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.
Wednesday, March 1, 2017
An individual engaged in a farming (or fishing) business can elect to spread whatever portion of current taxable income attributable to any farming business (termed “elected farm income”) evenly over the three prior taxable years by using Schedule J. I.R.C. §1301. Thus, if rates were lower in the prior years, the taxpayer will get the benefit of applying the lower rates to current taxable income from farming. The current year's income tax liability is calculated by determining the current year's tax (without the amount of elected farm income) plus the increases in income tax for each of the three prior taxable years by taking into account the allocable share of elected farm income for each of those years. Any adjustment for any taxable year is taken into account for income averaging purposes in subsequent tax years.
Income averaging can be a great tool for farm clients in certain situations? But what are those situations, and how best can the election be utilized? Farm income averaging planning – that’s the focus of today’s post – after reviewing the basics of the provision.
Basics of Averaging
Who is eligible? Only individuals with farm (or fishing) income are eligible to utilize income averaging. Estates and trusts are not eligible and C corporations are not considered to be individuals. For entities taxed as partnerships, it is the individual partners or members, that can be eligible to elect income averaging. For Subchapter S corporations engaged in farming, the S corporation is not eligible to make an income averaging election, but the S corporation individual shareholder is. Likewise, income attributable to a farming business carried on by a partnership can be averaged without regard to the partner’s level of participation in the partnership or the size of the ownership interest.
Engaged in a “farming business.” An individual electing income averaging must be “engaged in a farming business” in the year for which the election is made. But, the individual doesn’t need to necessarily have been engaged in a farming business in the three prior carryback years. A “farming business” means a trade or business involving the cultivation of the land or the raising and harvesting of any agricultural or horticultural commodities, but does not include the processing of commodities or products “beyond those activities which are normally incident to the growing, raising or harvesting of such products.”
An individual's relationship to the “farming business” is critical in determining eligibility. Clearly eligible for income averaging are operators of farming businesses that bear the risks of production and the risks of price change and provide substantial involvement in management. That means that a landlord is engaged in a rental activity and not in a farming business if the rental is a fixed rent (cash rent). Whether the landlord materially participates in the tenant’s farming business is irrelevant for income averaging purposes. But, non-materially participating landlords are only eligible for income averaging if the landlord’s share of a tenant’s production is set in a written rental agreement before the tenant begins significant activities on the land.
What about a recently retired farmer? Individuals who have ceased farming operations with the only activity in the year in question being the sale of inventory and the sale of machinery are not engaged in a “farming business” in that year. However, gains or losses from property regularly used in a farming business after cessation of the farming business are treated as attributable to a farming business if the property is sold within a reasonable time after cessation of the farming business. If the sale or other disposition of such assets occurs within one year of the cessation of farming, it is presumed to be within a reasonable time. After that, it is a facts and circumstance test.
Are gains eligible? Gains from the “sale or other disposition of property (other than land) regularly used by the taxpayer in such a farming business for a substantial period” are eligible for averaging. I.R.C. § 1301(b)(1)(B). Clearly, gains from the sale or exchange of land do not qualify. Although not completely clear, it would appear that gain from land sales is ineligible for averaging whether that gain is taxed as capital gain, ordinary income, recaptured depreciation or “unrecaptured § 1250 gain” and where that gain is attributable to the soil.
The IRS position is that gains from assets considered to be part of the land (buildings, fences and tile lines, for example) are eligible for income averaging.
Phase-outs, rates and limitations. Income averaging doesn’t impact the taxable income or tax of any of the three base years. That means that it is not a “carryback” of current income to the base year. Instead, it’s just a reference to the base year’s marginal income tax rate for the purpose of applying that rate to a portion of current year taxable income. What that means is that income averaging does not change the phase-outs or percentage limitations of the base year tax returns. Treas. Reg. §1.1301-1(d)(1). Also, when tax rates go up, all else staying the same, an income averaging election can benefit top bracket filers. In that situation, the election will always reduce the tax rate. While an increase in rates isn’t going to happen in the near future, when they increased starting in 2013, top bracket filers benefited from income averaging for 2013, 2014 and 2015.
Capital gain rate reduction. The averaging election can be made on both ordinary and capital gains, but clarification by the IRS indicates that an equal portion of each type of income must be carried to each prior year. From a tax planning standpoint, an income averaging election can be made on ordinary income and, with proper planning, the effective rate on non-farm capital gains can be reduced. Likewise, when the top capital gain rate increased 33 percent to a 20 percent rate beginning in 2013, the averaging election had the impact of reducing the rate to 15 percent. It also could, perhaps, eliminate it. That could be a big deal for a farmer that sells breeding stock or other assets that trigger capital gain.
Alternative minimum tax. The income averaging election has no direct impact on how the alternative minimum tax (AMT) is calculated. The taxpayer can’t “average” the AMT calculation. But, look to make the averaging election in a year in which the farmer triggers AMT. A tax benefit can be derived. Also, see whether an increase in taxable income might decrease the AMT. In that event, the marginal tax rate for top bracket farmers will drop. Likewise, look for situations where AMT income exceeds the phase-out of the AMT exemption and the tentative minimum tax exceeds the regular income tax before averaging both before and after adding incremental income. If you have that situation, the AMT will decline. Also, because there is no AMT floor on the use of averaging, the election can be quite beneficial in a year when a farmer has an income spike (maybe from a machinery sale or because a large amount of carryover grain is sold (especially at high prices). In addition, watch for planning opportunities when the farmer has substantial nonbusiness expenses that exceed nonbusiness income in the base years.
Other tax items. There are numerous other tax items that can potentially be impacted by an averaging election. Here’s a listing of a few of the more prevalent ones:
- An income averaging election doesn’t impact self-employment tax. But, it can generate big self-employment tax savings if it drops income beneath the social security base.
- As for the “kiddie tax,” making the election on the parents’ return will cause the child’s tax on investment income to be applied by using the parents’ rate after shifting the elected farm income. But, in the base years, the kiddie tax is not affected by the election. Reg. §1.1301-1(f)(5).
- For losses and carrybacks, any net operating loss carryovers or net capital loss carryovers to an election year are applied to the election year income before the elected farm income is subtracted. Think that one through. The election could create a tax advantage.
- An individual is not prohibited from making an income averaging election solely because the individual’s filing status is not the same as in the base years. Reg. § 1.1301-1(f)(2). However, the IRS has not provided guidance on how the remaining bracket amounts are to be divided between the spouses if both spouses have elected income averaging in a year following divorce.
- In addition, negative figures can be utilized. That’s good news for many farmers that are presently experiencing tough economic times. However, it appears that negative elected farm income figures in the year of election cannot be used to reduce tax liability as calculated with reference to the three carryback years.
- An income averaging election can be made on a late or amended return if the period of limitations on filing a claim for credit or refund has not expired. Also, a previous election can be changed or revoked if the period of limitations has not expired. This feature provides great flexibility in utilizing the election.
Farm income averaging can provide a significant tax savings for farm (and fishing) clients in certain situations. Watch for the retiring farmer that has carryover grain sales and/or income from a machinery auction. Also, it may be worthwhile to try to cause a farm client’s farm income to spike periodically (every three to four years) to avoid self-employment tax, while simultaneously lowering income tax costs by an election. Also, look to utilize the election on behalf of maximum tax bracket taxpayers. Finally, keep an eye on future tax legislation. Once it is known what the new rates and brackets will be, then a reevaluation can be done of the potential impact of farm income averaging for farm clients.
Monday, February 27, 2017
The Fair Labor Standards Act of 1938 (FLSA) (29 U.S.C. §§ 201 et seq.) as originally enacted, was intended to raise the wages and shorten the working hours of the nation's workers. The FLSA is very complex, and not all of it is pertinent to agriculture and agricultural processing, but the aspect of it that concerns “joint employment” is of major relevance to agriculture.
Most courts that have considered the issue have utilized an “economic realities” or “control” test to determine if one company’s workers are attributable to another employer for purposes of the FLSA. But, in Salinas v. Commercial Interiors, Inc., No 15-1915, 2017 U.S. App. LEXIS 1321 (4th Cir. Jan. 25, 2017), rev’g, No. JFM-12-1973, 2014 U.S. Dist. LEXIS 160956 (D. Md. Nov. 17, 2014), the court reversed the trial court and created a new test for joint employment under the FLSA. This new decision appears to expand the definition of “joint employment” and may create a split of authority in the Circuit Courts of Appeal on the issue. It’s a big issue for certain aspects of agricultural employment and is the focus of today’s post.
