Wednesday, November 22, 2017
For certain types of agricultural employment, federal labor laws are relevant. Exemptions exist that cover the vast majority of smaller operations, but there can come a point at which either the number of employees hired or the type of agricultural production involved will trigger the federal rules.
A recent case from Indiana illustrates the application of federal law, and why the classification of the type of employment matters. What is often involved is the line between “agricultural” employment, “secondary agriculture” or a job in an ag setting that is more properly designated as “commercial” employment.
The Indiana Case
Facts. In Kidd v. Wallace Pork Sys., No. 3:16-CV-210-MGG, 2017 U.S. Dist. LEXIS 163174 (N.D. Ind. Oct. 2, 2017).The defendant operated a hog farm and a feed mill. The plaintiffs were employed at the feed mill between 2013 and 2016, during which time they often worked more than forty hours per week and were never paid overtime. From the time of the feed mill’s inception until summer 2016 the defendant used its own employees to produce animal feed at the feed mill while simultaneously contracting with Bi-County Pork, Inc. to purchase feed produced by Bi-County’s own staff at its independent neighboring facilities using inputs provided solely by the defendant. Bi-County only produced feed for the defendant and the defendant purchased all the feed Bi-County produced. All of the defendant’s feed is either fed to animals that the defendant owns or raises or is sold to third-parties.
Before the plaintiffs began working for the defendant at the feed mill, at least one other feed mill employee (other than the plaintiffs) complained about not receiving overtime pay. The complaint prompted an investigation by the United States Department of Labor (DOL) into the applicability of the Fair Labor Standard Act’s (FLSA) overtime exemption for secondary agricultural labor at the feed mill. The DOL concluded that the feed mill’s operations warranted a secondary agricultural designation exempting feed mill employees from overtime pay because the primary use of the feed produced there was feeding the defendant’s hogs. The DOL also concluded that the defendant used 55 percent of the feed it produced itself and sold the remaining 45 percent. The DOL also pointed out that although the feed mill qualified as secondary agriculture at that time and date, the success with outside suppliers and clients might change that designation in the future.
The court’s analysis. The plaintiffs both sued alleging that the defendant’s failure to pay them overtime constituted violations of state (IN) minimum wage and wage payment statutes as well as the FLSA. The cases were subsequently removed to federal court based upon original jurisdiction arising from their claims under the federal FLSA. Through discovery actions, the defendant reported that about 75 percent of their total feed output was sold to third parties with 75-80 percent of that total feed output being produced by Bi-County. Under 29 U.S.C. § 213(b)(12), the overtime provisions of the FLSA do not apply “to any employee employed in agriculture.” The FLSA distinctly identifies two branches of agriculture: primary agriculture and secondary agriculture. The parties agreed that the work that the plaintiffs performed at the feed mill only qualified for the agricultural exemption from overtime pay if it constituted secondary agriculture. The federal court concluded that in order to defer to the DOL’s report it must first assess whether the totality of the circumstances especially with respect to the portion of the defendant’s income streams, during the time of the plaintiffs’ employment, changes significantly enough from the time covered by the DOL’s investigation to warrant reclassifying work at the feed mill from secondary agriculture to manufacturing. The court held that because the defendant failed to produce data specifying the total feed production and sales from the feed mill and Bi-County separately during the relevant period of the plaintiffs’ employment, a genuine issue of fact existed as to what proportion of the feed mill’s feed output was sold to third parties. As a result, the court concluded that neither party was entitled to summary judgement as a matter of law.
Employment matters in agriculture sometimes trigger the application of federal law (as well as certain state law requirements). The Indiana case is an example of how contemporary agricultural production activities might trigger their application.
To the readers of this blog, enjoy Thanksgiving with your families. As Abraham Lincoln stated in his Proclamation of Thanksgiving on October 3, 1863, take time to reflect and give thanks for the provision of the “blessings of fruitful fields and healthful skies.” The next post will be on November 28.
Monday, November 20, 2017
Last week, the House passed its version of legislation to overhaul the tax Code. H.R. 1 passed on a 227-205 (two abstentions). Also, last week, the Senate Finance Committee approved its version of tax legislation by a 14-12 vote. The bills are similar on some points, but dramatically different on others. While I tend not to focus to heavily on tax bills before the legislation takes the form of a bill that is headed to the President’s desk, there have been some items in these two bills that have required a detailed examination and commentary to staffers of Committee members with further explanation of their likely impact on the agricultural sector. My blog post of November 6 on the self-employment tax impact of the House bill was an example of that. Fortunately, those provisions were stripped out in a Chairman’s amendment.
Today, I compare some of the provisions contained in the bills and also point out a few areas of likely impact on ag producers and agribusiness activities. My friend, Tony Nitti (a CPA in Colorado) who is a contributor to Forbes, has done a great job in breaking down some of the provisions in both the House and Senate bills in one of his recent columns. Today’s post begins with Tony’s framework and expands into additional areas that have direct application to agricultural producers and businesses. I am also not covering every provision contained in either the House or Senate bills. The bills are each several hundred pages long.
For those interested in hearing my commentary on these provisions, I will be covering it on RFD-TV and my other radio interviews in the coming days. Those interviews and commentary will be captured and made available on www.washburnlaw.edu/waltr. I will also be discussing the two bills at upcoming practitioner seminars, including one this week in Kansas City. I will also cover the bills in Topeka, Salina and Wichita, Kansas the following week, and in Des Moines, Iowa on December 6 as well as in Pittsburg, KS on Dec. 14 (also simulcast over the web). My full CPE schedule can also be found on www.washburnlaw.edu/waltr.
The following is what I “think” the language in the House and Senate bills on the provisions discussed means at the present time. Some of the bill language is confusing and convoluted and practically impossible to discern. Thus, the reader is duly cautioned.
Ordinary Income Tax Brackets and Rates
The House bill contains four brackets (from 12% to 39.6% (with a tack-on for those with over $1 million of AGI).
The Senate bill has seven brackets (from 10% to 38.5%). While the rates are indexed for inflation, they sunset after 2025. In addition, based on the where the brackets begin and end, many people with modest-to-high incomes, particularly under the Senate Bill, will see a significant rate increase, at least as compared to the House Bill.
Capital Gain/Dividend Rates
The House bill preserves the present rates of 0 percent, 15 percent and 20 percent. The Senate bill is the same as the House bill on capital gain/dividend rates. Also, neither the House nor the Senate bill repeals (or otherwise modifies) I.R.C. §1411 – the 3.8 percent additional tax on passive sources of income that was added by the health care law. Thus, the maximum capital gain (or ordinary dividend) rate (based on the ordinary income tax rate applicable to the taxpayer) would be 23.8 percent. For estates and trusts, the capital gain rates are also 0 percent, 15 percent and 20 percent, with the 20 percent rate beginning amounts above $12,700. The 3.8 percent additional tax would also apply to passive gains.
Both the House bill and the Senate Bill essentially double the existing level of the standard deduction, setting it at $24,000 for a married couple filing jointly, for example.
The “price” for the doubling of the standard deduction, at least in part, is the elimination of the personal exemption for a taxpayer. The House bill, while it eliminates the personal exemption and the use of a flexible spending account for child care, enhances the existing child tax credit ($1,600 per qualified child; and increases the phase-out range), and adds a $300 credit for non-child dependents (through 2022), and a “Family Flexibility” credit of $300 for each spouse. The refundable portion of the child tax credit is set at $1,000, with the phase-out beginning (MFJ) at $230,000.
The Senate bill also eliminates the personal exemption, and increases the child tax credit to $2,000 (through 2025 for children under age 18, when it is then eliminated) with the phaseout range set much higher than the House phase-out range – it begins at $1,000,000 (MFJ).
The House bill eliminates all major deductions except for up to $10,000 of property taxes; mortgage interest (up to $500,000 on new loan and none for second home or on home equity loans); losses associated with federally declared disaster areas; and charitable deductions. As for charitable contributions, the contribution limit is increased to 60 percent. Also, the charitable mileage statutory cap of $.14 is eliminated and adjusted for inflation. In addition, the House bill requires that all charitable contributions (of any dollar amount) be substantiated.
The Senate bill also eliminates all major deductions except for medical expenses (they remain deductible to the extent they exceed 10 percent of AGI); mortgage interest (limited to $1,100,000 with no deduction on home equity loans); charitable contributions (same provisions as the House bill with additional specification that an electing small business trust must follow the charitable contribution deduction rules for individuals); alimony deduction; the deduction for student loan interest; and the educator deduction. Unlike the House bill, the Senate bill entirely eliminates all deductibility for property taxes. That last point on property tax deductibility will be a sticking point in getting a final bill to the President’s desk.
The House bill enhances the American Opportunity Tax Credit, but repeals the Lifetime Learning Credit and the Hope Scholarship Credit. Also, new Coverdell ESA contributions would be barred, but tax-free rollovers to an I.R.C. §529 plan would be allowed. Similarly, elementary and high school expenses of up to $10,000 annually would qualify for I.R.C. §529 plans. The House bill repeals the deductibility of interest expense on education loans; the exclusion for interest on U.S. savings bonds that are used to pay higher education expenses; the deduction for qualified tuition and related expenses; the exclusion for qualified tuition reduction programs, and the exclusion for employer-provided educational assistance. The House bill also includes a 1.4 percent excise tax on the endowment income of colleges, and treats tuition reductions for graduate students (and others) as taxable income.
The Senate bill, while not including many of the higher education provisions of the House bill, does impose a tax on the investment income of private colleges with endowments of at least $250,000 per student. It also increases the schoolteacher deduction to $500.
Pass-Through Business Income
The House bill establishes a top rate of 25 percent on S corporation income. That rate applies to all of a passive owner’s income, and it applies to 30 percent of a materially participating owner’s income that is attributable to the capital of the business. The balance of the owner’s income is taxed at the taxpayer’s applicable individual rate. The House bill establishes a presumption that none of the income of an owner of a service business is subject to the 25 percent rate. As noted above, the self-employment tax changes that were in the original House version have been removed.
Under the Senate bill, sole proprietors, S corporation owners and partnership members get a deduction of 17.4 percent of “qualified business income” (limited to 50 percent of FICA wages paid by the business owner). The deduction is not available to “specified service businesses.” The calculation of the deduction is brought over from the domestic production activity deduction (DPAD) provision of I.R.C. §199, which is removed by both the House and Senate versions. Unfortunately, it is impossible to tell whether the computation for the deduction is at the individual level or the entity level.
The House bill taxes “carried interest” (the portion of an investment fund’s profits (typically 20 percent) that is paid to investment managers), but limits the application of the capital gain rate to the gain on the sales of assets held three years or more (as opposed to one-year under current law).
The Senate bill mirrors the House bill.
Alternative Minimum Tax (AMT)
Both the House bill and the Senate bill eliminate the AMT.
The House bill contains no significant change in the manner of how a worker is classified either as an independent contractor or an employee.
The Senate bill establishes a safe harbor under which a worker is treated as an independent contractor and not an employee upon the satisfaction of three objective tests – the relationship between the parties; the location of the services or means by which they are provided; and the existence of a written contract stating the independent contractor relationship and acknowledging responsibility for taxes and a reporting/withholding obligation. The bill establishes a $1,000 threshold for Form 1099-K reporting, and raises the 1099-MISC threshold from $600 to $1,000. The Senate bill also limits the ability of the IRS to reclassify service providers as employees (and service recipients/payors as employers) in cases where the parties try in good faith to comply with the safe harbor, but fail. In other words, the IRS can only recharacterize the relationship as an employment relationship on a prospective basis. The Senate bill also amends Tax Court jurisdiction to allow a worker to bring a case challenging worker classification.
The House bill sets the applicable exclusion from estate, gift and generation-skipping transfer tax (GSTT) at $11.2 million for 2018. The House bill eliminates the estate tax and the GSTT after 2023. The House bill retains stepped-up basis for property included in a decedent’s estate, and also retains the gift tax.
The Senate bill does not repeal the estate or GSTT, but doubles the applicable exclusion (11.2 million for 2018).
The House does not repeal the penalty tax applied to an individual that is mandated to purchase health insurance (the so-called “Roberts” tax).
The Senate bill eliminates the individual mandate penalty tax.
The House bill establishes a 20 percent top corporate rate beginning in 2018. For personal service corporations, the rate is 25 percent. The bill also modifies current accounting rules in numerous aspects. For example, a C corporation must use accrual accounting if gross receipts exceed $25 million, and businesses with inventory must use accrual accounting if gross receipts exceed $25 million. The bill also requires a business to change from the completed contract method to the percentage of completion method for accounting for long-term contracts if gross receipts exceed $25 million. In addition, the House bill specifies that the uniform capitalization rules apply to inventory if the taxpayer’s gross receipts exceed $25 million. The bill also eliminates the carryback for net operating losses (NOLs) (except for small businesses and farms – they get a one-year carryback), but they can be carried forward indefinitely but are limited to 90 percent of pre-NOL taxable income. In addition, deductible net interest expense is limited to 30 percent of business “adjusted taxable income” (with a 5-year carryover). However, interest deductibility is retained for a business with average gross receipts up to $25 million, with an “opt-out” election for farmers. If the opt-out provision is elected, alternative depreciation will apply to all of the taxpayer’s farm property and a 10-year recovery period will apply. That could be an especially important election for larger cattle feedlots and other livestock facilities that are highly leveraged. Entertainment expenses are not deductible, and the I.R.C. §199 DPAD is eliminated.
The Senate bill is similar. The top corporate rate is set at 20 percent, but the bill delays the implementation of that rate until the start of 2019. Like the House bill, the Senate bill contains similar accounting rule changes from current law. Under the Senate bill, a C corporation must use accrual accounting if gross receipts exceed $15 million. Likewise, businesses with inventory must use accrual accounting if gross receipts exceed $15 million. Businesses will also be forced to change from the completed contract method to the percentage of completion method when accounting for long-term contracts if gross receipts exceed $15 million. Also, the uniform capitalization rules will apply to inventory if the taxpayer’s gross receipts exceed $15 million. Also, under the Senate bill, there is no carryback for net operating losses. However, a net operating loss can be carried forward indefinitely, subject to a limit of 90 percent of taxable income; deductible net interest expense is limited to 30 percent of adjusted taxable income capped at $15 million of revenue with an indefinite carryover. Also, entertainment expenses are not deductible, and the DPAD is eliminated.
The House bill specifies that the I.R.C. §179 limit is enhanced to $5 million (phaseout beginning at $20 million), and immediate expensing of assets is allowed for assets with a life of less than 20 years that are acquired and placed in service after September 27, 2017 through 2022. A tax-deferred exchange (I.R.C. §1031) would be allowed only for real property.
The Senate bill pegs the I.R.C. §179 limit at $1 million, and there is immediate expensing of new assets with a life of less than 20 years through 2022. Under the Senate bill, farm equipment would be depreciated over five years, and the 150 percent declining balance depreciation method for farm property would be eliminated (except for 15-year and 20-year property).
The Senate bill creates a new IRS Form – Form 1040SR. The 1040SR is to be a simplified return for those taxpayers over age 65.
The House bill reduces the existing $.023-per-kilowatt-hour tax credit for wind energy production to $.015/kWh and changes the definition of “under construction.” That definition applies in the context of defining when the credit availability begins. The House bill also eliminates the $7,500 electric vehicle tax credit and makes the investment tax credit for solar projects a targeted credit. The House bill also extends the credit for residential energy efficient property through 2021, with a reduced rate of 26 percent for 2020 and 22 percent for 2021.
The Senate bill largely leaves existing energy credits in place, including the existing credit for marginal wells.
The House bill provides for a 100 percent dividends-received deduction to U.S. corporations when amounts are repatriated from foreign subsidiaries. There is also a one-time “deemed repatriation” tax imposed that applies a 14 percent tax on cash parked overseas and seven percent on any illiquid assets
The Senate bill is the same as the House bill, except that the deemed repatriation tax is 10 percent on cash and 5 percent on illiquid assets.
The House bill also modifies the FICA tip credit. In addition, the Employer-Provided Child Care Credit is eliminated, as is the Rehabilitation Credit, the Work Opportunity Tax Credit, the New Markets Tax Credit, the deduction for certain unused business credits, and deductions for expenses incurred to provide access to disabled persons. In addition, the House bill repeals I.R.C. §118 (capital contributions to a corporation); the deduction for transportation fringe benefits; the deduction for on-premises gyms; and limits the deduction for qualifying businesses meals to 50 percent. The House bill makes deferred compensation taxable when there is no longer a substantial risk of forfeiture. The bill also imposes an excise tax on excess tax-exempt organization executive compensation – its 20 percent on compensation that exceeds $1 million (in certain situations).
The Senate bill specifies that the alternative depreciation system for residential rental property is shortened to 30 years. It also eliminates the deduction for meals provided for the convenience of the employer. The Senate bill allows for rollovers between I.R.C. §529 plans and ABLE plans, bars an increase in user fees for installment agreements, delays the deduction by lawyers for litigation costs associated with expenses paid on contingent fee cases until the contingency is resolved, and eliminates the deduction for attorney fees and settlement payments in sex harassment or abuse cases if there is a nondisclosure agreement. The Senate bill also proposes to significantly impact the tax strategy of grain gifting by a farmer to a child by changing the child’s tax rates on unearned income to be equal to the tax rates for estates and trusts. Thus, once the child reaches $12,700 (2018) of unearned income, the child will face a maximum tax rate of 38.5 percent on all income above the $12,700 threshold.
It remains to be seen whether any of the provisions described above will ever become law. Certainly, the “sausage-making” process will be interesting to watch. The cynic in me says nothing of significance will ultimately get accomplished this year. There are just too many in the Senate that don't want the President to be perceived to have achieved a legislative victory on anything. Perhaps I am wrong. Time will tell.
Thursday, November 16, 2017
When stock values decline, an investor loses money. But the tax law does not allow that loss to be claimed until the investor sells the stock. The investor can’t sell stock at a loss and simply turn around shortly after the sale and buy back substantially identical stock or securities and get to recognize the loss. However, if an investor sells stock at a gain and buys back identical stocks (or securities), the gain is not disallowed. The government wins in either situation. The rule barring the loss deduction in such a situation is known as the “wash sale” rule.
The wash sale rule can apply in situations involving transactions other than simply stock or securities. It can also apply when “related parties” are involved.
The wash-sale rule. That’s the focus of today’s post.
The Wash-Sale Rule
An investor often prefers to time deductions on investments by claiming then when they can get the greatest benefit. That might include a situation where a loss is desired to be deducted and the stock be retained because the investor thinks that the stock value will increase again. So, the idea might to sell the stock and then turn around and immediately buy it back. But, that’s where I.R.C. §1091 applies. That Code sections disallows a loss deduction incurred on the sale or other disposition of stock or securities where it appears that, within a period beginning 30 days before the date of such sale or disposition and ending 30 days after such date, the taxpayer has acquired (by purchase or by an exchange on which the entire amount of gain or loss was recognized by law), or has entered into a contract or option so to acquire, substantially identical stock or securities. The only exception is if the taxpayer is a dealer in stock or securities and the loss is sustained in a transaction made in the ordinary course of that business. Thus, the rule applies only to losses and bars a taxpayer from wiping out a gain from a sale by buying the same stock back within 30 days.
As is noted in the statute, for the wash-sale rule to be triggered, the stocks or securities must truly be “substantially identical.” Stocks or securities issued by one corporation are not considered substantially identical to stocks or securities of another. Are mutual funds caught by the rule? The IRS basically leaves that an open question subject to the facts and circumstances of the situation. But, selling one fund and buying a similar fund within 30 probably should be avoided. In addition, a “related party” rule can also come into play if a spouse or other “related party” such as the taxpayer’s controlled corporation is used to try to avoid the application of the rule.
Consequences. As can be discerned from the above commentary, the wash-sale period for any sale at a loss consists of 61 calendar days: the day of the sale, the 30 days before the sale and the 30 days after the sale. The wash sale rule has three consequences: (1) denial of the deductibility of the loss; (2) the amount of the disallowed loss is added to the basis of the replacement stock (which means that when the replacement stock is sold, the disallowed loss will either reduce gain or increase loss on the transaction); and (3) the taxpayer’s holding period for the replacement stock includes the holding period of the stock that was sold. This last rule prevents a taxpayer from converting a long-term loss into a short-term loss, which can produce a rather harsh result. In general, a taxpayer receives more tax savings from a short-term loss than a long-term loss.
Basis adjustment rule. The basis adjustment rule has the effect of preserving the benefit of the disallowed loss – the taxpayer will receive the benefit on a future sale of the replacement stock.
