Friday, May 26, 2017
Minority shareholders in a small, closely-held corporation are in a precarious position. They have no control over management of the corporation, and, for example, can’t force dividends to be paid or force a corporate liquidation. Clearly, corporate directors (including those acting as directors) owe a fiduciary duty to the corporation with respect to their actions as directors, and those fiduciary duties apply in the context of directors’ ability to manage the closely-held business within their discretion. However, while corporate directors can generally use their business judgment to operate the business as they deem appropriate, they must manage the business in a manner that is consistent with honesty and good faith toward all of the shareholders – the minority included.
A recent opinion of the Nebraska Court of Appeals involved an allegation of “oppression” of a minority shareholder is a closely-held farming corporation. While the minority shareholder was not able to establish that oppression had occurred, testimony was offered in the case by the corporation’s tax professional that merits a closer look.
In Jones v. McDonald Farms, Inc., 24 Neb. App. 649 (2017), the defendant was incorporated as an S corporation in 1976 by a married couple. The couple had four children – two sons and two daughters. The sons began farming with their parents in the mid-1970s. Upon incorporation, the parents were the majority shareholders and the sons held the minority interests. One of the sons became corporate president when the father resigned in 1989 and the other son became the vice-president. The mother died in 2010 and her corporate stock shares passed equally to all four children. In 2012, the father gifted his stock equally to the sons and, after the gift, the sons each owned 42.875 percent of the corporate stock and the daughters each owned 7.125 percent.
The father died in early 2014 at a time when the corporate assets included 1,100 acres of irrigated farmland and dry cropland. The corporation, since 1991, leased its land to two other corporations, one owned by one son and his wife, and the other corporation owned by the other son and his wife. The land leases were 50/50 crop share leases with each son’s corporation performing all of the farming duties under the leases. In 1993, the corporation converted to a C corporation with corporate employees being paid in-kind commodity wages. For tax planning purposes, corporate net income was kept near $50,000 annually to take advantage of the 15 percent tax rate by timing the purchase of crop inputs, replacing assets and paying in-kind wages. The father and sons did not receive any cash wages, but did receive an amount of commodity wages tied to crop prices and yields – all with an eye to keeping the corporate net income low. Hence, the amount of commodity wages varied widely from year-to-year. The corporation’s CPA testified that he believed the high commodity wages in the later years was appropriate because of the amount of accrued unpaid wages since 1976. The CPA also testified that the corporation was not legally obligated to pay any wages, but that it was merely optional for the corporation to do so.
The corporation’s articles of incorporation required a shareholder to offer their shares to the corporation for purchase at book value before selling, giving or transferring them to anyone else. Shortly after her father died, the plaintiff, one of the daughters, offered to sell her shares to the corporation for $240,650 – the fair market value of the shares based on a December 2010 valuation done for purposes of the mother’s estate. The corporation, in return, offered to buy the shares for $47,503.90, the book value as of December 2011 less $6,000 due to a corporate loss sustained by the plaintiff’s failure to return a form to the local Farm Service Agency office.
The plaintiff sued in early 2013 seeking an accounting, damages for breach of fiduciary duty and conflicting interests, judicial dissolution of the corporation based on oppressive conduct, misapplication and waste of corporate assets and illegal conduct. The trial court denied all of the plaintiff’s claims, finding specifically that the payment of commodity wages and purchase of expensive farm equipment were not unreasonable or inappropriate.
On appeal, the appellate court affirmed. The appellate court, noting that while NE law does provide a remedy to minority shareholders for oppressive conduct, the court stated that the remedy of dissolution and liquidation is so drastic that it can only be invoked with “extreme caution.” The court noted that the plaintiff was essentially challenging the corporation’s tax strategy, and asserting that the corporation should be maximizing its income and paying dividends and the failure to do so constitutes oppressive conduct particularly because, as the plaintiff noted, the corporation had over $13 million in assets and no debt.
The appellate court disagreed with the plaintiff, and made the following specific findings:
- A corporation is not required to pay dividends under state law, and the corporation had a long history of never paying dividends.
- The high level of commodity wages in the later years was not oppressive because it made up for years the shareholders worked without compensation.
- The plaintiff did not have a reasonable expectation of sharing in corporate profits because the plaintiff acquired her stock interest entirely by gift or devise and never committed capital to the corporation.
- Since incorporation in 1976, no minority shareholder had ever been paid profits.
- The payment of commodity wages was not illegal deferred compensation.
- The corporation’s offer to pay book value for the plaintiff’s shares was consistent with the corporate articles of incorporation, and the plaintiff did not challenge the method by which book value was calculated.
- The stock transfer restriction was upheld as enforceable contract.
Tax Planning Concerns
Commodity wages. As the facts of the case indicated, the corporation leased its land to two other corporations, with each of the lessee corporations owned by a son that was a shareholder of the landlord corporation. As noted, those sons were receiving commodity wages from the landlord corporation. Unless the landlord corporation was materially participating in the lease, the income derived under the lease (whether in cash or crop-share) is a rent receivable. Thus, the payment of commodity wages would trigger income to the corporation and payroll taxes to the sons at the time of the transfer of the commodity as a wage. The commodities are rent and not inventory that the corporation raised. While the corporation could pay commodity wages from its inventory (e.g., a crop that the corporation raises), it can’t pay commodity wages with a crop share that is classified as a rent receivable. The outcome is different, however, if the corporation is materially participating under the lease in the production of the commodities. In addition, that material participation must be achieved via the corporation’s employees.
That last point is important. Since material participation must be satisfied by the corporate employees, reasonable compensation must be paid for those services. That compensation will either need to take the form of a landlord’s share of the rent or a portion of the crop that the corporation raised (via material participation under the lease).
As for wages, an appropriate amount must be paid for services rendered. If services are not rendered, no wages should be paid. The point is that wages are not optional. Dividends are optional. However, the facts of the case indicated that the father (while living) and sons had numerous years where they did not receive any wages, with those unpaid wages being made up in later years in the form of high commodity wages. That’s an interesting (and highly relevant) fact from a tax standpoint. There are innumerable court cases addressing unreasonably high compensation (paid in order to lower C corporation income). As a landlord corporation under a crop share arrangement, the corporation provides the land and the tenant provides the services. Landlord services would be minimal. Indeed, in the NE case, the court noted that each son’s corporation performed the farming duties – not the landlord corporation. But, it was the landlord corporation that paid the commodity wages. That could cause the IRS to assert that the compensation was unreasonably high. Alternatively, if the landlord corporation were materially participating under the lease, a question could arise as to whether the 50-50 crop share arrangement sufficiently compensated the corporation for the material services that were rendered.
Another concern with having unpaid wages is the lack of documentation. With documentation, though, the corporation would have a deferred compensation plan, subject to onerous taxes unless payment requirements are strictly satisfied.
Why were wages paid in-kind instead of in cash? For agricultural labor, only cash wages are subject to Social Security tax. Wages paid in-kind to agricultural labor are not subject to FICA tax, FUTA (Federal Unemployment Tax Act) tax, or income tax withholding, but they are subject to income tax. I.R.C. §§3121(a)(8); 3306(b)(11). In 1994, an IRS Task Force produced guidelines that set forth several factors as relevant in determining when a particular in-kind payment qualifies for the exemption. To the IRS, the payment of at least some cash wages is important. That’s another area of concern with the wage arrangement of the corporation in the NE case.
A drawback of paying wages-in kind is that they don’t generate W-2 wages for purposes of the domestic production activities deduction of I.R.C. §199. They are also not considered wages for purposes of determining the amount of earnings in retirement.
Other tax issues. Another question concerns the value of the corporate assets. The court noted that the corporation had $13 million in assets. Depending on the mix of corporate assets (land and non-real estate assets), the corporation might have triggered the personal holding company (PHC) tax. I.R.C. §541. If a C corporation has too much investment income, the PHC tax will apply. When more than a single entity is utilized, the landholding C corporation will receive the bulk, if not all, of its income from leasing the land to the production entity or entities. If the lease is not structured properly, the income under the lease can be construed as passive investment income which may trigger application of the personal holding company tax. The personal holding company tax is levied at a 20 percent rate on undistributed personal holding company income, and serves as a “penalty tax” in addition to the corporation's income tax that is normally owed.
To be a personal holding company, two tests must be met. The first test is an ownership test, and is satisfied if five or fewer people own more than 50 percent of the corporate stock during the last half of the taxable year. Most farming and ranching operations automatically meet this test, and it was satisfied in the NE case. The second test is an income test and is satisfied if 60 percent or more of the corporation's adjusted gross income (gross receipts reduced by production costs) comes from passive investment sources. Rental income is included in adjusted ordinary gross income unless adjusted rental income is at least 50 percent of adjusted ordinary gross income, and dividends for the taxable year equal or exceed the amount (if any) by which the corporation's non-rent personal holding company income for that year exceeds 10 percent of its ordinary gross income. In other words, if the mixture of rental income and other passive income sources exceed 10 percent and the rental income exceeds 50 percent, the personal holding company tax could be triggered. Thus, farming and ranching corporations engaged predominantly in rental activity may escape application of the personal holding company tax. But if the corporation's non-rent personal holding company income (dividends, interest, royalties and annuities) is substantial, the corporation must make taxable dividend distributions to avoid imposition of the personal holding company tax. Thus, for corporations owning agricultural land that is cash rented out and the corporation's only passive income source is cash rent, there is no personal holding company tax problem. There is not enough detail provided by the NE court to make this determination.
Another possible complication is the accumulated earnings (AE) tax. I.R.C. §531. The AE tax applies only to amounts unreasonably accumulated during the taxable year. Thus, the real issue is the extent to which corporate earnings and profits can accumulate before triggering application of the accumulated earnings tax. All corporations are permitted to accumulate earnings and profits of $250,000 without imposition of the tax except for service corporations (fields of health, law, engineering, architecture, accounting, actuarial science, performing arts and consulting) where the amount is $150,000. The accumulated earnings tax rate for tax years after 2012 is 20 percent. However, not every corporation that exceeds $250,000 (or $150,000) of accumulated earnings and profits will trigger application of the accumulated earnings tax. The tax applies only if a particular corporation has accumulated more than $250,000 (or $150,000) in earnings and profits and the accumulation is beyond the reasonable needs of the business. In the NE case, the corporation was deliberately leaving $50,000 of taxable income to be taxed. If the corporation has a lot of investment assets, the IRS could seemingly make a strong argument that the corporation is subject to the AE tax. In a recent IRS Chief Counsel’s Advice (CCA), the IRS noted that the corporation could be held responsible for the AE tax without any investment assets. I blogged on the CCA and its implications in early January. http://lawprofessors.typepad.com/agriculturallaw/2017/01/c-corporation-penalty-taxes-time-to-dust-off-and-review.html
There are other comments that could be made about the legal issues involving minority shareholder oppression, but today’s post is long enough already. While the corporation and its majority shareholders prevailed in the NE case, care should always be taken by tax professionals when they provide testimony in cases that aren’t purely tax-related. Some things, in that context, probably shouldn’t be commented on.
Wednesday, May 24, 2017
I.R.C. §1402(a) defines net earnings from self-employment as “the gross income derived by an individual from any trade or business carried on by such individual, less deductions allowed by this subtitle which are attributable to such trade or business, plus his distributive share (whether or not distributed) of income or loss from any trade or business carried on by a partnership of which he is a member.”
That seems fairly clear – the business activity must be carried on by and “individual.” If that’s the case, that provides some planning opportunities for farm and ranch businesses (and other businesses too). That’s what today’s post takes a look at, based on a piece that I wrote for the University of Illinois Tax Workbook in recent years. That’s a workbook that is used at tax seminars in many states each fall and is a great resource for your tax library.
Business of a Trust Not Subject to Self-Employment Tax
The regulations provide that a trade or business must be carried on by an individual, either personally or through agents or employees. The regulations further provide “accordingly, income derived from a trade or business carried on by an estate or trust is not included in determining the net earnings from self-employment of the individual beneficiaries of such estate or trust.” Treas. Reg. §1.1402(a)-2(b).
As a result of this statutory and regulatory language, income derived from a business maintained by a trust (or an estate) is not included in determining net earnings from self-employment of the individual beneficiaries. Thus, in situations where a trade or business is carried on by an estate or trust rather than an individual, the income derived from the entity is not includable in determining the self-employment earnings of an individual beneficiary (or executor) unless there is a basis for disregarding the entity for purposes of the Code.
What type of a situation would serve as a basis for disregarding the entity (estate or a trust)? One example would be where the grantor of the trust is also the trust beneficiary. For example, in Huval v. Comr., T.C. Memo. 1985-568, a surviving spouse operated an oil and gas lease in her capacity as executrix of her husband’s estate, rather than in her individual capacity. That meant that the leasing business was conducted by the estate, and the Tax Court held that the lease income was not net earnings from self-employment for the surviving spouse.
What is a Trust?
A “trust” is subject to trust taxation, which means that self-employment tax savings can be achieved. Treas. Reg. §301.7701-4(a) addresses the definition of trusts for purposes of the Code, noting that trusts generally refer to arrangements created by either will or inter vivos declaration for the purpose of either protecting or conserving property for beneficiaries. Where the beneficiaries of the trust are the persons who created the trust, the trust will be recognized under the Code if it was created for the purpose of protecting or conserving trust property for beneficiaries who stand in the same relation to the trust as they would if the trust had been created by others for them. But, a trust that is treated as a grantor trust under the provisions of I.R.C. §§671-679 is treated as owned directly by the grantor. That’s because the grantor retains the control to direct the trust income or assets. Consequently, trust taxation does not apply, and self-employment tax savings will not be achieved.
A “business trust” is not subject to trust taxation, and won’t result in saving self-employment tax. Treas. Reg. §301.7701-4(b) addresses business trusts, describing them as arrangements where legal title to property is conveyed to trustees for the benefit of beneficiaries, but which are not classified as trusts for purposes of the Code because they are not arrangements to protect or conserve property for beneficiaries. These trusts are described as being created by the beneficiaries simply as a device to carry on a profit-making business that normally would have been carried on through business organizations that are classified as corporations or partnerships under the Code.
Let’s take a look at an example. Assume that Bob was a farmer at the time of his death. When he died, his farm assets were placed in a trust created under the terms of his will. Bob’s surviving widow, Brenda, was named as the sole trustee of the trust and the sole beneficiary of a QTIP trust and a credit-shelter bypass trust. Both of these trusts became irrevocable upon Bob’s death. Brenda participated in the operations and the management of the farming activity. Brenda reported the income and the distributions from the trusts on her Form 1040 Schedule E where it was not subject to self-employment tax.
This is the factual setting that the IRS was faced with in Tech. Adv. Memo. 200305001 (Jul. 24, 2002). The IRS determined that the QTIP trust and the credit shelter bypass trust were trusts with a separate existence. Thus, the pass-through income from the trusts was not deemed to be net earnings from self-employment to Brenda. The trusts were not found to be business trusts whose separate existence would be ignored under the Code. However, the IRS noted that there could be an issue of whether the wife, as trustee, received adequate payments for the services she performed for these two trusts, and suggested that a determination be made by the IRS Examination Division as to whether the payments that the wife received were reasonable and of sufficient amount for the services that she provided to these trusts.
Let’s change the facts slightly. Assume that Jack died, and an irrevocable, testamentary trust went into effect as a result. His surviving widow, Mary and their son, Doug, were the trustees and beneficiaries of the trust. The trust paid a fee to Doug for managing the farming operation, and paid a fee to Mary for maintaining the farming records. Doug and his mother reported the fees as self-employment income, but did not report the income received as beneficiaries of the trust as subject to self-employment tax.
These facts were involved in Tech Adv. Memo. 200305002 (Jul. 24, 2002). There, there IRS treated the trust as a separate entity with the result that the earnings were not subject to self-employment tax. The trust was to be separately respected under the Code. But, again, the IRS noted that there could be an issue of whether the wife received adequate payments for her services, and whether the son received reasonable and sufficient payments for his management activities.
These IRS Memos suggest that a trust can insulate the beneficiaries from SE income on an actively conducted farming operation, but only if two conditions are met:
- The trust is created to preserve the property for another party or in a testamentary manner that suggests it is not merely an attempt to move business operations into a trust entity (i.e., it is not a business trust);
- The trustees or other individuals rendering management or other services to the trust are reasonably compensated for their services in a manner that is subject to either FICA or self-employment With respect to the second issue, a testamentary trust can serve in much the same manner as an S corporation, where the issue at hand is the reasonableness of fees or compensation to those owners of the entity that also receive Schedule K-1 income exempt from self-employment tax.
As an additional thought, an individual receiving a distribution from a trust as a beneficiary who is also paid for trade or business services that the individual provides to the trust should be able to document that their compensation is reasonable based on what would have to be paid to a third party for the services.
An active business conducted through a trust can achieve self-employment tax savings. But, proper structuring is critical. As is the case with other estate or business planning techniques, whether to use a trust to achieve self-employment tax savings is to be considered in light of a host of planning considerations, both tax and non-tax.
Monday, May 22, 2017
Meals and lodging furnished in-kind to an employee (including the employee’s spouse and children) for the convenience of the employer on the employer’s business premises are excluded from the employee’s gross income. I.R.C. §119. They are also deductible by the employer (as a non-cash fringe benefit) if they are provided in-kind. I.R.C. §162.
