Thursday, February 23, 2017

Some Thoughts On Long-Term Care Insurance

Overview

For many persons, estate planning also includes planning for the possibility of long-term health care.  Nursing home care is expensive (even though rural Kansas has some of the lowest costs in the country, it can still exceed $5,000/month in those areas) and can require the liquidation of assets to generate the funds necessary to pay the nursing home bill unless appropriate planning has been taken.  How will that expense be funded?  Medicaid is one option.  That’s the joint federal/state program that pays for long-term health care in a nursing home.  To be able to receive Medicaid benefits, an individual must meet numerous eligibility requirements but, in short, must have a very minimal level of income and assets.  States set their own asset limits and determine what assets count toward the limit.  Assets exceeding the limit must be spent on the applicant’s nursing home care before Medicaid eligibility can be established.

Another option is long-term care (LTC) insurance.  I get numerous questions concerning LTC insurance.  That’s the topic of today’s post

LTC Insurance

Why not much usage?  Like many other industries in recent years, the LTC insurance industry has shrunk dramatically in terms of the number of companies that issue policies.  Compared to about 15 years ago, there are only about one-tenth of the number of companies that presently sell LTC policies that were doing so then.  Relatedly, annual sales have dropped.  The result is that roughly 10 percent of the U.S. population has some sort of long term care plan in place.  What I mean by that is any type of plan – LTC insurance or otherwise.   Of those 10 percent, LTC insurance would be a component of only a portion of them.  So, the point is that LTC insurance is underutilized.  Why?  Well, LTC insurance suffers from a fundamental problem – those that can afford it don’t need it and those that need it can’t afford it!  For example, the annual premiums for a couple around age 60 can vary widely anywhere from $1,700 to over $3,000 depending on the type of policy and type of coverage obtained, and the particular state.  That’s a tough amount to swallow for many people.

How much coverage to get?  It’s also hard to predict how much coverage is going to be needed.  Women typically need it longer than men – about a year and one-half longer so says the U.S. Department of Health and Human Services.  If long-term care will cost $75,000 annually (and that’s a conservative estimate), then at least a benefit totaling $150,000-$200,000 is probably necessary as a minimum.  To get five years’ worth of benefit coverage, that would indicate sufficient premiums should be paid to get about $400,000 worth of benefits.  That could push annual premiums to $5,000 year for that couple near age 60.  Why five years?  That’s the present ‘look-back” period for asset transfer without adequate consideration.  The value of transfers outside that window aren’t deemed to be available to the transferor for Medicaid eligibility purposes.  But, keep in mind that the average nursing home stay is slightly less than a year for a male and about a year and one-half for a female (based on some recent studies that I have seen).  But, that’s only an average.  So, maybe a good rule of thumb is to price a policy based on 2 and 4 years of coverage.   

Custodial care.  LTC insurance doesn’t only deal with medical issues.  It also can be used to pay for daily assistance with common tasks such as bathing and dressing.  It’s this “custodial care” dimension that many people will find necessary as they age, whether or not they are in a nursing home.  Thus, LTC insurance can be used to plug a “gap” between Medicaid and Medicare.  Medicaid can cover institutionalized care, but only after resources have been depleted, and Medicare won’t cover custodial care.  So, unless a person has family or friends or is self-insured, there will be a need, but perhaps no way to pay for it while simultaneously avoiding disposing of assets to come up with the funds to pay for custodial care.  That’s a tough spot to be in.  LTC should be looked at as one possibility in that situation.      

Peculiarities of policies.  It is possible that some of the LTC policies will discount the premium cost if a couple buys the policies together as a package.  Also, watch what the policy says about how you can use the benefits.  Do you have to use the entire monthly benefit, or can you use only a part of it and private pay the balance and stretch-out the coverage?  Some policies will allow that, but others won’t. 

Another detail to look for in a policy is whether premiums can change and, if they can, whether you will be notified of when that will occur.  The last thing a person wants to have happen is to pay on a policy for a number of years and then have the premium go up to an extent that they can no longer afford it and they drop the policy as a result.   

It’s also a good idea to analyze any particular policy on the basis of whether it is an indemnity plan or a reimbursement plan.  An indemnity plan basically means that the insured will get paid a cash benefit that is the same thing as the daily benefit.  On the other hand, a reimbursement plan pays the full daily benefit when the actual cost of care either equals or exceeds the daily benefit.  Which type of policy is more desirable?  Again, it depends.  Cash benefit policies cost more, but they do give the policy holder greater flexibility in paying a family member to provide care.  To some people, that is in important option to have.

Another question to ask of the insurer is how the policy works if nursing home care is required and the policy holder returns to their home at some later point.  It might be that the benefits paid out to cover the nursing home bill will reduce the available benefits if the insured has to go back to the nursing home at some later point in time.  That may not be the case, but it is worth knowing what might happen.

From an economic standpoint, examine any given policy to determine if there is inflation protection built in.  Nursing home costs will go up.  Will the policy benefits also increase?  If there is built-in inflation protection, how much does the premium go up?  Can this issue be addressed by delaying payment of benefits under the policy once institutionalization occurs?  That might be possible.

Conclusion

As an investment, LTC insurance is probably not at the top of the list of the good ones.  If it is purchased early and there is no pre-existing condition, and benefits are triggered early on, then it can turn out to be a good deal.  But, a person could be better off simply setting aside funds every month in an investment account that is earmarked as being set aside to cover long-term care costs.  That’s particularly the case if benefits under the policy won’t be used for some time in the future.

Whether or not to obtain LTC insurance is a difficult decision.  There are numerous things to think about, and some of those involve predicting what might happen in the future.  How clear is your crystal ball?

February 23, 2017 | Permalink | Comments (0)

Tuesday, February 21, 2017

The Scope and Effect of the “Small Partnership Exception”

Overview

Every partnership (defined as a joint venture or any other unincorporated organization) that conducts a business is required to file a return for each tax year that reports the items of gross income and allowable deductions. I.R.C. §§761(a), 6031(a).  If a partnership return is not timely filed (including extensions) or is timely filed but is inadequate, a monthly penalty is triggered that equals $200 times the number of partners during any part of the tax year for each month (or fraction thereof) for which the failure continues.  However, the penalty amount is capped at 12 months.  Thus, for example, the monthly penalty for a 15-partner partnership would be $3,000 (15 x $200) capped at $36,000.  Such an entity is also subject to rules enacted under the Tax Equity and Fiscal Responsibility Act (TEFRA) of 1982.  These rules established unified procedures for the IRS examination of partnerships, rather than a separate examination of each partner.

An exception from the penalty for failing to file a partnership return and the TEFRA audit procedures could apply for many small business partnerships and farming operations.  However, it is important to understand the scope of the exception, and what is still required of such entities even if a partnership return is not filed.  In many instances, such entities may find that simply filing a partnership return in any event is a more practical approach.   

Just exactly what is the “small partnership exception”?  That’s the focus of today post.    

Exception for Failure to File Partnership Return

The penalty for failure to file is assessed against the partnership.  While there is not a statutory exception to the penalty, it is not assessed if it can be shown that the failure to file was due to reasonable cause. I.R.C. §6689(a). The taxpayer bears the burden to show reasonable cause based on the facts and circumstances of each situation.  On the reasonable cause issue, the IRS, in Rev. Proc. 84-35, 1984-1 C.B. 509, established an exception from the penalty for failing to file a partnership return for a “small partnership.”  Under the Rev. Proc., an entity that satisfies the requirements to be a small partnership will be considered to meet the reasonable cause test and will not be subject to the penalty imposed by I.R.C. §6698 for the failure to file a complete or timely partnership return.  However, the Rev. Proc. noted that each partner of the small partnership must fully report their shares of the income, deductions and credits of the partnership on their timely filed income tax returns.

So what is a small partnership?  Under Rev. Proc. 84-35 (and I.R.C. §6231(a)(1)(B)), a “small partnership” must satisfy six requirements:

  • The partnership must be a domestic partnership;
  • The partnership must have 10 or fewer partners;
  • All of the partners must be natural persons (other than a nonresident alien), an estate of a deceased partner, or C corporations;
  • Each partner’s share of each partnership item must be the same as the partner’s share of every other item;
  • All of the partners must have timely filed their income tax returns; and
  • All of the partners must establish that they reported their share of the income, deductions and credits of the partnership on their timely filed income tax returns if the IRS requests.      

Applying the Small Partnership Exception – Practitioner Problems

So how does the small partnership exception work in practice? Typically, the IRS will have asserted the I.R.C. §6698 penalty for the failure to file a partnership return.  The penalty can be assessed before the partnership has an opportunity to assert reasonable cause or after the IRS has considered and rejected the taxpayer’s claim.  When that happens, the partnership must request reconsideration of the penalty and establish that the small partnership exception applies so that reasonable cause exists to excuse the failure to file a partnership return.

Throughout this process, the burden is on the taxpayer. That’s a key point.  In most instances, the partners will likely decide that it is simply easier to file a partnership return instead of potentially getting the partnership into a situation where the partnership (and the partners) have to satisfy an IRS request to establish that all of the partners have fully reported their shares of income, deductions and credits on their own timely filed returns. As a result, the best approach for practitioners to follow is to simply file a partnership return so as to avoid the possibility that IRS would assert the $200/partner/month penalty and issue an assessment notice.  IRS has the ability to identify the non-filed partnership return from the TIN matching process.  One thing that is for sure is that clients do not appreciate getting an IRS assessment notice.

The Actual Relief of the Small Partnership Exception

Typically, the small partnership exception is limited in usefulness to those situations where the partners are unaware of the partnership return filing requirement or are unaware that they have a partnership for tax purposes, and the IRS asserts the penalty for failing to file a partnership return.  In those situations, the partnership can use the exception to show reasonable cause for the failure to file a partnership return.  But, even if the exception is deemed to apply, the IRS can require that the individual partners prove that they have properly reported all tax items on their individual returns. 

In addition, if the small partnership exception applies, it does not mean that the small partnership is not a partnership for tax purposes.  It only means that the small partnership is not subject to the penalty for failure to file a partnership return and the TEFRA audit procedures.

Why does the “small partnership exception” only apply for TEFRA audit procedures and not the entire Internal Revenue Code?  It’s because the statutory definition of “small partnership” contained in I.R.C. §6231(a)(1)(B) applies only in the context of “this subchapter.”  “This subchapter” means Subchapter C of Chapter 63 of the I.R.C.  Chapter 63 is entitled, “Assessment.”  Thus, the exception for a small partnership only means that that IRS can determine the treatment of a partnership item at the partner level, rather than being required to determine the treatment at the partnership level.  The subchapter does not contain any exception from a filing requirement.  By contrast, the rules for the filing of a partnership return (a “partnership” is defined in I.R.C. §761, which is contained in Chapter 1) are found in Chapter 61, subchapter A – specifically I.R.C. §6031.  Because a “partnership” is defined in I.R.C. §761 for purposes of filing a return rather than under I.R.C. §6231, and the requirement to file is contained in I.R.C. §6031, the small partnership exception has no application for purposes of filing a partnership return.  Thus, Rev. Proc. 84-35 states that if specific criteria are satisfied, there is no penalty for failure to file a timely or complete partnership return.  There is no blanket exception from filing a partnership return.  A requirement to meet this exception includes the partner timely reporting the share of partnership income, deductions and credits on the partner’s tax return. Those amounts can’t be determined without the partnership computing them, using accounting methods determined by the partnership and perhaps the partnership making elections such as I.R.C. §179. 

The small partnership exception does not apply outside of TEFRA. Any suggestion otherwise is simply a misreading of the Internal Revenue Code.

Conclusion

The small partnership exception usually arises as an after-the-fact attempt at establishing reasonable cause to avoid penalties for failure to file a partnership return.  The exception was enacted in 1982 as part of TEFRA to implement unified audit examination and litigation provisions which centralize treatment of partnership taxation issues and ensure equal treatment of partners by uniformly adjusting the tax liability of partners in a partnership.  It is far from a way to escape partnership tax complexity, and not a blanket exemption from the other requirements that apply to all partnerships.  The failure to file a partnership return could have significant consequences to the small partnership.  Ignoring Subchapter K also could have profound consequences, the least of which is dealing with penalty notices.

Under the Balanced Budget Act of 2015 (BBA) (Pub. L. No. 114-74, §1101(a), 129 Stat. 584 (2015)), new partnership audit rules are instituted effective for tax returns filed for tax years beginning on or after January 1, 2018 (although a taxpayer can elect to have the BBA provisions apply to any partnership return filed after the date of enactment (November 2, 2015).  The BBA contains a revised definition of a “small partnership” by including within the definition those partnerships that are required to furnish 100 or fewer K-1s for the year.  If a partnership fits within the definition and desires to be excluded from the BBA provisions, it must make an election on a timely filed return and include the name and identification number of each partner.  If the election is made, the partnership will not be subject to the BBA audit provisions and the IRS will apply the audit procedures for individual taxpayers.  Thus, the partnership will be audited separately from each partner and the TEFRA rules will not apply, and the reasonable cause defense to an IRS assertion of penalties for failure to file a partnership return can be raised.

February 21, 2017 | Permalink | Comments (0)

Friday, February 17, 2017

Kansas Water Law - Reactions to and Potential Consequences of the Garetson decision

Overview

Last week I posted a summary of a recent Kansas county district court decision on remand that involved the prior appropriation doctrine.  The summary contained the thoughts of my colleague at the Washburn University School of law, Prof. Burke Griggs  That post discussed  the Haskell County District Court’s recent decision in Garetson Bros. v. American Warrior et al., (Dist. Ct. No. 2012-CV-09), in which the court protected a senior vested water right from impairment by issuing a permanent injunction prohibiting two junior wells from pumping.  From a purely judicial standpoint, the case is not complicated.  It stands for the proposition that Kansas water law—specifically the prior appropriation doctrine—means what it says: first in time is first in right, and owners of senior wells impaired by junior water rights are entitled to injunctive protections, unqualified by mitigating economic factors.

Today, in part two of the discussion, Prof. Griggs discusses what could be the consequences of the court’s decision. 