Example: In the mid-1990s, Sam bought 100 shares of ABC, Inc. at $40 per share. The stock declined to $15 per share, and Sam sold the stock in 2000 to take the loss deduction. But, Sam then read a significant amount of good news about the stock and the economy in general and bought the stock back for $20, less than 31 days after the sale. Sam will not be able to deduct the loss of $25 per share. But he can add $25 per share to the basis of his replacement shares. Those shares have a basis of $65 per share: the $40 Sam paid, plus the $25 wash sale adjustment. In other words, Sam is treated as if he bought the shares for $65. If Sam ends up selling the shares for $70, he’ll only report $5 per share of gain. If he sells them for $40 (the same price he paid to buy them), he’ll report a loss of $25 per share.
Because of the basis adjustment rule, a wash-sale is usually not a major disaster taxwise. In many instances, the result is a simple postponement of the tax benefit of having sold stock at a loss. Indeed, if the taxpayer receives the tax benefit later in the same tax year, there may not actually be any impact on taxes. But, there are times when the wash sale rule can have a significantly negative tax impact. For example, If the taxpayer doesn’t sell the replacement stock in the same year, the loss will be postponed, possibly to a year when the deduction is of far less value. Also, if the taxpayer dies before selling the replacement stock, neither the taxpayer nor the taxpayer’s heirs will benefit from the basis adjustment rule. Similarly, the benefit of the deduction can be permanently lost if the taxpayer sells the stock and arranges to have a related person buy replacement stock. Furthermore, a wash sale involving shares of stock acquired through an incentive stock option can be a planning disaster.
Sales to Related Parties
As noted, a related party rule can come into play even though the wash-sale rule does not explicitly contain a related-party rule. The rule bars loss deductibility when a “taxpayer” sells stock at a loss, and then the “taxpayer” buys substantially identical securities within 30 days before or after the sale as replacement shares. But, the way the IRS interprets “taxpayer” is in terms of control. For example, the IRS has ruled that a taxpayer triggers the wash sale rule when stock is sold at a loss and the taxpayer’s IRA buy’s substantially identical stock within 30 days before or after the sale. Rev. Rul. 2008-5, 2008-3 I.R.B. 272. The rationale was that the taxpayer had retained control over the stock. The IRS later extended its position to stock a taxpayer sells which is then bought by the taxpayer’s spouse or controlled corporation. See, e.g., IRS Pub. 550. In essence the IRS position will capture any transaction that involves any type of entity that a taxpayer uses to maintain indirect ownership of other assets, including stock.
The end result of the IRS position is that even if repurchases by a related taxpayer don't fall within the wash sale rule, a loss can be disallowed under the related taxpayer rules of I.R.C. §267. In addition, the U.S. Supreme Court has held that a transaction between related taxpayers consisting of two separate parts might be treated as a single sale to a related taxpayer, resulting in a disallowed loss. McWilliams v. Comr., 331 U.S. 694 (1947). However, transactions between related parties through an exchange that is purely coincidental and is not prearranged are not caught by the related party rule.
Planning for Wash-Sales
What, if anything, can be done to plan around the wash-sale rule? Clearly, a taxpayer can sell the stock and wait 31 days before buying it again. But, the risk with this strategy is that the stock may rise in price before it is repurchased. If the taxpayer is convinced that the stock is at rock bottom, the strategy might be to buy the replacement stock 31 days before the sale. If the stock happens to go up during that period the gain is doubled, and if it stock value stays even, the taxpayer can sell the older stock and claim the loss deduction. But, the strategy could backfire – if the projection about the stock turns out to be wrong, a further decline in value could be painful. If the stock has a strong tendency to move in tandem with some other stock, it might be possible to reduce the risk of missing a big gain by buying stock in a different company as "replacement" stock. This is not a wash-sale because the stocks are not substantially identical. Thirty-one days later the taxpayer could switch back to the original stock if desired. But, there's no guarantee that any two stocks will move in the same direction, or with the same magnitude.
So, the bottom line is that there is no risk-free way to get around the wash-sale rule. But it’s just as true that continuing to hold a stock that has lost value isn't risk-free, either. It’s really up to each particular investor to evaluate all the risks, and balance them against the benefit that can be obtained by claiming a loss deduction.
The wash-sale rules are important to understand in terms of what losses they disallow. They are designed to prevent a taxpayer from manipulating the tax code for the taxpayer’s advantage with respect to stocks or securities. Sometimes, the rules come into play with respect to IRAs and entities, with little opportunity in taxpayers to avoid their impact.
Tuesday, November 14, 2017
In the context of Chapter 12 (farm) bankruptcy, unless a secured creditor agrees otherwise, the creditor is entitled to receive the value, as of the effective date of the plan, equal to the allowed amount of the claim. Thus, after a secured debt is written down to the fair market value of the collateral, with the amount of the debt in excess of the collateral value treated as unsecured debt which is generally discharged if not paid during the term of the plan, the creditor is entitled to the present value of the amount of the secured claim if the payments are stretched over a period of years.
What does “present value” mean? It means that a dollar in hand today is worth more than a dollar to be received at some time in the future. It also means that an interest rate will be attached to that deferred income. But, what interest rate will make a creditor whole? A recent decision by the Second Circuit Court of Appeals for the Second Circuit sheds some light on the issue.
Determining Present Value
Basically, present value represents the discounted value of a stream of expected future incomes. That stream of income received in the future is discounted back to present value by a discount rate. The determination of present value is highly sensitive to the discount rate, which is commonly express in terms of an interest rate. Several different approaches have been used in Chapter 12 bankruptcy cases (and nearly identical situations in Chapters 11 and 13 cases) to determine the discount rate. Those approaches include the contract rate – the interest rate used in the debt obligation giving rise to the allowed claim; the legal rate in the particular jurisdiction; the rate on unpaid federal tax; the federal civil judgment rate; the rate based on expert testimony; a rate tied to the lender’s cost of funds; and the market rate for similar loans.
In 2004, however, the U.S. Supreme Court, in, addressed the issue in the context of a Chapter 13 case that has since been held applicable in Chapter 12 cases. Till v. SCS Credit Corporation, 541 U.S. 465 (2004). In Till, the debtor owed $4,000 on a truck at the time of filing Chapter 13. The debtor proposed to pay the creditor over time with the payments subject to a 9.5 percent annual interest rate. That rate was slightly higher than the average loan rate to account for the additional risk that the debtor might default. The creditor, however, argued that it was entitled to a 21 percent rate of interest to ensure that the payments equaled the “total present value” or were “not less than the [claim’s] allowed amount.” The bankruptcy court disagreed, but the district court reversed and imposed the 21 percent rate. The United States Court of Appeals for the Seventh Circuit held that the 21 percent rate was “probably” correct, but that the parties could introduce additional concerning the appropriate interest rate.
On further review by the U.S. Supreme Court, the Court held that the proper interest rate was 9.5 percent. That rate, the Court noted, was derived from a modification of the average national loan rate to account for the risk that the debtor would default. The Court’s opinion has been held to be applicable in Chapter 12 cases. See, e.g., In re Torelli, 338 B.R. 390 (Bankr. E.D. Ark. 2006); In re Wilson, No. 05-65161-12, 2007 Bankr. LEXIS 359 (Bankr. D. Mont. Feb. 7, 2007); In re Woods, 465 B.R. 196 (B.A.P. 10th Cir. 2012). The Court rejected the coerced loan, presumptive contract rate and cost of funds approaches to determining the appropriate interest rate, noting that each of the approaches was “complicated, impose[d] significant evidentiary costs, and aim[ed] to make each individual creditor whole rather than to ensure the debtor’s payments ha[d] the required present value.” A plurality of the Court explained that these difficulties were not present with the formula approach. The Court opined that the formula approach requires that the bankruptcy court determine the appropriate interest rate by starting with the national prime rate and then make an adjustment to reflect the risk of nonpayment by the debtor. While the Court noted that courts using the formula approach have typically added 1 percent to 3 percent to the prime rate as a reflection of the risk of nonpayment, the Court did not adopt a specific percentage range for risk adjustment.
Since the Supreme Court’s Till decision, the Circuit Courts have split on whether the appropriate interest rate for determining present value should be the market rate or a rate based on a formula. In the most recent Circuit Court case on the issue, the Second Circuit held that a market rate of interest should be utilized if an efficient market existed in which the rate could be determined. In re MPM Silicones, L.L.C., No. 15-1682(l), 2017 U.S. App. LEXIS 20596 (2nd Cir. Oct. 20, 2017). In the case, the debtor filed Chapter 11 and proposed a reorganization plan that gave first-lien holders an option to receive immediate payment without any additional “make-whole” premium, or the present value of their claims by utilizing an interest rate based on a formula that resulted in a rate below the market rate. The bankruptcy court confirmed the plan, utilizing the formula approach of Till. The federal district court affirmed. On further review, the appellate court reversed noting that Till had not conclusively specified the use of the formula approach in a Chapter 11 case. The appellate court remanded the case to the bankruptcy court for a determination of whether an efficient market rate could be determined based on the facts of the case.
The interest rate issue is an important one in reorganization bankruptcy. The new guidance of the appropriate interest rate in a Chapter 11 is instructive. That’s particularly true because of the debt limit of $4,153,150 that applies in a Chapter 12. That limit is forcing some farmers to file Chapter 11 instead. There is no debt limit in a Chapter 11 case. Whether the Second Circuit’s recent decision will be followed by other appellate courts remains to be seen. But, the market rate, as applied to an ag bankruptcy, does seem to recognize that farm and ranch businesses are subject to substantial risks and uncertainties from changes in price and from weather, disease and other factors. Those risks are different depending on the type of agricultural business the debtor operates. A market rate of interest would be reflective of those factors.
Friday, November 10, 2017
Amidst all of the news recently about tax proposals in the Congress and the attention that has garnered, there is another important date that is creeping up on many livestock producers. Unless an extension is granted, on November 15, a reporting rule administered by the federal Environmental Protection Agency (EPA) will be triggered that will apply to certain livestock operations. The reporting applies to certain “releases” of “hazardous” substances and the requirement that the government be notified.
The federal government has been involved in regulating air emissions for over 50 years. The first serious effort at the national level concerning air quality was passage of the 1963 Clean Air Act (CAA) amendments. This legislation authorized the then Department of Health, Education and Welfare (now Department of Health and Human Services) to intervene directly when air pollution threatened the public “health or welfare” and the state was unable to control the problem.
The 1970 CAA amendments represented a major step forward at the federal level in terms of regulating the activities contributing to air pollution. This legislation created air quality control regions and made the individual states responsible for sustaining air quality in those regions. The states could regulate existing sources of pollution with less restrictive requirements. See, e.g., State, ex rel. Cooper v. Tennessee Valley Authority, et al., 615 F.3d 291 (4th Cir. 2010).
Additional federal Specifically, under the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA) and the Emergency Planning and Community Right-to-Know Act (EPCRA), the federal government is to be notified when large quantities of hazardous materials are released into the environment. Once notified, the Environmental Protection Agency (EPA) has discretion to take remedial actions or order further monitoring or investigation of the situation.
On January 21, 2005, the EPA announced the Air Quality Compliance Consent Agreement to facilitate the development of scientifically credible methodologies for estimating emissions from animal feeding operations (AFOs). A key part of the agreement is a two-year benchmark study of the air emissions from livestock and poultry operations. The study was designed to gather data relative to the thresholds of the CAA, the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA) and the Emergency Planning and Community Right-to-Know Act (EPCRA), and set national air policies so that excessive levels could be regulated. Under both CERCLA and EPCRA, the federal government is to be notified when large quantities of hazardous materials are released into the environment. Once notified, the EPA has discretion to take remedial actions or order further monitoring or investigation of the situation.
In mid-2007, the U.S. Court of Appeals for the D.C. Circuit upheld the EPA’s ability to enter into the consent agreements with participating AFOs. Association of Irritated Residents v. EPA, 494 F.3d 1027 (D.C. Cir. 2007). Community and environmental groups had challenged the consent agreements as rules disguised as enforcement actions, that the EPA had not followed proper procedures for rulemaking and that EPA had exceeded its statutory authority by entering into the agreements. The court disagreed, holding that the consent agreements did not constitute rules, but were enforcement actions within EPA’s statutory authority that the court could not review.
In early 2009, EPA, pursuant to the EPCRA, issued a final regulation regarding the reporting of emissions from confined AFO’s – termed a “CAFO.” The rule applies to facilities that confine more than 1,000 beef cattle, 700 mature dairy cows, 1,000 veal calves, 2,500 swine (each weighing 55 pounds or more), 10,000 swine (each weighing less than 55 pounds), 500 horses and 10,000 sheep. The rule requires these facilities to report ammonia and hydrogen sulfide emissions to state and local emergency response officials if the facility emits 100 pounds or more of either substance during a 24-hour period.
2008 Regulations and Court Case
In late 2008, the EPA issued a final regulation exempting farms from the reporting/notification requirement of CERCLA (Sec. 103) for air releases from animal waste on the basis that a federal response would most often be impractical and unlikely. However, the EPA retained the reporting/notification requirement for CAFOs under the EPCRA’s public disclosure rule. Various environmental activist groups challenged the exemption in the final regulation on the basis that the EPA acted outside of its delegated authority to create the exemption. Agricultural groups claimed that the carve-out for CAFOs was also impermissible, but for a different reason.
The environmental groups claimed that emissions of ammonia and hydrogen sulfide (both hazardous substances under CERCLA) should be reported as part of furthering the overall regulatory objective. The court noted that there was no clear way to best measure the release of ammonia and hydrogen sulfide, but noted that continuous releases are subject to annual notice requirements. The court held that the EPA’s final regulation should be vacated as an unreasonable interpretation of the de minimis exception in the statute. As such, the challenge brought by the agriculture groups to the CAFO carve out was mooted and dismissed. Waterkeeper Alliance, et al. v. Environmental Protection Agency, No. 09-1017, 2017 U.S. App. LEXIS 6174 (D.C. Cir. Apr. 11, 2017).
The court set a deadline for the beginning of the reporting of releases, but the EPA sought an extension. In response, the court extended the date by which farms must begin reporting releases of ammonia and hydrogen to November 15, 2017. The reporting requirement will have direct application to larger livestock operations with air emissions that house beef cattle, dairy cattle, horses, hogs and poultry. It is estimated that approximately 60,000 to 100,000 livestock and poultry operations will be subject to the reporting requirement.
EPA Interim Guidance
On October 26, 2017, the EPA issued interim guidance designed to educate livestock operations about the upcoming reporting requirements for emissions from animal waste.
Under the guidance, the EPA notes that the reportable quantity for each of ammonia and hydrogen sulfide is triggered at a release into the air of 100 pounds or more within a 24-hour period. That level would be reached by a facility with approximately 330-head (for a confinement facility) according to a calculator used by the University of Nebraska-Lincoln which is based on emissions produced by the commingling of solid manure and urine. If that level of emission occurs for either substance, the owner (or operator) of the “facility” must inform the U.S. Coast Guard National Response Center (NRC) of any individual release by calling (800) 424-8802. Unless changed at the last minute, this reporting must be done by November 15, 2017. In addition, a written report must also be filed with the regional EPA office within 30 days of the NRC reporting.
If releases will be “continuous and stable,” “continuous release reporting” is available by filing an “initial continuous release notification” to the NRC and the regional office of the EPA. Once that is done, reporting is only required annually unless the facility’s air emissions change significantly. However, unless an extension is granted, the initial “continuous release” notification is to be filed on or before November 15, 2017.
While air emissions occurring from the crop application of manure or federally registered pesticides are not subject to reporting, spills and accidents that involve manure (other fertilizers) and pesticides must be reported if they are over applicable thresholds.
The EPA Guidance also indicates that reporting does not apply under the EPCRA to air emissions from substances that are used in “routine agricultural operations.” Those substances, according to the EPA don’t meet the definition of “hazardous.” “Routine agricultural operations,” EPA states, includes “regular and routine” operations at farms AFOs, nurseries and other horticultural and aquacultural operations. That would include, EPA notes, on-farm manure storage used as fertilizer, paint for maintaining farm equipment, fuel used to operate farm machinery or heat farm buildings, and chemicals for growing and breeding fish. It would also appear to include livestock ranches where cattle are grazed on grass. A similar conclusion could be reached as to the term “facility” – a “facility” under CERCLA should not include a cow/calf grass operation where the livestock graze on grass. However, at the present time, the EPA has not provided any official guidance concerning the issue.
There doesn’t appear to be any harm in reporting when it is not clearly required. In other words, while the land application of livestock manure would appear to fall under the “fertilizer” exemption and not be included in the definition of “facility” a producer could still report such emissions. While grass operations could also report to be on the side of caution, the reportable emission level (if it were to apply to a grass operation) will be triggered at a higher head count of livestock because commingled solid waste and urine will not be present.
Recently, the EPA filed a motion with the court to push the November 15 deadline back. Also, on November 9, 2017, the National Pork Producers Council and the U.S. Poultry and Egg Association filed an amicus brief in support of the EPA’s motion. They are asking the court to give the EPA more time to “provide farmers more specific and final guidance before they must estimate and report emissions.” In addition, the EPA notes that getting additional time will allow to finalize a reporting system.
Whenever the reporting requirement becomes effective, either November 15 or sometime later if the court grants an extension, it will be important for livestock producers to comply. For now, livestock producers should study the EPA interim guidance. That guidance is available here: https://www.epa.gov/epcra/cercla-and-epcra-reporting-requirements-air-releases-hazardous-substances-animal-waste-farms#Resources. If reportable quantities of emissions will occur, the compliance deadline and proper reporting in a timely manner is very important so that applicable fines are avoided. It is also suggested the livestock producers look for guidance from their state and national livestock associations.
Wednesday, November 8, 2017
Next June, Washburn University School of Law will be sponsoring a two-day seminar in Pennsylvania on farm income tax and farm estate and business planning. I will be one of speakers at the event as will Paul Neiffer, the author of the Farm CPA Today blog. Paul and I have done numerous events together over the past few years and I thoroughly enjoy working with Paul. The K-State Department of Agricultural Economics will be co-sponsoring the event, and we are looking forward to working with the Pennsylvania Society of CPAs and Farm Credit East. The seminar dates will be June 7-8 and the location, while not set at the present time, will be within a couple of hours of Harrisburg, PA.
Our two-day event will precede the 2018 conference in Harrisburg of the National Association of Farm Business Analysis Specialists (NAFBAS) and the National Farm and Ranch Business Management Education Association, Inc. (NFRBMEA) which begins on June 10. We are looking forward to partnering with the two groups to provide technical and practical tax information in an applied manner that the attendees to the NAFBAS/NFRBMEA conference will find to be a beneficial supplement to their conference. Accordingly, we are planning the agenda to supplement the information that will be provided at the NAFBAS/NFRBMEA conference.
We will follow our traditional two-day seminar approach with farm income tax information on Day 1 and farm estate and business planning topics on Day 2. On Day 1, we will provide an update on recent cases and rulings. Of course, if there is new tax legislation, we will cover its application to various client situations. We will also provide farm income averaging planning strategies, farm financial distress tax planning issues, self-employment tax and how to structure leases and entities. Also on Day 1, we will explain how to handle indirect production costs and the application of the repair/capitalization regulations. In addition, we will explain the proper handling of farm losses and planning opportunities with farming C corporations.
On Friday, Day 2, we will cover the most recent developments in farm estate and business planning. Of course, if there is legislation enacted that impacts the transfer tax system, we will cover it in detail. We will also have a session on applicable tax planning strategies for the retiring farmer, and ownership transition strategies. Also discussed on Day 2 will be the procedures and tax planning associated with incorporating the farm business tax-free. We will also get into long-term health care planning, how best to structure the farming business to take maximum advantage of farm program payments, special use valuation as well as installment payment of federal estate tax. Those handling fiduciary returns will also find our session on trust and estate taxation and associated planning opportunities to be of great benefit.
Mark your calendars now for the June7-8 seminar in PA. If flying, depending on the location we settle on, flights into either Pittsburgh, Philadelphia or Baltimore will be relatively close. Be watching www.washburnlaw.edu/waltr for further details as the weeks go by. Until then, upcoming tax seminars will find me next week in North Dakota, and then Kansas in the following two weeks. In early December, I will be leading-off the Iowa Bar’s Bloethe Tax School in Des Moines with a federal tax update. I have also heard from numerous Iowans that will be attending tax school in Overland Park in late November, and I am looking forward to seeing you there along with the other attendees. Next week’s seminar from Fargo will be simulcast over the web in case you can’t attend in-person. Also, the seminar from Pittsburg, KS will be simulcast over the web. In addition, there will be a 2-hour ethics seminar/webinar on Dec. 15. Be watching my CPE calendar on www.washburnlaw.edu/waltr for more details.
