fall, a victory for South Dakota could do damage to the Commerce Clause and the concept of due process and contemporary commerce.
An update on state taxation of internet sales, the possible implications of the Court’s recent decision and what the impact could be on small businesses – that’s the focus of today’s post.
In 1967, the U.S. Supreme Court determined that the Commerce Clause grants “exclusive authority [to] Congress to regulate trade between the States” in holding that Illinois could not subject a mail order seller located in Missouri to use tax where the seller had no physical presence in Illinois. National Bellas Hess, Inc. v. Illinois Department of Revenue, 386 U.S. 753 (1967). In holding the law unconstitutional, the Court reasoned that subjecting the seller’s interstate business to local “variations in rates of tax…and record-keeping requirements” would violate the purpose of the Commerce Clause “to ensure a national economy free from…unjustifiable local entanglements.”
Twenty-five years later, the Court reaffirmed the limitations of the Commerce Clause on state regulatory authority in Quill Corporation v. North Dakota, 504, U.S. 298 (1992). In Quill, the Court held that a mail order house with no physical presence in North Dakota was not subject to North Dakota use tax for “property purchased for storage, use, or consumption within the State.” The Court followed closely its holding in National Bellas Hess, Inc. because doing so “encourage[d] settled expectations and …foster[ed] investment by businesses and individuals.” As applied to internet sales, Quill (which predated the internet) does not exempt all internet sales from state sales taxes – just sales by sellers who don’t have a physical presence in a particular state. National retailers have a presence in many states.
More recently, in 2015, the Court examined a Colorado “tattletale” law that required out-of-state sellers with no physical presence in the state “to notify…customers of their use tax liability and to report” sales information back to Colorado. Direct Marketing Association v. Brohl, 135 S. Ct. 1124 (2013). The trial court enjoined enforcement of the law on Commerce Clause grounds. On appeal, the Tenth Circuit held that it couldn’t hear the challenge to the law because the Tax Injunction Act (28 U.S.C. §1341) divested it of jurisdiction and the matter belonged in state court and, ultimately, the U.S. Supreme Court. The Tenth Circuit remanded the case for dismissal of the Commerce Clause claims and dissolution of the permanent injunction. The U.S. Supreme Court reversed and remanded the decision of the Tenth Circuit on the jurisdiction issue and, on remand, the Tenth Circuit, invalidated the Colorado law on Commerce Clause grounds. Direct Marketing Association v. Brohl, 814 F.3d 1129 (10th Cir. 2016).
In the U.S. Supreme Court’s reversal and remand of the Tenth Circuit’s decision in Direct Marketing Association, Justice Kennedy wrote a concurring opinion that essentially invited the legal system to find an appropriate case that would allow the Court to reexamine the Quill and National Bellas Hess holdings. Hence, the South Dakota legislation.
South Dakota Legislation and Litigation
S.B. 106 was introduced in the 2016 legislative session of the South Dakota legislature. It requires the collection of sales taxes from certain remote sellers – those with “gross revenue” from sales in South Dakota of over $100,000 per calendar year or with 200 or more “separate transactions” in the state within the same timeframe. Interestingly, S.B. 106 authorized the state to bring a declaratory judgment action in circuit court against any person believed to be subject to the law. The law also authorized a motion to dismiss or a motion for summary judgment in the court action, and provided that the filing of such an action “operates as an injunction during the pendency of the” suit that would bar South Dakota from enforcing the law.
S.B. 106 was signed into law on March 22, 2016, and the state Department of Revenue soon thereafter began issuing notices to sellers that it thought were in violation of the law. Several out-of-state sellers that received notices did not register for sale tax licenses as the law required. Consequently, the state brought a declaratory judgment action against the sellers in circuit court, and sought a judicial declaration that the S.B. 106 requirements were valid and applied to the sellers. The state also sought an order enjoining enforcement of S.B. 106 while the action was pending in court, and an injunction that required the sellers to register for licenses to collect and remit sales tax.
The sellers tried to remove the case to federal court based on federal question jurisdiction, but the federal court rejected that approach and remanded the case to the South Dakota Supreme Court. South Dakota v. Wayfair, Inc., 229 F. Supp. 3d 1026 (D. S.D. Jan. 17, 2017). On remand, the South Dakota Supreme Court invalidated S.B. 106 on Commerce Clause based on the U.S. Supreme Court precedent referenced above. State v. Wayfair, Inc., et al., 901 N.W.2d 754 (S.D. 2017). The state of South Dakota announced shortly after the South Dakota Supreme Court’s decision that it would file a petition for certiorari with the U.S. Supreme Court by mid-October. They did, the U.S. Supreme Court granted the petition and heard the case which lead to last week’s opinion.
U.S. Supreme Court Decision
Article I, Section 8 of the U.S. Constitution says that, “The Congress shall have the power...to regulate commerce…among the several states…”. That was the key point of the Court’s 1967 Bellas Hess, Inc. decision. As noted above, in that case the Court stated that the Commerce Clause grants “exclusive authority [to] Congress to regulate trade between the States.” Apparently, that is not the case anymore, at least according to the majority in Wayfair – Justices Kennedy, Thomas, Ginsburg, Alito and Gorsuch. Under the new interpretation of the Commerce Clause, states can impose sale tax obligations on businesses that have no physical presence in the state. But is that completely true? Can the Court’s opinion be construed as giving the states a “blank check” to tax out-of-state businesses? Maybe not.
In Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977), the Court ruled that a state tax would be upheld if it applied to an activity having a substantial nexus with the state; was fairly apportioned; did not discriminate against interstate commerce; and, was fairly related to the services that the state provided. Later, in the Quill case, the Court determined that a physical presence in the taxing jurisdiction was what satisfied the Brady “substantial nexus” requirement.
In Wayfair, the Court determined that a “substantial nexus” could be present without the party subjected to tax having a physical presence in the taxing jurisdiction. But, the key point is that the “substantial nexus” test of Brady remains. Likewise, the other three requirements of Brady remain – fair apportionment; no discrimination against interstate commerce, and; fairly related to services that the state provides. In other words, taxing a business without a physical presence in the state cannot unduly burden interstate commerce. The Wayfair majority determined that the South Dakota law satisfied these tests because of the way it was structured – limited application (based on transactions or dollars of sales); not retroactive; the state was a member of the Streamlined Sales and Use Tax Agreement; the sellers at issue were national businesses with a large online presence; and South Dakota provided tax software to ease the administrative burden.
The dissent in Wayfair, authored by Chief Justice Roberts, noted that there was no need for the Court to overturn Quill. The Chief Justice noted that, “E-commerce has grown into a significant and vibrant part of our national economy against the backdrop of established rules, including the physical-presence rule. Any alteration to those rules with the potential to disrupt the development of such a critical segment of the economy should be undertaken by Congress.” That’s precisely the point of the Commerce Clause, and Chief Justice Roberts pointed it out – the Court had no business wading into this issue. In fact, several members of the Congress filed briefs with the Court in the case to inform the Court that various pieces of legislation were pending that would address the issue.
The question then is what, if any, type of a state taxing regime imposed on out-of-state sellers would be determined to violate the Commerce Clause post-Wayfair. Of course, the answer to that question won’t be known until a state attempts more aggressive taxation on out-of-state sellers than did South Dakota, but a few observations can be made. Presently, 23 states are “full members” of the Streamlined Sales and Use Tax Agreement. For those states, the Wayfair majority seemed to believe that had the effect of minimizing the impact on interstate commerce. Also, it would appear that any state legislation would have to have exceptions for small businesses with low volume transactions and sales revenue. Whether a series LLC (in some states such as Iowa) or subsidiaries of a business could be created, each with sales below the applicable threshold, remains to be seen.
Now, it appears that state legislatures crafting tax statutes need not give much, if any, thought to the reason for the tax or who the parties subject to the tax might be. The only consideration appears to be the relative burden of the tax. With Wayfair, states have gained more power – the power to tax people and businesses for whom the state provides no services and who cannot vote the people out of office that created the tax. That would not appear to square with traditional concepts of due process.
The whole notion of a state taxing a business that has no physical presence in the state is incompatible with the principles of federalism that bar states from taxing (whether income, property or sales tax, for instance) non-resident individuals or businesses (with a few, minor exceptions). As noted earlier, a state that imposes such a taxing regime would be able to generate revenue from taxpayers who use none of the services provided by the taxing jurisdiction.
Post Wayfair, where will the line be drawn? Wayfair involved state sales tax. Will states attempt to go after a portion of business income of the out-of-state business via income tax? That seems plausible. However, the Interstate Income Act of 1959 (15 U.S.C. §381-384), requires that a business (or individual – the business form does not matter because corporations have long held personhood status under the Constitution (see, Bank of the United States v. Deveaux, 9 U.S. 61 (1809); Burwell v. Hobby Lobby Stores, Inc., 134 S. Ct. 2751 (2014)) have some sort of connection with a state before its income can be taxed (at least with respect to the solicitation of orders for tangible personal property). Is that legislation now unconstitutional too? Or, is there a distinction remaining between taxing receipts as opposed to income?
Only time will tell.
Friday, June 22, 2018
When land is sold, is the gain on sale taxed as capital gain (preferential rate) or as ordinary income? As with most answers to tax questions, the answer is that “it depends.” Most of the time, when a farmer or ranchers sells land, the gain will be a capital gain. But, there can be situations where the gain will be ordinary in nature – particularly when farmland is subdivided or sold off in smaller tracts. That’s a technique, by the way of some farm real estate sellers, especially in the eastern third of the United States. Does selling the land in smaller tracts, or subdividing it create ordinary gain rather than capital gain?
A recent case illustrated the issue of what a capital asset is and the safe harbor that can apply when land is sold that has been subdivided or sold off in smaller tracts.
The character of gain on sale of land and a possible “safe harbor” – that’s the topic of today’s post.
What Is A Capital Asset?
I.R.C.§1221(a) broadly defines the term “capital asset” as all property held by the taxpayer. Eight exceptions from that broad definition are provided. The first exception, I.R.C. §1221(a)(1), states that property that is either inventory or like inventory cannot qualify as a “capital asset.” In particular, I.R.C. §1221(a)(1) says a capital asset does not include “property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.” Whether a landowner is holding land primarily for sale to customers depends on the facts. As the U.S. Circuit Court of Appeals for the Tenth Circuit put in in the classic case of Mauldin v. Commissioner, 195 F.2d 714 (10th Cir. 1952), “There is no fixed formula or rule of thumb for determining whether property sold by the taxpayer was held by him primarily for sale to customers in the ordinary course of his trade or business. Each case must, in the last analysis, rest upon its own facts.” The Fifth Circuit has said essentially the same thing in Suburban Realty Co., v. United States, 615 F.2d 171 (5th Cir. 1980).
Subdividing Real Estate
When property is subdivided and then sold, the IRS may assert that the property was being held for sale to customers in the ordinary course of the taxpayer’s trade or business. If that argument holds, the gain will generate ordinary income rather than capital gain. However, there is a Code provision that can come into play. I.R.C. §1237 provides (at least) a partial safe harbor that allows a taxpayer “who is not otherwise a dealer”… to dispose of a tract of real property, held for investment purposes, by subdividing it without necessarily being treated as a real estate dealer.” If the provision applies, the taxpayer is not treated as a “dealer” just simply because the property was subdivided in an attempt to sell all or a part of it. But, the safe harbor only applies if there is a question of whether capital gain treatment applies. If capital gain treatment undoubtedly applies, I.R.C. §1237 does not apply. See, e.g., Gordy v. Comr., 36 T.C. 855 (1961).