The Prior Appropriation Doctrine

Westerners supposedly love the prior appropriation doctrine: like frontier whiskey, it is clear and works quickly, even if its effects can be rather harsh. As the Colorado Court of Appeals pointed out long ago in Armstrong v. Larimer County Ditch Co. (27 P. 235, 237 (1891)), the seniors-take-all approach of the prior appropriation doctrine works better than the fair and balanced equities-based approach of eastern water law: it works better because there is not enough water to supply all rights in dry years, and sharing the shortage would make all water rights owners so short of water that no one could make productive use of their share. In the West, as Frank Trelease memorably wrote, “priority is equity.”

If only the issue were that simple. While the clarity of the prior appropriation doctrine shines through the legal decisions in the Garetson case (and especially the earlier and largely controlling opinion in Garetson Bros. v. Am. Warrior, Inc., 347 P.3d 687 (2015)), hydrological, administrative, and political considerations are increasingly clouding that doctrinal clarity.

Hydrological considerations.  Garetson is a conflict between rival irrigators who access the non-renewable waters of the Ogallala Aquifer.  But, there is also a conflict with groundwater that raises certain hard problems for the prior appropriation doctrine. When the chief engineer shuts off (or “administers”) junior water rights to a stream or river system, the effect of that administration is typically clear and immediate; water prevented from reaching a junior’s canal headgate flows down to supply a senior’s. The administration of rights in an alluvial groundwater system—where the wells are close to the river—has similarly prompt and predictable effects. The Ogallala is different: because its supplies are dispersed and non-renewable, it is not always easy to determine with precision how the groundwater pumping of junior rights in a water rights neighborhood affects or impairs the pumping of a senior right. The architects of the original 1945 Kansas Water Appropriation Act (“KWAA”) recognized this hydrological difference, but deliberately decided to extend the doctrine to groundwater—including the supplies of the Ogallala. The KWAA softened the standards for granting new rights to the Ogallala, but clearly maintained the priority rule for protecting existing rights. The 1957 revisions to the KWAA were focused on allowing the development of new Ogallala water rights, and the chief engineers did their statutory duty: because water was available for rights under these softer standards, more water rights were granted to the Ogallala than the aquifer could durably sustain. As a consequence, by 1970 or so, groundwater depletion was becoming a serious problem. The Kansas Division of Water Resources (“DWR”) responded to this hydrological problem by developing procedures (at K.A.R. 5-4-1 and 5-4-1a) which set forth the process by which DWR investigates and determines impairment complaints in a groundwater system. Despite these procedures, however, a hard hydrological fact of the Ogallala remains: in order to fully protect one groundwater right to the Ogallala, it may be necessary to shut down many junior rights, more rights than are administered in a typical surface water rights administration. This is the principal reason why so few impairment complaints have been filed over the Ogallala. Owners of senior water rights know their rights, but they also know that the administration of junior rights may affect many of their neighbors—as well as junior rights which they themselves own.

Administrative difficulties. The conflict between the legal clarity of the prior appropriation doctrine and the administrative difficulty of determining impairment in a groundwater-exclusive system is one of the central issues in the Garetson case. Although DWR was investigating the impairment of the Garetsons’ senior right, they decided to withdraw their impairment complaint, and took the matter to court directly. K.S.A. 82a-717a and 82a-716 clearly provide a court-based avenue for protecting senior rights, independent of DWR.  Under that approach, the senior right holder can obtain injunctive relief upon a finding of impairment—which is just what the Garetsons obtained. However, it is important to note that the facts in Garetson are somewhat unusual.   The court was able to use hydrological data along with data concerning pumping effects which DWR and the Kansas Geological Survey had produced during the time in which the Garetsons were pursuing the administrative avenue of resolving their impairment through K.A.R. 5-4-1a. Without such existing data—and the impairment reports which DWR produced in a very timely fashion in this case—the court would likely not have been able to issue its temporary and permanent injunctions so expeditiously.

Kansas water politics.  Those who lose in court often seek redress in the legislature, and often do so for less money. The clarity of the court’s injunctions in Garetson has promoted a substantial legislative reaction. In 2016, the defendants (American Warrior) and Southwest Kansas Groundwater Management District #3 sponsored legislation which would have substantially weakened the ability of senior water rights holders to protect their rights through the independent court-based avenues of K.S.A. 82a-716 and 82a-717a. This legislation did not succeed, but the ongoing importance of Garetson prompted the Kansas Department of Agriculture (“KDA”), which exercises supervisory authority over DWR, to consider a legislative compromise between the administrative-based avenues of K.A.R. 5-4-1 and 5-4-1a and the above-mentioned court-based avenues. Together with major agricultural powers such as the Kansas Farm Bureau and the Kansas Livestock Association, they are sponsoring H.B. 2099. http://www.kslegislature.org/li/b2017_18/measures/documents/hb2099_00_0000.pdf 

Distilled to its essence, the legislation eliminates the two-avenue approach in favor of a sequential one: the senior water rights holder claiming impairment must first seek administrative relief through DWR to protect his or her right; DWR must promptly act upon the impairment complaint; only then, after the administrative process is complete, can the senior holder pursue an injunction in court.  But, this last step might not be necessary, provided that DWR deploys the impairment report in the service of water rights administration.

H.B. 2099 is a classic case of a wide-ranging legislative reaction to a single lawsuit. It raises at least three difficult questions. First of all, is the legislation legally necessary? Not really: Garetson was properly decided, and we have yet to see a snowballing effect wherein thousands of senior water rights owners begin to use the priority doctrine in an ominous way, threatening their junior neighbors. (Such threats would be perfectly legal, albeit impolite.) Second, should a conflict between water users—competing property owners—be completely transformed into a regulatory action in which the chief engineer’s impairment investigation and any consequent decisions about water rights administration are the central issues under judicial review?  Perhaps.  It is, after all, the chief engineer’s statutory duty to investigate impairment and to protect senior rights. That is why Kansas has an administrative system for water rights protection in the first place. But there is a third and troubling question: does the legislation diminish the courts’ undeniable powers to protect private property rights? Influential stakeholders may jealously guard their political clout, and use it in the legislature to obtain the ends they seek; but the courts are just as jealous and protective of their independent powers to resolve property disputes and to protect property rights, with or without the procedures prescribed by H.B. 2099. Moreover, the KWAA provides numerous protections for owners of senior rights, outside of K.S.A. 82a-716 and 82a-717a. Even if H.B. 2099 were to be enacted, the courts might cite those and other protections to circumvent it—including protections available under the Kansas Judicial Relief Act. They have done it before in construing the scope of the KWAA.

Conclusion

In sum, the Kansas water rights community is again facing a choice: whether to accept the consequences of prior appropriation in a groundwater context, or to attenuate those consequences by limiting the options of senior water rights holders to protect their private property rights. In this they are only human.  As St. Augustine famously wrote, “please Lord, grant me chastity and continence, but not yet.”

February 17, 2017 | Permalink | Comments (0)

Wednesday, February 15, 2017

The Ability of Tenants-in-Common To Bind Co-Tenants to a Farm Lease – and Related Issues

Overview

A question that I sometimes get involves an interesting aspect of farm lease law (although it’s probably not unique to agriculture) when the land is co-owned.  The question is whether, when co-owned farmland is leased, must all of the co-owners agree to lease the property?  On the flip side, must all of them agree to a termination of the lease?  Those are interesting and important questions. 

A few years ago, I discussed these issues with the former Dean of the University of Iowa College of Law who had written a bit on the matter in the 1960s.  Today’s blog post is loosely based on that conversation (and an initial article that my staff attorney Erica Eckley, and myself authored in 2013 – the original article is available at www.calt.iastate.edu).

Ohio Case

While most of the caselaw on the issue is relatively dated, there is a recent case from Ohio on point.  In H & H Farms, Inc. v. Huddle, No. 3:13 CV 371, 2013 U.S. Dist. LEXIS 72501 (N.D. Ohio May 22, 2013), a married couple owned a tract of farmland.  Over a period of time, they transferred undivided fractional interests in the farmland to a son – the defendant in the case.  The wife eventually died, with the husband remaining in the farm home.  At the time the case was filed, the son owned an undivided 94 percent interest in the farmland and his father owned 6 percent.  The plaintiff had been the tenant on the property for a number of years and was the father’s grandson and nephew of the son.  The father entered into an 11-year lease with the plaintiff for $150/year.  However, the son did not consent to the lease and claimed that it was unenforceable and that the plaintiff would be trespassing if he attempted to farm the land.  The plaintiff sought a declaratory judgment regarding the legal sufficiency of the lease, and the son filed a motion to dismiss. There was only one issue before the court - whether a legally plausible claim had been alleged.

The court addressed the legal standard for possession when tenants in common lease real estate. In Ohio, tenants in common each have a distinct title and right to enter upon the entire tract of real estate and take possession of it even if the ownership share is less than other tenants in common. If a tenant in common is not in possession of the real estate (i.e., an absentee landlord), that co-tenant is entitled to receive the reasonable rental value of the property from the co-tenant in possession consistent with the (absentee) co-tenant’s ownership interest.  The court also noted that, under Ohio law, when an owner conveys property via a lease, the owner retains the fee simple interest in the property. Ohio courts have held that the possession of the tenant is synonymous with the lessor’s possession.  Thus, tenants in common have a present possessory interest in the property. So, the father’s possession under the facts of the case was also the co-tenant’s possession. 

The son’s motion to dismiss was based on the argument that a tenant in common cannot convey, encumber, or divest the rights of a co-tenant. The court disagreed because of the principle that a lease does not divest the possession of the land from the co-tenant. The court held that because the son’s possessory rights were not divested, there would be no need for him to approve the lease.  Thus, the court declared that the plaintiff had stated a claim for which relief could be granted, and the motion to dismiss would not be granted.

The court, however, went on to state that it believed that when a six percent owner leases a farm to a third party for 11 years, it would be inequitable for the lease to remain with the land following a partition sale. But, that statement was merely dicta because it was not germane to the issue before the court and the motion to dismiss.  

So, the tenant’s possessory interest is strong and cannot be disturbed.  That also can mean that, absent a provision in a written lease, the landowner doesn’t have the right to hunt the leased ground absent the tenant’s permission.  Of course, not allowing the tenant to hunt the ground will likely result in the tenant being terminated as soon as possible under state law.

Related Issues

Accounting for rents.  Some states, such as Iowa have a statutory provision on this issue. Iowa Code § 557.16 explicitly states that a co-tenant in possession is liable for the reasonable rent to the co-tenant not in possession.  See, e.g., Meier v. Johannsen, 47 N.W.2d 793, 242 Iowa 665 (1951).   

Partition action.  Because the tenant’s right of possession during the term of the lease is strong and cannot be interfered with, that can mean that once there is a valid lease, the tenant’s rights probably cannot be dislodged by a partition action.  Similarly, property that is subject to a life estate cannot be partitioned.  Redding v. Redding, 284 N.W. 167, 226 Iowa 327 (1939).

Termination of lease.  In Dethlefs v. Carrier, 64 N.W.2d 272, 245 Iowa 786 (1954), a tenant had a written lease on 40 acres of farmland.  The land was owned by a brother and sister as tenants in common and the lease was entered into between the tenant and the sister.  The brother did not sign the lease.  Upon the sister’s death, the brother became the sole owner, but did not follow state law to terminate the lease.  The brother claimed that the sister’s death terminated not only her interest in the land, but also terminated the lease and eliminated the requirement that he give notice to terminate the lease.  The court disagreed on the basis that, in such a situation, a presumption arises that the lease was made with the knowledge and consent of each co-tenant.  There was no evidence to overcome the presumption  

Similarly, the tenant’s possessory interest also is an issue when the landlord dies during the term of the lease and a growing crop exists. Entitlement to the crop is fairly clear when the landlord owns a fee simple interest in the leased land — the landlord’s heirs succeed to the landlord’s share of the crop. However, if the landlord owns less than a fee simple interest in the leased land (such as a life estate), the outcome may be different. The question is whether the deceased landlord’s estate or the holder of the remainder interest is entitled to the landlord’s share. In two 1977 Kansas cases, Finley v. McClure, 222 Kan. 637, 567 P.2d 851 (1977) and Rewerts v. Whittington, 1 Kan. App. 2d 557, 571 P.2d 58 (1977), the landlord owned only a life estate interest in certain farm ground and leased it on shares to a tenant. The landlord died before the growing wheat crop was harvested, and the court held that the landlord’s crop share was a personal asset of the landlord, entitling the landlord’s estate to the landlord’s crop share on the basis that growing crops are personal property. The remainderman takes nothing. The Nebraska Supreme Court has reached a similar conclusion. Heinold v. Siecke, 257 Neb. 413, 598 N.W.2d 58 (1999).  However, the Colorado Supreme Court has held that the remainderman was entitled to the landlord’s share on the basis that the language in the deed creating the reserved life estate in the decedent had divested the estate of any rights to profits from the crops.  Williams v. Stander, 143 Colo. 469, 354 P.2d 492 (1960).

Conclusion

Whenever farmland is owned by multiple parties or the ownership interests include a life estate, a partition action is likely not possible, but an absentee co-tenant may not be required to consent to a lease.  It may be that a presumption arises that the lease was made with each co-tenant’s knowledge and consent.  An issue also arises if the landlord owns less than a full fee simple interest.  If you encounter these issues, consulting legal counsel would be a good idea.

February 15, 2017 | Permalink | Comments (0)

Monday, February 13, 2017

IRS To Continue Attacking Cash Method For Farmers Via the “Farming Syndicate Rule”

Overview

IRS has a long history of challenging taxpayers that it believes are distorting income reporting by use of the cash method of accounting.  As examples of the continued IRS attack on farmers using the cash method of accounting, in 2016, the IRS tried to deny a farmer’s surviving spouse a deduction for the cost of inputs she used to plant the crop that he had purchased before death, but died before he could use them to plant the spring crop.  Estate of Backemeyer v Comr., 147 T.C. No. 17 (2016).  While the farmer had deducted the costs of the inputs as pre-paid expenses in the year before he died, the IRS claimed she couldn’t deduct the same amount the following year on her return even though the value of the inputs were included in his estate under I.R.C. §1014.  The IRS position revealed a complete misunderstanding of associated tax rules and the Tax Court let the IRS know it in ruling for the estate. 

