Wednesday, April 26, 2017
The range fires in Kansas, Oklahoma and Texas earlier this year have generated numerous questions. I have addressed several of those in earlier posts. Another one is on the table for discussion today and concerns associated liability issues. In particular, whether a landowner is liable for smoke damage to others and whether there is any obligation to inform people that might be affected by the smoke.
Range Fire or Controlled Burns?
It is important to distinguish between a true range fire and a controlled burn. For a range fire that starts by some external event that the landowner has no control over or involvement in, there simply is no liability to others. This is the situation for the recent range fires in the Southern Plains. It’s just one of those situations that unfortunately occurs and landowners try their best to contain it and deal with it. The outpouring of support from farmers and ranchers across the country was heartening to see.
Many areas of Kansas and elsewhere engage in controlled burns of pasture. For controlled burns, each state has rules and regulations what govern the procedures to be followed. Those rules may include a duty to notify adjoining landowners and local authorities before starting a burn. It is important to understand the rules and follow them closely to avoid fines and other penalties that could apply.
Smoke Drift As a Trespass?
For a controlled burn, can smoke drift onto another’s property constitute a trespass and make the person conducting the burn liable for any resulting damages? Trespass is the unlawful or unauthorized entry upon another person's land that interferes with that person's exclusive possession or ownership of the land. The tort of trespass is conceptually related to the tort of nuisance, but a nuisance is an invasion of an individual's interest in use and enjoyment of land rather than an interference with the exclusive possession or ownership of the land. The law governing trespass to land is particularly important to farmers and ranchers because real estate plays a significant role in the economic life of the typical farmer or rancher.
A trespass consists of two basic elements: (1) intent and (2) force. Most jurisdictions do not impose absolute liability for trespass. Instead, proof of intentional invasion, reckless or negligent conduct, or inherently or abnormally dangerous activity is required. In these jurisdictions, proof of intent to commit a trespass is not necessary. Rather, the plaintiff must show that the trespasser either intended the act that resulted in the unlawful invasion or acted so negligently or in such a dangerous manner that willfulness can be assumed as a matter of law. A minority of jurisdictions still follow the common law approach holding an individual liable for any interference with the possession of land, even if that interference was completely unintentional. In these jurisdictions, it is immaterial whether the act was done accidently, in good faith, or by mistake.
Trespass also involves an element of force. Liability for trespass may result from any willful act, whether the intrusion is the immediate or inevitable consequence of a willful act or of an act that amounts to willfulness.
At its most basic level, a trespass is the intrusion on to another person's land without the owner's consent. However, many other types of physical invasions that cause injury to an owner's possessory rights abound in agriculture. These types of trespass include dynamite blasting, flooding with water or residue from oil and gas drilling operations, erection of an encroaching fence, unauthorized grazing of cattle, or raising of crops and cutting timber on another's land without authorization, among other things. In general, the privilege of an owner or possessor of land to utilize the land and exploit its potential natural resources is only a qualified privilege. The owner or possessor must exercise reasonable care in conducting operations on the land so as to avoid injury to the possessory rights of neighboring landowners. That can include controlled burn activities and the resulting smoke drift. For example, in Ream v. Keen, 112 Or. App. 197, 828 P.2d 1038 (1992), smoke from field burning drifted to an adjoining home and the neighbor sued for soot removal costs and emotional and physical damages. The trespass claim was submitted to a jury and the appellate court ultimately determined that the elements of an intentional trespass had been established and sent the case back to the trial court for a determination of damages.
As in any trespass case, the outcome turns on the facts of each case. Each case is different.
Is A Controlled Burn an Unnatural Land Use?
“Unnatural” land uses are typically governed by a rule of strict liability. That means that intent doesn’t matter. If damage occurs to others, there is liability. The strict liability approach for “non-natural” land use activities was applied in an 1868 English case. Rylands v. Fletcher. L.R. 3 H.L. 330 (1868). In Rylands, the defendants hired an independent contractor to construct a reservoir on their property. When the reservoir was filled up, water broke from it and flowed into abandoned mine shafts on the property, and then flooded adjacent mine shafts owned by the plaintiffs. The defendants themselves were not aware of the abandoned shafts, and were therefore not negligent (although the contractor probably was). After the lowest court denied liability, the case came before the Exchequer Chamber, in effect an intermediate appeals court. The court reversed, holding that there was liability because “...the person who for his own purposes brings on his lands and collects and keeps there anything likely to do mischief if it escapes, must keep it in at his peril, and if he does not do so, is prima facie answerable for all the damage which is the natural occurrence of its escape.” The case then went to the House of Lords, the final appellate tribunal. The holding of the Exchequer Chamber was affirmed, but was significantly limited. Liability existed because, the court said, the defendants put their land to a “non-natural use for the purpose of introducing [onto it] that which in its natural condition was not in or upon it”, i.e., a large quantity of water. If, on the other hand, the court said, the water had entered during a “natural use” of the land, and had then flowed off onto the plaintiff's land, there would have been no liability.
Initially, American courts frequently misconstrued the Ryland's decision and purported to reject it. They focused on the Exchequer Chamber version, which would have imposed liability for escaping forces even where the land is put to a natural use. Eventually, however, the vast majority of American courts accepted at least the practical result of Rylands, even if not the case by name.
Today, the rule has been extended to include most activities that are extremely dangerous. However, in Koger v. Ferrin, 926 P.2d 680 (Kan. Ct. Ap. 1996), the court refused to apply a strict liability rule in a situation involving the spread of a fire that was not intentionally started. In an important passage, the court stated the following:
“In Kansas, farmers and ranchers have a right to set controlled fires on their property for agricultural purposes and will not be liable for damages resulting if the fire is set and managed with ordinary care and prudence, depending on the conditions present [citation omitted]. There is no compelling argument for imposing strict liability on a property owner for failing to prevent the spread of a fire that did not originate with that owner or operator. Because the essential facts of this case are undisputed, as a matter of law, the doctrine of strict liability is not applicable under the facts presented.”
Liability for smoke damage from fires depends on the facts and circumstances surrounding the fire. For controlled burns, carefully following any applicable rules and regulations will go a long way to eliminating liability for any resulting damages. Range fires typically don’t lead to personal liability issues.
Monday, April 24, 2017
Farmers and ranchers buy and sell commodity futures and options to hedge against fluctuating prices. They also buy and sell commodity futures and options to speculate with fluctuating prices. They also enter into cash forward grain contracts and hedge-to-arrive contracts. The tax issues associated with commodity trading are important to understand, and are the focus of today’s post.
Hedging or Speculation
A hedging transaction is defined as a transaction that a taxpayer enters into in the normal course of the taxpayer’s trade or business, primarily to reduce (as opposed to simply managing) the risk of price changes or currency fluctuations with respect to ordinary property, or to reduce the risk of interest rate or price changes or currency fluctuations with respect to borrowing or ordinary obligations. I.R.C. §1221; Treas. Reg. §1.1221-2(b). To receive tax treatment as a hedge, the transaction must be identified by the taxpayer as a hedging transaction before the close of the day the hedge is entered into. I.R.C. §1221(a)(7); Treas. Reg. §1.1221-2(f)(1). The item being hedged must be identified no more than 35 days after the hedging transaction. Treas. Reg. §1.1221-2(f)(2)(ii). If the transaction is not timely identified as a hedge, the straddle rules and mark-to-market rules may apply. I.R.C. §§1092; 263(g); I.R.C. §1256.
A taxpayer uses a hedge to lock in a position in a particular commodity. Once locked in, if the physical commodity increases in value, the taxpayer’s value of the futures position should go down – one should offset the other with the net result that the hedge maintains the taxpayer’s position.
Speculation involves a commodity transaction entered into other than in the context of the taxpayer’s trade or business. Speculation can be illustrated by the farmer who harvests corn, sells the corn, and buys futures in the marketplace in anticipation of prices rising and believing this strategy is better than storing the commodity. This is speculation and is subject to the mark-to-market rules of I.R.C. §1256. The mark-to-market rules require taxpayers to report on Form 6781 gains and losses from regulated futures contracts and other “Section 1256 contracts” on an annual basis under the mark-to-market rule. These rules close out speculative transactions as of December 31. They are marked to market by treating each contract held by the taxpayer as if it were sold for fair market value on the last business day of the tax year, thereby requiring profit or loss to be reported on the taxpayer’s income tax return. The net gain or loss is allocated 40 percent to short-term capital gain (or loss) and 60 percent to long-term capital gain (or loss).
Tax difference. Gain and loss from transactions that are hedges generate ordinary income and loss and are not subject to the loss deferral rules and the “mark-to-market” rules that apply to speculative transactions. I.R.C. §1221 and Treas. Reg. §1.1221-2. Because a hedge is entered into in the normal course of the taxpayer’s business (such as to lock-in a position in a particular commodity), any resulting gain is subject to self-employment tax.
However, if the transaction involves speculation, resulting gains and losses are treated as capital gains and losses. Capital gains can offset capital losses, but capital losses deductible
against ordinary income are capped at $3,000 per year. In addition, corporations are not eligible for the $3,000 deduction against ordinary income. Also, speculative transactions are subject to the loss deferral and “mark-to-market” rules. Speculative transactions do not trigger self-employment tax.
Farmers and ranchers will often buy options. When a put option is purchased by the producer of a commodity, the producer acquires the right to sell the commodity at a future point in time. If the sale occurs just before the crop is planted or while the crop is growing, the transaction is a hedge. If the right to sell is triggered after the crop is sold, the transaction is speculative.
A farmer or rancher may also buy a call option. A call option gives the producer the right to buy the commodity at some future point in time. Transactions involving the purchase of a call option for the purchase of a commodity by a crop producer are speculative regardless of when the option is exercised. However, a livestock farmer may enter into a call option for feed, or a crop farmer may enter into a call option for crop inputs. The question of whether a transaction is a hedge or is speculation turns on whether it was entered into in the normal course of the taxpayer’s business to reduce risk.
Any income, deduction, gain or loss from a hedging transaction is matched with the income, deduction, gain or loss on the item being hedged. Also, in some situations, the hedge timing rules apply irrespective of whether the transaction has been identified as a hedge. Rev. Rul. 2003-127, 2003-2 C.B. 1245. In essence, the tax rules for hedging transactions address both character and timing, and are designed to match the character and timing of a hedging transaction with the character and timing of the item being hedged. The timing Farmers participating in true hedging programs likely have multiple transactions for a single crop and may combine option purchases and sales to minimize the cost of these programs or to create both a ceiling and a floor for prices. Properly identifying and reporting these many transactions is a challenge for the taxpayer and tax preparer and IRS Pub. 550 can be helpful.
Just as important as the matching principle with commodity transactions is what constitutes “property.” I.R.C. §1001 governs the computation of gain or loss on the sale or exchange of property, with gain being the excess of the amount realized over the adjusted basis of the property, and the loss is the excess of the adjusted basis of the property over the amount realized. Thus, for gain or loss to be computed on a transaction, the taxpayer must know the identity and amount of property that will be delivered. That isn’t known until the contract is settled.
In Estate of McKelvey v. Comr., 148 T.C. No. 13 (2017), the decedent had entered into contracts to sell corporate stock to Bank of America and Morgan Stanley & Co., International. The contracts were structured as variable prepaid forward contracts (VPFC) that required the banks to pay a forward price (discounted to present value) to the decedent on the date the contracts were executed, rather than the date of contract maturity. Accordingly, the decedent received a cash prepayment from Bank of America of approximately $51 million on September 14, 2007. On September 27, 2017, the decedent received a cash prepayment from Morgan Stanley & Co. of slightly over $142 million. The prepayments obligated the decedent to deliver to the banks stock shares pledged as collateral at the time of contract formation, and certain other stock shares that weren’t pledged as collateral or an equal amount of cash. The actual number of shares or their cash equivalent is determined via a formula that accounts for stock market changes.
Under the contracts as originally executed in September of 2007, the decedent was to deliver to the banks every day for 10 consecutive business days in September of 2008. Each day, one-tenth of the total number of shares agreed to be transferred was to be delivered as determined by adjusting the number of shares by the ratio of an agreed floor price over the stock closing price for that particular day, or a cash equivalent to the stock. However, in July of 2008, the banks agreed to extend the settlement dates to early 2010. To get the extension, the decedent paid Morgan Stanley & Co. slightly over $8 million on July 15, 2008, for delivery over 10 consecutive days in early January of 2010, and paid Bank of America approximately $3.5 million on July 24, 2008, for delivery over 10 consecutive days in early February of 2010.
For tax purposes, the decedent treated the original transactions as “open” transactions in accordance with Rev. Rul. 2003-7, 2003-1 C.B. 363 and did not report any gain or loss for 2007 related to the contracts. In addition, the decedent did not report any gain or loss related to the contract extensions that were executed in 2008 on the basis that the extensions also involved “open” transactions. The decedent died in late 2008, and on July 15, 2009, the decedent’s estate transferred shares of stock to settle the Morgan Stanley & Co. contracts. The estate filed a Form 1040 for the decedent’s taxable year 2008, and the IRS issued a deficiency notice for over $41 million claiming that when the decedent executed the extensions in 2008, he triggered a realized capital gain of slightly over $200 million comprised of a short-term capital gain of $88 million and $112 of long-term capital gain from the constructive sale of shares pledged under the contracts. The IRS claimed that the decedent had no tax basis in the stock pledged as collateral.
The court disagreed with the IRS on the basis that the “open transaction” doctrine applied because of the impossibility of computing gain or loss with any reasonable accuracy at the time the contracts were entered into. In addition, the court rejected the argument of the IRS that the extensions of the original contracts closed the contracts which triggered gain or loss at the time the extensions were executed. The court specifically noted that, in accordance with Rev. Rul. 2003-7, VPFCs are open transactions at the time of execution and don’t trigger gain or loss until the time of delivery because the taxpayer doesn’t know the identity or amount of property to be delivered until the future settlement date arrives and delivery is made. Until delivery, the only thing that the decedent had was an obligation to deliver; this was not property that could be exchanged under I.R.C. §1001. The court also noted that the open transaction doctrine applied because the identity and adjusted basis of the property sold, disposed of or exchanged was not known until settlement occurred. The court also stated that an option is a “familiar” type of open transaction from which we can distill applicable principles.”
Many commodity transactions in which farmers engage are “open” transactions, with the producer holding merely a contractual obligation at the time of contract execution. An option, for example, is a type of “open transaction.” See, e.g., Rev. Rul. 78-182, 1978-1 C.B. 256. Forward grain contracting, hedge-to-arrive contracts, and other types of commodity transactions may also delay tax consequences until the contract requirements are fulfilled. The Tax Court’s recent decision helps confirm that point.
Thursday, April 20, 2017
Even though the federal estate and gift tax exclusion is high enough to discourage many people from gifting solely for tax purposes, I still receive numerous gift tax questions. So, gifting is not usually utilized as a strategy for minimizing potential estate tax at death. However, many people accumulate significant amounts of property, both tangible and intangible, as well as cash during life. Among the common estate planning goals of many clients is a desire to preserve that accumulated wealth during life, as well as transfer ownership interests in family businesses to other family members before death as a supplement to property transfers occurring at death.
Today’s post examines the basic rules surrounding the gifting of property during life and some common gift planning strategies.
Present Interest Annual Exclusion
The present interest annual exclusion is a key component of the federal gift tax. For gifts made in 2017, the exclusion is $14,000 per donee. That means that a donor can make cumulative gifts of up to $14,000 (in cash or an equivalent amount of property) to as many donees as desired without triggering any gift tax, and without any need to file Form 709 – the federal gift tax return. Because the exclusion “renews” each year and is not limited by the number of potential donees, but only the amount of the donor’s funds and interest in making gifts, the exclusion can be a key estate planning tool. Used wisely, the exclusion can facilitate the passage of significant value to others (typically family members) pre-death to aid in the succession of a family business or a reduction in the potential size of the donor’s taxable estate, or both.
But, to qualify for the exclusion, the gift must be a gift of a present interest – the exclusion does not apply to future interests. A present interest is an “unrestricted right to immediate use, possession, or enjoyment or property or the income from the property. Treas. Reg. §25.2502-3(b). A remainder interest, for example, would be a future interest.
There’s a special rule that comes into play for gifts made by spouses. They can elect “split gift” treatment regardless of which spouse actually owns the gifted property, if certain conditions are satisfied and the spouses consent to gift splitting treatment. They are simply treated as owning the property equally. This allows gifts of up to $28,000 per donee annually. So, as an example, let’s say that Mom and Dad have 4 children and 5 (unmarried) grandchildren. Also assume that each child has a spouse. That makes 13 persons that Mom and Dad could make annual exclusion gifts to without triggering the need to file a federal gift tax return. That would be 13 present interest annual exclusion gifts of $14,000 each for Mom and Dad - $182,000 each, annually. In addition, if those gifts are of interests in a closely held business, discounting those interests for lack of marketability and minority interest could leverage those present interest gifts and increase the total amount that can be given gift-tax free by another 30 percent or so.