What is a “dealer”? It’s not just subdividing land that can cause a taxpayer to be a “dealer” in real estate with gains on sale taxes as ordinary income. That’s the result if the taxpayer is engaged in the business of selling real estate; holds property for the purpose of selling it and has sold other parcels of land from the property over a period of years; or the gain is realized from a sale in the ordinary operation of the taxpayer’s business. In addition, it’s possible that a real estate dealer may be classified as an investor with respect to some properties sold and capital gains treatment on investment properties. But, as to other tracts, the dealer could be determined to be in the business of selling real estate with the sale proceeds taxed as ordinary income. See, e.g., Murray v. Comr., 370 F.2d 568 (4th Cir. 1967).
The “Safe Harbor”
I.R.C. §1237 specifies that gain from the sale or exchange of up to five lots sold from a tract of land can be eligible for capital gain treatment. Sale or exchange of additional lots will result in some ordinary income. To qualify for the safe harbor, both the taxpayer and the property must meet the requirements of I.R.C. §1237 and make an election to have the safe harbor apply. For the taxpayer to qualify for the election, the taxpayer cannot be a C corporation. Presumably, an LLC taxed as a partnership would qualify. For property to qualify, it must have not previously been held by the taxpayer primarily for sale to customers in the ordinary course of business; in the year of sale, the taxpayer must not hold other real estate for sale as ordinary income property; no substantial improvement that considerably enhances the property value has been made to the property (see I.R.C. §1237(b(3); Treas. Reg. §1.1237-1(c)); and the taxpayer must have held the property for at least five years. I.R.C. §1237(a).
If the requirements are satisfied, the taxpayer can elect to have the safe harbor apply by submitting a plat of the subdivision, listing all of the improvements and providing an election statement with the return for the year in which the lots covered by the election were sold.
In Sugar Land Ranch Development, LLC v. Comr., T.C. Memo. 2018-21, the taxpayers formed a partnership in 1998 to buy and develop land outside of Houston for the purpose of turning that land into housing developments and commercial developments. The partnership acquired various parcels of land totaling about 950 acres. The land had been a former oil field and so over the years the partnership cleaned up the land, built a levee, and entered into a development contract with the city of Sugar Land, Texas to set up the rules for developing the lots. All of this sounds like the characteristics of a “developer” doesn’t it?
By 2008, the partnership had done a lot of work developing the land. But, then the downturn in the real estate market hit and the partnership stopped doing any more work. It wasn’t until 2012 that the partnership sold any significant part of the land. In that year it sold two parcels (about 530 acres) to a homebuilding company. The homebuilding company paid a lump sum for each parcel, and also agreed to make future payments relating to the expected development. A flat fee was paid for each plat recorded, and the homebuilding company paid two percent of the final sales price of each house developed on one of the parcels.
The partners entered into a “Unanimous Consent” dated December 16, 2008, declaring that the partnership would no longer attempt to develop the land but would instead hold the land until the real estate market recovered enough to sell at a profit.
The partnership reported an $11 million gain from the sale of one parcel and a $1.6 million loss on the other parcel. It took the position that the land sold was a “capital asset” and so the gains and losses were capital gains and losses. The IRS disagreed. After all, it pointed out that the partnership acquired the property to develop it and merely delayed doing so because of the economic downturn.
Ultimately, the Tax Court agreed that the partnership had successfully changed its operations after 2008 from “developer” to “investor” such that the land it sold in 2012 was a capital asset and the gain was a capital gain. That made a big bottom-line tax difference.
The partnership in Sugar Land Ranch Development, LLC never actually subdivided the property at issue into separate lots, and the IRS still claimed it was acquired and held for development purposes. While capital gain classification is based on a facts and circumstances test, subdividing land for sale doesn’t necessarily mean that it’s no longer a capital asset. That’s the point of I.R.C. §1237 and the safe harbor. In addition, the facts can cause the reason for holding property to change over time. That, in turn, can change the tax result.
Wednesday, June 20, 2018
Contracts are a fundamental part of life. We all enter into various contracts on many occasions. But, sometimes a deal doesn’t live up to expectations. It’s those times that we might attempt to back out of the deal. But, is that possible? When can a deal be negated if the other party or parties to the agreement don’t want to cancel the deal?
Rescinding a contract – that’s the topic of today’s post.
Rescission refers generally to the cancellation of a contract. Rescission can occur as a result of innocent or fraudulent representation, mutual mistake, lack of legal capacity, an impossibility to perform a contract not contemplated by the parties, or duress and undue influence. Rescission may be mutual – all of the parties to the agreement agree (in writing) to terminate their respective duties and obligations under the contract. Rescission may also be unilateral – where one party to the agreement seeks to have the contract cancelled and the parties restored to the position they were in economically at the time the agreement was entered into.
An innocent as well as intentional misrepresentation may serve as the basis for a unilateral rescission of contract. To be successful on such a claim, the plaintiff must have justifiably relied on a false statement, which was material to the transaction. The rule prevents parties who later become disappointed at the outcome of their bargain from capitalizing on any insignificant discrepancy to void the contract.
Duty to investigate? There is a split of authority regarding a buyer’s duty to investigate a seller’s fraudulent statements, but the prevailing trend is toward placing a minimal duty on the buyer. With respect to land sale transactions, the general rule is that a seller’s defense that the buyer failed to exercise due care is disallowed if the seller has made a reckless or knowing misrepresentation. See, e.g., Cousineau v. Walker, 613 P.2d 608 (Alaska 1980); Fox v. Wilson, 211 Kan. 563 (1973). However, the defense is typically allowed if the buyer’s fault was so negligent that it amounted to a failure to act in good faith and in accordance with reasonable standards of fair dealing. So, in general, a purchaser of land may rely on material representations of the seller and is not obligated to ascertain whether such representations are truthful.
Illustrative case. In a 2006 New York case, Boyle, et al. v. McGlynn, et al., 814 N.Y.S.2d 312 (2006), the plaintiff bought the defendant’s farm (including the residence) and later sought to have the sale contract rescinded based on the seller’s alleged fraud and misrepresentations for not disclosing that plans were in the works for the construction of large aerogenerators on an adjacent parcel. The plaintiffs submitted the affidavit of a neighbor of the defendant who detailed two conversations with the defendant that occurred months before the defendant put his farm on the market during which the wind energy development project was discussed. The defendant, at that time, stated that the presence of commercial aerogenerators on the adjacent tract would “force” him to sell his farm. When the plaintiff sought to rescind the contract, the defendant claimed he had no duty to the plaintiff and that the doctrine of caveat emptor (“buyer beware”) was a complete defense to the action.
The appellate court affirmed the trial court’s denial of the defendant’s summary judgment motion. The appellate court noted the plaintiff’s claim that the defendants were well aware of their desire to buy a property with a scenic view that was free of environmental controversy and land use battles, and that the status of the land where the aerogenerators were planned was specifically discussed with the defendant before the contract closed. The appellate court also noted that during this same conversation, the defendant told the plaintiff that the property was “protected.” In addition, the sale brochure for the property stated that the property as “backing up to one of the largest areas of undeveloped land in the County.” The defendant also apparently told the plaintiff that “what you see if what you get” and that the area was “secluded and protected.”
The appellate court further noted that while there was an article in a local paper about the development project before the purchase offer for the property was made, the appellate court also noted that the plaintiff did not live in the area. Likewise, no public documents concerning the project were filed with the local planning board until a month after the parties’ closing.
It is important to note that the purchaser's claims in Boyle were based on the purchaser's allegations of unclear oral conversations between the purchaser and the seller, and a statement in a real estate brochure used to market the property. The principle in Boyle could be applied in similar agricultural land sale transactions where plans are being made for the development of any activity that could be considered a nuisance. In addition to the wind energy development project at issue in Boyle, known future development of a large-scale animal confinement operation, ethanol plant or similar activity that produces odors, obscures view or could create unreasonably objectionable noise, light or traffic, may need to be disclosed to a buyer to avoid a rescission action.
Monday, June 18, 2018
The “Swampbuster” rules were enacted as part of the conservation provisions of the 1985 Farm Bill. In general, the rules prohibit the conversion of “wetland” to crop production by producers that are receiving farm program payments. A farmer that is determined to have improperly converted wetland is deemed ineligible for farm program payments. But, an exception exists for wetland that was converted to crop production before December 23, 1985 – the effective date of the 1985 Farm Bill.
Under the Swampbuster rules, “wetland” has: (1) a predominance of hydric soil; (2) is inundated by surface or groundwater at a frequency and duration sufficient to support a prevalence of hydrophytic vegetation typically adapted for life in saturated soil conditions, and (3) under normal circumstances does support a prevalence of such vegetation. 7 C.F.R. §12.2(a). In other words, to be a wetland, a tract must have hydric soils, hydrophytic vegetation and wetland hydrology.
However, there have been several prominent cases in recent years illustrating that the Natural Resources Conservation Service (NRCS) has trouble applying the definition as it attempts to determine whether a particular tract has wetlands. A recent decision of the United States Department of Agriculture (USDA) National Appeals Division (NAD) makes the point.
Wetlands under the farm program rules – that’s the topic of today’s post.
In B & D Land & Livestock Co. v. Schafer, 584 F. Supp. 2d 1182 (N.D. Iowa 2008), the plaintiff purchased the tract in issue in 1997. The tract had been farmed by the prior owner’s tenant from 1972 to 1986, and was enrolled in the Conservation Reserve Program (CRP) from 1987 to 1997. The plaintiff purchased the property in 1999, before the USDA determined that a portion of the tract was wetland. Despite that determination, the plaintiff removed some woody vegetation in 2000 because it was a nuisance to the plaintiff’s farming operation. The USDA determined that the plaintiff had “converted” 0.9 acres of wetland. However, the plaintiff claimed that the tract had been cropped before December 23, 1985, thereby making it prior converted cropland. Also, the plaintiff introduced evidence that a drainage tile had been installed before December 23, 1985, and that the tile, along with a road ditch, removed the wetland hydrology from the tract. But, USDA believed that the tile was not functioning as of December 23, 1985, because woody vegetation existed.
The plaintiff’s expert civil engineer, however, concluded that if the drainage tile had been plugged, when the USDA broke the tile during the on-site field investigation, the resulting hole would have filled full of water and saturated the ground and would have continued to be fed from water from further up the tile line. But, that did not occur. So, the plaintiff argued that the drainage tile coupled with the installation of a road ditch removed the presence of wetland hydrology from the tract. USDA disagreed, claiming that the presence of hydrophytic vegetation, by itself, demonstrated wetland hydrology was present.
The court didn’t buy the USDA’s argument. The court noted the statute clearly specifies that a “wetland” has three separate, mandatory requirements: (1) hydric soil; (2) wetland hydrology, and; (3) hydrophytic vegetation. In addition, the court noted that the presence of hydrophytic vegetation is not sufficient to meet the wetland hydrology requirement. In addition, the court determined that the USDA reached its conclusion by disregarding evidence contrary to its experts that were relevant on the issues involved.
Accordingly, the court ruled that the USDA hearing officer’s “final” determination must be overturned as arbitrary and capricious, an abuse of discretion, or contrary to law. As for attorney fees, the court stated that it would reserve the issue for consideration upon a specific application for attorney fees.
In a recent dispute involving a tract of land in Virginia, the USDA NAD again determined that the NRCS didn’t follow applicable rules when determining the existence of wetlands. In re Hood, No. 2017E000755 (USDA NAD, Jun. 14, 2018). The landowner participated in the NRCS Environmental Quality Incentives Program (EQIP) for almost a decade. The contract covered most of his 31-acre tract. In 2006, the NRCS determined that the landowner had converted 18.74 acres of wetland on the tract to cropland. The NRCS issued a certified wetland determination to that effect, but neither the landowner nor the NRCS took any other action at that time.