FLSA Wage Requirements
One area where the joint employment issue is particularly relevant involves the FLSA wage requirements. The FLSA requires that agricultural employers who use 500 “man-days” or more of agricultural labor in any calendar quarter of a particular year must pay the agricultural minimum wage to certain agricultural employees in the following calendar year. Man-days are those days during which an employee performs any agricultural labor for not less than one hour. The man-days of all agricultural employees count in the 500 man-days test, except those generated by members of an incorporated employer's immediate family. 29 U.S.C. § 203(e)(3). Five hundred man-days is roughly equivalent to seven workers working five and one-half days per week for thirteen weeks (5.5 x 7 x 13 = 501 man-days). Under the FLSA, “agriculture” is defined to include “among other things (1) the cultivation and tillage of the soil, dairying, the production, cultivation, growing and harvesting of any agricultural or horticultural commodities; (2) the raising of livestock, bees, fur-bearing animals, or poultry; and (3) any practices (including any forestry or lumbering operations) performed by a farmer or on a farm as an incident to or in conjunction with such farming operations, including preparation for market, delivery to storage or to market or to carriers for transportation to market.” 29 U.S.C. § 203(f).
The minimum wage must be paid to all agricultural employees except: (1) members of the employer's immediate family, unless the farm is incorporated; (2) local hand-harvest, piece-rate workers who come to the farm from their permanent residences each day, but only if such workers were employed less than 13 weeks in agriculture in the preceding year; (3) children, age 16 and under, whose parents are migrant workers, and who are employed as hand-harvest piece-rate workers on the same farm as their parents, provided that they receive the same piece-rate as other workers; and (4) employees engaged in range production of livestock. 29 U.S.C. § 213(a)(6). A higher monthly wage rate applies to a “ranch hand” who does not work in a remote location and works regular hours. See, e.g., Mencia v. Allred, 808 F.3d 463 (10th Cir. 2015). Where the agricultural minimum wage must be paid to piece-rate employees, the rate of pay for piece-rate work must be sufficient to allow a worker reasonably to generate that rate of hourly income.
A common scenario in many agricultural settings is that a farmer will have crops harvested by an independent contractor. In this situation, the farmer is considered to be a joint employer with the contractor who supplies the harvest hands if the farmer has the power to direct, control, or supervise the work, or to determine the pay rates or method of payment for the harvest hands. 29 C.F.R. § 780.305(c). See also, Gonzalez-Sanchez v. Int’l. Paper Co., 346 F.3d 1017 (11th Cir. 2003). In such event, each employer must include the contractor's employees in the man-day count in determining whether each one's man-day test is met. Each employer is considered responsible for compliance with the minimum wage and child labor requirements of the FLSA with respect to the employees who are jointly employed. A big issue in this realm is, for example, whether a particular crew leader was an independent contractor or an employee of the farmer. In Castillo v. Givens, 704 F.2d 181 (5th Cir. 1983), the crew leader involved was a registered farm labor contractor who recruited and transported an unskilled crew, supervised cotton chopping, kept minimal records and disbursed the crew's pay. In spite of those activities, the crew leader was characterized as an employee of the farmer rather than an independent contractor. The court found it persuasive that the crew leader supplied crews to no other farmer, had no business of his own, did not set crew wages, had no meaningful investment in his “business”, and was dependent economically on the farmer's operation. For purposes of the FLSA, the crew members were considered to be employees of the farmer rather than employees of the crew leader.
The new test. In both Gonzalez-Sanchez and Castillo referenced above, both the Eleventh Circuit and the Fifth Circuit determined whether joint employment existed based on the economics of the relationship of the parties and who controlled the employment situation. Most recently, the Fourth Circuit in Salinas, determined whether joint employment existed under the FLSA based on a two-step process. The case did not involve ag employment, but the principles involved could easily spill-over to cases involving ag employment under the FLSA. In Salinas, a drywall installer was a subcontractor that employed the plaintiffs. The subcontractor employed the plaintiffs on the behalf of a general contractor. The general contractor specified how the employees of the subcontractor would dress while working on a job and also provided all of the tools and equipment for the subcontractor’s employees to use. The general contractor required the subcontractor’s employees to sign in and sign out, and also supervised the subcontractor’s employees’ work every day. The general contractor also told the subcontractor’s employees to tell people that they worked for the general contractor. The employees sued for unpaid overtime under the FLSA based on the joint employment of the subcontractor and the general contractor.
While it seems obvious that joint employment would have existed under the economic realities or control test, the court reached that result but under a different rationale. The court held that the test under the FLSA for joint employment involved two steps. The first step involved a determination as to whether two or more persons or entities share or agree to allocate responsibility for, whether formally or informally, directly or indirectly, the essential terms and conditions of a worker’s employment. The second step involves a determination of whether the combined influence of the parties over the essential terms and conditions of the employment made the worker an employee rather than an independent contractor. If, under this standard, the multiple employers were not completely disassociated, a joint employment situation existed. The court also said that it was immaterial that the subcontractor and general contractor engaged in a traditional business relationship. In other words, the fact that general contractors and subcontractor typically structure their business relationship in this manner didn’t matter. The Salinas court then went on to reason that separate employment exists only where the employers are “acting entirely independent of each other and are completely disassociated with respect to” the employees.
The “complete disassociation” test of the Fourth Circuit appears that it could result in a greater likelihood that joint employment will result in the FLSA context than would be the case under the “economic realities” or “control” test. While the control issue is part of the “complete disassociation” test, joint determination in hiring or firing, the duration of the relationship between the employers, where the work is performed and responsibility over work functions are key factors that are also to be considered. To me, that looks as if joint employment could be found in the Fourth Circuit but perhaps not in a similar situation elsewhere.
Employers (including ag employers) beware in Maryland, North Carolina, South Carolina, Virginia and West Virginia.
Thursday, February 23, 2017
For many persons, estate planning also includes planning for the possibility of long-term health care. Nursing home care is expensive (even though rural Kansas has some of the lowest costs in the country, it can still exceed $5,000/month in those areas) and can require the liquidation of assets to generate the funds necessary to pay the nursing home bill unless appropriate planning has been taken. How will that expense be funded? Medicaid is one option. That’s the joint federal/state program that pays for long-term health care in a nursing home. To be able to receive Medicaid benefits, an individual must meet numerous eligibility requirements but, in short, must have a very minimal level of income and assets. States set their own asset limits and determine what assets count toward the limit. Assets exceeding the limit must be spent on the applicant’s nursing home care before Medicaid eligibility can be established.
Another option is long-term care (LTC) insurance. I get numerous questions concerning LTC insurance. That’s the topic of today’s post
Why not much usage? Like many other industries in recent years, the LTC insurance industry has shrunk dramatically in terms of the number of companies that issue policies. Compared to about 15 years ago, there are only about one-tenth of the number of companies that presently sell LTC policies that were doing so then. Relatedly, annual sales have dropped. The result is that roughly 10 percent of the U.S. population has some sort of long term care plan in place. What I mean by that is any type of plan – LTC insurance or otherwise. Of those 10 percent, LTC insurance would be a component of only a portion of them. So, the point is that LTC insurance is underutilized. Why? Well, LTC insurance suffers from a fundamental problem – those that can afford it don’t need it and those that need it can’t afford it! For example, the annual premiums for a couple around age 60 can vary widely anywhere from $1,700 to over $3,000 depending on the type of policy and type of coverage obtained, and the particular state. That’s a tough amount to swallow for many people.
How much coverage to get? It’s also hard to predict how much coverage is going to be needed. Women typically need it longer than men – about a year and one-half longer so says the U.S. Department of Health and Human Services. If long-term care will cost $75,000 annually (and that’s a conservative estimate), then at least a benefit totaling $150,000-$200,000 is probably necessary as a minimum. To get five years’ worth of benefit coverage, that would indicate sufficient premiums should be paid to get about $400,000 worth of benefits. That could push annual premiums to $5,000 year for that couple near age 60. Why five years? That’s the present ‘look-back” period for asset transfer without adequate consideration. The value of transfers outside that window aren’t deemed to be available to the transferor for Medicaid eligibility purposes. But, keep in mind that the average nursing home stay is slightly less than a year for a male and about a year and one-half for a female (based on some recent studies that I have seen). But, that’s only an average. So, maybe a good rule of thumb is to price a policy based on 2 and 4 years of coverage.
Custodial care. LTC insurance doesn’t only deal with medical issues. It also can be used to pay for daily assistance with common tasks such as bathing and dressing. It’s this “custodial care” dimension that many people will find necessary as they age, whether or not they are in a nursing home. Thus, LTC insurance can be used to plug a “gap” between Medicaid and Medicare. Medicaid can cover institutionalized care, but only after resources have been depleted, and Medicare won’t cover custodial care. So, unless a person has family or friends or is self-insured, there will be a need, but perhaps no way to pay for it while simultaneously avoiding disposing of assets to come up with the funds to pay for custodial care. That’s a tough spot to be in. LTC should be looked at as one possibility in that situation.
Peculiarities of policies. It is possible that some of the LTC policies will discount the premium cost if a couple buys the policies together as a package. Also, watch what the policy says about how you can use the benefits. Do you have to use the entire monthly benefit, or can you use only a part of it and private pay the balance and stretch-out the coverage? Some policies will allow that, but others won’t.
Another detail to look for in a policy is whether premiums can change and, if they can, whether you will be notified of when that will occur. The last thing a person wants to have happen is to pay on a policy for a number of years and then have the premium go up to an extent that they can no longer afford it and they drop the policy as a result.