There is also a special rule that allows for the direct payment of certain educational and medical expenses. Under the rule, these transfers are not even deemed to be gifts. Thus, the limitation of the present interest annual exclusion does not apply to those gifts.
“Coupled Estate and Gift Tax Systems”
The estate and gift tax systems are “unified.” The unified credit $2,141,800 (for 2017) offsets lifetime taxable gifts of $5.49 million or a taxable estate of $5.49 million. The unification or “coupling” of the estate and gift tax systems create tremendous opportunities for higher net worth individuals and families to leverage the $5.49 million exemption equivalent of the unified credit through lifetime gifting. Present interest annual exclusion gifts do not count against the lifetime $5.49 million limitation.
Valuation of Gifts
It’s also necessary to know the value of the property at the time of the gift. The donor needs this information to determine whether the gift exceeds the $14,000 annual exclusion amount and, if so, the amount to report on Form 709 that will be required to be filed. The recipient of the gift may also need this information to determine whether a deduction is available if the property is later sold at a loss. Gifts are valued for gift tax purposes at their fair market value as of the time of the gift. I.R.C. §2512. Fair market value is defined as “the price at which the property would change hands between a [hypothetical] willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.” Treas. Reg. 20.2031-1(b). As noted above, discounts from fair market value can be recognized for interests in closely-held entities that are minority interests and/or lack marketability, as well as fractional interests in real estate.
Generation-Skipping Transfer Tax (GSTT) Implications.
The GSTT is imposed on both outright gifts and transfers in trust to or for the benefit of related persons that are more than a generation younger than the donor, or unrelated persons who are more than 37.5 years younger than the donor. The GSTT is imposed only if the transfer avoids incurring a gift or estate tax at each generation level. For 2017, each individual has a $5.49 million exemption from the GSTT. With respect to split gifts made during a calendar year, each spouse is treated as the transferor for GSTT purposes of one-half of all gifts eligible for gift-splitting. Thus, each spouse can allocate their GSTT exemption to one-half of each gift that is split.
A gift of income-producing property does not trigger income in the hands of the donee to the extent the gifts are true gifts. But, income tax cannot be avoided, for example, on money or other property received in exchange for services.
The recipient of a gift of income-producing property must report any income that the property produces after the gifted property is received. For example, a gift of stock would require the recipient of the stock to report any dividends paid on the stock after the gift. Gifts of income-producing property can also be used to shift the income from the property to other family members that are in a lower tax bracket.
Sometimes a gift of income producing property is made in the form of interests in a business entity as part of an overall family estate and succession plan. If the entity owns only non-income producing property (such as vacant real estate) another potential problem arises in that the gifted property may not qualify for the present interest annual exclusion if it is determined to not be a gift of a present interest.
Income Tax Basis and Holding Period
Now, there’s a potentially major drawback to gifting. If the gift consists of property other than cash, the basis and holding period of the property in the hands of the donee is the same as it was in the hands of the donor. I.R.C. §1015. It’s important for the recipient to know when the donor acquired the property, the cost of the property, and any other information that would affect the property’s basis. Ideally, the recipient of the gift should also receive records that will provide adequate proof of these facts. So, while gifts of property during the donor’s lifetime will remove the gifted property from the donor’s estate computation, the gift also removes the ability to obtain a stepped-up basis on that property. Measuring estate tax savings against the tax implications of reduced basis step-up is an important part of the overall planning process. With the coupled estate and gift tax exclusion at $5.49 million for 2017, the basic plan for many people would be to hold the property until death to achieve a basis step-up. The tax savings for the heirs that might later sell the property will often outweigh that estate tax cost of having the property included in the estate.
The change in the rules governing the transfer tax system a few years ago has significantly changed gifting strategies. While there still remain significant income tax incentives to gifting, the transfer tax system rules indicate to many people that it may be better to not gift property and thereby cause it to be included in the estate at death where the exclusion will prevent it from being subject to federal estate tax. By causing the property to be include in the estate will result in a basis step-up equal to the fair market value of the property as of the date of death.
When considering gifting assets or doing significant estate planning, make sure to consult professionals for assistance.
Tuesday, April 18, 2017
Private property and the ability to exclude others is very important to farmers and ranchers. Land is typically the largest asset in terms of value that an ag producer owns and much farm and ranch machinery and equipment is often outdoors frequently during planting and harvesting. Not to mention buildings and livestock. So, trespassing is a big issue for rural landowners.
One issue that has popped-up recently in South Dakota involves public access to farmland that has become flooded. What are the rules associated with the recreational use of water? That’s the focus of today’s post.
In the United States, the individual states own the beds of navigable streams or lakes that flow or exist within their borders, and hold them in trust for their citizens. Under this public ownership concept, states may license use of the beds or lease rights to minerals found there. The right of the public to recreate over the bed can be asserted either because there is a federal navigational servitude or because the state has an expanded definition of navigability which allows more public uses than exist under federal law.
Under state law, the public's right to use rivers or lakes for recreational purposes is typically limited to those waters where the state owns the bed. For non-navigable streams, the title to the bed is held by the adjacent upland owner. Consequently, ownership of the bed is related to the concept of navigability. In general, navigability for title purposes is determined by the “natural and ordinary condition” of the water.
Although a federal test for bed title controlled the rights that states received upon joining the Union, state title tests are still important. When the states received title to the beds, they had the power to keep or dispose of them. Before the Supreme Court decisions which required federal law to be used in determining bed ownership, there were many state court decisions. These tests are still in use today and many conflict with federal law. When they do, federal law controls for title purposes (under the definition of “navigability”), but state law has been incorporated into this to determine what rights the state retains and what rights were granted to adjacent landowners. For example, some states keep title to watercourse beds only where there is a title influence. Other states follow a rule of “navigability in fact” similar to the federal rule. In these jurisdictions, the state retains title to watercourse beds only if the watercourse is navigable in fact. The remaining states use other approaches.
In early 2014, the New Mexico attorney general issued a non-binding opinion taking the position that a private landowner cannot prevent persons from fishing in a public stream that flows across a landowner’s property if the stream is accessible without trespassing across privately owned adjacent lands. Att’y. Gen. Op. 14-04 (Apr. 1, 2014). That opinion was based on New Mexico being a prior appropriation state and, as a result, unappropriated water in streams belongs to the public and is subject to appropriation for beneficial use irrespective of whether the adjacent landowner owns the streambed. Thus, the public has an easement to use stream water for fishing purposes if they can access the stream without trespassing on private property.
There are several other ways states have power over the water within their boundaries. Under its police power, a state may regulate its waters, whether or not they are navigable under the federal test, in order to protect the public's health, safety, and general welfare. Some western states claim ownership of all the water in the state, and as the owner, they claim the power to regulate. Other states limit their control to those waters considered navigable under bed ownership tests. As a result, state laws on public use of watercourses are a complex mix of cases and legislation.
The South Dakota Situation
Under South Dakota law, “the owner of land in fee has the right to the surface and everything permanently situated beneath or above it.” S.D.C.L. §43-16-1. In addition, South Dakota law provides that (with some specifically delineated exceptions), “…no person may fish, hunt or trap upon any private land without permission from the owner or lessee of the land….”. S.D.C.L. §41-9-1. Numerous states have similar statutory provisions. South Dakota also claims to own all wildlife in the state, including wildlife on private land. But, hunters cannot hunt that wildlife without the landowner’s permission unless the landowner is participating with the South Dakota Department of Game, Fish and Parks (GFP) in the “walk-in” program. Under that program, and landowner can give permission to the public to hunt on the landowner’s property in exchange for a payment from the GFP. Many other states also claim to own the wildlife found in the state and offer some sort of “walk-in” program.
South Dakota law, just like the laws of many other states, also bars “road hunting” outside of the public right-of-way. Thus, by barring hunting over private land from a public roadway, the state is recognizing landowners have “air rights” over their private property.
But, what about fishing? In a March decision, the South Dakota Supreme Court ruled that all water in the state is held in the public trust for “beneficial use.” That doesn’t seem unreasonable – other state high courts have reached the same conclusion. But, the Court held that the “beneficial use” rule applies to flooded private land (non-meandered lakes). This became an issue in South Dakota due to excess rainfall in 1993 which caused the formation of large lakes on private land in the northeastern part of the state. Fishermen flocked to the expanded lakes and the SD GFP didn’t stop them. The matter boiled over into litigation resulting in the Court’s recent decision.
The South Dakota Case
In Duerre v. Hepler, No. 27885, 2017 S.D. LEXIS 29 (S.D. Sup. Ct. Mar. 15, 2017), landowners sued the SD GFP for declaratory and injunctive relief concerning the public’s right to use the waters and ice overlying the landowners’ private property for recreational purposes. As noted above, in 1993, excessive rainfall submerged portions of the landowners’ property. In accordance with instructions from the United States Surveyor General’s Office, commissioned surveyors surveyed bodies of water in SD in the late 1800s. Pursuant to those survey instructions, if a body of water was 40 acres or less or shallow or likely to dry up or be greatly reduced by evaporation, drainage or other causes, surveyors were not to draw meander lines around the body of water but include it as land available for settlement. The meander lines delineated the water body for the purpose of measuring the property that abuts the water. When originally surveyed, the lands presently in question were small sized sloughs that were not meandered. Thus, the landowners owned the lakebeds under them. The 1993 flooding resulted in the sloughs expanding in size to over 1,000 acres each. The public started using the sloughs in 2001 and established villages of ice shacks, etc. In the spring and fall, boats would launch in to the waters via county roads. After the landowners complained to the GFP about trash, noise and related issues, the GFP determined that the public could use the waters if they entered them without trespassing. That’s sounds exactly like the New Mexico Attorney General opinion in 2014.
In 2014, the landowners sued. The trial court certified a defendant class to include those individuals who used or intended to use the floodwaters for recreational purposes, appointing the Secretary of the GFP as the class representative. On cross motions for summary judgment, the trial court entered declaratory and injunctive relief against the defendants. The trial court held that the public had no right of entry onto the water or ice without a landowner’s permission, and entered a permanent injunction in favor of the landowners.
On appeal, the South Dakota Supreme Court upheld the trial court’s decision to certify the class and include non-residents users in the class. The Court also upheld the trial court’s determination that the landowners had established the elements necessary for class certification and that the GFP Secretary was the appropriate class representative. The Court also upheld the trial court’s grant of declaratory relief to the landowners, noting that prior caselaw had left the matter up to the legislature and the legislature had not yet enacted legislation dealing with the issue. The legislature had neither declared that the public must obtain permission from private landowners, nor declared that the public’s right to use waters of the State includes the right to use waters for recreational purposes.
The Court remanded the order of declaratory relief and modified it to direct the legislature to determine whether the public can enter or use any of the water or ice located on the landowners’ property for any recreational use. As for the injunctive relief, the Court modified the trial court’s order to state that the GFP was barred from facilitating public access to enter or use the bodies of water or ice on the landowners’ property for any recreational purpose.
In short, the SD Supreme Court found that neither the GFP nor the landowners have a superior property right, but that the issue is up to the legislature to determine if recreation is a “beneficial use.” The issue is not just an important one for landowners in South Dakota. State rules for determining access rights to private property are important in every state. It certainly seems like a reasonable solution could be reached in South Dakota to protect private property rights while simultaneously providing reasonable access for fishermen. Time will tell.
Friday, April 14, 2017
With many things, it is true that there is a right way and a wrong way to do things. The same maxim holds true in business entity structuring. There is a right way to structure and a wrong way to structure the entity when it comes to many legal and tax issues, including self-employment tax liability. A recent Tax Court case illustrates that last point – proper structuring makes a difference on the self-employment tax liability issue.
So, how can self-employment tax be minimized when the desired structure is a limited liability company (LLC)? That’s today’s focus.
LLCs and Self-Employment Tax
Whether LLC members can avoid self-employment tax on their income from the entity depends on their member characterization. Are they general partners or limited partners? Under I.R.C. §1402(a)(13), a limited partner does not have self-employment income except for any guaranteed payments paid for services rendered to the LLC. So what is a limited partner? Under existing proposed regulations (that were barred by the Congress in the late 1990s from being finalized), an LLC member has self-employment tax liability if: (1) the member has personal liability for the debts or claims against the LLC by reason of being a member; (2) the member has authority under the state’s LLC statute to enter into contracts on behalf of the LLC; or (3) the member participated in the LLC’s trade or business for more than 500 hours during the LLC’s tax year. Prop. Treas. Reg. §1.1402(a)-2(h)(2). If none of those tests are satisfied, then the member is treated as a limited partner.
The Castigliola case. In Castigliola, et al. v. Comr, T.C. Memo. 2017-62, a group of lawyers structured their law practice as member-managed Professional LLC (PLLC). On the advice of a CPA, they tied each of their guaranteed payments to what reasonable compensation would be for a comparable attorney in the locale with similar experience. They paid self-employment tax on those amounts. However, the Schedule K-1 showed allocable income exceeding the member’s guaranteed payment. Self-employment tax was not paid on the excess amounts. The IRS disagreed with that characterization, asserting self-employment tax on all amounts allocated.
The Tax Court agreed with the IRS. Based on the Uniform Limited Partnership Act of 1916, the Revised Limited Partnership Act of 1976 and Mississippi law (the state in which the PLLC operated), the court determined that a limited partner is defined by limited liability and the inability to control the business. The members couldn’t satisfy the second test. Because of the member-managed structure, each member had management power of the PLLC business. In addition, because there was no written operating agreement, the court had no other evidence of a limitation on a member’s management authority. In addition, the evidence showed that the members actually did participate in management by determining their respective distributive shares, borrowing money, making employment-related decisions, supervising non-partner attorneys of the firm and signing checks. The court also noted that to be a limited partnership, there must be at least one general partner and a limited partner, but the facts revealed that all members conducted themselves as general partners with identical rights and responsibilities. In addition, before becoming a PLLC, the law firm was a general partnership. After the change to the PLLC status, their management structure didn’t change.
The court did not mention the proposed regulations, but even if they had been taken into account the outcome of the case would have been the same. Member-managed LLCs are subject to self-employment tax because all members have management authority. It’s that simple. In addition, as noted below, there is an exception in the proposed regulations that would have come into play.
Note: As a side-note, the IRS had claimed that the attorney trust funds were taxable to the PLLC. The court, however, disagreed because the lawyers were not entitled to the funds.
Structuring to minimize self-employment tax. There is an entity structure that can minimize self-employment tax. An LLC can be structured as a manager-managed LLC with two membership classes. With that approach, the income of a member holding a manager’s interest is subject to self-employment tax, but if non-managers that participate less than 500 hours in the LLC’s business hold at least 20 percent of the LLC interests, then any non-manager interests held by members that participate more than 500 hours in the LLC’s business are not subject to self-employment tax on the pass-through income attributable to their LLC interest. Prop. Treas. Reg. §1.1402(a)-2(h)(4). They do, however, have self-employment tax on any guaranteed payments. However, this structure does not achieve self-employment tax savings for personal service businesses, such as the one involved in Castigliola. Prop. Treas. Reg. §1.1402(a)-2(h)(5) provides an exception for service partners in a service partnership. Such partners cannot be a limited partner under Prop Treas. Reg. §1.1402(a)-2(h)(4) (or (2) or (3), for that matter). Thus, for a professional services partnership (such as the law firm at issue in the case), structuring as a manager-managed LLC would have no beneficial impact on self-employment tax liability.
However, for LLCs that are not a “service partnership,” such as a farming operation, it is possible to structure the business as a manager-managed LLC with a member holding both manager and non-manager interests that can be bifurcated. The result is that a member holding both manager and non-manager interests is not subject to self-employment tax on the non-manager interest, but is subject to self-employment tax on the pass-through income and a guaranteed payment attributable to the manager interest.
Here's what it might look like for a farming operation:
A married couple operates a farming business as an LLC. The wife works full-time off the farm and does not participate in the farming operation. But, she holds a 49 percent non-manager ownership interest in the LLC. The husband conducts the farming operation full-time and also holds a 49 percent non-manager interest. But, the husband, as the farmer, also holds a 2 percent manager interest. The husband receives a guaranteed payment for his manager interest that equates to reasonable compensation for his services (labor and management) provided to the LLC. The result is that the LLC’s income will be shared pro-rata according to the ownership percentages with the income attributable to the non-manager interests (98 percent) not subject to self-employment tax. The two percent manager interest is subject to self-employment tax along with the guaranteed payment that the husband receives. This produces a much better self-employment tax result than if the farming operation were structured as a member-managed LLC.