In 2015, the IRS tried to deny a deduction for a California farming corporation that deducted the cost of fieldpacking materials until the year the materials were actually consumed.  The IRS lost the case based on its own regulation.  Agro-Jal Farming Enterprises, Inc., et al. v. Comr., 145 T.C. 145 (2015).  A year earlier, a federal appeals court, in a case involving a Texas cattle and horse breeding limited partnership sternly disagreed with the IRS attack on that operation’s use of cash accounting via the “farming syndicate rule.”  Burnett Ranches, Limited v. United States, 753 F.3d 143 (5th Cir. 2014).  Despite the rebuke, the IRS has now issued a non-acquiescence to the court’s decision, signaling that their attack on the cash method will continue.  AOD 2017-7; 2017-7 IRB 868.

In both the 2014 Texas case and the 2015 California case, the IRS trotted-out the “farming syndicate” rule in an attempt to bar the deductions.  Because the IRS has now issued a non-acquiescence to the 2014 Fifth Circuit decision which signals its intent to continue examining the issue outside the Fifth Circuit, today’s blogpost is a reminder to practitioners of what the IRS is looking for and why the Courts have rejected their theories.

The Farming Syndicate Rule

In the farm and ranch sector, that alleged distortion often arises in the context of pre-payment for inputs such as fertilizer, seed, feed or chemicals.  Various tests and rules have been adopted over the years to deal with material distortions of income when pre-purchases are involved.  See, e.g., Rev. Rul. 79-229, 1979-2 C.B. 210.  One of those rules, which is designed to place a limitation on deductions for farming operations, was developed in the 1970s and is known as the Farming Syndicate Rule.  I.R.C. §461(j).   The Congress enacted the rule in 1976, and it eliminates “farming syndicates” from taking deductions for feed, seed, fertilizer and other farm supplies before the year in which the supplies are actually used or consumed.  The rule establishes two tests for determining whether a farming syndicate is present.  A farming syndicate is (1) a partnership or other enterprise (except a regularly taxed corporation) engaged in farming if the ownership interests in the firm have been offered for sale in any offering required to be registered with any federal or state securities agency (I.R.C. §461(j)(1)(A)) or (2) a partnership or other enterprise (other than a C corporation) engaged in farming if more than 35 percent of the losses during any period are allocable to limited partners or “limited entrepreneurs.” I.R.C. §461(j)(1)(B).

IRS Position.  The “farming syndicate” rule does not impact many farming and/or ranching operations, but it does catch some of the extremely large operations and a few individuals who are inactive investors in farming operations.  That’s because there is an exception to the rule for holdings attributable to “active management.”  If an “individual” has actively participated (for a period of not less than 5 years) in the management of the farming activity, any interest in a partnership or other enterprise that is attributable to that active participation is deemed to not be held by a limited partner or a limited entrepreneur.  I.R.C. §461(j)(2)(A).  That means that the interest doesn’t count toward the 35 percent test.  But, IRS has taken a strict interpretation of the statute.  In the IRS view, the exception for active management only applies to an “individual.”   Indeed, the statute does state, “in the case of any individual [emphasis added] who has actively participated…”.  I.R.C. §461(j)(2)(A).  Thus, in C.C.A. 200840042 (Jun. 16, 2008), the Chief Counsel’s office determined that a partnership interest held by an S corporation with only one shareholder was to be treated as held by a limited partner for purposes of the farming syndicate rule.  The partnership raised and bred livestock, and its members were two trusts along with the S corporation.  The S corporation was owned by a trustee who was also a beneficiary of the trusts.  One of the trusts was the general partnership of the partnership.  The partnership reported income on the cash method, but IRS took the position that the partnership interest that the S corporation held had to be treated as a limited partner interest because it wasn’t held by an “individual.”  This was the result, according to the IRS, even though the S corporation’s sole shareholder was an individual.  Thus, for purposes of the farming syndicate rule, the interest held by the S corporation was treated as an interest that was held by a limited partner.

Texas Case

Burnett Ranches involved a Texas cattle and horse breeding limited partnership that was 85 percent owned by an S corporation as a limited partner.  As such, the limited partnership met the definition of a farming syndicate.  However, the court held that the ranch qualified for the active participation exception to the farming syndicate rule even though the majority owner actively participated in managing the cattle operation through the owner’s wholly-owned S corporation.  The court noted that the west Texas operation had been family-run for many generations dating back into the 1800s, with the current majority owner family member simply owning her interest via an S corporation.   There was no question that that majority owner managed the operation and would satisfy the active management test in her own right. The IRS acknowledged as much.  But, IRS said the farming syndicate rule was triggered and cash accounting was not available because the ownership interest was held in an S corporation rather than directly by the majority shareholder as an individual.  Consequently, IRS said that the partnership could not use cash accounting for the years in issue – 2005-2007.  The limited partnership paid the alleged deficiencies (which amounted to several million dollars) and sued for a refund in federal district court.  The sole basis for the IRS denial of the cash method under the farming syndicate rule and the required switch to the accrual method was the fact that the S corporation owned the partnership interest, even though it was an S corporation that was 100 percent owned by the person that performed the entire management function of the business.  The district court ruled for the limited partnership.

The IRS appealed, continuing to maintain that the majority owner’s interest in the limited partnership via her S corporation barred the active management exception from applying.  The court disagreed, largely on policy grounds.  The court noted that the Congressional intent behind the active management exception of I.R.C. §464(c)(2)(A) was to target high-income, non-farm investors, not the type of taxpayer that the majority owner represented.  The court stated, “Ms. Marion’s business and ownership history with these ranches and their operations is the very antithesis of the “farming syndicate” tax shelters that §464 was enacted to thwart….”.  Indeed, the owner of the S corporation was the current descendant in a long line of descendants of the founder of the ranching operation dating to the mid-1800s.  The court went on to state, “[We] doubt that our interpretation of §464 will stymie the I.R.S., an agency tasked with uncovering abusive tax-avoidance schemes of myriad forms, not just those in the nature of a farming syndicate….  We deem it beyond peradventure that her limited partnership interest in Burnett Ranches is excepted from §464’s primary thrust of requiring farming syndicates to employ the accrual basis of accounting.”   

The court also noted that the statutory term “interest” was not synonymous with legal title or direct ownership, but rather was tied to involvement with or participation in the underlying business.  Thus, the court determined that there was no basis for distinguishing between “the partnership interest of a rancher who has structured his business as a sole proprietorship and a rancher who has structured his business as [a subchapter S] corporation.”  The term “individual” was used in the statute to refer to the provision of active management rather than in reference to having an interest in the activity at issue. 

Conclusion

The court’s opinion provides needed guidance on the narrow interpretation of the farming syndicate rule by the IRS.  The opinion is binding authority inside the Fifth Circuit - Louisiana, Mississippi and Texas.  But, with AOD 2017-7; 2017-7 IRB 868, the IRS has signaled that it will pick more battles on the same issue elsewhere.  That seems a bit ridiculous on this issue.   The IRS is spending its budget to pursue collection of tax dollars based upon its technical reading of required “active participation,” ignoring the 85 percent effective ownership of the person who, as was stipulated, actively participated.

It is no wonder that Congress has reduced the IRS budget over the years trying to send the message to the IRS to go after the real abuses, and don’t bother taxpayers that are trying to comply with the tax laws. This family involved in Burnett Ranches actively managed the ranches for over 150 years, long before the income tax was a problem (and in fact, before the area became part of the United States!). The IRS should leave honest taxpayers alone, and go after syndicates that are truly abusive.

February 13, 2017 | Permalink | Comments (0)

Thursday, February 9, 2017

The Home Office Deduction

Overview

Many self-employed farmers (as well as other self-employed persons) have an office in their home.  If strict rules are satisfied some generous above-the-line business expense deductions can be claimed.  But, to claim the expenses the 43-line Form 8829 with complex calculations must be completed and filed unless an optional safe harbor is utilized.  A farmer claims the deductions attributable to the home office on Schedule F of Form 1040.  IRS Pub. 587 provides helpful worksheets when computing the deduction.  

Business Use of the Home

Taxpayers with an office in the residence that is maintained regularly and exclusively for business purposes may deduct the costs associated with that office on IRS Form 8829. The office must be the principal place of business for the taxpayer (the most important or significant place for the business) or it must be a place of business used by clients or customers in the normal course of the taxpayer's trade or business.  What does that mean?  It means that the home office must be used exclusively and on a regular basis for business purposes – with limited exceptions for day care providers and inventory storage.  In addition, the home office is the “principal place of business” if it is used for administrative or management activities of the business or it is the most important place where the business is conducted.  Also, an important point for many farming business is that the “home” office can be located in a separate unattached structure on the same property as the home.  So, an office in a workshop or unattached garage or similar structure still can generate deductions.

Deductible Expenses

So, what above-the-line deductions can be claimed?  The deductible expenses are the “direct expenses” of the home office.  Direct expenses include, for example, the costs of painting or repairing the home office, as well as depreciation deductions for depreciable items that are used in the home office.  Indirect expenses include expenses associated with maintaining the home office.  These expenses include the properly allocable share of utility costs, depreciation, insurance, mortgage interest, and real estate taxes.  In addition, if the home office is the “principal place of business,” computers and related equipment used in the home office are not subject to the “listed property” limitations. 

Deduction Limitations

In Part II of Form 8829, the overall amount of the deductions associated with the home office is limited by the income attributable to the use of the home office.  But, any home office expenses that can't be deducted due to a limitation may be carried over and deducted in later years.

Optional Safe Harbor

Beginning in 2013, an optional safe harbor can be used to calculate the amount of the deduction for expenses associated with the business use of a residence.  Rev. Proc. 2013-13.  Individual taxpayers who elect this method can deduct an amount determined by multiplying the allowable square footage by $5. The allowable square footage is the portion of the house used in a qualified business use, but not to exceed 300 square feet.  Thus, the maximum a taxpayer can deduct annually under the safe harbor is $1,500.  In addition, the deduction cannot exceed the amount of gross income derived from the qualified business use of the home (less deductions).  It is not possible to carry over any excess to another tax year. The election is made on a timely-filed original tax return, and taxpayers are allowed to change their treatment from year-to-year. However, the election made for any tax year is irrevocable.

The sale-harbor is only available if all of the other requirements for a home-office deduction are satisfied.  Thus, the office in the home must be used exclusively for business purposes.  In addition, the safe harbor is not really an election.  The taxpayer simply chooses to use it at the time the return is filed, on a year-by-year basis.

Conclusion

Many farmers will be able to utilize the office in the home deduction.  The IRS has provided a simplified method safe harbor in recent years.  But, the safe harbor approach may not maximize the deduction.  The approach that provides the best result depends on the situation and the taxpayer’s unique set of facts.

February 9, 2017 | Permalink | Comments (0)

Tuesday, February 7, 2017

Prior Appropriation – First in Time, First in Right

Overview

Water has a significant influence on agriculture in the United States.  Over time, different systems for allocating water have developed.  Most of the United States west of the 100th Meridian utilizes the prior appropriation system for purposes of allocating water.  The prior appropriation system is based on a recognition that water is more scarce, and establishes rights to water based on when water is first put to a beneficial use.  The doctrine grants to the individual first placing available water to a beneficial use, the right to continue to use the water against subsequent claimants.  Thus, the doctrine is referred to as a “first in time, first in right” system of water allocation. The oldest water right on a stream is supplied with the available water to the point at which its state-granted right is met, and then the next oldest right is supplied with the available water and so on until the available supply is exhausted.  In order for a particular landowner to determine whether such person has a prior right as against another person, it is necessary to trace back to the date at which a landowner's predecessor in interest first put water to a beneficial use.  The senior appropriator, in the event of dry conditions, has the right to use as much water as desired up to the established right of the claimant to the exclusion of all junior appropriators. 

Water rights in a majority of the prior appropriation states are acquired and evidenced by a permit system that largely confirms the original doctrine of prior appropriation.  The right to divert and make consumptive use of water from a watercourse under the prior appropriation system is typically acquired by making a claim, under applicable procedure, and by diverting the water to beneficial use.  The “beneficial use” concept is basic; a non-useful appropriation is of no effect.  What constitutes a beneficial use depends upon the facts of each particular case.

As applied to groundwater, the prior appropriation doctrine holds that the person who first puts groundwater to a beneficial use has a priority right over other persons subsequently desiring the same water.  This doctrine is applied in many western states that also follow the prior appropriation doctrine with respect to surface water.  In many of these states, appropriation rights are administered through a state-run permit system.

A water dispute testing the application of the prior appropriation doctrine to groundwater rights in western Kansas had a recent significant development.  Today’s post explaining the case are the thoughts of Professor Burke Griggs of Washburn School of Law.  Prof. Griggs is part of our Rural Law Program at the law school.  Before joining the law school in 2016, Prof. Griggs   represented the State of Kansas in federal and interstate water matters, and has advised Kansas' natural resources agencies on matters of natural resources law and policy. He has also been engaged in the private practice of law. 

Facts of the Case

On February 1, 2017, the Haskell County Kansas District Court issued its latest decision in Garetson Bros. v. American Warrior et al., (Dist. Ct. No. 2012-CV-09).  The case involves a longstanding dispute between rival groundwater pumpers in southwestern Kansas (just west of the 100th Meridian). Applying a fundamental principle of Kansas water law—first in time, first in right— the court protected the plaintiffs’ senior well and groundwater right from impairment by issuing a permanent injunction prohibiting the use of the defendants’ junior rights.  Although the case stands for the simple proposition that the prior appropriation doctrine grants senior rights holders the right to enjoin junior groundwater diversions which are impairing their senior rights, the court’s application of the doctrine to groundwater rights which access the Ogallala Aquifer may well produce regulatory and political reactions that are anything but simple.  