In 2016, the NRCS again reviewed the property for compliance with the wetland provisions. They conducted a site visit and again concluded that the landowner had converted 18.76 acres of wetland to cropland after November 28, 1990, by sheering stumps (the tract had formerly been used as a tree farm) and planting crops on former wetland. An appeal to the Farm Service Agency (FSA) County Committee which upheld the NRCS final technical determination and held the landowner ineligible for USDA farm program benefits. The landowner appealed the FSA decision to the NAD asserting that the FSA decision was wrong because the underlying 2006 NRCS wetland determination was inaccurate and “incompetent.” Specifically, the landowner claimed that the NRCS did not follow its soil map, and didn’t properly identify the actual soil on his tract. The landowner also claimed that the NRCS did not properly follow the “50/20” rule (a method to select dominant aspects for wetland evaluation. The landowner claimed that the FSA’s decision resulted from the erroneous 2006 wetland determination, and that current and former USDA personnel had advised him that his wetland was farmable because it lacked the characteristics for wetland and contained upland and non-wetland plants. The landowner also claimed that the tract was drained by the federal government in the 1930s via the installation of three ditches which lowered the water table, changed the land’s hydrology and made the tract dry. The landowner also claimed that the allegedly converted wetlands were atypical and the NRCS should have reevaluated them as such.
The landowner also asserted that the NRCS engaged in misconduct by targeting him by taking over 120 soil samples in search of a wetland as part of an ongoing feud that the NRCS had with him as a part-time FSA employee.
The USDA NAD Secretary determined that the FSA determination was erroneous. The landowner had sufficiently demonstrated that a natural event of water receding altered the hydrology of the land. This hydrological change, the NAD Secretary reasoned, established that the wetland determinations were no longer reliable indicators of site conditions on the land. The NAD Secretary specifically found that the United States Geological Survey (USGS) maps showed no wetlands or swampland related to the cleared part of the land or on any of the land not adjacent to the stream lying on the north/northwest of the property line. Indeed, the NRCS national cooperative soil survey maps, the NAD Secretary noted, showed that the land was comprised of non-hydric sandy loam soils.
The NAD Secretary did not have the authority to review the landowner’s claim that the FSA and/or NRCS committed misconduct. However, the NAD Secretary noted that the landowner could file a complaint with the USDA’s Office of Inspector General. The NAD Secretary noted that the FSA could seek NAD Director Review by filing a request within 30 days of the Secretary’s decision.
When the government’s position is not substantially justified, attorney fees and other expenses can be awarded. In the Iowa case referred to above, the plaintiff’s lawyer did, indeed, make an application for $57,768.59 in fees and $683.00 in costs, $3,414.17 in expenses, and $13,380.43 in other fees and costs. Those fees, costs and expenses were the result of work performed on the case that the USDA chose to drag out for over eight years. The Equal Access to Justice Act (EAJA) allows for an award of attorney fees in cases where the plaintiff prevails against the U.S. Government and satisfies three requirements – (1) a final judgment has been rendered; (2) the plaintiff prevailed; and (3) the government’s position was not substantially justified. The USDA denied the plaintiff’s request for fees, claiming instead that their position was substantially justified, that special circumstances made an award of fees unjust, and that the plaintiff’s lawyer put excessive hours in on the case at too high an hourly rate and didn’t have any particular expertise in wetland matters.
The court noted that fees and other expenses are to be awarded under the EAJA unless the government’s position was substantially justified or special circumstances would make awarding fees and costs unjust. To be substantially justified, the government’s position must only have a reasonable basis in law and fact. That’s a rather low threshold. Basically, if the government can come up with any reasonable interpretation of statutory law, they win and no award of fees and costs will be required. In addition, even if the government loses in court, that doesn’t create a presumption that the government’s position was not substantially justified. But, the government still has the burden of proof to establish that its position was substantially justified.
The court held that the government had absolutely no reasonable basis for its “conflation of the separate “hydrophytic vegetation” and “wetland hydrology” requirements for a “wetland,” and improperly placing the burden on B&D to demonstrate why wetlands were not present based on criteria not identified in the statute or regulations.” The court also noted that USDA disregarded “saturation” evidence, disregarded evidence that wetland hydrology had already been removed because of pre-existing drainage and the adjacent road and the ditch. The court, in a particularly pointed comment, stated:
“At each stage of the proceedings, the government sought to uphold its prior “wetlands” determination, without regard to any evidence or law to the contrary, suggesting an entrenched bureaucracy’s refusal to admit error, not an interest in proper application of the law.”
The court also held that no special circumstances existed to deny an award of fees and costs. As for the government’s claim that the plaintiff’s attorney billed too many hours at too high an hourly rate, the court noted that the statutory rate specified $125/hour as a maximum rate unless the attorney had particular expertise. The plaintiff’s attorney had billed some work on the case at $175/hour and other work at $185/hour. The attorney justified the fee rate based on an inflation adjustment to the statutory rate and the attorney’s specialized skill in wetland matters. The court agreed on both points. USDA complained that the plaintiff’s lawyer didn’t need to put time in on a brief for injunctive relief because USDA had promised that it wasn’t necessary because they would continue to pay federal farm program benefits. The court wouldn’t bite, stating “the court…cannot…say…that the government’s assurances were so unequivocal or binding on the government that no preliminary injunction was warranted, particularly in light of the credible threat of bankruptcy for the plaintiff posed by any enforcement action by the government during the pendency of this action.”
In the Iowa case, the USDA basically harassed the plaintiff with bogus wetland violation claims for many years which placed the plaintiff within the potential peril of bankruptcy. In addition, the USDA continued to maintain its bogus claims in an attempt to avoid paying the plaintiff’s attorney fees. In the Virginia matter, the USDA/NRCS was conducting itself similarly and the NAD Secretary would have none of it.
The government’s conduct in both of these matters is something that the U.S. Court of Appeals for the Eighth Circuit was concerned with in Barthel v. United States Department of Agriculture, 181 F.3d 934 (8th Cir 1999). In that case, the court stated, in rejecting the USDA’s interpretation of the statute governing wetland drainage activities, that “…there is no worse statute than one misunderstood by those who interpret it.”
The USDA is now under new leadership, but lower level field staff remain from prior Administrations. Perhaps the requirement to pay attorney fees and costs for unreasonable positions will cause them to take more care to follow their own regulations when delineating wetlands.
Thursday, June 14, 2018
Self-employment tax is a concern for many farmers and ranchers, with many having an as an objective the avoidance of self-employment tax through whatever planning techniques can be utilized. That’s especially the case for those farmers and ranchers that are fully “vested” in the Social Security system.
But, what about the farmer that leases out machinery and equipment to someone else? Is the income from machinery and equipment leases subject to self-employment tax? Such an arrangement may be entered into, for example, to assist another person get established in farming or supply a need that another person has with respect to that other person’s farming operation.
As is the case with many answers to tax questions, the answer is “it depends.” Today’s post takes a look at leases of farm machinery and equipment and the self-employment tax implications.
Under I.R.C. §1402(a) “net earnings” from self-employment” means the gross income derived by an individual from any trade or business that the individual conducts. However, rental income is generally reported on Schedule E of Form 1040. From there, it flows to page one of the Form 1040. As such, it is not subject to self-employment tax. A rental activity is just that – it’s a rental activity. Under I.R.C. §1402(a)(1), “rentals from real estate” are excluded from the I.R.C. §1402(a) definition of “net earnings from self-employment.”
Exception for Personal Property Leases
The I.R.C. §1402(a)(1) exception from self-employment tax for “rentals from real estate” says, in full, “there shall be excluded rentals from real estate and from personal property leased with the real estate…” [emphasis added]. But, the non-application of self-employment tax only applies to the rental of real estate or the rental of personal property in connection with real estate.
Inapplicability of Exception
If the personal property is not tied to a land lease, the income from leasing personal property is subject to self-employment tax if the rental activity is conducted as a regular business activity of the taxpayer. See, e.g., Stevenson v. Comr., T.C. Memo. 1989-357. Indeed, a notation at the top of Schedule E indicates that if the taxpayer has a business of renting personal property then the income should be reported on Schedule C. Those same instructions also direct a taxpayer to use Schedule C to report income an expense associated with renting personal property if the rental activity is a business activity of the taxpayer. The rental activity constitutes a business if it is engaged in with the primary purpose of making a profit and the activity is engaged in with regularity and continuity. See, e.g., Comr. v. Groetzinger, 480 U.S. 23 (1987).
But, if an activity is engaged in on a one-time only basis the income derived from the activity will not be subject to self-employment tax because the activity is not engaged in on a basis that is regular and continuous. See, e.g., Batok v. Comr., T.C. Memo. 1992-727. Thus, if the rental of personal property is merely casual the Schedule E instructions state that the rental receipts should be reported as “Other Income” on page 1 of Form 1040. Any related deductions are to be reported on the total deduction line (Total Adjustments) on the bottom of page 1 of Form 1040 and the notation “PPR” is to be entered on the dotted line next to the amount. That is what indicates a personal property rental.
For a farmer that owns machinery and equipment and leases it to someone else or to their own farming business entity, the risk is real that the rental income will be subject to self-employment tax. That will be the result if the rental activity in engaged in with regularity and continuity such that the activity rises to the level of a trade or business. Self-employment tax can be avoided if the lease of the personal property is tied in with a land lease. Alternatively, a farm taxpayer could transfer the machinery and equipment to a pass-through entity with the income flowing through to the taxpayer without self-employment tax. In that situation, however, compensation from the entity would be required for any personal services provided.
An additional consideration is that, at least in some states, paying rent to lease farm equipment and machinery is subject to sales tax at the state level. Also, income from a rental activity may trigger the application of the passive loss rules under I.R.C. §469. That last point is a topic for discussion in a subsequent post.
Tuesday, June 12, 2018
Normally, property is valued in a decedent's estate at its fair market value as of the date of the decedent's death. The Code and Treasury Regulations bear this our. See I.R.C. §1014). But, neither the Code nor the regulations rule out the possibility that post-death events can have a bearing on the value for assets in a decedent’s estate. The real question is what post-death events are relevant for determining the actual date-of-death value of property for estate tax purposes.
Post-death events and their impact on valuation, that’s the topic of today’s post.
Cases on the Valuation Issue
The cases reveal that consideration may be given to subsequent events that are reasonably foreseeable at the date of death. Those events have a bearing on date-of-death value.
Numerous cases illustrate that it is simply not true that, except for the alternate valuation election under I.R.C. §2032, changes in valuation after death are immaterial. The following cases are illustrative:
- In Gettysburg National Bank v. United States, 1:CV-90-1607, 1992 U.S. Dist. LEXIS 12152 (D. M.D. Pa. Jul. 17, 1992), property was sold to a third party in an arm’s length transaction 16 months after the decedent’s death (13 months after its appraisal for estate tax purposes) for less than 75 percent of the value at which it was included in the gross estate. The court allowed the estate to reduce its value, stating that the subsequent sale may be relevant evidence that the appraised fair market value was incorrect.
- In Estate of Scull v. Comr., C. Memo. 1994-211, sales of artwork at auction 10 months after the valuation date were the best indicators of fair market value for federal estate tax purposes notwithstanding that the market had changed in the interim, and the court applied a 15 percent discount to reflect appreciation in the market between the date of the decedent’s death and the auction.
- In Rubenstein v. United States, 826 F. Supp. 448 (S.D. Fla. 1993), the court determined that the best evidence of a claim’s value is the amount for which the claim was settled after the decedent’s death.
- In Estate of Andrews v. United States, 850 F. Supp. 1279 (E.D. Va. 1994), the court reasoned that reasonably foreseeable post-death facts relating to a publication contract under negotiation when the decedent died were germane to the determination of what a willing buyer would pay for the right to use the decedent’s name.