It’s also a good idea to analyze any particular policy on the basis of whether it is an indemnity plan or a reimbursement plan. An indemnity plan basically means that the insured will get paid a cash benefit that is the same thing as the daily benefit. On the other hand, a reimbursement plan pays the full daily benefit when the actual cost of care either equals or exceeds the daily benefit. Which type of policy is more desirable? Again, it depends. Cash benefit policies cost more, but they do give the policy holder greater flexibility in paying a family member to provide care. To some people, that is in important option to have.
Another question to ask of the insurer is how the policy works if nursing home care is required and the policy holder returns to their home at some later point. It might be that the benefits paid out to cover the nursing home bill will reduce the available benefits if the insured has to go back to the nursing home at some later point in time. That may not be the case, but it is worth knowing what might happen.
From an economic standpoint, examine any given policy to determine if there is inflation protection built in. Nursing home costs will go up. Will the policy benefits also increase? If there is built-in inflation protection, how much does the premium go up? Can this issue be addressed by delaying payment of benefits under the policy once institutionalization occurs? That might be possible.
As an investment, LTC insurance is probably not at the top of the list of the good ones. If it is purchased early and there is no pre-existing condition, and benefits are triggered early on, then it can turn out to be a good deal. But, a person could be better off simply setting aside funds every month in an investment account that is earmarked as being set aside to cover long-term care costs. That’s particularly the case if benefits under the policy won’t be used for some time in the future.
Whether or not to obtain LTC insurance is a difficult decision. There are numerous things to think about, and some of those involve predicting what might happen in the future. How clear is your crystal ball?
Tuesday, February 21, 2017
Every partnership (defined as a joint venture or any other unincorporated organization) that conducts a business is required to file a return for each tax year that reports the items of gross income and allowable deductions. I.R.C. §§761(a), 6031(a). If a partnership return is not timely filed (including extensions) or is timely filed but is inadequate, a monthly penalty is triggered that equals $200 times the number of partners during any part of the tax year for each month (or fraction thereof) for which the failure continues. However, the penalty amount is capped at 12 months. Thus, for example, the monthly penalty for a 15-partner partnership would be $3,000 (15 x $200) capped at $36,000. Such an entity is also subject to rules enacted under the Tax Equity and Fiscal Responsibility Act (TEFRA) of 1982. These rules established unified procedures for the IRS examination of partnerships, rather than a separate examination of each partner.
An exception from the penalty for failing to file a partnership return and the TEFRA audit procedures could apply for many small business partnerships and farming operations. However, it is important to understand the scope of the exception, and what is still required of such entities even if a partnership return is not filed. In many instances, such entities may find that simply filing a partnership return in any event is a more practical approach.
Just exactly what is the “small partnership exception”? That’s the focus of today post.
Exception for Failure to File Partnership Return
The penalty for failure to file is assessed against the partnership. While there is not a statutory exception to the penalty, it is not assessed if it can be shown that the failure to file was due to reasonable cause. I.R.C. §6689(a). The taxpayer bears the burden to show reasonable cause based on the facts and circumstances of each situation. On the reasonable cause issue, the IRS, in Rev. Proc. 84-35, 1984-1 C.B. 509, established an exception from the penalty for failing to file a partnership return for a “small partnership.” Under the Rev. Proc., an entity that satisfies the requirements to be a small partnership will be considered to meet the reasonable cause test and will not be subject to the penalty imposed by I.R.C. §6698 for the failure to file a complete or timely partnership return. However, the Rev. Proc. noted that each partner of the small partnership must fully report their shares of the income, deductions and credits of the partnership on their timely filed income tax returns.
So what is a small partnership? Under Rev. Proc. 84-35 (and I.R.C. §6231(a)(1)(B)), a “small partnership” must satisfy six requirements:
- The partnership must be a domestic partnership;
- The partnership must have 10 or fewer partners;
- All of the partners must be natural persons (other than a nonresident alien), an estate of a deceased partner, or C corporations;
- Each partner’s share of each partnership item must be the same as the partner’s share of every other item;
- All of the partners must have timely filed their income tax returns; and
- All of the partners must establish that they reported their share of the income, deductions and credits of the partnership on their timely filed income tax returns if the IRS requests.
Applying the Small Partnership Exception – Practitioner Problems
So how does the small partnership exception work in practice? Typically, the IRS will have asserted the I.R.C. §6698 penalty for the failure to file a partnership return. The penalty can be assessed before the partnership has an opportunity to assert reasonable cause or after the IRS has considered and rejected the taxpayer’s claim. When that happens, the partnership must request reconsideration of the penalty and establish that the small partnership exception applies so that reasonable cause exists to excuse the failure to file a partnership return.
Throughout this process, the burden is on the taxpayer. That’s a key point. In most instances, the partners will likely decide that it is simply easier to file a partnership return instead of potentially getting the partnership into a situation where the partnership (and the partners) have to satisfy an IRS request to establish that all of the partners have fully reported their shares of income, deductions and credits on their own timely filed returns. As a result, the best approach for practitioners to follow is to simply file a partnership return so as to avoid the possibility that IRS would assert the $200/partner/month penalty and issue an assessment notice. IRS has the ability to identify the non-filed partnership return from the TIN matching process. One thing that is for sure is that clients do not appreciate getting an IRS assessment notice.
The Actual Relief of the Small Partnership Exception
Typically, the small partnership exception is limited in usefulness to those situations where the partners are unaware of the partnership return filing requirement or are unaware that they have a partnership for tax purposes, and the IRS asserts the penalty for failing to file a partnership return. In those situations, the partnership can use the exception to show reasonable cause for the failure to file a partnership return. But, even if the exception is deemed to apply, the IRS can require that the individual partners prove that they have properly reported all tax items on their individual returns.
In addition, if the small partnership exception applies, it does not mean that the small partnership is not a partnership for tax purposes. It only means that the small partnership is not subject to the penalty for failure to file a partnership return and the TEFRA audit procedures.
Why does the “small partnership exception” only apply for TEFRA audit procedures and not the entire Internal Revenue Code? It’s because the statutory definition of “small partnership” contained in I.R.C. §6231(a)(1)(B) applies only in the context of “this subchapter.” “This subchapter” means Subchapter C of Chapter 63 of the I.R.C. Chapter 63 is entitled, “Assessment.” Thus, the exception for a small partnership only means that that IRS can determine the treatment of a partnership item at the partner level, rather than being required to determine the treatment at the partnership level. The subchapter does not contain any exception from a filing requirement. By contrast, the rules for the filing of a partnership return (a “partnership” is defined in I.R.C. §761, which is contained in Chapter 1) are found in Chapter 61, subchapter A – specifically I.R.C. §6031. Because a “partnership” is defined in I.R.C. §761 for purposes of filing a return rather than under I.R.C. §6231, and the requirement to file is contained in I.R.C. §6031, the small partnership exception has no application for purposes of filing a partnership return. Thus, Rev. Proc. 84-35 states that if specific criteria are satisfied, there is no penalty for failure to file a timely or complete partnership return. There is no blanket exception from filing a partnership return. A requirement to meet this exception includes the partner timely reporting the share of partnership income, deductions and credits on the partner’s tax return. Those amounts can’t be determined without the partnership computing them, using accounting methods determined by the partnership and perhaps the partnership making elections such as I.R.C. §179.
The small partnership exception does not apply outside of TEFRA. Any suggestion otherwise is simply a misreading of the Internal Revenue Code.
The small partnership exception usually arises as an after-the-fact attempt at establishing reasonable cause to avoid penalties for failure to file a partnership return. The exception was enacted in 1982 as part of TEFRA to implement unified audit examination and litigation provisions which centralize treatment of partnership taxation issues and ensure equal treatment of partners by uniformly adjusting the tax liability of partners in a partnership. It is far from a way to escape partnership tax complexity, and not a blanket exemption from the other requirements that apply to all partnerships. The failure to file a partnership return could have significant consequences to the small partnership. Ignoring Subchapter K also could have profound consequences, the least of which is dealing with penalty notices.
Under the Balanced Budget Act of 2015 (BBA) (Pub. L. No. 114-74, §1101(a), 129 Stat. 584 (2015)), new partnership audit rules are instituted effective for tax returns filed for tax years beginning on or after January 1, 2018 (although a taxpayer can elect to have the BBA provisions apply to any partnership return filed after the date of enactment (November 2, 2015). The BBA contains a revised definition of a “small partnership” by including within the definition those partnerships that are required to furnish 100 or fewer K-1s for the year. If a partnership fits within the definition and desires to be excluded from the BBA provisions, it must make an election on a timely filed return and include the name and identification number of each partner. If the election is made, the partnership will not be subject to the BBA audit provisions and the IRS will apply the audit procedures for individual taxpayers. Thus, the partnership will be audited separately from each partner and the TEFRA rules will not apply, and the reasonable cause defense to an IRS assertion of penalties for failure to file a partnership return can be raised.