In terms of Kansas water law, the case is relatively straightforward. The Garetsons own a senior, vested (pre-1945) groundwater right, which depends on the same local source of groundwater supply as two neighboring and junior groundwater rights held by American Warrior, an oil and gas production company.  In 2005, the Garetsons filed an impairment complaint with the Kansas Department of Agriculture’s Division of Water Resources (DWR), so that DWR could investigate and resolve the dispute according to K.A.R. § 5-4-1a, which sets forth a detailed procedure for addressing impairment complaints for water from Ogallala Aquifer water sources.  For reasons not set forth in the decision, the Garetsons withdrew their complaint in 2007, but later in 2012 sued to obtain an injunction against American Warrior’s pumping, claiming a senior water right under the Kansas Water Appropriation Act (“KWAA”).  In November of that year, the trial court appointed the DWR as a fact-finder pursuant to the limited reference procedure set forth at K.S.A. § 82a-725.  The DWR filed its first report on April 1, 2013, which found that the Garetson well was being impaired by the two American Warrior wells.  Based on the DWR’s uncontested finding of impairment, the Garetsons obtained a preliminary injunction shortly thereafter. After several rounds of motion pleading, the DWR issued its second report on March 27, 2014, also finding impairment, and the court issued a second temporary injunction on May 5 of that year, ordering the curtailment of pumping from the defendant’s two wells. 

The Appellate Decision and Remand

The defendants timely filed an interlocutory appeal to reverse the temporary injunction.  In 2015, the Kansas Court of Appeals affirmed the district court’s granting of the injunction and remanded the case back to Haskell County. Garetson Bros. v. Am. Warrior, Inc., 347 P.3d 687, 51 Kan. App. 2d 370 (2015), rev. den., No. 14-111975-A, 2016 Kan. LEXIS 50 (Kan. Sup. Ct. Jan. 25, 2016).

The resolution of the central issue on appeal effectively decided the issue on remand.  The issue centers on the two distinct definitions of “impairment” under the KWAA. Within the context of reviewing new applications for water rights pursuant to K.S.A. §§82a-711 and 82a-711a, the DWR uses one definition: “impairment shall include the unreasonable raising and lowering of the static water level . . . at the [senior] water user’s point of diversion beyond a reasonable economic limit (emphasis added). However, when the DWR is called upon to protect senior water rights from impairment by already-existing junior water rights, that impairment standard does not include the “beyond a reasonable economic limit” qualifier. K.S.A. §§ 82a717a, 82a-716. Because this dispute concerned the latter situation, the Court of Appeals declined defendant-appellant’s efforts to apply the former definition of impairment, and upheld the injunction.

Remanded back to Haskell County, and before a different judge, the court held hearings in October of 2016. Central to the record in the case were the findings by both the Kansas Geological Survey and the DWR that groundwater levels were declining in the area, and that the defendants’ junior groundwater pumping was responsible for substantially impairing the plaintiffs’ senior right. With these principal conclusions established in the record, the court applied the standard test for permanent injunctions, and found that a permanent injunction should issue in this case. In making that finding, the trial court judge followed the “ordinary definition of impair” [pursuant to K.S.A. §§ 82a-716 and 82a-717] which the legislature intended should apply in situations such as this, where the senior right holder seeks injunctive relief to protect against diversions by junior water right holders, when the diversion “diminishes, weakens, or injures the prior right.”  In deciding that an injunction against the defendant’s junior rights should issue, the court declined to adopt a remedy suggested by the DWR in its second report—that the junior water rights surrounding Garetson’s (including those owned by non-parties) could be allowed to operate on a limited and rotating basis. In declining to adopt that remedy, the court stressed that it “does not wish to draft an order that would micro-manage future use” by the junior rights.

Conclusion

The prior appropriation doctrine means what it says when it comes to protecting senior water rights to the Ogallala Aquifer - first in time is first in right.  In addition, “impairment” means “impairment,” unqualified by economic reasonableness. Whether Kansas irrigators and the Kansas legislature can accept such clarity will be the subject of a subsequent post, where we will speculate on what type of legislative reaction the case might provoke.

February 7, 2017 | Permalink | Comments (0)

Friday, February 3, 2017

Recreational Use Statutes – What is Covered?

Overview

A recent court decision from Michigan involving that state’s recreational use statute raised a question that I sometimes get from farmers, ranchers and rural landowners – just what type of activity does a recreational use statute cover?  It’s a good question.  The answer is, “it depends.”  Each state provision is unique, but there are some basic general points that can be made.

Model Legislation

In 1965, the Council of State Governments proposed the adoption of a Model Act to limit an owner or occupier's liability for injury occurring on the owner's property. The stated purpose of the Model Act was to encourage owners to make land and water areas available to the public for recreational purposes by limiting their liability toward persons who enter the property for such purposes.  Liability protection was extended to holders of a fee ownership interest, tenants, lessees, occupants, and persons in control of the premises.  Land which receives the benefit of the act include roads, waters, water courses, private ways and buildings, structures and machinery or equipment when attached to the realty. Recreational activities within the purview of the act include hunting, fishing, swimming, boating, camping, picnicking, hiking, pleasure driving, nature study, water skiing, water sports, and viewing or enjoying historical, archeological, scenic or scientific sites.  Most states have enacted some version of the 1965 Model legislation.

Under the model legislation, an owner or occupier owes no duty of care to keep the premises safe for entry or use by others for recreational purposes, or to give any warning of dangerous conditions, uses, structures, or activities to persons entering the premises for such recreational purposes. Similarly, if an owner, directly or indirectly, invites or permits any person without charge to use the property for recreational purposes, the owner does not extend any assurance the premises are safe for any purpose, confer the status of licensee or invitee on the person using the property, or assume responsibility or incur liability for any injury to persons or property caused by any act or omission of persons who are on the property.

The protection afforded by the Model Act is not absolute, however.  Should injury to users of the property be caused by the willful or malicious failure to guard or warn against a dangerous condition, use, structure, or activity, the protection of the act would be lost.  Likewise, if the owner imposes a charge on the user of the property, the protection of the act is lost.  The 1965 Model Act contained a specific provision that did not exempt anyone from liability for injury in any case where the owner of land charges a fee to the person or persons who enter or go onto the land for recreational purposes.  Under most state statutes patterned after the Model Act, if a fee is charged for use of the premises for recreational purposes, it converts the entrant's status to that of an invitee.  Some states (such as Wisconsin) establish a monetary limit on what a landowner may receive in a calendar year and still have the liability protection of the statute.  The North Dakota statute provides immunity for landowners that invite the public onto their land for recreational rather than commercial purposes, with the distinction between the two classifications largely turning on whether a fee is directly charged.

Signs, Release Language and Gross Negligence

Many fee-based recreational use operations require guests to sign a form releasing the landowner from liability for any injury a guest may sustain while recreating on the premises.  To be an effective shield against liability, a release must be drafted carefully and must be clear, unambiguous, explicit and not violate public policy. Courts generally construe release language against the drafter and severely limit the landowner’s ability to contract away liability for its own negligence. Likewise, most courts that have considered the question have held that a parent cannot release a minor child’s prospective claim for negligence.  This has led some state legislatures to consider legislation designed to protect organizations while not allowing wrongdoers to escape liability for intentional or grossly negligent conduct.  This is where that recent Michigan case fits in.

In Otto v. Inn at Watervale, No. 330214, 2017 Mich. App. LEXIS 68 (Mich. Ct. App. Jan. 17, 2017). the plaintiff, the mother of a 10-year-old girl sued the defendant for burn injuries her daughter suffered while using the defendant’s beach area. The daughter was playing on the beach with friends when she stepped on hot coals that were covered up in the beach’s sand. The defendant had allowed guests in the past to have “fire rings” on the beach, and they had become covered with sand blown by the wind which had not yet been uncovered from the prior fall season. There had also been prior problems with guests not properly extinguishing fires on the beach in the past. The plaintiff sued based in negligence and the defendant moved for summary judgment on the basis that the claim was barred by the state (MI) Recreational Land Use Act (RLUA) (MCL §324.73301). The RLUA bars an action to recover for injuries incurred while on the land of another without paying a fee for the purpose of “fishing, hunting, trapping, camping, hiking sightseeing, motorcycling, snowmobiling, or any other outdoor recreational use or trail use with or without permission,…unless the injuries were caused by gross negligence or willful and wanton misconduct of the owner, tenant or lessee. The trial court granted the defendant’s motion, but allowed the plaintiff to amend the complaint to add gross negligence and willful and wanton misconduct claims. The plaintiff amended the complaint, claiming that the defendant’s conduct was reckless in letting guests have beach bonfires without properly supervising or providing instructions for putting the fires out, and for not properly warning the public of the possibility of hot fire coals. The defendant claimed that the hot coals were buried and not visible and that a reasonable inspection would not have disclosed them and that staff cleaned embers from fire rings on a weekly basis. The trial court again granted summary judgment for the defendant. On appeal, the appellate court reversed. The court noted that a child’s play on a beach was not the type of activity that was of the same kind, class, character or nature of the listed activities in the RLUA. In addition, the court determined that the child was not engaged in “any other outdoor recreational use or trail use.” As such, the RULA did not apply and the court reversed the trial court’s determination. 

Inherent Risks

With increased interest by farm and ranch owners in providing recreational activities to generate additional income, some states have passed ag immunity laws designed to supplement the protection provided by recreational liability acts.  In general, the various state statutes provide liability protection for landowners against the injury or death of a participant in a recreational activity arising from the “inherent risks” of the activity.  The Colorado statute, for example, is written in this manner. 

Negligent Supervision

Recreational use statutes generally do not preclude legal claims based on negligent supervision.  In one case from Maine, the plaintiff was engaged in cutting and making firewood on the defendant’s property and was injured while loading a wood splitter.  The state recreational use statute covered the harvesting or gathering of forest products and would have shielded the defendant from liability for the plaintiff’s injuries.  As a result, the plaintiff alleged negligent supervision and instruction concerning the use of the wood splitter.  The court held that the plaintiff’s claim was not precluded by the recreational use statute inasmuch as the statute only precluded claims alleging premises liability, and allowed the case to proceed to trial on the negligent supervision claim.  Dickinson v. Clark, 767 A.2d 303 (Me. 2001).

Conclusion

While this discussion just scratches the surface, the point is that a rural landowner should have at least some knowledge of their state’s recreational use statute, or at least have legal counsel that does.  Each state’s particular statutory language is unique, and there are a seemingly endless number of situations that could invoke the statute.  Given that agricultural land is prone to activities of third party entrants that could create liability situations for the landowner, knowledge of the rules (and insurance) are key.

February 3, 2017 | Permalink | Comments (0)

Wednesday, February 1, 2017

The Burden of Proof in Tax Cases – What are the Rules?

Overview

The burden of proof in litigation is an important procedural matter.  In civil litigation, the plaintiff bears the burden to prove their case by a preponderance of the evidence.  In criminal cases, the government bears the burden to prove that the facts to support the government’s position beyond a reasonable doubt.  But, what about the burden of proof in tax litigation?  The rule is a bit different.  Normally, the taxpayer bears the burden.  But, there are circumstances in which the burden can shift to the government.  That’s today’s focus.

The Shifting Burden

When a taxpayer gets a notice of deficiency, the taxpayer normally bears the burden of proof.  The deficiency is, essentially, presumed to be correct.  Thus, the taxpayer bears the burden to prove that the IRS is wrong.  But, there is a burden-shifting statute.  I.R.C. §7491 states that “If, in any court proceeding, a taxpayer introduces credible evidence with respect to any factual issue relevant to ascertaining the liability of the taxpayer for any tax imposed by subtitle A or B, the Secretary shall have the burden of proof with respect to such issue.”  Of course, to shift the burden, the taxpayer must properly substantiate all issues in controversy, maintain records, and reasonably cooperate with the IRS with respect to its requests for meetings, witnesses, information, documents and interviews.  However, the statutory burden shifting doesn’t apply to corporations, partnerships, and trusts with a high net worth.  For partnerships, a recent law change places the burden on the partnership rather than the partners, which creates issues of its own.  But, remember, even if the burden does shift, the taxpayer has the burden of going forward with evidence throughout the trial process.

Recent Case

Facts.  A recent case, Cavallaro v. Comr., 842 F.3d 16 (1st Cir. 2016), aff’g. in part, and rev’g. in part, and remanding, T.C. Memo. 2014-189, involved the merger of two corporations, one owned by the parents and one owned by a son. The parents' S corporation developed and manufactured a machine that the son had invented. The son did not patent the invention, and the parents' corporation claimed the research and development credits associated with the machine. The sons' corporation sold the machine (liquid dispenser) to various users, but the intellectual property rights associated with the machine were never formally received. The two corporations were merged for estate planning purposes, with the parents' receiving less stock value than their asset ownership value. The lawyers involved in structuring the transaction "postulated" a technology transfer for significant value from the son to the parents that had occurred in 1987. The transfer was postulated because there were no documents concerning the alleged transaction executed in 1987. Instead, the lawyers executed the transfer documents in 1995.  The IRS asserted that no technology transfer had occurred and that the merger resulted in a gift from the parents to the son of $29.6 million for which no gift tax return had been filed and no taxes paid.  In essence, the IRS claimed that the parents’ corporation was valueless.  But, later, the IRS determined that part of the deficiency was wrong and that the parents’ corporation actually did have some value. 

I.R.C. §7491.  The parents claimed that the burden of proof shifted under I.R.C. §7491(a)(1).  However, the IRS started the examination of the return at issue in the case before the statute took effect.  The statute only applies to IRS examinations commenced after July 22, 1998.  The IRS beat that effective date by a few months. 

Excessive and arbitrary.  The parents also claimed that the initial deficiency was excessive and arbitrary (bore no factual relationship to their tax liability) and, as a result, shifted the burden of proof to the IRS.  The Tax Court noted that an excessive and arbitrary notice of deficiency can shift the burden of proof to the IRS, but concluded that the deficiency involved valuation issues of the corporations, and that the IRS had a sufficient foundation for the initial notice.  Basically, according to the Tax Court, all the IRS had to do was make some sort of evidentiary showing in support of the deficiency and the burden won’t shift. 

Procedural rule.  But, there is also a procedural rule (Rule 142(a)(1)) that says that even though a notice of deficiency is presumed to be correct, the burden shifts when a “new matter” is raised at trial.  This was also tied into the valuation issue.  The parents pointed out that the IRS initial notice asserted that their corporation had no value, but then the IRS later claimed that it had some value.  That, according to the parents, would shift the burden of proof.  But, the Tax Court didn’t think so.  The court noted that the issue was valuation throughout the entire process and that the taxpayers knew that.  There was no “new matter” so there was no burden shifting under the procedural rule.