I have a new book out, published by West Academic – “Agricultural Law in a Nutshell.” Here’s the link to more information about the book and how to order. http://washburnlaw.edu/practicalexperience/agriculturallaw/waltr/agriculturallawnutshell/index.html If you are involved in agriculture or just like to read up on legal issues involving those involved in agricultural production or agribusiness, the book would make a great stocking-stuffer. If you are teaching or taking an agricultural law class in the spring semester of 2018, this is a “must have” book.
There are always plenty of legal issues to write about and current developments to keep up on. Readers of this blog are well aware of that fact.
Monday, November 6, 2017
H.R. 1, the House tax bill, was publicly released last week. Of course, it’s getting a lot of attention for the rate changes for individuals and corporations and flow-through entities. However, there is an aspect that is getting relatively little focus – how the self-employment tax rules would change and impact leasing and entity structuring.
Most farmers don’t like to pay self-employment tax, and utilize planning strategies to achieve that end. Such a strategy might include entity structuring, tailoring lease arrangements to avoid involvement in the activity under the lease, and equipment rentals, just to name a few. However, an examination of the text of the recently released tax bill, H.R. 1, reveals that self-employment tax planning strategy for farmers will change substantially if the bill becomes law. If enacted, many farmers would see an increase in their overall tax bill while others would get a tax break. In addition, existing business structures put in place to minimize the overall tax burden would likely need to be modified to achieve that same result.
Today’s post examines the common strategies employed to minimize self-employment tax, and the impact of H.R. 1 on existing business structures and rental arrangements.
The Basics – Current Law
The statute. In addition to income tax, a tax of 15.3 percent is imposed on the self-employment income of every individual. Self-employment income is defined as “net earnings from self-employment.” The term “net earnings from self-employment” is defined as gross income derived by an individual from a trade or business that the individual conducts. I.R.C. §1402. For individuals, the 15.3 percent is a tax on net earnings up to a wage base (for 2017) of $127,200. It’s technically not on 100 percent of net earnings up to that wage base for an individual, but 92.35 percent. That’s because the self-employment tax is also a deductible expense. In addition, there is a small part of the self-employment tax that continues to apply beyond the $127,200 level.
In general, income derived from real estate rents (and personal property leased with real estate) is not subject to self-employment tax (see I.R.C. §1402(a)(1)) unless the arrangement involves an agreement between a landowner or tenant and another party providing for the production of an agricultural commodity and the landowner or tenant materially participates. I.R.C. §1402(a)(1)(A). For rental situations not involving the production of agricultural commodities where the taxpayer materially participates, rental income is subject to self-employment tax only if the activity constitutes a trade or business “carried on by such individual.” See, e.g., Rudman v. Comr., 118 T.C. 354 (2002). Similarly, an individual rendering services is subject to self-employment tax if the activity rises to the level of a trade or business.
This all means that real estate rentals are not subject to self-employment tax, nor is rental income from a lease of personal property (such as equipment) that is tied together with a lease of real estate. But, when personal property is leased by itself, if it constitutes a business activity the rental income would be subject to self-employment tax. See, e.g., Stevenson v. Comr., T.C. Memo. 1989-357.
Trade or business. Clearly, the key to the property reporting of personal property rental income is whether the taxpayer is engaged in the trade or business of renting personal property. The answer to that question, according to the U.S. Supreme Court, turns on the facts of each situation, with the key being whether the taxpayer is engaged in the activity regularly and continuously with the intent to profit from the activity. Comr. v. Groetzinger, 480 U.S. 23 (1987). But, a one-time job of installing windows over a month’s time wasn’t regular or continuous enough to be a trade or business, according to the Tax Court. Batok v. Comr., T.C. Memo. 1992-727.
As noted above, for a personal property rental activity that doesn’t amount to a trade or business, the income should be reported on the “Other Income” line of page 1 of the Form 1040 (presently line 21). Associated rental deductions are reported on the line for total deductions which is near the bottom of page 1 of the Form 1040. A notation of “PPR” is to be entered on the dotted line next to the amount, indicating that the amount is for personal property rentals.
Planning strategy. The income from the leasing of personal property such as machinery and equipment will trigger self-employment tax liability if the leasing activity rises to the level of a trade or business. But, by tying the rental of personal property to land, I.R.C. §1402(a)(1) causes the rental income to not be subject to self-employment tax. Alternatively, a personal property rental activity could be conducted via an S corporation or limited partnership. If that is done, the income from the rental activity would flow through to the owner without self-employment tax. However, with an S corporation, reasonable compensation would need to be paid. For a limited partnership that conducts such an activity, any personal services that a general partner provides would generate self-employment income.
Passive loss rules. In general, rental income is passive income for purposes of the passive loss rules of I.R.C. §469. But, there are a couple of major exceptions to this general rule. Under one of the exceptions, net income from a rental activity is deemed to not be from a passive activity if less than 30 percent of the unadjusted basis of the property is depreciable. Treas. Reg. §1.469-2T(f)(3). The effect of this exception is to convert rental income (and any gain on disposition of the activity) from passive to portfolio income. But, that is only the result if there is net income from the activity. If the activity loses money, the loss is still passive.
Under another exception, the net rental income from an item of property is treated as not from a passive activity if it is derived from rent for use in a business activity in which the taxpayer materially participates. Treas. Reg. §1.469-2(f)(6).
LLC members. Whether LLC members can avoid self-employment tax on their income from the entity depends on their member characterization. Are they general partners or limited partners? Under I.R.C. §1402(a)(13), a limited partner does not have self-employment income except for any guaranteed payments paid for services rendered to the LLC. So what is a limited partner? Under existing proposed regulations, an LLC member has self-employment tax liability if: (1) the member has personal liability for the debts or claims against the LLC by reason of being a member; (2) the member has authority under the state’s LLC statute to enter into contracts on behalf of the LLC; or (3) the member participated in the LLC’s trade or business for more than 500 hours during the LLC’s tax year. Prop. Treas. Reg. §1.1402(a)-2(h)(2). If none of those tests are satisfied, then the member is treated as a limited partner.
Structuring to minimize self-employment tax. There is an entity structure that can minimize self-employment tax. An LLC can be structured as a manager-managed LLC with two membership classes. With that approach, the income of a member holding a manager’s interest is subject to self-employment tax, but if non-managers that participate less than 500 hours in the LLC’s business hold at least 20 percent of the LLC interests, then any non-manager interests held by members that participate more than 500 hours in the LLC’s business are not subject to self-employment tax on the pass-through income attributable to their LLC interest. Prop. Treas. Reg. §1.1402(a)-2(h)(4). They do, however, have self-employment tax on any guaranteed payments. However, this structure does not achieve self-employment tax savings for personal service businesses. Prop. Treas. Reg. §1.1402(a)-2(h)(5) provides an exception for service partners in a service partnership. Such partners cannot be a limited partner under Prop Treas. Reg. §1.1402(a)-2(h)(4) (or (2) or (3), for that matter). Thus, for a professional services partnership structuring as a manager-managed LLC would have no beneficial impact on self-employment tax liability.
However, for LLCs that are not a “service partnership,” such as a farming operation, it is possible to structure the business as a manager-managed LLC with a member holding both manager and non-manager interests that can be bifurcated. The result is that a member holding both manager and non-manager interests is not subject to self-employment tax on the non-manager interest, but is subject to self-employment tax on the pass-through income and a guaranteed payment attributable to the manager interest.
Here's what it might look like for a farming operation:
A married couple operates a farming business as an LLC. The wife works full-time off the farm and does not participate in the farming operation. But, she holds a 49 percent non-manager ownership interest in the LLC. The husband conducts the farming operation full-time and also holds a 49 percent non-manager interest. The husband, as the farmer, also holds a 2 percent manager interest. The husband receives a guaranteed payment with respect to his manager interest that equates to reasonable compensation for his services (labor and management) provided to the LLC. The result is that the LLC’s income will be shared pro-rata according to the ownership percentages with the income attributable to the non-manager interests (98 percent) not subject to self-employment tax. The two percent manager interest is subject to self-employment tax along with the guaranteed payment that the husband receives. This produces a much better self-employment tax result than if the farming operation were structured as a member-managed LLC.
Additional benefit. There is another potential benefit of utilizing the manager-managed LLC structure. Until the health care law is repealed or changed in a manner that eliminates I.R.C. §1411, the Net Investment Income Tax applies to a taxpayer’s passive sources of income when adjusted gross income exceeds $250,000 on a joint return ($200,000 for a single return). While a non-manager’s interest in a manager-managed LLC is typically considered passive with the income from the interest potentially subject to the 3.8 percent surtax, a spouse can take into account the material participation of a spouse who is the manager. I.R.C. §469(h)(5). Thus, the material participation of the manager-spouse converts the income attributable to the non-manager interest of both spouses from passive to active income that will not be subject to the 3.8 percent surtax. Based on the example above, the result would be that self-employment tax is significantly reduced (it’s limited to 15.3 percent of the husband’s reasonable compensation (in the form of a guaranteed payment) and his two percent manager interest) and the net investment income surtax is avoided on the wife’s income.
What about an S corporation? The manager-managed LLC provides a better result than that produced by the member-managed LLC for LLCs that are not service partnerships. For those that are service providers, the S corporation is the business form to use to achieve a better tax result. For an S corporation, “reasonable” compensation will need to be paid subject to FICA and Medicare taxes, but the balance drawn from the entity can be received free of self-employment tax. The disadvantage of operating a business or holding property in the S corporation is inflexibility. Appreciated property cannot be removed from the S corporation without triggering gain. Upon the death of an S corporation shareholder, the tax bases of the underlying assets are not adjusted to fair market value. The partnership is the more tax-friendly and flexible structure.
Impact of H.R. 1 on Business Structures
In general. The new proposals (contained in H.R. 1) add complexity in many situations involving partnerships and leasing arrangements. Section 1004 of H.R. 1 eliminates the rental real estate exception from self-employment tax of existing I.R.C. §1402(a)(1) and proposes a new maximum tax of 25 percent to income received from a flow-through entity (such as a partnership, LLC or S corporation). The 25 percent rate applies to all net passive income, plus all “qualified business income.” Under Sec. 1004 of H.R. 1, “qualified business income” is the greater of 30 percent of active business income or a deemed return from the sum of the investment in depreciable property plus real property used in the business. Depreciable property is determined without regard to bonus depreciation and Section 179. Also in Sec. 1004, the deemed return is set at seven percent plus the short-term Applicable Federal Rate (AFR) as of the end of the year. The short-term AFR is slightly over 1 percent at the present time.
How does the formula for the application of the 25 percent tax flow-through rate work? Consider the following:
Robert has capital invested in his farming S corporation of $4 million (based on depreciated values not including Section 179 and bonus depreciation). His allowed deemed return is 7 percent plus the short-term AFR rate as of the end of the year (assume, for purposes of the example, one percent). Thus, if Robert’s farming activity generates $320,000 or less, the farm income will be subject to the 25 percent rate, but not self-employment tax. If Robert’s S corporation generates more than $320,000, the excess amount will also be subject to self-employment tax.
In essence, H.R. 1 replaces the self-employment tax on business income with a computation that deems 70 percent of the business income to be attributable to labor and subject to self-employment tax, in accordance with the formula above. This applies to businesses of all types – sole proprietorships, partnerships and S corporations. That has some very important implications.
S corporations. S corporations have never been subject to self-employment tax. They will be under H.R. 1 in what appears to be an attempt to conform the business tax rate with the self-employment tax. For instance, if 70 percent of the income of the S corporation is subject to the labor rate, then 70 percent of the overall income of the S corporation (considering the amount of shareholders wages) should also be subject to self-employment tax.
Partnerships. The distributive share of a general partner in a general partnership has always been subject to self-employment tax. The distributive share of a limited partner has not. That changes under H.R. 1 via the repeal of I.R.C. §1402(a)(13) contained in Sec. 1004. Thus, a portion of a limited partner’s distributive share of partnership income will become subject to self-employment tax.
Sole proprietorships. The self-employment tax changes of H.R. 1 will also impact sole proprietorships. But, in this instance, the impact of the self-employment tax changes of H.R. 1 could work in the opposite direction. While sole proprietorship farming operations will also be subject to the 70 percent provision, it would actually result in a decrease in self-employment. tax. Under present law, 100 percent of the income of an active farmer that is reported on Schedule F is subject to self-employment. tax. Under H.R. 1, only 70 percent of Schedule F income would be subject to self-employment tax, but 70 percent of passive rental income would also be subject to S.E. tax. The bottom line – the ultimate tax outcome depends upon the mix that any particular farmer has of Schedule F (farm) income relative to Schedule E (passive rental income).
Multiple entities. Farmers who have arranged their farming business such that the land is in a separate entity (such as a limited liability company or other flow-through entity) and is leased to their operating farming business, would see an increase in self-employment tax. In addition, if the taxable income of these farmers has been taxed at a 25 percent rate or less, they won’t have the income tax benefits from the maximum 25 percent rate applied to flow-through entities. They will see a tax increase, because more of the income will be subject to S.E. tax.
This impact of this change in self-employment tax in the context of multiple entity farming arrangements is important to understand. The recent taxpayer victory in Martin v. Comr., 149 T.C. No. 12 (2017) which expanded the exception of McNamara v. Comr., 236 F.3d 410 (8th Cir. 2000) for fair market leases to leases beyond the jurisdiction of the U.S. Court of Appeals for the Eighth Circuit, could be short-lived. Under the language of H.R. 1, the IRS will most assuredly argue that such rental income is part of an active trade or business such that 70 percent of it would be subject to self-employment tax.
What About Conservation Reserve Program (CRP) Income?
The IRS has long argued that CRP income is not rental income that could be excluded from self-employment tax under I.R.C. §1402(a). With that Code section removed, CRP income becomes business income under H.R. 1. As business income, the land owner is certainly passive in the CRP activity, which makes it business income subject to the maximum tax rate of 25 percent and not subject to self-employment tax. Even If CRP income were materially participating business income, however, only 70 percent of it would be subject to the self-employment tax at the labor rate of 25 percent. In any event, this change to the self-employment tax rules would likely stop IRS audits of CRP income.
Conclusion. So, what’s the bottom-line? The typical farmer that owns land and farms it either as a sole proprietor or as a general partner in a general partnership will see an overall tax decrease. That will be particularly true for these farmers in the high tax brackets. That’s because only 70 percent of the farm income will be subject to self-employment tax. However, a farmer that owns the land and rents it to a separate farming entity will incur more S.E. tax than under present law. If that farmer would be in a tax bracket higher than 25 percent, the benefit of the maximum business rate may fully offset the additional S.E. tax. That’s probably an oversimplification of the impact of H.R. 1. Obviously, each situation is unique and will require its own analysis. And, remember, H.R. 1 is only a proposal. It may never actually become law.
Thursday, November 2, 2017
The Uniform Commercial Code (UCC) holds merchants to a higher standard of business conduct than other participants to sales transactions. In every sale by a merchant who deals in goods of the kind sold, there is an implied warranty that the goods are merchantable. The warranty of merchantability exists even if the seller made no statements or promises and did not know of any defect in the goods.
What are the rules for merchantable goods?
What are Merchantable Goods?
In order for goods to be merchantable, they must be goods that:
- pass without objection in the trade under the contract description;
- in the case of fungible goods, are of fair average quality within the description;
- are fit for the ordinary purposes for which such goods are used;
- run, within the variations permitted by the agreement, of even kind, quality and quantity within each unit and among all units involved;
- are adequately contained, packaged, and labeled as the agreement may require; and
- conform to the promises or affirmations of fact made on the container or label if any.
Requirements (a) through (c) above are most often encountered in agricultural sales, with much of the focus on whether the goods are fit for the ordinary purposes for which they are used. For instance, as to the fair average quality requirement, one court held that beetle infestation exceeding an acceptable level of contamination for fungible flour made the flour unmerchantable. T.J. Stevenson & Co., Inc. v. 81,193 Bags of Flour, 629 F.2d 338 (5th Cir. 1980). As for the requirement that the goods be properly packaged, the warranty is breached when defective packaging results in damage to the product or personal injury, when the package does not adequately warn about dangers with the product, and when misleading packaging inhibits subsequent resales. See, e.g., Agricultural Services Association, Inc. v. Ferry-Morse Seed Co., Inc., 551 F.2d 1057 (6th Cir. 1977).
The ordinary purpose standard is breached when goods are not reasonably safe or when they cannot be used to meet their normal functions. For example, in Latimer v. William Mueller & Son, 149 Mich. App. 620, 386 N.W.2d 618 (1986), the Michigan Court of Appeals ruled that bean seed was unfit for its ordinary purpose when the purchaser discovered, after planting, that the seed was infected with a seed-borne bacterial disease. This defect, the court held, invalidated the label provisions that attempted to disclaim warranties for merchantability and fitness. Likewise, in Eggl v. Letvin Equipment Co., 632 N.W.2d 435 (N.D. 2001), the court found that a tractor sold with defective O-rings was not fit for the ordinary purpose for which it was intended and, thus, breached the warranty of merchantability.
Requirement (d) involves bulk purchases and specifies that goods sold in bulk must be of an even kind, quality and quantity. Requirements (e) and (f) pertain to goods that are sold in containers or packaging, and reflect an overlap between express warranties and the implied warranty of merchantability. They are especially important in sales of labeled goods, such as feed, seed or pesticides. Some courts have suggested that statements on labels or containers create both an express and an implied warranty.
Merchantability also involves the standard of merchantability in the particular trade. Usage of trade is defined as “any practice or method of dealing having such regularity of observance in a place, vocation or trade as to justify an expectation that it will be observed with respect to the transaction in question.” UCC § 1-205(2). If a product fails to satisfy industry standards, an implied warranty of merchantability may arise. For example, in one case, the Pennsylvania Supreme Court held that feed for breeding cattle normally does not contain the female hormone stilbestrol because it is known to cause abortions in pregnant cows and sterility in bulls. Kassab v. Central Soya, 432 Pa. 217, 246 A.2d 848 (1968).
Even if a particular farmer does not qualify as a “merchant,” known product defects must be disclosed to a potential buyer. Every seller with knowledge of defects must fully disclose defects that are not apparent to the buyer on reasonable inspection. This duty arises out of the underlying rationale behind the implied warranty of merchantability, which is to assure that the buyer is getting what is being paid for, and the UCC’s requirement that market participants operate in “good faith.”
The UCC warranty provisions also apply to sales transactions involving livestock. In a series of cases in the 1970s, courts applied the UCC implied warranty provisions to the sale of livestock as goods. See, e.g., Vorthman v. Keith E. Myers Enterprises, 296 N.W.2d 772 (Iowa 1980); Holm v. Hansen, 248 N.W.2d 503 (Iowa 1976); Ruskamp v. Hog Builders, Inc., 192 Neb. 168, 219 N.W.2d 750 (1974); Hinderer v. Ryan, 7 Wash. App. 434, 499 P.2d 252 (1972). The livestock industry strongly reacted and successfully lobbied for an exclusionary provision limiting the application of implied warranties in livestock sales. Some version of the statutory exclusion now exists in about half of the states, especially those states where the livestock industry is of major economic importance. The statutes are of three general types: those that exempt sellers from implied warranties in all situations, those providing that no implied warranty exists unless the seller knew the animals were sick at time of sale, and those providing an exemption if certain conditions are met.
The statutory exclusion of warranties in livestock sale transactions applies only to implied warranties; express warranties are not affected. Express warranties can still be made in livestock transactions and may be particularly important in transactions involving breeding livestock. Many sellers tend to make statements that might rise to the level of an express warranty in order to induce buyers to conclude the sale. Such statements can become a part of the basis of the bargain and create an express warranty enforceable against the seller.
The typical statutory exclusion also is inapplicable in situations where the seller “knowingly” sells animals that are diseased or sick. However, it is likely to be difficult for a livestock buyer to prove that the seller knew animals were diseased or sick at the time they were sold. Under the UCC, a seller “‘knows’ or ‘has knowledge’ of a fact when the seller has ‘actual knowledge’ of it.” UCC § 1-201(25). Thus, in order to overcome the statutory exclusion, the buyer must prove (most likely by circumstantial evidence) the seller’s actual knowledge regarding the animal’s disease or sickness.