- In Estate of Necastro v. Comr., C. Memo. 1994-352, environmental contamination was discovered five years after the decedent’s death and the court allowed the estate to file a claim for refund, reducing the value from the value as reported, which was based on facts known at the date of death; the revaluation resulted in a reduction of over 33 percent from the value of the property determined before the contamination was discovered. The court’s opinion did not, however, address the substantive issue whether facts discovered after death may influence valuation if willing buyers and sellers would not have known the relevant facts as of the valuation date.
- In Estate of Jephson v. Comr., 81 T.C. 999 (1983), the court concluded that “[e]vents subsequent to the valuation date may, in certain circumstances, be considered in determining the value as of the valuation date.”
- In Estate of Keller v. Comr., C. Memo. 1980-450, the court stated that a “sale of property to an unrelated party shortly after date of death tends to establish such value at date of death. The property sold involved a farm and growing crop where both the sale of the farm and the harvesting of the crop occurred post-death.
- In Estate of Stanton, C. Memo. 1989-341, the court stated that the sale of the property shortly after death is the best evidence of fair market value. Under the facts of the case, the selling price of comparable property sold six months after the decedent’s death was also considered with a downward adjustment to reflect the greater development potential of the comparable property and the 10 months of appreciation that occurred after the decedent’s death in the actual estate property owned and sold.
- In Estate of Trompeter v. Comr., 279 F.3d 767 (9th Cir. 2002), the Tax Court was reversed for failing to sufficiently articulate the basis for its decision regarding omitted assets and the rationale for the valuation discount selected, but the court nevertheless considered the value of assets using post-death developments, including redemption for $1,000 per share of stock valued at $10 per share 16 months earlier, and a coin collection returned at roughly half the value subsequently assigned to it by the taxpayer’s estate in an effort to enjoin auction of that asset.
- In Morris v. Comr., 761 F.2d 1195 (6th Cir. 1985), the court considered speculative post-death commercial development events for purposes of valuing farmland in the decedent’s estate as of the date of the decedent’s death. The decedent’s farmland was approximately 15 miles north of downtown Kansas City and approximately five miles west of the Kansas City International Airport. At the time of death, plans were in place for a sewer line to service the larger of the two tracts the decedent owned. Also, residential development was planned within two miles of the same tract. In addition, significant roadways and the site for the planned construction of a major interstate were located close to the property. While none of these events had occurred as of the date of death, the court found them probative for determining the value of the farmland as of the date the decedent died. The decedent’s son, the owner of the farmland as surviving joint tenant, tried to introduce evidence of the failed closing of some post-death sales to support his claim that the post-death events were speculative. But, the court disagreed, establishing the value of the farmland at $990,000 rather than the estate’s valuation of $332,151.
The court’s opinion makes it look like that evidence to confirm an appraiser’s date-of-death prediction of future events is more likely to be received than evidence adduced to prove wrong an appraiser’s prediction concerning future events. In any event, however, the case stands for the proposition that post-death events are relevant for establishing death-time value – even if they are somewhat speculative.
- In Okerlund v. United States, 365 F.3d 1044 (Fed. Cir. 2004), the court dealt with the issue of stock valuation in a closely held company for stock that was gifted shortly before the company founder died and the company (a milk processing operation) suffered a salmonella outbreak. The taxpayers argued that these events should result in a lower gift tax value of the stock, with the issue being the relevance of post-death events on the value of the gifts. The court stated that “[i]t would be absurd to rule an arms-length stock sale made moments after a gift of that same stock inadmissible as post-valuation date data….The key to use of any data in a valuation remains that all evidence must be proffered in support of finding the value of the stock on the donative date.” The court ultimately affirmed the trial court’s denial of a lower gift tax valuation based on the reality that the risk factors (the founder’s death and matters that could materially affect the business) had already been accounted for in the valuation of the stock.
Clearly, post-death events and other facts that are reasonably predictable as of the date of death or otherwise relevant to the date of death value can serve as helpful evidence of value and allow either an increase (to obtain a higher income tax basis) or decrease (to reduce federal estate tax) in value as a matter or record. For farmland (and other real estate) the market is not static as of the date of death. Thus, appraisers can reasonably look to the arc of sales extending from pre-death dates to post-death dates in arriving at the date-of-death value.
Friday, June 8, 2018
Wind “farms” can present land-use conflict issues for nearby landowners by creating nuisance-related issues associated with turbine noise, eyesore from flicker effects, broken blades, ice-throws, and collapsing towers, for example.
Courts have a great deal of flexibility in fashioning a remedy to deal with nuisance issues. A recent order by a public regulatory commission is an illustration of this point.
Wind Farm Nuisance Litigation
Nuisance litigation involving large-scale “wind farms” is in its early stages, but there have been a few important court decisions. A case decided by the West Virginia Supreme Court in 2007 illustrates the land-use conflict issues that wind-farms can present. In Burch, et al. v. Nedpower Mount Storm, LLC and Shell Windenergy, Inc., 220 W. Va. 443, 647 S.E.2d 879 (2007), the Court ruled that a proposed wind farm consisting of approximately 200 wind turbines in close proximity to residential property could constitute a nuisance. Seven homeowners living within a two-mile radius from the location of where the turbines were to be erected sought a permanent injunction against the construction and operation of the wind farm on the grounds that they would be negatively impacted by turbine noise, the eyesore of the flicker effect of the light atop the turbines, potential danger from broken blades, blades throwing ice, collapsing towers and a reduction in their property values. The court held that even though the state had approved the wind farm, the common-law doctrine of nuisance still applied. While the court found that the wind-farm was not a nuisance per se, the court noted that the wind-farm could become a nuisance. As such the plaintiffs’ allegations were sufficient to state a claim permitting the court to enjoin the creation of the wind farm.
In another case involving nuisance-related aspects of large-scale wind farms, the Kansas Supreme Court upheld a county ordinance banning commercial wind farms in the county. Zimmerman v. Board of County Commissioners, 218 P.3d 400 (Kan. 2009). The court determined that the county had properly followed state statutory procedures in adopting the ordinance, and that the ordinance was reasonable based on the county’s consideration of aesthetics, ecology, flora and fauna of the Flint Hills. The Court cited the numerous adverse effects of commercial wind farms including damage to the local ecology and the prairie chicken habitat (including breeding grounds, nesting and feeding areas and flight patterns) and the unsightly nature of large wind turbines. The Court also noted that commercial wind farms have a negative impact on property values, and that agricultural and nature-based tourism would also suffer.
A recent settlement order of the Minnesota Public Utilities Commission (Commission)requires a wind energy firm to buy-out two families whose health and lives were materially disaffected by a wind farm complex near Albert Lea, Minnesota. As a result, it is likely that the homes will be demolished so that the wind farm can proceed unimpeded by local landowners that might object to the operation. That’s because the order stated that if the homes remained and housed new residents, those residents could not waive the wind energy company’s duty to meet noise standards even if the homeowners were willing to live with violations of the Minnesota Pollution Control Agency’s ambient noise standard in exchange for payment or through some other agreement.
In re Wisconsin Power and Light, Co., No. ET-6657/WS-08-573, Minn. Pub. Util. Commission (Jun. 5, 2018) has a rather lengthy procedural history preceding the Commission’s order. On October 20, 2009, the Commission issued a large wind energy conversion system site permit to Wisconsin Power and Light Company (WPL) for the approximately 200-megawatt first phase of the Bent Tree Wind Project, located in Freeborn County, Minnesota. The project commenced commercial operation in February 2011. On August 24, 2016, the Commission issued an order requiring noise monitoring and a noise study at the project site. During the period of September 2016 through February 2018 several landowners in the vicinity filed over 20 letters regarding the health effects that they claim were caused by the project. On September 28, 2017, the Department of Commerce Energy Environmental Review Analysis Unit (EERA) filed a post-construction noise assessment report for the project, identifying 10 hours of non-compliance with Minnesota Pollution Control Agency (MPCA) ambient noise standards during the two-week monitoring period.
On February 7, 2018, EERA filed a phase-two post construction noise assessment report concluding that certain project turbines are a significant contributor to the exceedances of MPCA ambient noise standards at certain wind speeds. The next day, WPL filed a letter informing the Commission that it would respond to the Phase 2 report at a later date and would immediately curtail three turbines that were part of the project, two of which were identified in the phase 2 report. On February 20, 2018, the landowners filed a Motion for Order to Show Cause and for Hearing, requesting that the Commission issue an Order to Show Cause why the site permit for the project should not be revoked, and requested a contested-case hearing on the matter.
On April 19, 2018, WPL filed with the Commission a Notice of Confidential Settlement Agreement and Joint Recommendation and Request, under which WPL entered into a confidential settlement with each landowner, by which the parties agreed to the terms of sale of their properties to WPL, execution of easements on the property, and release of all the landowners’ claims against WPL. The agreement also outlined the terms by which the agreement would be executed. The finality of the agreement was conditioned upon the Commission making specific findings on which the parties and the Department agreed. These findings include, among others: dismissal of the landowners’ February 2018 motion and all other noise-related complaints filed in this matter; termination of the required curtailment of turbines; transfer of possession of each property to WPL; and a requirement that compliance filing be filed with commission. The Commission determined that resolving the dispute and the terms of the agreement were in the public interest and would result in a reasonable and prudent resolution of the issues raised in the landowner’s complaints. Therefore, the Commission approved the agreement with the additional requirement that upon the sale of either of the landowners’ property, WPL shall file with the Commission notification of the sale and indicate whether the property will be used as a residence. If the property is intended to be used as a residence after sale or upon lease, the permittee must file with the Commission several things - notification of sale or lease; documentation of present compliance with noise standards of turbines; documentation of any written notice to the potential residence of past noise studies alleging noise standards exceedances, and if applicable, allegations of present noise standards exceedances related to the property; and any mitigation plans or other relevant information.
The order issued in the Minnesota matter is not entirely unique. Several decades ago, the Arizona Supreme Court ordered a real estate developer to pay the cost of a cattle feedlot to move their feeding operations further away from the area where the developer was expanding into. Spur Industries, Inc. v. Del E. Webb Development Co., 108 Ariz. 178, 494 P.2d 700 (1972).
However, the bottom-line is that the matter in Minnesota is an illustration of what can happen to a rural area when a wind energy company initiates development in the community.
Wednesday, June 6, 2018
Much of tort law centers around the concept of negligence. The negligence system is designed to provide compensation to those who suffer personal injury or property damage. It’s also a fault-based system in most instances. When negligence is based on fault, the injured party (plaintiff) must be able to prove that their injury was the defendant’s fault. Without that proof, the defendant will not be liable. In addition, the plaintiff must prove each element of their negligent tort case by a preponderance of the evidence
Establishing fault and, as a result, liability – that’s the focus of today’s post.
For a person to be deemed legally negligent, certain conditions must exist. These conditions can be thought of as links in a chain. Each condition must be present before a finding of negligence can be obtained.
Legal duty. The first condition is that of a legal duty giving rise to a standard of care. To be liable for a negligent tort, the defendant's conduct must have fallen below that of a “reasonable and prudent person” under the circumstances. A reasonable and prudent person is what a jury has in mind when they measure an individual's conduct in retrospect - after the fact, when the case is in court. The conduct of a particular tortfeasor (the one causing the tort) who is not held out as a professional is compared with the mythical standard of conduct of the reasonable and prudent person in terms of judgment, knowledge, perception, experience, skill, physical, mental and emotional characteristics as well as age and sanity. For those held out as having the knowledge, skill, experience or education of a professional, the standard of care reflects those factors.
Breach. If a legal duty exists, it is necessary to determine whether the defendant's conduct fell short of the conduct of a “reasonable and prudent person (or professional) under the circumstances.” This is called a breach, and is the second element of a negligent tort case.
Causation. Once a legal duty and breach of that duty are shown to exist, a causal connection (the third element) must be established between the defendant's act and (the fourth element) the plaintiff's injuries (whether to person or property). In other words, the resulting harm to the plaintiff must have been a reasonably foreseeable result of the defendant's conduct at the time the conduct occurred. Reasonable foreseeability is the essence of causality (also known as proximate cause).