Expert witness.  One other area where the burden can shift involves expert witnesses.  In the case, the Tax Court rejected the expert reports of the taxpayers because the court thought they were based on the assumption that the son’s corporation owned technology that the parents’ corporation owned.  That court believed that was an incorrect assumption.  Consequently, the government’s expert produced the only report that was based on a correct assumption – that the parents’ corporation owned the technology.  So, there was no burden-shifting on this point either. 

Tax Court’s conclusion.  So, the burden of proof didn’t shift to the IRS and they bore the burden to show the proper amount of their tax liability. But, they didn’t have any valuations to help them do so and had no basis to claim that the government got the valuation issue wrong.  The Tax Court was left with adopting the government’s valuation claim even though noting that the court was troubled by the government’s numbers.  The end result was that the resulting gift tax (at 1995 rates) was $14.8 million.

Appellate decision.  On appeal, the parents claimed that the Tax Court erred by not shifting the burden of proof to the IRS because the original notices of deficiency were arbitrary and excessive and/or because the IRS relied on a new theory of liability. The parents also alleged that the Tax Court incorrectly concluded that the parents’ company owned all of the technology and that the Tax Court erred by misstating their burden of proof and then failing to consider alleged flaws in the IRS expert’s valuation of the two companies. The appellate court reversed and remanded on the issue of the nature of the parents’ burden of proof and the Tax Court’s failure to allow them to rebut the IRS expert’s report. However, the appellate court determined that the parents bore the burden to prove that the deficiency notices were in error and that the burden of proving a gift tax deficiency didn’t shift to the IRS even though the IRS later conceded somewhat on the valuation issue because the initial conclusion of IRS on value was not arbitrary.

The appellate court also determined that the parents could not shift the burden of proof on the grounds that the IRS raised a new matter because the IRS theory that their corporation was undervalued was consistently postulated throughout and the original notices that implied that undervaluation of the parents’ corporation allowed for a disguised gift transfer from the parents to their adult children. The Tax Court’s finding that the parents’ corporation owned the technology was also upheld.  But, the appellate court did allow the parents to challenge the IRS expert’s valuation and how the Tax Court handled the objections to the valuation. Thus, the court remanded on that issue. 

The end result was that the taxpayers didn’t have to prove the correct amount of their tax liability.  They also get a shot to challenge the government’s expert report.  If they are successful on the challenge, the Tax Court will have to determine what the tax liability is. 

Conclusion

To shift the burden of proof to the IRS in a tax case, substantiate everything, keep good records, and cooperate with the IRS throughout the process.  Also, make sure that any experts that are utilized are qualified and base their reports on correct assumptions.  If the IRS raises a “new matter” during the litigation, that can also shift the burden.

February 1, 2017 | Permalink | Comments (0)

Monday, January 30, 2017

Another Issue When the Definition of “Agriculture” Matters – Property Tax

Overview

Agricultural law is often “law by the exception.”  Numerous situations exist where being a “farmer” or being engaged in “agriculture” results in different, and more favorable, treatment under the law.  One of those areas of favorability has to do with the tax treatment of property that is used for agricultural purposes. 

One might think that it is easy to determine if a tract of land is used for an agricultural purpose.  Often it is.  The property is either cropped or grazed.  But, other situations are not as easy.  Today, we take a look at those blurry situations.

Mechanics of Real Property Taxation

In many states, real property is listed and valued every two years.  In each year in which real property is not regularly assessed, the assessor lists and assesses any real property not included in the previous assessment and any improvements made since the previous assessment.  Normal and necessary repairs up to a threshold amount per building per year do not increase the taxable value.  The tax rate, typically expressed in dollars per $1,000 of actual value, is applied against actual value or a percentage of actual value.  Actual value is usually the “fair and reasonable market value” of the property.  “Market value” is defined as the result of a “fair and reasonable exchange in the year in which the property is listed and valued between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and each being familiar with all the facts relating to the particular property.” 

In general, the actual value of agricultural property is to be determined on the basis of productivity and net earning capacity on the basis of use for agricultural purposes.  This typically results in lower valuation for real property tax purposes for agricultural property than nonagricultural property.  Thus, to obtain favorable tax treatment, the parcel in question must be used as farm or ranch land for agricultural purposes in accordance with the particular state statute.  While agricultural dwellings are typically valued as rural residential property and are assessed at the same percentage of actual value as other residential property, the lower “use” valuation of agricultural real estate when compared with nonagricultural real estate has spawned numerous cases construing the boundary of the definition of “agricultural land” and “agricultural activities.”

Illustrative Cases

The following is a listing of some of the more illustrative cases that provide a flavor of the issues that can arise and how the courts deal with them:

  • In Drost v. Mahaska County Board of Review, et al., 840 N.W.2d 726 (Iowa Ct. App. 2013), the court held that the assessment of $410,480 was correct instead of the plaintiffs’ claimed $75,000. Even though the plaintiffs had sold a wetland easement on 283 acres to the federal government, the ag land still had “net earning capacity,” encompassing potential productivity.
  • Under Colorado law (Colo. Rev. Stat. § 39-1-102(3.5)), agricultural products must originate from the land’s productivity. There have been numerous cases involving the application of the statute.  For example, in Welby Gardens Co. v. Colorado Bd. of Assessment Appeals, 56 P.3d 1121 (Colo. Ct. App. 2002), even though greenhouses produced horticultural products, and the statute defined agriculture as including horticulture, the products did not originate from the land’s productivity and the property was not eligible to be taxed as farm property. 
  • In Bond County Board of Review v. Property Tax Appeal Board, 796 N.E.2d 628 (Ill. Ct. App. 2003), subdivided lots used for raising and storing of hay and storing of logs were properly valued as agricultural land. The statute did not require subdivided lots to be assessed as residential property. 
  • In Schmeig v. County of Chisago, 740 N.W.2d 770 (Minn. 2007), Minnesota law, “agricultural land” defined as “all land used during the preceding year for agricultural purposes,” and the statute contemplated that a particular tract may be subject to more than one classification. The classification of the entire tract as commercial was not appropriate where bees were raised on part of the tract.
  • In Hanneken v. Missouri State Tax Commission, No. 96-73000 (Dec. 19, 1996), a portion of lake front property was accepted into a governmental conservation program for timber improvement. The tract qualified for agricultural classification even though it was not part of an ongoing farming operation and there would be a long-time period before trees would be harvestable.
  • In Mollica v. Divison of Property Valuation and Review, 2008 Vt. 60 (2008), a “Christmas Cottage” on a Christmas tree farm used as sales office and warming hut for customers during Christmas season and rented guest house during off-season remained eligible for enrollment in a tax abatement program as farm property. The property was used as “rental property” only during the “non-farm” season and still remained actively used in a farming operation during Christmas tree harvesting season.
  • In In re Goddard, 39 Kan. App.2d 325 (2008), a sawmill operation was not “farming” for purpose of state ad valorem property tax exemption, but a yarding tractor used to harvest trees was exempt farm equipment.
  • In another Colorado case, Douglas County Board of Equalization v. Clarke, 921 P.2d 717 (Colo. 1996), the taxpayer was required to prove that actual grazing of the parcel at issue occurred during the tax year unless there was a conservation practice being utilized that prevented grazing.
  • Also in Colorado, C.P. Bedrock, LLC v. Denver County Board of Equalization, 259 P.3d 514 (Colo. Ct. App. Apr. 14, 2011), writ of cert. dismissed, 2011 Colo. LEXIS 569 (Colo. Sup. Ct. Jun. 20, 2011), the property at issue did not qualify as “agricultural” property for tax purposes. There was no grazing of livestock or crop growing activities present, and the property was not sufficiently connected by use with other land so as to be classified as agricultural land.  The property was also not used for conservation purposes.
  • In Elmstad v. Lane County Assessor, No. TC-MD 101235D, 2011 Ore. Tax LEXIS 226 (Or. Tax Ct. Jun. 6, 2011), the taxpayer was not entitled to ad valorem real property tax assessment as farm because the property was not used primarily for making profit. The taxpayer’s testimony was that he intended to start vineyard and grow hay and blueberries and filberts on 9.27 acres.  The statute focused on the current use of the land, and the land had been laying fallow for more than one year.  The sales of a few pounds of honey was insufficient to show a profit motive. 
  • In Terry v. Sperry, et al., 130 Ohio St. 3d 125, 956 N.E.2d 276 (2011), involved a situation where, under the applicable state statute, township zoning commissions, boards of township trustees or boards of zoning appeals were barred from prohibiting agricultural uses on land or the use of buildings or structures incident to “agricultural uses.” Under the statute, a township could not regulate the zoning of buildings used primarily for venting and selling wine, and no requirement existed that venting and selling of wine be a secondary or subordinate use of the property or that viticulture be the primary use of the property.  Thus, the township could not prohibit use of property for venting and selling wine if any part of property used for viticulture.
  • In McLendon v. Nikolits, No. 4D15-4003, 2017 Fla. App. LEXIS 765 (Fla. Ct. App. Jan. 25, 2017),the defendant, county property appraiser, denied the plaintiff’s request for an ag tax classification on all of the plaintiff’s property. The plaintiff owned a five-acre tract and used the land to raise wild birds for sale as pets – aviculture. The plaintiff spent about $50,000 to buy cages, sheds, fences, feeders and structures for storage. From 2006-2012, the defendant classified the property as agriculture because of its dual use for aviculture and cattle. In 2012, the defendant denied an ag tax classification for the requested 4.5 acres, instead issuing it for 2.25 acres. The plaintiff appealed to the Value Adjustment Board (VAB) which held that the entire 4.5 acres should have ag classification. In 2013, the defendant denied ag classification to the portion of the property used for aviculture, which decision was reversed by the VAB. The defendant appealed the VAB’s decision and also denied ag classification for tax year 2014. Both parties motioned for summary judgment. The trial court ruled for the defendant on the basis that only poultry qualified as ag under the applicable statute and entered summary judgment for the defendant. On further review, the appellate court reversed. The appellate court held that if, on remand, the plaintiff could establish that aviculture is useful to humans, then agricultural classification should apply. The court reached that conclusion because the applicable statute defined “farm product” as “any…animal…useful to humans.” 

Conclusion

The cases illustrate that in situations that don’t involve traditional crop or livestock usage of real estate can lead to interesting property tax questions.  Niche farming activities are an example.  A new one recently involves marijuana growing activities in those states where it is legal under state law.  In any event, it is a good idea to be familiar with the particularities of state law.  Each state defines “agriculture” and “agricultural activity” differently and the court constructions of those statutes also vary.  Determining what state law is and bringing an activity within the definition of “agriculture” can save tax dollars.

January 30, 2017 | Permalink | Comments (0)

Thursday, January 26, 2017

Another Issue With Producing Livestock on Contract - Insurance

Overview

Many farmers and ranchers produce agricultural products under a production contract for someone else.  These contracts generally provide for the raising of livestock, birds or crops with the farmer supplying the facilities and labor and the integrator supplying the livestock, birds or seeds and the feed and other supplies.  The integrator generally retains title to the livestock, birds or crops and the contract generally establishes the amount paid to the farmer by the quantity and quality of the final product.  Many of these contracts are forms drafted by the integrator, with no terms negotiated by the parties.  That feature, by itself can raise an issue about fairness.  Other issues can include the economic impact of production contracts. 

But what about insurance?  Does a farmer’s comprehensive general liability policy cover losses sustained by livestock produced under contract?  The insurance angle is the focus of today’s post

Exclusionary Language

As noted above, it’s not uncommon for livestock (particularly hogs) and poultry to be produced under contract.  But, with livestock raised in a farmer’s barns that are owned by someone else, which party is responsible for any loss that occurs to the animals?  The producer or the supplier?  Typically, the party that has the control over the livestock (or poultry) produced under contract is the liable party.  Indeed, production contracts commonly state that, even though the supplier owns the livestock/poultry, the producer is responsible for any death loss. 

In that event, it is important that the producer has insurance coverage for any losses to the livestock or poultry.  But, the standard farm comprehensive liability policy probably does not cover losses if that loss can in any way be attributed to the negligence of the producer to animals in the “care, custody or control” of the producer.    

There are numerous cases involving the question of insurance coverage for livestock and poultry produced under contract.  In many of those cases, the producer has even identified in advance that they needed additional coverage for livestock and/or poultry raised on contract and, as a result, has sought additional coverage.  The additional coverage that is purchased is typically in the form of a “custom feeding endorsement” that says that if “the bodily injury or property damage arises from the activities of care or raising of livestock or poultry by an insured person for any other person or organization in accordance with a written or oral agreement…” the policy provides coverage.  But, what does that language mean?  One recent Iowa court decision illustrates the problem that faces contract growers.

In the Iowa case, Schulz Farm Enterprises, Inc. v. IMT Insurance, No. 15-1960, 2017 Iowa App. LEXIS 11 (Iowa Ct. App. Jan. 11, 2017), the plaintiff farming operation contracted with a company to custom feed hogs that the plaintiff owned at a third party’s site. The company was to take delivery of 50-pound hogs and raise and care for them until they reached 275 pounds. The plaintiff owned the hogs, but they were under the care of the company. The company contacted its insurance agent to get coverage for the custom feeding of the hogs, telling the agent that the company neither owned the hogs nor the facility in which they were raised, but that the company was responsible for the care and feeding of the hogs and building maintenance. The agent recommended a liability policy, and a custom feeding endorsement for an additional $118 annually. The custom feeding endorsement extended coverage for custom feeding and deleted exclusions in the liability policy that pertained to custom feeding. The ventilation system in the building failed when an electrical breaker tripped and 837 hogs died. The company filed a claim with the defendant for coverage, and the defendant denied coverage. The company then assigned its claim to the plaintiff who sued the defendant, the insurer.

The trial court granted the defendant’s motion for summary judgment. On appeal, the plaintiff claimed that because the endorsement deleted the exclusions pertaining to custom feeding, the death of the hogs produced in the custom feeding operation was a covered loss.  However, the court determined that the custom feeding endorsement functioned only to remove the exclusion for bodily injury or property damage arising out of the insured’s performance of, or failure to perform, relating to the custom feeding of the hogs. In other words, by removing that exclusion, the company had coverage for bodily injury or property damage to others or the insured as a result of the custom feeding operation (i.e., damage caused by the hogs).  But, the court determined that the endorsement did not eliminate the exclusion of coverage for damage to the hogs. Damage to the building caused by fire, smoke or explosion was a covered loss. The court reached this conclusion because the company paid only $118 annually for the endorsement which the court believed did not correspond to the additional risk of insuring the hogs. The court believed that the $118 annual charge did reflect the additional risk of damage caused by the hogs. The court provided no data for its conclusion (I don’t know whether there was data in the record) and no analysis of the endorsement language, instead merely citing a 2013 opinion of the state (IA) Supreme Court where the Court held that a custom feeding endorsement did not cover the loss of 535 feeder pigs that died due to suffocation. 