Under most state exclusionary statutes, the meaning of “diseased or sick” is unclear. For instance, in breeding animals, the failure to provide offspring may result from recognizable diseases or from defects, often genetic, that historically have not been considered diseases. It is uncertain whether the statutory exclusion of implied warranties applies in circumstances involving genetic defects. Presently, no court in a jurisdiction having the exclusion has addressed the issue. Similarly, uncertainty exists with respect to the application of the exclusion to the sale of semen or embryo transfers, which are increasingly common in the livestock industry. Arguably, the livestock exclusion does not apply to semen sales since semen is not “livestock.”
The implied warranty of merchantability arises in many sales transactions involving agricultural goods. The rule for merchantability have produced some very interesting cases over the years.
Tuesday, October 31, 2017
Sometimes, I receive questions about the deductibility of interest. Often, the question comes up when money is borrowed. However, regardless of what the question relates to, the answer of whether interest is deductible can be complicated. That’s because the answer depends on how the taxpayer plans on using the borrowed funds. Are they used for business purposes? Investment? Or will the use of the borrowed funds be solely for personal purposes?
The issue has also gotten attention lately because of discussions by some on the tax writing committees in the Congress about eliminating interest deductibility.
Interest deductibility, that’s the topic of today’s post.
Personal interest (such as that associated with car loans, home appliances and credit cards) is not deductible unless the debt is secured by a mortgage on the principal residence. This exception for “qualified residence interest” applies for interest associated with the taxpayer's principal residence and one other residence selected by the taxpayer. To qualify, the residence must be used by the taxpayer or a member of the family for more than the greater of two weeks or 10 percent of the number of days when the residence is rented for a fair rent to persons other than family members. The maximum mortgage amount that interest can be claimed on is $1,000,000 of acquisition indebtedness. In addition, an interest deduction is available for home equity indebtedness up to a $100,000 loan amount. The deductions are on a per mortgage basis.
Investment interest is deductible (for those taxpayers that itemize deductions) to the extent of the taxpayer's net investment income. However, interest on debt associated with tax-free investments is not deductible. Also, interest on debt associated with land used by a farmer or rancher for agricultural purposes is not investment interest – it’s business interest. Similarly, the investment interest rules do not apply to any interest resulting from passive activities. The term “passive activities” means any activity involving the conduct of a trade or business in which the taxpayer does not materially participate and includes any rental activity. Crop share and livestock share leases with substantial involvement in decision making should be deemed businesses for this purpose.
Business interest is interest on debt associated with a business activity in which the taxpayer materially participates. Business interest is fully deductible, and if it is associated with the farm or ranch, it should be taken as a deduction. In 1993, the United States District Court for the District of North Dakota held that interest paid on an income tax deficiency attributable to income reported on Schedule F was business interest deductible on the Schedule F for the year it was paid. Miller v. United States, 841 F. Supp. 305 (D. N.D. 1993). However, the trial court’s decision was overturned on appeal, and numerous federal courts have since upheld the IRS regulations that disallow the interest deduction in such situations.
Passive Activity Interest
Interest on debt associated with a business (or other income-producing activity) in which the taxpayer doesn’t “materially participate” is deductible only if the income from passive activities exceeds expenses from those activities. This can be an issue for taxpayers that are engaged in rental real estate activities. There are special passive loss allowance rules that apply, but for interest on debt associated with these activities to be deductible, the income from the activity must exceed expenses.
Classification of Interest
Given the different categories of interest and the various rules of deductibility associated with each category, it is crucial to properly classify interest in order to determine which rules of deductibility apply. In general, the nature of interest is determined by examining of the use of the borrowed funds. This is known as the “tracing rule.” For example, if the use of the borrowed funds is for personal purposes, the interest is personal. Similarly, if borrowed funds are used to purchase a tractor, the interest is deductible business interest if the tractor is used in the taxpayer's farming or ranching business. If funds are borrowed as a second loan for the purpose of paying interest on a prior debt, interest on the second loan is allocated to the same purposes as the first loan. For example, if a second loan is contracted to pay the interest on a debt incurred to purchase the farm, the interest on the second loan is allocated to the purchase of the farm and is business interest. Any compound interest is allocated in accordance with the original interest to the uses of the original debt.
Segregation of Interest
As a matter of planning, it is important for farmers borrowing funds to maintain separate bank accounts for the business and for family expenditures. To maintain deductibility, loan proceeds should not be deposited in accounts from which non-business expenditures are paid.
Prepayment of Interest
Similar to the prepayment of inputs for the farming operation, the prepayment of interest used to be quite common. Indeed, it was common for farmers and ranchers in the past to go to the bank or the Production Credit Association at the end of December and line up their credit for the following year and, at the same time, prepay a year's worth of interest or even more. This is no longer permissible as interest cannot be prepaid. Cash basis taxpayers of all types are essentially placed on accrual accounting for deducting prepayments of interest. Interest is deductible in the year it is earned as the payment for borrowed funds. Distortion of income is no longer a relevant consideration.
Deductibility of Points
While the general rule is that interest paid in advance must be deducted over the life of the loan, exception exists for points paid on indebtedness incurred in connection with the purchase or improvement of the taxpayer's principal residence. “Points” on indebtedness incurred in connection with the purchase or improvement of, and secured by, the principal residence continue to be deductible in the year of payment if it is an established business practice in the community to pay points on such loans and the amount of the payment does not exceed the amount generally charged in the area. One “point” equals one percent of the loan. A deduction may be claimed for points if paid by the seller. An amount is considered paid by the seller if the buyer provides, from funds not borrowed, an amount at least equal to the points in the form of down payment, escrow deposits, earnest money or other funds paid at the closing. However, this rule does not apply to refinancing loans or home improvement loans on the principal residence and to all loans that involve a residence other than the principal residence, although one court permitted a deduction for points paid in conjunction with refinancing a home mortgage. Huntsman v. Comm’r, 905 F.2d 1182 (8th Cir. 1990).
Proper Handling of Year-End Interest Payments and Loan Rollovers
Late year-end payments pose special problems where interest is paid from proceeds of a new loan and the indebtedness continues. An important factor in determining if interest payments to a lender are “paid” is whether the borrower exercised unrestricted control over the loan proceeds. Interest is generally considered to be paid if the borrower has unrestricted control over the loan funds. However, a taxpayer should avoid borrowing funds for interest payments from the same lender that furnished the original loan even if unrestricted control is maintained over the loan proceeds. See, e.g., Davison v. Comm’r, 141 F.3d 403 (2d Cir. 1998). The IRS has indicated that an interest deduction will be denied if the taxpayer borrows funds from the same lender for the purpose of satisfying the interest obligation to that lender. I.R.S. News Release IR 83-93 (July 6, 1983).
For loans of more than one year, the “original issue discount” rules authorize an interest deduction evenly over the life of the loan.
The proper characterization of interest is critical to understanding whether interest is deductible. Have you been handling interest deductibility properly?
Friday, October 27, 2017
In its 2017-2018 Priority Guidance Plan, the IRS states that it plans to finalize regulations under I.R.C. §469(h)(2) – the passive loss rules. That provision creates a per se rule of non-material participation for limited partner interests in a limited partnership unless the Treasury specifies differently in regulations. Those regulations were initially issued in temporary form and became proposed regulations in 2011.
Is the IRS preparing to take a move to finalize regulations taking the position that they the Tax Court refused to sanction? Only time will tell, but the issue is important for LLC and LLP members.
Passive Loss Rules
The passive loss rules (I.R.C. §469) can have a substantial impact on farmers and ranchers as well as investors in farm and ranch land. The effect of the rules is that deductions from passive trade or business activities, to the extent the deductions exceed income from all passive activities may not be deducted against other income.
The proper characterization of the loss depends on whether the taxpayer is materially participating in the business. I.R.C. §469(h). But, I.R.C. §469(h)(2) creates a per-se rule of non-material participation for limited partner interests in a limited partnership unless the Treasury specifies differently in regulations. The statute was written before practically all state LLC statutes were enacted and before the advent of LLPs, and the Treasury has never issued regulations to detail how the statue is to apply to these new types of business forms.
A few years ago, the issue of how losses incurred by taxpayers that are members of LLCs (and LLPs) are to be treated under the passive loss rules surfaced in four court opinions - three by the U.S. Tax Court and one by the U.S. Court of Federal Claims. In the cases, IRS stood by its long-held position that the per-se rule of non-material participation applies to ownership interests in LLCs because of the limited liability feature of the entity.
Material Participation Tests - Passive Losses
The key question presented in the cases was whether the taxpayer satisfied the material participation test. As mentioned above, a passive activity is a trade or business in which the taxpayer does not materially participate. Material participation is defined as “regular, continuous, and substantial involvement in the business operation.” I.R.C. §469(h)(1). The regulations provide seven tests for material participation in an activity. Temp. Treas. Reg. §1.469-5T(a)(1)-(7). The tests are exclusive and provide that an individual generally will be treated as materially participating in an activity during a year if:
- The individual participates more than 500 hours during the tax year;
- The individual’s participation in the activity for the tax year constitutes substantially all of the participation in the activity of all individuals (including individuals who are not owners of interests in the activity) for the tax year;
- The individual participates in the activity for more than 100 hours during the tax year, and the individual’s participation in the activity for the tax year is not less than the participation in the activity of anyone else (including non-owners) for the tax year;
- The activity is a significant participation activity and the individual’s aggregate participation in all significant participation activities during the tax year exceeds 500 hours;
- The individual materially participated in the activity for any five taxable years during the ten taxable years that immediately precede the tax year at issue;
- The activity is a personal service activity, and the individual materially participated in the activity for any three taxable years preceding the tax year at issue; or
- Based on all the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during the tax year
As noted, if the taxpayer is a limited partner of a limited partnership, the taxpayer is presumed to not materially participate in the partnership’s activity, “except as provided in the regulations.” I.R.C. §469(h)(2). The regulations provide an exception to the general presumption of non-material participation of limited partners in a limited partnership if the taxpayer meets any of one of three specific material participation tests that are included in the seven-part test for material participation under Treas. Reg. 1.469-5T(a)(1)-(7). Those three tests are:
- The 500 hour test;
- The five out of 10 year test; and
- The test involving material participation in a personal service activity for any three years preceeding the tax year at issue.
Thus, the standard of “material participation” for a limited partner is higher than that for a general partner, and the question presented in the cases was whether the more rigorous standard for material participation for limited partners in a limited partnership under I.R.C. §469(h)(2) applied to the taxpayers (who held membership interests in LLCs and LLPs) with the result that their interests were per-se presumptively passive.
Garnett v. Com’r, 132 T.C. No. 19 (2009)
Facts. The taxpayers, a married couple residing in Nebraska, owned interests in various LLCs and partnerships that were organized under Iowa law as well as certain tenancy-in-common interests that were all engaged in agricultural production activities. They held direct ownership interests in one LLP and and LLC and indirect interests in several other LLPs and LLCs. Their ownership interests were denoted as “limited partners” in the LLP and “limited liability company members” in the LLC – which did have a designated manager. The interests that they held in the two tenancies-in-common were also treated similarly. For tax years 2000-2002, the taxpayers ran up large losses and treated them as ordinary losses.
The IRS claimed that an LLC member is always treated as a limited partner because of limited liability under state law and because the Code specifies that a limited partnership interest never counts as an interest with respect to which the taxpayer materially participates. I.R.C. §469(h)(2). Thus, the IRS characterized the losses as passive, basing their position on the regulation which, for purposes of I.R.C. §469, treats a partnership interest as a limited partnership interest if “the liability of the holder of such interest for obligations of the partnership is limited, under the law of the State in which the partnership is organized, to a determinable fixed amount.” Temp. Treas. Reg. §1.469-5T(e)(3)(i)(B). On the other hand, the taxpayers argued that the Code and regulations did not apply to them because none of the entities that they had interests in were limited partnerships and because, in any event, they were general partners rather than limited partners. The taxpayers also pointed out that the Federal District Court for Oregon had previously ruled that, under the Oregon LLC Act, I.R.C. §469(h)(2) did not apply to LLC members. Gregg v. United States, 186 F. Supp. 2d 1123 (D. Ore. 2000).
Analysis. The Tax Court first noted that I.R.C. §469(h)(2) was enacted at a time when LLCs and LLPs were either new or nonexistent business entities and, as such, did not make reference to those entities. The court also pointed out that the regulations did not refer explicitly to LLPs or LLCs. Accordingly, the court rejected the IRS argument that a limitation on liability automatically qualifies an interest as a limited partnership interest under I.R.C. §469(h)(2). On the contrary, the court held that the correct analysis involved a determination of whether an interest in a limited partnership (or LLC) is, based on the particular facts, actually a limited partnership interest. That makes a state’s LLC statute particularly important. Does it grant LLC and LLP members power and authority beyond those that limited partners have traditionally been allowed.? The IRS conceded that the statute at issue in the case did just that. Other distinguishing features were also present. The court noted that limited partnerships have two classes of partners, one of which runs the business (general partners) and the other one which typically involves passive investors (limited partners). The limited partners enjoy limited liability, but that protection can be lost by participating in the business. By comparison, an LLP is essentially a general partnership in which the general partners have limited liability even if they participate in management. Likewise, the court noted that LLC members can participate in management and retain limited liability.
The court made a key point that it was not invalidating the temporary regulations, but was simply declining to write a regulation for the Treasury that applied to interests in LLCs and LLPs. Importantly, the court refused to give deference to the Treasury’s litigating position in absence of such a regulation.
Thompson v. United States, 87 Fed. Cl. 728 (2009)
Facts. The taxpayer held a 99 percent interest in an LLC that was formed under the Texas LLC statute. He held the other one percent interest indirectly through an S corporation. The LLC’s articles of organization designated the taxpayer as the manager. The LLC did not make an election to be taxed as a corporation and, thus, defaulted to partnership tax status. The LLC, which provided charter air services, incurred losses in 2002 and 2003 of $1,225,869 and $939,878 respectively which flowed through to the taxpayer. The IRS disallowed most of the losses on the basis that the taxpayer did not meet the more rigorous test for material participation that applied to limited partners in limited partnerships. The taxpayer paid the additional tax of $863,124 and filed a refund claim for the same amount. The IRS denied the refund claim and the taxpayer sued for the refund, plus interest. Both the taxpayer and the IRS moved for summary judgment.
The IRS stood by its position that the more rigorous material participation test applied because the taxpayer enjoyed limited liability by owning the interests in the LLC just like he would if he held limited partnership interests. Thus, according to the IRS, the taxpayer’s interest was identical to a limited partnership interest and the regulation applied triggering the passive loss rules.
The court disagreed with the IRS. While both parties agreed that the statute and regulations trigger application of the passive loss rules to limited partnership interests, the taxpayer pointed out that he didn’t hold an interest in a limited partnership. The court noted that the language of the regulation (Treas. Reg. § 1.469-5T(e)(3)) explicitly required that the taxpayer hold an interest in an entity that is a partnership under state law, and that the Treasury had never developed a regulation to apply to LLCs. It was clear that the taxpayer’s entity was organized under Texas law as an LLC. In addition, the court pointed out that the taxpayer was a manager of the LLC, and IRS had even conceded at trial that the taxpayer would be deemed to be a general partner if the LLC were a general partnership. The court noted that the position of the IRS that an LLC taxed as a partnership triggers application of the Treas. Reg. §1.469-5T(e)(3)(ii) was “entirely self-serving and inconsistent.” The court also stated that it was irrelevant whether the taxpayer was a manager of the LLC or not – by virtue of the LLC statute, the taxpayer could participate in the business and not lose the feature of limited liability.
Hegarty v. Comr., T.C. Sum. Op. 2009-153
In this summary opinion, the Tax Court reiterated its position that the reliance by IRS on I.R.C. § 469(h)(2) to treat members of LLCs as automatically limited partners for passive loss purposes is misplaced. Instead, the general tests for material participation apply and the petitioners in the case (a married couple) were determined to have materially participated in their charter fishing activity for the tax year at issue. They participated more than 100 hours and their participation was not less than the participation of any other individual during the tax year.
Newell v. Comr., T.C. Memo. 2010-23
In this case, the taxpayer’s primary business activity was managing various real estate investments. He spent more than one-half of his time and more than 750 hours annually in real property trade or business activities. During the years at issue, the taxpayer was the sole owner of an S corporation that manufactured and installed carpentry items, and his participation is that business qualified as a significant participation activity for purposes of the passive loss rules. He also owned 33 percent of the member interests in a California-law LLC engaged in the business of owning and operating a golf course, restaurant and country club. The LLC was treated taxwise as a partnership. It was undisputed that the taxpayer was the managing member of the LLC. For tax years 2001-2003, IRS claimed that the losses the taxpayer incurred from both the S corporation and the LLC were passive losses that were not currently deductible. While the parties agreed that the taxpayer’s participation in both the S corporation and the LLC satisfied the significant participation activity test under the passive loss rules, IRS again asserted its position that I.R.C. §469(h)(2) required that the taxpayer’s interest in the LLC be treated as a passive limited partnership interest, even though IRS conceded that the taxpayer held the managing member interest in the LLC.
The Tax Court rejected the IRS’ argument, noting again that the general partner exception of Treas. Reg. §1.469-5T(e)(3)(ii) was not confined to the situation where a limited partner also holds a general partnership interest. Under the exception, an individual who is a general partner is not restricted from claiming that the individual materially participated in the partnership. Here, it was compelling that the taxpayer held the managing member interest in the LLC. As such, the taxpayer’s losses were properly deducted.
Chambers v. Comr., T.C. Sum. Op. 2012-91
Here, the taxpayer owned rental property with his spouse that produced a loss. The taxpayer was also a managing member of an LLC that owned rental properties. The LLC also owned rental property, and produced losses with one-third of the losses allocated to the taxpayer. The taxpayer was also employed by the U.S. Navy. He deducted his rental losses in full on the basis that he was a real estate professional. In order to satisfy the “more than 50 percent test,” he combined his hours spent on his personally-owned rental activity with his management activity for the LLC. The IRS invoked I.R.C. §469(h) to disallow the taxpayer’s LLC managerial hours, but the court disagreed. The court held that the taxpayer’s LLC interest was not defacto passive. Thus, his hours spent in LLC managerial activities counted toward his total “real estate” hours. However, he still failed to meet more than 50 percent test. In addition, the court noted that the fallback test of active participation allowing $25,000 of rental real estate losses was not available because the taxpayer’s AGI exceeded $150,000 for the year in issue.
The issue boils down to the particular provisions of a state’s LLC statute and whether there are sufficient factors under the state statute that distinguish an LLC from a limited partnership. That will be the case until IRS issues regulations dealing specifically with LLCs and similar entities.
As noted above, in late 2011, the Treasury Department proposed regulations defining “limited partner” for purposes of the passive loss rules. Notice of Proposed Rulemaking REG-109369-10 (Nov. 28, 2011). The proposed definition would make it easier for LLC members and some limited partners to satisfy the material participation requirements for passive loss purposes, consistent with the court opinions that IRS has recently lost on the issue. Specifically, the proposed regulations require that two conditions have to be satisfied for an individual to be classified as a limited partner under I.R.C. §469(h)(2): (1) the entity must be classified as a partnership for federal income tax purposes; and (2) the holder of the interest must not have management rights at any time during the entity’s tax year under local law and the entity’s governing agreement. Thus, LLC members of member-managed LLCs would be able to use all seven of the material participation tests, as would limited partners that have at least some rights to participate in managerial control or management of a partnership.
But, with the recent statement in the 2017-2018 Priority Guidance Plan, is the IRS going to finalize the proposed regulations as written or will there be modifications? What will the standard be for material participation? It’s an important issue for farmers, ranchers and others that utilize the LLC or LLP form of structure, of which there are many.
Wednesday, October 25, 2017
Next week begins the first of the fall tax schools that I will be a part of this fall. The schools start in western Kansas and cover the state with eight two-day schools sponsored by Kansas State University. I also participate in two schools in North Dakota sponsored by the University of North Dakota.
Of course, what’s happening on the legislative front in D.C. will be discussed. As of right now, that discussion will be rather short. Talk of tax reform started in August of 2016 with the release of the “House Blueprint” and many of the reforms enumerated in that document continue to be discussed under the banner of “tax reform.” However, in my view, prospects for something coming into form and passing the Congress by the end of the year look slim. If there are any developments, I will be covering those at the schools.