The IRS, at least in certain parts of the country, appears to have an audit program that examines farm and ranch corporations on the meals and lodging issue. In light of that, today’s post takes a look at the basic rules and what might cause concern for the IRS.
In general. For the value of lodging to be excluded, the employer must furnish the lodging to the employee and the employee must be required to accept the lodging on the premises as a condition of employment and for the convenience of the employer. I.R.C. §119(a)(2). The term “lodging” includes such items as heat, electricity, gas, water and sewer service unless the employee contracts for the utilities directly from the supplier. Rev. Rul. 68-579, 1968-2 C.B. 61. The term also includes household furnishings and telephone services. See, e.g., Turner v. Comr., 68 T.C. 48 (1977); Hatt v. Comr., T.C. Memo. 1969-229. However, if the employee is required to pay for the utilities without reimbursement from the employer, the utilities are not furnished by the employer and are not excludible from income. Turner v. Comr., 68 T.C. 48 (1977). Also, the lodging must be provided “in-kind.” Cash allowances for lodging (and meals) are includible in gross income to the extent the allowance constitutes compensation.
As a condition of employment. The employee must accept the employer-provided lodging as a condition of employment. That can only occur if the employee’s acceptance of the lodging is necessary for the employee to property perform their job duties. Thus, it makes no difference if the employee is required to accept the employer-provided lodging. The key is whether the employer provided lodging is necessary for the performance of the employee’s duties. Thus, the standard is an objective one and it is immaterial, for example, that corporate documents (such as a board resolution) require the employee to live in corporate-provided lodging. See, e.g., Peterson v. Comr., T.C. Memo. 1966-196; Winchell v. United States, 564 F. Supp. 131 (D. Neb. 1983).
Convenience of the employer. With respect to employer-provided lodging, the “convenience of the employer test” is basically the same as the requirement that the lodging be provided as a condition of employment. Thus, if the lodging meets the test as being provided as a condition of employment it will also be deemed to be provided for the convenience of the employer. For example, in MaschMeyer’s Nursery, Inc. v. Comr., T.C. Memo. 1996-78, the petitioner, an agricultural nursery, provided its sole shareholder a residence at the nursery. The petitioner claimed that the shareholder’s presence was necessary on a full-time basis as a security measure for the equipment, oversee employees and handle shipments that came in after normal business hours. The Tax Court held that the provision of the lodging met the requirements of I.R.C. §119.
On the business premises. To be excluded from income, meals must be furnished “on the business premises” of the employer. §119(a)(1). For lodging, the employees must be required to accept the “lodging on the business premises of his employer.” Thus, both meals and lodging must be provided on the business premises. The regulations specify that “business premises of the employer” generally means the place of employment of the employee. Treas. Reg. §1.119-1(c). It doesn’t necessarily matter if the lodging is not physically contiguous to the actual business premises if the employee conducts significant business activities in the residence. See, e.g., Faneuil v. United States, 585 F.2d 1060 (Fed. Cl. 1978). In addition, it is immaterial whether the meals and lodging are provided on premises that the corporation leases rather than owns. On this point, the regulations state, “For example, meals and lodging furnished in the employer’s home to a domestic servant would constitute meals and lodging furnished on the business premises of the employer. Similarly, meals furnished to cowhands while herding their employer’s cattle on leased land is regarded as being furnished on the business premises of the employer.” Regs. §1.119-1(c)(1).
As noted above, whether the employer actually owns the property where the lodging (and meals) is provided is irrelevant. The key is that the lodging (and meals) is provided on the business premises, and ownership has no bearing on that determination.
For additional caselaw on the “business premises” issue, see the following:
- Dole Comr., 43 T.C. 697 (1965), aff’d., 351 F.2d 308 (1st Cir. 1965).
- Comr. v. Anderson, 371 F.2d 59 (6th Cir. 1966), rev’g, 42 T.C. 410 (1964).
- McDonald v. , 66 T.C. 223 (1976).
- Boykin v. , 268 F.2d 249 (8th Cir. 1958)
- Lindeman v. Comr., 60 T.C. 609 (1973)
- Benninghoff v. Comr., 614 F.2d 398 (5th Cir. 1980)
In most of the farm and ranch cases decided to date, whether the meals and lodging were provided “on the business premises” has not been an issue, but there are a few cases where it has been an issue. The following cases illustrate the application in farm/ranch settings:
- Peterson v. , T.C. Memo. 1966-196.
- Wilhelm United States, 257 F. Supp. 16 (D. Wyo. 1966).
- Caratan Comr., 442 F.2d 606 (9th Cir. 1971).
- Grant Farms, Inc. v. Comr., T.C. Memo 1985-174
- Johnson Comr., T.C. Memo 1985-17
- Dilts v. Comr., 845 F. Supp. 1505 (D. Wyo. 1994).
- Waterfall Farms, v. Comr., T.C. Memo 2003-327
Exclusion of Employer-Provided Meals
On the business premises. To be excluded from an employee’s income, the meals must be furnished on the employer’s business premises. The “business premises” is the employee’s place of employment where the employee performs a significant portion of his duties or the employer conducts a significant portion of its business. Treas. Reg. §1.119-1(c)(1); Rev. Rul. 71-411, 1971-2 CB 103. Thus, the meals cannot be furnished at someplace that is merely near the place of employment or where significant duties are performed, but is a convenient place to provide the meals.
For the employer’s convenience. The meals must also be provided for the convenience of the employer. If they are not, the value of the meals is subject to FICA and FUTA taxes. Rev. Rul. 81-222,1981-2 C.B. 205. The key is that the meals (or lodging) must not be intended as compensation. On this point, an employment contract that fixes the terms of employment isn’t controlling, by itself. The same is true for a state statute. In essence, why an employer provides meals and lodging to employees is based on objective facts and not on stated intentions. There must be some reasonable connection between providing employees with meals and lodging and the business interests of the employer.
Example: FarmCo operates on property that it leases from its shareholders/officers. Farmco requires the corporate officers to be on the farm premises at all times to monitor activities and deal with issues as they come up. Farmco reimburses the shareholders’ grocery expenses. In addition, the shareholders’ residence was on the farm and groceries were cooked in the shareholders’ home.
This type of arrangement is problematic because IRS can make a decent argument that it appears to be for the employees’ convenience rather than that of the employer. Also, it’s a problem if other employees aren’t similarly treated and the reimbursement isn’t necessary to unexpected corporate issues. Also, a question can be raised as to whether the lease covers the residence on the property. See, e.g., Dobbe v. Comr., T.C. Memo. 2000-330. If it does, it’s best to have a written lease detailing the amount of rent the corporation is to pay and detailing the corporation’s access right to the residence.
Allowances? Cash meal allowances or reimbursements are includible in gross income to the extent the allowance constitutes compensation. Likewise, meal allowances provided on a routine basis for overtime work are not “occasional meal money” for purposes of the de minimis rules, and are treated as wages for FICA, and withholding purposes (and presumably for FUTA as well).
What are “meals”? As to what can count as “meals,” the U.S. Court of Appeals for the Third Circuit, in a case involving employer-provided housing that met the test for excludability (discussed later), held that the cost of groceries (including such things as napkins, toilet tissue and soap) were excludible from the employees’ income. Jacob v. United States, 493 F.2d 1294 (3d Cir. 1974). The court reached this conclusion because the employee was required to live on the business premises as a condition of employment.
However, the U.S. Tax Court (and, on appeal, the Ninth Circuit) has reached a different conclusion. See Tougher v. Comr., 51 T.C. 737 (1969). Tougher involved an employee (taxpayer) of the Federal Aviation Agency (FAA) that was stationed on a remote island in the Pacific with only a handful of people and very few places to eat. As a result, the taxpayer bought groceries from the FAA commissary and used them to prepare meals at his home. The Tax Court determined that the groceries did not meet the definition of “meals” under I.R.C. §119. The Tax Court’s decision was affirmed on appeal. As a result, the IRS does not follow the Third Circuit’s opinion outside of the Third Circuit, and takes the position in those jurisdictions that the value of such items is wages for FICA purposes.
The Tax Court got another chance to deal with the “groceries as meals” issue in a 1973 case. In Harrison v. Comr., T.C. Memo. 19810-211, two farm families incorporated a farming operation. They lived on the farm and were also corporate employees. The corporation purchased groceries that the farm wives used to prepare meals for all of the family members and hired help. The Tax Court, finding that the groceries counted as “meals” for purposes of I.R.C. §119, determined that the wives had a duty as employees of the corporation to buy the groceries and prepare meals that were then provided to all of the corporate employees. Construed in that light, the groceries were “meals.”
As an additional note, meals provided without lodging can also qualify under I.R.C. §119 if they are consumed on the business premises. Thus, meals provided to farm employees in the field during harvesting and planting would be covered. But, if the employees take a break and drive to town to eat meals, the cost would not be deductible.
Treatment of meals as a fringe benefit. If more than one-half of the employees to whom meals are provided on an employer’s premises are provided for the convenience of the employer, then all of the meals are treated as furnished for the employer’s convenience. I.R.C. §119(b)(4). If that test is met, the value of all meals is excludible from the employee’s income and is deductible by the employer.
Employee option. If employees have the option of not purchasing meals provided by the employer at a cost, the IRS has taken the position that the excess of fair market value over the price of the meals is taxable income to the employees. Priv. Ltr. Rul. 7740010 (Jun. 30. 1977).
What About Partnerships?
Generally, a partner is treated as a self-employed owner of the business rather than an employee. So, by its terms, I.R.C. 119 does not apply. However, it can apply when a partner transacts with the partnership in a non-partner capacity. I.R.C. §707(a). The regulations say that this could occur in “the rendering of services by the partnership to the partner or by the partner to the partnership. Treas. Reg. §1.707-1(a). A key case supporting the application of I.R.C. §119 in the context of a partnership is Armstrong v. Phinney, 394 F.2d 661 (5th Cir. 1968). See also Papineau v. Comr., 16 T.C. 130 (1951), non-acq., 1952-2 C.B. 5; but see, Comr. v. Doak, 234 F.2d 704 (4th Cir. 1956); Moran v. Comr., 236 F.2d 595 (8th Cir. 1956); Comr. v. Robinson, 273 F.2d 503 (3d Cir. 1959), cert. den., 363 U.S. 810 (1960). In a case involving a ranch partnership, the managing partner had to include amounts received from the partnership for meal reimbursements in gross income. Wilson v. United States, 376 F.2d 280 (Ct. Cl. 1967).
Relatedly, an S corporation is not a “corporation” for purposes of I.R.C. §119. Dilts v. Comr., 845 F. Supp. 1505 (D. Wyo. 1994).
Employer-provided meals and lodging is an important fringe benefit that corporations can provide for their employees. But, it is important to properly structure such arrangements within the confines of the guidelines set forth by the IRS and the courts.
Thursday, May 18, 2017
Last month, U.S. Tax Court Judge Elizabeth Paris spent at day at Washburn Law School at my invitation. I have known Judge Paris for over 20 years, and it was a delight to see her again and spend the day with her. She had five events during the day, including an open session for the students and a continuing education event for lawyers and other tax professionals. During these two sessions, Judge Paris provided great insight into client representation in tax matters, and handling a tax case through the process all the way through to the Tax Court.
Today, I would like to share the insights of Judge Paris based on my notes of her discussions. I believe that those of you who represent clients in tax matters will find this very helpful. Even if you don’t represent clients in tax matters, I trust that you will find this information useful.
Judge Paris made the point that many areas of the tax law are neither black or white, but many different shades of grey. The complexity of the Code and regulations fosters this, and the outcome of cases that end up before the Tax Court are often heavily fact-dependent. In addition, the IRS not infrequently takes a position on an issue that is questionable or is contrary to existing caselaw. That is a frustrating aspect of tax practice. No taxpayer wants to have correspondence from the IRS, and a goal of many practitioners is to ensure that a position taken on a return will not generate any interest from the IRS. But, when a taxpayer does get a Notice from the IRS that asserts a deficiency, Judge Paris pointed out that procedure is very important.
Audits and Responding to An IRS Notice
Most IRS audits are not in-person. Instead, they are commonly done via correspondence. Often, the initial contact will involve the IRS seeking additional information from the taxpayer to clarify something on the return. Alternatively, if the taxpayer agrees with the additional tax asserted, the option exists to sign the form and mail it back. If the amount in issue is small, it may be best to pay the additional amount and get the matter closed instead of risking opening up other areas on the return for inspection. On the other hand, if the taxpayer doesn’t respond to the IRS correspondence, the next item received might be an Examination Report. This is commonly known as a “30-day” letter. The taxpayer has 30 days to respond with a “protest” letter that explains the taxpayer’s position. The IRS may agree and close the matter, but usually it rejects the taxpayer’s explanation and transfers the matter to the IRS Office of Appeals.
Unfortunately, it is not uncommon for the reasons given for the IRS rejection to not match-up with the reasons the taxpayer provided. That’s where things, hopefully, can get straightened out at Appeals. When I was in full-time practice, my experience with the IRS Appeals Office (out of Omaha at that time) was good. You actually got to sit down with a person well-versed in tax law that had lots of experience in handling complicated tax matters – even agricultural tax matters. Unfortunately, the IRS has put in place a new procedure that eliminates the possibility of a face-to-face meeting with an IRS Appeals Officer. There is no longer a right to an in-person appeal. Instead, what the taxpayer (and their representative) is left with is dealing with an “appeals tax specialist.” From conversations that I have had with practitioners, what I hear is that these persons lack the training and experience of the persons I dealt with years ago in Omaha.
If the matter is not resolved at Appeals (or the taxpayer doesn’t respond to the 30-day letter) the IRS will issue a Notice of Deficiency. This is also known as a “statutory notice of deficiency” or SNOD. It may also be referred to as a “90-day letter.” It’s a legal notice informing the taxpayer that receives it that the IRS has determined there to be a deficiency associated with the tax return. The IRS must issue the SNOD before it can assess additional income, estate, gift or certain excise taxes unless the taxpayer agrees to the additional assessment. I.R.C. §§6212; 6213. The SNOD is a legal determination, and it is presumed to be correct. It will show how the deficiency was computed and will inform the taxpayer of the right to petition the Tax Court to dispute what the IRS is proposing as an adjustment to the tax liability in the SNOD. The taxpayer has 90 days to respond, and that response is filing a petition in the U.S. Tax Court or paying the additional tax asserted and filing a refund suit in the federal district court.
U.S. Tax Court
As Judge Paris pointed out, a case before the Tax Court could be tried under simplified procedures if the taxpayer chooses to not be represented by counsel and the amount in controversy is less than $50,000. For these cases, the Tax Court will issue an “S” opinion which cannot be appealed to the applicable U.S. Circuit Court of Appeals and cannot be cited as precedence by other taxpayers. In other cases (those not qualifying for “S” status), the Tax Court will issue either a Memorandum opinion or a “Full” opinion if the case involves an issue that the court has not squarely addressed before.
Judge Paris noted that while the Tax Court building itself is in Washington, D.C., and that is where the law clerks are located, the judges (19 of them) travel around the country to federal courthouses to conduct trials. She discussed where cases can be heard and the application of state law to many of the Tax Court’s decisions. She also pointed out that the Tax Court’s procedural and evidentiary rules are streamlined. There is no jury. The case is tried directly to the judges. The taxpayer can call witnesses, and often many issues are stipulated to with the IRS before they are presented to the court.
When the Tax Court issues an opinion, that opinion (unless it is an “S” opinion) can be appealed to the Circuit Court of Appeals where the case arose from. One of the questions that Judge Paris received involved the IRS practice of issuing an “Action on Decision” indicating that it will not follow the Tax Court’s decision (in those cases where the Tax Court has ruled against the IRS) in subsequent cases. This is known as a “non-acquiescence.” For those of us that deal with ag tax cases, this is the technique that the IRS utilized in the Morehouse CRP litigation where it won in the Tax Court and then lost in the Eighth Circuit Court of Appeals. The IRS “non-acquiesced” to the Eighth Circuit’s opinion. IRS can also issue a “non-acquiescence” to a Tax Court opinion and continue to litigate the matter to a different Circuit in hopes of a different result. While Judge Paris acknowledged the frustration to taxpayers and tax practitioners of an administrative agency such as the IRS taking such a position, she noted that it is within the IRS’ province to do so.
Judge Paris also noted that an alternative to going the Tax Court route is for the taxpayer to pay the asserted deficiency and file a refund suit in the federal district court. But, she noted that many cases may not merit that approach because of the amount involved.
The “jurist in residence” day at Washburn Law School for Judge Paris was a great day for the students and the faculty. It’s not every day that we get to “rub shoulders” with a sitting U.S. Tax Court Judge. Judge Paris also made presentations in two different classes during her day at the law school, giving the students direct access to her. It helps put a practical application to the concepts that the students are learning in class and will make them better lawyers once they finish law school. After all, that’s what it’s all about.
Tuesday, May 16, 2017
This coming July 13-14 the Washburn University School of Law in conjunction with the Kansas State University, Department of Agricultural Economics and the Wyoming Society of CPAs are co-sponsoring a two-day CLE/CPE conference on agricultural tax and estate and business planning at Sheridan College in Sheridan, Wyoming. The event will also be streamed live over the internet. If you represent agricultural clients in the handling of tax work or the preparation of estate and business plans, this conference will be tailor-made for you. The presenters will be myself and Paul Neiffer of CliftonLarsonAllen. Paul and I have worked together for several years and it will be a joy to do join forces again in Sheridan.