Pointers for Producers

Contract growers seeking insurance coverage for the potential loss of the livestock or poultry produced under contract should take several common-sense steps to protect themselves.  It’s a good thing to start with a general review of the comprehensive farm liability policy.  Is there a custom farming exclusion?  Is there exclusionary language involving “care, custody or control”?  There likely is.  If so, then a custom feeding endorsement to the policy should be acquired.  But, that endorsement should contain language that specifically addresses both of those exclusions and specifically overrides them.  So, it’s really important to know exactly what the policy covers and that it covers what it needs to cover.  That is the case even if the owner of the livestock/poultry has coverage under their own policy.  It’s even a good idea try to get a written opinion from the insurance company delineating the specific types of death loss events that are covered under the policy. 

Conclusion

Uncovered losses for contract-produced livestock/poultry can result in significant financial problems for the producer.  It’s not only the producer that could face severe financial hardship.  A lender that provides financing for the producer is also at risk if that borrower defaults.  So, both the producer and the lender have a vested interest in making sure that losses to the animals/poultry are covered.  There are specific endorsements that exist that cover specific losses such as death loss of livestock by suffocation (such as when a building ventilation system fails).  Indeed, in one case about four years ago, the court upheld an insurance company’s denial of a $24,075 claim filed by a small farming operation that was raising hogs on contract when the hogs died as a result of suffocation.  After the litigation ended, the company started selling another endorsement covering livestock death by suffocation.

So, endorsements do exist that can cover the type and causes of losses that a producer needs coverage for.  Producers, and their counsel, should be very careful to ensure that the coverage that is obtained is precisely what is needed.

Just another thing for contract grower to think (and worry) about.

January 26, 2017 | Permalink | Comments (0)

Tuesday, January 24, 2017

Ag Supply Dealer Liens – Important Tool in Tough Financial Times

Overview

The present economic conditions in agriculture are reminiscent of the 1980s.  For those of you that attended the agribusiness symposium last September put on by Washburn University School of Law and Kansas State University, you saw the close parallels.  One of the legislative attempts to assist farm producers during that time involved the creation of an agricultural supply dealer’s lien in those states that were experiencing an extraordinarily high number of agricultural bankruptcies. 

For those farmers and ranchers, it was likely that all of their property was claimed subject to perfected security interests under Article 9 of the Uniform Commercial Code, leaving the supply dealer as an unsecured creditor with large unpaid bills.  Thus, the theory behind an ag supply dealer lien is that parties who supply necessary inputs such as seed, feed, fertilizer, chemicals and petroleum products should have a method whereby they are assured of payment for the inputs supplied to agricultural producers. 

Various Statutory Approaches; Various Issues

Agricultural supply dealer lien statutes are rather complex, but most follow a common procedure.  One common type gives an ag commodity dealer that sells an ag product a lien on the ag product or its sale proceeds.  But what if the input subject to the lien is feed that is consumed by livestock that are collateral for another lender’s security interest?  The Idaho statute, for example, specifies that the lien only extends to an “agricultural product” or the “proceeds of the sale of the agricultural product.”  As a result, one court has held that the lien was extinguished when it was consumed as feed by the livestock because “livestock” were not included in the statutory definition of “agricultural products.”  Farmers National Bank v. Green River Dairy, LLC, 318 P.3d 622, 155 Idaho 853 (2014).  But, another court, construing a different state statute has held that the ag supply dealer lien applied to the full amount of feed supplied and fully attached to the animals consuming it.  In re Schley, No. 10-03252, 2017 Bankr. LEXIS 115 (Bankr. N.D. Iowa Jan. 13, 2017).

For crop input suppliers, when a farmer or rancher attempts to purchase supplies on credit or on open account, the supplier can obtain a lien on the crops produced with those inputs.  But, there is typically a process the supplier must go through.  For instance, under the Iowa statute (a statute that has been litigated frequently), the supplier must discover what other parties, if any, have a security interest in the purchaser's crops or livestock.  Iowa Code §570A.  The supplier is required to contact these creditors and inquire about the purchaser's financial abilities.  This puts the creditors on notice that the supplier may be attempting to take a statutory lien.  The creditors can either agree to finance the purchase or send the supply dealer the buyer's financial records.  If the creditors refuse to extend credit, the supply dealer can make the sale and obtain a lien by filing in the appropriate office, usually the Secretary of State's office.  The lien is effective at the time of the purchase and is “perfected” by the filing of a financing statement within 31 days of the purchase.  The lien applies to crops related to the purchased supply or livestock consuming the feed sold to the farmer by the dealer.  The amount of the lien is the amount owed to the dealer for the “retail cost of the agricultural supply, including labor.”  Courts have determined that the lien is perfected for the amount of supplies that the debtor buys from the supplier within 31 days before the supplier files the financing statement.  See, e.g., In re Shulista, 451 B.R. 867 (Bankr. N.D. Iowa 2011); In re Big Sky Farms, Inc., No. 12-01711, 2014 Bankr. LEXIS 1725 (Bankr. N.D. Iowa Apr. 18, 2014).    The lien also extends to the proceeds of the input(s) supplied.  In re Schley, 509 B.R. 901 (Bankr. N.D. Iowa 2014).  The perfected lien does not continue nor does it cover future advances.  If additional supplies are sold to a debtor after the initial 31-day period, another financing statement must be filed within 31 days of sale to perfect the lien for those additional supplies that are provided. 

The Iowa ag supply dealer’s lien has been held to beat out a bank’s prior perfected security interest in hogs even though the supply dealer had not provided the statutory certified notice to the creditor (bank) before selling feed to the debtor on credit. In Oyens Feed Supply, Inc. v. Primebank, 808 N.W.2d 186 (Iowa 2011), the court reasoned that the state ag supply dealer lien statute did not provide for the certified notice affirmative defense in the context of a lien in livestock feed dealers.  The court was persuaded by the feed dealer’s argument that requiring a feed dealer to comply with the certification requirement would result in a “windfall” for the prior perfected lender who would benefit from the increase in the collateral value (livestock) provided for by the feed supplier.  Such “superpriority” status, however, only applies to the extent the acquisition value of the livestock is exceeded by the livestock’s value at the time the lien attaches or its ultimate sale price.  The secured lender still has priority up to the livestock’s acquisition price. 

Most state statutes provide that an agricultural supply dealer lien is superior to subsequently filed Article 9 security interests, and of equal priority to Article 9 interests already in existence.  However, Minn. Stat. § 514.952 (1994) provides that upon a supplier providing a lender a lien notification statement and the lender refuses in writing within 10 days to issue a letter of commitment, the rights of the lender and supplier are unaffected.  The statute was at issue in Underwood Grain Co. v. Harthun, 563 N.W.2d 278 (Minn. Ct. App. 1997), where a lender with a prior perfected interest in cattle was determined to have priority over an agricultural production input lien upon refusal to issue a letter of commitment.  Also, it’s important to understand whether a state ag lien statute applies to crops “produced” with the supplier's inputs.  There might be a time limit specified in the statute.  See, e.g, In re Schlote, 177 B.R. 315 (Bankr. D. Neb. 1995).

A question can arise concerning the total amount of inputs a supply dealer's lien secures.  For instance, in Tracy State Bank v. Tracy-Garvin Cooperative, 573 N.W.2d 393 (Minn. Ct. App. 1998), a farmer borrowed money from a bank and granted the bank a security interest in the farmer's property.  The bank perfected the interest.  The farmer obtained feed on credit from a supplier and the supplier filed with the bank a notification of agricultural input lien, listing the lien amount at $65,000.  The bank received the notification, but did not respond to it, thus giving the supplier a priority lien for $65,000 under Minnesota law.  The supplier, however, actually provided the farmer with $73,748 in feed during the dates listed and the farmer paid on the account during that period such that the debt stood at $44,682 when the farmer liquidated the farm.  The supplier argued that the lien protected a revolving line of credit of up to $65,000 regardless of the payments made by the farmer so that the entire $44,682 was covered by the lien.  The bank argued that only $65,000 of the total amount supplied on credit, less the amounts paid by the farmer, was subject to the lien.  The court held that, under Minnesota law, the notification stated the retail cost of the anticipated production inputs to be provided.  Therefore, the notification statement's listing of $65,000 established the total limit on the inputs covered by the lien.  The court also noted that if a supplier provides more than the notification amount, Minnesota law allows the notification to be amended to provide for priority for the additional amount. Because the plaintiff did not file an amended notification, the lien covered only $65,000 of the feed less the amounts the farmer actually paid on the debt.

“Super Priority”

Because statutory liens grant “super priority” status only to the extent that they are perfected, it is important that a party seeking to gain super priority status understand the particulars of the statutory lien and follow the requirements to perfect the lien as intended.  It is also important to clearly understand the type of lien obtained because nuances exist amongst state statutory liens.  For example, in First National Bank v. Profit Pork, LLC, et al., 820 N.W.2d 592 (Minn. Ct. App. 2012), a feed supplier was found to have a production-input lien rather than a superior feeder’s lien under a different statutory provision because the supplier also provided nutritional advice, feed and labor to produce custom-made feed for the debtor.  As previously noted, the Iowa ag supply dealer’s lien statute is perfected only for the amount of supplies that are purchased from the supplier within 31 days before the supplier files the financing statement.  The perfected lien does not continue, nor does it cover future advances.  Thus, if additional supplies are sold to a debtor after the initial 31-day period, another financing statement must be filed within 31 days of the sale to perfect the lien for those additional supplies that are provided. In re Shulista, 451 B.R. 867 (Bankr. N.D. Iowa 2011).   But, there is no limit on the amount that is purchased from the supplier, even if it is for future periods.

Unanswered Questions

There remain some unanswered questions about ag supply dealer liens.  For example, where must an ag supply dealer’s lien be filed?  Is it to be filed in the state where feed is supplied, or in the state of incorporation of the owner of the livestock, if that is different?  Clearly, the safest course of action would be to file in both states as it is relatively inexpensive to do so and avoids the necessity of litigation to determine whether the lien was properly filed.  Also, what about a feedlot owner that provides feed to cattle in the feedlot?  Can the feedlot owner file an ag supply dealer’s lien to secure the value of the feed supplied to the cattle?  Some feedlot owners have filed these liens seeking to assert a lien prior to the lien of the bank.  Will that work?

Conclusion

This is just one of the topics that will be discussed at next weeks’ farm financial distress seminar at Washburn law school.  If you can’t attend in person, the seminar will be simulcast live over the web.  If you work with farm/ranch clients that are dealing with a difficult economic situation, this seminar and the accompanying materials is what you need.  Here’s registration information:  http://washburnlaw.edu/employers/cle/farmersandranchers.html

January 24, 2017 | Permalink | Comments (0)

Friday, January 20, 2017

Rights of Refusal and the Rule Against Perpetuities

Overview

It’s not uncommon that a right of refusal is utilized when agricultural land is sold.  It could be used to facilitate estate and succession planning objectives, avoid an unwanted co-tenant, give preference to a longstanding farm tenant, or give a neighbor a chance to own an adjacent tract that would fit well into their current farming operation.  But, the actual drafting language of the provision can have an important impact.  If the drafting language is not precise, it can void the right of refusal as being in violation of the Rule Against Perpetuities.  That’s today’s focus – the application of an ancient rule to a modern contract provision that is commonly used in agricultural real estate transactions.

The Rule Against Perpetuities

While some states have repealed it, the vast majority of states retain the Rule Against Perpetuities (RAP).  Basically, the rule puts a time limit to a restriction on a conveyance of real estate.  Under the common-law rule, the restriction can’t last more than 21 years after a particularly identified person dies.  So, you can’t tie up property for too long after the lives of the people living at the time the instrument was drafted creating the conveyance.  The RAP dates back to the late 1600s in England, and it is typically difficult to apply (as evidenced by the numerous court decisions that have struggled with it). 

So what does the RAP have to do with a right of refusal associated with the sale of farmland?  If the right of refusal is not drafted carefully, the RAP could void the conveyance.  Whether it does or not largely depends on how great a restriction it puts on the alienability (transferability) of land, so careful drafting is the key to staying out of litigation on the matter.  A recent case from Kansas illustrates these points.

Kansas Case

In a recent case from Kansas, Trear v. Chamberlain, et al., No. 115,819, 2017 Kan. App. LEXIS 56 (Kan. Ct. App. Jan. 13, 2017), the plaintiff bought some real estate from a married couple in 1986. The purchase contract contained a right of refusal stating that if the defendants (the sellers) offered to sell the land adjoining the land the plaintiff purchased, the plaintiff would be offered a right to buy the land at a price and on terms that the parties mutually agreed upon. The adjoining land contained the couple’s home. The right of refusal was to lapse if the parties could not agree on purchase terms. The purchase contract was also “binding upon the heirs, legal representatives, and assigns of the parties hereto.”  That language inadvertently ended up creating an issue with the RAP.

The husband-seller died in 2013 and his surviving wife sought to sell the adjoining tract later that same year. As a result, her lawyer sent a letter to the plaintiff offering to sell it to him for $289,000. The plaintiff did not respond to the offer, and the surviving wife listed the tract with a real estate company for $295,000. The plaintiff did not make an offer on the property. The tract did not sell and was taken off of the market. The surviving wife then sold 64 of the 73 acres of the adjoining tract (not including the house) to her daughter and a third party for $91,125. Upon learning of the sale, the plaintiff sued to enforce the right of refusal and to have the property transferred to himself. The surviving wife, her daughter and the third party motioned for summary judgment. The trial court determined that the right of refusal violated the RAP and was nullified.  Another issue not relevant for our discussion here is that the trial court determined that the right of refusal did not violate the Statute of Frauds because the adjoining tract could be identified.