Of course, detailed coverage and analysis will be provided on numerous topics. Included in the coverage will be tax issues associated with employment, including the tax difference between an employee and an independent contractor; Section 530 relief; taxation of fringe benefits; household employees and foreign workers. Also on the agenda are investment tax issues (information reporting; covered and noncovered securities; associated IRS forms; interest on loans; and issues associated with puts, calls, options, and short sales of securities.
A full update of what’s happening within the IRS will be provided. On that note, I observed earlier this week that IRS listed in its Priority Guidance List that it plans on finalizing regulations associated with I.R.C. §469(h)(2). That’s the code provision that deals with material participation by a limited partner. The IRS lost several cases a few years ago on the issue and I suspect it will take a position in the final regulations that sets forth the IRS position that the courts disagreed with.
Of course, a full update on ag tax issues will be provided with a specific look at audit issues, C corporation penalty taxes, cash method issues, indirect production costs, depreciation strategies and planning opportunities, loss issues, farm income averaging and tax issues associated with financial distress.
The latest significant IRS rulings and court cases will be addressed and their relevance to tax practice explained. Also, an in-depth discussion of installment sales will occur getting into associated issues such as electing out, handling the receipt of payments, escrow arrangements, depreciation recapture, like-kind exchanges, sale of a business, disposition of the obligation, repossession and SCINS. Other issues that will be discussed include crowdfunding, self-directed IRAs, fantasy sports and legal fees.
Particular issues associated with small businesses will also be covered, including: small business stock; health plans; bonus depreciation; recapture on sale of business assets; correcting depreciation errors and how to handle the sale of an asset that is acquired in a like-kind exchange.
Partners and partnership tax issues will be discussed in detail. The tricky issue of inside and outside basis will be covered as will distributions and guaranteed payments and self-employment taxes. Also, loans by partners and income from the discharge of debt and the disposition of a partnership interest. As for partnership issues, the key issues will be addressed – electing out of partnership taxation; capital accounts; liabilities; the I.R.C. §754 election; allocations; and distributions, dispositions and terminations.
Tax issues associated with estates and beneficiaries will also be covered. The discussion of these issues will also include pointers on estate planning under the current transfer tax system. Of course, estate planning could change significantly if the estate tax is eliminated and/or the stepped-up basis rule is modified or eliminated.
On the whole, each of the two-day seminars is packed with information that can be used by practitioners in preparing returns for the upcoming tax season after the start of the year. The educational information will also include a state income tax update for the respective state.
A separate ethics session is provided after the first day of each of the North Dakota schools, and after the last of the Kansas schools. I will participate in the ethics session in Kansas with Prof. Lori McMillan who is also of Washburn Law School.
The North Dakota school in Fargo will also be webcast live on November 14 and 15. The last of the Kansas schools, in Pittsburg, will also be simulcast over the web on December 13-14, as will the ethics session on December 15. For those interested in attending in-person from further away, flights into Kansas City will put you within an hour of the Topeka tax school on November 27-28 and about 40 minutes from the Overland Park tax school on November 20 and 21, as well as about a two-hour drive from the Pittsburg tax school on December 13-14. Also, Fargo and Mandan are easily accessible by flights from Minneapolis, MN.
For those in Iowa, I will be opening the Iowa Bar Bloethe Tax School on December 6 in Des Moines with an hour session providing an update on federal tax issues. The tax manual for that school is also an excellent set of materials that can be used during tax season and beyond.
All told, the tax seminars that are about to begin provide excellent opportunities for tax practitioners and their staff to get prepared for the next tax season that will soon be upon us. For more information on the schools, the teaching teams, dates and locations, and accommodations you can find more at the following links:
Monday, October 23, 2017
The death of a family member or other loved-one is often difficult circumstance for the family and other close ones that are left behind. From a financial and tax standpoint, however, proper and thorough estate planning is the key to minimizing and potentially eliminating more distress associated with the decedent’s passing.
One aspect of estate planning that does not involve technical tax planning or entity structuring or other crucial legal aspects involves cataloguing where the decedent’s important documents are located and who has access to them. In the past, that has often involved counseling clients to make sure that they have a filing system for key items such as insurance policies, contact information for utility companies, and contracts and warranty information for equipment and appliances, etc. In addition, a safety deposit box and/or safe has commonly been suggested for the storage of critical documents such as a will, power of attorney, or trust as well as real estate deeds and similar items.
But, in recent years a new issue has arisen in the estate planning realm. This issue involves the decedent’s digital assets such as electronic mail (email) accounts, bank accounts, credit cards, mortgages, and any other type of digital record as well as electronically stored information and social media accounts. Even business assets have become digitized. Depending on the decedent’s type of business, the extent of digitization of business records and information can be quite large.
So, what is the big estate planning issue with digital assets? It involves who has access to those assets upon death and whether appropriate language is included in estate planning documents to provide that access. A recent court decision in Massachusetts brings the issue front and center.
That’s the topic of today post – digital assets and estate planning.
Interestingly, federal law governing privacy rights to electronic communications goes back over 30 years. The Stored Communications Act (SCA) was included as part of the Electronic Communications Privacy Act of 1986. 18 U.S.C. §§2701-2712. That SCA created privacy rights to particular electronic communications and associated files from disclosure by online service providers. However, with the development of the internet and email communication that started in the mid-1990s, the SCA created a significant problem for fiduciaries and family members that needed access to the decedent’s online records and accounts. The SCA bars an online service provider from disclosing the decedent’s files and/or accounts to the estate fiduciaries or others unless the requirements for an exception contained in 18 U.S.C. §2702(b) are satisfied. But, even if an exception is satisfied, the service provider is not required to provide access to or otherwise disclose the contents of the decedent’s digital files or online accounts. Voluntary disclosure is the rule upon “lawful consent” of the “originator” or “subscriber.” 18 U.S.C. §2702(b)(3). In addition, the statute does not clearly state whether an estate fiduciary (e.g., executor or personal representative) can give the required “lawful consent.”
Facts. In a recent decision, the highest court in Massachusetts held that “…the personal representatives may provide lawful consent on the decedent’s behalf to the release of the contents of the Yahoo email account.” Ajemian v. Yahoo!, Inc., 478 Mass. 169 (2017). The facts of the case indicate that the decedent died intestate in 2006 as the result of a bicycle accident. The decedent had, at the time of death, an email account. However, he didn’t leave any instructions regarding how to handle the account after his death. Two of his siblings were appointed the personal representatives of his estate, and sought access to the contents of the email account. But, the service provider refused to provide access on the basis that it was barred from doing so by the SCA. The service provider also claimed that the terms of service that governed the email account gave the service provider the discretion to reject the personal representatives’ request.
Court determinations. The personal representatives sued, and the probate court granted the service provider’s motion to dismiss the case. On appeal, the appellate court vacated that judgment and remanded the case for a determination of whether the SCA barred the service provider from releasing the contents of the decedent’s email account to the personal representatives. On remand, the service provider claimed that the SCA prevented disclosure and, even if it did not, the terms-of-service agreement gave the service provider the right to deny access to (and even delete the contents of) the account. The appellate court granted summary judgment for the service provider on the basis that the SCA prohibited disclosure (but not on the basis of the terms of service contract).
On further review at the Massachusetts Supreme Judicial Court, the personal representatives claimed that they were the decedent’s agents for purposes of the exception of 18 U.S.C. §2702(b)(1) which gave the service provider the ability to disclose the contents of the decedent’s email account to them. However, the Supreme Judicial Court did not buy that argument, determining instead that a person appointed by a court does not fall within the common law meaning of “agent” citing Restatement (Third) of Agency §1.01 comment f. As to whether the personal representatives “stepped into the shoes” of the decedent as the originator of the account and, thus, could lawfully consent to the release of the contents of the email account under 18 U.S.C. §2702(b)(3), the Supreme Judicial Court held that they could, reasoning that there was nothing in the statutory definition or legislative history that indicated an intent to preempt state probate and/or common law allowing personal representatives to provide consent on a decedent’s behalf. The Supreme Judicial Court vacated the appellate court’s judgment and remanded the case to the probate court.
Revised Uniform Fiduciary Access To Digital Assets Act
While the Ajemian decision holds that a personal representative can meet the “lawful consent” exception of the SCA, a service provider is still not required to provide the desired access to digital records. However, under the Revised Uniform Fiduciary Access to Digital Assets Act (RUFADAA), a state law procedure is provided that fiduciaries can use to get access to online accounts (or other digital assets) of a decedent. The RUFADAA defines a “fiduciary” as a person appointed to manage the property of another person in that other’s person’s best interest. In essence, the RUFADAA empowers a fiduciary to manage another person’s “digital assets.” However, under the RUFADAA, the fiduciary must still get consent from the “owner” to be able to manage certain digital assets such as electronic communications and social media accounts unless the original user consented in a will, trust, power of attorney, or other record. Once that consent is obtained for digital assets that require it, if the service provider doesn’t comply with a disclosure request, §16(a) of the RUFADAA allows the personal representative to file a legal action seeking a court order requiring the service provider to comply with the personal representative’s request.
The majority of states have enacted the RUFADAA (or a substantially similar version thereof). Those that haven’t are: CA, DE, GA, KY, LA, MA, ME, MO, NH, OK, PA, RI, WV and the District of Columbia. Some of these states may enact the law in the near future. 2017 saw action in numerous state legislatures. As noted, MA has not enacted the RUFADAA, so a question is raised as to whether the court’s analysis in Ajemian would have differed, as well as how the RUFADAA would have impacted the SCA.
Digital Asset Planning Suggestions
What needs to be considered with respect to digital assets and an estate plan? The access question looms large. Who is to have access to digital assets and information post-death? From a will drafting standpoint, if a specific gift of digital assets is not made, the digital assets will be disposed of under the will’s residuary clause (“all the rest, residue and remainder of my estate”). Also, what type of access is the estate fiduciary to have? The type of access (such as the ability to read the substance of electronic communications) should be clearly specified in the owner’s will or trust. If access to digital assets and information is to be granted to a third party before death, the type and extent of access should be set forth in a power of attorney. On this point, the type of power of attorney matters.
Even with the authority to act as provided in a will, trust or power of attorney, it is likely that a service provider (or similar “custodian”) will require that the fiduciary obtain a court order before the release of any digital information or the granting of access.
While many people do not have estate planning documents in place at death, a very high percentage of decedents have at least some digital assets and/or accounts at the time of death. Some may have significant value. Others may have significant sentimental worth (such as photos). Thus, the ability to deal with and manage those assets post-death is very important. Technology has created additional legal and planning issues that should be accounted for.
The RUFADAA contains many associated comments that answer a lot of questions. To learn more, click on http://www.uniformlaws.org. Under the “Acts” tab, click on “Fiduciary Access To Digital Assets Act.”
Thursday, October 19, 2017
It can be beneficial (for business and tax purposes) for a farmer that utilizes the cash method of accounting to prepay for supplies. It’s one method to reduce a current years’ tax burden - simply purchase next year's fertilizer, feed, seed, chemicals and other inputs without near the end of the year and deduct all of that expense against that year's income.
As I have noted in prior posts, the IRS has mounted an attack on farmers’ use of the cash method of accounting. One avenue of attack has been its attempt to deny the use of pre-paid expenses. Thus, it’s imperative for a farmer to properly pre-pay expenses to be able to claim the deduction in the year of the pre-payment. As we get closer to the end of the year, and the timeframe during which many pre-payments occur, it’s a good idea to review the rules and get pre-payment arrangements properly structured so that deductions can be taken in the year of the payment, favorable prices can be received for input supplies and planting can be made more efficient due to having adequate input supplies on hand.
The pre-paid expense rules. That’s the topic of today’s post.
The IRS issued a revenue ruling in 1979 that identified three conditions that must be satisfied for pre-paid expenses for inputs such as fertilizer, seed and chemicals to successfully generate a deduction in the year of pre-payment. Rev. Rul. 79-229, 1979-2 C.B. 210. Failure to meet any one of these conditions results in an allowable deduction only when the input is used or consumed.
Binding contract. The first condition requires the pre-purchase to be an actual purchase evidenced by a binding contract for specific goods (of a minimum quantity) that are deductible items that will be used in the taxpayer’s farming business over the next year. An absence of specific quantities or a right to a refund of any unapplied credit are indicative of a deposit. Likewise, if the farmer retains the right to substitute other goods or services for those denoted in the purchase contract, a deposit is indicated. For example, a 1982 case from the Fifth Circuit Court of Appeals involved a Texas farmer who went to the local elevator near year's end, wrote a check for $25,000, and told the elevator operator that he would be back sometime in the following year to pick up $25,000 worth of supplies. The farmer then deducted those expenses for that tax year and the IRS challenged the deductions. The farmer lost because the transaction looked like a mere deposit. Schenk v. Comr., 686 F.2d 315 (5th Cir. 1982).
While the IRS thinks that how the seller of the inputs characterizes the transaction on its books matters, that should be immaterial as to the characterization of the transaction for the farmer’s tax purposes. That’s particularly the case because of Treas. Reg. §1.451-5(c) which allows the seller to treat the transaction as a deposit without affecting the farmer’s ability to deduct for the amount of the pre-paid expenses. In addition, the farmer has no control over how an input seller treats the transaction on its books and deductibility should not turn on the seller’s characterization.
So, if a written contract is entered into for specific goods that are otherwise deductible items that will be used in the farming business within the next year, and the payment does not exceed (in total) the price and quantity established in the contract, the first condition is satisfied and the transaction is a pre-payment rather than a deposit.
Business purpose. The second IRS condition that is used to determine whether pre-purchased items are deductible is whether the transaction has a business purpose or was entered into solely for tax avoidance purposes. This is the easiest of the three tests because if a taxpayer is not pre-purchasing to assure the taxpayer a set price, the taxpayer is pre-purchasing to assure supply availability. Another legitimate business purpose associated with pre-purchasing include avoiding a feed shortage. Thus, in practically all conceivable transactions, it is fairly easy to think of a business reason for what the taxpayer is doing. But see, Peterson v. United States, 6 Fed. Appx. 547 (8th Cir. 2001).
Material distortion of income. The third condition requires that the transaction must not materially distort income. While pre-purchasing distorts income, the key is whether the distortion is “material.” There is no bright-line test to determine whether income has been materially distorted in any particular case. The IRS, however, gets most upset when a taxpayer's pattern of pre-purchases bears a suspicious tandem relationship to income. For example, if a taxpayer's income goes up in one year and the level of pre-purchases also rises, and in a subsequent year, income goes down along with the level of pre-purchases, the IRS could question the transaction. In addition, the IRS will likely examine the relation of the purchase size to prior purchases and the time of year payment was made. Thus, it’s important for a farmer to stay consistent with their customary business practices in buying supplies and the business purpose(s) for the pre-payment. Also, the pre-payment transaction should not provide a tax benefit that extends longer than 12 months. See Treas. Reg. §1.162-3(c)(1)(iii).
Some courts have approved deductions for prepaid inputs if the expenditure was made in the course of prudent business practice unless a gross distortion of income resulted. However, recent cases have found material distortion of income and disallowed the deduction even though a legitimate purpose existed. In any event, a survey of the decisions indicates that for year-end purchases of the next year's supplies, a taxpayer should try to take delivery or at least enter into a binding, no refund, no substitutes contract. Likewise, it appears that if a taxpayer stays within the confines of the IRS rulings, the deduction will be allowed. See, e.g., Comr. v. Van Raden, 650 F.2d 1046 (9th Cir. 1981).
There is an overall limitation on the amount of deduction for pre-paid expenses. The limit is 50 percent of total deductible farming expenses excluding prepaid expenses. This is largely drawn right off of Schedule F (including current year depreciation expense). The taxpayer simply takes into account all of the expenses and is eligible to deduct up to 50 percent on a prepaid basis. Thus, if a taxpayer has total deductible farming expenses for the year of $80,000, and has prepaid an additional $50,000, the most the taxpayer could deduct would be $40,000 which means the other $10,000 is carried over and deducted the following year.
Exceptions. There are two exceptions to the 50 percent test. One of these exceptions is for a change in business operations caused by extraordinary circumstances. A farmer is permitted to continue to deduct prepaid expenses even though the prepaid expenses exceed 50 percent of the deductible farming expenses for that year if the failure to meet the 50 percent test was because of a change in business operations directly attributable to extraordinary circumstances. If the reason for a taxpayer's reduced level of inputs was because of something extraordinary such as a major change in federal farm programs, like a 1983-style payment-in-kind program that idled a lot of land, or because of a big casualty loss, or because of a disease outbreak in livestock or something of that nature, that constitutes an extraordinary circumstance and removes the taxpayer from the 50 percent rule.
The second exception permits a “qualified farm-related taxpayer” to meet the 50 percent test over the last three years (computed on an aggregate basis) rather than the last one year. A “qualified farm-related taxpayer” is a taxpayer whose principal residence is on a farm or whose principal occupation is farming or who is a member of the family of a taxpayer whose principal residence is on a farm or who has a principal occupation of farming. A corporation carrying on farming operations can qualify as a “farm-related taxpayer.” See Golden Rod Farms, Inc. v. United States, 115 F.3d 897 (11th Cir. 1997).
If the aggregate prepaid farm supplies for the three taxable years preceding the taxable year are less than 50 percent, then there is no limitation on deductibility of prepaid expenses. There is a question, however, concerning how the expenses over the past three years are to be aggregated. Guidance is needed as to whether carry-over expenses to or from the three-year period are ignored, or whether the 50 percent test applies each year with the excess carried over to the following year.
The ability of a cash method farmer to pre-pay and deduct expenses is a critical tax management tool. A typical famer’s amount of pre-payments can easily exceed $100,000. In addition, it should be noted that rent can also be pre-paid (and currently deducted) if it doesn’t extend beyond 12 months. Treas. Reg. §1.263(a)-4(f)(8), Example 10. But, for pre-paid rent, the potential application of §467 will need to be considered.
Have you been following the rules and structuring pre-payment transactions properly?
Tuesday, October 17, 2017
A popular tax technique for certain taxpayers, including farmers and ranchers, involves the donation of a permanent conservation easement. A conservation easement is a voluntary restriction on the use of land that a landowner negotiates with a private charitable conservation organization (commonly referred to as a "land trust") or government agency that the landowner chooses to "hold" the easement. That means that the donee organization has the right to enforce the restrictions that the easement imposes.
Normally, the donation of a partial interest in property does not generate a tax deduction for the donor. However, a deduction can be obtained for a “qualified conservation contribution.” I.R.C. §170(f). Thus, a donor can receive a charitable deduction for the donation if the transaction is structured properly. But, those rules must be strictly satisfied to get the desired tax benefit. Numerous cases have been litigated that illustrate how closely the rules must be followed. Indeed, in Notice 2004-1, 2004-28, IRB 31, the IRS announced that it was increasing its scrutiny of conservation easement transactions. The audit activity and the litigated cases have picked up steam since that time
Today’s post summarizes some of the most recent cases involving donated easements and one particular issue – the need that the easement be protected in perpetuity. That’s what a “permanent” easement donation means.
For qualified conservation contributions (i.e., contribution of a qualified real property interest to a qualified organization exclusively for conservation), a 50 percent limit on the contribution base, less all other contributions, applies, and the carryforward period is 15 years. I.R.C. §170(b)(1)(E)(ii). However, for qualified farmers and ranchers (as defined by I.R.C. §2032A(e)(5) – see I.R.C. §170(b)(1)(E)(v)) the limit is 100 percent of the contribution base less all other contributions. For property in agriculture or livestock production to be eligible for the 100 percent limit, the qualified real property interest has to include a restriction that the property remains generally available for such production.
A qualified conservation contribution is one that is of a “qualified real property interest” donated to a “qualified organization” exclusively for “conservation purposes” where the donee is barred from making certain transfers. I.R.C. §170(h)(1)(A-C). In addition, as noted above, the donated easement must also be perfected in perpetuity. If these requirements are satisfied, the starting point for determining the deductible amount of the donation is determined by the difference between the value of the burdened property before and after the donation.
But, as noted above, the IRS requires strict compliance to all of the rules governing the donated easement so as to generate a deduction. Recent cases highlight the need to protect the easement in perpetuity.
The Perpetuity Requirement
Under I.R.C. §170(h)(2) and (h)(5)(A), to be deductible, the donated easement must be granted in perpetuity. These perpetuity Code sections have been at issue in a few recent cases.