Additional benefit. There is another potential benefit of utilizing the manager-managed LLC structure. Until the health care law is repealed or changed in a manner that eliminates I.R.C. §1411, the Net Investment Income Tax applies to a taxpayer’s passive sources of income when adjusted gross income exceeds $250,000 on a joint return ($200,000 for a single return). While a non-manager’s interest in a manager-managed LLC is typically considered passive with the income from the interest potentially subject to the 3.8 percent surtax, a spouse can take into account the material participation of a spouse who is the manager. I.R.C. §469(h)(5). Thus, the material participation of the manager-spouse converts the income attributable to the non-manager interest of the other spouse from passive to active income that will not be subject to the 3.8 percent surtax.
Based on the example above, the result would be that self-employment tax is significantly reduced (it’s limited to 15.3 percent of the husband’s reasonable compensation (in the form of a guaranteed payment) and his two percent manager interest) and the net investment income surtax is avoided on the wife’s income.
The manager-managed LLC provides a better result than the result produced by the member-managed LLC for LLCs that are not service partnerships. For those that are, such as the PLLC in Castigliola, the S corporation is the business form to use to achieve a better tax result. For an S corporation, “reasonable” compensation will need to be paid subject to S.E. tax, but the balance drawn from the entity can be received self-employment tax free. But, for farming operations with land rental income, the manager-managed LLC can provide a better overall tax result than the use of an S corporation because of the ability to eliminate the net investment income tax.
Of course, the self-employment tax and the net investment income tax are only two pieces of the puzzle to an overall business plan. Other non-tax considerations may carry more weight in a particular situation. But for some, this strategy can be quite beneficial.
The decision in Castigliola would appear to further bolster the manager-managed approach – an individual that is a “mere member” appears to now have an even stronger argument for limited partner treatment. In addition, the court didn’t impose penalties on the PLLC because of reliance on an experienced professional for their filing position. I am not so sure about that one and believe that the judge was simply being nice, perhaps because the professional tax advisor died before the trial. But, the outcome they were seeking was easy to obtain if they had just structured the entity properly and had taken some time to carefully draft an operating agreement.
Wednesday, April 12, 2017
Any depreciable business asset is only depreciable if it has been placed in service during the tax year. “Placed in service” means that the asset is in a state of readiness for use in the taxpayer’s trade or business. See, e.g., Brown v. Comr., T.C. Sum. Op. 2009-71. In the year that an asset is place in service, all or part of the income tax basis can be deducted currently. A key point is that it is not actually necessary that the asset be used in the taxpayer’s trade or business for the taxpayer to begin claiming depreciation attributable to that asset.
The Code and regulations seem abundantly clear on what “placed in service” means. A court decision involving a retail building that was decided in early 2015 bore that out. But, IRS has now muddied the water by disagreeing with that court’s decision which, in turn, means that they are disagreeing with their own regulation on the issue and even their own audit technique guide on the matter.
Today’s post takes a look at what “placed in service” means and the confusing IRS position.
Code and Regulations
As noted above, property that is “placed in service” means that it is placed in a state of readiness or availability for use in the taxpayer’s trade or business, regardless of the time of year that the asset is placed in service. Treas. Reg. §1.167(a)-10(b). That means that the asset must be ready for the taxpayer to use by the taxpayer by the end of the tax year if the taxpayer so desires. It doesn’t mean that the taxpayer must have begun using the asset in the taxpayer’s trade or business by the end of the tax year. But, an item of property is not deemed to be placed in service if it is simply manufactured and is sitting at the dealership, or if an order has been placed but the property has not yet been built. So, simply signing a purchase contract or taking delivery of a depreciable materials (such as for the construction of a pole barn, etc.) to be used in the taxpayer’s business does not mean that those assets are depreciable – they aren’t yet ready for use in the taxpayer’s business. The asset must be ready for use in the taxpayer’s business whether or not they have actually been used by the taxpayer in the business by the end of the tax year. For a building in which the taxpayer’s retail business is conducted, for example, the store doesn’t have to be open for business in order for the building by the end of the tax year for the building to be deemed to be placed in service for depreciation purposes for that tax year. Treas. Reg. §1.167(a)-11(e)(1)(i). The building is considered to be placed in service on the date that its construction is considered to be substantially complete or in the state or readiness and availability regardless of whether depreciable items in the building meet the placed in service test. Id.
The Stine Case
In Stine, LLC v. United States, No. 2:13-03224, 2015 U.S. Dist. LEXIS 9850 (W.D. La. Jan. 27, 2015), non-acq., 2017-02 (Apr. 10, 2017), the taxpayer operated a retail business that sold home building materials and supplies. The taxpayer built two new retail stores. As of December 31, 2008, the buildings were substantially complete and partially occupied and the taxpayer had obtained certificates of completion and occupancy and customers could enter the stores. However, the stores were not open for business as of the end of 2008. The taxpayer claimed the 50 percent GoZone depreciation allowance for 2008 on the two buildings which created a tax loss for 2008 and allowed the taxpayer to carry back the losses to the 2003-2005 tax years and receive a refund. The IRS disallowed the depreciation deduction on the basis that the taxpayer had not placed the buildings in service and assessed a deficiency of over $2.1 million for tax years 2003-2008. The taxpayer paid the deficiency and sued for a refund. The IRS argued that allowing the depreciation would offend the "matching principle" because the taxpayer's revenue from the buildings would not match the depreciation deductions for a particular tax year. The court held that this argument was "totally without merit."
On the placed in service issue, the IRS maintained that the two buildings were not “open for business” as of the end of the tax year so no depreciation could be claimed for that year. The court disagreed, noting the government’s own regulation that defied that argument. The court noted that Treas. Reg. §1.167(a)-11(e)(1) says that placed in service means that the asset is in a condition of readiness and availability for its assigned function. With respect to a building, the court noted that this meant that the building must be in a state of readiness and availability without regard to whether equipment or machinery housed in the building has been placed in service. The court held that there was no requirement that the taxpayer's business must have begun by year-end. Cases that the IRS cited involving equipment (in one case an airplane) being placed in service were not applicable, the court determined. The court also noted that the IRS's own Audit Technique Guide for Rehabilitation Tax Credits stated that "[A] 'Certificate of Occupancy' is one means of verifying the 'Placed in Service' date for the entire building (or part thereof)". The court noted that the IRS had failed to cite even a single authority for the proposition that "placed in service" means "open for business," and that during oral arguments IRS had admitted that no authority existed. Thus, the court granted summary judgment for the taxpayer and also specified that the taxpayer could pursue attorney fees against the government if desired.
The IRS reaction. The court’s decision in Stine was based precisely on the regulation. It’s common sense, also. For retail businesses that are constructing stores, once the product is received to be placed into the display shelves at the constructed building, the building will be considered to have been placed in service. That’s what the regulation seems pretty clear about. The court sure believed so.
The IRS did not file an appeal with the U.S. Court of Appeals for the Fifth Circuit. That’s not surprising, considering how badly the IRS lost the case. Recently, however, the IRS issued a non-acquiescence to the court’s decision. A.O.D. 2017-02. That means that the IRS disagrees with the court’s decision and will continue to audit the issue outside of the Western District of Louisiana. Unfortunately, the IRS didn’t give any reason(s) why it disagreed with its own regulation and audit technique guide on the matter. That’s understandable – they have none.
An asset is placed in service for depreciation purposes when it is ready and available for use in the taxpayer’s trade or business. The Stine case makes that clear. It’s an issue that comes up in agriculture also. Just think back to the end of the year promotional ads that have appeared on TV and in farm magazines in recent years stating that a contract could be signed or delivery be taken before year end for a business asset to be depreciable. That’s not correct. While the asset need not be “used” by the taxpayer to be placed in service, it still has to be ready and available for use. Merely signing a contract or taking delivery of parts and materials that have to be assembled is not enough.
Monday, April 10, 2017
The Endangered Species Act (ESA) establishes a regulatory framework for the protection and recovery of endangered and threatened species of plants, fish and wildlife. 16 U.S.C. § 1531 et seq (2002). The U.S. Fish and Wildlife Service (USFWS), within the Department of the Interior, is the lead administrative agency for most threatened or endangered species.
The ESA has the potential to restrict substantially agricultural activities because many of the protections provided for threatened and endangered species under the Act extend to individual members of the species when they are on private land. Approximately 90 percent of endangered species have some habitat on private land, with almost 70 percent of the endangered or threatened species having over 60 percent of their total habitat on nonfederal lands. A recent decision of the U.S. Court of Appeals for the Tenth Circuit reiterates that the ESA applies to activities on private land. That’s the focus of today’s post.
The Impact of Species “Listing”
Once a species has been listed as endangered or threatened, the ESA prohibits various activities involving the listed species unless an exemption or permit is granted. For example, with respect to endangered species of fish, wildlife and plants, the ESA makes it unlawful for any person to import or export such species, deliver, receive, carry, transport or ship in interstate or foreign commerce by any means whatsoever, and sell or offer for sale in interstate or foreign commerce any such species. The ESA, with regard to endangered species of fish or wildlife, but not species of plants, makes it unlawful for any person subject to the jurisdiction of the United States to “take” any such species. 16 U.S.C. §§ 1538(a)(1)(B), (C) (2008). The ESA defines the term “take” to mean harass, harm, pursue, hunt, shoot, wound, kill, trap, capture, or collect, or to attempt to engage in any such conduct. The prohibition against “taking” an endangered species applies to actions occurring on private land as well as state or federal public land, and financial penalties apply for violating the prohibition.
1982 amendments to the ESA establish an incidental take permit process that allows a person or entity to obtain a permit to lawfully take an endangered species “if such taking is incidental to, and not the purpose of, the carrying out of an otherwise lawful activity.” 16 U.S.C. §1539(a)(1)(B). A person may seek an incidental take permit from the USFWS by filing an application that includes a Habitat Conservation Plan (HCP) which includes a description of the impacts that will likely result from the taking, proposed steps to minimize and mitigate those impacts, and alternatives to the taking that the applicant considered and the reasons why those alternatives were not selected. If the permit is issued, the FWS will monitor the project for compliance with the HCP and the effects of the permitted action and the effectiveness of the conservation program. The FWS may suspend or revoke all or part of an incidental take permit if the permit holder fails to comply with the conditions of the permit or the laws and regulations governing the activity.
Impact on Private Land Use Activities
The denial of an incidental take permit involving habitat modification of an underground cave bug of no known human commercial value and only found in two Texas counties has been upheld against a Commerce Clause challenge. GDF Realty Investments, LTD, et al. v. Norton, 326 F.3d 622 (5th Cir. 2004), reh’g en banc denied, 362 F.3d 286 (5th Cir. 2004), cert. denied, 545 U.S. 1114 (2005). The landowner claimed the federal government had no jurisdiction due to the lack of connection with interstate commerce. The court upheld the denial of the incidental take permit on the basis that the bug could be aggregated with all other endangered species to show a sufficient connection with interstate commerce. Likewise, in Rancho Viejo, LLC v. Norton, 323 F.3d 1062 (D.C. Cir. 2003), reh’g en banc denied, 334 F.3d 1158 (D.C. Cir. 2003), cert. denied, 540 U.S. 1218 (2004), a different court held that the ESA extended to the Southwestern Arroyo Toad even though the Arroyo Toad only resided in southern California and never has been an article of commerce. In 2009, a commercial wind farm was enjoined from further development until receipt of an incidental take permit due to the project’s impact on the endangered Indiana bat. The court held that it was a “virtual certainty” that Indiana bats would be “harmed, wounded or killed” by the wind farm in violation of the ESA during times that they were not hibernating. Animal Welfare Institute, et al. v. Beech Ridge Energy LLC, et al., 675 F. Supp. 2d 540 (D. Md. 2009).
An important issue for farmers and ranchers is whether habitat modifications caused by routine farming or ranching activities are included within the definition of the term “take.” In 1975, the Department of Interior issued a regulation defining “harm” as “an act or omission which actually injures or kills wildlife, including acts which annoy it to such an extent as to significantly disrupt essential behavior patterns, which include, but are not limited to, breeding, feeding or sheltering; significant environmental modification or degradation which has such effects is included within the meaning of ‘harm’.” 50 C.F.R. § 17.3; 40 Fed. Reg. 44412, 44416. The regulation was amended in 1981 to emphasize that actual death or injury to the listed species is necessary, but the inclusion of “habitat modification” in the definition of “harm” led to a series of legal challenges.
The regulation was upheld by the Ninth Circuit Court of Appeals in 1988 in a case involving an endangered bird species whose critical habitat was on state-owned land in Hawaii. Palila v. Hawaii Dept. of Land & Natural Resources, 639 F.2d 495 (9th Cir. 1981). The court held that the grazing of goats and sheep threatened to destroy the endangered birds' woodland habitat and resulted in harm and a “taking” of the endangered bird. The court ordered the Hawaii Department of Land and Natural Resources to remove the goats and sheep from the birds' critical habitat. In subsequent litigation, the plaintiffs sought the removal of an additional variety of sheep from the birds' critical habitat. The defendant argued that, under the ESA, “harm” included only the actual and immediate destruction of the birds' food source, not the potential for harm which could drive the bird to extinction. However, the Ninth Circuit held that “harm” is not limited to immediate, direct physical injury to the species, but also includes habitat modification which may subsequently result in injury or death of individuals of the endangered species. Palila v. Hawaii Dept. of Land & Natural Resources, 852 F.2d 1106 (9th Cir. 1988).
Recent case. In People for the Ethical Treatment of Property Owners v. Unites States Fish and Wildlife Service, No. 14-4151, 2017 U.S. App. LEXIS 5440 (10th Cir. Mar. 29, 2017). the U.S. Court of Appeals for the Tenth Circuit again illustrated the impact of the ESA on private land activities in a case involving protected prairie dogs. In the case, the plaintiffs were landowners in Utah whose experienced problems with the prevalence of the Utah prairie dog damaging their tracts. The Utah prairie dog is a threatened species under the ESA and has approximately 70 percent of its population on private land. The Utah prairie dog is found only in Utah, and its population has increased about 12 times over since 1973.
As a threatened species, the USFWS issued a special rule regulating the “taking” of the Utah prairie dog. Under the rule, “taking” was limited to agricultural land, property within one-half mile of conservation land and areas where the species creates serious human safety hazards or disturb the sanctity of significant cultural or burial sites. Incidental taking is allowed if it occurs as part of standard agricultural practices. The plaintiffs challenged the rule as applied to private land as not authorized under either the Commerce Clause or the Necessary and Proper Clause of the U.S. Constitution and sought declaratory and injunctive relief.
The trial court granted the plaintiffs motion for summary judgment on the basis that the Commerce Clause does not authorize the Congress to enact legislation authorizing the regulation of the taking of a purely intrastate species without a substantial effect on interstate commerce and the Necessary and Proper Clause did not authorize the regulation of taking of the species because the regulation is not essential to the ESA’s economic scheme. The government appealed.
On review, the appellate court reversed. The appellate court determined that the “substantial effect” on interstate commerce was to be determined under the rational basis standard. Under that standard, the appellate court held that the Congress has the power to regulate purely local activities that are part of an economic class of activities that have a substantial effect on interstate commerce. Thus, because (in this court’s view) the Commerce Clause authorized the regulation of noncommercial purely intrastate activity that is an essential part of a broader regulatory scheme, the “take” regulation was constitutional. The appellate court noted that approximately 68 percent of ESA-protected species have habitats that do not cross state borders, as such the court reasoned that the ESA could be severely undercut if the ESA only allowed protection to those species whose habitats were in multiple states.
The ESA and the underlying regulations have a significant impact on private landowners and associated agricultural activities. With new leadership in the White House and regulatory agencies it remains to be seen whether that will amount to any change in how the rules are applied on private land.
Thursday, April 6, 2017
Yesterday the U.S. House Committee on Agriculture Heard Testimony concerning the impact of the tax code on the agricultural industry. I teach farm income tax at the law school, and a significant focus of the course for the students is on those areas of tax law where the rules are different for agricultural producers and agricultural businesses than they are for other taxpayers. The stated (and largely correct) reason for the different treatment of agriculture is that there are unique risks that the sector faces.
One of the speakers at the hearing focused on the uniqueness of farm income tax. I found that interesting and today’s post will summarize the testimony of that speaker – Chris Hesse. Chris is a principal of CliftonLarsonAllen. I am only focusing on the portions of his testimony that dealt with tax issues unique to agricultural producers and businesses. It’s important for legislators to understand these unique provisions and how they apply to agricultural producers.
Installment method. Farm businesses can report income on the installment method. That means that income is recognized when payment is received instead of when the sale is made. This rule can apply to the sales of raised crops and livestock, for example. Nonfarm businesses cannot report the income from the sale of products manufactured or held for sale to customers using the installment method. A seller of ag equipment (e.g., an implement dealer) is not a “farmer” and can’t use the installment method.