Friday, February 17, 2017
Last week I posted a summary of a recent Kansas county district court decision on remand that involved the prior appropriation doctrine. The summary contained the thoughts of my colleague at the Washburn University School of law, Prof. Burke Griggs That post discussed the Haskell County District Court’s recent decision in Garetson Bros. v. American Warrior et al., (Dist. Ct. No. 2012-CV-09), in which the court protected a senior vested water right from impairment by issuing a permanent injunction prohibiting two junior wells from pumping. From a purely judicial standpoint, the case is not complicated. It stands for the proposition that Kansas water law—specifically the prior appropriation doctrine—means what it says: first in time is first in right, and owners of senior wells impaired by junior water rights are entitled to injunctive protections, unqualified by mitigating economic factors.
Today, in part two of the discussion, Prof. Griggs discusses what could be the consequences of the court’s decision.
The Prior Appropriation Doctrine
Westerners supposedly love the prior appropriation doctrine: like frontier whiskey, it is clear and works quickly, even if its effects can be rather harsh. As the Colorado Court of Appeals pointed out long ago in Armstrong v. Larimer County Ditch Co. (27 P. 235, 237 (1891)), the seniors-take-all approach of the prior appropriation doctrine works better than the fair and balanced equities-based approach of eastern water law: it works better because there is not enough water to supply all rights in dry years, and sharing the shortage would make all water rights owners so short of water that no one could make productive use of their share. In the West, as Frank Trelease memorably wrote, “priority is equity.”
If only the issue were that simple. While the clarity of the prior appropriation doctrine shines through the legal decisions in the Garetson case (and especially the earlier and largely controlling opinion in Garetson Bros. v. Am. Warrior, Inc., 347 P.3d 687 (2015)), hydrological, administrative, and political considerations are increasingly clouding that doctrinal clarity.
Hydrological considerations. Garetson is a conflict between rival irrigators who access the non-renewable waters of the Ogallala Aquifer. But, there is also a conflict with groundwater that raises certain hard problems for the prior appropriation doctrine. When the chief engineer shuts off (or “administers”) junior water rights to a stream or river system, the effect of that administration is typically clear and immediate; water prevented from reaching a junior’s canal headgate flows down to supply a senior’s. The administration of rights in an alluvial groundwater system—where the wells are close to the river—has similarly prompt and predictable effects. The Ogallala is different: because its supplies are dispersed and non-renewable, it is not always easy to determine with precision how the groundwater pumping of junior rights in a water rights neighborhood affects or impairs the pumping of a senior right. The architects of the original 1945 Kansas Water Appropriation Act (“KWAA”) recognized this hydrological difference, but deliberately decided to extend the doctrine to groundwater—including the supplies of the Ogallala. The KWAA softened the standards for granting new rights to the Ogallala, but clearly maintained the priority rule for protecting existing rights. The 1957 revisions to the KWAA were focused on allowing the development of new Ogallala water rights, and the chief engineers did their statutory duty: because water was available for rights under these softer standards, more water rights were granted to the Ogallala than the aquifer could durably sustain. As a consequence, by 1970 or so, groundwater depletion was becoming a serious problem. The Kansas Division of Water Resources (“DWR”) responded to this hydrological problem by developing procedures (at K.A.R. 5-4-1 and 5-4-1a) which set forth the process by which DWR investigates and determines impairment complaints in a groundwater system. Despite these procedures, however, a hard hydrological fact of the Ogallala remains: in order to fully protect one groundwater right to the Ogallala, it may be necessary to shut down many junior rights, more rights than are administered in a typical surface water rights administration. This is the principal reason why so few impairment complaints have been filed over the Ogallala. Owners of senior water rights know their rights, but they also know that the administration of junior rights may affect many of their neighbors—as well as junior rights which they themselves own.
Administrative difficulties. The conflict between the legal clarity of the prior appropriation doctrine and the administrative difficulty of determining impairment in a groundwater-exclusive system is one of the central issues in the Garetson case. Although DWR was investigating the impairment of the Garetsons’ senior right, they decided to withdraw their impairment complaint, and took the matter to court directly. K.S.A. 82a-717a and 82a-716 clearly provide a court-based avenue for protecting senior rights, independent of DWR. Under that approach, the senior right holder can obtain injunctive relief upon a finding of impairment—which is just what the Garetsons obtained. However, it is important to note that the facts in Garetson are somewhat unusual. The court was able to use hydrological data along with data concerning pumping effects which DWR and the Kansas Geological Survey had produced during the time in which the Garetsons were pursuing the administrative avenue of resolving their impairment through K.A.R. 5-4-1a. Without such existing data—and the impairment reports which DWR produced in a very timely fashion in this case—the court would likely not have been able to issue its temporary and permanent injunctions so expeditiously.
Kansas water politics. Those who lose in court often seek redress in the legislature, and often do so for less money. The clarity of the court’s injunctions in Garetson has promoted a substantial legislative reaction. In 2016, the defendants (American Warrior) and Southwest Kansas Groundwater Management District #3 sponsored legislation which would have substantially weakened the ability of senior water rights holders to protect their rights through the independent court-based avenues of K.S.A. 82a-716 and 82a-717a. This legislation did not succeed, but the ongoing importance of Garetson prompted the Kansas Department of Agriculture (“KDA”), which exercises supervisory authority over DWR, to consider a legislative compromise between the administrative-based avenues of K.A.R. 5-4-1 and 5-4-1a and the above-mentioned court-based avenues. Together with major agricultural powers such as the Kansas Farm Bureau and the Kansas Livestock Association, they are sponsoring H.B. 2099. http://www.kslegislature.org/li/b2017_18/measures/documents/hb2099_00_0000.pdf
Distilled to its essence, the legislation eliminates the two-avenue approach in favor of a sequential one: the senior water rights holder claiming impairment must first seek administrative relief through DWR to protect his or her right; DWR must promptly act upon the impairment complaint; only then, after the administrative process is complete, can the senior holder pursue an injunction in court. But, this last step might not be necessary, provided that DWR deploys the impairment report in the service of water rights administration.
H.B. 2099 is a classic case of a wide-ranging legislative reaction to a single lawsuit. It raises at least three difficult questions. First of all, is the legislation legally necessary? Not really: Garetson was properly decided, and we have yet to see a snowballing effect wherein thousands of senior water rights owners begin to use the priority doctrine in an ominous way, threatening their junior neighbors. (Such threats would be perfectly legal, albeit impolite.) Second, should a conflict between water users—competing property owners—be completely transformed into a regulatory action in which the chief engineer’s impairment investigation and any consequent decisions about water rights administration are the central issues under judicial review? Perhaps. It is, after all, the chief engineer’s statutory duty to investigate impairment and to protect senior rights. That is why Kansas has an administrative system for water rights protection in the first place. But there is a third and troubling question: does the legislation diminish the courts’ undeniable powers to protect private property rights? Influential stakeholders may jealously guard their political clout, and use it in the legislature to obtain the ends they seek; but the courts are just as jealous and protective of their independent powers to resolve property disputes and to protect property rights, with or without the procedures prescribed by H.B. 2099. Moreover, the KWAA provides numerous protections for owners of senior rights, outside of K.S.A. 82a-716 and 82a-717a. Even if H.B. 2099 were to be enacted, the courts might cite those and other protections to circumvent it—including protections available under the Kansas Judicial Relief Act. They have done it before in construing the scope of the KWAA.
In sum, the Kansas water rights community is again facing a choice: whether to accept the consequences of prior appropriation in a groundwater context, or to attenuate those consequences by limiting the options of senior water rights holders to protect their private property rights. In this they are only human. As St. Augustine famously wrote, “please Lord, grant me chastity and continence, but not yet.”
Wednesday, February 15, 2017
A question that I sometimes get involves an interesting aspect of farm lease law (although it’s probably not unique to agriculture) when the land is co-owned. The question is whether, when co-owned farmland is leased, must all of the co-owners agree to lease the property? On the flip side, must all of them agree to a termination of the lease? Those are interesting and important questions.
A few years ago, I discussed these issues with the former Dean of the University of Iowa College of Law who had written a bit on the matter in the 1960s. Today’s blog post is loosely based on that conversation (and an initial article that my staff attorney Erica Eckley, and myself authored in 2013 – the original article is available at www.calt.iastate.edu).
While most of the caselaw on the issue is relatively dated, there is a recent case from Ohio on point. In H & H Farms, Inc. v. Huddle, No. 3:13 CV 371, 2013 U.S. Dist. LEXIS 72501 (N.D. Ohio May 22, 2013), a married couple owned a tract of farmland. Over a period of time, they transferred undivided fractional interests in the farmland to a son – the defendant in the case. The wife eventually died, with the husband remaining in the farm home. At the time the case was filed, the son owned an undivided 94 percent interest in the farmland and his father owned 6 percent. The plaintiff had been the tenant on the property for a number of years and was the father’s grandson and nephew of the son. The father entered into an 11-year lease with the plaintiff for $150/year. However, the son did not consent to the lease and claimed that it was unenforceable and that the plaintiff would be trespassing if he attempted to farm the land. The plaintiff sought a declaratory judgment regarding the legal sufficiency of the lease, and the son filed a motion to dismiss. There was only one issue before the court - whether a legally plausible claim had been alleged.