Subordination requirement. The easement must be granted in perpetuity at the time of the grant. The Tax Court made that point clear in Mitchell v. Comr., 138 T.C. 324 (2012). In that case, the petitioner did not subordinate an underlying mortgage on the property until two years after the easement grant. That fact, the Tax Court held in a case of first impression, barred a charitable contribution deduction. The Tenth Circuit later affirmed the Tax Court’s decision. Mitchell v. Comr., 775 F.3d 1243 (10th Cir. 2015)
In a more recent case, the Tax Court continued to strictly apply the subordination requirement. In Palmolive Building Investors, LLC v. Comr., 149 T.C. No. 18 (2017), the petitioner transferred a façade easement via deed to a qualified charity. The easement deed placed restrictions on the petitioner and its successors with respect to the façade easement and the building. The building was subject to two mortgages, but before executing the easement deed, the petitioner obtained mortgage subordination agreements from banks holding the mortgages. But, the easement deed provided that if the easement were eliminated due to the government’s exercise of its eminent domain power, the banks would have claims to any condemnation award in order to satisfy the underlying mortgage before the charity had any rights to the award.
The petitioner claimed a charitable contribution deduction for the tax year of the easement contribution. The IRS disallowed the deduction, claiming that the easement deed failed to satisfy the perpetuity requirements of I.R.C. §170 and Treas. Reg. §1.170A-14(g)(6)(ii) because it provided the mortgagees with prior claims to the extinguishment proceeds in preference to the donee. Specifically, the lender had agreed to subordinate the debt to the charity’s claims, but the easement deed said that the lender would have priority access to any insurance proceeds on the property to the extent that the donor had insurance on the property. The easement deed also said that the lender would have priority to any condemnation proceeds.
The petitioner claimed that the First Circuit’s decision in Kaufman v. Comr., 687 F.3d 21 (1st Cir. 2012) applied. In that case, the First Circuit rejected the view that a subordination agreement must remove any preferential treatment of the lender in all situations. Instead the First Circuit created an exception for “unusual situations” that had the potential to occur at some future point. The First Circuit claimed that the Tax Court’s strict reading of what is necessary to grant a perpetual easement would eliminate easement donations because an easement represented only a partial interest in property. In addition, the First Circuit reasoned that the Tax Court’s rationale was improper because, for example, a tax lien could arise if the donor failed to pay property tax when they became due.
However, in the present case, the Tax Court rejected the First Circuit’s view, noting that the Tax Court’s decision in the present case would be appealable to the Seventh Circuit. That meant that the Tax Court was not bound by the First Circuit’s decision. The Tax Court reasoned that because the lender had superior rights in certain situations, the mortgages did not meet the subordination requirement of Treas. Reg. §1.170A-14(g). Thus, the donated easement did not meet the perpetuity requirement of I.R.C. §170(h)(5).
The Tax court also pointed out that other Circuits did not agree with Kaufman, and noted a difference concerning what must be done to subordinate an existing liability at the time of the donation (such as a mortgage) as opposed to a possible future liability that was not yet in existence. The Tax Court also noted that the Treasury Regulations specifically mentioned mortgages in the list of requirements necessary to satisfy the perpetuity requirement, but made no mention of tax liens.
The subordination requirement was also at issue in RP Golf, LLC v. Comr., 860 F.3d 1096 (8th Cir. 2017), aff’g., T.C. Memo. 2016-80. In this case, the petitioner made a charitable contribution of a permanent conservation easement on two private golf courses in the Kansas City area in 2003 valued at $16.4 million. The IRS challenged the charitable contribution deduction on numerous grounds, and in an earlier action, the petitioner conceded that the donation did not satisfy the open space conservation test, granting the IRS summary judgment on that issue, with other issues remaining in dispute. At the time of the donation, two banks held senior deeds of trust on the land at issue.
Subordination agreements were not recorded until approximately three months after the donation stating that they were effective at the time of the donation. In addition, the petitioner had no power or authority to enforce the easement with respect to a portion of the property due to its lack of ownership of the property. The Tax Court cited Mitchell v. Comr., 775 F.3d 1243 (10th Cir. 2015) and Minnick v. Comr., 796 F.3d 1156 (9th Cir. 2015) as precedent on the issue that the donor must obtain a subordination agreement from the lender at the time the donation is made. Here, the court held that the evidence failed to establish that the petitioner and the lenders entered into any agreements to subordinate their interests that would be binding under state (MO) law on or before the date of the transfer to the qualified charity. As a result, the donated easement was not protected into perpetuity and failed to qualify as a qualified conservation contribution.
Deed recordation. Failure to record the deed can also result in the easement not being protected in perpetuity. In Ten Twenty Six Investors v. Comr., T.C. Memo. 2017-115, the petitioner owned an old warehouse and executed a “Conservation Deed of Easement” that granted a façade easement on the warehouse to the National Architectural Trust (NAT). The deed was accepted in late 2004, but was not recorded until late in 2006. On its 2004 tax return, the petitioner, claimed a noncash charitable deduction of $11.4 million in accordance with an appraisal. The IRS disallowed the deduction in its entirety, and imposed a 40 percent gross valuation misstatement penalty or, alternatively, the 20 percent accuracy-related penalty. To support the deduction, it is imperative that the donee have a legally enforceable right under state law. However, because the deed was not recorded until late 2006, the perpetuity requirement could not be satisfied in 2004. Citing prior caselaw based on New York (NY) law, the Tax Court determined that the deed was effective only upon recording and that a deed to create an easement must be recorded to be effective. Thus, the Tax Court upheld the IRS determination.
Similarly, in Carroll, et al. v. Comr., 146 T.C. 196 (2016), the Tax Court determined that a conservation easement was not protected in perpetuity with the result that the deduction was limited. The petitioner contributed a conservation easement on a tract of land to two qualified organizations. The easement provided that if the conservation purpose was extinguished because of changed circumstances surrounding the donated property, the that donees were entitled to a proportionate share of extinguishment proceeds. If extinguishment occurred, the donees were entitled to receive at least the amount allowed as a deduction to the donor for federal income tax purposes over the fair market value of the property at the time of the contribution. The plaintiff claimed a charitable contribution for the year of the contribution and carried forward the remaining balance to tax years 2006-2008. Under Treas. Reg. §1.170A(g)(6)(i), when a change in conditions extinguishes a perpetual conservation restriction, the donee, on later sale, exchange or conversion of the property, must be entitled to a portion of the proceeds at least equal to that proportionate value of the perpetual conservation restriction. Because the easement at issue provided that the value of the contribution for purposes of the donees’ right to extinguishment proceeds is the amount of the petitioner’s allowable deductions rather than the fair market value of the easement, the court determined that the easement violated the Regulation and was not protected in perpetuity under I.R.C. §170(h)(5)(A). The court also imposed an accuracy-related penalty.
The IRS takes a close look at donated conservation easements. It simply does not like the granting of a significant tax deduction while the donor continues to use the underlying property in largely the same manner as before the easement on the property was donated. Thus, all of the requirements necessary to obtain the deduction must be followed. That includes satisfying the perpetuity requirement.
The IRS has also produced an audit technique guide concerning the donation of permanent conservation easements. That guide should be reviewed by parties interested in donating permanent easements. It is accessible here: https://www.irs.gov/pub/irs-utl/conservation_easement.pdf
Friday, October 13, 2017
Cash is often inconvenient as a payment medium in transactions that involve large sums of money or where an ordinary promise to pay is unsuitable. A “negotiable instrument” is a document that guarantees that payment will be made of a certain sum of money. Payment will be made either upon demand or at a specified time by the person (or entity) named on the document. A check, for example, is considered to be a negotiable instrument.
Essentially, a negotiable instrument is a contract that promises the payment of money. That means, therefore, that rights and liabilities attach to a transaction involving a negotiable instrument. The law of negotiable instruments arose, at least in part, to provide a convenient and safe substitute for cash in these types of situations. Presently, Article 3 of the Uniform Commercial Code (UCC) governs negotiable instruments, and Article 4 (concerning bank deposits and collections) specifies the rules regarding bank processing of negotiable instruments.
The rights and liabilities of the parties to a negotiable instrument – that’s the focus of today’s post.
Types of Liability
Once an instrument is determined to be negotiable, it is necessary to determine whether or not a particular person is liable on the instrument and, if so, the nature of that liability. Liability can be based on contract principles involving a person's transfer of property related to the instrument, or on a tort theory relating to a breach of warranty on the instrument that intentionally or negligently causes loss to others.
Contract liability. The contract liability of the maker (also known as the issuer) of a note is based on that person's promise to pay. Article 3 requires the maker of a note, cashier's check or other draft to pay the instrument “according to its terms” either at the time of issue or at the time it first comes into possession of the holder. UCC § 3-413. The maker's promise is unconditional, and the maker owes the obligation “to a person entitled to enforce the instrument.” That includes the holder of the instrument, a non-holder in possession of the instrument who has the rights of a holder, or a person not in possession of the instrument who is entitled to enforce the instrument. UCC § 3-301. Thus, only two parties can be primarily liable - the maker and the acceptor. However, a person can still be entitled to enforce the instrument even though such person does not own the instrument or is in wrongful possession of the instrument.
A party that receives a check in payment of a debt expects the bank on which the check is drawn to pay the specified amount. However, until the bank accepts the check, the bank is not obligated to pay anything on the check. UCC § 3-411(2), Comment 2. Even if the bank arbitrarily dishonors a check, the payee or holder ordinarily has no cause of action against the bank on the instrument. As such, a payee may wish to obtain assurance that the bank will carry out the drawer's order. In particular, the payee or other holder may demand that the bank “accept” the draft and thus become primarily liable on the instrument. When a bank upon which a check is drawn accepts the check (usually by signing vertically across the face of the instrument), the bank is said to have certified the check. Once a bank accepts a check, it becomes primarily liable to all subsequent holders and the drawer of the check is discharged. UCC § 3-411(1).
The drawer of a draft drawn on a bank or other party is only “secondarily” liable on the instrument. Someone other than the drawer is expected to pay. The holder must make an attempt to collect elsewhere before the drawer must pay. While the drawer of a check, like the issuer of a note, signs the instrument in the lower right-hand corner, the drawer's contract is unlike the issuer's in that the drawer orders another to make payment and promises to pay only if the order bears no fruit. The holder of a draft looks first to the bank for payment and if it cannot be had there, to the drawer. If an unaccepted draft is dishonored, the drawer is obliged to pay the draft according to its terms at the time it was issued or if it was not issued, at the time it first came into possession of the holder. UCC § 3-413(2). With the 1990 changes to Article 3, it is no longer necessary that a holder give the drawer notice of the dishonor.
Article 3 frees a drawer from an obligation to pay a check if the check is not presented for payment within 30 days or given to a depository bank for collection within that time. However, this rule applies only where the drawee bank fails and because of the delay, the drawer is deprived of funds. In that event, the drawer is discharged, but only to the extent that the drawer is deprived of funds. On this point, consider the following example:
Example: Sam bought a rare Arabian quarter horse from Kenny, and wrote Kenny a check for $265,000 drawn against Sam's account at Wea Cheatum State Bank. Kenny misplaced the check and found it four months later under a stack of papers in his office. In the meantime, Wea Cheatum State Bank failed. If the bank was federally insured, Sam would collect $250,000 in federal bank deposit insurance, and his obligation to pay Kenny the remaining $15,000 would be discharged because Sam would otherwise be deprived of funds that he could have withdrawn from the bank before it failed. Sam would assign to Kenny his drawer's rights against the drawee, and it would be up to Kenny to try to collect the $15,000 balance.
An indorser of a negotiable instrument is also secondarily liable. Indorsement is the formal act that passes title to the indorser's transferee and obligates the indorser on the contract. Indorsement can also serve as a means of protecting against conflicting claims later on by restricting payment of the instrument. For example, the indorsement “for deposit only” not only serves to pass title or incur a guarantor's liability, it also prevents a party that accepts a stolen check from later claiming HDC status.
An indorsement can accomplish three functions: (1) negotiating the instrument; (2) restricting payment of the instrument; or (3) incurring an indorser's liability on the instrument. Thus, every signature that satisfies one or more of the above functions is an indorsement. This is true even if the indorsement is not in its usual place on the back of the instrument, but even in that event indorsers are normally liable in the order in which their names appear on the instrument.
All indorsements fall into three broad categories: special, blank and qualified. A special indorsement is an indorsement that identifies a person to whom the instrument is payable. A negotiable instrument that has been specially indorsed becomes payable to the identified person and may be negotiated only by the indorsement of that person. For example, “pay to the order of John Doe, \s\ Jim Jones” is a special indorsement that converts the negotiable instrument into an “order instrument” if the instrument is not already an order instrument. A blank indorsement converts a negotiable instrument into a “bearer instrument” and the instrument becomes payable to bearer and may be negotiated by transfer of possession alone until it is specially indorsed. For example, a blank indorsement “\s\ John Doe” makes the instrument bearer paper and is payable to anyone, with negotiation occurring solely by delivery (or possession for lost or stolen bearer paper).
A qualified or restrictive indorsement is utilized by individuals that want to limit their liability if the instrument is dishonored. Restrictive indorsements such as “for deposit only,” “pay any bank,” and similar phrases establish the terms for further negotiation of the instrument. Most often, their main purpose is to prevent thieves and embezzlers from cashing checks, but some phrases may constitute offers or terms of underlying agreements between the parties (i.e. “in full satisfaction of all claims”). If an indorser adds the words “without recourse” to its indorsement, the indorsement is qualified and the indorser transfers title to the instrument, but does not promise to pay should the instrument be dishonored upon presentation.
In one prominent Kansas case, a co-op employee forged customer signatures on co-op checks made payable to the customers and absconded with the funds. The co-op sued the bank for not honoring the restrictive indorsement on the checks which specified that the checks were for deposit only. Instead, the bank paid the cash amounts directly to the co-op employee. The bank was held liable for breach of the express contract with its depositor. Cairo Cooperative Exchange v. First National Bank of Cunningham, 620 P.2d 805 (Kan. 1980).
A tort is a civil wrong for which a court will award recovery. The essence of a tort case is that the defendant owed a duty to the plaintiff that was breached, with the breach constituting the proximate cause of the plaintiff's damage. All of the elements must be present before the plaintiff can recover. As applied in the negotiable instrument context, if a bank wrongfully dishonors a customer’s check, and the wrongful discharge proximately causes the customer’s damages, tort liability may apply. See, e.g., Maryott v. First National Bank of Eden, 624 N.W.2d (S.D. 2001).
Article 3 also imposes tort liability for actions grounded in negligence and conversion. For example, if a check is altered and the alteration should be obvious upon reasonable inspection, a bank making payment on such check may be deemed to have not paid the check in good faith for failing to exercise reasonable care, and may be liable to the drawer to the extent the drawer is damaged by the alteration, unless the drawer's negligence, such as not adequately safeguarding checks and embossing equipment, substantially contributed to the alteration. See, e.g., Commercial Credit Corp. v. First Alabama Bank, 636 F.2d 1051 (5th Cir. 1981).
Banking transactions are often straightforward. However, when a transaction doesn’t turn out as expected, or fraudulent conduct is involved, or a bank fails, it’s helpful to know the applicable rules.
Wednesday, October 11, 2017
Many legal cases are settled out-of-court. Cases could involve divorce, wrongful death, securities fraud, false advertising, civil rights, sexual harassment, product liability, reverse discriminations, or damages for a spilled cup of hot coffee just to name a few. But, if a recovery from a lawsuit or out-of-court settlement is obtained, the tax consequences must be considered.
The tax treatment of settlements and court judgments, that’s today’s topic.
Recoveries from out-of-court settlements or as a result of judgments obtained may fall into any one of several categories. Quite clearly, damages received on account of personal physical injury or physical sickness are excluded from income. I.R.C. §104(a)(2). Thus, amounts received on account of sickness or mental distress may be received tax-free if the sickness or distress is directly related to personal injury. For instance, settlement proceeds from a wrongful termination suit that are allocable to mental distress are excludible from income where the mental distress is caused directly by the wrongful termination. See, e.g., Barnes v. Comr., T.C. Memo. 1997-25. Those amounts that are allocated to punitive damages are not excludible. Id.
As the regulations point out, nontaxable damages include “an amount received (other than workmen's compensation) through prosecution of a legal suit or action based on tort or tort-type rights, or through a settlement agreement entered into in lieu of such prosecution.” Treas. Reg. § 1.104-1 (1970). The IRS has determined, for example, that excludible damages include damages for wrongful death (Priv. Ltr. Rul. 9017011 (Jan. 24, 1990)); payments to Vietnam veterans for injuries from Agent Orange (Priv. Ltr. Rul. 9032036 (May 16, 1990)); and damages from gunshot wounds received during a robbery (Priv. Ltr. Rul. 8942083 (Jul. 27, 1989)).
Categorization of a settlement or award is also highly dependent on how the wording of the legal complaint, settlement and release are drafted. Wording matters. This point was evident in a recent Tax Court case. In Stepp v. Comr., T.C. Memo. 2017-191, the petitioners, a married couple, could not exclude payments received in settlement of the wife’s Equal Employment Opportunity Commission complaint in which she alleged disability and gender-based discrimination, and retaliatory harassment for a job reassignment. The Tax Court noted that each of the complaint, settlement and release provided for emotional and financial harms. There wasn’t mention of any physical injury or sickness. Perhaps those documents were drafted without much thought given to the tax consequences of any eventual award or settlement.
1996 Legislation and the Aftermath
1996 legislation specified that recoveries representing punitive damages are taxable as ordinary income regardless of whether they are received on account of personal injury or sickness. Small Business Job Protection Act of 1996, P.L. 104-188, Sec. 1605(a). See, e.g., O'Gilvie v. United States, 519 U.S. 79 (1996); Whitley v. Comr., T.C. Memo. 1999-124. But punitive damages that are awarded in a wrongful death action are not taxable if applicable state law in effect on September 13, 1995, provides (by judicial decision or state statute) that only punitive damages may be awarded. In that case, the award is excludible to the extent it was received on account of personal injury or sickness. Small Business Job Protection Act, P.L. 104-188, § 1605(d)). The enactment also made it clear that damages not attributable to physical injury or physical sickness are includible in gross income.
In 2006, the U.S. Circuit Court of Appeals for the District of Columbia ruled that the distinction drawn in the 1996 amendment was unconstitutional. Murphy v. United States, 460 F.3d 79 (D.C. Cir. 2006). In the case, the plaintiff sued her former employer and was awarded $70,000 ($45,000 for mental pain and anguish and $25,000 for “injury to professional reputation”). The plaintiff originally reported the entire $70,000 as taxable and then filed amended returns excluding the income. The IRS maintained that the entire $70,000 was taxable, and the trial court agreed. On appeal, the court held that the $70,000 was not excludible from income under the statute, but that I.R.C. §104(a)(2) was unconstitutional under the Sixteenth Amendment since the entire award was unrelated to lost wages or earnings, but were, instead, payments for the restoration of the taxpayer’s human capital. Thus, the entire $70,000 was excludible from income. However, in late 2006, the court vacated its opinion and set the case for rehearing. Upon rehearing, the court reversed itself and held that even if the taxpayer’s award was not “income” within the meaning of the Sixteenth Amendment, it is within the reach of the power of the Congress to tax under Article I, Section 8 of the Constitution. In addition, the court reasoned that the taxpayer’s award was similar to an involuntary conversion of assets – the taxpayer was forced to surrender some part of her mental health and reputation in return for monetary damages.” Murphy v. Internal Revenue Service, 493 F.3d 170 (D.C. Cir. 2007), reh’g. den., 2007 U.S. App. LEXIS 22173 (D.C. Cir. Sept. 14, 2007), cert. den., 553 U.S. 1004 (2008).
What About Lost Profit?
In many lawsuits, there is almost always some lost profit involved, and recovery for lost profit is ordinary income. See, e.g., Simko v. Comm’r, T.C. Memo. 1997-9. For recoveries in connection with a business, if the taxpayer can prove that the damages received were for injury to capital, no income results except to the extent the damages exceed the income tax basis of the capital asset involved. The recovery is, in general, a taxable event except to the extent the amount recovered represents a return of basis. Recoveries representing a reimbursement for lost profit are taxable as ordinary income.
What if Contingent Fees are Part of an Award?
If the amount of an award or court settlement includes contingent attorney fees, the portion of the award representing contingent attorney fees is includible in the taxpayer’s gross income. Comr. v. Banks, 543 U.S. 426 (2005), rev’g and rem’g sub. nom., Banks v. Comr., 345 F.3d 373 (6th Cir. 2003). For fees and costs paid after October 22, 2004, with respect to a judgment or settlement occurring after that date, legislation enacted in 2004 provides for a deduction of attorney’s fees and other costs associated with discrimination in employment or enforcement of civil rights. I.R.C. § 62(a)(19).