Commodity Credit Corporation (CCC) loans. The CCC is the USDA’s financing institution with programs administered by the Farm Service Agency (FSA). Among other things, the CCC makes commodity and farm storage facility loans to farmers where the farmers’ crops are pledged as collateral. These loans are part of the price and income support system of the federal farm programs. Farmers have an option for treating the loan on the return – either as a loan or as income in the year that the loan proceeds are received.
Crop insurance. Farmers can defer the receipt of crop insurance proceeds that are paid for physical damage or destruction to crops. Deferred planting payments are also deferrable. But, if the policy pays based on anything other than physical damage or destruction to covered crops, the payments are not deferrable
Livestock sales on account of weather-related conditions. There are two basic deferral rules that can apply when excess livestock are sold on account of weather-related conditions. I recently blogged on these two rules in light of the wildfires in Kansas, Oklahoma and Texas that has impacted cattle ranchers in those areas. One rule provides for a one-year deferral and the other rule provides the ability to replace the excess livestock with replacement animals and deferral of the gain until the replacement animals are disposed of.
Hedging. As Chris pointed out in his testimony, farmers may reduce price risk for both the sale of crops and livestock and for the purchase of inputs. Puts, calls, and the commodity futures markets are available to hedge prices for the inputs and sales. The hedging opportunities provide ordinary income or loss treatment upon using techniques to lock-in prices. Without this provision, a loss on a commodity futures contract would be capital gain, the deductibility of which is limited to capital gains plus $3,000.
Cancelled debt income. The default treatment for the discharge of indebtedness is as taxable income. However, exclusions are available. One of those is unique to farmers and involves the discharge of qualified farm indebtedness. My blog post of March 29, 2017, dealt with this rule.
Raising livestock. Farmers may deduct the costs of raising livestock, even though dairy cattle, for example, otherwise have a pre-productive period of more than two years. Consequently, when cattle are culled from the breeding or dairy herd, the farmer recognizes I.R.C. §1231 gain, usually taxed as capital gain.
Raising crops. Farmers may deduct the costs of raising crops in the year paid for a cash method farmer, except for those crops that have a more than two-year pre-productive period. But, an election is available for the crops with a more than two-year pre-productive period which allows a current deduction for the costs of establishing the crop. If election is made, depreciation on all farm assets must be computed using slower methods over longer cost recovery periods. The cost of raising the crops is deductible in the year paid for the cash method farmer.
I.R.C. §199. The Domestic Production Activities Deduction (DPAD) of I.R.C. §199 reduces the overall tax rate from growing and production activities for farmers that pay W-2 wages. It’s a nine percent deduction from net farm income (but it doesn’t reduce self-employment income). This provision is uniquely applied to agriculture in the context of cooperatives, farm landlords, crop insurance payments, Farm Service Agency subsidies, custom feeding operations, hedging transactions and the storage of ag commodities.
Fertilizer and soil conditioning expenditures. Farmers can elect to deduct fertilizer and soil conditioner expenses in the year purchased.
Farm supplies. Farm supplies are deductible in the year that they are paid for, rather than in the year of their use.
Charitable donation of conservation easement. Farmers get an enhanced limitation for the donation of a conservation easement. Instead of a 50 percent of adjusted gross limitation for non-farm taxpayers, a farmer or rancher may claim a charitable deduction up to 100 percent of adjusted gross income. If the charitable deduction is greater than the limitation, the excess charitable deduction may be carried forward for up to 15 years.
Charitable contribution of food. Farmers may deduct up to 50 percent of the value of apparently wholesome food given for the benefit of the needy. This provision provides the same incentive to grower/packer/shippers who own cash basis inventory, as provided to the local grocery store that has excess food inventory nearing its expiration date.
Other Provisions Unique to Agriculture
Estimated tax. Form 1040 farmers need not pay estimated taxes if the tax return is filed by March 1. Farmers who don’t file by March 1 can pay one estimated tax payment on January 15. This flexibility helps farmers by not having to pay income tax on expected income that doesn’t arise to the risks mentioned above.
Farm income averaging. Farmers can average their income over a three-year period. This helps deal with fluctuating commodity prices, and is useful upon retirement.
Net operating losses. Farmers have the option of using a net operating loss carryback period of five years, rather than the two-year provision applicable to non-farmers.
Optional self-employment tax. Farmers benefit from the optional self-employment tax, to earn credits toward the Social Security system even though suffering a loss in a current year. Non-farm taxpayers may elect optional self-employment tax for only five years. Farmers do not have a limit.
Farm supplies. Farmers may deduct farm supplies in the year paid, rather than the year consumed (within limits).
Chapter 12 bankruptcy. Farm bankruptcy (Chapter 12) contains a special rule that allows taxes owed to a governmental entity to be changed from priority to non-priority status. This wasn’t in Chris’ testimony, but it’s a crucial provision particularly in this time of financial distress in agriculture. A current problem, however, is that the debt test for Chapter 12 needs to be raised. Numerous farming operations now have aggregate debt levels high enough that they are precluded from filing Chapter 12. For those, the tax provision is of no use.
CRP rents for a farmer receiving Social Security. A special tax rule allows active farmers who receive Conservation Reserve Program (CRP) payments to not pay self-employment tax on those payments if the farmer is also receiving Social Security benefits. This was also not a part of Chris’ testimony.
It was apparent at the hearing that interest deductibility for interest associated with farmland purchases is a key tax provision that should be retained. There had been some discussion during the summer of 2016 that its removal was a possibility. At least that was mentioned as a possibility in the “Blueprint” made public by the House Ways and Means Committee. That doesn’t seem to be the case now. Also, the hearing pointed out that the current tax-deferred exchange rules are necessary to retain.
On the federal estate tax, while the exemptions are high enough to exempt out the vast majority of farmers, the point was made that a significant reason of its inapplicability to farmers is that they engage in costly and time-consuming planning to avoid the tax. That’s what is called a “dead weight loss.” That point is never mentioned by the proponents of keeping the federal estate tax in place who claim they have no evidence of a farm or ranch ever having been sold to pay the tax. The retention of basis “step-up” at death is of particular importance to farm and ranch families.
Another panelist gave testimony that focused on proposals that could incentive farmers that are retiring from farming to transfer their assets before death. I haven’t seen much interest in the Congress over the past few years to enact the proposals suggested, but it’s still good to have the discussion and put the issues back out in the open.
It’s always nice when those in D.C. get to hear from those in the trenches that have to deal with the rules the Congress enacts. Hopefully the hearing was beneficial for the legislators.
Tuesday, April 4, 2017
A nuisance is an invasion of an individual's interest in the use and enjoyment of land rather than an interference with the exclusive possession or ownership of the land. The concept has become increasingly important in recent years due to land use conflicts posed by large-scale, industrialized confinement livestock operations. But, that’s not the only activity that has generated nuisance litigation. “Renewable” energy also has started to produce its own subset of nuisance cases. In these cases, the claim might involve allegations of noise, vibration, flicker, and damage to local aesthetics, among other annoyances.
But, can a nuisance claim be based solely on a claim of harm to aesthetics? If so, that could spell trouble for sources of renewable energy. The issue has been addressed by court on numerous occasions, but came up most recently in Vermont involving the installation of solar panels in a rural area – a so-called solar farm.
The issue of aesthetics (visual blight) and nuisance is the focus of today’s post.
Nuisance – In General
Nuisance law prohibits land uses that unreasonably and substantially interfere with another individual's quiet use and enjoyment of property. The doctrine is based on two interrelated concepts: (1) landowners have the right to use and enjoy property free of unreasonable interferences by others; and (2) landowners must use property so as not to injure adjacent owners.
Nuisance law is rooted in the common law and two primary issues are at stake in any agricultural nuisance dispute - whether the use alleged to be a nuisance is reasonable for the area and whether the use alleged to be a nuisance substantially interferes with the use and enjoyment of neighboring land. Each case is highly fact-dependent with the court considering multiple factors.
A private nuisance is a civil wrong that is based on a disturbance of rights in land. A private nuisance may consist of an interference with the physical condition of the land itself, as by vibration or blasting which damages a house, the destruction of crops, flooding, the raising of the water table, or the pollution of a stream or underground water supply. A private nuisance may also consist of a disturbance of the comfort or convenience of the occupant as by unpleasant odors, smoke, dust or gas, loud noises, excessive light, high temperatures, or even repeated telephone calls. The remedy for a private nuisance lies in the hands of the individual whose rights have been disturbed. A public nuisance, on the other hand, is an interference with the rights of the community at large. A public nuisance may include anything from the obstruction of a highway to a public gaming house or indecent exposure. The normal remedy is in the hands of the state.
Nuisance and Renewable Energy Production Activities
Odors from large-scale livestock confinement operations are not the only activities on rural property that give rise to nuisance actions. While such activities tend to predominate nuisance actions, especially in the Midwest, the development of large-scale wind turbine operations is also generating a great deal of conflict among rural landowners. While nuisance litigation involving large-scale “wind farms” is in its early stages, a significant opinion from 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 West Virginia Supreme 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. The court remanded the case to the trial court for a trial. At trial, the defendant was given an opportunity to establish that the operation of the wind farm did not unreasonably interfere with the plaintiffs’ use and enjoyment of their property. That’s how most of the cases positioned like this would turn out. Courts thend not to permit a claim for “anticipatory nuisance.” A party is entitled to show that they can conduct their activity without creating a nuisance.
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.
Aesthetic Injury Only?
But what if the only complained-of problem is aesthetic? Is that enough to make out a claim for nuisance? The issue came up recently in a court case from Vermont that involved solar panels. In Myrick v. Peck Electric Co., et al., No. 16-167, 2017 Vt. LEXIS 4 (Vt. Sup. Ct. Jan. 13, 2017), the plaintiff was a landowner that sued the defendant, two solar energy companies, when the plaintiff’s neighbors leased property to the defendants for the purpose of constructing commercial solar arrays (panels). The plaintiff claimed that the solar arrays constituted a private nuisance by negatively affecting the surrounding area’s rural aesthetic which also caused local property values to decline. The trial court granted summary judgment to the defendants. On appeal, the Vermont Supreme Court affirmed. The Court noted that Vermont law has held, dating back to the late 1800s, that private nuisance actions based on aesthetic disapproval alone are barred. The Court rejected the plaintiff’s argument that the historic Vermont position should change based on changed society. The Court also rejected the notion that Vermont private nuisance law was broad enough to apply to aesthetic harm, stating that, “An unattractive sight, without more, is not a substantial interference as a matter of law because the mere appearance of the property of another does not affect a citizen’s ability to use and enjoy his or her neighboring land.” Emotional distress is not an interference with the use or enjoyment of land, the court stated. But, if the solar panels casted reflections, for example, that could be an interference with the use and enjoyment of one’s property. Aesthetic values, the court noted, are inherently subjective and the court wasn’t going to set an aesthetic standard. The Court also noted that the plaintiffs had conceded at oral argument that they were not pursuing a claim that diminution in value, by itself, was sufficient to constitute a nuisance. However, the Court went on to state that a nuisance claim based solely on loss in value invites speculation that the Court would not engage in.
The decision from Vermont follows the majority rule among jurisdictions in the United States. Of course, there are some exceptions. For example, a few courts have held that proof of general damages (diminished quality of life) may be sufficient evidence to support a monetary award. See, e.g., Stephens, et al. v. Pillen, 12 Neb. App. 600 (2004). But, in general, aesthetic injury, by itself, is not enough to make a claim for nuisance. However, if it is coupled with claims of substantial interference with use and enjoyment of property, a nuisance claim might successfully be made. Renewable energy generation tends to require a large amount of land for its operation, but unsightliness, by itself, probably won’t be enough to make it a nuisance.
Friday, March 31, 2017
Recent wildfires in Kansas, Oklahoma and Texas have resulted in thousands of livestock deaths and millions of dollars of losses to the agricultural sector in those states. Last week, one of the blog posts was devoted to casualty losses and involuntary conversions. Today, I tackle another related subject – the USDA Livestock Indemnity Program (LIP) and how to report LIP payments.
2014 Farm Bill – The LIP Program
The LIP program, administered by USDA’s Farm Service Agency (FSA), was created under the 2014 Farm Bill to provide benefits to livestock producers for livestock deaths that exceed normal mortality caused by adverse weather, among other things. The amount of a LIP payment is set at 75 percent of the market value of the livestock at issue on the day before the date of death, as the Secretary determines. Eligible livestock include beef bulls and cows, buffalo, beefalo and dairy cows and bulls. Non-adult beef cattle, beefalo and buffalo are also eligible livestock. The livestock must have died within 60 calendar days from the ending date of the “applicable adverse weather event” and in the calendar year for which benefits are requested. To be eligible, the livestock must also have been used in a farming (ranching) operation as of the date of death. Contract growers of livestock are also eligible for LIP payments. However, ineligible for LIP payments are wild animals, pets, or animals that are used for recreational purposes (i.e., hunting dogs, etc.).
As previously noted, LIP payments are set at 75 percent of the market value of the livestock as of the day before their death. That market value is tied to a “national payment rate” for each eligible livestock category as published by the USDA. For contract growers, the LIP national payment rate is based on 75 percent of the average income loss sustained by the contract grower with respect to the livestock that died. Any LIP payment that a contract grower is set to receive will be reduced by the amount of monetary compensation that the grower received from the grower’s contractor for the loss of income sustained from the death of the livestock grown under contract.
As for FSA payment limitations, a $125,000 annual payment limitation applies for combined payments under the LIP, Livestock Forage Program, and the Emergency Assistance for Livestock, Honey Bees and Farm-Raised Fish program. In addition, to the payment limitation, and eligible farmer or rancher is one that has average adjusted gross income (AGI) over a three-year period that is less than or equal to $900,000. For 2017, the applicable three-year period is 2013-2015. For a particular producer, that could mean that tax planning strategies to keep average AGI at or under $900,000 need to be implemented. That could include the use of deferral strategies, income averaging and amending returns to make or revoke an I.R.C. §179 election.
An eligible producer can submit a notice of loss and an application for LIP payments to the local FSA office. The notice of loss must be submitted within the earlier of 30 days of when the loss occurred (or became apparent) or 30 days after then end of the calendar year in which the livestock loss occurred. For contract growers, a copy of the grower contract must be provided. For all producers, it is important to submit evident of the loss supporting the claim for payment. Photographs, veterinarian records, purchase records, loan documentation, tax records, and similar data can be helpful in documenting losses. Of course, the weather event triggering the livestock losses must also be documented. In addition, certification of livestock deaths can be made by third parties on Form CCC-854, if certain conditions can be satisfied
Given that the wildfires occurred in the early part of 2017, it is likely that any LIP payments will also be received in 2017. That’s not always the case. Sometimes LIP payments are not paid until the calendar year after the year in which the loss was sustained. For example, livestock losses in South Dakota a few years ago occurred late in the year, but payments weren’t received until the following year. In any event, for LIP payments that are paid out, the FSA will issue a 1099G for the full amount of the payment.
Death of breeding livestock. While the 1099G simply reports the gross amount of any LIP payment to a producer for the year, there may be situations where a portion of the payment is compensation for the death loss of breeding livestock. If the producer would have sold the breeding livestock, the sale would have triggered I.R.C. §1231 gain that would have been reported on Form 4797. That raises a question as to whether it is possible to allocate the portion of the disaster proceeds allocable to breeding livestock from Schedule F to Form 4797. This is an issue that many producers that have sustained livestock losses will have. While it is true that gains and losses from the sale of breeding livestock sales are reported on Form 4797, the IRS will look for Form 1099-G amounts paid for livestock losses to show up on Schedule F – most likely on line 4a.
Income inclusion and deferral. The general rule is that any benefits associated indemnity payments (or feed assistance) are reported in income in the tax year that they are received. That would mean, for example, that payments received in 2017 for livestock losses occurring in 2017 will get reported on the 2017 return. Likewise, payments for livestock losses occurring in 2016 that were received in 2017 would also be reported in 2017.
The receipt and inclusion in income of LIP payments could also put a livestock producer in a higher income tax bracket for 2017. In that instance, there might be other tax rules that can be used to defer the income associated with the livestock losses. Under I.R.C. §451(e), the proceeds of livestock that are sold on account of weather-related conditions can be deferred for one year. Under another provision, I.R.C. §1033(e), the income from livestock sales where the livestock are held for draft, dairy or breeding purposes that are involuntarily converted due to weather can be deferred if the livestock are replaced with like-kind livestock within four years. The provision applies to the excess amount of livestock sold over sales that would occur in the course of normal business practices.