Day 1 – Farm and Ranch Tax Day
Thursday, July 13, will be devoted to agricultural tax-related topics. We will start the day with an overview of recent developments in ag taxation. While it appears doubtful at this time that there will be any significant tax legislation to discuss in July, there have been many key court developments and IRS rulings impacting agriculture that will be covered. We will also have sessions on this day concerning farm income averaging, financial distress and income tax deferral opportunities for ag clients. During the afternoon session, we will take a deep look at the continued IRS attack on the cash method of accounting, including analysis of the recently decided Agro-Jal Farms case from California and the Estate of Backemeyer case from Nebraska. We will also provide an update on the capitalization/repair regulations, and go over in some detail various tax planning strategies for farmers and ranchers. To round out the day will be coverage of numerous miscellaneous ag tax topics.
Day 2 – Farm and Ranch Estate and Business Planning
On Friday, July 14, we will focus on estate and business planning issues for farm and ranch clients. Any legislative developments will be covered along with their impact on the planning process, as will recent case and rulings. We will also cover the use of charitable trusts, and the present planning landscape in light of higher exemptions and portability. Also addressed on Friday will be FSA planning and tax issues associated with the sale of a decedent’s residence. The afternoon session will focus on how the business structure can impact self-employment tax liability, long-term care planning strategies, profits interests and portability planning.
As noted above the two-day session will be webcast. Glen McBeth, Instructional Technology at Washburn Law School, will be handling the webcasting. You will be able to see and hear both myself and Paul and interact with us if you wish.
There are plenty of things to see and do in the Sheridan area if you are attending the conference in person. Sheridan is just east of the Bighorn Mountains and there are plenty of things to see and do. The 87th Annual PRCA Sheridan Rodeo will be on while we are there. It starts on July 12 and goes through the 15th. Paul and I are planning a fishing event for Saturday the 15th. If, you would like to join us, please let us know so that we can plan accordingly.
We certainly hope that you will join us in Sheridan. If you can’t join in person, you can join via the web. Either way, the conference will be a great opportunity for you to pick up concepts that you can use with your clients.
You can learn more about the conference and register here: http://washburnlaw.edu/employers/cle/farmandranchincometax.html
Friday, May 12, 2017
Generally, an exchange of property for other property is treated as a sale with gain or loss being recognized on the transaction. I.R.C. §§61(a)(3); 1001. However, no gain or loss is recognized if property held for productive use in a trade or business or for investment is exchanged for property of a like-kind to be held either for productive use in a business or for investment. I.R.C. §1031. Federal and state income tax is not avoided, it is simply deferred until the replacement property is sold (except that gain is immediately recognized to the extent of any boot or unlike property received in the exchange). The rationale is that the replacement property is viewed as causing no material change in the taxpayer’s economic position. It’s just a continuation of the original property.
Like-kind exchanges are popular in agriculture for various reasons. Those reasons can include the facilitation of an estate or business plan, Medicaid asset preservation planning, or simply for tax deferral reasons. Sometimes an exchange is straightforward as a direct, two-party exchange. Other times it is a “deferred” exchange or a “reverse” exchange. When an exchange is other than a direct, two-party exchange, special rules must be followed. Several years ago, the IRS established a “safe harbor” for such exchanges, but recently the U.S. Tax Court said that a transaction that wasn’t within the confines of the safe harbor still qualified for tax deferral.
The implications of the Tax Court decision on deferred or like-kind exchanges is our focus today.
Like-Kind Exchange Details
With respect to the trade of tangible personal property, such as farm machinery, the Treasury Regulations determine if property is like-kind by reference to being within the same product class. Also, property is of a like-kind to property that is of the same nature or character. Like-kind property does not necessarily have to be of the same grade or quality. In addition, for intangible assets, the determination of like-kind must be made on an asset-by-asset basis. Thus, a like-kind trade can involve a bull for a bull, a combine for a combine, but not a combine for a sports car or a farm or ranch for publicly traded stock.
With respect to real estate, a much broader definition of like-kind applies. Virtually any real estate used for business or investment can be exchanged for any other real estate if the exchanger continues to use the replacement property for business or investment. Even water rights, if they are not limited in duration, can be like-kind to a fee interest in land. See, e.g., Priv. Ltr. Rul. 200404044 (Oct. 23, 2003). Thus, agricultural real estate may be traded for residential real estate. See also Treas. Reg. §1.1031(a)-(1)(c). However, if bare farmland is traded for farmland with depreciable structures on it, tax issues can arise. Many farm depreciable buildings and structures are I.R.C. §1245 property. For example, commodity storage facilities and single-purpose agricultural structures are I.R.C. §1245 property, as are irrigation systems, drainage tile, and other improvements to farm real estate. If property with an I.R.C. §1245 depreciation recapture attribute is disposed of in an I.R.C. §1031 exchange, the I.R.C. §1245 depreciation recapture must be recognized to the extent that the replacement property has insufficient I.R.C. §1245 property. IRS Form 8824 provides a location for reporting the I.R.C. §1245 depreciation recapture if non-I.R.C. §1245 property is received in exchange.
Deferred exchanges. An exchange may qualify for the like-kind exchange treatment even if the replacement property is received after the relinquished property has been given up. I.R.C. §1031(a)(3) and Treas. Reg. §1.1031(k)-1. This is known as a deferred exchange, and a qualified intermediary (Q.I.) is to be used to facilitate the exchange. The Q.I. is a party unrelated to the taxpayer that, pursuant to a written agreement with the taxpayer, holds the proceeds from the sale of the relinquished property in trust or an escrow account. The Q.I. takes title to the property that is sold (the relinquished property) and receives the sales proceeds. This is done to ensure that the taxpayer is not in constructive receipt of the sale proceeds.
After the relinquished property is transferred, replacement property must be identified within 45 days after the date of the transfer of the relinquished property, and the replacement property must be received before the earlier of 180 days or the due date of the income tax return, including extensions, for the tax year in which the relinquished property is transferred. Treas. Reg. §1.1031(k)-1(b).
Reverse exchanges. With a reverse exchange, the taxpayer receives the replacement property before the transfer of the relinquished property. Often, a reverse exchange is facilitated by a “parking” transaction or a “build-to-suit” transaction where the replacement property is “parked” with an exchange facilitator that holds title to the replacement property, usually until improvements to the property are completed.
Safe Harbor. While the Code doesn’t address reverse exchanges and regulations haven’t been developed to provide guidance, the IRS did issue a safe harbor in 2000 for such transactions. Rev. Proc. 2000-37, 2000-2, C.B. 308. Under the safe harbor, the Q.I. must hold the property for the taxpayer’s benefit and be treated as the beneficial owner for federal tax purposes. In addition, for the safe harbor to apply, the IRS said that the 45-day and 180-day requirements must be met. The IRS made no comment on the tax treatment of “parking” transactions that don’t satisfy the safe harbor. But, a major difference between the safe harbor and the Treasury Regulations governing deferred exchanges is that, under the safe harbor, the Q.I. must take title and beneficial ownership of the replacement property. In a deferred exchange, the Q.I. only need “facilitate” the exchange. That doesn’t require taking legal title. Later, in 2004, the IRS tightened the safe harbor so that it didn’t apply to taxpayers who acquire replacement property that the taxpayer or a related party owned before the exchange. Rev. Proc. 2004-51, 2004-2, C.B. 294.
Clearly, with Rev. Proc. 2004-51, the IRS didn’t want taxpayers to use reverse exchanges to reinvest proceeds from the sale of one property into improvements to other real estate that the taxpayer had previously owned. For example, assume that a farmer owns a tract of land that is not in close proximity to his primary farming operation and has become inconvenient to operate. Thus, the farmer wants to sell the tract and use the proceeds to build a livestock facility on other land that he owns that is adjacent to his farming operation. In an attempt to structure the transaction in a manner to qualify as a tax-deferred exchange, the farmer transfers title to the land where the livestock facility will be built to a Q.I. The farmer provides the financing and the Q.I. has the livestock facility built. The farmer then transfers the tract that he desires to dispose of to the Q.I. and the Q.I. sells it and uses the sale proceeds to retire the debt on the livestock facility. Because the farmer owned the land on which the livestock facility was built before the exchange occurred, Rev. Proc. 2004-51 would operate to bar the transaction from tax-deferred treatment.
In Estate of Bartell v. Comr., 147 T.C. No. 5 (2016), a taxpayer (a drugstore chain) sought a new drugstore while it was still operating an existing drugstore that it owned. The taxpayer identified the location where the new store was to be built, and assigned its rights to the purchase contract in the property to a Q.I. in April of 2000. The taxpayer then entered into a second agreement with the Q.I. that provided that the Q.I. would buy the property, with the taxpayer having the right to buy the property from the Q.I. for a stated period and price. The taxpayer, in June of 2001, leased the tract from the Q.I. until it disposed of the existing drugstore in September of 2001. The taxpayer then used the proceeds of the existing drugstore to buy the new store from the intermediary, with the transaction closing in December of 2001. Because the new store was acquired before the existing store was disposed of, it met the definition of a reverse exchange. However, the safe harbor did not apply because the exchange was undertaken before the safe harbor became effective. If the safe harbor had applied, the transaction would not have been within it because the Q.I. held title for much longer than 180 days. Despite that, the IRS nixed the tax deferral of the exchange because it viewed the taxpayer as having, in substance, already acquired the replacement property. In other words, it was the taxpayer rather than the Q.I. that held the burdens and benefits of ownership before the transfer which negated income tax deferral. An exchange with oneself is not permissible. As a result, eliminated was the deferral of about $2.8 million of gain realized on the transaction in 2001.
The Tax Court noted that existing caselaw did not require the Q.I. to acquire the benefits and burdens of ownership as long as the Q.I. took title to the replacement property before the exchange. The Tax Court noted that it was important that the third-party facilitator was used from the outset. While the safe harbor didn’t apply to the transaction, the Tax Court noted that 45 and 180-day periods begin to run on “the date on which the taxpayer transfers the property relinquished in the exchange,” and that the taxpayer satisfied them. The Tax Court also noted that caselaw does not impose any specific time limits, and supported a taxpayer’s pre-exchange control and financing of the construction of improvements on the replacement property during the time a Q.I. holds title to it. The taxpayer’s temporary possession of the replacement property via the lease, the court reasoned, should produce the same result.
What impact does the court’s decision have on the safe harbor? For starters, even though the safe harbor didn’t apply in the case, the court’s decision certainly illustrates that the safe harbor only applies with respect to reverse exchanges. Another point is that because the facts of the case involved pre-2004 years, the Tax Court did not need to address Rev. Proc. 2004-51 and how the IRS tightened the screws on the safe harbor at that time. That means that Estate of Bartell probably shouldn’t be relied too heavily upon and a reverse exchange transaction should be structured to come within the safe harbor, as modified by Rev. Proc. 2004-51. But, the safe harbor is just that – a safe harbor.
Wednesday, May 10, 2017
In general, the law only punishes those individuals who have the capacity to make a moral choice of whether to engage in the prohibited behavior. Consequently, insane persons who commit crimes are generally believed to lack the moral fault necessary for punishment. Similarly, persons below a certain age are deemed to lack the full capacity for criminal liability and are typically liable only as juvenile delinquents. Likewise, those who commit crimes while voluntarily intoxicated are liable for their behavior, though sometimes at a lesser level.
Sometimes, however, conduct that would otherwise constitute a crime is not because it is deemed necessary. That’s an issue that sometimes arises in agriculture.
Necessity - Defined
The Model Penal Code (MPC) states that conduct that is believed to be necessary to avoid a harm or evil to oneself or to another is justifiable, provided that the harm or evil sought to be avoided is greater than that sought to be prevented by the law defining the offense charged, and the law does not provide another exception or defense. Under a necessity defense, for example, property may be destroyed to prevent the spread of a fire or a speed limit may be violated in pursuing a suspected criminal.
In 1884, in a case brought before the Queen's Bench in England, the court completely rejected the necessity defense. R. v. Dudley & Stephens, 15 Cox Crim. Cas. 624 (QB 1884). The defendants, while adrift on a lifeboat about 1,000 miles from land, killed a weak and sick boy, and fed upon his body to avoid their own death by starvation. The Queen's Bench found that this act constituted willful murder and sentenced the defendants to death, the only penalty then available for murder. Later, the Crown commuted the sentence to six-months imprisonment. In the United States, however, the approach of the English court has been rejected.
In a prominent Wyoming Supreme Court decision in 1962 (Cross v. State, 370 P.2d 371 (Wyo. 1962)), the court found the defendant not guilty of illegally shooting game animals in defense of his property due to the constitutional guarantee that one cannot be deprived of property without due process of law. Under the facts of the case, a rancher was charged on six counts for various acts associated with shooting two moose in violation of Wyoming law. He plead not guilty, but the jury found him guilty on all of the charges. The problem stemmed from a large herd of wild game in a nearby refuge that followed natural water courses and creek bottoms in the winter time in search of food that caused them to ultimately gather on the defendant’s ranch. The wild game, including a large herd of moose, did serious and substantial damage to the defendant’s ranch by consuming pasture and other forage that was for the defendant’s livestock. The wild game also prevented the production of hay and other natural grasses on the defendant’s ranch, as well as destroying fences. Overall, the defendant’s ranching operations were substantially interrupted.
Because of these problems, the defendant sought help from the Wyoming State Game and Fish Department, and ultimately ended up in litigation designed to induce the Department to enforce sufficient controls to protect his ranch and residents in the area. The Department and the defendant took various measures to keep the moose away, but to no avail. The two moose at issue were in feeding in the defendant’s meadow and he tried to “spook” them away. One of them ran into his fence and got entangled in the wire. When the moose tried to free itself, it instead tore down a considerable amount of good fence. The defendant shot the moose to protect his property from further destruction.
After being charged, the defendant plead that he was justified in protecting his private property. While the trial court disagreed with the defendant, the Wyoming Supreme Court reversed and dismissed the complaint. The state claimed that the defendant had violated the state’s game law. However, the Wyoming Supreme Court noted that the power of the state cannot conflict with constitutional provisions. Framed that way, the issue was whether the state could bar the defendant from protecting his property from the depredations of wild animals. The court determined that the defendant should not be penalized because the killing of the moose was reasonable necessary (based on the facts) for the protection of his private property. The court did emphasize that before force can be taken to protect one’s property from wild animals that are protected by law, a person must use every available before killing the animals. Then, the property owner can use only such force as is reasonably necessary and suitable to protect the private property and that force must be what a reasonably prudent person would use under the circumstances.
Defending Property – Generally
In certain parts of the United States damage to crops, poultry and livestock by wildlife is a significant concern. All states have criminal statutes that prohibit the taking of protected wildlife out of season and without a license. However, a broader question is whether such a statute violates a state Constitutional provision vesting state citizens with certain inalienable rights – including the right to protect one’s property. For instance, the Iowa Constitution provides that, "All men and women are, by nature, free and equal, and have certain inalienable rights among which are those of enjoying and defending life and liberty, acquiring, possessing and protecting property, and pursuing and obtaining safety and happiness.” Iowa Const. art. I, §1.
The Constitutional defense of property provisions most often make a difference in cases where the defendant claims a right to kill wild animals to protect property. Courts considering these cases have read the right to protect property as a judicially enforceable constitutional right that trumps state statutes and regulations. The longest line of such cases comes from Pennsylvania, where, from 1917 to 2000, the courts held that the constitutional right to protect property entitles landowners and their agents to kill wild animals that are threatening the landowner's crops, and that it is unconstitutional for state game laws barring the killing of wild animals to be applied in such situations. Courts from Iowa, Kentucky, Montana, New Hampshire, and Ohio have taken the same view. Courts from Alabama, South Carolina, Washington, and Wyoming have taken this view even though the respective state constitutions do not have an express provision for the protection of property.
In a 1997 Ohio case, State v. Troyer, No. 97CA0015, 1997 Ohio App. LEXIS 5207 (Ohio Ct. App. Nov. 19, 1997), the defendant’s primary source of income was from the raising of exotic and domestic birds on his farm. To combat the threat from great horned owls preying on his birds, the defendant erected traps at various locations on the farm near where his birds were located. He was charged and convicted of violating a state statute which provided that “…hawks or owls causing damage to domestic animals or fowl may be killed by the owner of the domestic animal or fowl while such damage is occurring.” The State claimed that the defendant was attempting to take or kill an owl at a time when damage to his property was not occurring. The defendant claimed that waiting until an owl had actually caught one of his birds in its beak would be too late to prevent damage to his property. On appeal, his conviction was reversed on the basis that the statute unconstitutionally abridged the defendant’s right to protect his property. The court noted that the statute should be construed in such a manner to allow the defendant to use such force as is reasonably necessary to protect his property from predatory owls.
Under the MPC, the necessity defense is limited to those situations where the harm or evil sought to be avoided is greater than that sought to be prevented by the law defining the offense charged, and a legislative purpose to exclude the justification claimed does not plainly appear. MPC §3.02
It is certainly frustrating for farmers, ranchers and rural landowners to have property damaged or destroyed by wildlife. If the wildlife are protected game under state law, it’s important to know your rights before taking action to remedy the situation.