Interest on Judgments
Statutory interest imposed on tort judgments, however, must be included in gross income under I.R.C. § 61(a)(4), even if the underlying damages are excludible. See, e.g., Brabson v. United States, 73 F.3d 1040 (10th Cir. 1996).
Under I.R.C. § 104(a), amounts received under workmen’s compensation as compensation for personal injuries or sickness are excludible. However, the exclusion is unavailable to the extent the payment is determined by reference to the employee’s age or length of service.
The Causation Issue
It’s important to determine whether payments received are for physical injury resulting from emotional distress or whether the payments received are for emotional distress resulting from physical injury. This key point on causation was at issue in a recent case decided by the Tax Court. In Collins v. Comr., T.C. Sum. Op. 2017-74, the petitioner sued his employer for workplace discrimination and retaliation, alleging that he “suffered severe emotional distress and anxiety, with physical manifestations, including high blood pressure.” The parties settled the case with the employer paying the petitioner a settlement amount of $275,000 that included an $85,000 allocation to “emotional distress.” The petitioner excluded the amount from his taxable income on his return, but the IRS denied the exclusion.
The Tax Court agreed with the IRS. The court noted that I.R.C. §104(a)(2) excludes from gross income damages paid on account of physical injury or sickness. However, the court noted that this Code section also says that emotional distress, by itself, does not count as physical injury or sickness. Thus, damages paid on account of emotional distress are not excludible. The court noted the legislative history behind I.R.C. §104(a) states that the Congress “intended that the term emotional distress includes symptoms (e.g., insomnia, headaches, stomach disorders) which may result from such emotional distress.” However, the court also noted that Treas. Reg. §1.104-1(c)(2) states that emotional distress damages “attributable to a physical injury or physical sickness” are excluded from gross income. Thus, the court noted that if emotional distress results from a physical injury any resulting damages are excluded from gross income. However, if the physical injury results from emotional distress, damage payments are not excludible. In this case, the petitioner’s damage payment was paid on account of emotional distress that then caused physical injury and were not excludible.
Farmers and ranchers end up in litigation just like non-farmers and ranchers. In many instances those cases settle out-of-court. Sometimes those settlement amounts are significant. That makes the proper understanding of the tax treatment of the settlement award important. When cases don't settle and a judgment is obtained, it's still important to understand the tax consequences.
Monday, October 9, 2017
The farm economy continues to struggle. Of course, certain parts of the country are experiencing more financial trauma than are other parts of the country, but recent years have been particularly difficult in the Corn Belt and Great Plains. Aggregate U.S. net farm income has dropped by approximately 50 percent from its peak in 2011. It is estimated to increase slightly in 2017, but it has a long way to go to get back to the 2011 level. In addition, the value of farmland relative to the value of the crops produced on it has fallen to its lowest point ever. A dollar of farm real estate has never produced less value in farm production, and real net farm income relative to farm real estate values have not been as low as presently since 1980 to 1983.
A deeper dive on farm financial data indicates that after multiple years of declining debt-to-asset ratios, there was an uptick in 2015 and 2016. Relatedly, default risk remains low, but it also increased in 2015 and 2016. Also, there has been a decline in the ratio of working capital to assets, and a drop in the repayment capacity of ag loans. As a financial fitness indicator, repayment capacity is a key. At the beginning of the farm debt crisis in the early 1980s, it dropped precipitously due to a substantial increase in interest payments and a decline in farm production. That meant that land values could no longer be supported, and they dropped substantially. Consequently, many farmers found themselves with collateral value that was lower than the amount borrowed. Repayment capacity is currently a serious issue that could lead to additional borrowing.
While financial conditions may improve a bit in 2017 and on into 2018, working capital may continue to erode in 2017 which could lead to increased debt levels. That’s because average net farm income will remain at low levels. This could lead to some agricultural producers and lenders having to make difficult decisions before next spring. It also places a premium on understanding clause language in lending document and the associated rights and obligations of the parties.
Two clauses deserve close attention. One clause contains “cross collateralization” language. “Cross-collateralization” is a term that describes a situation when the collateral for one loan is also used as collateral for another loan. For example, if a farmer takes out multiple loans with the same lender, the security for one loan can be used as cross-collateral for all the loans. A second clause contains a “co-lessee” provision. That’s a transaction involving joint and several obligations of multiple parties.
Today’s post takes a deeper look at the implications of cross-collateral and co-lessee language in lending documents. My co-author for today’s post is Joe Peiffer of Peiffer Law Office in Hiawatha, Iowa. Joe brought the issues with cross-collateralization and co-lessee clause language to my attention. Joe has many years of experience working with farmers in situations involving lending and bankruptcy, and has valuable insights.
As noted above, clause language in lending and leasing documents should be carefully reviewed and understood for their implications. This is particularly true with respect to cross-collateralization language. For example, the following is an example of such a clause that appears to be common in John Deere security agreements. Here is how the language of one particular clause reads:
“Security Interest; Missing Information. You grant us and our affiliates a security interest in the Equipment (and all proceeds thereof) to secure all of your obligations under this Contract and any other obligations which you may have to us or any of our affiliates or assignees at any time and you agree that any security interest you have granted or hereafter grant to us or any of our affiliates shall also secure your obligations under this Contract. You agree that we may act as agent for our affiliates and our affiliates may as agent for us, in order to perfect and realize on any security interest described above. Upon receipt of all amounts due and to become due under this Contract, we will release our security interest in the Equipment (but not the security interest for amounts due an affiliate), provided no event of default has occurred and is continuing. You agree to keep the Equipment free and clear of all liens and encumbrances, except those in favor of us and our affiliates as described above, and to promptly notify us if a lien or encumbrance is placed or threated against the Equipment. You irrevocably authorize us, at any time, to (a) insert or correct information on this Contract, including your correct legal name, serial numbers and Equipment descriptions; (b) submit notices and proofs of loss for any required insurance; (c) endorse your name on remittances for insurance and Equipment sale or lease proceeds; and (d) file a financing statement(s) which describes either the Equipment or all equipment currently or in the future financed by us. Notwithstanding any other election you may make, you agree that (1) we can access any information regarding the location, maintenance, operation and condition of the Equipment; (2) you irrevocably authorize anyone in possession of that information to provide all of that information to us upon our request; (3) you will not disable or otherwise interfere with any information gathering or transmission device within or attached to the Equipment; and (4) we may reactivate such device.”
So, what does that clause language mean? Several points can be made:
- The clause grants Deere Financial and its affiliates a security interest in the equipment pledged as collateral to secure the obligations owed to it as well as its affiliates.
- When all obligations (including debt on the equipment purchased under the contract and all other debts for the purchase of equipment that Deere Financial finances) to Deere under the contract are paid, Deere Financial will release its security interest in the equipment. That appears to be straightforward and unsurprising. However, the release does not release the security interest of the Deere’s affiliates. This is the cross-collateral provision.
- The clause also makes Deere Financial the agent of its affiliates, and it makes the affiliates the agent of Deere Financial for purposes of perfection. What the clause appears to mean is that if a financing statement was not filed timely, perfection by possession could be pursued.
- The clause also irrevocably authorizes John Deere to insert or correct information on the contract.
- The clause allows John Deere to access any information regarding the location, maintenance, operation and condition of the collateral.
- The clause also irrevocably authorizes anyone in possession of that information to provide it to John Deere upon request.
- Also, under the clause, the purchaser agrees not to disable or interfere with any information gathering or transmission device in or attached to the Equipment and authorizes John Deere to reactivate any device.
Example. Consider the following example of the effect of cross-collateralization by machinery sellers and financiers:
Equity by Item
JD 4710 Sprayer 90' Boom
JD 333E Compact Track Loader
JD 8410T Crawler Tractor
JD 612C 12 Row Corn Head
Equity with Cross Collateralization
Equity without Cross Collateralization
The equity in the equipment without cross-collateralization is the sum of the equity in the Compact Track Loader, the Crawler Tractor and the Row Corn Head.
Sellers that finance the purchase price of the item(s) sold (termed a “purchase money” lender) seem to be using cross-collateralization provisions with some degree of frequency. As noted, the cross-collateralization provisions of the John Deere security agreement will allow John Deere to offset its under-secured status on some machinery by using the equity in other financed machines to make up the unsecured portion of its claims. Other machinery financiers (such as CNH and AgDirect) are utilizing similar cross-collateral provisions in their security agreements.
Can A “Dragnet” Lien Defeat a Cross-Collateralization Provision?
Would a bank’s properly filed financing statement and perfected blanket security agreement be sufficient to defeat a cross-collateralization provision? It would seem inequitable to allow an equipment financier’s subsequently filed financing statement to defeat the security interest of a bank. So far, it appears that when a purchase money security interest holder has sought to enforce a cross-collateralization clause, the purchase money security interest holder has always backed down. For example, in one recent scenario, John Deere Financial sought to enforce its cross-collateralization agreement against a Bank in a situation similar to the one set forth above. The Bank properly countered that its blanket security interest in farm equipment perfected before any of the Deere Financial purchase money security interests were perfected defeated the Deere Financial cross-collateralization. Deere Financial backed down thereby allowing the Bank to have all the equity in the equipment, $80,000, be paid to the Bank by the auctioneer after the liquidation auction.
A “Co-Lessee” Clause
When a guarantee on a loan cannot be obtained, a proposal may be made for “joint and several obligations.” In that situation, the lessor tries to compel one lessee to cover another lessee’s obligations or joint obligations. It’s a lease-sublease structure, with the original lessee becoming the sublessor. While the original lessee/sublessor has no rights to use the equipment (those rights are passed to the sublessee), the original lessee/sublessor remains legally obligated for performance. The sublease can then be assigned as collateral to the original lessor.
While a co-borrower situation is not uncommon, a transaction involving co-lessees is different inasmuch as a lease involves the right to use and possess property along with the obligation to pay for the property. A loan document simply involves the repayment of debt. So, what if a co-lessee arrangement goes south and the lessor tries to compel one lessee to cover another lessee’s joint obligation? What is the outcome? That’s hard to say simply because there aren’t any litigated cases on the issue with published opinions. But, numerous legal (and (tax) issues would be involved. For instance, with a true lease (see an earlier post on the distinction between a true lease and a capital lease), what if the lessees argue over the use and possession of the equipment or the removal of liens or maintenance of the property or the rental or return of the property? What about the payment of taxes? Similar issues would arise in a lease/purchase situation that encounters problems. What is known is that in such a dispute numerous Uniform Commercial Code issues are likely to arise under both Article 2 and Article 9.
The following is an example of John Deere’s co-lessee clause when it has an additional party sign on a lease:
“By signing below, each of the co-lessees identified below (each, a “Co-Lessee”) acknowledges and agrees that (1) the Lessee indicated on the above referenced Master Lease Agreement (the “Master Agreement”) and EACH CO-LESSEE SHALL BE JOINTLY AND SEVERALLY LIABLE FOR ANY AND ALL OF THE OBLIGATIONS set forth in the Master Agreement and each Lease Schedule entered into from time to time thereunder including, but not limited to, the punctual payment of any periodic payments or any other amounts which may become due and payable under the terms of the Master Agreement, whether or not said Co-Lessee signs each Lease Schedule or receives a copy thereof, and (2) it has received a complete copy of the Master Agreement and understands the terms thereof.
In the event (a) any Co-Lessee fails to remit to the Lessor indicated above any Lease Payment or other payment when due, (b) any Co-Lessee breaches any other provision of the Master Agreement or any Lease Schedule and such default continues for 10 days; (c) any Co-Lessee removes any Equipment (as such term is more fully described in the applicable Lease Schedule) from the United States; (d) a petition is filed by or against any Co-Lessee or any guarantor under any bankruptcy or insolvency law; (e) a default occurs under any other agreement between any Co-Lessee (or any of Co-Lessee's affiliates) and Lessor (or any of Lessor's affiliates); (f) or any Co-Lessee or any guarantor merges with or consolidates into another entity, sells substantially all its assets, dissolves or terminates its existence, or (if an individual) dies; or (g) any Co-Lessee fails to maintain the Insurance required by Section 6 of the Master Agreement, Lessor may pursue any and all of the rights and remedies available to Lessor under the terms of the Master Agreement directly against any one or more of the Co-Lessees. Nothing contained in the Addendum shall require Lessor to first seek or exhaust any remedy against any one Co-Lessee prior to pursuing any remedy against any other Co-Lessee(s).
Capitalized terms not defined in this Addendum shall have the meaning provided to them in the Master Agreement.”
Clearly, a party signing on as a co-lessee on a John Deere lease is assuming a great deal of risk.
Times are tough for many involved in production agriculture. The same is true for many agribusiness and agricultural lenders. If a producer is presented with a lending transaction that involves either a cross-collateralization or a co-lessee clause, legal counsel with experience in such transactions should be consulted. Fully understanding the risks involved can pay big dividends. Failing to understand the terms of these clauses can lead to the financial failure of the farmer that signs the document.
Thursday, October 5, 2017
Not all contractual transactions for agricultural goods function smoothly and without issues. From the buyer’s perspective, what rights does the buyer have if the seller breaches the contract? That’s an important issue for contracts involving agricultural goods. Ag goods, such as crops and livestock, are not standard, “cookie-cutter” goods. They vary in quality, size, shape, and moisture content, for example. All of those aspects can lead to questions as to contract breach.
So, what rights does a buyer have if there is a breach? A basic review of those rights is the topic of today’s post.
Right of Rejection
A buyer has a right to reject goods that do not conform to the contract. Under the Uniform Commercial Code (UCC), a buyer may reject nonconforming goods if such nonconformity substantially impairs the contract. A buyer usually is not allowed to cancel a contract for only trivial defects in goods. For example, in a 1995 New York case, a manufacturer of potato chips rejected shipments of potatoes for failure to conform to the contract based on the color of the potatoes. The court held that the failure to conform substantially impaired the contract and justified the manufacturer’s refusal to accept the potatoes. The defect was not merely trivial. Hubbard v. UTZ Quality Foods, Inc., 903 F. Supp. 444 (W.D. N.Y. 1995).
Triviality is highly fact dependent. It will be tied to industry custom, past practices between the parties and the nature of the goods involved in the contract.
Right To “Cover”
The traditional measure of damages for a seller’s total breach of contract is the difference between the market price and the contract price of the goods. For example, in Tongish v. Thomas, 251 Kan. 728, 840 P.2d 471 (1992), the seller breached a contract to sell sunflower seeds to a buyer. The buyer recovered damages for the difference in the market price and the contract price. The UCC retains this rule, (UCC § 2-713(1)) but also allows an aggrieved buyer to “cover” by making a good faith purchase or contract to purchase substitute goods without unreasonable delay. UCC § 2-712(1). The buyer that covers is entitled to recover from the seller the difference between the cost of cover and the contract price. UCC § 2-712(1).
Most of the agricultural cases concerning “covering” focus on the difference between the goods purchased as cover and the goods called for in the contract (cover goods must be like-kind substitutes), and the timeframe within which cover was carried out (there must be no unreasonable delay). On the timeframe issue, a Nebraska case serves as a good illustration of how the courts analyze the issue. In, Trinidad Bean and Elevator Co. v. Frosh, 1 Neb. App 281 494 N.W.2d 347 (1992), a navy bean producer was able to terminate a contract without penalty, even though prices had doubled by harvest (the delivery date specified in the contract). The farmer notified the elevator in May, when market prices were identical to the forward price, that the farmer would not fulfill the contract later that fall. The court noted that under the UCC when a seller repudiates a forward contract before delivery is required, the buyer is entitled to the difference between the contract price and the price of the goods on the date of repudiation if it is commercially reasonable for the buyer to cover at that time. The court ruled that the elevator was not entitled to damages because it could have filled the contract at the forward contract price at the time it was notified of the seller’s contract repudiation.
Right Of Specific Performance
If the goods are unique, the buyer may obtain possession of the goods by court order. This is known as specific performance of the contract. Contracts for the sale of real estate or art work, for example, are contracts for the sale of unique goods and the buyer’s remedy is to have the contract specifically performed. Monetary damages can be awarded to a contracting party along with specific performance if it can be shown that damages resulted from the other party’s failure to render timely performance. See, e.g., Perry v. Green, 313 S.C. 250, 437 S.E.2d 150 (1993).
A buyer has a right before acceptance to inspect delivered goods at any reasonable place and time and in any reasonable manner. The reasonableness of the inspection is a question of trade usage and past practices between the parties. If the goods do not conform to the contract, the buyer may reject them all within a reasonable time and notify the seller, accept them all despite their nonconformance, or accept part (limited to commercial units) and reject the rest. Any rejection must occur within a reasonable time, and the seller must be notified of the buyer's unconditional rejection. For instance, in In re Rafter Seven Ranches LP v. C.H. Brown Co., 362 B.R. 25 (B.A.P. 10th Cir. 2007), leased crop irrigation sprinkler systems failed to conform to the contract. However, the buyer indicated an attempt to use the systems and did not unconditionally reject the systems until four months after delivery. As a result, the buyer was held liable for the lease payments involved because the buyer failed to make a timely, unconditional rejection.
The buyer’s right of revocation is not conditioned upon whether it is the seller or the manufacturer that is responsible for the nonconformity. UCC § 2-608. The key is whether the nonconformity substantially impairs the value of the goods to the buyer.
A buyer rejecting nonconforming goods is entitled to reimbursement from the seller for expenses incurred in caring for the goods. The buyer may also recover damages from the seller for non-delivery of suitable goods, including incidental and consequential damages. If the buyer accepts nonconforming goods, the buyer may deduct damages due from amounts owed the seller under the contract if the seller is notified of the buyer’s intention to do so. See, e.g., Gragg Farms and Nursery v. Kelly Green Landscaping, 81 Ohio Misc. 2d 34; 674 N.E.2d 785 (1996)
Timeframe for Exercising Remedies
The UCC allows buyers a reasonable time to determine whether purchased goods are fit for the purpose for which the goods were purchased, and to rescind the sale if the goods are unfit. Whether a right to rescind is exercised within a reasonable time is to be determined from all of the circumstances. UCC §1-204. The buyer’s right to inspect goods includes an opportunity to put the purchased goods to their intended use. Generally, the more severe the defect, the greater the time the buyer has to determine whether the goods are suitable to the buyer.
Statute Of Limitations
Actions founded on written contracts must be brought within a specified time, generally five to ten years. For unwritten contracts, actions generally must be brought within three to five years. In some states, however, the statute of limitations is the same for both written and oral contracts. A common limitation period is four years. Also, by agreement in some states, the parties may reduce the period of limitation for sale of goods but cannot extend it.
Most contractual transactions for agricultural goods function smoothly. However, when the seller breaches, it is helpful for the buyer to know the associated rights and liabilities of the parties.
Tuesday, October 3, 2017
Estate tax portability allows a surviving spouse to carry over any unused portion of the deceased spouse’s estate tax exclusion (DSUE) to be used to offset estate tax in the surviving spouse’s estate, if necessary. It gets added to the surviving spouse’s own exemption. The DSUE has become a key aspect of post-2012 estate planning, and makes it quite simple for married couple to utilize the full estate tax exclusion over both of their estates. The full estate and gift tax coupled exclusion is $5.49 million per individual for deaths in 2017 and gifts made in 2017.
One of the concerns about portability is the ability of the IRS to audit the estate of the deceased spouse where portability was elected. Does the IRS have an open-ended statute of limitations to go back and examine that estate to determine if the “ported” amount of the unused exclusion was computed properly? A recent Tax Court decision confirms that the IRS does.
The election. To “port” the unused exclusion at the death of the first spouse to the surviving spouse, an election must be made. As noted, the amount available to be “ported” to the estate of the surviving spouse is the deceased spouse’s unused exclusion (DSUE). IRC §2010(c)(4); Treas. Reg. §20.2010-2. The portability election must be made on a timely filed Form 706 for the first spouse to die. I.R.C. §2010(c)(5)(A); Treas. Reg. §20.2010-2(a)(1). This also applies for nontaxable estates, and the return is due by the same deadline (including extensions) as taxable estates. The deadline for filing is nine months after the decedent’s date of death (with a six-month extension possible). The election is revocable until the deadline for filing the return expires.
While an affirmative election is required by statute, part 6 of Form 706 (which is entirely dedicated to the portability election, the DSUE calculation, and roll forward of the DSUE amount) provides that "a decedent with a surviving spouse elects portability of the DSUE amount, if any, by completing and timely-filing the Form 706. No further action is required to elect portability…". This election, therefore, is made by default if there is a DSUE amount and an estate tax return is filed (as long as the box in section A of part 6 is not checked, which affirmatively elects out of portability).