The court addressed the legal standard for possession when tenants in common lease real estate. In Ohio, tenants in common each have a distinct title and right to enter upon the entire tract of real estate and take possession of it even if the ownership share is less than other tenants in common. If a tenant in common is not in possession of the real estate (i.e., an absentee landlord), that co-tenant is entitled to receive the reasonable rental value of the property from the co-tenant in possession consistent with the (absentee) co-tenant’s ownership interest. The court also noted that, under Ohio law, when an owner conveys property via a lease, the owner retains the fee simple interest in the property. Ohio courts have held that the possession of the tenant is synonymous with the lessor’s possession. Thus, tenants in common have a present possessory interest in the property. So, the father’s possession under the facts of the case was also the co-tenant’s possession.
The son’s motion to dismiss was based on the argument that a tenant in common cannot convey, encumber, or divest the rights of a co-tenant. The court disagreed because of the principle that a lease does not divest the possession of the land from the co-tenant. The court held that because the son’s possessory rights were not divested, there would be no need for him to approve the lease. Thus, the court declared that the plaintiff had stated a claim for which relief could be granted, and the motion to dismiss would not be granted.
The court, however, went on to state that it believed that when a six percent owner leases a farm to a third party for 11 years, it would be inequitable for the lease to remain with the land following a partition sale. But, that statement was merely dicta because it was not germane to the issue before the court and the motion to dismiss.
So, the tenant’s possessory interest is strong and cannot be disturbed. That also can mean that, absent a provision in a written lease, the landowner doesn’t have the right to hunt the leased ground absent the tenant’s permission. Of course, not allowing the tenant to hunt the ground will likely result in the tenant being terminated as soon as possible under state law.
Accounting for rents. Some states, such as Iowa have a statutory provision on this issue. Iowa Code § 557.16 explicitly states that a co-tenant in possession is liable for the reasonable rent to the co-tenant not in possession. See, e.g., Meier v. Johannsen, 47 N.W.2d 793, 242 Iowa 665 (1951).
Partition action. Because the tenant’s right of possession during the term of the lease is strong and cannot be interfered with, that can mean that once there is a valid lease, the tenant’s rights probably cannot be dislodged by a partition action. Similarly, property that is subject to a life estate cannot be partitioned. Redding v. Redding, 284 N.W. 167, 226 Iowa 327 (1939).
Termination of lease. In Dethlefs v. Carrier, 64 N.W.2d 272, 245 Iowa 786 (1954), a tenant had a written lease on 40 acres of farmland. The land was owned by a brother and sister as tenants in common and the lease was entered into between the tenant and the sister. The brother did not sign the lease. Upon the sister’s death, the brother became the sole owner, but did not follow state law to terminate the lease. The brother claimed that the sister’s death terminated not only her interest in the land, but also terminated the lease and eliminated the requirement that he give notice to terminate the lease. The court disagreed on the basis that, in such a situation, a presumption arises that the lease was made with the knowledge and consent of each co-tenant. There was no evidence to overcome the presumption
Similarly, the tenant’s possessory interest also is an issue when the landlord dies during the term of the lease and a growing crop exists. Entitlement to the crop is fairly clear when the landlord owns a fee simple interest in the leased land — the landlord’s heirs succeed to the landlord’s share of the crop. However, if the landlord owns less than a fee simple interest in the leased land (such as a life estate), the outcome may be different. The question is whether the deceased landlord’s estate or the holder of the remainder interest is entitled to the landlord’s share. In two 1977 Kansas cases, Finley v. McClure, 222 Kan. 637, 567 P.2d 851 (1977) and Rewerts v. Whittington, 1 Kan. App. 2d 557, 571 P.2d 58 (1977), the landlord owned only a life estate interest in certain farm ground and leased it on shares to a tenant. The landlord died before the growing wheat crop was harvested, and the court held that the landlord’s crop share was a personal asset of the landlord, entitling the landlord’s estate to the landlord’s crop share on the basis that growing crops are personal property. The remainderman takes nothing. The Nebraska Supreme Court has reached a similar conclusion. Heinold v. Siecke, 257 Neb. 413, 598 N.W.2d 58 (1999). However, the Colorado Supreme Court has held that the remainderman was entitled to the landlord’s share on the basis that the language in the deed creating the reserved life estate in the decedent had divested the estate of any rights to profits from the crops. Williams v. Stander, 143 Colo. 469, 354 P.2d 492 (1960).
Whenever farmland is owned by multiple parties or the ownership interests include a life estate, a partition action is likely not possible, but an absentee co-tenant may not be required to consent to a lease. It may be that a presumption arises that the lease was made with each co-tenant’s knowledge and consent. An issue also arises if the landlord owns less than a full fee simple interest. If you encounter these issues, consulting legal counsel would be a good idea.
Monday, February 13, 2017
IRS has a long history of challenging taxpayers that it believes are distorting income reporting by use of the cash method of accounting. As examples of the continued IRS attack on farmers using the cash method of accounting, in 2016, the IRS tried to deny a farmer’s surviving spouse a deduction for the cost of inputs she used to plant the crop that he had purchased before death, but died before he could use them to plant the spring crop. Estate of Backemeyer v Comr., 147 T.C. No. 17 (2016). While the farmer had deducted the costs of the inputs as pre-paid expenses in the year before he died, the IRS claimed she couldn’t deduct the same amount the following year on her return even though the value of the inputs were included in his estate under I.R.C. §1014. The IRS position revealed a complete misunderstanding of associated tax rules and the Tax Court let the IRS know it in ruling for the estate.
In 2015, the IRS tried to deny a deduction for a California farming corporation that deducted the cost of fieldpacking materials until the year the materials were actually consumed. The IRS lost the case based on its own regulation. Agro-Jal Farming Enterprises, Inc., et al. v. Comr., 145 T.C. 145 (2015). A year earlier, a federal appeals court, in a case involving a Texas cattle and horse breeding limited partnership sternly disagreed with the IRS attack on that operation’s use of cash accounting via the “farming syndicate rule.” Burnett Ranches, Limited v. United States, 753 F.3d 143 (5th Cir. 2014). Despite the rebuke, the IRS has now issued a non-acquiescence to the court’s decision, signaling that their attack on the cash method will continue. AOD 2017-7; 2017-7 IRB 868.
In both the 2014 Texas case and the 2015 California case, the IRS trotted-out the “farming syndicate” rule in an attempt to bar the deductions. Because the IRS has now issued a non-acquiescence to the 2014 Fifth Circuit decision which signals its intent to continue examining the issue outside the Fifth Circuit, today’s blogpost is a reminder to practitioners of what the IRS is looking for and why the Courts have rejected their theories.
The Farming Syndicate Rule
In the farm and ranch sector, that alleged distortion often arises in the context of pre-payment for inputs such as fertilizer, seed, feed or chemicals. Various tests and rules have been adopted over the years to deal with material distortions of income when pre-purchases are involved. See, e.g., Rev. Rul. 79-229, 1979-2 C.B. 210. One of those rules, which is designed to place a limitation on deductions for farming operations, was developed in the 1970s and is known as the Farming Syndicate Rule. I.R.C. §461(j). The Congress enacted the rule in 1976, and it eliminates “farming syndicates” from taking deductions for feed, seed, fertilizer and other farm supplies before the year in which the supplies are actually used or consumed. The rule establishes two tests for determining whether a farming syndicate is present. A farming syndicate is (1) a partnership or other enterprise (except a regularly taxed corporation) engaged in farming if the ownership interests in the firm have been offered for sale in any offering required to be registered with any federal or state securities agency (I.R.C. §461(j)(1)(A)) or (2) a partnership or other enterprise (other than a C corporation) engaged in farming if more than 35 percent of the losses during any period are allocable to limited partners or “limited entrepreneurs.” I.R.C. §461(j)(1)(B).
IRS Position. The “farming syndicate” rule does not impact many farming and/or ranching operations, but it does catch some of the extremely large operations and a few individuals who are inactive investors in farming operations. That’s because there is an exception to the rule for holdings attributable to “active management.” If an “individual” has actively participated (for a period of not less than 5 years) in the management of the farming activity, any interest in a partnership or other enterprise that is attributable to that active participation is deemed to not be held by a limited partner or a limited entrepreneur. I.R.C. §461(j)(2)(A). That means that the interest doesn’t count toward the 35 percent test. But, IRS has taken a strict interpretation of the statute. In the IRS view, the exception for active management only applies to an “individual.” Indeed, the statute does state, “in the case of any individual [emphasis added] who has actively participated…”. I.R.C. §461(j)(2)(A). Thus, in C.C.A. 200840042 (Jun. 16, 2008), the Chief Counsel’s office determined that a partnership interest held by an S corporation with only one shareholder was to be treated as held by a limited partner for purposes of the farming syndicate rule. The partnership raised and bred livestock, and its members were two trusts along with the S corporation. The S corporation was owned by a trustee who was also a beneficiary of the trusts. One of the trusts was the general partnership of the partnership. The partnership reported income on the cash method, but IRS took the position that the partnership interest that the S corporation held had to be treated as a limited partner interest because it wasn’t held by an “individual.” This was the result, according to the IRS, even though the S corporation’s sole shareholder was an individual. Thus, for purposes of the farming syndicate rule, the interest held by the S corporation was treated as an interest that was held by a limited partner.