Damages. If the plaintiff is able to establish that the defendant breached a duty that was owed to the plaintiff, the plaintiff must also prove that the breach of the duty caused damages. The damages must be more than trivial and must be proved.
A recent case involving a dairy operation from the state of Washington illustrates the importance of being able to prove damages and that those damages were causally related to the defendant’s conduct. In White River Feed Co. v. Kruse Family, LP, No. 76562-1-I, 2018 Wash. App. LEXIS 1031(Wash. Ct. App. Apr. 30, 2018), the plaintiff claimed that the defendant supplied contaminated feed that caused illness in the plaintiff’s milking cows. During April of 2013 the plaintiff fed the cows the plaintiff’s own “green-chop” as well as the defendant’s custom grain feed blend. The dry cows (i.e., cows that were not milking) and the bulls were fed only “green-chop.” The “green-chop” had been incorporated into the rations on April 17. The third grain delivery had been fed as soon as it had been delivered on the 18th. On April 19, the milking cows showed a decreased appetite and developed diarrhea. By April 22, the plaintiff’s veterinarian, had been called to examine and treat the milking cows.
The veterinarian initially diagnosed the cows with an ionophore toxicity. Further investigations, however, revealed that the cows had salmonella poisoning. Grain from the calf barn, which the plaintiff stated came from the April 18 feed delivery, tested negative for salmonella. The “green-chop” was never tested as it had all been fed to the herd. The plaintiff’s veterinarian concluded with an eighty percent probability that the milking cows had become ill from the defendant’s grain. Most of the veterinarian’s opinion was based upon the fact that the dry cows and bulls had not become ill because they had not been fed any grain. The plaintiff’s veterinarian did acknowledge, however, that the calves were fed the grain and did not become ill. However, he hypothesized that the milk in their diet kept them from eating the grain or the industry practice of feeding calves the “crumbs” from the cows limited the salmonella.
The illness caused the plaintiff loss of twenty to twenty-five head which either died or were culled and another thirty head were sold for beef due to substantial weight loss In addition to claiming damages for the loss of cows, the plaintiff reported a decrease in milk production and loss of fetuses in the infected cows. The plaintiff sued for damages from the salmonella illness, and the defendant countered with claims of breach of contract and unjust enrichment for the outstanding accounts. The defendant also requested a jury trial and moved for summary judgment based on their own veterinarian’s expert opinion. The defendant’s veterinarian stated that the data was insufficient to pinpoint salmonella from the grain as the cause of the illness. Due to the negative test results, the fact the calves or any other farms experienced the same illness, and low moisture content of the grain, the defendant’s expert believed that no expert could have arrived at the diagnosis that the plaintiff’s veterinarian did.
The trial court granted the defendant’s summary judgment motion. The plaintiff moved for reconsideration, and submitted a declaration of an opinion from another veterinarian. This declaration stated that the negative results from the test may not be representative of the entire batch of feed. The trial court denied the motion to reconsider, The appellate court affirmed. The appellate court did not give much weight to the hypothetical projections of the initial veterinarian’s diagnosis. Also, the appellate court questioned why the veterinarian ignored the negative test results for salmonella or did not test for non-feed sources of salmonella that the other expert stated could be a cause. In addition, the court found that the expert opinion was abstract evidence rather than an issue of fact that could overcome the motion for summary judgment.
Proving damages is an essential element of a negligent tort case. Even though the defendant may have owed a duty to the plaintiff, breach that duty and the breach caused the plaintiff’s damages, if those damages can’t be proven or can’t be shown to be causally related to the defendant’s conduct, the plaintiff will not prevail on the claim. In the farm and ranch setting there can be many intervening factors that may cut-off the defendant’s liability. Make sure to think through each element before bringing suit.
Monday, June 4, 2018
Federal law regulates the handling of agricultural commodities in commerce by establishing marketing orders with the purpose of insuring that consumers receive an adequate supply of a commodity at a stable price. Marketing orders have long been used in the fruit, nut, vegetable and milk industries and typically require that a handler (dealer) pay a fixed minimum price to the producer of a commodity. In addition, the marketing of a commodity must follow a system of rules.
Separate legislation has established mandatory assessments for promotion of particular agricultural products. An assessment (or “check-off”) is typically levied on handlers or producers of commodities with the collected funds to be used to support research promotion and information concerning the product. Such check-off programs have been challenged on First Amendment free-speech grounds. Indeed, a recent case from California involved a mandatory assessment for the generic marketing of grapes. A group of grape producers that believed they produced high quality grapes objected to being required to pay for the advertising of grapes in general.
Mandatory assessments for generic advertising of ag commodities – that’s the focus of today’s post.
In United States v. United Foods, Inc., 533 U.S. 405 (2001), the U.S. Supreme Court held that mandatory assessments for mushroom promotion under the Mushroom Promotion, Research, and Consumer Identification Act violated the First Amendment. The assessments were directed into generic advertising, and some handlers objected to the ideas being advertised. In an earlier decision, Glickman v. Wileman Brothers & Elliott, Inc., 521 U.S. 457 (1997), the Court had upheld a marketing order that was part of a greater regulatory scheme with respect to California tree fruits. In that case, producers were compelled to contribute funds for cooperative advertising and were required to market their products according to cooperative rules. In addition, the marketing orders had received an antitrust exemption. None of those facts was present in the United Foods case, where the producers were entirely free to make their own marketing decisions and the assessments were not tied to a marketing order. The Supreme Court did not address, however, whether the check-offs at issue were government speech and, therefore, not subject to challenge as an unconstitutional proscription of private speech.
The government speech issue was before the court in 2005. In Johanns v. Livestock Marketing Association, 544 U.S. 550 (2005), the Supreme Court upheld the beef check-off as government speech. Under the Beef Checkoff, a $1.00/head fee is imposed at the time cattle are sold. The money generated funds promotional campaigns and research, and state beef councils can collect the funds and retain half of the collected amount with the balance going to the Cattleman’s Beef Production and Research Board (Beef Board). But, a producer can direct that all of the producer’s assessment go to the Beef Board.
The case involved (in the majority’s view) a narrow facial attack on whether the statutory language of the legislation authorizing the beef check-off created an advertising program that could be classified as government speech. That was the only issue before the Court. At the time, the government speech doctrine was relatively new not well-developed but, prior Supreme Court opinions not involving agricultural commodity check-offs indicated that to constitute government speech, a check-off must clear three hurdles - (1) the government must exercise sufficient control over the content of the check-off to be deemed ultimately responsible for the message; (2) the source of the check-off assessments must come from a large, non-discrete group; and (3) the central purpose of the check-off must be identified as the government’s.
Based on that analysis, it was believed that the beef check-off would clear only the first and (perhaps) the third hurdle, but that the program would fail to clear the second hurdle. Indeed, the source of funding for the beef check-off comes from a discrete identifiable source (cattle producers) rather than a large, non-discrete group. The point is that if the government can compel a targeted group of individuals to fund speech with which they do not agree, greater care is required to ensure political accountability as a democratic check against the compelled speech. That is less of a concern if the funding source is the taxpaying public which has access to the ballot box as a means of neutralizing the government program at issue and/or the politicians in support of the program. While the dissent focused on this point, arguing that the Act does not establish sufficient democratic checks, Justice Scalia, writing for the majority, opined that the compelled-subsidy analysis is unaffected by whether the funds for the promotions are raised by general taxes or through a targeted assessment. That effectively eliminates the second prong of the government speech test. The Court held that the other two requirements were satisfied in as much as the legislation vested substantial control over the administration of the check-off and the content of the ads in the Secretary.
The court did not address (indeed, the issue was not before the court) whether the advertisements, most of which are credited to “America’s Beef Producers,” give the impression that the objecting cattlemen (or their organizations) endorse the message. Because the case only involved a facial challenge to the statutory language of the Act, the majority examined only the Act’s language and concluded that neither the statute nor the accompanying Order required attribution of the ads to “America’s Beef Producers” or to anyone else. Thus, neither the statute nor the Order could be facially invalid on this theory. However, the Court noted that the record did not contain evidence from which the Court could determine whether the actual application of the check-off program resulted in the message of the ads being associated with the plaintiffs. Indeed, Justice Thomas, in his concurring opinion, noted that the government may not associate individuals or organizations involuntarily with speech by attributing an unwanted message to them whether or not those individuals fund the speech and whether or not the message is under the government’s control.
After the Supreme Court’s decision in the beef-checkoff case, the U.S. Circuit Court of Appeals for the Ninth Circuit decided a case involving the California Pistachio check-off. Paramount Land Company, LP v. California Pistachio Commission, 491 F.3d 1003 (9th Cir. 2007). The court determined that the First Amendment was not implicated because, consistent with Johanns, the Secretary of the California Department of Food and Agriculture retained sufficient authority to control both the activities and the message under the Pistachio Act. The court reasoned that the fact that the Secretary had not actually played an active role in controlling pistachio advertising could not be equated with the Secretary abdicating his regulatory role.
In another California case, a court held that milk producer assessments used for generic advertising to stimulate milk sales were constitutional under the Johanns rationale. Gallo Cattle Co. v. A.G. Kawamura, 159 Cal. App. 4th 948, 72 Cal. Rptr. 3d 1 (2008).
In more recent litigation, Ranchers-Cattlemen Action Legal Fund, United Stockgrowers of America v. Vilsack, No. CV-16-41-GF-BMM-JTL, D. Mont. Dec. 12, 2016), the plaintiff (cattle producers) claimed that the federal law requiring funding of the Montana Beef Council (MBC) via funds from the federal beef checkoff was constitutionally defective. The court, as part of the findings and recommendations of a U.S. Magistrate Judge, determined that the plaintiff had standing and had stated a claim upon which relief could be granted. The cattle producers claimed that the use of the collected funds violated their First Amendment rights by forcing them to pay for “speech” with which they did not agree. The cattle producers objected to being forced to fund a generic message that “beef is beef” regardless of where the cattle from which the beef was derived or born. That message, the cattle producers claimed, was contrary to their interests of capitalizing on marketing their superior beef products produced from cattle produced in the United States.
The defendant (USDA) motioned to dismiss, but the Magistrate Judge denied the motion. The court determined that the plaintiffs had standing, and that the U.S. Supreme Court had held in prior cases that forcing an individual to fund a private message that they did not agree with violated the First Amendment. Any legal effect of an existing “opt-out” provision was not evaluated. The court also rejected the defendant’s claim that the case should be delayed until federal regulations with respect to the opt-out provision were finalized because the defendant was needlessly dragging its heels on developing those rules and had no timeline for finalization. The court entered a preliminary injunction barring the MBC from spending funds received from the checkoff. Upon further review, the federal trial court upheld the preliminary injunction. Ranchers- Cattlemen Action Legal Fund, United Stockgrowers of America v. Perdue, No. CV 16-41-GF-BMM, 2017 U.S. Dist. LEXIS 95861 (D. Mont. Jun. 21, 2017).
On further review, the U.S. Court of Appeals for the Ninth Circuit affirmed. Ranchers-Cattlemen Action Legal Fund, United Stockgrowers of America v. Perdue, 718 Fed. Appx. 541 (9th Cir. 2018). The Ninth Circuit determined that the trial court had properly evaluated the beef-checkoff under the standards set forth in Johanns and Paramount.