Monday, May 8, 2017
Most assets are valued at fair market value as of the date of the decedent’s death. The IRS defines fair market value as the price at which a willing buyer and a willing seller would exchange the property, neither being under any compulsion to buy or sell and each having full knowledge of all relevant facts. Treas. Reg. § 20.2031-1(b). For stored grain, for example, fair market value is what the elevator would pay. For feed on hand at death, selling price is an appropriate measure of fair market value.
A major exception to the general valuation rule is special use valuation. I.R.C. §2032A. The provision contains many complex rules, and the proper type of lease arrangement is a significant issue for many estates seeking to qualify to make a special use valuation election or avoid having to refund the taxes saved by the valuing farm or ranch real estate at the lower use value amount.
Cash leases and special use valuation is today’s topic.
Special Use Valuation
The only major exception to the willing buyer/willing seller test is special use valuation of land used in a farming or ranching business. I.R.C. § 2032A. Special use valuation allows the executor of an estate to make an election on the estate’s return to elect to value real property devoted to farming or ranching (or other closely-held businesses) at its special use or “use” value rather than its fair market value. This valuation provision, however, cannot reduce the gross estate by more than $1,120,000 (for 2017). Consequently, special use valuation has the potential to be an enormous federal estate tax saver for agricultural estates and can easily trim more than $100,000 off the federal estate tax bill with the right set of facts. Theoretically, the maximum saving could be $448,000 (40 percent of $1,120,000) in 2017, but savings of that magnitude are unusual.
The idea behind the provision is to make it easier for a family farming or ranching business to continue in operation without losing some of the land and other assets to pay the federal estate tax bill. That was a particular concern when the exemption from federal estate tax was much lower than it is today, but with the increase in land values in recent years (with some pullback in recent months) special use is still important. It also is useful for farming operations that are experiencing upward price pressure on land values due to the potential for commercial/residential development, but where the family wants to continue farming.
A special use valuation election requires a lot of work for the practitioner. Not only does a great deal of data have to be acquired in determining the special use value of the decedent’s land, a decision has to be made on how much of the land to make the election on, and each pre-death requirement must be satisfied so that the election can be made. In addition, there are numerous post-death requirements that must be satisfied for 10 years after the date of death. Those rules are in place to ensure that the provision is limited in use to those that are truly farmers, and to make sure that the land continues to be farmed by the decedent’s family for at least 10 year after the decedent dies.
Cash leasing. There are special rules that apply to leases. This is a big issue for estates where the special use valuation election is being considered to be utilized or has been made. In the pre-death qualification period, cash renting to a member of the family or family-owned entity is permissible. Treas. Reg. §20.2032A-3. However, the land must not be cash rented to anyone else. In the post-death period the rule is different.
Specifically, there can be no cash renting in the post-death period, with three exceptions: (1) a surviving spouse can cash rent to members of the surviving spouse’s family (I.R.C. §2032A(c)(7)(E)); (2) cash renting is permissible during a two-year grace period which extends for two years after the date of death; and (3) a lineal descendant of the decedent can rent the land on a “net cash basis” to a member of the lineal descendant’s family. If the post-death bar on cash leasing (outside of the exceptions) is violated, then the tax saved by making the election must be paid back, with interest. This is known as “recapture.”
So, if the land isn’t leased to a family member pre-death, can the estate make the special use election? What type of lease qualifies post-death? If the decedent was an active farmer at the time of death, then there is no problem. If the decedent was a landlord, the rules require the decedent to have borne the risk of production and risk of price change for a set period of time before death if the lease isn’t to a family member. That means a crop-share/livestock share lease that subjects the landlord’s share to self-employment tax. Post-death, each qualified heir must have an equity interest in the operation. I.R.C. § 2032A(c)(6)(A). Failure of a qualified heir to meet the qualified use test causes recapture with respect to that heir’s interest. As noted above, that means cash renting in the recapture period outside of the two-year grace period triggers recapture, except for cash leases by surviving spouses to members of the surviving spouse’s family, and, cash leases by a lineal descendant of the decedent to a member of the lineal descendant’s family.
Special use valuation is a complex provision with many requirements that must be satisfied before death, and numerous requirements that the heirs must satisfy for 10-years post-death. Only those estates comprised of a significant amount of farm land and farm real and personal property that has been owned and operated as a farm for a set amount of time before death is will qualify to make the election. In addition, the elected land must pass in a prescribed manner to qualified heirs. Not every person that is typically thought of as a family member counts for purposes of I.R.C. §2032A.
Special use valuation is a useful tool for some farm and ranch estates where the intent is to continue the farming or ranching business after the death of a family member. But, if a lease is involved, it must be the right type of lease. Cash leasing can cause problems. However, surviving spouses have a special rule that applies to them when it comes to cash leasing land. They can cash rent to a member or their family. But, check the rules to make sure that the tenant is actually a member of the family as defined by the statute.
To restate, special use valuation is a very complex part of the Code. Today’s post has given only a cursory review of a piece of the statute.
Thursday, May 4, 2017
On a daily basis, I field many questions from practitioners, farmers, ranchers, agribusiness professional and others. Some areas of tax and ag law seem to generate more questions than others and, of course, the facts behind each question often dictate the correct answer. But, sometimes a question comes in that I have never had before. I recently got a new one – when valuing an individual retirement account (IRA), is the potential federal income tax liability to the beneficiaries to be considered?
Valuation discounting and IRAs, that’s today’s topic.
Valuation discounts have been in the news recently. Last fall the IRS issued new I.R.C. §2704 proposed regulations that could seriously impact the ability to generate valuation discounts for the transfer of family-owned entities. While it doesn’t look likely now that the proposed regulations will be finalized, if they do become finalized in their present form, they would largely eliminate the ability to derive valuation discounts through various estate planning techniques.
Over the past few decades, valuation discounting through the use of family-owned business entities has become a popular estate and gift tax planning technique. If structured properly, the courts have routinely validated discounts ranging from 10 to 45 percent. Valuation discounting has proven to be a very effective strategy for transferring wealth to subsequent generations. It is a particularly useful technique with respect to the transfer of small family businesses and farming/ranching operations. Similar, but lower, valuation discounts can also be achieved with respect to the transfer of fractional interests in real estate.
The basic concept behind discounting is grounded in the IRS standard for determining value of a transferred interest – the willing-buyer, willing-seller test. In other words, the fair market value of property is the price it would changes hands at between a hypothetical willing-buyer and a willing-seller, with neither party being under any compulsion to buy or sell. Under this standard, it is immaterial whether the buyer and seller are related – it’s based on a hypothetical buyer and seller. Thus, there is no attribution of ownership between family members that would change a minority interest into a majority interest.
Family limited partnership (FLP). The principal objective of an FLP is to carry on a closely-held business where management and control are important. FLPs have non-tax advantages, but a significant tax advantage is the transfer of present value as well as future appreciation with reduced transfer tax. See, e.g., Estate of Kelley v. Comr., T.C. Memo, 2005-235. Commonly in the ag setting, the parents contribute most of the partnership assets in exchange for general and limited partnership interests. However, as the use of FLPs expanded, so did the focus of the IRS on methods to avoid or reduce the discounts. In general, FLPs have withstood IRS attack and produce significant transfer tax savings. But, there are numerous traps for the unwary. Formation shortly before death can result in the FLP being disregarded for valuation purposes. See, e.g., Priv. Ltr. Rul. 9719006 (Jan. 14, 1997); Priv. Ltr Rul. 9725002 (Mar. 3, 1997). Indeed, if the only purpose behind the formation of a family limited partnership is to depress asset values, with nothing of substance changed as a result of the formation, the restrictions imposed by the partnership agreement are likely to be disregarded. See, e.g., F.S.A. 200049003 (Sept. 1, 2000). There also should be a business purpose for the FLP’s formation. See, e.g., Estate of Bongard v. Comr., 124 T.C. 95 (2005).
Corporate liquidation and built-in gain. Until 1998, the IRS disallowed discounts when valuing interests in C corporations to reflect built-in capital gains tax. But, the courts then began focusing on the level of the discount until, in 2007, a federal appellate court ruled that in determining the estate tax value of holding company stock, the company’s value is to be reduced by the entire built-in capital gain as of the date of death. Estate of Jelke III v. Comr., 507 F.3d 1317 (11th Cir. 2007). Later, the Tax Court allowed a dollar-for-dollar discount for built-in gain. Estate of Litchfield v. Comr., T.C. Memo. 2009-21; Estate of Jensen v. Comr., T.C. Memo. 2010-82. That makes sense. When a buyer purchases C corporate stock, the value of the stock to the buyer is what it takes to get cash in a liquidation. One of the “things” it takes is the payment of deferred income tax. The discount reflects that.
Restricted Management Account. An alternative to the FLP is the restricted management account (RMA). An RMA is an investment account where the investor gives up control of certain assets to an investment manager for a certain period of time and the manager exclusively manages the account assets. During the term of the account (as set forth in a written agreement), the investor cannot make withdrawals, and transfer to family members are limited. Based on these restrictions, the argument has been that the value of the assets in the RMA should be discounted for transfer tax purposes. But, in 2008, IRS said that the restrictions in an RMA agreement do not result in anything other than valuation of the account assets at fair market value. Rev. Rul. 2008-35, 2008-2 C.B. 116.
Discounts for IRAs?
Back to the question at hand – can a discount from fair market value be taken for the potential income tax liability to the beneficiaries of an IRA when the assets in the account are distributed to them? The issue was presented to the Tax Court in Estate of Khan v. Comr., 125 T.C. 227 (2005). The decedent died owning two IRAs. One IRA was valued at $1.4 million at the time of death and the other one slightly over $1.2 million. The executor reduced the estate tax value of the accounts by 21 percent and 22.5 percent respectively to reflect the anticipated income tax liability on distribution to the beneficiaries. But, the court rejected the discounts because the inherent tax liability cannot be passed on to a hypothetical buyer. On this point, the Tax Court followed the lead of the Fifth Circuit in Smith v. United States, 391 F.3d 621 (5th Cir 2004), aff’g., 300 F. Supp. 2d 474 (S.D. Tex. 2004) in noting that I.R.C. §691(c) provides for a deduction for estate tax that is attributable to income in respect of a decedent (IRD), which IRAs are. That eliminates the potential income tax inherent in assets that are also subject to estate tax, and serves as a statutory substitute for the valuation discount. In other words, a hypothetical buyer would not take into consideration the income tax liability of a beneficiary on the IRD because the hypothetical buyer is not the beneficiary and would not be paying the income tax on the gain inherent in the IRA. Thus, any additional reduction in estate tax for potential income tax would not be appropriate. A marketability discount is also not appropriate because there aren’t any restrictions barring the IRA assets from being distributed to beneficiaries upon the account owner’s death. See, e.g., Priv. Ltr. Rul. 200247001 (Nov. 22, 2002).
While valuation discounts are still viable for minority interests and lack of marketability in closely-held entities, valuation discounts are not available for assets that are IRD. That means that IRAs and similar items of IRD will be valued at fair market value for transfer tax purposes. With an IRA, the IRA doesn’t have a tax liability. The beneficiary does.
Tuesday, May 2, 2017
The distribution of property in accordance with a decedent’s will or trust can be a straightforward matter, or it can prove to be a trying event for the family. But, what if, for example, a parent dies and specifies in a will or trust that a particular family member is to get a specific item of property and it doesn’t exist at the time of death? Perhaps the specifically devised property has already been gifted to the beneficiary in satisfaction of the specific devise. Or, maybe the specifically devised asset has been disposed of pre-death and the will or trust still contains the specific devise language.
When either of these events happens, the legal doctrine of ademption is invoked. The pre-death gift situation is called an ademption-by-satisfaction, and the pre-death disposal situation is called “ademption -by extinction.” Ademption has the possibility of occurring anytime there is language in a will or trust that devised specifically identified property. It can even occur as the result of a rather straightforward tax-deferred exchange transaction, and frustrate the intentions of a testator’s estate plan.
Ademption - the topic of today’s blogpost.
Ademption – What Is It?
Ademption is a legal rule that governs the disposition of a bequest of specific property that is no longer in the decedent’s estate at the time of the decedent’s death. In general, for devises of specific items of property, called specific gifts, the property is adeemed, and the gift fails. For example, if a parent leaves a specific tractor to an identified beneficiary, but the parent didn’t own the tractor at the time of death, then the gift is said to have been adeemed and the beneficiary would either receive no gift at all or a portion of the gift. This is the likely result with specific bequests of tangible personal property and real estate.
Some gifts, however, are never adeemed. An example would be a gift of cash. If there is not enough cash in the testator’s estate to satisfy the gift, then other assets in the residuary estate are sold to raise the necessary cash. Some gifts are in a gray area, where the testator’s specific intent must be determined. Also, ademption may be waived if the property leaves the estate after the testator has been declared incompetent and a guardian has been appointed, or an agent acting under a power of attorney disposes of the property. See, e.g., In re Estate of Anton,731 N.W.2d 19 (Iowa 2007). Generally stock splits and stock mutations in the context of a business reorganization don’t trigger the doctrine – that’s just an exchange of specifically devised shares of stock for new stock, or the creation of more shares. However, the specific language in the dispositive instrument at death is key.
For real estate sales, the doctrine can apply even if the property hasn’t sold before the testator dies, but a contract for sale has been entered into before death. For instance, assume that a testator executes a will (or trust) that devises a property (for instance, a specific home) to an individual. Before death, the testator enters into a contract to sell the home to a buyer, but then dies before the closing. The devise of the home may be adeemed and the buyer will be entitled to specific performance of the contract. The rationale would likely be that once the contract is executed, equitable conversion occurred – the testator owned a contract right to the proceeds of sale and not the home. This result can be avoided if the will or trust says that the proceeds of sale follow the specifically devised property.
While an exchange of stock in a company as a result of a reorganization is not an ademption, what about an I.R.C. §1031 exchange of real estate. That’s a rather common transaction in agriculture. Does that trigger ademption when a specifically devised tract is traded for another tract? Indeed, it can if the tract is specifically identified and is not in the decedent’s estate at death.
In In re Steinberg Family Living Trust, No. 16-0380, 2017 Iowa Sup. LEXIS 44 (Iowa Sup. Ct. Apr. 28, 2017), a married couple created a trust and named themselves and one of their sons as co-trustees. Upon the last of the parents to die, the two sons were to be the co-trustees. Dad died in 2011 and the Mom died in 2013. The trust became irrevocable upon the Mom’s death and the sons became co-trustees. The trust provided that one son was to receive a specific 40-acre Iowa tract, and the other son would receive a specific 80-acre Iowa tract and have the first right to buy or rent the other 40-acre Iowa tract. Both tracts were identified by their legal description. The balance of the trust assets was to be split equally between the sons.
Sounds like a fine estate plan. The idea is to give each son a specific tract so they don’t have to deal with co-ownership issues after the last of the parents to die (and the seemingly inevitable forced-sale scenario), and give one son the first right to buy or rent the other son’s tract. But, here’s the rub – in 2008, the trust did a tax-deferred exchange of the 80-acre Iowa tract for the 80-acre Minnesota property. Thus, when the trust became irrevocable upon Mom’s death, the trust held the 80-acre Minnesota tract and the 40-acre Iowa tract (and other non-real estate assets). The son with the purchase option gave notice to buy the Iowa tract, and the other son then filed a declaratory judgment action claiming that the option only gave his brother the right to rent the property from him while he continued to own it. He also claimed that the Minnesota tract should be split between the two brothers, because the specific bequest of the 80-acre Iowa tract to his brother had been adeemed by the like-kind exchange. Of course, the other son claimed that the 80-acre Minnesota tract should be devised to him directly because it merely replaced the Iowa tract in a tax-deferred exchange transaction.
The trial court held that the gift of the 80-acre Iowa tract had been adeemed and, consequently, it was subject to the trust provision requiring it to be owned equally by the two sons. The trial court also held that the option only gave the one brother the first right to rent the Iowa tract from his brother for the price specified in the trust for as long as the other brother owned it.
On further review, the Iowa Supreme Court affirmed on the ademption issue, not recognizing any exception from ademption under Iowa law for property received in a like-kind exchange. The court refused to adopt §2-606(a)(5) of the Uniform Partnership Act which states, “a specific devisee has a right to specifically devised property in the testator’s estate at the testator’s death and to any real property or tangible personal property owned by the testator at death which the testator acquired as a replacement for specifically devised real property or tangible personal property.” The court opined that it was up to the legislature to specifically adopt the UPC provision, as it has done with other selected UPC provisions. Thus, the court affirmed the trial court’s decision and the brothers ended up owning the replacement property equally.
While the Iowa Supreme Court stated that its rule of interpretation for trusts was that “the testator’s intent is paramount,” that’s a stretch as applied in this instance. The result the court reached on the ademption issue most likely violated the precept by resulting in a co-owned tract of farmland which the trust provisions appear to have been trying to avoid. The court vacated the trial court’s ruling on the option provision and remanded the issue for consideration of extrinsic evidence as to its meaning.
Lessons? What looks to be purely a tax transaction can have extraneous implications in the law. Chances are that a non-lawyer tax practitioner has never heard of “ademption.” The client may want to do a like-kind exchange, for example, but if a tract is specifically identified in an estate plan and then it is exchanged, that can throw off the entire plan. While, it’s not the tax practitioner’s responsibility to worry about non-tax matters, perhaps knowing that the possibility of ademption exists can result in a question being asked to make sure the client checks with their attorney about the impact of the exchange on an existing estate plan. In the Iowa case, the exchange occurred about five years before Mom died. There was plenty of time to modify the trust language to avoid the impact of ademption. But, that doesn’t mean that strictly applying the rule of ademption was consistent with the decedent’s intent. It’s probably more likely that they never even thought of such a thing as ademption and its impact on the estate plan.