Burnett Ranches involved a Texas cattle and horse breeding limited partnership that was 85 percent owned by an S corporation as a limited partner. As such, the limited partnership met the definition of a farming syndicate. However, the court held that the ranch qualified for the active participation exception to the farming syndicate rule even though the majority owner actively participated in managing the cattle operation through the owner’s wholly-owned S corporation. The court noted that the west Texas operation had been family-run for many generations dating back into the 1800s, with the current majority owner family member simply owning her interest via an S corporation. There was no question that that majority owner managed the operation and would satisfy the active management test in her own right. The IRS acknowledged as much. But, IRS said the farming syndicate rule was triggered and cash accounting was not available because the ownership interest was held in an S corporation rather than directly by the majority shareholder as an individual. Consequently, IRS said that the partnership could not use cash accounting for the years in issue – 2005-2007. The limited partnership paid the alleged deficiencies (which amounted to several million dollars) and sued for a refund in federal district court. The sole basis for the IRS denial of the cash method under the farming syndicate rule and the required switch to the accrual method was the fact that the S corporation owned the partnership interest, even though it was an S corporation that was 100 percent owned by the person that performed the entire management function of the business. The district court ruled for the limited partnership.
The IRS appealed, continuing to maintain that the majority owner’s interest in the limited partnership via her S corporation barred the active management exception from applying. The court disagreed, largely on policy grounds. The court noted that the Congressional intent behind the active management exception of I.R.C. §464(c)(2)(A) was to target high-income, non-farm investors, not the type of taxpayer that the majority owner represented. The court stated, “Ms. Marion’s business and ownership history with these ranches and their operations is the very antithesis of the “farming syndicate” tax shelters that §464 was enacted to thwart….”. Indeed, the owner of the S corporation was the current descendant in a long line of descendants of the founder of the ranching operation dating to the mid-1800s. The court went on to state, “[We] doubt that our interpretation of §464 will stymie the I.R.S., an agency tasked with uncovering abusive tax-avoidance schemes of myriad forms, not just those in the nature of a farming syndicate…. We deem it beyond peradventure that her limited partnership interest in Burnett Ranches is excepted from §464’s primary thrust of requiring farming syndicates to employ the accrual basis of accounting.”
The court also noted that the statutory term “interest” was not synonymous with legal title or direct ownership, but rather was tied to involvement with or participation in the underlying business. Thus, the court determined that there was no basis for distinguishing between “the partnership interest of a rancher who has structured his business as a sole proprietorship and a rancher who has structured his business as [a subchapter S] corporation.” The term “individual” was used in the statute to refer to the provision of active management rather than in reference to having an interest in the activity at issue.
The court’s opinion provides needed guidance on the narrow interpretation of the farming syndicate rule by the IRS. The opinion is binding authority inside the Fifth Circuit - Louisiana, Mississippi and Texas. But, with AOD 2017-7; 2017-7 IRB 868, the IRS has signaled that it will pick more battles on the same issue elsewhere. That seems a bit ridiculous on this issue. The IRS is spending its budget to pursue collection of tax dollars based upon its technical reading of required “active participation,” ignoring the 85 percent effective ownership of the person who, as was stipulated, actively participated.
It is no wonder that Congress has reduced the IRS budget over the years trying to send the message to the IRS to go after the real abuses, and don’t bother taxpayers that are trying to comply with the tax laws. This family involved in Burnett Ranches actively managed the ranches for over 150 years, long before the income tax was a problem (and in fact, before the area became part of the United States!). The IRS should leave honest taxpayers alone, and go after syndicates that are truly abusive.
Thursday, February 9, 2017
Many self-employed farmers (as well as other self-employed persons) have an office in their home. If strict rules are satisfied some generous above-the-line business expense deductions can be claimed. But, to claim the expenses the 43-line Form 8829 with complex calculations must be completed and filed unless an optional safe harbor is utilized. A farmer claims the deductions attributable to the home office on Schedule F of Form 1040. IRS Pub. 587 provides helpful worksheets when computing the deduction.
Business Use of the Home
Taxpayers with an office in the residence that is maintained regularly and exclusively for business purposes may deduct the costs associated with that office on IRS Form 8829. The office must be the principal place of business for the taxpayer (the most important or significant place for the business) or it must be a place of business used by clients or customers in the normal course of the taxpayer's trade or business. What does that mean? It means that the home office must be used exclusively and on a regular basis for business purposes – with limited exceptions for day care providers and inventory storage. In addition, the home office is the “principal place of business” if it is used for administrative or management activities of the business or it is the most important place where the business is conducted. Also, an important point for many farming business is that the “home” office can be located in a separate unattached structure on the same property as the home. So, an office in a workshop or unattached garage or similar structure still can generate deductions.
So, what above-the-line deductions can be claimed? The deductible expenses are the “direct expenses” of the home office. Direct expenses include, for example, the costs of painting or repairing the home office, as well as depreciation deductions for depreciable items that are used in the home office. Indirect expenses include expenses associated with maintaining the home office. These expenses include the properly allocable share of utility costs, depreciation, insurance, mortgage interest, and real estate taxes. In addition, if the home office is the “principal place of business,” computers and related equipment used in the home office are not subject to the “listed property” limitations.
In Part II of Form 8829, the overall amount of the deductions associated with the home office is limited by the income attributable to the use of the home office. But, any home office expenses that can't be deducted due to a limitation may be carried over and deducted in later years.
Optional Safe Harbor
Beginning in 2013, an optional safe harbor can be used to calculate the amount of the deduction for expenses associated with the business use of a residence. Rev. Proc. 2013-13. Individual taxpayers who elect this method can deduct an amount determined by multiplying the allowable square footage by $5. The allowable square footage is the portion of the house used in a qualified business use, but not to exceed 300 square feet. Thus, the maximum a taxpayer can deduct annually under the safe harbor is $1,500. In addition, the deduction cannot exceed the amount of gross income derived from the qualified business use of the home (less deductions). It is not possible to carry over any excess to another tax year. The election is made on a timely-filed original tax return, and taxpayers are allowed to change their treatment from year-to-year. However, the election made for any tax year is irrevocable.
The sale-harbor is only available if all of the other requirements for a home-office deduction are satisfied. Thus, the office in the home must be used exclusively for business purposes. In addition, the safe harbor is not really an election. The taxpayer simply chooses to use it at the time the return is filed, on a year-by-year basis.
Many farmers will be able to utilize the office in the home deduction. The IRS has provided a simplified method safe harbor in recent years. But, the safe harbor approach may not maximize the deduction. The approach that provides the best result depends on the situation and the taxpayer’s unique set of facts.
Tuesday, February 7, 2017
Water has a significant influence on agriculture in the United States. Over time, different systems for allocating water have developed. Most of the United States west of the 100th Meridian utilizes the prior appropriation system for purposes of allocating water. The prior appropriation system is based on a recognition that water is more scarce, and establishes rights to water based on when water is first put to a beneficial use. The doctrine grants to the individual first placing available water to a beneficial use, the right to continue to use the water against subsequent claimants. Thus, the doctrine is referred to as a “first in time, first in right” system of water allocation. The oldest water right on a stream is supplied with the available water to the point at which its state-granted right is met, and then the next oldest right is supplied with the available water and so on until the available supply is exhausted. In order for a particular landowner to determine whether such person has a prior right as against another person, it is necessary to trace back to the date at which a landowner's predecessor in interest first put water to a beneficial use. The senior appropriator, in the event of dry conditions, has the right to use as much water as desired up to the established right of the claimant to the exclusion of all junior appropriators.
Water rights in a majority of the prior appropriation states are acquired and evidenced by a permit system that largely confirms the original doctrine of prior appropriation. The right to divert and make consumptive use of water from a watercourse under the prior appropriation system is typically acquired by making a claim, under applicable procedure, and by diverting the water to beneficial use. The “beneficial use” concept is basic; a non-useful appropriation is of no effect. What constitutes a beneficial use depends upon the facts of each particular case.
As applied to groundwater, the prior appropriation doctrine holds that the person who first puts groundwater to a beneficial use has a priority right over other persons subsequently desiring the same water. This doctrine is applied in many western states that also follow the prior appropriation doctrine with respect to surface water. In many of these states, appropriation rights are administered through a state-run permit system.