While I.R.C. §451(e) requires that a sale or exchange of the livestock must have occurred, that is not the case with the receipt of indemnity payments for livestock losses. So, that rule doesn’t provide any deferral possibility. The involuntary conversion rule of I.R.C. §1033(3) is structured differently. It doesn’t require a sale or exchange of the livestock, but allows a deferral opportunity until the animals acquired to replace the (excess) ones lost in the weather-related event Thus, only the general involuntary conversion rule of I.R.C. §1033(a) applies rather than the special one for livestock when a producer receives indemnity (or insurance) payments due to livestock deaths. Thus, for LIP payments received in 2017, they will have to be reported unless the recipient acquires replacement livestock within the next two years – by the end of 2019. Any associated gain would then be deferred until the replacement livestock are sold. At that time, any gain associated gain would be reported and the gain in the replacement animals attributable to breeding stock would be reported on Form 4797.
Livestock losses due to weather-related events can be difficult to sustain. LIP payments can help ease the burden. Having the farming or ranching operation structured properly to receive the maximum benefits possible is helpful, as is understanding the tax rules and opportunities for reporting the payments.
Wednesday, March 29, 2017
The drop in crop prices in recent months has introduced financial strain for some producers. Bankruptcy practitioners are reporting an increase in clients dealing with debt workouts and other bankruptcy-related concerns.
An important part of debt resolution concerns the income tax consequences of any debt relief to the debtor. One of those rules concerns the tax treatment of discharged “qualified farm indebtedness.” The rule can be a useful tool in dealing with the income tax issues associated with debt forgiveness for farmers that are not in bankruptcy. There’s also another option that might come into play in certain situations – a purchase price adjustment.
That’s the focus of today’s post.
Except for debt associated with installment land contracts and Commodity Credit Corporation loans, most farm debt is recourse debt. With recourse debt, the collateral stands as security on the loan. If the collateral is insufficient to pay off the debt, the debtor is personally liable on the obligation and the debtor's non-exempt assets are reachable to satisfy any deficiency.
When the debtor gives up property, the income tax consequences involve a two-step process. Basically, it is as if the property is sold to the creditor, and the sale proceeds are applied on the debt. There is no gain or loss (and no other income tax consequence) up to the income tax basis on the property. Then, the difference between fair market value and the income tax basis is gain or loss. Finally, if the indebtedness exceeds the property's fair market value, the debtor remains liable for the difference and if it is forgiven, the amount is discharge of indebtedness income.
However, special rules can apply to minimize the tax impact of discharge of indebtedness income.
Under I.R.C. §108(a)(1)(A)-(C), a debtor need not include in gross income any amount of discharge of indebtedness if the discharge occurs as part of a bankruptcy case or when the debtor is insolvent, or if the discharge is of qualified farm debt. If one of these provisions applies to exclude the debt from income, Form 982 must be completed and filed with the return for the year of discharge.
Qualified Farm Indebtedness
What is it? The qualified farm debt rule applies to the discharge of qualified farm indebtedness that is discharged via an agreement between a debtor engaged in the trade or business of farming and a “qualified person.” A qualified person includes a lender that is actively and regularly engaged in the business of lending money and is not related to the debtor or to the seller of the property, is not a person from which the taxpayer acquired the property, or is a person who receives a fee with respect to the taxpayer’s investment in the property. I.R.C. §49(a)(1)(D)(iv). Under I.R.C. §108(g)(1)(B), a “qualified person” also includes federal, state or local governments or their agencies.
In addition, qualified farm debt is debt that is incurred directly in connection with the taxpayer’s operation of a farming business; and at least 50 percent of the taxpayer’s aggregate gross receipts for the three tax years (in the aggregate) immediately preceding the tax year of the discharge arise from the trade or business of farming. I.R.C. §§108(g)(2)(A)-(B). Off-farm income and passive rental arrangements can cause complications in meeting the gross receipts test.
Solvency. The qualified farm debt exclusion rule does not apply to the extent the debtor is insolvent or is in bankruptcy. Farmers are also under a special rule – for all debtors other than farmers, once solvency is reached there is income from the discharge of indebtedness. The determination of a taxpayer’s solvency is made immediately before the discharge of indebtedness. “Insolvency” is defined as the excess of liabilities over the fair market value of the debtor’s assets. Both tangible and intangible assets are included in the calculation. In addition, both recourse and nonrecourse liabilities are included in the calculation, but contingent liabilities are not. The separate assets of the debtor’s spouse are not included in determining the extent of the taxpayer’s insolvency. Property exempt from creditors under state law is included in the insolvency calculation. Carlson v. Comr., 116 T.C. 87 (2001).
Maximum amount discharged. There is a limit on the amount of discharged debt that can be excluded from income under the exception. The excluded amount cannot exceed the sum of the taxpayer’s adjusted tax attributes and the aggregate adjusted bases of the taxpayer’s depreciable property that the taxpayer holds as of the beginning of the tax year following the year of the discharge.
Reduction of tax attributes. The debt that is discharged and which is excluded from the taxpayer’s gross income is applied to reduce the debtor’s tax attributes. I.R.C. §108(b)(1). Unless the taxpayer elects to reduce the basis of depreciable property first, I.R.C. §108(b)(2) sets forth the general order of tax attribute reduction (which, by the way occurs after computing tax for the year of discharge (I.R.C. §108(b)(4)(A)). The order is as follows: net operating losses (NOLs) for the year of discharge as well as NOLs carried over to the discharge year; general business credit carryovers; minimum tax credit; capital losses for the year of discharge and capital losses carried over to the year of discharge; the basis of the taxpayer’s depreciable and non-depreciable assets; passive activity loss and credit carryovers; and foreign tax credit carryovers.
Those attributes that can be carried back to tax years before the year of discharge are accounted for in those carry back years before they are reduced. Likewise, any reductions of NOLs or capital losses and carryovers first occur in the tax year of discharge followed by the tax year in the order in which they arose.
The tax attributes are generally reduced on a dollar-for-dollar basis (i.e., one dollar of attribute reduction for every dollar of exclusion). However, any general business credit carryover, the minimum tax credit, the foreign tax credit carryover and the passive activity loss carryover are reduced by 33.33 cents for every dollar excluded.
If the amount of income that is excluded is greater than the taxpayer’s tax attributes, the excess is permanently excluded from the debtor’s gross income and is of no tax consequence. Alternatively, if the taxpayer’s tax attributes are insufficient to offset all of the discharge of indebtedness, the balance reduces the basis of the debtor’s assets as of the beginning of the tax year of discharge.
Discharged debt that would otherwise be applied to reduce basis in accordance with the general attribute reduction rules specified above and also constitutes qualified farm indebtedness is applied only to reduce the basis of the taxpayer’s qualified property. I.R.C. §1017(b)(4)(A). The basis reduction is to the qualified property that is depreciable property, then to the qualified property that is land used or held for use in the taxpayer’s farming business, and then to any other qualified property that is used in the taxpayer’s farming business or for the production of income. This is the basis reduction order unless the taxpayer elects to have any portion of the discharged amount applied first to reduce basis in the taxpayer’s depreciable property, including real property held as inventory. I.R.C. §§108(b)(5)(A); 1017(b)(3)(E).
Purchase Price Adjustment
Instead of triggering discharge of indebtedness income, if the original buyer and the original seller agree to a price reduction of a purchased asset at a time when the original buyer is not in bankruptcy or insolvent, the amount of the reduction does not have to be reported as discharge of indebtedness income. I.R.C. §108(e)(5)(A). The seller also doesn’t have immediate adverse tax consequences from the discharge. Instead, the profit ratio that is applied to future installment payments is impacted. Priv. Ltr. Rul. 8739045 (Jun. 20, 1987).
Farmers often have favorable tax rules. The qualified farm indebtedness rule is one of those. In the right situation, it can provide some relief from the tax consequences of financial distress.
Monday, March 27, 2017
Charitable giving is an important part income tax and estate planning for some clients. Often the charitable gift is made directly by the individual, but there can be benefits to making the contributions from a trust. Individuals can be limited in the amount given to charity. For example, the amount an individual can deduct for charitable contributions generally is limited to 50% of adjusted gross income (AGI). The deduction may be further limited to 30% or 20% of AGI, depending on the type of property donated and the type of organization it is donated to. Other limits can apply to qualified conservation contributions, unless the donor is a qualified farmer or rancher. However, trusts are entitled to an unlimited deduction.
The benefit of making charitable contributions via a trust is the topic of todays’ blog post.
The general rule is that an individual can’t take a charitable deduction for more than 50 percent of AGI for the year. This limit applies to the so-called “50 percent organizations” unless the donation is of capital gain property and the taxpayer computes the deduction using the donated property’s fair market value without reducing for depreciation. In that instance, the limitation is 30 percent unless fair market value of the property is reduced by the amount that would have been long-term capital gain if the property had been sold rather than donated. A “50 percent organization” includes churches, educational organizations, hospitals, the U.S., publicly supported charities, and private foundations.
A 30 percent limitation applies to contributions to all other qualified organizations, except that the limitation is 20 percent if the contribution is of capital gain property.
For qualified conservation contributions, the limit is 50 percent of AGI, less the deduction for all other charitable contributions. A carryover rule applies. For qualified farmers and ranchers, the deduction for a qualified conservation contribution is 100 percent of AGI. A qualified farmer or rancher has gross income from the trade or business of farming that exceeds 50 percent of gross income for the tax year.
What About Trusts?
Unlimited deduction. There are advantages in making charitable contributions from a trust compared to contributions from an individual. Trusts are not subject to percentage limitations on the amount of the charitable deduction. The deduction is unlimited (I.R.C. §642(c)) unless the donated amount of the trust’s gross income consists of unrelated business income. I.R.C. §170. Thus, the trust language should specify that payments to charity should be paid from gross income first to the extent that gross income is not unrelated business income. But, it remains uncertain whether such clause language would prevail for tax purposes. In the right case, the IRS might challenge that language, and the law is not entirely clear on the point.
Flexibility and additional tax benefit. In addition, a trust takes a charitable deduction in the year in which the income is donated to charity even if it was earned in prior years. In that situation, the trust can make an election to treat the payment as having been made in the prior year in which the gross income was earned. I.R.C. §642(c)(1). In addition, if a trust is potentially subject to the 3.8 percent net investment income tax of I.R.C. §1411 (which is triggered when trust income reaches $12,500 for 2017), the trust can reduce its net investment income subject to the 3.8 percent tax by the amount donated to charity.
Obtaining the deduction. A trust can claim a charitable deduction under I.R.C. §642(c) if the donated amount is from gross income, is made in accordance with the trust’s terms, and is made for a charitable purpose – one that is specifically denoted in I.R.C. §170(c). For a case on the issue of having the payments being authorized by and made in accordance with the trust’s terms see Hubbell Trust v. Commissioner, T.C. Sum. Op. 2016-67. Also, a donation to charity from a trust made pursuant to the exercise of a power of appointment would appear to meet the test. However, for a contrary view see Brownstone v. United States., 465 F.3d 525 (2nd Cir. 2006).
What if a trust fails to contain language that authorizes distributions to charity and the objective now is to make such contributions? One possibility is to decant the asset to be contributed to charity to another trust. That trust could then contain a power of appointment granting the power to a third party to make charitable distributions. Whether this strategy would actually work is an open question. Does the original grantor have to have the charitable intent? Another possibility, according to an IRS revenue ruling is to contribute assets to a partnership where a partnership interest is a trust asset and then have the partnership make the charitable contribution from the partnership’s gross income. See Rev. Rul. 2004-5, 2004-3 IRB 295.
Are mandatory distributions required? That answer is clearer – as long as the trust authorizes discretionary charitable distributions, the distributions will qualify for the charitable deduction.
Also, the trust can authorize either the trustee, the beneficiaries or others to direct that charitable distributions be made. In addition, trust language can provide for beneficiary (or third party) consent before charitable distributions can be made. The same consent can be made applicable before the exercise of a power of appointment in a charity’s favor, and restrictions can be placed on distributions without eliminating the deduction.
What is “gross income”? What does it mean to satisfy the requirement that the donated amount come from “gross income”? That’s a more difficult question to answer because tracing the source of the income is not necessarily easy. A recent case provides some helpful, and some would assert, surprising guidance. In Green v. United States, 144 F. Supp. 3d 1254 (W.D. Okla. 2015), a dynasty trust created in 1993 expressly authorized the trustee to “distribute to charity such amounts from the gross income of the Trust as the trustee determines appropriate.” The trust also provided that “[a] distribution may be made from the Trust to charity only when both the purpose of the distribution and the charity are as described in Section 170(c) of the Code.” The trust wholly owned a single-member LLC and, in 2004, the LLC donated properties that it had purchased to three qualified charities. Each property had a fair market value that exceeded basis. The LLC received the funds to buy the properties from a limited partnership's distribution to the trust in which the trust was a 99 percent limited partner. The limited partnership owned and operated most of the Hobby-Lobby stores in the U.S. The IRS claimed that the trust could not take a charitable deduction equal to the full fair market value, but instead took the position that the charitable deduction should be limited to the trust's basis in each property. The trust claimed a charitable deduction in excess of $20 million on Form 1041 for 2004, and later filed an amended Form 1041 increasing the claimed charitable deduction to just shy of $30 million, and seeking a tax refund of over $3 million. The IRS denied the refund, claiming that the charitable deduction was limited to cost basis. The trust paid the deficiency and sued for a refund. On the trust's motion for summary judgment, the parties agreed that the donated properties were acquired by the trust with funds coming from gross income from a pre-2004 tax year. Thus, according to the trust, I.R.C. Sec. 642(c)(1) allowed the charitable deduction to be computed based on the donated property's fair market value. The court agreed, noting that I.R.C. Sec. 642(c)(1) allowed a deduction without limitation contrary to the basis limitation contained in I.R.C. Sec. 170, and that charitable deduction provisions are to be construed liberally in the taxpayer's favor. The court noted that the donated properties were all acquired with distributions from the limited partnership to the trust, and each distribution was part of the LLC's gross income for the year of distribution. Thus, the donated properties were clearly bought with funds traceable to the trust's gross income and were donated under the terms of the trust. The court noted that the IRS admitted that there was no caselaw or other substantial authority that supported the government's position. The court granted summary judgment for the trust – the trust was entitled to a deduction for the full fair market value of the appreciated property.
Donating to charity from a trust can be beneficial. There are no percentage limitations that apply. However, there are other requirements that apply and care should be taken in drafting trust language so that those requirements are satisfied.
Thursday, March 23, 2017
Farm and ranch property is exposed to weather-related events that can seriously damage or ruin the property. The massive wildfires in parts of Kansas and the horrific pictures have illustrated the devastation that the affected farmers and ranchers have suffered. It’s truly gruesome to see the pictures of dead livestock and the burned-up fences and pastures, not to mention the buildings, structures and homes that were lost. The financial losses are large, but there are some tax provisions that can be utilized to at least partially soften the blow. A blog post last fall visited this issue, at least in part. Today’s post revisits the issue.
A casualty loss is the complete or partial destruction of property resulting from an identifiable event of a sudden, unexpected or unusual nature. Casualty losses are deductible regardless of whether the property is used in the trade or business, held for the production of income or held for personal purposes although the rules differ slightly on how the loss is calculated.
Sometimes, the issue in a particular case comes down to drawing a line between what is a casualty and what is ordinary wear and tear. For purposes of this post, a casualty is assumed. The recent Kansas wildfire situation, for example, leaves no doubt that the losses are casualty losses for tax purposes.
The amount of the deduction for casualty losses is the lesser of the difference between the fair market value before the casualty or theft and the fair market value afterwards, and the amount of the adjusted income tax basis for purposes of determining loss. The deduction can never exceed the basis in the item that suffers the casualty. In effect, the measure of the loss is the economic loss suffered limited by the basis (and any insurance recovery).
Here's a simple example:
Assume a rancher has five Hereford cows and one Hereford bull in a pasture. A lightning strike ignites a wildfire, and the wildfire spreads rapidly by high winds and the cows and bull are caught in the fire and are killed. The cows were raised and have a basis of $0.00 and a fair market value of $4,500. The bull, which was purchased for $5,000, had a fair market value of $6,000 at the time of death. The amount of the casualty loss is the difference in the fair market value before and after the loss is $10,500 ($10,500 - $0.00). However, the total basis in all of the animals is only $5,000 - the basis of the bull. Since the deductible loss can never exceed the basis, the amount of the deduction is limited to $5,000.
In addition, any casualty loss must be reduced by any insurance recovery. Thus, returning to the example, if the rancher collected $4,500 of insurance on the dead cattle, the deductible loss would be limited to $500. The deduction is to be taken in the year in which the loss was incurred. It is claimed on Section B of Form 4684 and on Form 4797.
Note: If the rancher’s casualty loss causes his deductions to exceed his income for the year in which he claims the loss, the rancher may have a net operating loss (NOL) for the year of the casualty that is entitled to a two-year carryback and a 20-year carryforward. However, the portion of the NOL arising from the casualty loss has a three-year carryback period. I.R.C. §172(b)(1)(E).