So, whenever a specific gift of real property is provided for by testamentary instrument, the testator should be made aware of the possibility of ademption. But, check state law. Some states have “anti-ademption” statutes or use the UPC rule mentioned above.
Friday, April 28, 2017
The title of today’s post may seem odd. But you might be surprised to know that the issue does come up from time to time. I vividly remember an estate planning conference I had with a married couple when I was in full-time practice. When I was one on one with the husband, he commented to me that he wanted to cut his wife out of everything. He was serious, and it presented some interesting representation issues. After the initial shock of the question, I was able to make a few points that seemingly changed his mind.
But, can a spouse be disinherited? While generally the answer is “no,” there are some things that can be done (at least in some states) that can seriously diminish what a spouse receives upon death. It’s important to have a basic understanding of how this can happen, and a recent court opinion illustrates the point.
First things first – spousal rights largely depend on state law. With that in mind, when a person executes a will, they have the ability to say who gets their property upon their death – with a major exception. That exception is designed to protect a surviving spouse. The surviving spouse can’t be intentionally disinherited, unless they have signed a prenuptial or postnuptial agreement (in states where those are recognized).
In some states, the extent to which the surviving spouse is protected depends on the length of the marriage, or whether the couple had children born of the marriage, or whether the deceased spouse had “probatable” assets. Further complicating matters, some states are “community property” states. In these states, the surviving spouse automatically gets one-half of the couple’s “community property” (basically, property acquired during marriage while domiciled in a community property state). Other states follow the Uniform Probate Code (UPC). In these states, the surviving spouse can automatically take a portion of the deceased spouse’s probate estate, non-probate property and property that is titled in the name of either spouse. Yet other states follow only part of the UPC and allow the surviving spouse to make an election to take part of the deceased spouse’s probate estate and a portion of the non-probate assets. Still other states don’t follow the UPC and limit a disinherited spouse to take only a part of the deceased spouse’s probate estate. So, if there aren’t any probate assets (basically, assets that don’t have a beneficiary designation or survivorship feature) the surviving spouse is at risk of receiving little to nothing. In these states, for example, the use of a revocable living trust (coupled with a “pourover” will) can be used to hold what would otherwise be probate assets to avoid probate and a claim of the surviving spouse.
Of course, there are nuances in each state’s law, but the above comments paint a picture of how a surviving spouse can be left a limited to non-existent inheritance.
A recent court opinion from Iowa highlights how a spouse can be, at least partially, disinherited. In In re Estate of Gantner III, No. 16-1028, 2017 Iowa Sup. LEXIS 40 (Iowa Sup. Ct. Apr. 21, 2017), the decedent died, leaving a surviving spouse and two daughters. The marriage was a second marriage for both spouses and they had only been married a few months when the husband, an investment advisor, died accidentally. His will provided for the distribution of his personal property and established a trust for the benefit of his daughters. In addition, 90 percent of the residue of the estate was to be distributed to the daughters. In accordance with her rights under state law, the surviving spouse filed for an elective share of the estate and requested a spousal support allowance of $4,000 per month. The daughters resisted the surviving spouse’s application for spousal support, claiming that the decedent’s retirement accounts (two IRAs and a SEP IRA) were not subject to the spousal allowance because they were not part of the decedent’s probate estate. The IRAs were traditional, pre-tax, self-employed IRA plans and executed spousal consent forms were provided to the court. However, the issue that the surviving spouse had consented to the beneficiary designations was never brought up as a defense to the statutory claim for a spousal allowance. The focus was solely on a provision in state law.
The probate court determined that the decedent’s probate estate would not have had enough assets to pay a spousal allowance without the retirement accounts included. The surviving spouse claimed that the retirement accounts should have been included in the probate estate for purposes of spousal support based on Iowa Code §633D8.1 that provides that “a transfer at death of a security registered in beneficiary form is not effective against the estate of the deceased sole owner…to the extent…needed to pay…statutory allowances to the surviving spouse.” The surviving spouse argued that because the funds in the accounts were likely mutual funds or index funds, that the accounts should be “securities” within the statutory meaning. The daughters disagreed on the basis that the Uniform Iowa Securities Act excludes any interest in a pension or welfare plan subject to ERISA. The probate court ruled for the daughters on the basis that the retirement accounts were not available for spousal support because they were not probate assets and became the personal property of the daughters at the time of their father’s death. The probate court also noted that the Iowa legislature would have to take action to make beneficiary accounts available to satisfy a spousal allowance.
On appeal, the Iowa Supreme Court affirmed. The court noted that the accounts were traditional IRAs governed by I.R.C. §408 that pass outside of the probate estate under Iowa law and were not covered by Iowa Code §633D as a transfer-on-death security. The retirement accounts were not “security” accounts merely because they contained securities. Rather, it is a custodial account that does not actually transfer on death to anyone other than a spouse.
The point that the IRAs were traditional IRAs is a key one. Had they been “qualified plans” (known as a “401k” plan), I.R.C. §417(a)(2) in conjunction with I.R.C. §401 requires the spouse’s consent to not be named as a beneficiary. While the spouse had executed the necessary consent forms to the decedent’s traditional IRAs (which the court didn’t focus on, instead focusing on state law), had they been qualified plans, then the federal rules would have controlled and provided greater protection for the surviving spouse.
Some state legislatures have taken action in recent years to protect spousal inheritance rights upon death. In some state, for instance, no longer is it possible to use a revocable trust to effectively disinherit a spouse. Other states, have modified the rules on transfer on death accounts or payable on death accounts. In any event, knowing and understanding spousal inheritance rights is something worth knowing about. There are many situations that can arise which could lead to the rules becoming very important to a surviving spouse or, as in the case of the husband that asked the question those many years ago, a spouse wanting to leave the surviving spouse little to nothing.
Wednesday, April 26, 2017
The range fires in Kansas, Oklahoma and Texas earlier this year have generated numerous questions. I have addressed several of those in earlier posts. Another one is on the table for discussion today and concerns associated liability issues. In particular, whether a landowner is liable for smoke damage to others and whether there is any obligation to inform people that might be affected by the smoke.
Range Fire or Controlled Burns?
It is important to distinguish between a true range fire and a controlled burn. For a range fire that starts by some external event that the landowner has no control over or involvement in, there simply is no liability to others. This is the situation for the recent range fires in the Southern Plains. It’s just one of those situations that unfortunately occurs and landowners try their best to contain it and deal with it. The outpouring of support from farmers and ranchers across the country was heartening to see.
Many areas of Kansas and elsewhere engage in controlled burns of pasture. For controlled burns, each state has rules and regulations what govern the procedures to be followed. Those rules may include a duty to notify adjoining landowners and local authorities before starting a burn. It is important to understand the rules and follow them closely to avoid fines and other penalties that could apply.
Smoke Drift As a Trespass?
For a controlled burn, can smoke drift onto another’s property constitute a trespass and make the person conducting the burn liable for any resulting damages? Trespass is the unlawful or unauthorized entry upon another person's land that interferes with that person's exclusive possession or ownership of the land. The tort of trespass is conceptually related to the tort of nuisance, but a nuisance is an invasion of an individual's interest in use and enjoyment of land rather than an interference with the exclusive possession or ownership of the land. The law governing trespass to land is particularly important to farmers and ranchers because real estate plays a significant role in the economic life of the typical farmer or rancher.
A trespass consists of two basic elements: (1) intent and (2) force. Most jurisdictions do not impose absolute liability for trespass. Instead, proof of intentional invasion, reckless or negligent conduct, or inherently or abnormally dangerous activity is required. In these jurisdictions, proof of intent to commit a trespass is not necessary. Rather, the plaintiff must show that the trespasser either intended the act that resulted in the unlawful invasion or acted so negligently or in such a dangerous manner that willfulness can be assumed as a matter of law. A minority of jurisdictions still follow the common law approach holding an individual liable for any interference with the possession of land, even if that interference was completely unintentional. In these jurisdictions, it is immaterial whether the act was done accidently, in good faith, or by mistake.
Trespass also involves an element of force. Liability for trespass may result from any willful act, whether the intrusion is the immediate or inevitable consequence of a willful act or of an act that amounts to willfulness.
At its most basic level, a trespass is the intrusion on to another person's land without the owner's consent. However, many other types of physical invasions that cause injury to an owner's possessory rights abound in agriculture. These types of trespass include dynamite blasting, flooding with water or residue from oil and gas drilling operations, erection of an encroaching fence, unauthorized grazing of cattle, or raising of crops and cutting timber on another's land without authorization, among other things. In general, the privilege of an owner or possessor of land to utilize the land and exploit its potential natural resources is only a qualified privilege. The owner or possessor must exercise reasonable care in conducting operations on the land so as to avoid injury to the possessory rights of neighboring landowners. That can include controlled burn activities and the resulting smoke drift. For example, in Ream v. Keen, 112 Or. App. 197, 828 P.2d 1038 (1992), smoke from field burning drifted to an adjoining home and the neighbor sued for soot removal costs and emotional and physical damages. The trespass claim was submitted to a jury and the appellate court ultimately determined that the elements of an intentional trespass had been established and sent the case back to the trial court for a determination of damages.
As in any trespass case, the outcome turns on the facts of each case. Each case is different.
Is A Controlled Burn an Unnatural Land Use?
“Unnatural” land uses are typically governed by a rule of strict liability. That means that intent doesn’t matter. If damage occurs to others, there is liability. The strict liability approach for “non-natural” land use activities was applied in an 1868 English case. Rylands v. Fletcher. L.R. 3 H.L. 330 (1868). In Rylands, the defendants hired an independent contractor to construct a reservoir on their property. When the reservoir was filled up, water broke from it and flowed into abandoned mine shafts on the property, and then flooded adjacent mine shafts owned by the plaintiffs. The defendants themselves were not aware of the abandoned shafts, and were therefore not negligent (although the contractor probably was). After the lowest court denied liability, the case came before the Exchequer Chamber, in effect an intermediate appeals court. The court reversed, holding that there was liability because “...the person who for his own purposes brings on his lands and collects and keeps there anything likely to do mischief if it escapes, must keep it in at his peril, and if he does not do so, is prima facie answerable for all the damage which is the natural occurrence of its escape.” The case then went to the House of Lords, the final appellate tribunal. The holding of the Exchequer Chamber was affirmed, but was significantly limited. Liability existed because, the court said, the defendants put their land to a “non-natural use for the purpose of introducing [onto it] that which in its natural condition was not in or upon it”, i.e., a large quantity of water. If, on the other hand, the court said, the water had entered during a “natural use” of the land, and had then flowed off onto the plaintiff's land, there would have been no liability.
Initially, American courts frequently misconstrued the Ryland's decision and purported to reject it. They focused on the Exchequer Chamber version, which would have imposed liability for escaping forces even where the land is put to a natural use. Eventually, however, the vast majority of American courts accepted at least the practical result of Rylands, even if not the case by name.
Today, the rule has been extended to include most activities that are extremely dangerous. However, in Koger v. Ferrin, 926 P.2d 680 (Kan. Ct. Ap. 1996), the court refused to apply a strict liability rule in a situation involving the spread of a fire that was not intentionally started. In an important passage, the court stated the following:
“In Kansas, farmers and ranchers have a right to set controlled fires on their property for agricultural purposes and will not be liable for damages resulting if the fire is set and managed with ordinary care and prudence, depending on the conditions present [citation omitted]. There is no compelling argument for imposing strict liability on a property owner for failing to prevent the spread of a fire that did not originate with that owner or operator. Because the essential facts of this case are undisputed, as a matter of law, the doctrine of strict liability is not applicable under the facts presented.”
Liability for smoke damage from fires depends on the facts and circumstances surrounding the fire. For controlled burns, carefully following any applicable rules and regulations will go a long way to eliminating liability for any resulting damages. Range fires typically don’t lead to personal liability issues.
Monday, April 24, 2017
Farmers and ranchers buy and sell commodity futures and options to hedge against fluctuating prices. They also buy and sell commodity futures and options to speculate with fluctuating prices. They also enter into cash forward grain contracts and hedge-to-arrive contracts. The tax issues associated with commodity trading are important to understand, and are the focus of today’s post.
Hedging or Speculation
A hedging transaction is defined as a transaction that a taxpayer enters into in the normal course of the taxpayer’s trade or business, primarily to reduce (as opposed to simply managing) the risk of price changes or currency fluctuations with respect to ordinary property, or to reduce the risk of interest rate or price changes or currency fluctuations with respect to borrowing or ordinary obligations. I.R.C. §1221; Treas. Reg. §1.1221-2(b). To receive tax treatment as a hedge, the transaction must be identified by the taxpayer as a hedging transaction before the close of the day the hedge is entered into. I.R.C. §1221(a)(7); Treas. Reg. §1.1221-2(f)(1). The item being hedged must be identified no more than 35 days after the hedging transaction. Treas. Reg. §1.1221-2(f)(2)(ii). If the transaction is not timely identified as a hedge, the straddle rules and mark-to-market rules may apply. I.R.C. §§1092; 263(g); I.R.C. §1256.
A taxpayer uses a hedge to lock in a position in a particular commodity. Once locked in, if the physical commodity increases in value, the taxpayer’s value of the futures position should go down – one should offset the other with the net result that the hedge maintains the taxpayer’s position.
Speculation involves a commodity transaction entered into other than in the context of the taxpayer’s trade or business. Speculation can be illustrated by the farmer who harvests corn, sells the corn, and buys futures in the marketplace in anticipation of prices rising and believing this strategy is better than storing the commodity. This is speculation and is subject to the mark-to-market rules of I.R.C. §1256. The mark-to-market rules require taxpayers to report on Form 6781 gains and losses from regulated futures contracts and other “Section 1256 contracts” on an annual basis under the mark-to-market rule. These rules close out speculative transactions as of December 31. They are marked to market by treating each contract held by the taxpayer as if it were sold for fair market value on the last business day of the tax year, thereby requiring profit or loss to be reported on the taxpayer’s income tax return. The net gain or loss is allocated 40 percent to short-term capital gain (or loss) and 60 percent to long-term capital gain (or loss).
Tax difference. Gain and loss from transactions that are hedges generate ordinary income and loss and are not subject to the loss deferral rules and the “mark-to-market” rules that apply to speculative transactions. I.R.C. §1221 and Treas. Reg. §1.1221-2. Because a hedge is entered into in the normal course of the taxpayer’s business (such as to lock-in a position in a particular commodity), any resulting gain is subject to self-employment tax.
However, if the transaction involves speculation, resulting gains and losses are treated as capital gains and losses. Capital gains can offset capital losses, but capital losses deductible
against ordinary income are capped at $3,000 per year. In addition, corporations are not eligible for the $3,000 deduction against ordinary income. Also, speculative transactions are subject to the loss deferral and “mark-to-market” rules. Speculative transactions do not trigger self-employment tax.
Farmers and ranchers will often buy options. When a put option is purchased by the producer of a commodity, the producer acquires the right to sell the commodity at a future point in time. If the sale occurs just before the crop is planted or while the crop is growing, the transaction is a hedge. If the right to sell is triggered after the crop is sold, the transaction is speculative.
A farmer or rancher may also buy a call option. A call option gives the producer the right to buy the commodity at some future point in time. Transactions involving the purchase of a call option for the purchase of a commodity by a crop producer are speculative regardless of when the option is exercised. However, a livestock farmer may enter into a call option for feed, or a crop farmer may enter into a call option for crop inputs. The question of whether a transaction is a hedge or is speculation turns on whether it was entered into in the normal course of the taxpayer’s business to reduce risk.
Any income, deduction, gain or loss from a hedging transaction is matched with the income, deduction, gain or loss on the item being hedged. Also, in some situations, the hedge timing rules apply irrespective of whether the transaction has been identified as a hedge. Rev. Rul. 2003-127, 2003-2 C.B. 1245. In essence, the tax rules for hedging transactions address both character and timing, and are designed to match the character and timing of a hedging transaction with the character and timing of the item being hedged. The timing Farmers participating in true hedging programs likely have multiple transactions for a single crop and may combine option purchases and sales to minimize the cost of these programs or to create both a ceiling and a floor for prices. Properly identifying and reporting these many transactions is a challenge for the taxpayer and tax preparer and IRS Pub. 550 can be helpful.
Just as important as the matching principle with commodity transactions is what constitutes “property.” I.R.C. §1001 governs the computation of gain or loss on the sale or exchange of property, with gain being the excess of the amount realized over the adjusted basis of the property, and the loss is the excess of the adjusted basis of the property over the amount realized. Thus, for gain or loss to be computed on a transaction, the taxpayer must know the identity and amount of property that will be delivered. That isn’t known until the contract is settled.
In Estate of McKelvey v. Comr., 148 T.C. No. 13 (2017), the decedent had entered into contracts to sell corporate stock to Bank of America and Morgan Stanley & Co., International. The contracts were structured as variable prepaid forward contracts (VPFC) that required the banks to pay a forward price (discounted to present value) to the decedent on the date the contracts were executed, rather than the date of contract maturity. Accordingly, the decedent received a cash prepayment from Bank of America of approximately $51 million on September 14, 2007. On September 27, 2017, the decedent received a cash prepayment from Morgan Stanley & Co. of slightly over $142 million. The prepayments obligated the decedent to deliver to the banks stock shares pledged as collateral at the time of contract formation, and certain other stock shares that weren’t pledged as collateral or an equal amount of cash. The actual number of shares or their cash equivalent is determined via a formula that accounts for stock market changes.