In Delano Farms Company v. California Table Grape Commission, No. S226538, 2018 Cal. LEXIS 3634 (Cal. Sup. Ct. May 24, 2018), the plaintiffs were several California grape growers. They claimed that the defendant violated the plaintiffs’ First Amendment free speech rights by collecting mandated fees to pay for a range of services including advertising and marketing. Specifically, the plaintiffs claimed the collection of assessments by the defendant under the California Ketchum Act subsidized promotional speech on behalf of California table grapes as a generic category that violated their rights to free speech, free association, due process, liberty and privacy under the California Constitution (Article I, Section 2). They took this position because the claimed to have developed specialty grapes that they wanted to market in their own manner without also being forced to pay for generic grape advertising that sponsored a viewpoint that they disagreed with.
The trial court ruled that the defendant was a governmental entity, and therefore its speech was government speech that could be funded by assessments collected from the plaintiffs under a constitutional analysis that is significantly deferential and is not subject to heightened scrutiny. As such, the trial court determined that the speech did not implicate Article 1, Section 2.
On appeal, the California Supreme Court affirmed. The Court noted that the relevant circumstances established sufficient government responsibility for and control over the messaging at issue such that the advertising constituted government speech that the plaintiffs could be required to subsidize without any implication of their constitutional rights under Article 1, Section 2. Specifically, the Court noted that the California legislature developed and endorsed the central message that the defendant promulgated with respect to California fresh grapes generically. The articulation and broadcasting of that message was entrusted to market participants acting through the defendant. The Court viewed this as meaningful oversight by the public and other governmental actors and included oversight mechanisms serving to ensure that the defendant’s messaging remained within the statutory parameters. The Court also stated that there is no right not to fund government speech, and also determined that the Ketchum Act did not bar the plaintiffs from speaking.
Mandatory assessments for generic advertising for ag commodities is understandably frustrating for some producers. However, the U.S. Supreme Court has provided a measuring stick for evaluating the constitutionality of such programs. If the administration of the particular check-off is substantially controlled by the government, and the government controls the contents of the ads at issue, the assessments are likely to be upheld as government speech.
Thursday, May 31, 2018
Numerous states have enacted agritourism legislation designed to limit landowner liability to those persons engaging in an “agritourism activity.” Typically, such legislation protects the landowner (commonly defined as a “person who is engaged in the business of farming or ranching and provides one or more agritourism activities, whether or not for compensation”) from liability for injuries to participants or spectators associated with the inherent risks of a covered activity. There’s a lot packed into that definition, and unpacking it is not the purpose of today’s post.
What today’s post takes a brief look at is one aspect of agritourism statutes – the extent to which the statutes can be used to exempt activities from county zoning. Indeed, that was the focus of a recent court decision in North Carolina.
State agritourism statues tend to be written very broadly and can apply to such things as corn mazes, hay rides and even hunting and fishing activities. Under the Maine statute, for example, inherent risks associated with being on an active farm include hazards from the natural surface and subsurface conditions of land, vegetation, and waters; the behavior of wild and domestic animals; ordinary dangers of structures and equipment used in farming and ranching; and potential injuries caused by the participant’s or others’ failure to follow instructions given or in failing to exercise reasonable caution while engaging in activities. Maine Rev. Stat. Title 7, Part 1, Chapter 8-E, Section 251, Subsection 5.
Quite often, the state laws related to agritourism relate to financial incentives via tax credits or cost-sharing, promotion, protecting the ag real property tax classification of the property involved, or liability protection. But, to get the protection of the statute the use of the land must be for agricultural purposes. That’s particularly the case when county zoning rules are implicated – as they were in a recent North Carolina case.
In Jeffries v. Harnett County, No. COA17-729, 2018 N.C. App. LEXIS 494 (N.C. Ct. App. May 15, 2018), a property owner operated a sport hunting business on the their 12-acre parcel. The business activities included shooting ranges, 3-D archery courses, clay targets and pistol pits. Initially, the defendant raised fowl on the property for controlled hunting. Over time, however, the business evolved into a multi-function facility.
Adjacent landowners wrote to the county to inquire if the defendant was exempt from zoning as an “agritourism” business. The county zoning board responded that the ranges and controlled hunting were agritourism and, as such, were exempt from county zoning. The neighbors appealed to the County Board of Adjustment which upheld the zoning authority’s decision. Over the next several years, litigation ensued involving the issue of which activities on the land constituted agritourism that were exempt from county zoning. Ultimately, the matter came before the appellate court which determined that the various activities on the farm did not constitute “agriculture” and, therefore, were subject to county zoning. Being “agriculture” was a precondition to being an agritourism activity.
Specifically, the appellate court determined that the hunting-associated activities were not agritourism and were, therefore, not exempt from county zoning. The mere fact that the activities occurred on agricultural land was not enough for the appellate court to conclude that the hunting business qualified as agritourism. The governing statute (N.C. Gen. Stat. § 153A-340(b)(2a)), set forth the definition of agritourism, mentioning “rural activities” but it did not list hunting per se. The appellate court turned to other precedents to determine if rural activities included hunting.
Prior case law held that domestically raised animals for controlled hunting qualified as a rural activity, but that is as far as they went. The cases did not extend that rationale to other types of shooting sports. The appellate court determined that activities that are based in agriculture and the natural use of the land qualify as agritourism. Because shooting ranges did not produce anything “natural” from the land, they didn’t count. Furthermore, the part of the statute explaining the inherent risk of agritourism provided only “farming and ranching” but did not include hunting in the list of dangers. The appellate court believed it was critical that the legislature left out any mention of hunting activities in the statute. Thus, shooting ranges and other hunting sports that do not include the harvesting of animals, did not fit squarely within the statute as a rural activity or a natural activity even if operated on farm ground. That meant that county zoning applied – it wasn’t an agricultural activity and, therefore, was not agritourism.
Agritourism statutes are important to farmers, ranchers and rural landowners. They do provide liability protection to activities on farm and ranch land that can generate additional income sources to farming and ranching operations. However, the particulars of the state statue must be closely followed. Failure to conform to the statutory requirements can result in liability exposure and having the activity subjected to county zoning because it is not “agriculture.”
Tuesday, May 29, 2018
Economic times continue to be difficult in much of agriculture. Many crop prices have declined from their peak a few years ago. The same is true for much of livestock agriculture. What’s more, great yields rarely if ever make up for low prices. As a result, farm bankruptcy filings are occurring at an increased rate, particularly in areas that have both crops and dairy operations.
An important issue that can come up in a farm bankruptcy is known as the “preferential payment rule.” It can be a surprise not only to farmers in financial distress, but also to creditors who receive payment or buy agricultural goods shortly before the debtor files bankruptcy. It’s an issue that can arise in the normal course of doing business before bankruptcy is filed when nothing “unusual” appears to be happening.
Today’s post takes a look at this unique bankruptcy provision – the preferential payment rule.
11 U.S.C. §547 provides in general that when a debtor makes a payment to a creditor and the debtor files bankruptcy within 90 days of making the payment, the bankruptcy trustee can “avoid” the payment by making the creditor pay the amount received to the bankruptcy estate where it will be distributed to the general creditors of the debtor. The timeframe expands from 90 days to one year is the creditor is an “insider.” The rule can come as a shock to a creditor that has received payment, paid their own creditors from the funds received from the debtor, and now has no funds to pay the bankruptcy estate to satisfy the bankruptcy trustee’s avoidance claim.
The preferential payment rule does come with some exceptions. The exceptions basically comport with usual business operations. In other words, if the transaction between the debtor and the creditor occurred in the normal course of the parties doing business with each other, then the trustee’s “avoidance” claim will likely fail. So, if the payment was made as part of a contemporaneous exchange for new value given, the trustee’s avoidance claim will be rejected. Also, if the payment was made in the “ordinary course of business” between the debtor and the creditor where invoices are paid in the time period required on the invoice, or payment is made in accordance with industry custom or past dealings, the trustee’s claim will likely fail. Likewise, if the transfer creates a security interest in property that the debtor acquires that secures new value given in accordance with a security agreement, the trustee’s claim will also likely not be granted.
A recent court decision from Arkansas illustrates how the preferential payment rule can apply in an agricultural setting. In Rice v. Prairie Gold Farms, No. 2:17CV126 JLH, 2018 U.S. Dist. LEXIS 51678 (E.D. Ark. Mar. 28, 2018), the debtor was a partnership engaged in wheat farming activities. The debtor entered into two contracts for the sale of wheat with a grain broker. The contracts called for a total of 10,000 bushels of wheat to be delivered to the broker anytime between June 1, 2014 and July 31, 2014. In return, the debtor was to be paid $6.78/bushel for 5,000 bushels and $7.09/bushel for the other 5,000 bushels for a total price of $69,350. The debtor delivered the wheat in fulfillment of the contracts on July 21, 2014 and August 4, 2014 and received $71,957.10 later in August, in return for a total delivery of 10,813.07 bushels.
The debtor subsequently filed Chapter 11 bankruptcy on October 23, 2014 (which was later converted to Chapter 7). The Chapter 7 trustee sought to avoid the transfer of the debtor’s wheat crop as a preferential transfer under 11 U.S.C. §547(b) and return the wheat crop to the bankruptcy estate for distribution to creditors. The trial court disagreed with the trustee, noting that 11 U.S.C. §547(c)(1) disallowed avoidance of a transfer if it is made in a contemporaneous exchange for new value that the debtor received. The trustee claimed that the transfer of wheat was not contemporaneous because the contract was entered into in May and the wheat was not delivered and payment made until over two months later.
The trial court determined that the transfer was for new value and payment occurred in a substantially contemporaneous manner corresponding to the delivery of the wheat. Thus, the exception of 11 U.S.C. §547(c)(1) applied. The court also noted that the wheat sale contracts were entered into in the ordinary course of the debtor’s business and, thus, also met the exception of 11 U.S.C. §547(c)(2). The debtor and the grain broker had a business history of similar transactions, and the court noted that the trustee failed to establish that the wheat contracts were inconsistent with the parties’ history of business dealings.
The preferential payment rule is important to know about, especially in the context of agricultural bankruptcies. The matter can get complicated in agricultural settings with the use of deferred payment contracts, forward grain contracts and the various types of unique business relationships that farmers often find themselves in. In the Arkansas case, the court noted that the parties had prior dealings that they conducted in the same manner and that nothing was out of the ordinary. There wasn’t any attempt to defraud creditors or shield assets from the reach of creditors. That’s really the point behind the rule. Continue conducting business as usual and the rule won’t likely come into play.
Friday, May 25, 2018
The Tax Cuts and Jobs Act (TCJA) made significant changes to individual income taxes, the tax on C corporations, and also created a new deduction for pass-through entities. The TCJA also modified some of the rules applicable to I.R.C. 529 College Savings Plans (“Section 529 Plans”). In light of the changes applicable to Section 529 plans, it’s worth examining those changes and how they might impact planning.
That’s the focus of today’s post – the TCJA changes to Section 529 plans.
Origination. Section 529 plans originated at the state level, particularly the pre-paid tuition program of the State of Michigan. The idea was to provide a vehicle to help minimize the cost of college tuition be creating a fund to which Michigan residents could pay a fixed amount in exchange for a promise that the fund would pay a designated beneficiary’s college tuition at a Michigan public college or university. The trust invested the contributed amounts to pay tuition costs of beneficiaries in the future. Basically, this allowed the prepayment of college education at a fixed rate un-impacted by tuition increases in future years. The concept was aided by the IRS when the IRS determined that purchasers of the "prepaid tuition contract" were not taxed on the contract value accruing value until the year(s) in which funds were either distributed or refunded. 1996 federal legislation authorized qualified state tuition programs.
Types. A Section 529 plan can be one of two types – a prepaid tuition plan or a college savings plan. All states have at least one type of plan. Under a prepaid tuition plan, the account holder buys units (credits) at a participating “eligible educational institution” for future tuition and fees at current prices for the beneficiary of the account. With a “college savings plan,” a person opens an investment account to save for the beneficiary’s future tuition fees as well as room and board.