What if, in the example above, the rancher’s pasture was destroyed by the wildfire but he had other livestock that survived? But, without usable pasture, the rancher had to sell the livestock. That’s where another tax provision can apply.
When a farmer sells livestock (other than poultry) held for draft, dairy or breeding purposes in excess of the number that would normally be sold during the time period, the sale or exchange of the excess number may be treated as a nontaxable involuntary conversion if the sale occurs because of drought, flood or other weather-related condition. The livestock sold or exchanged must be replaced within two years after the year in which proceeds were received with livestock similar or related in service or use (in other words, dairy cows for dairy cows, for example), and be held for the same purpose that the animals given up were held. Thus, dairy cows can be replaced with dairy cows, but they can’t be replaced with breeding animals.
The tax on the sale is triggered when the replacement animals are sold. If it is not feasible to reinvest the proceeds in property similar or related in use, the proceeds can be reinvested in other property used for farming purposes (except real estate). Similarly, if it is not feasible to reinvest the proceeds from involuntarily converted livestock into other like-kind livestock due to soil or other environmental contamination, the proceeds can be invested into property that is not like-kind or real estate used for farming purposes. I.R.C. §1033(f).
If the replacement property is livestock, the new livestock must be held for the same purpose as the animals disposed of because of the weather-related condition. Treas. Reg. § 1.1033(e)-1(d). The two-year replacement period is extended to four years in areas designated as eligible for assistance by the federal government (i.e., by the President or any agency or department of the federal government). I.R.C. §1033(e)(2)(A). Presumably, any livestock sales that occur before the designation of an area as eligible for federal assistance would also qualify for the extended replacement period if the drought, flood, or other weather-related conditions that caused the sale also caused the area to be so designated. The replacement property must be livestock that is similar or related in service or use to the animals disposed of. Also, the Treasury Secretary has the authority to extend, on a regional basis, the period for replacement if the weather-related conditions continue for more than three years. I.R.C. §1033(e)(2)(B).
The election to defer the gain is made by attaching a statement to the return providing evidence of the weather-related condition that caused the early sale, the computation of the gain realized, the number and kind of livestock sold and the number and kind of livestock that would have been sold under normal business practices. The election can be made at any time within the normal statute of limitations for the period in which the gain is recognized, assuming that it is before the expiration of the period within which the converted property must be replaced. If the election is filed and eligible replacement property is not acquired within the applicable replacement period (usually four years), an amended return for the year in which the gain was originally realized must be filed to report the gain. But, if the animals are replaced, for the tax year in which the livestock are replaced, the taxpayer should include information with the return that shows the purchase date of the replacement livestock, the cost of the replacement livestock and the number and kind of the replacement livestock. The election must be made in the return for the first tax year in which any part of the gain from the sale is realized. It’s also very important for a taxpayer to maintain sufficient records to support the nonrecognition of gain.
Note: For livestock that are partnership property and are sold by the partnership, the election is the responsibility of the partnership. The partners do not individually make the election to defer recognizing the gain. See Rosefsky v. Comr., 599 F.2d 515 (2d Cir. 1979).
The Interaction of the Two Rules
Returning to the example above, assume that the rancher received insurance proceeds exceeding $5,000, the net book value of the animals. For instance, if the rancher received $6,000 of insurance proceeds, the $1,000 exceeding the tax basis of the dead animals would be taxable. That is a potential taxable gain that can be deferred if the rancher makes a valid election to defer the gain, and the livestock are replaced within the applicable timeframe. In that instance, the $1,000 casualty gain can be deferred until the replacement animals are sold. However, it may be advantageous from a tax standpoint for the rancher to report the gain on the animals in order to claim ordinary depreciation on the replacement animals.
Another Rule – One-Year Deferral
Under another rule, if farm and ranch taxpayers on the cash method of accounting are forced because of drought or other weather-related condition to dispose of livestock (raised or purchased animals that are held either for resale or for productive use) in excess of the number that would have been sold under usual business practices, they may be able to defer reporting the gain associated with the excess until the following taxable year. I.R.C. §451(e). The taxpayer's principal business must be farming in order to take advantage of this provision. This brings up a key observation – at the time the tax return is due for the year of the casualty, the livestock owner may not be sure of which election is the best one to make. In that event, a “protective” election can be made under I.R.C. §1033 for that tax year. If the livestock can be replaced within the applicable replacement period, the involuntary election can be revoked and the return for the casualty year can be amended to make the election to defer the gain for one year. In that instance, the return for the year after the casualty would also have to be amended to report the deferred gain.
Relatedly, a taxpayer can make an election under I.R.C. §451(e) until the four-year period for reinvestment of the property under I.R.C. §1033 expires. That means that if a livestock owner elects involuntary conversion treatment and fails to acquire the replacement livestock within the four-year period, the I.R.C. §451(e) election to defer the gain for one year can still be made. If that happens the livestock owner will have to file an amended return for the casualty year to make the I.R.C. §451(e) election and revoke the I.R.C. §1033(e) election, and the next year to report the gain deferred to that year.
Farming operations organized in a form other than as a C corporation which have received “applicable subsidies” are subject to an overall limitation on farming losses of the greater of $300,000 ($150,000 in the case of a farmer filing as married filing separately) or aggregate net farm income over the previous five-year period. Farming losses from casualty losses or losses by reason of disease or drought are disregarded for purposes of figuring this limitation. I.R.C. §461(j).
Farm income averaging can also be a useful tool as an election in a tax year in which a substantial casualty has been sustained. The interaction of the income averaging election, casualty loss rules, the tax treatment of livestock sold on account of weather-related conditions and loss carryback rules can provide some significant tax planning opportunities.
Sustaining a casualty loss can be extremely difficult for a farmer or rancher, or any other taxpayer for that matter. But, there are tax rules that can be used to soften the blow.
Tuesday, March 21, 2017
Several decades ago, many farmers had diversified crop and livestock operations. It was not uncommon for a farmer to have cows, hogs, sheep, chickens and also grow row crops such as soybeans and corn along with having hayfields and wheat. But, over time, the standard of living increased, agricultural production became increasingly mechanized and specialization took hold. Grain farming became profitable enough on its own that many farmers no longer needed to also raise livestock. Likewise, machinery costs rose to such a level that, for many farmers, it was no longer economical to have machinery for each of the separate facets of a diversified farming operation.
With this transformation of production agriculture came complexity. The process by which agricultural products are produced has become much more complex. Likewise, the associated tax and legal issues have also become more numerous and complex. In addition, farming operations are larger and also are more likely to employ others than in the past.
That last point brings us to today’s topic. Having employees means those employees need to get paid. Paying employees obliges the employer to withhold payroll taxes. Failing to withhold payroll taxes can lead to huge penalties, even if there was no intent to violate the tax law.
The Tale of Dr. McClendon
McClendon v. United States, No. H-15-2664, 2016 U.S. Dist. LEXIS 159271 (S.D. Tex. Nov. 17, 2016), involved a Texas doctor whose clinic got behind in withholding and paying payroll taxes – way behind. The doctor founded his clinic in 1979 and hired a Chief Financial Officer (CFO) in 1995. By 2009, the clinic had unpaid payroll and other withholding taxes exceeding $10 million. The doctor learned about the unpaid taxes in May of 2009, and the CFO pleaded guilty to embezzlement. The doctor ultimately shut the clinic down and sent the remaining receivables to the IRS in partial payment of the tax liability. But, thinking of the clinic’s employees, the good doctor loaned the clinic $100,000 so that the clinic could make payroll before shutting down. The employees got paid, but the IRS didn’t. In addition, the IRS didn’t care that he was nice to his employees. It assessed the good doctor a total of $4,323,343.70 in tax penalties under I.R.C. §6672. The doctor paid a small part of that liability and then sued for a refund and abatement of the remaining penalty amount. The IRS moved for summary judgment.
Trust Fund Recovery Penalties
Under I.R.C. §§3102(a) and 3402(a), an employer must withhold their employees' share of federal social security and income taxes from the employees' wages. The employer holds these "trust fund taxes" in trust for the benefit of the United States. To ensure that the taxes are remitted to the United States, I.R.C. §26 U.S.C. § 6672(a) imposes a penalty equal to the entire amount of the unpaid taxes. To be held liable for the penalty, the taxpayer must be a “responsible person” that willfully failed to collect, account for, or pay over the taxes.
The “Willfullness” of Dr. McClendon
The doctor conceded that he was a responsible person, but claimed that the penalty didn’t apply because he didn’t willfully fail to collect, account for, or pay the taxes that the clinic owed the IRS. The court disagreed. The focus was on the $100,000 loan the doctor made to his clinic to make sure the employees got paid. The doctor claimed (based on applicable Fifth Circuit caselaw) that because those funds were “encumbered” to cover payroll, he didn’t direct “unencumbered” funds away from the IRS. Therefore, he claimed, he didn’t willfully not pay the IRS and the penalty shouldn’t apply. However, the court rejected that reasoning because the doctor testified that the loaned the money so that the employees could get paid. In other words, he paid the employees instead of the IRS and the funds, the court reasoned, were not “encumbered” in any relevant sense. In addition, the court reasoned that “willful” only required a voluntary, conscious, and intentional act, not a bad motive or evil intent. The doctor also claimed that he had reasonable cause to provide a way to get his employees paid because “he acted morally and generously in using his own money to make sure [clinic] staff . . . were paid for the work they had performed. . . .". However, the court determined that the doctor’s motives were not relevant. He didn’t pay the IRS. He did pay another creditor (the employees). That’s all that mattered. So, the doctor was personally stuck with a tax penalty exceeding $4 million, plus pre-judgment and post-judgment interest until the penalty was paid. The $100,000 loan bought him much more than he bargained for. A small payment to someone other than the IRS can trigger a huge penalty. The penalty isn’t limited to the amount paid to the other creditor(s), it’s the full unpaid amount.
So why is this case a big deal for agriculture? As noted above, as farms have become more prosperous, the duties, obligations and responsibilities of a farmer are increasing. In addition, an increasing percentage of farming operations have employees. Thus, as more farmers shift the payroll compliance duties to others so that the farmer has more time to devote to conducting farming operations, this case sounds a loud warning - shifting the payroll duties does not shift the responsibility to see that trust fund withholdings have been paid to the IRS. The farmer will be held liable. The responsibility can’t be delegated. Make sure to watch payroll taxes. This is also a problem to watch out for in times of financial distress, such as what much of agriculture is going through at the present time.
The Electronic Federal Tax Payment System (EFTPS) is a secure government website that allows users to make federal tax payments electronically. That’s the system that IRS wants businesses to use to remit payroll taxes through. EFTPS is also easy to check online to ensure that payments have been made. Otherwise, there are firms that handle payroll taxes. If you use a private firm, make sure it is reputable and bonded.
Just another thing for a farmer to think about. Don’t forget the payroll taxes.
Friday, March 17, 2017
While purchased livestock that is held primarily for sale must be included in inventory (along with all items that are held for sale or for use as feed, seed, etc., that remain unsold at the end of the year), livestock that is acquired (e.g., purchased or raised) for draft, breeding or dairy purposes may be depreciated by a farmer using either the cash or accrual method of accounting, unless the livestock is included in inventory. Treas. Reg. §1.167(a)-6(b). Cash basis farmers and ranchers are allowed to currently deduct all costs of raising livestock, thus only purchased livestock are required to be capitalized and held in inventory or depreciated.
The decision to depreciate livestock (including fur-bearing livestock) or include them in inventory can be an important one for many farmers and ranchers. That’s the focus of today’s blog post.
Section 1231 Assets
I.R.C. §1231 refers to depreciable business property that has been held for more than one year, and includes buildings and equipment, timber, natural resources, unharvested crops, and livestock among other types of business assets. One benefit of I.R.C. §1231 is that gains and losses on I.R.C. §1231 property are netted against each other in the same manner as capital gains and losses except that a net I.R.C. §1231 gain is capital in nature (e.g., taxed at a preferential rate), but a net I.R.C. §1231 loss is treated as an ordinary loss. A special provision in I.R.C. §1231(b)(3) requires that cattle and horses held for draft, breeding , dairy or sporting purposes must be held for at least 24 months to qualify for I.R.C. §1231 status. Other livestock is only required to be held for at least 12 months. It does not include, for example, inventory and property held for sale in the ordinary course of business.
I.R.C. §1231 tax treatment is not available if the taxpayer includes livestock in inventory. However, a farmer might have animals listed in the closing inventory in a year that are then transferred to the depreciation schedule in the next year upon the animals reaching maturity and becoming productive. In that event, the inventory value of the animals in the first year’s closing inventory should be subtracted from the beginning inventory for the subsequent year.
Even some livestock that does not come within the category of I.R.C. §1231 is depreciable. For example, poultry held for more than one year for breeding or egg-laying purposes may be depreciated if not held primarily for resale. Treas. Regs. §§1.167(a)-3; 1.167(a)-6(b). But, livestock held for sporting purposes is not made specifically depreciable. See Treas. Reg. §1.167(a)-6(b). However, sporting assets may be depreciated as business assets.
Sheep and furbearing animals have been held to be I.R.C. §1231 assets. That at least implies that the animals would be depreciable. See Treas. Reg. §§1231-1; 1.1231-2(a)(3). One case, however, has disallowed depreciation deductions for sheep held for breeding, wool and resale purposes. Belknap v. United States, 55 F. Supp. 90 (W.D. Ky. 1944).
Depreciate or Include in Inventory – That is the Question
The key question for a farmer/rancher is whether livestock should be depreciated or included in inventory. The depreciation of livestock is beneficial to the producer for many reasons. First, depreciation is an ordinary deduction and thus reduces the farmer’s net income and self-employment income. Second, although the depreciation taken on the livestock must be recaptured under I.R.C. §1245, this recapture is not subject to self-employment tax for Schedule F and farmers operating in the partnership form. Third, the amount of gain in excess of original cost, if held for the applicable period, is taxed at favorable capital gains rates under I.R.C. §1231.
Farmer Jones purchases a cow for breeding purposes and pays $2,000 on January 1, 20X1. Over the next three years, Farmer Jones takes $1,160 of depreciation on the cow, thus reducing his farm income and self-employment income by this amount. He then sells it for $3,000 on January 1, 20X4. At that time, Farmer Jones is required to recapture the $1,160 of depreciation originally taken on the cow at ordinary income tax rates (however, it is not subject to self-employment tax) and the $1,000 gain in excess of original cost of $2,000 is subject to long-term capital gains rates since he held the cow for more than two years.
So, is this a better tax result than capitalizing the cow and holding it in inventory? The answer turns on whether a current deduction for depreciation will outweigh subsequent capital gain treatment upon sale. Also, that eventual capital gain treatment will be limited by depreciation recapture which means that ordinary income rates will apply to the portion of the gain on sale attributable to the amount of depreciation previously claimed.
What About Accural Basis Taxpayers?
In general, if an accrual basis farm taxpayer wants to achieve a lower tax rate on future gains from the qualified sale of breeding, draft, dairy or sporting livestock, livestock should generally be inventoried at the lowest possible value. If that is done, care should be taken in selecting the inventory method that is utilized. Because any particular animal’s inventory value pegs its basis for the computation of gain or loss on sale, the inventory method impacts the ordinary gain on sale. Thus, any method that assigns a relatively low value to an animal will result in a relatively greater ordinary gain upon the animal’s sale. Remember, any livestock held for sale that is not breeding, draft, dairy or sporting livestock is subject to ordinary income tax rates, regardless of the period of time held. It is only livestock held for breeding, draft, dairy or sporting purposes that qualify for long-term capital gain rates under I.R.C §1231.
Here are the available methods, and whichever one is utilized must conform to generally accepted accounting principles and must clearly reflect income.
- Cost method. This method simply values inventory at its cost, including all direct and indirect costs.
- Lower-of-cost-or market method. This method compares the market value of each animal on hand at the inventory date with its cost, and uses the lower of the two values as the inventory value for that animal.
- Farm-price method. This inventory method values inventories at market price less the direct cost of disposition. If this method is utilized, it generally must be applied to all property that the taxpayer produces in the taxpayer’s trade or business of farming – except for any livestock that are accounted for by election under the unit- livestock-price method of accounting.
- Unit-livestock-price method. Under this method of inventorying livestock, the livestock are classified into groups based on age and kind and then the livestock in each group (class) is valued by using a standard unit price for each animal in that class. Essentially, the taxpayer divides the livestock into classifications that are reasonable based on age and kind, with the unit prices for each class accounting for the normal costs of producing and raising those animals. If purchased livestock are not mature, the cost of the livestock must be increased at the end of each year in accordance with the established unit prices, except for animals acquired during the last six months of the year. This can result in a situation where the taxpayer receives a current deduction attributable to the costs of raising the livestock without any additional unit increase in the animal’s closing inventory.