Late election relief. In Rev. Proc. 2014-18, 2014-7 IRB 513, the IRS provided a simplified method for certain estates to obtain an extended time to make the portability election. That relief has now expired and has been extended by Rev. Proc. 2017-34, 2017-26 IRB 1282. The portability election must be submitted with a complete and properly filed Form 706 by the later of January 2, 2018, or the second anniversary of the decedent's death. After January 2, 2018, the extension is, effectively, for two years. The extension is only available to estates that are not otherwise required to file an estate tax return. Other estates can only obtain an extension under Treas. Reg. §301.9100-3. Form 706 must state at the top that the return is "FILED PURSUANT TO REV. PROC. 2017-34 TO ELECT PORTABILITY UNDER §2010(c)(5)(A)."
An estate that files late, but within the extended deadlines of Rev. Proc. 2017-34, cannot rely on the revenue procedure if it later learns that it should have filed a Form 706. If a valid late election is made and results in a refund of estate or gift taxes for the surviving spouse, the time period for filing for a refund is not extended from the normal statutory periods. In addition, a claim for a tax refund or credit is treated as a protective claim for a tax credit or refund if it is filed within the time period of §6511(a) by the surviving spouse or the surviving spouse's estate in anticipation of Form 706 being filed to elect portability under Rev. Proc. 2017-34.
Election requirements. Treas. Reg. §20.2010-2 requires that the DSUE election be made by filing a complete and properly prepared Form 706. Treas. Reg. §20.2010-2(a)(7)(ii)(A) permits the “appointed” executor who is not otherwise required to file an estate tax return to use the executor's "best estimate" of the value of certain property and then report on Form 706 the gross amount in aggregate, rounded up to the nearest $250,000.
Treas. Reg. §20.2010-2(a)(7)(ii) sets forth simplified reporting for particular assets on Form 706, which allows for good faith estimates. The simplified reporting rules apply to estates that do not otherwise have a filing requirement under IRC §6018(a). This means that if the gross estate exceeds the basic exclusion amount ($5.49 million in 2017), simplified reporting is not applicable.
Simplified reporting is only available for marital and charitable deduction property (under IRC §§2056, 2056A, and 2055) but not to such property if certain conditions apply. Treas. Reg. §20.2010-2(a)(7)(ii)(A).
Assets reported under the simplified method are to be listed on the applicable Form 706 schedule without any value entered in the column for "Value at date of death." The sum of the asset values included in the return under the simplified method are rounded up to the next $250,000 increment and reported on lines 10 and 23 of part 5 of Form 706 (as assets subject to the special rule of Treas. Reg. §20.2010-2(a)(7)(ii)).
In addition to listing the assets on the appropriate schedules, the regulations require that certain additional information must be provided for each asset. Treas. Reg. §20.2010-2(a)(7)(ii)(A).
Availability. The inherited DSUE amount is available to the surviving spouse as of the date of the deceased spouse's death. It is applied to gifts and the estate of the surviving spouse before their own exemption is used. Accordingly, the surviving spouse may use the DSUE amount to shelter lifetime gifts from gift tax or to reduce the estate tax liability of the surviving spouse's estate at death. Treas. Reg. §20.2010-3(b)(ii).
The regulations allow the surviving spouse to use the DSUE before the deceased spouse’s return is filed (and before the amount of the DSUE is established). Treas. Reg. §20.2010-3(ii). However, the DSUE amount is subject to audit until the statute of limitations expires on the surviving spouse’s estate tax return. Temp. Treas. Regs. §§20.2010-3T(c)(1) and 25.2505-2T(d)(1). However, the regulations do not address whether a presumption of survivorship can be established. Thus, there is no guidance on what happens if both spouses die at the same time and the order of death cannot be determined and it is not known whether the IRS would respect estate planning documents that include a provision for simultaneous deaths.
Statute of Limitations – IRS Audits
The statute of limitations for assessing additional tax on the estate tax return is the later of three years from the date of filing or two years from the date the tax was paid. However, the IRS can examine the DSUE amount at any time during the period of the limitations for the second spouse as it applies to the estate of the first spouse. Treas. Reg. §20.2010-2(d) allows the IRS to examine the estate and gift tax returns of each of the decedent's predeceased spouses. Any materials relevant to the calculation of the DSUE amount, including the estate tax (and gift tax) returns of each deceased spouse, can be examined. Thus, a surviving spouse needs to retain appraisals, work papers, documentation supporting the good-faith estimate, and all intervening estate and gift tax returns to substantiate the DSUE amount.
New Case On The Audit Issue
Facts. In Estate of Sower v. Comr., 149 T.C. No. 11 (2017), the decedent died in August of 2013 as the surviving spouse. Her predeceased spouse died in early 2012. His estate reported no federal estate tax liability on its timely filed Form 706. His estate also reported no taxable gifts although he had made $997,920 in taxable gifts during his life. However, his estate did include $845,420 in taxable gifts on the worksheet provided to calculate taxable gifts to be reported on the return. His estate reported a deceased spouse unused exclusion (DSUE) amount of $1,256,033 and a portability election of the DSUE was made on his estate’s Form 706 to port the DSUE to the surviving spouse.
The decedent’s estate filed a timely Form 706 claiming the ported DSUE of $1,256,033 and paid an estate tax liability of $369,036, and then an additional $386,424 of tax and interest to correct a math error on the original return. The decedent’s estate also did not include lifetime taxable gifts (of which there were $997,921) on the return, simply leaving the entry for them blank. About two months later, the IRS issued an estate tax closing letter to the husband’s estate showing no estate tax liability and noting that that the return had been accepted as filed.
IRS audit. In early 2015, the IRS began its examination of the decedent’s return. In connection with that exam, the IRS opened an exam of the husband’s estate to determine the proper DSUE to be ported to the decedent’s estate. As a result of this exam, the IRS made an adjustment for the amount of the pre-deceased spouse’s lifetime taxable gifts and issued a second closing letter and also reducing the DSUE available to port to the decedent’s estate of $282,690. The IRS also adjusted the decedent’s taxable estate by the amount of her lifetime taxable gifts and reduced it for funeral costs. The end result was an increase in federal estate tax liability for the decedent’s estate of $788,165, and the IRS sent the decedent’s estate a notice of deficiency for that amount and the estate disputed the full amount by filing a petition in Tax Court.
Estate’s arguments. The estate claimed that the IRS was estopped from reopening the estate of the predeceased spouse after the closing letter had been initially issued to that estate. The estate also claimed that the IRS was precluded from adjusting the DSUE for gifts made before 2010. The estate additionally claimed that I.R.C. §2010(c)(5)(B) (allowing IRS to examine an estate tax return to determine the correct DSUE notwithstanding the normal applicable statute of limitations) was unconstitutional for lacking due process because it overrode the statute of limitations on assessment contained in I.R.C. §6501.
Tax Court opinion. The Tax Court disagreed with the estate on all points. The court noted that I.R.C. §2010(c)(5)(B) gave the IRS the power to examine the estate tax return of the predeceased spouse to determine the correct DSUE amount. That power, the court noted, applied regardless of whether the period of limitations on assessment had expired for the predeceased spouse’s estate. This, the Tax Court noted, was bolstered by temporary regulations in place at the time of the predeceased spouse’s (and the decedent’s) death. I.R.C. §7602, the Tax Court noted, also gave the IRS broad discretion to examine a range of materials to determine whether a return was correct, including estate tax returns.
The Tax Court also determined that the closing letter did not amount to a closing document under I.R.C. §7121, which required a Form 866 and Form 906, and there had been no negotiation between the IRS and the estate. The Tax Court also held that the decedent’s estate had not satisfied the elements necessary to establish equitable estoppel against the IRS. The IRS had not made a false statement or had been misleadingly silent that lead to an adverse impact on the estate.
Also, the Tax Court noted that there had not been any second examination. No additional information had been requested from the pre-deceased spouse’s estate and no additional tax was asserted. The effective date of the proposed regulation was for estates of decedent’s dying after 2010 and covered gifts made by such estates irrespective of when those gifts were made.
There was also no due process violation because adjusting the DSUE did not amount to an assessment of tax against the estate of the pre-deceased spouse. Consequently, the Tax Court held that the IRS properly adjusted the DSUE and the decedent’s estate had to include the lifetime taxable gifts in the estate for estate tax liability computation purposes.
Because the election to utilize portability allows the IRS an extended timeframe to question valuations, the use of a bypass/credit shelter trust that accomplishes the same result for many clients may be a preferred approach. However, in those situations, it should be a routine practice for practitioners to obtain a signed acknowledgement and waiver from the executor of the first spouse’s estate that the potential benefit of portability in the surviving spouse’s death has been explained fully and has been waived.
As the Tax Court points out, the IRS has the power to audit the first spouse’s estate tax return and can add any increased tax to the surviving spouse’s estate tax return – no matter how many years have passed since the first spouse’s death. That means it should also be routine practice for practitioners to make sure that Form 706 for the first spouse’s estate is prepared with absolute perfection.
Friday, September 29, 2017
Self-employment tax applies to income that is derived from a “trade or business.” That’s a fact-based determination. In addition, by statute, “rentals from real estate and from personal property leased with the real estate” are excluded from the definition of net earnings from self-employment. I.R.C. §1402(a)(1). Likewise, income from crop share and/or livestock share rental arrangements for landlords who are not materially participating in the farming or ranching operation will not be classified as self-employment income. Only if the rents are produced under a crop or livestock share lease where the individual is materially participating under the lease does the taxpayer generate self-employment income. Income received under a cash rental arrangement is not subject to self-employment tax.
But, what is “material participation”? A lease is a material participation lease if (1) it provides for material participation in the production or in the management of the production of agricultural or horticultural products, and (2) there is material participation by the landlord. Both requirements must be satisfied. While a written lease is not required, a written lease certainly makes a material participation arrangement easier to establish (or not established, if that is desired).
But, what about leases of farmland to an operating entity in which the lessor is also a material participant in the operating entity? Does the real estate exemption from the definition of net earnings from self-employment apply in that situation? Does the type of lease or the rate of rent charged under the lease matter? In 1995, the Tax Court rendered an important decision on the first question that, apparently, also answered the second question. Mizell v. Comr., T.C. Memo. 1995-571. Later, the U.S. Court of Appeals for the Eighth Circuit carved out an exception from the 1995 Tax Court decision for fair market leases. McNamara, et al. v. Comr., 263 F.3d 410 (8th Cir. 2000), rev’g., T.C. Memo 1999-333. Now, the Tax Court, in a full Tax Court opinion, has applied the Eighth Circuit’s analysis and holding to a case with similar facts coming from Texas – a jurisdiction outside the Eighth Circuit. Martin v. Comr., 149 T.C. No. 12 (2017).
The Mizell Case
In Mizell, the petitioner was a farmer who, in 1986, structured his farming operation to become a 25 percent co-equal partner in an active farming partnership with his three sons. In addition, in 1988, leased about 730 acres of farmland to the farm partnership. The lease called for the petitioner to receive a one-quarter share of the crop, and the partnership was responsible for all expenses. The petitioner reported his 25 percent share of partnership income as self-employment earnings. However, the crop share rent on the land lease was treated as rents from real estate that was exempt from self-employment tax.
The IRS disagreed with that tax treatment of the land rent, assessing self-employment tax on the crop share lease income for the years 1988, 1989 and 1990. The parties agreed that he materially participated in the agricultural production of his farming operation. The IRS took the position that the crop share rental and the farming partnership constituted an “arrangement” that needed to be considered in light of the entire farming enterprise in measuring self-employed earned income. Thus, the IRS position was that the landlord role could not be separated from the employee or partner role. That meant that any employee or partner-level participation by the landowner triggered self-employment tax on the rental income. On the other hand, the petitioner, argued that the crop share lease did not involve material participation and that the crop share rental income should be exempt from self-employment tax. In other words, the IRS looked to the overall farming arrangement to find a sufficient level of material participation on the petitioner’s part, but the petitioner confined the analysis to the terms of the lease which wasn’t a material participation lease.
While, rents from real estate, whether cash rent or crop share, are excluded from the definition of self-employment income, there is an exception, however, if three criteria are met:
- The rental income is derived under an arrangement between the owner and lessee which provides that the lessee shall produce agricultural commodities on the land;
- The arrangement calls for the material participation of the owner in the management or production of the agricultural commodities; and
- There is actual material participation by the owner.. R.C. §1402(a)(1)(A); Treas. Reg. §1.1402(a)-4(b)(1).
The Tax Court, agreeing with the IRS, focused on the word "arrangement" in both the statute and the regulations, noting that this implied a broader view than simply the single contract or lease for the use of the land between the petitioner and the farming partnership. By measuring material participation with consideration to both the crop share lease and the petitioner’s obligations as a partner in the partnership, the court found that the rental income must be included in the petitioner’s net earnings for self-employment purposes.
Following its win in Mizell, the IRS privately ruled in 1996 that a married couple who cash-rented land to their agricultural corporation were subject to self-employment tax on the cash rental income, because both the husband and wife were employees of the corporation. T.A.M. 9637004 (May 6, 1996).
Implications of Mizell. The Mizell decision was a landmine that posed a clear threat to the common set-up in agriculture where an individual leases farmland to an operating entity in which the individual is also a material participant. Importantly, the type of lease was apparently immaterial to the court. On that point, the wording of Treas. Reg. § 1.1402(a)-4(b)(2) appears to be broad enough to include income in any form, crop share or cash, if received in an arrangement that contemplates the material participation of the landowner.
Exception to the Mizell “Arrangement” Theory
The Tax Court, in 1998, decided three more Mizell-type cases. In Bot v. Comr., T.C. Memo. 1999-256, the court determined that rental income (at the rate of $90 per acre) received by a wife for 240 acres of land, paid to her by her husband’s farm proprietorship, was subject to self-employment tax. The wife also received an annual salary from the proprietorship of approximately $15,000, and the court said that the rental amount and the salary amounted to a single arrangement. In Hennen v. Comr., T.C. Memo1999-306, the court again held that self-employment tax applied to rental income that a wife received on land leased to her husband’s farming business. Like Mrs. Bot, Mrs. Hennen worked for the farming business and was paid a salary ($3,500/year). McNamara v. Comr., T.C. Memo. 1999-333, also involved a husband and wife who owned land that they leased to their farming C corporation under a written, cash rent lease. The rent payment averaged about $50,000 per year. The husband was employed full time by the corporation, and the wife was employed doing part-time bookkeeping and farm errand duties. She was paid a nominal amount – about $2,500 annually. The court again determined that the rental arrangement and the wife’s employment were to be combined, which meant that the rental income was subject to self-employment tax.
All three cases were consolidated on appeal to the U.S. Court of Appeals for the Eighth Circuit. The Eighth Circuit, reversing the Tax Court, determined that the lessor/lessee relationship was to be analyzed separate and distinct from the employer-employee relationship. The Eighth Circuit interpreted I.R.C. §1402(a)(1) as requiring material participation by the landlord in the rental arrangement itself in order to subject the arrangement to self-employment tax. The court stated that, “The mere existence of an arrangement requiring and resulting in material participation in agricultural production does not automatically transform rents received by the landowner into self-employment income. It is only where the payment of those rents comprise part of such an arrangement that such rents can be said to derive from the arrangement.”
The Eighth Circuit remanded the case to the Tax Court for the purpose of giving the IRS an opportunity to illustrate that there was a connection between the rental amount and the labor arrangement. The IRS could not establish a connection. The rents were cash rents that were at or slightly below fair market value. However, the IRS later issued a non-acquiescence to the Eighth Circuit’s decision. A.O.D. 2003-003, I.R.B. 2003-42 (Oct. 22, 2003). That meant that the IRS would continue to litigate the issue outside of the Eighth Circuit.
As the non-acquiescence indicated, the IRS continued to litigate the matter and two more cases found their way to the Tax Court. In Johnson v. Comr., T.C. Memo. 2004-56, the petitioners verbally cash leased 617 acres of land to their farm corporation. They also had a verbal employment agreement with the corporation and received a nominal salary. The farming operation was located within the Eighth Circuit, which meant that the if the land rental and the employment agreement were two separate arrangements the land rental income would not be subject to self-employment tax. Ultimately, the Tax Court determined that the rental amount under the lease was representative of a fair market rate of rent, and the rental payments were not tied to any services the petitioners provided to the farming corporation. The compensation paid to the petitioners was also not understated.
However, in Solvie v. Comr., T.C. Memo. 2004-55, the Tax Court reached a different conclusion on a set of facts similar to those involved in Johnson. In Solvie, the petitioners leased real estate to their controlled corporation and also received compensation as corporate employees. Later, an additional hog barn was constructed which increased the total rent paid to the petitioners which the IRS claimed was subject to self-employment tax. The Tax Court agreed because the additional rent was much greater than the rental amounts the received from the corporation for the other hog buildings even though the new building had a smaller capacity. In addition, the court noted that the petitioners’ wages did not increase even they overall hog production increased, and the additional rent was computed on a per-head basis which meant that no building rent would be paid if there was no hog production.
The Downfall of Mizell?
In Martin v. Comr., 149 T.C. No. 12 (2017), the Tax Court (in an opinion authored by Judge Paris) delivered its most recent opinion concerning the self-employment tax treatment of leases of farmland to an operating entity in which the lessor is also a material participant in the operating entity. Under the facts of the case, the petitioners, a married couple, operated a farm in Texas – a state not located within the Eighth Circuit’s jurisdiction. In late 1999, they built the first of eight poultry houses to raise broilers under a production contract with a large poultry integrator. The petitioners formed an S corporation in 2004, and set up oral employment agreements with the S corporation based on an appraisal for the farm which guided them as to the cost of their labor and management services. They also pegged their salaries at levels consistent with other growers. The wife provided bookkeeping services and the husband provided labor and management. In 2005, they assigned the balance of their contract to the S corporation. Thus, the corporation became the “grower” under the contract. In 2005, the petitioners entered into a lease agreement with the S corporation. Under the agreement, the petitioners rented their farm to the S corporation, under which the S corporation would pay rent of $1.3 million to the petitioners over a five-year period. The court noted that the rent amount was consistent with other growers under contract with the integrator. The petitioners reported rental income of $259,000 and $271,000 for 2008 and 2009 respectively, and the IRS determined that the amounts were subject to self-employment tax because the petitioners were engaged in an “arrangement” that required their material participation in the production of agricultural commodities on their farm.
The Tax Court noted that the IRS agreed that the facts of the case were on all fours with McNamara. In addition, the court determined that the Eighth Circuit’s rationale in McNamara was persuasive and that the “derived under an arrangement” language in I.R.C. §1402(a)(1) meant that a nexus had to be present between the rents the petitioners received and the “arrangement” that required their material participation. In other words, there must be a tie between the real property lease agreement and the employment agreement. The court noted the petitioners received rent payments that were consistent with the integrator’s other growers for the use of similar premises. That fact was sufficient to establish that the rental agreement stood on its own as an appropriate measure as a return on the petitioners’ investment in their facilities. Similarly, the employment agreement was appropriately structured as a part of the petitioners’ conduct of a legitimate business. Importantly, the court noted that the IRS failed to brief the nexus issue, relying solely on its non-acquiescence to McNamara and relying on the court to broadly interpret “arrangement” to include all contracts related to the S corporation. Accordingly, the court held that the petitioner’s rental income was not subject to self-employment tax.
A dissenting judge complained that the IRS should not have the burden of producing evidence of establishing a nexus between the land lease and the employment agreement once the petitioner establishes that the land lease is a fair market lease. Another dissenter would have continued to apply the Mizell arrangement theory outside of the Eighth Circuit.
The cases point out that leases should be drafted to carefully specify that the landlord is not providing any services or participating as part of the rental arrangement. Services and labor participation should remain solely within the domain of the employment agreement. In addition, leases where the landlord is also participating in the lessee entity must be tied to market value for comparable land leases. If the rental amount is set too high, the IRS could argue that the lease is part of “an arrangement” that involves the landlord’s services. If lessor does provide services, a separate employment agreement should put in writing the duties and compensation for those services.
The Martin decision, a full Tax Court opinion, is a breath of fresh air for agricultural operations that are structured with leases of farmland to an operating entity in which the lessor is also a material participant. Proper structuring of the land lease and a separate employment agreement can provide protection from an IRS claim that self-employment tax applies to the land rental income. Now there is substantial authority for that proposition outside the Eighth Circuit.