On appeal, the appellate court reversed on the RAP issue, finding that the right of refusal, based on a 1994 Kansas Supreme Court decision, was a personal right to the plaintiff that expired on his death and couldn’t be passed to anyone else.  In addition, the court determined that the contract language making the contract binding on the “heirs, legal representatives and assigns” made the contract binding on the seller’s heirs, legal representatives and assigns as long as the plaintiff was living. In addition, the right of refusal was not voided by the plaintiff’s failure to act on the surviving wife’s first offer of the property to the plaintiff. There had not yet been an offer from anyone else for the property at the time it was offered to the plaintiff. Thus, the right of refusal had not been triggered.  But, when the surviving wife sold some of the remaining tract to her daughter and a third party, the plaintiff was not given the opportunity to buy it on the same terms as the right of refusal required.  Because the price at which it was sold to the daughter and third party was much less than the price at which the full tract was offered to the plaintiff, that raised a fact issue as to good faith resulting in the court denying the summary judgment motion.  However, the appellate court upheld the trial court’s determination that the contract satisfied the Statute of Frauds - the contract was in writing, the material terms were stated with reasonable certainty and the adjoining tract could be identified.

Key Points

As noted earlier, rights of refusal are often used in real estate transactions involving farm and ranch land.  So, how can a right of refusal be drafted to avoid questions about its enforceability?  A mere de minimis restraint on the alienability of property won’t violate the RAP.  So, if a right of refusal arises only when a property owner receives a bona fide offer and the holder of the right chooses not to purchase the property and the owner remains free to sell to the third party, the RAP will likely not be violated.  That’s why the right of refusal in the Kansas case didn’t violate the RAP.  But, if the right is tied to a fixed price or a long time-period during which the holder can chose to buy the property, then it runs a higher risk of violating the RAP.  By not tying the right of refusal to a fixed price the seller can sell the property for market value and will still have an incentive to improve it and offer it for sale.

It’s also probably a good idea for a right of refusal to also clearly specify how notice of the offer to buy is to be sent to the holder of the right.  How soon after receiving an offer must the holder be notified?  It’s best to allow the holder to have a reasonable time to arrange for financing, conduct surveys and perform due diligence with respect to environmental and USDA regulatory issues.  On this point, it can speed the process along if the third-party offeror is required to share information pertinent to the property (such as surveys, etc.) with the holder of the right refusal.  Also, in what manner is the holder to be notified?  How much time does the holder have to respond to the notice?  Must the holder’s response, if the holder want to exercise the option, match precisely the terms and conditions of the third party’s offer?  What if there are any non-monetary terms of the offer?  In addition, a good contract should specify that the landowner cannot create any restrictions on the property (such as easements, for example) that would run counter to the holder’s known future use of the property.

Another point to consider when drafting a right of refusal is to clearly define what triggers the exercise of the right.  Is it triggered only by an offer by a third party?  What if the landowner dies and the property is transferred via will?  What if it is gifted?  What if the owner gets in financial trouble and the property is sold at a foreclosure sale or in bankruptcy?  Do those events trigger the exercise of the right of refusal?  The question is basically whether those events rise to the level of a bona fide purchase.

Conclusion

A right of refusal is a useful and commonly tool in agricultural land sales.  But, language used to create the right is critical to avoiding misunderstandings and benefit both the seller of the property and the holder of the right.

January 20, 2017 | Permalink | Comments (0)

Wednesday, January 18, 2017

Checkoffs, The Courts and Free Speech

Overview

Check-offs are back in the news.  In Oklahoma, federal authorities are investigating the possible embezzlement of about $2.5 million in beef checkoff funds, and in Montana a federal Magistrate Judge has enjoined the Montana beef checkoff from spending funds received from the checkoff.  There’s also separate litigation ongoing over the use of checkoff funds in the federal district court in D.C.

So, what’s all of the fuss about?  Checkoff programs (as well as federal marketing orders) involve constitutional free speech issues.  It’s a matter that’s important to many ag producers and is worth understanding the legal issues that are involved.

Check-Offs and the Constitution

An assessment (or “check-off”) is typically levied on handlers or producers of commodities with the collected funds to be used to support research promotion and information concerning the product.  For example, the beef check-off involves the levy of a $1.00/head at the time livestock are sold.  Such check-off programs have been challenged on First Amendment free-speech grounds.  For example, in United States v. United Foods, Inc., 533 U.S. 405 (2001), the U.S. Supreme Court held that mandatory assessments for mushroom promotion under the Mushroom Promotion, Research, and Consumer Identification Act violated the First Amendment.  The assessments were directed into generic advertising, and some handlers objected to the ideas being advertised.

Lower courts have also addressed the government speech issue with respect to agricultural check-off programs.  For example, in Livestock Marketing Association v. United States Department of Agriculture, 335 F.3d 711 (8th Cir. 2003), cert. granted sub. nom., Veneman v. Livestock Marketing Association, 541 U.S. 1062 (2004), the Eighth Circuit held unconstitutional the beef check-off authorized under the Beef Promotion and Research Act of 1985.  The court ruled that the mandatory assessment of one dollar per-head violated the free-speech rights of those who objected to the generic advertising of beef funded by the check-off because cattle producers and sellers were not regulated nearly to the extent the California tree fruit industry was regulated in an earlier Supreme Court opinion, Glickman v. Wileman Brothers & Elliott, Inc., 521 U.S. 457 (1997).  As such, the beef industry was similar to the mushroom industry, and United Foods controlled. The court also ruled that the beef check-off did not constitute government speech. 

The Supreme Court agreed to hear the Livestock Marketing Association case on the narrow grounds of whether the beef check-off was government speech, reversed the Eighth Circuit and upheld the check-off against a free-speech challenge as government speech.  Johanns v. Livestock Marketing Association, 544 U.S. 550 (2005).  The case involved (in the majority’s view) a narrow facial attack on whether the statutory language of the Act created an advertising program that could be classified as government speech. That was the only issue before the Court.

While the government speech doctrine is relatively new and is not well-developed, prior Supreme Court opinions not involving agricultural commodity check-offs indicated that to constitute government speech, a check-off must clear three hurdles - (1) the government must exercise sufficient control over the content of the check-off to be deemed ultimately responsible for the message; (2) the source of the check-off assessments must come from a large, non-discrete group; and (3) the central purpose of the check-off must be identified as the government’s. Based on that analysis, it was believed that the beef check-off would clear only the first and (perhaps) the third hurdle, but that the program would fail to clear the second hurdle. Indeed, the source of funding for the beef check-off comes from a discrete identifiable source (cattle producers) rather than a large, non-discrete group. The point is that if the government can compel a targeted group of individuals to fund speech with which they do not agree, greater care is required to ensure political accountability as a democratic check against the compelled speech. That is less of a concern if the funding source is the taxpaying public which has access to the ballot box as a means of neutralizing the government program at issue and/or the politicians in support of the program. While the dissent focused on this point, arguing that the Act does not establish sufficient democratic checks, Justice Scalia, writing for the majority, opined that the compelled-subsidy analysis is unaffected by whether the funds for the promotions are raised by general taxes or through a targeted assessment.  That effectively eliminates the second prong of the government speech test. The Court held that the other two requirements were satisfied inasmuch as the Act vests substantial control over the administration of the check-off and the content of the ads in the Secretary.

Separate from the speech issue, the Supreme Court’s analysis in United States v. United Foods, Inc., has been used as the basis for other courts deciding checkoff cases.  In one case, the court granted challengers to the Washington apple checkoff a preliminary injunction against the checkoff, pending trial.  In re Washington State Apple Advertising Commission, 257 F. Supp. 2d 1290 (E.D. Wash. 2003).  The court found that the apple industry was highly regulated but that the regulation did not collectivize the marketing of apples and that no government speech was involved. Another court held the Florida citrus “box tax” unconstitutional because the advertising purchased with the “box tax” was not government speech and no comprehensive regulation of the citrus industry was found. Tampa Juice Services, Inc. v. Florida, No. 6C-6-00-3488 (Fla. Cir. Ct. Mar. 31, 2003). The Louisiana Fur and Alligator Public Education and Marketing Fund and the Louisiana Alligator Resource Fund has been held unconstitutional for the same reasons. Pelts & Skins, L.L. C. v. Jenkins, 259 F. Supp. 2d 482 (M.D. La. 2003).     Similarly, the California grape checkoff has been held unconstitutional because the court found no collectivization of the marketing aspects of the industry, and 90 percent of assessment money was spent on generic advertising of grapes. Delano Farms Co. v. California Table Grape Commission, 318 F.3d 895 (9th Cir. 2003).  The same analysis has resulted in the dairy checkoff being ruled unconstitutional. Cochran v. Veneman, 359 F.3d 263 (3d Cir. 2004), rev’g, 252 F. Supp. 2d 126 (M.D. Pa. 2003).  The court specifically noted the extensive regulation of the marketing aspects of the dairy industry concerning price and production.

Other Recent Checkoff Litigation

In 2011, the Office of Inspector General for the USDA initiated an audit of the Beef Checkoff Program, released it in 2013, withdrew it, and later re-released it in 2014. The checkoff program bars the producer-derived funds from being used for policy activities. The initial audit said that the National Cattleman Beef Association (NCBA) was in full compliance, but the re-released audit removed that statement. Before the OIG audit, there was an independent audit that disclosed problems with the use of checkoff funds by NCBA. In 2013, a livestock market advocacy group (assisted by the Humane Society of the U.S.) filed a Freedom of Information Act (FOIA) request with respect to OIG the audit reports. After that filing, the OIG withdrew the initial audit for further consideration. In 2014, the same group filed a complaint for injunctive relief against the OIG requesting that the OIG make a final determination and release all required records related to the audits. The advocacy group sought the information to determine if there is a connection between the drop in cattle-producer numbers and the price of calves and losses, and the use of checkoff funds. The NCBA claims that the audit activities will weaken the checkoff and asserts that the audits have found the NCBA to be in full compliance with the checkoff rules. In 2016, the NCBA sought to intervene in the injunction case, and in late September the advocacy group filed its response. NCBA sought intervention because some of the information in the audit reports involved confidential business information unrelated to the checkoff. It has been reported that there are approximately 9.300 pages of financial data involving the beef checkoff. The case is filed in the U.S. District Court for the District of Columbia and a ruling is soon expected on the NCBA’s request for intervention.  It’s an interesting case.  The U.S. Supreme Court has ruled, as noted above that the beef checkoff is government speech.  That’s true for the program as a whole, but what about the business information that’s involved?  That’s a dicey issue and it will be interesting to see how the court sorts it out.

In the Montana litigation, Ranchers-Cattlemen Action Legal Fund, United Stockgrowers of America v. Vilsack, No. CV-16-41-GF-BMM-JTL, D. Mont. Dec. 12, 2016), a cattle rancher group, claimed that the federal law requiring funding of the Montana Beef Council (MBC) via funds from the federal beef checkoff was constitutionally defective. The court, as part of the findings and recommendations of a U.S. Magistrate Judge, determined that the plaintiff had standing and had stated a claim upon which relief could be granted. Under the Beef Checkoff, a $1.00/head fee is imposed at the time cattle are sold. The money generated funds promotional campaigns and research, and state beef councils can collect the funds and retain half of the collected amount with the balance going to the Cattleman’s Beef Production and Research Board (Beef Board). But, a producer can direct that all of the producer’s assessment go to the Beef Board. The plaintiff claimed that the use of the collected funds violated their First Amendment rights by forcing them to pay for “speech” with which they did not agree. The defendant (USDA) motioned to dismiss, but the Magistrate Judge denied the motion. The court determined that the plaintiffs had standing, and that the U.S. Supreme Court had held in prior cases that forcing an individual to fund a private message that they did not agree with violated the First Amendment. Any legal effect of an existing “opt-out” provision was not evaluated. The court also rejected the defendant’s claim that the case should be delayed until federal regulations with respect to the opt-out provision were finalized because the defendant was needlessly dragging its heels on developing those rules and had no timeline for finalization. The court entered a preliminary injunction barring the MBC from spending funds received from the checkoff. The court’s decision will be reviewed by the federal trial court.  On December 23, 2016, the defendant filed its objections to the Magistrate Judge's recommendations, and on January 5, 2017, the plaintiff filed its opposition brief to the defendant's objections.  

Conclusion

There’s a lot going on right now in agriculture concerning check-offs.  It’s a big issue for many producers.  In 2017, the courts will decide the pending litigation mentioned above and there is also more litigation that isn’t mentioned above.  Also, the change in leadership at USDA may have some influence on what the future holds for agricultural check-offs.

January 18, 2017 | Permalink | Comments (0)

Monday, January 16, 2017

Divisive Reorganizations of Farming and Ranching Corporations

Overview

Last week I posted on the accumulated earnings tax and the personal holding company tax.  Those two taxes are possible in the C corporation context, and there could be more C corporations formed in the future if the corporate tax rate is cut as proposed. 

Another issue related to C corporation is the opposite side of the coin.  What if C corporate shareholders want out of the C corporate form?  Perhaps there is hostility among the shareholders, or the C corporation no longer fits with the estate and succession planning desires of the family.  Or maybe there is some other reason to change the structure of the business. 

Well, when it comes to getting out of the C corporate structure, most of the options aren’t good from a tax standpoint. But, a “Type D” divisive reorganization can be a tax-favored way to get out of the C corporation and also satisfy the family’s estate and business planning objectives.  The Type D divisive reorganization is the most widely used type of corporate reorganization for farming and ranching operations and is carried out in three steps.  First, a subsidiary corporation is formed.  Then, an exchange of property for stock occurs by carving out the machinery, livestock and land that is to be transferred to the new subsidiary.  Finally, the new owners of the subsidiary give up the stock in the parent corporation for all of the stock in the subsidiary.  At this point, the subsidiary is cut loose from the parent corporation.  If the reorganization is conducted properly, it should be tax-free.  However, a corporate division will not be tax-free unless it is carried out for a legitimate business purpose and there is an active trade or business.  Those two requirements are the focus of today’s post.

 

Tax-free Reorganization Basics

A separation of business interests through a divisive reorganization in accordance with I.R.C. §368 and §355 is the only tax-free method of separating a corporation’s business.  There are various types of reorganizations in the Code but, as noted above, a " Type D" reorganization is governed by I.R.C. §368(a)(1)(D) which requires that after the transfer of assets to a newly created subsidiary corporation in exchange for stock in that entity, the original corporation must distribute the stock of the new corporation to its shareholders in a transaction qualifying under I.R.C. §355.