There can be numerous tax benefits at the state level that apply to contributions to a Section 529 plan. These can include the ability to deduct contributions from state income tax or the availability of matching grants. If funds in an account are withdrawn to pay qualified education expenses, then the account earnings are not subject to federal (and often) state income tax. If the withdrawals aren’t used to pay qualified educational expenses, a penalty applies. In that situation, each withdrawal is treated as containing a pro-rata portion of earnings and principal. The earnings portion of a non-qualified withdrawal is taxed at ordinary income rates and is also subjected to a 10 percent additional tax absent an exception.
Distributions from a Section 529 plan for an eligible student that are used for qualifying higher education expenses at an eligible institution are not include in income. An “eligible student” is one that is enrolled in a program leading to recognized educational credentials; enrolled at least one-half time; and without any federal or state felony drug conviction.
Eligible Educational Institution
An “eligible educational institution” includes colleges, universities, vocational schools, or other postsecondary schools eligible to participate in a student aid program of the Department of Education. Under the TCJA, an “eligible educational institution” is expanded to include public, private or religious elementary schools and secondary schools. As originally proposed, homeschool expenses would have also qualified for Section 529 plans but were struck by the parliamentarian in the Senate as a violation of the “Byrd Rule.”
Section 529 plans can be used to fund up to $10,000 of tuition cost per year per beneficiary that is required for attendance at an eligible educational institution. In other words, under the TCJA Section 529 plan funds can be used to pay tuition expenses of up to $10,000 per student annually from all of a taxpayer’s Section 529 accounts for tuition of a beneficiary that is incurred for enrollment or attendance at a public, private or religious elementary or secondary level.
Definition. “Qualified Expenses” include reasonable costs for room and board. That is generally limited to the lesser of room and board costs of attendance as published by the educational institution or actual expenses. However, if the student beneficiary is living on campus, actual costs can be used even if in excess of published room and board costs. Likewise, Section 529 plan funds can be used to cover fees, books, supplies and equipment but only if they are required for enrollment or attendance at an eligible educational institution.
“Qualified higher education expenses” included tuition, fees, books, supplies, and required equipment, as well as reasonable room and board if the student was enrolled at least half-time. Eligible schools included colleges, universities, vocational schools, or other postsecondary schools eligible to participate in a student aid program of the Department of Education. This includes nearly all accredited public, nonprofit, and proprietary (for-profit) postsecondary institutions.
The TCJA retools the definition of what constitutes “qualified expenses” for purposes of distributions from a Section 529 plan. For distributions after Dec. 31, 2017, “qualified higher education expenses” is broadened to include (as noted above) tuition at an elementary or secondary public, private, or religious school, up to a $10,000 limit per tax year. I.R.C. §529(c)(7).
As for computer-related technology, qualified costs include the computer and any necessary peripheral equipment. Also included is computer software, internet access and related services. However, expenses associated with computer technology can only be covered by Section 529 funds if the technology is used by a plan beneficiary during the years that they are enrolled in an eligible educational institution. Importantly, computer technology expenses do not include software designed for sports, games, and hobbies unless the software is predominantly educational in nature.
Reduction. Qualifying expenses must be reduced for tax-free scholarships that the beneficiary receives as well as other educational assistance. They must also be reduced for the amount of qualifying expenses that are used to obtain education credit.
Special Needs Beneficiary and ABLE Accounts.
Section 529 plan funds can also be used to provide for expenses associated with a special needs beneficiary. These include special needs services incurred in connection with the enrollment or attendance at an eligible educational institution.
For distributions after December 22, 2017, the TCJA allows amounts from a Section 529 plan to be rolled over to an ABLE account without penalty if the ABLE account owner is either the designated beneficiary of the Section 529 plan account or a member of the designated beneficiary’s family. I.R.C. §529(c)(3). Created by legislation in 2014, ABLE accounts are tax-advantaged savings accounts for individuals with disabilities and their families. The account beneficiary is the account owner, and account earns income tax-free. Contributions to the account (which can be made by any person) must be made using post-tax dollars. As such, account contributions are not tax deductible at the federal level. It is possible, however, that some states may allow deductible contributions on the state return.
Any amount that is rolled-over from a Section 529 plan account to an ABLE account is counted towards the overall limitation on amounts that can be contributed to an ABLE account within a tax year ($15,000 for 2018), and any amount rolled over in excess of this limitation is includible in the distributee’s gross income.
Some expenses cannot be paid with funds from a Section 529 plan. Non-qualifying expenses include books, supplies, or equipment that is not required for enrollment or classes. Also not qualifying are transportation expenses to and from school. This includes car travel expenses, airline tickets and parking, etc.). Health insurance covering the beneficiary also is not a qualifying expenses, nor is any expense for athletic events or activities not required for coursework. Fraternity or sorority dues are likewise not qualified expenses, nor are the costs of cell phones or student loan repayment amounts.
Section 529 plans have been around for some time now. However, the amendments made by the TCJA make them a more powerful tool to fund the education of a beneficiary on a tax-favored basis.
Wednesday, May 23, 2018
The Tax Cuts and Jobs Act (TCJA) that was signed into law on December 22, 2017, represents a major change to many provisions of the tax Code that impact individuals and business entities. I have discussed of the major changes impacting farm and ranch taxpayers and businesses in prior posts. But, the TCJA also makes substantial changes with respect to the income taxation of trusts and estates. Those changes could have an impact on the use of trusts as an estate planning/wealth transfer device. Likewise, the TCJA changes that impact decedent’s estate must also be noted.
The TCJA’s changes that impact trusts and estates – that’s the focus of today’s post.
While the media has largely focused on the TCJA’s rate reductions for individuals and C corporations, the rates and bracket amounts were also modified for trusts and estates. The new rate structure for trusts and estates are located in I.R.C. §1(j)(2)(E) and are as follows: 10%: $0: $2,550; 24%: $2,551-$9,150; 35%: $9,151-$12,500; 37% - over $12,500. As can be noted, the bracket structure for trusts and estates remains very compressed. Thus, the pre-TCJA planning approach of not trapping income or gains inside a trust or an estate remains the standard advice. That’s because the TCJA did not change the tax rates for qualified dividends and long-term capital gains, although the bracket cut-offs are modified slightly as follows: 0%: $0-$2,600; 15%: $2,601-$12,700; 20%: Over $12,700. Those rates and brackets remain advantageous compared to having the income or gain taxed at the trust or estate level.
Other Aspects of Trust/Estate Taxation
Post-TCJA, it remains true that an estate or trust’s taxable income is computed in the same manner as is income for an individual. I.R.C. §641(b). However, the TCJA amends I.R.C. §164(b) to limit the aggregate deduction for state and local real property taxes and income taxes to a $10,000 maximum annually. But, this limit does not apply to any real estate taxes or personal property taxes that a trust or an estate incurs in the conduct of a trade or business (or an activity that is defined under I.R.C. §212). Thus, an active farm business conducted by a trust or an estate will not be subject to the limitation.
The TCJA also suspends miscellaneous itemized deductions for a trust or an estate. That means, for example, that investment fees and expenses as well as unreimbursed business expenses are not deductible. This will generally cause an increased tax liability at the trust or estate level as compared to prior law. Why? With fewer deductions, the adjusted taxable income (ATI) of a trust or an estate will be higher. For simple trusts, this is also a function of distributable net income (DNI) which, in turn, is a function of the income distribution deduction (IDD). I.R.C. §651(b) allows a simple trust to claim an IDD limited to the lesser of fiduciary accounting income (FAI) or DNI. Under prior law, all trust expenses could be claimed when determining DNI, but only some of those expenses were allocated to principal for purposes of calculating FAI. Now, post-TCJA, ATI for a trust or an estate will be higher due to the loss of various miscellaneous itemized deductions (such as investment management fees). As ATI rises, DNI will decline but FAI won’t change (the allocation of expenses is determined by the trust language or state law). The more common result is likely to be that FAI will be the actual limitation on the IDD, and more income will be trapped inside the estate or the trust. That’s what will cause the trust or the estate to pay more tax post-TCJA compared to prior years.
But, guidance is needed concerning the deductibility of administrative expenses such as trustee fees. It’s not clear whether the TCJA impacts I.R.C. §67. That Code section does not apply the two percent limitation to administrative expenses that are incurred solely because the property is held inside a trust or an estate. There is some support for continuing to deduct these amounts. I.R.C. §67(g) applies to miscellaneous itemized deductions, but trustee fees and similar expenses are above-the-line deductions for a trust or an estate that impact the trust or estate’s AGI. Thus, I.R.C. §67 may not apply. I am told that guidance will be forthcoming on that issue during the summer of 2018. We shall see.
A trust as well as an estate can still claim a $600 personal exemption (with the amount unchanged) under I.R.C. §642. Don’t confuse that with the TCJA’s suspension of the personal exemption for individuals. Also, don’t confuse the removal of the alternative minimum tax (AMT) for corporations or the increased exemption and phaseout range for individuals with the application of the AMT to trusts and estates. No change was made concerning how the AMT applies to a trust or an estate. See I.R.C. §55.(d)(3). The exemption stays at $24,600 with a phaseout threshold of $82,050. Those amounts apply for 2018 and they will be subsequently adjusted for inflation (in accordance with the “chained” CPI).
Other TCJA Impacts on Trusts and Estates
The new 20 percent deduction for pass-through entities under I.R.C. §199A can be claimed by an estate or a trust with non-C corporate business income. The deduction is claimed at the trust or the estate level, with the $157,500 threshold that applies to a taxpayer filing as a single person applying to a trust or an estate. The rules under the now-repealed I.R.C. §199 apply for apportioning between fiduciaries and beneficiaries any W-2 wages and unadjusted basis of qualified property under the limitation based on W-2 wages and capital. There is no separate computation required for alternative minimum tax purposes.
The eligibility of a trust or an estate for the I.R.C. §199A deduction may provide some planning opportunities to route pass-through income from a business that is otherwise limited or barred from claiming the deduction through a non-grantor trust so that the deduction can be claimed or claimed to a greater extent. For example, assume that a sole proprietorship farming operation nets $1,000,000 annually, but pays no qualified wages and has no qualifying property (both factors that result in an elimination of the deduction for the business). If business income is routed through a trust (or multiple truss) with the amount of trust income not exceeding the $157,500 threshold, then an I.R.C. §199A deduction can be generated. However, before this strategy is utilized, there are numerous factors to consider including overall family estate planning/succession planning goals and the economics of the business activity at issue.
Clarification is needed with respect to a charitable remainder trust (CRT) that has unrelated business taxable income (UBIT). UBIT is income of the CRT that comes from an unrelated trade or business less deductions “allowed by Chapter 1 of the Code” that are “directly connected” with the conduct of a trade or business. Treas. Reg. §1.512(a)-1(a). Is the new I.R.C. §199A deduction a directly connected deduction? It would seem to me that it is because it is tied to business activity conducted by the trust. If that construction is correct, I.R.C. §199A would reduce the impact of the UBIT on a CRT. Certainly, guidance is needed from the Treasury on this point.
Related to the CRT issue, the TCJA would appear to allow an electing small business trust (ESBT) to claim the I.R.C. §199A deduction on S corporate income. But, again, guidance is needed. An ESBT calculates the tax on S corporate income separately from all other trust income via a separate schedule. The result is then added to the total tax calculated for the trust’s non-S corporate income. Thus, the ESBT pays tax on all S corporate income. It makes no difference whether the income has been distributed to the ESBT beneficiaries. Also, in computing its tax, the deductions that an ESBT can claim are set forth in I.R.C. §641(c)(2). However, the TCJA does not include the I.R.C. §199A deduction in that list. Was that intentional? Was that an oversight? Your guess is as good as mine.