When an animal is included in inventory at its unit price at maturity, its inventory value cannot be written down later to reflect a decline in its value because of, for example, a loss in value due to aging irrespective of whether the animal has not yet reached marketable age.
For taxpayers that anticipate generating significant income from the sale of draft, dairy or breeding livestock and who inventory livestock, an inventory method (such as the lower of cost or market method and the unit-livestock-price method) that maximizes capital gain on sale rather than income in the years preceding sale will likely be beneficial. However, consideration should be given to the principle that inventorying livestock will usually cause a reduction in current deductions against ordinary income. On the other hand, for livestock that are depreciated, depreciation deductions previously taken are recaptured as ordinary income upon sale of the livestock, but this income is not subject to self-employment tax and the amount of gain in excess of original cost is subject to favorable long-term capital gains treatment.
Wednesday, March 15, 2017
How a farming operation is structured influences eligibility for federal farm program payment limitations and the amount of payments that can be received. The rules can become complex in their application, but a basic point should not be missed – each “separate person” is entitled to a payment limit. But, what does that mean? How is that term defined? How does the structure of the farming operation impact separate person status?
Those are all important questions when it comes to payment limitation planning, and a recent case from Montana illustrates why proper structuring matters in the realm of payment limitation planning. That’s the focus of today’s post.
Payment Limitation Basics
Monetary limits. For payment limitation and eligibility purposes, a "person" is separately entitled to receive payments up to the applicable limit. Under the 2014 Farm Bill, the total amount of payments received, directly and indirectly, by a person or legal entity (except joint ventures or general partnerships) for Price Loss Coverage (PLC) Agricultural Risk Coverage (ARC), marketing loan gains, and loan deficiency payments (other than for peanuts), may not exceed $125,000 per crop year. A person or legal entity that receives payments for peanuts has a separate $125,000 payment limitation ($250,000 for married persons). Cotton transition payments are limited to $40,000 per year. For the livestock disaster programs, a total $125,000 annual limitation applies for payments under the Livestock Indemnity Program, the Livestock Forage Program, and the Emergency Assistance for Livestock, Honey Bees and Farm-Raised Fish program. A separate $125,000 annual limitation applies to payments under the Tree Assistance Program.
What (or who) is a “person”? "Persons" may be individuals, corporations, limited liability companies, and certain other business organizations (such as trusts, estates, charitable organizations, and states and their agencies), but general partnerships, joint ventures, and similar “joint operations” may not be "persons." Notice the difference. Individuals, along with entities that limit liability, can be a separate person entitled to a payment limit. But, other business structures that don’t limit liability are not a separate person for payment limitation purposes. Let me restate that a different way to drive the key point home - C corporations, S corporations and Limited Liability Companies (i.e., any type of entity that limits liability) all have one payment limitation. The Farm Service Agency (FSA) then implements the direct attribution rule down to the shareholders/members to the fourth level for each of the respective entities. Thus, the entity has a limitation, and then each member has a limitation. If benefits are sought in the name of an entity and there are four shareholders or members of the entity, for example, there is a single payment limit.
However, general partnerships, joint ventures, cooperative marketing associations, and other entities that don’t limit liability are not eligible for "person" status.
Note: The definition of “person” is contained at 7 C.F.R. §1400.3
As a general rule, for farming operations other than those that are small, general partnerships and joint ventures are more advantageous for payment limitation and eligibility purposes than corporations, limited liability companies, and limited partnerships. Why? While a corporation, limited liability company, or limited partnership will be only one "person" irrespective of the number of its shareholders or members, each of the partnership's or joint venture’s members may be a separate "person" (unless there is a “combination” of “persons” under one of the so-called “combination rules”). Therefore, more "persons" are potentially available to a farming operation conducted by an entity that doesn’t limit liability than farming is a farming operation conducted by an entity that does limit liability. But, of course, with no limitation on liability comes joint and several liability. Farmers will generally not be comfortable with that, but it can be addressed by having the general partnership farming operation consist of single-member limited liability companies (or other types of limited liability structures) in lieu of individuals.
“Separate and distinct” requirement. Each “separate person" must have a "separate and distinct" economic investment in the farming operation. That is measured by a three-part test.
* Each separate person must have a separate and distinct interest in the land or the crop involved;
* Each separate person must exercise separate responsibility for the separate interest; and
* Each separate person must maintain funds or accounts separate from that of any other individual or entity for that interest.
Note: General partnerships and joint ventures may satisfy these requirements on behalf of their members.
Farmers and farm families sometimes jointly purchase inputs or exchange equipment or services. That is permissible under the rules, but farming operations that are separate have to stay that way – separate and distinct. Thus, it is important to make sure that transactions are done at arm’s-length and a paper trail is created that clearly shows that separate farming operations are, indeed, separate and that each one meets all of the applicable requirements. Care should be taken to avoid a USDA argument that there is a commingling of funds between farming operations. Promptly paying for joint purchases is a good idea, as is making sure any equipment exchanges are equivalent. The idea is to avoid the appearance that one farming operation is responsible for what another farming operation is doing.
In addition, to be a “separate person,” that “person” must “[m]aintain funds or accounts separate from that of any other individual or entity for such interest [in the land or crop involved].” This requirement is a prohibition against commingling of funds. It is not a bar on “financing.” The rules on financing are probably a topic for another blog post. In general, financing restrictions are in the payment limitation and payment eligibility rules as part of the definitions of “capital,” “equipment,” and “land” and apply to “actively engaged in farming” determinations, not “person” determinations.
In a recent case involving a Montana farming operation, Harmon v. United States Department of Agriculture, No. 14-35228, 2016 U.S. App. LEXIS 23105 (9th Cir. Dec. 22, 2016), the plaintiff received federal farm program payments from 2005 through 2008. The USDA determined that the plaintiff was not a separate “person” from his LLC which also received farm program payments for the same years. As a result, the USDA required the plaintiff to refund to the government the payments that he had received. The plaintiff exhausted his administrative remedies with the USDA to no avail, and the trial court upheld the USDA’s determination on summary judgment.
On appeal, the appellate court affirmed. The court noted that the plaintiff was required to show that he was “actively engaged in farming” and that he was a “separate person” from the LLC because the definition of “person” applied to all of part 1400 of the Code of Federal Regulations (C.F.R.) which contains the “separate person” rules and, consequently, the USDA’s interpretation of its own regulation defining “person” for payment limitation purposes that is set forth in 7 C.F.R. §1400.3 was consistent with the regulation and not plainly erroneous. The court also determined that substantial evidence supported the conclusion that the plaintiff was not a separate person from his LLC due to many unexplained transfers or loans between the plaintiff and the LLC without accompanying documentation. That suggested a commingling of funds, as did the making of operating loans back and forth between the plaintiff and the LLC. As such, the appellate court believed it was not possible to determine the true assets and liabilities of either the plaintiff or the LLC.
The appellate court also believed that the plaintiff had not made a good faith effort to comply with the per-person payment limitations, was not a separate person from the LLC and was entitled to only one payment limit instead of two. Also, the finality rule which makes a determination by a state or county FSA final and binding 90 days from the date an application for benefits was filed did not bar the FSA from evaluating the plaintiff’s program eligibility because the determination was based on misrepresentations that the plaintiff should have known were erroneous. On the application, the plaintiff had represented that he provided all of the capital and labor on his farm and didn’t receive any operating loans from related entities. In addition, while the decision of the Director of the USDA National Appeals Division did not meet the 30-day deadline, it was not void because the statute at issue (7 U.S.C. §6998(b)(2)) contains no remedy for failure to comply.
A key problem with the Montana farming operation was its structure. The LLC was a “person” under the rules, so the individual had to meet the tests for being a “separate person” from the LLC. He couldn’t do that with the result that only a single payment limitation applied. A better approach would have been to set the farming operation up as a general partnership. The general partnership would not have qualified as a “separate person,” but the individual farmer could have as a single-member LLC. That still would have resulted in one payment limitation, but additional family members could have been added as members with each having their own single-member LLC. That structure might also help address problems with commingling of funds with the operating entity.
In any event a professional that understands the rules can help to create a structure that can result in compliance with the rules and keep the farming operation from becoming tangled in needless litigation. That’s particularly the case for medium and larger-sized farming operations where the payment limit is in play.
Monday, March 13, 2017
The conservation-compliance provisions of the 1985 Farm Bill introduced the concept of “Swampbuster.” It was originally presented as only impacting truly aquatic areas and allowing drainage to continue where substantial investments had been made. The concept was met with virtually no congressional opposition, and provided that any person who in any crop year produced an agricultural commodity on converted wetlands would be ineligible for federal agricultural subsidies with regard to that commodity.
But, the Swampbuster rules have become a “quagmire” of a bureaucratic mess for many farmers and their legal counsel over the years. Today’s post takes a brief look at the issues involved in the hope that farmers and lawyers representing them can find a bit of guidance.
The original intent of Swampbuster was to deny federal farm program benefits to persons planting agricultural commodities for harvest on converted wetlands. 16 U.S.C. § 3821(a)-(b). Committee reports indicated that the Congress did not intend the Swampbuster provisions to authorize the USDA to regulate the use of private land and wanted producers to remain eligible for farm program benefits if the production of agricultural commodities occurred on converted wetlands where the impact of such conversion on wetland functional values was slight. A wetland conversion was deemed to have “commenced” when a person had obligated funds or begun actual modification of a wetland.
The legislation charged the Soil Conservation Service (SCS) with creating an official wetland inventory with a particular tract being classified as a wetland if it had (1) the presence of hydric soil; (2) wetland hydrology (soil inundation for at least seven days or saturated for at least 14 days during the growing season); and (3) the prevalence of hydrophytic plants under undisturbed conditions. In other words, to be a wetland, a tract must have hydric soils, hydrophytic vegetation and wetland hydrology. All three must be present, just having hydrophytic vegetation, for example, is not enough. See B&D Land & Livestock Co. v. Schafer, 584 F. Supp. 2d 1182 (N.D. Iowa 2008).
The final Swampbuster rules were issued in 1987 and greatly differed from the interim rules. The final Swampbuster rules eliminated the right to claim prior investment as a commenced conversion. Added were farmed wetlands, abandoned cropland, active pursuit requirements, Fish and Wildlife Service concurrence, a complicated “commenced determination” application procedure, and special treatment for prairie potholes. Under the “commenced conversion” rules, an individual producer or a drainage district is exempt from Swampbuster restrictions if drainage work began before December 23, 1985 (the effective date of the 1985 Farm Bill). If the drainage work was not completed by December 23, 1985, a request could be made of the USDA on or before September 19, 1988, to make a commencement determination. In addition, drainage districts must satisfy several requirements under the “commenced conversion” rules. A project drainage plan setting forth planned drainage must be officially adopted. Also, the district must have begun installation of drainage measures or legally committed substantial funds toward the conversion by contracting for installation or supplies.
On-Site Wetland Identification Criteria
The USDA Natural Resource Conservation Service (USDA-NRCS) on-site wetland identification criteria are contained in 7 C.F.R. §12.31. Those rules lay out the procedures that USDA is to use to determine whether a tract contains wetlands. But, the implementation of the procedures has also led to litigation. For example, in Boucher v. United States Department of Agriculture, 149 F. Supp. 3d 1045 (S.D. Ind. 2016), the court determined that the NRCS followed regulatory procedures found in 7 C.F.R. §12.31(b)(2)(ii) for determining wetland status on the land that was being farmed by comparing the land to comparable tracts that were not being farmed. The court also noted that existing regulations do not require site visits during the growing season and “normal circumstances” of the land does not refer to normal climate conditions but instead refers to soil and hydrologic conditions normally present without regard to the removal of vegetation. The court also determined that the ten-year timeframe between the preliminary determination and the final determination did not deprive the plaintiff of due process rights. As a result, the court granted the government’s motion for summary judgment.
Likewise, in Foster v. Vilsack, 820 F.3d 330 (8th Cir. 2016), the court determined that the defendant’s method for determining hydrology by using aerial photographs taken when the tract was under normal environmental conditions was proper, given that the tract was drier than normal during the defendant’s site visit and because the plaintiffs had tilled the tract such that it was not in its normal condition at the time of the site visit. The plaintiffs’ claim that the defendant had relied on “color tone” differences in the photographs to identify the tract as a wetland was dismissed because the defendant had actually identified some of the specifically authorized wetland signatures rather than just relying on changes in color tone. The court also rejected the plaintiffs’ claim that the defendant had relied on a comparison site too distant from the tract at issue that wasn’t within the local area as the regulations required. The comparison site chosen was 40 miles away but was within the same Major Land Resource Area. As such, the comparison site satisfied the regulatory criteria contained in 7 C.F.R. §12.31(b)(2) to find a similar tract in its natural vegetative state. Accordingly, the defendant’s use of the comparison site was not arbitrary, capricious or contrary to the law. Earlier this year, the U.S. Supreme Court declined to hear the case.
The final rules defined “farmed wetlands” 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). Prior converted wetlands can be farmed, but they revert to protected status once abandoned. A prior converted wetland is a wetland that was totally drained to make it more suitable for farming before December 23, 1985. 16 U.S.C. §3801(a)(6). If a wetland was drained before December 23, 1985, but wetland characteristics remain, it is a “farmed wetland” and only the original drainage can be maintained.
Drainage activities on land designated as “farmed wetlands” have led to litigation. In Gunn v. United States, 118 F.3d 1233 (8th Cir. 1997), cert. den., 522 U.S. 1111 (1998), the Eighth Circuit Court of Appeals held that conversion from wetland to farmland of the land in question did not begin before 1985 even though the land had been cropped for 85 consecutive years after the county drainage district installed a tile main to drain the land for crop production in 1906. Because wetland traits occurred over time in wet years as the drainage system became incapable of draining the land, a portion of the farm was classified as “farmed wetland” and a 1992 replacement of the 1906 tile main with an open ditch was held to be an illegal improvement in the drainage beyond that which existed on December 23, 1985. The court reached this conclusion even though drainage district assessments had been paid on the land for decades.
Unfortunately, the Gunn court did not precisely address the issue of the original “scope and effect” of the 1906 drainage activities. Under USDA regulations, farmed wetland can be used as it was before December 23, 1985, and a hydrologic manipulation can be maintained to the same “scope and effect” as before December 23, 1985. The USDA is responsible for determining the scope and effect of original manipulation on all farmed wetlands. Arguably, if the 1906 drainage allowed crop production to occur on all of the land at issue at that time, then the effect of the 1906 drainage on the wetland was to convert it to crop production, and that status could be maintained by additional drainage activities after December 23, 1985. However, for farmed wetlands, 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. In 1999, the U.S. Court of Appeals for the Eighth Circuit invalidated the government’s interpretation of the “scope and effect” regulation. Barthel v. United States Department of Agriculture, 181 F.3d 934 (8th Cir. 1999). 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.
Changes in the Rules
In 1990, the Congress tightened the Swampbuster rules by adding a new provision which provided that “any person who in any crop year subsequent to November 28, 1990, converts a wetland by draining, dredging, filling, leveling, or any other means for the purpose, or to have the effect, of making the production of an agricultural commodity possible on such converted wetlands shall be ineligible for USDA farm benefits. 16 U.S.C. § 3821(b)-(c). The rules were also changed to add a stronger penalty for wetland conversions. While converting a wetland before Nov. 28, 1990, resulted in only a proportional loss of benefits, conversion after that date results in the loss of all USDA benefits on all land the farmer controls until the wetland is restored or the loss is mitigated. 16 U.S.C. § 3821(c) (2008). After the 1990 Swampbuster rule change, the USDA took the position that activities that made ag production “possible” on converted wetland meant that any activity that made such land more farmable was prohibited. The USDA’s regulatory position was upheld by Clark v. United States Department of Agriculture, 537 F.3d 934 (8th Cir. 2008). but rejected by Koshman v. Vilsack, 865 F. Supp.2d 1083 (E.D. Cal. 2012).
Under the 1996 Farm Bill, a farmed wetland located in a cropped field can be drained without sacrificing farm program benefit eligibility if another wetland is created elsewhere. Thus, through “mitigation,” a farmed wetland can be moved to an out-of-the-way location. In addition, the 1996 legislation provides a good faith exemption to producers who inadvertently drain a wetland. If the wetland is restored within one year of drainage, no penalty applies. The legislation also revises the concept of “abandonment.” Cropland with a certified wetland delineation, such as “prior converted” or “farmed wetland” is to maintain that status, as long as the land is used for agricultural production. In accordance with an approved plan, a landowner may allow an area to revert to wetland status and then convert it back to its previous status without violating Swampbuster.
While the Congressional intent behind the Swampbuster rules was a good one, the actual implementation has created difficult problems for farmers and ranchers. Will a new Administration and new heads of federal agencies bring more common sense to the application of that original intent of the Congress? Only time will tell.