Under the contracts as originally executed in September of 2007, the decedent was to deliver to the banks every day for 10 consecutive business days in September of 2008. Each day, one-tenth of the total number of shares agreed to be transferred was to be delivered as determined by adjusting the number of shares by the ratio of an agreed floor price over the stock closing price for that particular day, or a cash equivalent to the stock. However, in July of 2008, the banks agreed to extend the settlement dates to early 2010. To get the extension, the decedent paid Morgan Stanley & Co. slightly over $8 million on July 15, 2008, for delivery over 10 consecutive days in early January of 2010, and paid Bank of America approximately $3.5 million on July 24, 2008, for delivery over 10 consecutive days in early February of 2010.
For tax purposes, the decedent treated the original transactions as “open” transactions in accordance with Rev. Rul. 2003-7, 2003-1 C.B. 363 and did not report any gain or loss for 2007 related to the contracts. In addition, the decedent did not report any gain or loss related to the contract extensions that were executed in 2008 on the basis that the extensions also involved “open” transactions. The decedent died in late 2008, and on July 15, 2009, the decedent’s estate transferred shares of stock to settle the Morgan Stanley & Co. contracts. The estate filed a Form 1040 for the decedent’s taxable year 2008, and the IRS issued a deficiency notice for over $41 million claiming that when the decedent executed the extensions in 2008, he triggered a realized capital gain of slightly over $200 million comprised of a short-term capital gain of $88 million and $112 of long-term capital gain from the constructive sale of shares pledged under the contracts. The IRS claimed that the decedent had no tax basis in the stock pledged as collateral.
The court disagreed with the IRS on the basis that the “open transaction” doctrine applied because of the impossibility of computing gain or loss with any reasonable accuracy at the time the contracts were entered into. In addition, the court rejected the argument of the IRS that the extensions of the original contracts closed the contracts which triggered gain or loss at the time the extensions were executed. The court specifically noted that, in accordance with Rev. Rul. 2003-7, VPFCs are open transactions at the time of execution and don’t trigger gain or loss until the time of delivery because the taxpayer doesn’t know the identity or amount of property to be delivered until the future settlement date arrives and delivery is made. Until delivery, the only thing that the decedent had was an obligation to deliver; this was not property that could be exchanged under I.R.C. §1001. The court also noted that the open transaction doctrine applied because the identity and adjusted basis of the property sold, disposed of or exchanged was not known until settlement occurred. The court also stated that an option is a “familiar” type of open transaction from which we can distill applicable principles.”
Many commodity transactions in which farmers engage are “open” transactions, with the producer holding merely a contractual obligation at the time of contract execution. An option, for example, is a type of “open transaction.” See, e.g., Rev. Rul. 78-182, 1978-1 C.B. 256. Forward grain contracting, hedge-to-arrive contracts, and other types of commodity transactions may also delay tax consequences until the contract requirements are fulfilled. The Tax Court’s recent decision helps confirm that point.
Thursday, April 20, 2017
Even though the federal estate and gift tax exclusion is high enough to discourage many people from gifting solely for tax purposes, I still receive numerous gift tax questions. So, gifting is not usually utilized as a strategy for minimizing potential estate tax at death. However, many people accumulate significant amounts of property, both tangible and intangible, as well as cash during life. Among the common estate planning goals of many clients is a desire to preserve that accumulated wealth during life, as well as transfer ownership interests in family businesses to other family members before death as a supplement to property transfers occurring at death.
Today’s post examines the basic rules surrounding the gifting of property during life and some common gift planning strategies.
Present Interest Annual Exclusion
The present interest annual exclusion is a key component of the federal gift tax. For gifts made in 2017, the exclusion is $14,000 per donee. That means that a donor can make cumulative gifts of up to $14,000 (in cash or an equivalent amount of property) to as many donees as desired without triggering any gift tax, and without any need to file Form 709 – the federal gift tax return. Because the exclusion “renews” each year and is not limited by the number of potential donees, but only the amount of the donor’s funds and interest in making gifts, the exclusion can be a key estate planning tool. Used wisely, the exclusion can facilitate the passage of significant value to others (typically family members) pre-death to aid in the succession of a family business or a reduction in the potential size of the donor’s taxable estate, or both.
But, to qualify for the exclusion, the gift must be a gift of a present interest – the exclusion does not apply to future interests. A present interest is an “unrestricted right to immediate use, possession, or enjoyment or property or the income from the property. Treas. Reg. §25.2502-3(b). A remainder interest, for example, would be a future interest.
There’s a special rule that comes into play for gifts made by spouses. They can elect “split gift” treatment regardless of which spouse actually owns the gifted property, if certain conditions are satisfied and the spouses consent to gift splitting treatment. They are simply treated as owning the property equally. This allows gifts of up to $28,000 per donee annually. So, as an example, let’s say that Mom and Dad have 4 children and 5 (unmarried) grandchildren. Also assume that each child has a spouse. That makes 13 persons that Mom and Dad could make annual exclusion gifts to without triggering the need to file a federal gift tax return. That would be 13 present interest annual exclusion gifts of $14,000 each for Mom and Dad - $182,000 each, annually. In addition, if those gifts are of interests in a closely held business, discounting those interests for lack of marketability and minority interest could leverage those present interest gifts and increase the total amount that can be given gift-tax free by another 30 percent or so.
There is also a special rule that allows for the direct payment of certain educational and medical expenses. Under the rule, these transfers are not even deemed to be gifts. Thus, the limitation of the present interest annual exclusion does not apply to those gifts.
“Coupled Estate and Gift Tax Systems”
The estate and gift tax systems are “unified.” The unified credit $2,141,800 (for 2017) offsets lifetime taxable gifts of $5.49 million or a taxable estate of $5.49 million. The unification or “coupling” of the estate and gift tax systems create tremendous opportunities for higher net worth individuals and families to leverage the $5.49 million exemption equivalent of the unified credit through lifetime gifting. Present interest annual exclusion gifts do not count against the lifetime $5.49 million limitation.
Valuation of Gifts
It’s also necessary to know the value of the property at the time of the gift. The donor needs this information to determine whether the gift exceeds the $14,000 annual exclusion amount and, if so, the amount to report on Form 709 that will be required to be filed. The recipient of the gift may also need this information to determine whether a deduction is available if the property is later sold at a loss. Gifts are valued for gift tax purposes at their fair market value as of the time of the gift. I.R.C. §2512. Fair market value is defined as “the price at which the property would change hands between a [hypothetical] willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.” Treas. Reg. 20.2031-1(b). As noted above, discounts from fair market value can be recognized for interests in closely-held entities that are minority interests and/or lack marketability, as well as fractional interests in real estate.
Generation-Skipping Transfer Tax (GSTT) Implications.
The GSTT is imposed on both outright gifts and transfers in trust to or for the benefit of related persons that are more than a generation younger than the donor, or unrelated persons who are more than 37.5 years younger than the donor. The GSTT is imposed only if the transfer avoids incurring a gift or estate tax at each generation level. For 2017, each individual has a $5.49 million exemption from the GSTT. With respect to split gifts made during a calendar year, each spouse is treated as the transferor for GSTT purposes of one-half of all gifts eligible for gift-splitting. Thus, each spouse can allocate their GSTT exemption to one-half of each gift that is split.
A gift of income-producing property does not trigger income in the hands of the donee to the extent the gifts are true gifts. But, income tax cannot be avoided, for example, on money or other property received in exchange for services.
The recipient of a gift of income-producing property must report any income that the property produces after the gifted property is received. For example, a gift of stock would require the recipient of the stock to report any dividends paid on the stock after the gift. Gifts of income-producing property can also be used to shift the income from the property to other family members that are in a lower tax bracket.
Sometimes a gift of income producing property is made in the form of interests in a business entity as part of an overall family estate and succession plan. If the entity owns only non-income producing property (such as vacant real estate) another potential problem arises in that the gifted property may not qualify for the present interest annual exclusion if it is determined to not be a gift of a present interest.
Income Tax Basis and Holding Period
Now, there’s a potentially major drawback to gifting. If the gift consists of property other than cash, the basis and holding period of the property in the hands of the donee is the same as it was in the hands of the donor. I.R.C. §1015. It’s important for the recipient to know when the donor acquired the property, the cost of the property, and any other information that would affect the property’s basis. Ideally, the recipient of the gift should also receive records that will provide adequate proof of these facts. So, while gifts of property during the donor’s lifetime will remove the gifted property from the donor’s estate computation, the gift also removes the ability to obtain a stepped-up basis on that property. Measuring estate tax savings against the tax implications of reduced basis step-up is an important part of the overall planning process. With the coupled estate and gift tax exclusion at $5.49 million for 2017, the basic plan for many people would be to hold the property until death to achieve a basis step-up. The tax savings for the heirs that might later sell the property will often outweigh that estate tax cost of having the property included in the estate.
The change in the rules governing the transfer tax system a few years ago has significantly changed gifting strategies. While there still remain significant income tax incentives to gifting, the transfer tax system rules indicate to many people that it may be better to not gift property and thereby cause it to be included in the estate at death where the exclusion will prevent it from being subject to federal estate tax. By causing the property to be include in the estate will result in a basis step-up equal to the fair market value of the property as of the date of death.
When considering gifting assets or doing significant estate planning, make sure to consult professionals for assistance.
Tuesday, April 18, 2017
Private property and the ability to exclude others is very important to farmers and ranchers. Land is typically the largest asset in terms of value that an ag producer owns and much farm and ranch machinery and equipment is often outdoors frequently during planting and harvesting. Not to mention buildings and livestock. So, trespassing is a big issue for rural landowners.
One issue that has popped-up recently in South Dakota involves public access to farmland that has become flooded. What are the rules associated with the recreational use of water? That’s the focus of today’s post.
In the United States, the individual states own the beds of navigable streams or lakes that flow or exist within their borders, and hold them in trust for their citizens. Under this public ownership concept, states may license use of the beds or lease rights to minerals found there. The right of the public to recreate over the bed can be asserted either because there is a federal navigational servitude or because the state has an expanded definition of navigability which allows more public uses than exist under federal law.
Under state law, the public's right to use rivers or lakes for recreational purposes is typically limited to those waters where the state owns the bed. For non-navigable streams, the title to the bed is held by the adjacent upland owner. Consequently, ownership of the bed is related to the concept of navigability. In general, navigability for title purposes is determined by the “natural and ordinary condition” of the water.
Although a federal test for bed title controlled the rights that states received upon joining the Union, state title tests are still important. When the states received title to the beds, they had the power to keep or dispose of them. Before the Supreme Court decisions which required federal law to be used in determining bed ownership, there were many state court decisions. These tests are still in use today and many conflict with federal law. When they do, federal law controls for title purposes (under the definition of “navigability”), but state law has been incorporated into this to determine what rights the state retains and what rights were granted to adjacent landowners. For example, some states keep title to watercourse beds only where there is a title influence. Other states follow a rule of “navigability in fact” similar to the federal rule. In these jurisdictions, the state retains title to watercourse beds only if the watercourse is navigable in fact. The remaining states use other approaches.
In early 2014, the New Mexico attorney general issued a non-binding opinion taking the position that a private landowner cannot prevent persons from fishing in a public stream that flows across a landowner’s property if the stream is accessible without trespassing across privately owned adjacent lands. Att’y. Gen. Op. 14-04 (Apr. 1, 2014). That opinion was based on New Mexico being a prior appropriation state and, as a result, unappropriated water in streams belongs to the public and is subject to appropriation for beneficial use irrespective of whether the adjacent landowner owns the streambed. Thus, the public has an easement to use stream water for fishing purposes if they can access the stream without trespassing on private property.
There are several other ways states have power over the water within their boundaries. Under its police power, a state may regulate its waters, whether or not they are navigable under the federal test, in order to protect the public's health, safety, and general welfare. Some western states claim ownership of all the water in the state, and as the owner, they claim the power to regulate. Other states limit their control to those waters considered navigable under bed ownership tests. As a result, state laws on public use of watercourses are a complex mix of cases and legislation.
The South Dakota Situation
Under South Dakota law, “the owner of land in fee has the right to the surface and everything permanently situated beneath or above it.” S.D.C.L. §43-16-1. In addition, South Dakota law provides that (with some specifically delineated exceptions), “…no person may fish, hunt or trap upon any private land without permission from the owner or lessee of the land….”. S.D.C.L. §41-9-1. Numerous states have similar statutory provisions. South Dakota also claims to own all wildlife in the state, including wildlife on private land. But, hunters cannot hunt that wildlife without the landowner’s permission unless the landowner is participating with the South Dakota Department of Game, Fish and Parks (GFP) in the “walk-in” program. Under that program, and landowner can give permission to the public to hunt on the landowner’s property in exchange for a payment from the GFP. Many other states also claim to own the wildlife found in the state and offer some sort of “walk-in” program.
South Dakota law, just like the laws of many other states, also bars “road hunting” outside of the public right-of-way. Thus, by barring hunting over private land from a public roadway, the state is recognizing landowners have “air rights” over their private property.
But, what about fishing? In a March decision, the South Dakota Supreme Court ruled that all water in the state is held in the public trust for “beneficial use.” That doesn’t seem unreasonable – other state high courts have reached the same conclusion. But, the Court held that the “beneficial use” rule applies to flooded private land (non-meandered lakes). This became an issue in South Dakota due to excess rainfall in 1993 which caused the formation of large lakes on private land in the northeastern part of the state. Fishermen flocked to the expanded lakes and the SD GFP didn’t stop them. The matter boiled over into litigation resulting in the Court’s recent decision.
The South Dakota Case
In Duerre v. Hepler, No. 27885, 2017 S.D. LEXIS 29 (S.D. Sup. Ct. Mar. 15, 2017), landowners sued the SD GFP for declaratory and injunctive relief concerning the public’s right to use the waters and ice overlying the landowners’ private property for recreational purposes. As noted above, in 1993, excessive rainfall submerged portions of the landowners’ property. In accordance with instructions from the United States Surveyor General’s Office, commissioned surveyors surveyed bodies of water in SD in the late 1800s. Pursuant to those survey instructions, if a body of water was 40 acres or less or shallow or likely to dry up or be greatly reduced by evaporation, drainage or other causes, surveyors were not to draw meander lines around the body of water but include it as land available for settlement. The meander lines delineated the water body for the purpose of measuring the property that abuts the water. When originally surveyed, the lands presently in question were small sized sloughs that were not meandered. Thus, the landowners owned the lakebeds under them. The 1993 flooding resulted in the sloughs expanding in size to over 1,000 acres each. The public started using the sloughs in 2001 and established villages of ice shacks, etc. In the spring and fall, boats would launch in to the waters via county roads. After the landowners complained to the GFP about trash, noise and related issues, the GFP determined that the public could use the waters if they entered them without trespassing. That’s sounds exactly like the New Mexico Attorney General opinion in 2014.
In 2014, the landowners sued. The trial court certified a defendant class to include those individuals who used or intended to use the floodwaters for recreational purposes, appointing the Secretary of the GFP as the class representative. On cross motions for summary judgment, the trial court entered declaratory and injunctive relief against the defendants. The trial court held that the public had no right of entry onto the water or ice without a landowner’s permission, and entered a permanent injunction in favor of the landowners.
On appeal, the South Dakota Supreme Court upheld the trial court’s decision to certify the class and include non-residents users in the class. The Court also upheld the trial court’s determination that the landowners had established the elements necessary for class certification and that the GFP Secretary was the appropriate class representative. The Court also upheld the trial court’s grant of declaratory relief to the landowners, noting that prior caselaw had left the matter up to the legislature and the legislature had not yet enacted legislation dealing with the issue. The legislature had neither declared that the public must obtain permission from private landowners, nor declared that the public’s right to use waters of the State includes the right to use waters for recreational purposes.
The Court remanded the order of declaratory relief and modified it to direct the legislature to determine whether the public can enter or use any of the water or ice located on the landowners’ property for any recreational use. As for the injunctive relief, the Court modified the trial court’s order to state that the GFP was barred from facilitating public access to enter or use the bodies of water or ice on the landowners’ property for any recreational purpose.
In short, the SD Supreme Court found that neither the GFP nor the landowners have a superior property right, but that the issue is up to the legislature to determine if recreation is a “beneficial use.” The issue is not just an important one for landowners in South Dakota. State rules for determining access rights to private property are important in every state. It certainly seems like a reasonable solution could be reached in South Dakota to protect private property rights while simultaneously providing reasonable access for fishermen. Time will tell.
Friday, April 14, 2017
With many things, it is true that there is a right way and a wrong way to do things. The same maxim holds true in business entity structuring. There is a right way to structure and a wrong way to structure the entity when it comes to many legal and tax issues, including self-employment tax liability. A recent Tax Court case illustrates that last point – proper structuring makes a difference on the self-employment tax liability issue.
So, how can self-employment tax be minimized when the desired structure is a limited liability company (LLC)? That’s today’s focus.