A water dispute testing the application of the prior appropriation doctrine to groundwater rights in western Kansas had a recent significant development. Today’s post explaining the case are the thoughts of Professor Burke Griggs of Washburn School of Law. Prof. Griggs is part of our Rural Law Program at the law school. Before joining the law school in 2016, Prof. Griggs represented the State of Kansas in federal and interstate water matters, and has advised Kansas' natural resources agencies on matters of natural resources law and policy. He has also been engaged in the private practice of law.
Facts of the Case
On February 1, 2017, the Haskell County Kansas District Court issued its latest decision in Garetson Bros. v. American Warrior et al., (Dist. Ct. No. 2012-CV-09). The case involves a longstanding dispute between rival groundwater pumpers in southwestern Kansas (just west of the 100th Meridian). Applying a fundamental principle of Kansas water law—first in time, first in right— the court protected the plaintiffs’ senior well and groundwater right from impairment by issuing a permanent injunction prohibiting the use of the defendants’ junior rights. Although the case stands for the simple proposition that the prior appropriation doctrine grants senior rights holders the right to enjoin junior groundwater diversions which are impairing their senior rights, the court’s application of the doctrine to groundwater rights which access the Ogallala Aquifer may well produce regulatory and political reactions that are anything but simple.
In terms of Kansas water law, the case is relatively straightforward. The Garetsons own a senior, vested (pre-1945) groundwater right, which depends on the same local source of groundwater supply as two neighboring and junior groundwater rights held by American Warrior, an oil and gas production company. In 2005, the Garetsons filed an impairment complaint with the Kansas Department of Agriculture’s Division of Water Resources (DWR), so that DWR could investigate and resolve the dispute according to K.A.R. § 5-4-1a, which sets forth a detailed procedure for addressing impairment complaints for water from Ogallala Aquifer water sources. For reasons not set forth in the decision, the Garetsons withdrew their complaint in 2007, but later in 2012 sued to obtain an injunction against American Warrior’s pumping, claiming a senior water right under the Kansas Water Appropriation Act (“KWAA”). In November of that year, the trial court appointed the DWR as a fact-finder pursuant to the limited reference procedure set forth at K.S.A. § 82a-725. The DWR filed its first report on April 1, 2013, which found that the Garetson well was being impaired by the two American Warrior wells. Based on the DWR’s uncontested finding of impairment, the Garetsons obtained a preliminary injunction shortly thereafter. After several rounds of motion pleading, the DWR issued its second report on March 27, 2014, also finding impairment, and the court issued a second temporary injunction on May 5 of that year, ordering the curtailment of pumping from the defendant’s two wells.
The Appellate Decision and Remand
The defendants timely filed an interlocutory appeal to reverse the temporary injunction. In 2015, the Kansas Court of Appeals affirmed the district court’s granting of the injunction and remanded the case back to Haskell County. Garetson Bros. v. Am. Warrior, Inc., 347 P.3d 687, 51 Kan. App. 2d 370 (2015), rev. den., No. 14-111975-A, 2016 Kan. LEXIS 50 (Kan. Sup. Ct. Jan. 25, 2016).
The resolution of the central issue on appeal effectively decided the issue on remand. The issue centers on the two distinct definitions of “impairment” under the KWAA. Within the context of reviewing new applications for water rights pursuant to K.S.A. §§82a-711 and 82a-711a, the DWR uses one definition: “impairment shall include the unreasonable raising and lowering of the static water level . . . at the [senior] water user’s point of diversion beyond a reasonable economic limit (emphasis added). However, when the DWR is called upon to protect senior water rights from impairment by already-existing junior water rights, that impairment standard does not include the “beyond a reasonable economic limit” qualifier. K.S.A. §§ 82a717a, 82a-716. Because this dispute concerned the latter situation, the Court of Appeals declined defendant-appellant’s efforts to apply the former definition of impairment, and upheld the injunction.
Remanded back to Haskell County, and before a different judge, the court held hearings in October of 2016. Central to the record in the case were the findings by both the Kansas Geological Survey and the DWR that groundwater levels were declining in the area, and that the defendants’ junior groundwater pumping was responsible for substantially impairing the plaintiffs’ senior right. With these principal conclusions established in the record, the court applied the standard test for permanent injunctions, and found that a permanent injunction should issue in this case. In making that finding, the trial court judge followed the “ordinary definition of impair” [pursuant to K.S.A. §§ 82a-716 and 82a-717] which the legislature intended should apply in situations such as this, where the senior right holder seeks injunctive relief to protect against diversions by junior water right holders, when the diversion “diminishes, weakens, or injures the prior right.” In deciding that an injunction against the defendant’s junior rights should issue, the court declined to adopt a remedy suggested by the DWR in its second report—that the junior water rights surrounding Garetson’s (including those owned by non-parties) could be allowed to operate on a limited and rotating basis. In declining to adopt that remedy, the court stressed that it “does not wish to draft an order that would micro-manage future use” by the junior rights.
The prior appropriation doctrine means what it says when it comes to protecting senior water rights to the Ogallala Aquifer - first in time is first in right. In addition, “impairment” means “impairment,” unqualified by economic reasonableness. Whether Kansas irrigators and the Kansas legislature can accept such clarity will be the subject of a subsequent post, where we will speculate on what type of legislative reaction the case might provoke.
Friday, February 3, 2017
A recent court decision from Michigan involving that state’s recreational use statute raised a question that I sometimes get from farmers, ranchers and rural landowners – just what type of activity does a recreational use statute cover? It’s a good question. The answer is, “it depends.” Each state provision is unique, but there are some basic general points that can be made.
In 1965, the Council of State Governments proposed the adoption of a Model Act to limit an owner or occupier's liability for injury occurring on the owner's property. The stated purpose of the Model Act was to encourage owners to make land and water areas available to the public for recreational purposes by limiting their liability toward persons who enter the property for such purposes. Liability protection was extended to holders of a fee ownership interest, tenants, lessees, occupants, and persons in control of the premises. Land which receives the benefit of the act include roads, waters, water courses, private ways and buildings, structures and machinery or equipment when attached to the realty. Recreational activities within the purview of the act include hunting, fishing, swimming, boating, camping, picnicking, hiking, pleasure driving, nature study, water skiing, water sports, and viewing or enjoying historical, archeological, scenic or scientific sites. Most states have enacted some version of the 1965 Model legislation.
Under the model legislation, an owner or occupier owes no duty of care to keep the premises safe for entry or use by others for recreational purposes, or to give any warning of dangerous conditions, uses, structures, or activities to persons entering the premises for such recreational purposes. Similarly, if an owner, directly or indirectly, invites or permits any person without charge to use the property for recreational purposes, the owner does not extend any assurance the premises are safe for any purpose, confer the status of licensee or invitee on the person using the property, or assume responsibility or incur liability for any injury to persons or property caused by any act or omission of persons who are on the property.
The protection afforded by the Model Act is not absolute, however. Should injury to users of the property be caused by the willful or malicious failure to guard or warn against a dangerous condition, use, structure, or activity, the protection of the act would be lost. Likewise, if the owner imposes a charge on the user of the property, the protection of the act is lost. The 1965 Model Act contained a specific provision that did not exempt anyone from liability for injury in any case where the owner of land charges a fee to the person or persons who enter or go onto the land for recreational purposes. Under most state statutes patterned after the Model Act, if a fee is charged for use of the premises for recreational purposes, it converts the entrant's status to that of an invitee. Some states (such as Wisconsin) establish a monetary limit on what a landowner may receive in a calendar year and still have the liability protection of the statute. The North Dakota statute provides immunity for landowners that invite the public onto their land for recreational rather than commercial purposes, with the distinction between the two classifications largely turning on whether a fee is directly charged.
Signs, Release Language and Gross Negligence
Many fee-based recreational use operations require guests to sign a form releasing the landowner from liability for any injury a guest may sustain while recreating on the premises. To be an effective shield against liability, a release must be drafted carefully and must be clear, unambiguous, explicit and not violate public policy. Courts generally construe release language against the drafter and severely limit the landowner’s ability to contract away liability for its own negligence. Likewise, most courts that have considered the question have held that a parent cannot release a minor child’s prospective claim for negligence. This has led some state legislatures to consider legislation designed to protect organizations while not allowing wrongdoers to escape liability for intentional or grossly negligent conduct. This is where that recent Michigan case fits in.