Another limiting factor for an ESBT is that an ESBT can no longer (post-2017 and on a permanent basis) deduct 100 percent of charitable contributions made from the S corporation’s gross income. Instead, the same limitations that apply to individuals apply to an ESBT – at least as to the “S portion” of the ESBT. But, the charitable contribution need not be made from the gross income of the ESBT. In addition, the charitable contribution must be made by the S corporation for the ESBT to claim the deduction. If the ESBT makes the contribution, it is reported on the non-ESBT portion of the return. It is not allocated to the ESBT portion.
Under the TCJA, an ESBT can have a nonresident alien as a potential current beneficiary.
If a trust or an estate incurs a business-related loss, the TCJA caps the loss at $250,000 for 2018 (inflation-adjust for future years). The $250,000 amount is in the aggregate – it applies at the trust or estate level rather than the entity level (if the trust or estate is a partner of a partnership or an S corporation shareholder). I.R.C. §461(l)(2). Amounts over the threshold can be carried over and used in a future year.
The TCJA impacts a broad array of taxpayers. Its impacts are not limited to individuals and corporate taxpayers. Trusts and estates are also affected. For those with trusts or involved with an estate, make sure to consult tax counsel to make sure the changes are being dealt with appropriately.
Monday, May 21, 2018
In Part One last Thursday, I examined the basics of valuation discounting in the context of a family limited partnership (FLP). In Part Two today, I dig deeper on the I.R.C. §2036 issue, recent cases that have involved IRS challenges to valuation discounts under that Code section, and possible techniques for avoiding IRS challenges.
I.R.C. §2036 – The Basics
Historically, the most litigated issues involving valuation discounts surround I.R.C. §2036. Section 2036(a) specifies as follows:
(a) General rule. The value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money’s worth), by trust or otherwise, under which he has retained for his life or for any period not ascertainable without reference to his death or for any period which does not in fact end before his death—
(1) the possession or enjoyment of, or the right to the income from, the property, or
(2) the right, either alone or in conjunction with any person, to designate the persons who shall
possess or enjoy the property or the income therefrom.
(b) Voting rights
(1) In general. For purposes of subsection (a)(1), the retention of the right to vote (directly or indirectly) shares of stock of a controlled shall be considered to be a retention of the enjoyment of transferred property.
Retained interest. As you can imagine, a big issue under I.R.C. §2036 is whether assets that are contributed to an FLP (or an LLC) are pulled back into the transferor’s estate at death without any discount without the application of any discount on account of the restrictions that apply to the decedent’s FLP interest. The basic argument of the IRS is that the assets should be included in the decedent’s estate due to an implied agreement of retained enjoyment, even where the decedent had transferred the assets before death. See, e.g., Estate of Harper v. Comr., T.C. Memo. 2002-121; Estate of Korby v. Comr., 471 F.3d 848 (8th Cir. 2006).
In the statutory language laid out above, the parenthetical language of subsection (a) is important. That’s the language that estate planners use to circumvent the application of I.R.C. §2036. The drafting of the FLP agreement and the associated planning and implementation of the entity should ensure that there are legitimate and significant non-tax reasons for the use of the FLP/LLC. That doesn’t mean that a tax reason creating the entity cannot be present, but there must be a major non-tax reason present also.
If the IRS denies a valuation discount in the context of an FLP/LLC and the taxpayer cannot rely on the parenthetical language, the focus then becomes whether there existed an implied agreement of retained enjoyment in the transferred assets. There aren’t many cases that taxpayer’s win where the taxpayer’s argument is outside of the parenthetical exception and is based on the lack of retained enjoyment in the transferred assets, but there are some. See, e.g., Estate of Mirowski v. Comr., T.C. Memo. 2008-74; Estate of Kelley v. Comr., T.C. Memo. 2005-235.
Designating possession or enjoyment. What about the retained right to designate the persons who will possess or enjoy the transferred property or its income? In other words, what about the potential problem of subsection (a)(2)? A basic issue with the application of this subsection is whether the taxpayer can be a general partner of the FLP (or manager of an LLC). There is some caselaw on this question, but those cases involve unique facts. In both cases, the court determined that I.R.C. §2036(a)(2) applied to cause inclusion of the transferred property in the decedent’s gross estate. See, e.g., Estate of Strangi v. Comr., T.C. Memo. 2003-145, aff’d., 417 F.3d 468 (5th Cir. 2005); Estate of Turner v. Comr., T.C. Memo. 2011-209. In an earlier case in 1982, the Tax Court determined that co-trustee status does not trigger inclusion under (a)(2) if there are clearly identifiable limits on distributions. Estate of Cohen v. Comr., 79 T.C. 1015 (1982). That Tax Court opinion has generally led to the conclusion that (a)(2) also does not apply to investment powers.
While the Strangi litigation indicates that (a)(2) can apply if the decedent is a co-general partner or co-manager, the IRS appears to focus almost solely on situations where the decedent was a sole general partner or manager. The presence of a co-partner or co-manager is similar to a co-trustee situation and also can help build the argument that the entity was created with a significant non-tax reason.
Succession planning. From a succession planning perspective, it may be best for one parent to be the transferor of the limited partnership interests and the other to be the general partner. For example, both parents could make contributions to the partnership in the necessary amounts so that one parent receives a 1 percent general partnership interest and the other parent receives the 99 percent limited partnership interest. The parent holding the limited partnership interest then could make gifts of the limited partnership interests to the children (or their trusts). The other parent is able to retain control of the “family assets” while the parent holding the limited partnership interest is the transferor of the interests. Unlike IRC §672(e), which treats the grantor as holding the powers of the grantor’s spouse, IRC §2036 does not have a similar provision. Thus, if one spouse is able to retain control of the partnership and the other spouse is the transferor of the limited partnership interests, then IRC §2036 should not be applicable.
I.R.C. §2703 and Indirect Gifts
The IRS may also take an audit position against an FLP/LLC that certain built-in restrictions in partnership agreements should be ignored for tax purposes. This argument invokes I.R.C. §2703. That Code section reads as follows:
(a) General rule. For purposes of this subtitle, the value of any property shall be determined without regard to—
(1) any option, agreement, or other right to acquire or use the property at a price less than the fair market value of the property (without regard to such option, agreement, or right), or
(2) any restriction on the right to sell or use such property.
(b) Exceptions. Subsection (a) shall not apply to any option, agreement, right, or restriction which meets each of the following requirements:
(1) It is a bona fide business arrangement.
(2) It is not a device to transfer such property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth.
(3) Its terms are comparable to similar arrangements entered into by persons in an arms’ length transaction.
In both Holman v. Comr., 601 F.3d 763 (8th Cir. 2010) and Fisher v. United States, 1:08-cv-0908-LJM-TAB, 2010 U.S. Dist. LEXIS 91423 (S.D. Ind. Sept. 1, 2010), the IRS claimed that restrictions in a partnership agreement should be ignored in accordance with I.R.C. §2703. In Holman, the restrictions were not a bona fide business arrangement and were disregarded in valuing the gifts at issue. In Fisher, transfer restrictions were likewise ignored.
Several valuation discounting cases have been decided recently that provide further instruction on the pitfalls to avoid in creating an FLP/LLC to derive valuation discounts. Conversely, the cases also provide further detail on the proper roadmap to follow when trying to create valuation discounts via entities.
• Estate of Purdue v. Comr., T.C. Memo. 2015-249. In this case, the decedent and her husband transferred marketable securities, an interest in a building and other assets to an LLC. The decedent also made gifts annually to a Crummey-type trust from 2002 until death in 2007. Post-death, the beneficiaries made a loan to the decedent’s estate to pay the estate taxes. The estate deducted the interest payments as an administration expense. The court concluded that I.R.C. §2036 did not apply because the transfers to the LLC were bona fide and for full consideration. There was also a significant, non-tax reason present for forming the LLC and there was no commingling of the decedent’s personal assets with those of the LLC. In addition, both the decedent and her husband were in good health at that time the LLC was formed and the assets were transferred to it.
• Estate of Holliday v. Comr., T.C. Memo. 2016-51. The decedent’s predeceased husband established trusts and a family limited partnership (FLP). The FLP agreement stated that, “To the extent that the General Partner determines that the Partnership has sufficient funds in excess of its current operating needs to make distributions to the Partners, periodic distributions of Distributable Cash shall be made to the partners on a regular basis according to their respective Partnership Interests.” The decedent, who was living in a nursing home at the time the FLP was formed, contributed approximately $6 million of marketable securities to the FLP and held a 99.9 percent limited partner interest. Before death, the decedent received one check from the FLP (a pro-rata distribution of $35,000). At trial, the General Partner testified that he believed that the FLP language was merely boilerplate and that distributions weren’t made because “no one needed a distribution.” The court viewed the FLP language and the General Partner’s testimony as indicating that the decedent retained an implied right to the possession or enjoyment of the right to income from the property she had transferred to the FLP. The decedent also retained a large amount of valuable assets personally, thus defeating the General Partners’ arguments that distributions were not made to prevent theft and caregiver abuse. The court also noted that the FLP was not necessary for the stated purposes to protect the surviving spouse from others and for centralized management because trusts would have accomplished the same result. The decedent was also not involved in the decision whether to form an FLP or some other structure, indicating that she didn’t really express any desire to insure family assets remained in the family. The court also noted that there was no meaningful bargaining involved in establishing the FLP, with the family simply acquiescing to what the attorney suggested. The FLP also ignored the FLP agreement – no books and records were maintained, and no formal meetings were maintained.
Accordingly, the court determined that there was no non-tax purpose for the formation of the FLP, there was no bona fide sale of assets to the FLP and the decedent had retained an implied right to income from the FLP assets for life under I.R.C. §2036(c) causing inclusion of the FLP assets in the decedent’s estate.
• Estate of Beyer v. Comr., T.C. Memo. 2016-183. In this case, the decedent was in his upper 90s at the time of his death. He had never married and had no children, but he did have four sisters. The decedent had been the CFA of Abbott Lab and had acquired stock options from the company, starting exercising them in 1962 and had accumulated a great deal of Abbott stock. He formed a trust in 1999 and put 800,000 shares of Abbott stock into the trust. He amended the trust in 2001 and again in 2002. Ultimately, the decedent created another trust, and irrevocable trust, and it eventually ended up owning a limited partnership. Within three years of his death, the decedent made substantial gifts to family members from his living trust. Significant gifts were also made to the partnership.
The IRS claimed that the value of the assets that the decedent transferred via the trust were includable in the value of his gross estate under I.R.C. §2036(a). The estate claimed that the transfers to the partnership were designed to keep the Abbott stock in a block and keep his investment portfolio intact, and wanted to transition a family member into managing his assets. The IRS claimed that the sole purpose of the transfers to the partnership were to generate transfer tax savings. The partnership agreement contained a list of the purposes the decedent wanted to accomplish by forming the partnership. None of the decedent’s stated reasons for the transfers were in the list.
The court determined that the facts did not support the decedent’s claims and the transfers were properly included in his estate. The decedent also continued to use assets that he transferred to the partnership and did not retain sufficient assets outside of the partnership to pay his anticipated financial obligations. On the valuation issue, the court disallowed valuation discounts because the partnership held assets in a restricted management account where distributions of principal were prohibited.
As the cases point out, valuation discounts can be achieved even if asset management is consolidated. Also, it is important that the decedent/transferor is not financially dependent on distributions from the FLP/LLC, retains substantial assets outside of the entity to pay living expenses, does not commingle personal and entity funds, is in good health at the time of the transfers, and the entity follows all formalities of the entity structure. For gifted interests, it is important that the donees receive income from the interests. Their rights cannot be overly restricted. See, e.g., Estate of Wimmer v. Comr., T.C. Memo. 2012-157.
Appropriate drafting and planning are critical to preserve valuation discounts. Now that the onerous valuation regulations have been removed, they are planning opportunities. But, care must be taken.