LLCs and Self-Employment Tax
Whether LLC members can avoid self-employment tax on their income from the entity depends on their member characterization. Are they general partners or limited partners? Under I.R.C. §1402(a)(13), a limited partner does not have self-employment income except for any guaranteed payments paid for services rendered to the LLC. So what is a limited partner? Under existing proposed regulations (that were barred by the Congress in the late 1990s from being finalized), an LLC member has self-employment tax liability if: (1) the member has personal liability for the debts or claims against the LLC by reason of being a member; (2) the member has authority under the state’s LLC statute to enter into contracts on behalf of the LLC; or (3) the member participated in the LLC’s trade or business for more than 500 hours during the LLC’s tax year. Prop. Treas. Reg. §1.1402(a)-2(h)(2). If none of those tests are satisfied, then the member is treated as a limited partner.
The Castigliola case. In Castigliola, et al. v. Comr, T.C. Memo. 2017-62, a group of lawyers structured their law practice as member-managed Professional LLC (PLLC). On the advice of a CPA, they tied each of their guaranteed payments to what reasonable compensation would be for a comparable attorney in the locale with similar experience. They paid self-employment tax on those amounts. However, the Schedule K-1 showed allocable income exceeding the member’s guaranteed payment. Self-employment tax was not paid on the excess amounts. The IRS disagreed with that characterization, asserting self-employment tax on all amounts allocated.
The Tax Court agreed with the IRS. Based on the Uniform Limited Partnership Act of 1916, the Revised Limited Partnership Act of 1976 and Mississippi law (the state in which the PLLC operated), the court determined that a limited partner is defined by limited liability and the inability to control the business. The members couldn’t satisfy the second test. Because of the member-managed structure, each member had management power of the PLLC business. In addition, because there was no written operating agreement, the court had no other evidence of a limitation on a member’s management authority. In addition, the evidence showed that the members actually did participate in management by determining their respective distributive shares, borrowing money, making employment-related decisions, supervising non-partner attorneys of the firm and signing checks. The court also noted that to be a limited partnership, there must be at least one general partner and a limited partner, but the facts revealed that all members conducted themselves as general partners with identical rights and responsibilities. In addition, before becoming a PLLC, the law firm was a general partnership. After the change to the PLLC status, their management structure didn’t change.
The court did not mention the proposed regulations, but even if they had been taken into account the outcome of the case would have been the same. Member-managed LLCs are subject to self-employment tax because all members have management authority. It’s that simple. In addition, as noted below, there is an exception in the proposed regulations that would have come into play.
Note: As a side-note, the IRS had claimed that the attorney trust funds were taxable to the PLLC. The court, however, disagreed because the lawyers were not entitled to the funds.
Structuring to minimize self-employment tax. There is an entity structure that can minimize self-employment tax. An LLC can be structured as a manager-managed LLC with two membership classes. With that approach, the income of a member holding a manager’s interest is subject to self-employment tax, but if non-managers that participate less than 500 hours in the LLC’s business hold at least 20 percent of the LLC interests, then any non-manager interests held by members that participate more than 500 hours in the LLC’s business are not subject to self-employment tax on the pass-through income attributable to their LLC interest. Prop. Treas. Reg. §1.1402(a)-2(h)(4). They do, however, have self-employment tax on any guaranteed payments. However, this structure does not achieve self-employment tax savings for personal service businesses, such as the one involved in Castigliola. Prop. Treas. Reg. §1.1402(a)-2(h)(5) provides an exception for service partners in a service partnership. Such partners cannot be a limited partner under Prop Treas. Reg. §1.1402(a)-2(h)(4) (or (2) or (3), for that matter). Thus, for a professional services partnership (such as the law firm at issue in the case), structuring as a manager-managed LLC would have no beneficial impact on self-employment tax liability.
However, for LLCs that are not a “service partnership,” such as a farming operation, it is possible to structure the business as a manager-managed LLC with a member holding both manager and non-manager interests that can be bifurcated. The result is that a member holding both manager and non-manager interests is not subject to self-employment tax on the non-manager interest, but is subject to self-employment tax on the pass-through income and a guaranteed payment attributable to the manager interest.
Here's what it might look like for a farming operation:
A married couple operates a farming business as an LLC. The wife works full-time off the farm and does not participate in the farming operation. But, she holds a 49 percent non-manager ownership interest in the LLC. The husband conducts the farming operation full-time and also holds a 49 percent non-manager interest. But, the husband, as the farmer, also holds a 2 percent manager interest. The husband receives a guaranteed payment for his manager interest that equates to reasonable compensation for his services (labor and management) provided to the LLC. The result is that the LLC’s income will be shared pro-rata according to the ownership percentages with the income attributable to the non-manager interests (98 percent) not subject to self-employment tax. The two percent manager interest is subject to self-employment tax along with the guaranteed payment that the husband receives. This produces a much better self-employment tax result than if the farming operation were structured as a member-managed LLC.
Additional benefit. There is another potential benefit of utilizing the manager-managed LLC structure. Until the health care law is repealed or changed in a manner that eliminates I.R.C. §1411, the Net Investment Income Tax applies to a taxpayer’s passive sources of income when adjusted gross income exceeds $250,000 on a joint return ($200,000 for a single return). While a non-manager’s interest in a manager-managed LLC is typically considered passive with the income from the interest potentially subject to the 3.8 percent surtax, a spouse can take into account the material participation of a spouse who is the manager. I.R.C. §469(h)(5). Thus, the material participation of the manager-spouse converts the income attributable to the non-manager interest of the other spouse from passive to active income that will not be subject to the 3.8 percent surtax.
Based on the example above, the result would be that self-employment tax is significantly reduced (it’s limited to 15.3 percent of the husband’s reasonable compensation (in the form of a guaranteed payment) and his two percent manager interest) and the net investment income surtax is avoided on the wife’s income.
The manager-managed LLC provides a better result than the result produced by the member-managed LLC for LLCs that are not service partnerships. For those that are, such as the PLLC in Castigliola, the S corporation is the business form to use to achieve a better tax result. For an S corporation, “reasonable” compensation will need to be paid subject to S.E. tax, but the balance drawn from the entity can be received self-employment tax free. But, for farming operations with land rental income, the manager-managed LLC can provide a better overall tax result than the use of an S corporation because of the ability to eliminate the net investment income tax.
Of course, the self-employment tax and the net investment income tax are only two pieces of the puzzle to an overall business plan. Other non-tax considerations may carry more weight in a particular situation. But for some, this strategy can be quite beneficial.
The decision in Castigliola would appear to further bolster the manager-managed approach – an individual that is a “mere member” appears to now have an even stronger argument for limited partner treatment. In addition, the court didn’t impose penalties on the PLLC because of reliance on an experienced professional for their filing position. I am not so sure about that one and believe that the judge was simply being nice, perhaps because the professional tax advisor died before the trial. But, the outcome they were seeking was easy to obtain if they had just structured the entity properly and had taken some time to carefully draft an operating agreement.
Wednesday, April 12, 2017
Any depreciable business asset is only depreciable if it has been placed in service during the tax year. “Placed in service” means that the asset is in a state of readiness for use in the taxpayer’s trade or business. See, e.g., Brown v. Comr., T.C. Sum. Op. 2009-71. In the year that an asset is place in service, all or part of the income tax basis can be deducted currently. A key point is that it is not actually necessary that the asset be used in the taxpayer’s trade or business for the taxpayer to begin claiming depreciation attributable to that asset.
The Code and regulations seem abundantly clear on what “placed in service” means. A court decision involving a retail building that was decided in early 2015 bore that out. But, IRS has now muddied the water by disagreeing with that court’s decision which, in turn, means that they are disagreeing with their own regulation on the issue and even their own audit technique guide on the matter.
Today’s post takes a look at what “placed in service” means and the confusing IRS position.
Code and Regulations
As noted above, property that is “placed in service” means that it is placed in a state of readiness or availability for use in the taxpayer’s trade or business, regardless of the time of year that the asset is placed in service. Treas. Reg. §1.167(a)-10(b). That means that the asset must be ready for the taxpayer to use by the taxpayer by the end of the tax year if the taxpayer so desires. It doesn’t mean that the taxpayer must have begun using the asset in the taxpayer’s trade or business by the end of the tax year. But, an item of property is not deemed to be placed in service if it is simply manufactured and is sitting at the dealership, or if an order has been placed but the property has not yet been built. So, simply signing a purchase contract or taking delivery of a depreciable materials (such as for the construction of a pole barn, etc.) to be used in the taxpayer’s business does not mean that those assets are depreciable – they aren’t yet ready for use in the taxpayer’s business. The asset must be ready for use in the taxpayer’s business whether or not they have actually been used by the taxpayer in the business by the end of the tax year. For a building in which the taxpayer’s retail business is conducted, for example, the store doesn’t have to be open for business in order for the building by the end of the tax year for the building to be deemed to be placed in service for depreciation purposes for that tax year. Treas. Reg. §1.167(a)-11(e)(1)(i). The building is considered to be placed in service on the date that its construction is considered to be substantially complete or in the state or readiness and availability regardless of whether depreciable items in the building meet the placed in service test. Id.
The Stine Case
In Stine, LLC v. United States, No. 2:13-03224, 2015 U.S. Dist. LEXIS 9850 (W.D. La. Jan. 27, 2015), non-acq., 2017-02 (Apr. 10, 2017), the taxpayer operated a retail business that sold home building materials and supplies. The taxpayer built two new retail stores. As of December 31, 2008, the buildings were substantially complete and partially occupied and the taxpayer had obtained certificates of completion and occupancy and customers could enter the stores. However, the stores were not open for business as of the end of 2008. The taxpayer claimed the 50 percent GoZone depreciation allowance for 2008 on the two buildings which created a tax loss for 2008 and allowed the taxpayer to carry back the losses to the 2003-2005 tax years and receive a refund. The IRS disallowed the depreciation deduction on the basis that the taxpayer had not placed the buildings in service and assessed a deficiency of over $2.1 million for tax years 2003-2008. The taxpayer paid the deficiency and sued for a refund. The IRS argued that allowing the depreciation would offend the "matching principle" because the taxpayer's revenue from the buildings would not match the depreciation deductions for a particular tax year. The court held that this argument was "totally without merit."
On the placed in service issue, the IRS maintained that the two buildings were not “open for business” as of the end of the tax year so no depreciation could be claimed for that year. The court disagreed, noting the government’s own regulation that defied that argument. The court noted that Treas. Reg. §1.167(a)-11(e)(1) says that placed in service means that the asset is in a condition of readiness and availability for its assigned function. With respect to a building, the court noted that this meant that the building must be in a state of readiness and availability without regard to whether equipment or machinery housed in the building has been placed in service. The court held that there was no requirement that the taxpayer's business must have begun by year-end. Cases that the IRS cited involving equipment (in one case an airplane) being placed in service were not applicable, the court determined. The court also noted that the IRS's own Audit Technique Guide for Rehabilitation Tax Credits stated that "[A] 'Certificate of Occupancy' is one means of verifying the 'Placed in Service' date for the entire building (or part thereof)". The court noted that the IRS had failed to cite even a single authority for the proposition that "placed in service" means "open for business," and that during oral arguments IRS had admitted that no authority existed. Thus, the court granted summary judgment for the taxpayer and also specified that the taxpayer could pursue attorney fees against the government if desired.
The IRS reaction. The court’s decision in Stine was based precisely on the regulation. It’s common sense, also. For retail businesses that are constructing stores, once the product is received to be placed into the display shelves at the constructed building, the building will be considered to have been placed in service. That’s what the regulation seems pretty clear about. The court sure believed so.
The IRS did not file an appeal with the U.S. Court of Appeals for the Fifth Circuit. That’s not surprising, considering how badly the IRS lost the case. Recently, however, the IRS issued a non-acquiescence to the court’s decision. A.O.D. 2017-02. That means that the IRS disagrees with the court’s decision and will continue to audit the issue outside of the Western District of Louisiana. Unfortunately, the IRS didn’t give any reason(s) why it disagreed with its own regulation and audit technique guide on the matter. That’s understandable – they have none.
An asset is placed in service for depreciation purposes when it is ready and available for use in the taxpayer’s trade or business. The Stine case makes that clear. It’s an issue that comes up in agriculture also. Just think back to the end of the year promotional ads that have appeared on TV and in farm magazines in recent years stating that a contract could be signed or delivery be taken before year end for a business asset to be depreciable. That’s not correct. While the asset need not be “used” by the taxpayer to be placed in service, it still has to be ready and available for use. Merely signing a contract or taking delivery of parts and materials that have to be assembled is not enough.
Monday, April 10, 2017
The Endangered Species Act (ESA) establishes a regulatory framework for the protection and recovery of endangered and threatened species of plants, fish and wildlife. 16 U.S.C. § 1531 et seq (2002). The U.S. Fish and Wildlife Service (USFWS), within the Department of the Interior, is the lead administrative agency for most threatened or endangered species.
The ESA has the potential to restrict substantially agricultural activities because many of the protections provided for threatened and endangered species under the Act extend to individual members of the species when they are on private land. Approximately 90 percent of endangered species have some habitat on private land, with almost 70 percent of the endangered or threatened species having over 60 percent of their total habitat on nonfederal lands. A recent decision of the U.S. Court of Appeals for the Tenth Circuit reiterates that the ESA applies to activities on private land. That’s the focus of today’s post.
The Impact of Species “Listing”
Once a species has been listed as endangered or threatened, the ESA prohibits various activities involving the listed species unless an exemption or permit is granted. For example, with respect to endangered species of fish, wildlife and plants, the ESA makes it unlawful for any person to import or export such species, deliver, receive, carry, transport or ship in interstate or foreign commerce by any means whatsoever, and sell or offer for sale in interstate or foreign commerce any such species. The ESA, with regard to endangered species of fish or wildlife, but not species of plants, makes it unlawful for any person subject to the jurisdiction of the United States to “take” any such species. 16 U.S.C. §§ 1538(a)(1)(B), (C) (2008). The ESA defines the term “take” to mean harass, harm, pursue, hunt, shoot, wound, kill, trap, capture, or collect, or to attempt to engage in any such conduct. The prohibition against “taking” an endangered species applies to actions occurring on private land as well as state or federal public land, and financial penalties apply for violating the prohibition.
1982 amendments to the ESA establish an incidental take permit process that allows a person or entity to obtain a permit to lawfully take an endangered species “if such taking is incidental to, and not the purpose of, the carrying out of an otherwise lawful activity.” 16 U.S.C. §1539(a)(1)(B). A person may seek an incidental take permit from the USFWS by filing an application that includes a Habitat Conservation Plan (HCP) which includes a description of the impacts that will likely result from the taking, proposed steps to minimize and mitigate those impacts, and alternatives to the taking that the applicant considered and the reasons why those alternatives were not selected. If the permit is issued, the FWS will monitor the project for compliance with the HCP and the effects of the permitted action and the effectiveness of the conservation program. The FWS may suspend or revoke all or part of an incidental take permit if the permit holder fails to comply with the conditions of the permit or the laws and regulations governing the activity.
Impact on Private Land Use Activities
The denial of an incidental take permit involving habitat modification of an underground cave bug of no known human commercial value and only found in two Texas counties has been upheld against a Commerce Clause challenge. GDF Realty Investments, LTD, et al. v. Norton, 326 F.3d 622 (5th Cir. 2004), reh’g en banc denied, 362 F.3d 286 (5th Cir. 2004), cert. denied, 545 U.S. 1114 (2005). The landowner claimed the federal government had no jurisdiction due to the lack of connection with interstate commerce. The court upheld the denial of the incidental take permit on the basis that the bug could be aggregated with all other endangered species to show a sufficient connection with interstate commerce. Likewise, in Rancho Viejo, LLC v. Norton, 323 F.3d 1062 (D.C. Cir. 2003), reh’g en banc denied, 334 F.3d 1158 (D.C. Cir. 2003), cert. denied, 540 U.S. 1218 (2004), a different court held that the ESA extended to the Southwestern Arroyo Toad even though the Arroyo Toad only resided in southern California and never has been an article of commerce. In 2009, a commercial wind farm was enjoined from further development until receipt of an incidental take permit due to the project’s impact on the endangered Indiana bat. The court held that it was a “virtual certainty” that Indiana bats would be “harmed, wounded or killed” by the wind farm in violation of the ESA during times that they were not hibernating. Animal Welfare Institute, et al. v. Beech Ridge Energy LLC, et al., 675 F. Supp. 2d 540 (D. Md. 2009).
An important issue for farmers and ranchers is whether habitat modifications caused by routine farming or ranching activities are included within the definition of the term “take.” In 1975, the Department of Interior issued a regulation defining “harm” as “an act or omission which actually injures or kills wildlife, including acts which annoy it to such an extent as to significantly disrupt essential behavior patterns, which include, but are not limited to, breeding, feeding or sheltering; significant environmental modification or degradation which has such effects is included within the meaning of ‘harm’.” 50 C.F.R. § 17.3; 40 Fed. Reg. 44412, 44416. The regulation was amended in 1981 to emphasize that actual death or injury to the listed species is necessary, but the inclusion of “habitat modification” in the definition of “harm” led to a series of legal challenges.