In Otto v. Inn at Watervale, No. 330214, 2017 Mich. App. LEXIS 68 (Mich. Ct. App. Jan. 17, 2017). the plaintiff, the mother of a 10-year-old girl sued the defendant for burn injuries her daughter suffered while using the defendant’s beach area. The daughter was playing on the beach with friends when she stepped on hot coals that were covered up in the beach’s sand. The defendant had allowed guests in the past to have “fire rings” on the beach, and they had become covered with sand blown by the wind which had not yet been uncovered from the prior fall season. There had also been prior problems with guests not properly extinguishing fires on the beach in the past. The plaintiff sued based in negligence and the defendant moved for summary judgment on the basis that the claim was barred by the state (MI) Recreational Land Use Act (RLUA) (MCL §324.73301). The RLUA bars an action to recover for injuries incurred while on the land of another without paying a fee for the purpose of “fishing, hunting, trapping, camping, hiking sightseeing, motorcycling, snowmobiling, or any other outdoor recreational use or trail use with or without permission,…unless the injuries were caused by gross negligence or willful and wanton misconduct of the owner, tenant or lessee. The trial court granted the defendant’s motion, but allowed the plaintiff to amend the complaint to add gross negligence and willful and wanton misconduct claims. The plaintiff amended the complaint, claiming that the defendant’s conduct was reckless in letting guests have beach bonfires without properly supervising or providing instructions for putting the fires out, and for not properly warning the public of the possibility of hot fire coals. The defendant claimed that the hot coals were buried and not visible and that a reasonable inspection would not have disclosed them and that staff cleaned embers from fire rings on a weekly basis. The trial court again granted summary judgment for the defendant. On appeal, the appellate court reversed. The court noted that a child’s play on a beach was not the type of activity that was of the same kind, class, character or nature of the listed activities in the RLUA. In addition, the court determined that the child was not engaged in “any other outdoor recreational use or trail use.” As such, the RULA did not apply and the court reversed the trial court’s determination.
With increased interest by farm and ranch owners in providing recreational activities to generate additional income, some states have passed ag immunity laws designed to supplement the protection provided by recreational liability acts. In general, the various state statutes provide liability protection for landowners against the injury or death of a participant in a recreational activity arising from the “inherent risks” of the activity. The Colorado statute, for example, is written in this manner.
Recreational use statutes generally do not preclude legal claims based on negligent supervision. In one case from Maine, the plaintiff was engaged in cutting and making firewood on the defendant’s property and was injured while loading a wood splitter. The state recreational use statute covered the harvesting or gathering of forest products and would have shielded the defendant from liability for the plaintiff’s injuries. As a result, the plaintiff alleged negligent supervision and instruction concerning the use of the wood splitter. The court held that the plaintiff’s claim was not precluded by the recreational use statute inasmuch as the statute only precluded claims alleging premises liability, and allowed the case to proceed to trial on the negligent supervision claim. Dickinson v. Clark, 767 A.2d 303 (Me. 2001).
While this discussion just scratches the surface, the point is that a rural landowner should have at least some knowledge of their state’s recreational use statute, or at least have legal counsel that does. Each state’s particular statutory language is unique, and there are a seemingly endless number of situations that could invoke the statute. Given that agricultural land is prone to activities of third party entrants that could create liability situations for the landowner, knowledge of the rules (and insurance) are key.
Wednesday, February 1, 2017
The burden of proof in litigation is an important procedural matter. In civil litigation, the plaintiff bears the burden to prove their case by a preponderance of the evidence. In criminal cases, the government bears the burden to prove that the facts to support the government’s position beyond a reasonable doubt. But, what about the burden of proof in tax litigation? The rule is a bit different. Normally, the taxpayer bears the burden. But, there are circumstances in which the burden can shift to the government. That’s today’s focus.
The Shifting Burden
When a taxpayer gets a notice of deficiency, the taxpayer normally bears the burden of proof. The deficiency is, essentially, presumed to be correct. Thus, the taxpayer bears the burden to prove that the IRS is wrong. But, there is a burden-shifting statute. I.R.C. §7491 states that “If, in any court proceeding, a taxpayer introduces credible evidence with respect to any factual issue relevant to ascertaining the liability of the taxpayer for any tax imposed by subtitle A or B, the Secretary shall have the burden of proof with respect to such issue.” Of course, to shift the burden, the taxpayer must properly substantiate all issues in controversy, maintain records, and reasonably cooperate with the IRS with respect to its requests for meetings, witnesses, information, documents and interviews. However, the statutory burden shifting doesn’t apply to corporations, partnerships, and trusts with a high net worth. For partnerships, a recent law change places the burden on the partnership rather than the partners, which creates issues of its own. But, remember, even if the burden does shift, the taxpayer has the burden of going forward with evidence throughout the trial process.
Facts. A recent case, Cavallaro v. Comr., 842 F.3d 16 (1st Cir. 2016), aff’g. in part, and rev’g. in part, and remanding, T.C. Memo. 2014-189, involved the merger of two corporations, one owned by the parents and one owned by a son. The parents' S corporation developed and manufactured a machine that the son had invented. The son did not patent the invention, and the parents' corporation claimed the research and development credits associated with the machine. The sons' corporation sold the machine (liquid dispenser) to various users, but the intellectual property rights associated with the machine were never formally received. The two corporations were merged for estate planning purposes, with the parents' receiving less stock value than their asset ownership value. The lawyers involved in structuring the transaction "postulated" a technology transfer for significant value from the son to the parents that had occurred in 1987. The transfer was postulated because there were no documents concerning the alleged transaction executed in 1987. Instead, the lawyers executed the transfer documents in 1995. The IRS asserted that no technology transfer had occurred and that the merger resulted in a gift from the parents to the son of $29.6 million for which no gift tax return had been filed and no taxes paid. In essence, the IRS claimed that the parents’ corporation was valueless. But, later, the IRS determined that part of the deficiency was wrong and that the parents’ corporation actually did have some value.
I.R.C. §7491. The parents claimed that the burden of proof shifted under I.R.C. §7491(a)(1). However, the IRS started the examination of the return at issue in the case before the statute took effect. The statute only applies to IRS examinations commenced after July 22, 1998. The IRS beat that effective date by a few months.
Excessive and arbitrary. The parents also claimed that the initial deficiency was excessive and arbitrary (bore no factual relationship to their tax liability) and, as a result, shifted the burden of proof to the IRS. The Tax Court noted that an excessive and arbitrary notice of deficiency can shift the burden of proof to the IRS, but concluded that the deficiency involved valuation issues of the corporations, and that the IRS had a sufficient foundation for the initial notice. Basically, according to the Tax Court, all the IRS had to do was make some sort of evidentiary showing in support of the deficiency and the burden won’t shift.
Procedural rule. But, there is also a procedural rule (Rule 142(a)(1)) that says that even though a notice of deficiency is presumed to be correct, the burden shifts when a “new matter” is raised at trial. This was also tied into the valuation issue. The parents pointed out that the IRS initial notice asserted that their corporation had no value, but then the IRS later claimed that it had some value. That, according to the parents, would shift the burden of proof. But, the Tax Court didn’t think so. The court noted that the issue was valuation throughout the entire process and that the taxpayers knew that. There was no “new matter” so there was no burden shifting under the procedural rule.
Expert witness. One other area where the burden can shift involves expert witnesses. In the case, the Tax Court rejected the expert reports of the taxpayers because the court thought they were based on the assumption that the son’s corporation owned technology that the parents’ corporation owned. That court believed that was an incorrect assumption. Consequently, the government’s expert produced the only report that was based on a correct assumption – that the parents’ corporation owned the technology. So, there was no burden-shifting on this point either.
Tax Court’s conclusion. So, the burden of proof didn’t shift to the IRS and they bore the burden to show the proper amount of their tax liability. But, they didn’t have any valuations to help them do so and had no basis to claim that the government got the valuation issue wrong. The Tax Court was left with adopting the government’s valuation claim even though noting that the court was troubled by the government’s numbers. The end result was that the resulting gift tax (at 1995 rates) was $14.8 million.
Appellate decision. On appeal, the parents claimed that the Tax Court erred by not shifting the burden of proof to the IRS because the original notices of deficiency were arbitrary and excessive and/or because the IRS relied on a new theory of liability. The parents also alleged that the Tax Court incorrectly concluded that the parents’ company owned all of the technology and that the Tax Court erred by misstating their burden of proof and then failing to consider alleged flaws in the IRS expert’s valuation of the two companies. The appellate court reversed and remanded on the issue of the nature of the parents’ burden of proof and the Tax Court’s failure to allow them to rebut the IRS expert’s report. However, the appellate court determined that the parents bore the burden to prove that the deficiency notices were in error and that the burden of proving a gift tax deficiency didn’t shift to the IRS even though the IRS later conceded somewhat on the valuation issue because the initial conclusion of IRS on value was not arbitrary.
The appellate court also determined that the parents could not shift the burden of proof on the grounds that the IRS raised a new matter because the IRS theory that their corporation was undervalued was consistently postulated throughout and the original notices that implied that undervaluation of the parents’ corporation allowed for a disguised gift transfer from the parents to their adult children. The Tax Court’s finding that the parents’ corporation owned the technology was also upheld. But, the appellate court did allow the parents to challenge the IRS expert’s valuation and how the Tax Court handled the objections to the valuation. Thus, the court remanded on that issue.
The end result was that the taxpayers didn’t have to prove the correct amount of their tax liability. They also get a shot to challenge the government’s expert report. If they are successful on the challenge, the Tax Court will have to determine what the tax liability is.
To shift the burden of proof to the IRS in a tax case, substantiate everything, keep good records, and cooperate with the IRS throughout the process. Also, make sure that any experts that are utilized are qualified and base their reports on correct assumptions. If the IRS raises a “new matter” during the litigation, that can also shift the burden.