Thursday, March 9, 2017
Normally, land improvements constitute capital expenditures the cost of which would have to be added to the basis of the land. But, a farmer can currently deduct the cost of certain improvements and soil and water conservation expenses in the first year in which the farmer incurs the expenditures. I.R.C. §175. If the deduction is not taken in that first year, the result is that the taxpayer has elected not to deduct which is binding in subsequent years. In that case, the expenditures increase the basis of the property to which they relate. Once a method of reporting such expenses is adopted, it must be followed in subsequent years unless the IRS agrees to a change.
So, what expenditures are eligible to be currently deducted under I.R.C. §175? How is the deduction claimed? If there a possibility of recapture if the associated land is sold? These are the issues today’s post examines.
Soil and water conservation expenses that qualify under the I.R.C. §175 provision must be paid or incurred for soil or water conservation purposes with respect to land used in farming, or for the prevention of erosion on farmland. I.R.C. §175(a). Qualified expenses include various types of earth moving on farmland using in the business of farming. Expenses for leveling, conditioning, grading, terracing and contour furrowing are all eligible as are costs associated with the control and protection of diversion channels, drainage ditches, irrigation ditches, earthen dams, water courses, outlets and ponds. Even the cost of eradicating brush and the planting of windbreaks is eligible. I.R.C. §175(c)(1). Also included are drainage district assessments (and soil and water conservation district assessments) if such assessments would have been a deductible expense if the taxpayer had paid them directly. I.R.C. §175 (c)(1)(B).
Taxpayer engaged in farming. Several requirements must be met before soil and water conservation expenditures can be deducted. As noted above, the taxpayer must be engaged in the business of farming. A farm operator or landowner receiving rental income under a material participation crop share or livestock share lease satisfies the test. Treas. Reg. §1.175-3. Under that type of lease, the landlord bears the risk of production and the risk of price change. A share lease where the landlord’s report the income from it on Form 4835 also satisfies the test. However, a cash lease doesn’t meet the test. That’s a rental activity.
Land used in farming. The expenditures must pertain to land used in farming - to produce crops or sustain livestock. Specifically, the term “land used in farming” means land “used by the taxpayer or his tenant for the production of crops, fruits, or other agricultural products or for the sustenance of livestock.” I.R.C. §175(c)(2).
Improvements that are made to land that hasn’t been previously used in farming are not eligible. But, prior farming activity by a different taxpayer counts as does a different type of agricultural use. Treas. Reg. §1.175-4(a). In addition, expenses associated with assets that qualify as deductible as soil and water conservation expenses are not necessarily precluded from being depreciated by a subsequent purchaser of the real estate on which qualifying property has been placed. For example, in Rudolph Investment Corp. v. Comm’r, T.C. Memo. 1972-129, the court allowed the taxpayer to depreciate earthen dams and earthen water storage tanks located on ranchland even though the structures qualified for a current deduction under I.R.C. § 175.
NRCS plan and ineligible expenditures. The expenditures must be consistent with a conservation plan approved by the Natural Resources Conservation Service (NRCS) or, if there are no NRCS plans for the area, a state (or local) plan. I.R.C. §175(c)(3). See also 2016 IRS Pub. 225 (Ch. 5). On this point, expenditures for draining or filling of wetlands or land preparation for center-pivot irrigation are not deductible as soil and water conservation expenses. I.R.C. §(c)(3)(B). Similarly, expenses to clear land so that it can be farmed are not eligible and must be added to basis. IRS Pub. 225, Chapter 5, also points out that ineligible expenditures include those for various structures such as tanks, reservoirs, pipes, culverts, canals, dams, wells, or pumps composed of masonry, concrete, tile (including drainage tile), metal or wood. The costs associated with these items are recovered through depreciation. Similarly, costs associated with clearing land to prepare it for farming are not eligible and must be added to basis. Likewise, expenses that are currently deductible as repairs or are otherwise currently deductible under I.R.C. §162 as an ordinary and necessary business expense are not claimed under I.R.C. §175. Treas. Reg. §1.175-2(b)(2).
Deduction limit. The deduction may not exceed 25 percent of the taxpayer's “gross income derived from farming” in any taxable year. I.R.C. §175(b). The term “gross income derived from farming” includes gain from the sale of draft, dairy, breeding or sporting purpose livestock, but not gains from the sale of machinery or land. Excess amounts may be carried over to the succeeding years subject to the same 25 percent limit.
Note: It is possible that qualified expenditures could be subject to the 25 percent limitation if the farm taxpayer defers a sufficient amount of grain sales, for example, such that gross farm income is decreased.
How to Claim the Deduction
Line 12 of the 2016 Schedule F (Form 1040) is where soil and water conservation expenses can be reported. As noted above, if they are not claimed they are to be added to the land’s basis. In addition, as noted above, the decision to either currently deduct or capitalize soil and water conservation expenses is made in the first year in which the expenses are incurred and establishes a method of accounting. To change that method of accounting requires IRS approval.
If a deduction is taken for soil and water conservation expenses on farmland or ranchland and the land is disposed of within ten years of its acquisition, part or all of the deductions taken are recaptured as ordinary income up to the amount of gain on the disposition or the amount deducted multiplied by a percentage (as noted below), whichever is lower. I.R.C. §1252. The amount of recapture depends upon how long the land was held before disposition. For land held five years or less, all of the deductions are subject to recapture. For land held more than five years but less than ten, a sliding scale applies. A sale or disposition in the sixth year recaptures 80 percent, within the seventh year 60 percent, within the eighth year 40 percent, and within the ninth year 20 percent, of the deductions. If the land was held for more than nine years, there is no recapture of soil and water conservation deductions.
To restate, in the event recapture applies, the recaptured amount cannot exceed the amount of gain on the land. Also, if only a portion of the land is disposed of, the deductions attributable to the entire parcel are allocated to each part in proportion to the fair market value of each at the time of disposition. If disposition of the land is by gift, tax-free exchange or transfer at death, no gain is recognized from recapture.
The current deduction for soil and water conservation expenses can be a helpful provision for numerous farmers. When a farmer has qualifying expenses it’s a helpful tool to include in the tax planning arsenal.
Tuesday, March 7, 2017
The IRS recently issued interim guidance on a pilot program for Schedule F expenses for small business/self-employed taxpayer examinations. The program is to start on April 1, 2017 and run for one year. The focus will be on “hobby” farmers, and the program will be conducted through the IRS Brookhaven campus in Holtsville, NY. While the pilot will only consist of 50 tax returns from tax year 2015 being examined, it could be an indication that the IRS is looking to increase the audit rate of returns with a Schedule F. In addition, without knowing how the returns will be selected for examination, it may be more likely to impact the relatively smaller farming operations.
Focus of the Pilot Program
The interim guidance points out that the IRS believes that compliance issues may exist with respect to the deduction of expenses on the wrong form, or expenses that actually belonged to another taxpayer, or that should be subject to the hobby loss rules of I.R.C. §183. Indeed, the IRS notes that a filter for the project will be designed to identify those taxpayers who have W-2s with large income and who also file a Schedule F “and may not have time to farm.” IRS also says the filtering for expenses will be via the same process that it uses when it examines Schedule C, and notes that deductions that relate to the taxpayer’s W-2 employment, Schedule A or a corporate return should not appear on Schedule F. In addition, the guidance informs IRS personnel that the examined returns could have start-up costs or be a hobby activity which would lead to non-deductible losses.
The interim guidance directs the IRS examiners to consult IRS Pub. 225 (Farmers’ Tax Guide) and directs its examiners to look for a taxpayer with a primary residence on a farm where the principal business is farming. The interim guidance also directs examiners to look for deductions that “appear to be excessive for the income reported.” The implication is that such expenses won’t be deemed to be ordinary and necessary business expenses. How that might impact the practice of pre-paying farm expenses remains to be seen. One of the tests for pre-paying and deducting farming expenses is that the pre-payment must not materially distort income. Is the IRS implying in the interim guidance that it views a high level of pre-paid expenses when income is relatively low to be a material distortion of income? Perhaps that’s reading too much into the guidance and giving the IRS too much credit. The guidance does instruct that deposits are not deductible pre-payments, although it does state that a deposit is deductible if it is for future supplies. That is a strange statement. A pre-payment that constitutes a deposit is not deductible in accordance with Rev. Rul. 79-229, which the guidance doesn’t mention.
The IRS also instructs its examiners to separate deductible business expenses from capital expenses and personal expenses. On the capital expense issue, there is no mention of the $2,500 safe harbor (per invoice or per item) which allows a current deduction. The guidance also instructs examiners to pick through gas, oil, fuel, repairs, etc., to determine the “business and non-business parts” of the expense. Again, no mention is made of the safe harbor.
The interim guidance indicates that custom hire expense is deductible on line 13 of Schedule F. It also notes that fuel expense is deductible if it is used for conducting business on the farm. On that issue, the IRS believes that having an on-farm storage tank and accounting for personal use of fuel is important, and that fuel bought from a gas station needs further explanation to ensure it was not used for personal purposes.
As for mortgage interest, the interim guidance notes that it is deductible if it relates to real property that is used in the taxpayer’s farming business. The guidance also states that repair and maintenance expenses on the taxpayer’s personal residence are not deductible, without mentioning the situation that is common in agriculture – an office in the home for which related repairs and maintenance would be deductible.
The interim guidance does get into an explanation of the pre-paid expense rules and this time states that the pre-payment cannot be a deposit and states that the taxpayer must be able to document the reason for the prepayment.
The interim guidance would appear to be targeted toward taxpayers that either farm or crop share some acres where the income ends up on Schedule F, but where other non-farm sources of income predominate (e.g., W-2 income, income from leases for hunting, bed and breakfast, conservation reserve program payments, organic farming, etc.). In those situations, it is likely that the Schedule F expenses will exceed the Schedule F income. That’s particularly the case when depreciation is claimed on items associated with the “farm” - a small tractor, all-terrain vehicle, pickup truck, etc. That’s the typical hobby loss scenario that IRS is apparently looking for.
Keep in mind that the IRS is only going to examine 50 returns in their pilot project, and those returns will relate to the 2015 tax year. The IRS should focus its attention on those returns with small losses, but it’s not known whether that will be the IRS approach. Also, where is the IRS going to come up with the funds to audit, even if the pilot program indicates a widespread problem? Those funds aren’t available, and aren’t likely to be forthcoming in the near future.
In any event, it’s helpful to know what the IRS is up to.
Friday, March 3, 2017
President Trump campaigned, in part, on a promise to reign-in regulatory agencies and eliminate unnecessary regulations. That’s a big deal to agriculture. A significant amount of governmental regulation of agricultural activities is conducted by and through administrative agencies that promulgate regulations and make decisions. Regulatory activity occurs outside both the legislatures and the courts, where most of conventional lawmaking occurs. Consequently, with much of administrative law, the administrative agency that writes the regulation at issue serves as judge and jury over disputed matters involving those same regulations. This raises fundamental questions of fairness. In exercising their rule-making power, agencies of government cannot go beyond the authority provided by the legislative body. At least that’s the way it’s supposed to work.
Today’s post takes a deeper look at administrative agencies and how farmers and ranchers can best deal with them.
Administrative Agency Basics
At the federal level, the Congress enacts basic enabling legislation, but leaves the particular administrative departments (such as the USDA) to implement and administer congressionally created programs. As a result, the enabling legislation tends to be vague with the administrative agencies (such as the USDA) needing to fill in the specific provisions by promulgating regulations. The procedures that administrative agencies must follow in promulgating rules and regulations, and the rights of individuals affected by administrative agency decisions are specified in the Administrative Procedures Act (APA). 5 U.S.C. §§ 500 et seq. The provisions of the APA constitute the operative law for many of the relationships between farmers and ranchers and the government.
Administrative Agency Procedure
Usually, a farmer or rancher's contact with an administrative agency is in the context of participation in an agency-administered program, or being cited for failure to comply with either a statutory or administrative rule. So, it’s helpful for farmers and ranchers to have a general understanding of how administrative agencies work and the legal effects of their decisions. In general, disputed matters involving administrative agencies must first be dealt with in accordance with the particular agency's own procedural rules before the matter can be addressed by a court of law. This is known as exhausting administrative remedies. 7 U.S.C. §6912(e). See also Johnston v. Patterson, No. 4:14-CV-210-BO, 2014 U.S. Dist. LEXIS 172224 (E.D. N.C. Dec. 12, 2014). About the only exception to the rule of exhaustion that I have seen is if a facial challenge is made to the regulation itself. See Gold Dollar Warehouse, Inc. v. Glickman, 211 F.3d 93 (4th Cir. 2000). Thus, participating carefully in administrative proceedings can be vitally important to a farmer or rancher, especially in terms of properly preserving a record for subsequent court review.
Going through the administrative process is critical because, typically, an appeal to a court of law is made only on the basis of the record generated in the administrative proceeding. Courts are limited in the extent to which they can substitute their judgment for that of an administrative agency regarding the facts of the dispute. Thus, it is critical to preserve all disputed factual and legal issues in the record of the administrative proceeding so that they can later be considered by a court. The exhaustion of administrative remedies, as a general rule, also requires that legal issues must be raised during the administrative process so as to be preserved for judicial review. If they are raised in the administrative process, then they will likely be precluded. Also, exhaustion is required as to each legal issue. See, e.g., Ballanger v. Johanns, 495 F.3d 866 (8th Cir. 2007).
What’s the Standard For Reviewing Agency Action?
Courts generally consider only whether the administrative agency acted rationally and within its statutory authority. Consequently, a particular farmer or rancher bears the burden of insuring that the record is adequate for the appeal of the issues involved before the matter leaves the administrative process. Otherwise, an appeal of an administrative agency's decision must be based solely on arguments that the agency acted arbitrarily, capriciously, beyond legal authority or that it abused its discretion.
In general, when dealing with administrative appeals from a federal agency such as the USDA, the court generally defers to the agency’s interpretation of its regulations as contained in the agency’s interpretive manuals. Prevailing in court on this type of a claim can be quite difficult. However, in Christensen v. Harris County, 529 U.S. 576 (2000), the U.S. Supreme Court ruled that statutory interpretations made by governmental agencies in pronouncements that do not have the force of law, such as opinion letters, policy statements, agency manuals, and enforcement guidelines, are not entitled to such great deference. This is a significant case for the agricultural sector because the USDA often makes interpretations of the laws they administer in formats that do not have the force of law. Similarly, in Meister v. United States Department of Agriculture, 623 F.3d 363 (6th Cir. 2010), the court noted than an agency is not entitled to deference simply because it is a governmental agency. The case involved a claim that the U.S. Forest Service had failed to comply with its own regulations and a federal statute in developing its 2006 management plan for national forests in northern Michigan. The trial court granted the government’s motion for summary judgment, but the appellate court reversed. The appellate court noted that it was insufficient for the government to only identify the lands on which a particular activity (such as snowmobiling) could occur. Instead, the government had to identify the supply of lands on which participants in particular activities would experience a quality recreational experience. As a result, the issuance of the agency’s plan was arbitrary because the estimates of snowmobile and cross-country visitors to the forests were entirely arbitrary and there was no coordination with Michigan's recreational planning, and the agency did not minimize conflicts between off-road vehicle use and other uses and interests of the forests. The court specifically noted that agency deference was not automatic. Instead, the agency must apply the relevant statutory and regulatory authority.
On the deference issue, a change might be in the wind. In 1997, the U.S. Supreme Court again reiterated the principle of agency deference. Auer v. Robbins, 519 U.S. 452 (1997). However, the Court, in 2013 criticized the Court’s 1997 decision and suggested that it might be time to reconsider principles of agency deference. Decker v. Northwest Environmental Defense Center, 133 S. Ct. 1326 (2013).
The Equal Access to Justice Act (EAJA) (5 U.S.C. §§504 (2008); 28 U.S.C. §2412(d)(2)(A)) provides that a party who prevails administratively against government action can recover fees and expenses if the administrative officer determines that the government’s position was not substantially justified. However, the USDA’s longstanding position is that the EAJA does not apply to administrative hearings before the USDA’s National Appeals Division (NAD) because NAD proceedings are not adversarial adjudications that are held “under” the APA. But, the United States Court of Appeals for the Eighth Circuit rejected the USDA’s position in 1997. Lane v. United States Department of Agriculture, 120 F.3d 106 (8th Cir. 1997). The Ninth Circuit ruled similarly in 2007. Aageson Grain and Cattle, et al. v. United States Department of Agriculture, 500 F.3d 1038 (9th Cir. 2007). The Seventh Circuit ruled likewise in 2008. Five Points Road Venture, et al. v. Johanns, 542 F.3d 1121 (7th Cir. 2008).
Dealing with administrative agencies is a reality for the typical farmer or rancher. Perhaps the change in Administration with last fall’s election will provide some common-sense reform to the impact they have on the business activity of farmers and ranchers. Time will tell.