The regulation was upheld by the Ninth Circuit Court of Appeals in 1988 in a case involving an endangered bird species whose critical habitat was on state-owned land in Hawaii. Palila v. Hawaii Dept. of Land & Natural Resources, 639 F.2d 495 (9th Cir. 1981). The court held that the grazing of goats and sheep threatened to destroy the endangered birds' woodland habitat and resulted in harm and a “taking” of the endangered bird. The court ordered the Hawaii Department of Land and Natural Resources to remove the goats and sheep from the birds' critical habitat. In subsequent litigation, the plaintiffs sought the removal of an additional variety of sheep from the birds' critical habitat. The defendant argued that, under the ESA, “harm” included only the actual and immediate destruction of the birds' food source, not the potential for harm which could drive the bird to extinction. However, the Ninth Circuit held that “harm” is not limited to immediate, direct physical injury to the species, but also includes habitat modification which may subsequently result in injury or death of individuals of the endangered species. Palila v. Hawaii Dept. of Land & Natural Resources, 852 F.2d 1106 (9th Cir. 1988).
Recent case. In People for the Ethical Treatment of Property Owners v. Unites States Fish and Wildlife Service, No. 14-4151, 2017 U.S. App. LEXIS 5440 (10th Cir. Mar. 29, 2017). the U.S. Court of Appeals for the Tenth Circuit again illustrated the impact of the ESA on private land activities in a case involving protected prairie dogs. In the case, the plaintiffs were landowners in Utah whose experienced problems with the prevalence of the Utah prairie dog damaging their tracts. The Utah prairie dog is a threatened species under the ESA and has approximately 70 percent of its population on private land. The Utah prairie dog is found only in Utah, and its population has increased about 12 times over since 1973.
As a threatened species, the USFWS issued a special rule regulating the “taking” of the Utah prairie dog. Under the rule, “taking” was limited to agricultural land, property within one-half mile of conservation land and areas where the species creates serious human safety hazards or disturb the sanctity of significant cultural or burial sites. Incidental taking is allowed if it occurs as part of standard agricultural practices. The plaintiffs challenged the rule as applied to private land as not authorized under either the Commerce Clause or the Necessary and Proper Clause of the U.S. Constitution and sought declaratory and injunctive relief.
The trial court granted the plaintiffs motion for summary judgment on the basis that the Commerce Clause does not authorize the Congress to enact legislation authorizing the regulation of the taking of a purely intrastate species without a substantial effect on interstate commerce and the Necessary and Proper Clause did not authorize the regulation of taking of the species because the regulation is not essential to the ESA’s economic scheme. The government appealed.
On review, the appellate court reversed. The appellate court determined that the “substantial effect” on interstate commerce was to be determined under the rational basis standard. Under that standard, the appellate court held that the Congress has the power to regulate purely local activities that are part of an economic class of activities that have a substantial effect on interstate commerce. Thus, because (in this court’s view) the Commerce Clause authorized the regulation of noncommercial purely intrastate activity that is an essential part of a broader regulatory scheme, the “take” regulation was constitutional. The appellate court noted that approximately 68 percent of ESA-protected species have habitats that do not cross state borders, as such the court reasoned that the ESA could be severely undercut if the ESA only allowed protection to those species whose habitats were in multiple states.
The ESA and the underlying regulations have a significant impact on private landowners and associated agricultural activities. With new leadership in the White House and regulatory agencies it remains to be seen whether that will amount to any change in how the rules are applied on private land.
Thursday, April 6, 2017
Yesterday the U.S. House Committee on Agriculture Heard Testimony concerning the impact of the tax code on the agricultural industry. I teach farm income tax at the law school, and a significant focus of the course for the students is on those areas of tax law where the rules are different for agricultural producers and agricultural businesses than they are for other taxpayers. The stated (and largely correct) reason for the different treatment of agriculture is that there are unique risks that the sector faces.
One of the speakers at the hearing focused on the uniqueness of farm income tax. I found that interesting and today’s post will summarize the testimony of that speaker – Chris Hesse. Chris is a principal of CliftonLarsonAllen. I am only focusing on the portions of his testimony that dealt with tax issues unique to agricultural producers and businesses. It’s important for legislators to understand these unique provisions and how they apply to agricultural producers.
Installment method. Farm businesses can report income on the installment method. That means that income is recognized when payment is received instead of when the sale is made. This rule can apply to the sales of raised crops and livestock, for example. Nonfarm businesses cannot report the income from the sale of products manufactured or held for sale to customers using the installment method. A seller of ag equipment (e.g., an implement dealer) is not a “farmer” and can’t use the installment method.
Commodity Credit Corporation (CCC) loans. The CCC is the USDA’s financing institution with programs administered by the Farm Service Agency (FSA). Among other things, the CCC makes commodity and farm storage facility loans to farmers where the farmers’ crops are pledged as collateral. These loans are part of the price and income support system of the federal farm programs. Farmers have an option for treating the loan on the return – either as a loan or as income in the year that the loan proceeds are received.
Crop insurance. Farmers can defer the receipt of crop insurance proceeds that are paid for physical damage or destruction to crops. Deferred planting payments are also deferrable. But, if the policy pays based on anything other than physical damage or destruction to covered crops, the payments are not deferrable
Livestock sales on account of weather-related conditions. There are two basic deferral rules that can apply when excess livestock are sold on account of weather-related conditions. I recently blogged on these two rules in light of the wildfires in Kansas, Oklahoma and Texas that has impacted cattle ranchers in those areas. One rule provides for a one-year deferral and the other rule provides the ability to replace the excess livestock with replacement animals and deferral of the gain until the replacement animals are disposed of.
Hedging. As Chris pointed out in his testimony, farmers may reduce price risk for both the sale of crops and livestock and for the purchase of inputs. Puts, calls, and the commodity futures markets are available to hedge prices for the inputs and sales. The hedging opportunities provide ordinary income or loss treatment upon using techniques to lock-in prices. Without this provision, a loss on a commodity futures contract would be capital gain, the deductibility of which is limited to capital gains plus $3,000.
Cancelled debt income. The default treatment for the discharge of indebtedness is as taxable income. However, exclusions are available. One of those is unique to farmers and involves the discharge of qualified farm indebtedness. My blog post of March 29, 2017, dealt with this rule.
Raising livestock. Farmers may deduct the costs of raising livestock, even though dairy cattle, for example, otherwise have a pre-productive period of more than two years. Consequently, when cattle are culled from the breeding or dairy herd, the farmer recognizes I.R.C. §1231 gain, usually taxed as capital gain.
Raising crops. Farmers may deduct the costs of raising crops in the year paid for a cash method farmer, except for those crops that have a more than two-year pre-productive period. But, an election is available for the crops with a more than two-year pre-productive period which allows a current deduction for the costs of establishing the crop. If election is made, depreciation on all farm assets must be computed using slower methods over longer cost recovery periods. The cost of raising the crops is deductible in the year paid for the cash method farmer.
I.R.C. §199. The Domestic Production Activities Deduction (DPAD) of I.R.C. §199 reduces the overall tax rate from growing and production activities for farmers that pay W-2 wages. It’s a nine percent deduction from net farm income (but it doesn’t reduce self-employment income). This provision is uniquely applied to agriculture in the context of cooperatives, farm landlords, crop insurance payments, Farm Service Agency subsidies, custom feeding operations, hedging transactions and the storage of ag commodities.
Fertilizer and soil conditioning expenditures. Farmers can elect to deduct fertilizer and soil conditioner expenses in the year purchased.
Farm supplies. Farm supplies are deductible in the year that they are paid for, rather than in the year of their use.
Charitable donation of conservation easement. Farmers get an enhanced limitation for the donation of a conservation easement. Instead of a 50 percent of adjusted gross limitation for non-farm taxpayers, a farmer or rancher may claim a charitable deduction up to 100 percent of adjusted gross income. If the charitable deduction is greater than the limitation, the excess charitable deduction may be carried forward for up to 15 years.
Charitable contribution of food. Farmers may deduct up to 50 percent of the value of apparently wholesome food given for the benefit of the needy. This provision provides the same incentive to grower/packer/shippers who own cash basis inventory, as provided to the local grocery store that has excess food inventory nearing its expiration date.
Other Provisions Unique to Agriculture
Estimated tax. Form 1040 farmers need not pay estimated taxes if the tax return is filed by March 1. Farmers who don’t file by March 1 can pay one estimated tax payment on January 15. This flexibility helps farmers by not having to pay income tax on expected income that doesn’t arise to the risks mentioned above.
Farm income averaging. Farmers can average their income over a three-year period. This helps deal with fluctuating commodity prices, and is useful upon retirement.
Net operating losses. Farmers have the option of using a net operating loss carryback period of five years, rather than the two-year provision applicable to non-farmers.
Optional self-employment tax. Farmers benefit from the optional self-employment tax, to earn credits toward the Social Security system even though suffering a loss in a current year. Non-farm taxpayers may elect optional self-employment tax for only five years. Farmers do not have a limit.
Farm supplies. Farmers may deduct farm supplies in the year paid, rather than the year consumed (within limits).
Chapter 12 bankruptcy. Farm bankruptcy (Chapter 12) contains a special rule that allows taxes owed to a governmental entity to be changed from priority to non-priority status. This wasn’t in Chris’ testimony, but it’s a crucial provision particularly in this time of financial distress in agriculture. A current problem, however, is that the debt test for Chapter 12 needs to be raised. Numerous farming operations now have aggregate debt levels high enough that they are precluded from filing Chapter 12. For those, the tax provision is of no use.
CRP rents for a farmer receiving Social Security. A special tax rule allows active farmers who receive Conservation Reserve Program (CRP) payments to not pay self-employment tax on those payments if the farmer is also receiving Social Security benefits. This was also not a part of Chris’ testimony.
It was apparent at the hearing that interest deductibility for interest associated with farmland purchases is a key tax provision that should be retained. There had been some discussion during the summer of 2016 that its removal was a possibility. At least that was mentioned as a possibility in the “Blueprint” made public by the House Ways and Means Committee. That doesn’t seem to be the case now. Also, the hearing pointed out that the current tax-deferred exchange rules are necessary to retain.
On the federal estate tax, while the exemptions are high enough to exempt out the vast majority of farmers, the point was made that a significant reason of its inapplicability to farmers is that they engage in costly and time-consuming planning to avoid the tax. That’s what is called a “dead weight loss.” That point is never mentioned by the proponents of keeping the federal estate tax in place who claim they have no evidence of a farm or ranch ever having been sold to pay the tax. The retention of basis “step-up” at death is of particular importance to farm and ranch families.
Another panelist gave testimony that focused on proposals that could incentive farmers that are retiring from farming to transfer their assets before death. I haven’t seen much interest in the Congress over the past few years to enact the proposals suggested, but it’s still good to have the discussion and put the issues back out in the open.
It’s always nice when those in D.C. get to hear from those in the trenches that have to deal with the rules the Congress enacts. Hopefully the hearing was beneficial for the legislators.
Tuesday, April 4, 2017
A nuisance is an invasion of an individual's interest in the use and enjoyment of land rather than an interference with the exclusive possession or ownership of the land. The concept has become increasingly important in recent years due to land use conflicts posed by large-scale, industrialized confinement livestock operations. But, that’s not the only activity that has generated nuisance litigation. “Renewable” energy also has started to produce its own subset of nuisance cases. In these cases, the claim might involve allegations of noise, vibration, flicker, and damage to local aesthetics, among other annoyances.
But, can a nuisance claim be based solely on a claim of harm to aesthetics? If so, that could spell trouble for sources of renewable energy. The issue has been addressed by court on numerous occasions, but came up most recently in Vermont involving the installation of solar panels in a rural area – a so-called solar farm.
The issue of aesthetics (visual blight) and nuisance is the focus of today’s post.
Nuisance – In General
Nuisance law prohibits land uses that unreasonably and substantially interfere with another individual's quiet use and enjoyment of property. The doctrine is based on two interrelated concepts: (1) landowners have the right to use and enjoy property free of unreasonable interferences by others; and (2) landowners must use property so as not to injure adjacent owners.
Nuisance law is rooted in the common law and two primary issues are at stake in any agricultural nuisance dispute - whether the use alleged to be a nuisance is reasonable for the area and whether the use alleged to be a nuisance substantially interferes with the use and enjoyment of neighboring land. Each case is highly fact-dependent with the court considering multiple factors.
A private nuisance is a civil wrong that is based on a disturbance of rights in land. A private nuisance may consist of an interference with the physical condition of the land itself, as by vibration or blasting which damages a house, the destruction of crops, flooding, the raising of the water table, or the pollution of a stream or underground water supply. A private nuisance may also consist of a disturbance of the comfort or convenience of the occupant as by unpleasant odors, smoke, dust or gas, loud noises, excessive light, high temperatures, or even repeated telephone calls. The remedy for a private nuisance lies in the hands of the individual whose rights have been disturbed. A public nuisance, on the other hand, is an interference with the rights of the community at large. A public nuisance may include anything from the obstruction of a highway to a public gaming house or indecent exposure. The normal remedy is in the hands of the state.
Nuisance and Renewable Energy Production Activities
Odors from large-scale livestock confinement operations are not the only activities on rural property that give rise to nuisance actions. While such activities tend to predominate nuisance actions, especially in the Midwest, the development of large-scale wind turbine operations is also generating a great deal of conflict among rural landowners. While nuisance litigation involving large-scale “wind farms” is in its early stages, a significant opinion from the West Virginia Supreme Court in 2007 illustrates the land-use conflict issues that wind-farms can present. In Burch, et al. v. Nedpower Mount Storm, LLC and Shell Windenergy, Inc., 220 W. Va. 443, 647 S.E.2d 879 (2007), the West Virginia Supreme Court ruled that a proposed wind farm consisting of approximately 200 wind turbines in close proximity to residential property could constitute a nuisance. Seven homeowners living within a two-mile radius from the location of where the turbines were to be erected sought a permanent injunction against the construction and operation of the wind farm on the grounds that they would be negatively impacted by turbine noise, the eyesore of the flicker effect of the light atop the turbines, potential danger from broken blades, blades throwing ice, collapsing towers and a reduction in their property values. The court held that even though the state had approved the wind farm, the common-law doctrine of nuisance still applied. While the court found that the wind-farm was not a nuisance per se, the court noted that the wind-farm could become a nuisance. As such the plaintiffs’ allegations were sufficient to state a claim permitting the court to enjoin the creation of the wind farm. The court remanded the case to the trial court for a trial. At trial, the defendant was given an opportunity to establish that the operation of the wind farm did not unreasonably interfere with the plaintiffs’ use and enjoyment of their property. That’s how most of the cases positioned like this would turn out. Courts thend not to permit a claim for “anticipatory nuisance.” A party is entitled to show that they can conduct their activity without creating a nuisance.
In another case involving nuisance-related aspects of large-scale wind farms, the Kansas Supreme Court upheld a county ordinance banning commercial wind farms in the county. Zimmerman v. Board of County Commissioners, 218 P.3d 400 (Kan. 2009). The court determined that the county had properly followed state statutory procedures in adopting the ordinance, and that the ordinance was reasonable based on the county’s consideration of aesthetics, ecology, flora and fauna of the Flint Hills. The Court cited the numerous adverse effects of commercial wind farms including damage to the local ecology and the prairie chicken habitat (including breeding grounds, nesting and feeding areas and flight patterns) and the unsightly nature of large wind turbines. The Court also noted that commercial wind farms have a negative impact on property values, and that agricultural and nature-based tourism would also suffer.
Aesthetic Injury Only?
But what if the only complained-of problem is aesthetic? Is that enough to make out a claim for nuisance? The issue came up recently in a court case from Vermont that involved solar panels. In Myrick v. Peck Electric Co., et al., No. 16-167, 2017 Vt. LEXIS 4 (Vt. Sup. Ct. Jan. 13, 2017), the plaintiff was a landowner that sued the defendant, two solar energy companies, when the plaintiff’s neighbors leased property to the defendants for the purpose of constructing commercial solar arrays (panels). The plaintiff claimed that the solar arrays constituted a private nuisance by negatively affecting the surrounding area’s rural aesthetic which also caused local property values to decline. The trial court granted summary judgment to the defendants. On appeal, the Vermont Supreme Court affirmed. The Court noted that Vermont law has held, dating back to the late 1800s, that private nuisance actions based on aesthetic disapproval alone are barred. The Court rejected the plaintiff’s argument that the historic Vermont position should change based on changed society. The Court also rejected the notion that Vermont private nuisance law was broad enough to apply to aesthetic harm, stating that, “An unattractive sight, without more, is not a substantial interference as a matter of law because the mere appearance of the property of another does not affect a citizen’s ability to use and enjoy his or her neighboring land.” Emotional distress is not an interference with the use or enjoyment of land, the court stated. But, if the solar panels casted reflections, for example, that could be an interference with the use and enjoyment of one’s property. Aesthetic values, the court noted, are inherently subjective and the court wasn’t going to set an aesthetic standard. The Court also noted that the plaintiffs had conceded at oral argument that they were not pursuing a claim that diminution in value, by itself, was sufficient to constitute a nuisance. However, the Court went on to state that a nuisance claim based solely on loss in value invites speculation that the Court would not engage in.
The decision from Vermont follows the majority rule among jurisdictions in the United States. Of course, there are some exceptions. For example, a few courts have held that proof of general damages (diminished quality of life) may be sufficient evidence to support a monetary award. See, e.g., Stephens, et al. v. Pillen, 12 Neb. App. 600 (2004). But, in general, aesthetic injury, by itself, is not enough to make a claim for nuisance. However, if it is coupled with claims of substantial interference with use and enjoyment of property, a nuisance claim might successfully be made. Renewable energy generation tends to require a large amount of land for its operation, but unsightliness, by itself, probably won’t be enough to make it a nuisance.