Business Purpose Requirement 

In order for I.R.C. §355 to apply to the distribution of the newly-formed entity’s stock, the distribution cannot principally be a device for the distribution of earnings and profits of either or both corporations. I.R.C. §355(a)(1)(B).  The reorganization must be motivated, in whole or substantial part, by a corporate business purpose rather than a shareholder purpose.  That’s a determination that is based on all of the facts and circumstances surrounding the transaction.  

So, what qualifies as an acceptable business purpose?  Clearly, if the sole purpose of a transaction is to minimize federal income taxes, the transaction is likely doomed.  See, e.g., Wortham Machinery Co. v. United States, 521 F.2d 160 (10th Cir. 1975).   But, serious shareholder disagreements that could negatively affect the efficient operation of the corporation’s business qualify as a legitimate reason to divide the business tax-free.  See Athanasios v. Comr., T.C. Memo. 1995-72; Treas. Reg. §1.355-2(b).  That is good news for farming and ranching operations where there is family disharmony that could threaten the future of the operation.  See also Priv. Ltr. Rul. 9713020 (Dec. 30, 1996).  The corporation might be able to be divided tax-free with one shareholder or shareholder group being separated from another shareholder or group. 

But, there doesn’t necessarily have to be family problems for a corporate division to qualify as tax-free.  The IRS has ruled that a family farming operation can be divided and the business purpose requirement of Treas. Reg. § 1.355-2(b) satisfied even though the distribution is intended, in part, to further estate planning goals and family harmony.  This is similar to Treas. Reg. §1.355-2(b)(5) which says that a valid business purpose can exist even though the shareholder split is amicable rather than hostile where the reason for the split is different shareholder business interests.  In the IRS ruling, Rev. Rul, 2003-52, 2003-1 C.B. 960, the IRS ruled that the reorganization was motivated by substantial nontax business reasons, and accordingly met the I.R.C. §355 tax-free divisive reorganization rules. Although the reorganization advanced the personal estate planning goals of the parents and promoted family harmony, substantial business reasons were associated with the separation of the two children from the single business activity that the corporation used to conduct.

Active Business Requirement

I.R.C. §355 requires that after the distribution of the subsidiary corporation’s stock, both corporations must be engaged in the “active conduct of a trade or business.”  I.R.C. §355(b)(1)(A).  The Code does not define “active trade or business,” but the regulations state that, “A corporation shall be treated as engaged in a trade or business…if a specific group of activities are being carried on by the corporation for the purpose of earning income or profit, and the activities included in such group include every operation which forms a part of, or a step in, the process of earning income or profit. Such group of activities ordinarily must include the collection of income and the payment of expenses.”  Treas. Reg. §1.355-3(b)(2)(ii).  A rental activity is not considered an active business for this purpose “unless the owner performs significant services.”

A Type D reorganization can be complicated when the farm or ranch operation has an existing lease or leases with respect to its land.  For various reasons, it is fairly common for farm and ranch corporations to operate its business activity on certain tracts of land and lease other tracts to others – either unrelated tenants or shareholders. In these situations, it is common for the shareholders to want to transfer the leased ground (and perhaps some equipment) to the newly created corporation so that the departing shareholder(s) can operate that ground separately. But, this can create the potential for a fully taxable corporate separation if the IRS determines that the property transferred to the newly created subsidiary (the leased land) has not been used in the active conduct of a trade or business.  Treas. Reg. §1.355-3(b)(2)(iii). 

This all means that the type of lease matters, as does the involvement of the corporation with that leased land.  As noted earlier, the leasing of land generally does not constitute the active conduct of a trade or business.  Treas. Reg. §1.355-3(b)(2)(iv)(B).  Thus, If the primary asset to be transferred to the newly-created corporation is land leased to tenant farmers or to a shareholder, the corporate division may be unable to meet the requirement that both corporations are engaged in an active trade of business with a five-year history (another requirement not discussed in this post).

A standard cash lease arrangement would fail the active trade or business requirement.  Under the regulations, a corporation conducts an active business only when the corporation itself performs, “active and substantial management and operational functions.  In the case of a farm or ranch corporation leasing property under a crop-share arrangement, the degree of involvement of the officers and employees of the original corporation in the management and operational functions relating to the leased property will determine whether the corporate division can be accomplished tax-free.

Instructive on the leasing issue for farming operations are two IRS rulings.  Practitioners should compare Revenue Ruling 73-234, 1973-1 C.B. 180 with Rev. Rul. 86-126, 1986-2 CB 58.  What those ruling instruct is that merely leasing agricultural land under a crop-share arrangement, by itself, will not be treated as an active business within the meaning of I.R.C. §355.  A corporation leasing agricultural land will have to demonstrate more than a moderate degree of involvement in the managerial decisions relating to the farm or ranch activity.  This seems to indicate that a lease that meets the definition of a material participation crop-share lease for I.R.C. §1402 purposes is necessary.  In addition, the corporation must perform substantial managerial and operational activities.  Such things as hiring seasonal workers; supplying and maintaining equipment, arranging financing, planning crop rotation, planting and harvesting, selling crops and accounting to the tenant farmers are all helpful in meeting the standard.

Documenting a Type-D Reorganization

Over a decade ago, the IRS said it would no longer issue rulings on whether a proposed transaction qualified as a Type D reorganization.  While that’s still the case for the overall transaction, the IRS will now issue a letter ruling, upon request, on whether a distribution has a corporate business purpose or is a device for purposes of I.R.C. §355, but only when a legal issue is present and the matter is not entirely factual.  Rev. Proc. 2016-45, 2016-37 I.R.B. 344.  So, it’s still necessary to document in detail how a transaction meets all the requirements of a divisive reorganization, including the business purpose and active trade or business tests.

Conclusion

We’ve just scratched the surface of the details involved when a Type D corporate reorganization transaction is utilized.  But, for some farm and ranch operations, it is an option that can work well to facilitate estate and business planning goals when a C corporation is involved.

January 16, 2017 | Permalink | Comments (0)

Thursday, January 12, 2017

Farm Financial Stress – Debt Restructuring

Overview

The current financial situation in agriculture is difficult for many producers.  Low crop and livestock prices, falling land values and increasing debt levels are placing some ag producers in a serious bind.  Chapter 12 bankruptcy is an option for some, although the current debt limits of Chapter 12 are barring some from utilizing its relief provisions. 

When dealing with financial distress, restructuring debt is often involved.  This is one of the topics that Joe Peiffer (of Peiffer Law in Cedar Rapids, Iowa) and I will be addressing at Washburn Law School on February 1 during our 3-hour CLE event, “Common Problems Faced by Farmers and Ranchers in Difficult Financial Times.”  The seminar will also be simulcast live over the web for those that cannot attend in-person.  Here’s the link for registration:    http://washburnlaw.edu/farmersandrancherscleregister

One of the issues that we will be addressing are the strategies that can be used to negotiate with creditors and restructure debt.  While many ag deals are done at the coffee shop or while leaning-up against the pick-up or a fencepost, debt restructuring negotiations with creditors don’t typically occur in that manner.   Today’s post is a bit of a teaser of the upcoming seminar that is my summary of Joe’s thoughts on debt restructuring and the options and opportunities that might be present during that process.

Debt Restructuring Negotiations

Debt restructuring negotiations do not involve a formal, specifically prescribed process with one exception – mediation.  Rather, debt restructuring negotiations take place informally.  However, when mediation is utilized, it is a formal process that is often prescribed by state law.   So, what makes for a successful debt restructuring negotiation?  As with any negotiation on any subject, it is critical to understand what each party views as important.  What are their priorities?  For a creditor, collecting on a delinquent debt is always of supreme importance.  Likewise, if there is a non-delinquent, marginal loan, the creditor will be interested in obtaining guarantees, either private or via government entities such as the USDA or the Small Business Administration.  The creditor will also likely attempt to obtain additional collateral so that the farm debtor’s line of credit can continue and any projected loss to the creditor is minimized or eliminated. 

On the other side, a farmer’s goals typically include staying on the farm and continuing the farming business.  The farmer probably also wants to maintain ownership of assets and their lifestyle.  Also, another common goal of farm debtors is to get the farming operation to the most economical size (often downsizing) without triggering a tax bill that can’t be paid. 

Once the goals of the creditors and the farmer are identified, they must be prioritized.  That’s when reality begins to set in.  Are the goals realistic?  Are there any that can’t be achieved?  Those that can’t be achieved must be eliminated and the realistic goals focused on.  Creditors have to realize that debts won’t be paid in full and on time.  Farm debtors have to understand that they can’t retain all of their farm assets.  So, the parties should strive to find common ground somewhere in the middle.  There probably are some areas of agreement that can be reached.   But, to get there, both parties will likely have to compromise.  Neither the creditors nor the farm debtor should view negotiations in absolutist terms.  Still, even if a mediation agreement is reached and a release obtained, that doesn’t meet that the parties still won’t end up in court.  To avoid litigation, some “out-of-the-box” thinking will likely be required. 

Being creative.  Joe relates a matter that he dealt with a few years ago.  He was representing a farm debtor and the banker showed a great willingness to be creative in dealing with the farmer’s debt situation.  The balance on the loan owed the bank exceeded the collateral values by well over $1,000,000.  The farm debtor had a dairy operation that was losing money to the tune of more than $70,000 every month, and there was virtually no likelihood of a successful reorganization.  At mediation, the banker suggested that if the farmer would immediately surrender the cows, calves, grain, sileage and other personal property securing the loan, and agree to surrender the farm under non-judicial foreclosure he would pay Joe's clients $100,000.  The banker's reasoning was that by paying the farm debtor $100,000, the amount he expected to pay his attorney if the farmer filed a Chapter 12 bankruptcy, the farmer could have a fresh start and he would speedily obtain control of the collateral minimizing his losses. 

The farm debtor put a great deal of thought into the prospect of getting $100,000 and not having the uncertainty of a bankruptcy.  They opted to take the money offered to them.   The deal was structured so that the bank’s $100,000 payment was in consideration for them selling their homestead to the Bank.  Because the money constituted proceeds from the sale of their homestead, the funds were exempt under state (IA) law from the claims of their other creditors for a reasonable time to allow purchase of a later homestead.   After closing, the farm debtor held the proceeds in a “Homestead Account” separate from all other money they.  They did not add other money to that account, nor did they spend the money in that account until they purchased a new homestead.

 Non-Judicial Foreclosure Can be Beneficial

The use of a non-judicial foreclosure provided under state law (in Iowa, the procedure is set forth in Iowa Code § 654.18) allows farmers and their creditors to fashion remedies that can be mutually beneficial.  This remedy can be utilized either before or as a part of a mediated settlement.  The creditor gets possession and ownership of the real estate collateral much quicker than would be the case in a traditional foreclosure.  The right of redemption and right of first refusal present in a traditional foreclosure are eliminated.  The creditor waives any deficiency that could exist if the collateral cannot cover the indebtedness.  But, of course, a farm debtor must be mindful of the potential for discharge of indebtedness income if this procedure is utilized and the farmer has exempt assets that could make them solvent once a deficiency is forgiven.

A benefit to a farm debtor of non-judicial foreclosure is that the creditor is generally able to make other beneficial concessions.  Also, under a non-judicial foreclosure, the farmer deeds the farm to the creditor subject to a period of time (typically five-business days) during which the transaction can be cancelled.  If the transaction is not cancelled, the creditor gives notice of the non-judicial foreclosure to junior lien holders who then a period of time (generally 30 days) to redeem from the creditor and each other. 

Deed Back to Bank with Sale of Homestead Back to Farmer on Real Estate Contract

During the farm financial crisis of the 1980s in many parts of the Midwest and Great Plains, farm and ranch debt restructurings often involved debtors deeding back their farms to the creditor with the creditor then selling back the house and an acreage on a real estate contract.  This approach allowed the farmer to retain the homestead while allowing the bank to realize cash from the balance of its real estate collateral.  But, if the debtor missed a payment, the bank, could institute a contract forfeiture procedure that would take only 30 days to finish once the Notice of Forfeiture was properly served after mediation.

Sale of Non-Essential Assets in the Tax Year Before Filing Chapter 12

The “right-sizing” of a farm operation must always be considered as a part of a debt restructuring negotiation.  If the farmer has over-encumbered assets it can be in his best interest to liquidate some assets, reduce debt and restructure the farming operation.  The liquidation of assets that are not absolutely necessary to the “newer” farming operation can also have the effect of decreasing the farmer’s level of debt beneath the maximum allowable so that the farmer is eligible to file Chapter 12.    However, selling-off of farm assets often leads to incurring significant income taxes.  But, in a Chapter 12 farm bankruptcy, a special tax provision, 11 U.S.C. §1222(a)(2)(A), can be utilized to move taxes from a priority to a non-priority position which can then result in the taxes being discharged.

Formal Written Agreements Contained in Bank Minutes are Essential

Under federal law, to be enforceable in the event the institution is declared insolvent, debt restructuring agreement involving federally insured institutions must be in writing, approved by the board of directors, sealed and included in the bank’s minutes.  Reliance on any oral agreements with a bank is not wise as they are unenforceable (see, e.g., Iowa Code § 535.17 and 12 U.S.C. §1823(e)).  If the bank goes broke and the Debt Settlement Agreement is not memorialized as is required by 12 U.S.C. § 1823(e), the FDIC or the purchaser of the notes from the FDIC will not be bound by the Debt Settlement Agreement. Thus, if any agreement with a bank is to be enforced, it must be in writing signed by the proper parties and comply with any statutorily-required formalities.

Conclusion

As Joe has pointed out on numerous occasions, debt restructuring negotiations provide farmers and their creditors with substantial opportunities to reach an agreement that satisfies both parties’ needs.  Preparation is the key to a successful negotiation for both creditors and farmers.  Consideration of the other party’s priorities and needs can lead to opportunities for cooperation that will minimize the need for court intervention and bankruptcies.  Frequently, the need to “right-size” a farming operation will lead to significant income tax consequences that can only be addressed in a Chapter 12 bankruptcy.  When this occurs, cooperation between the creditor and farmer can allow the creditor to receive the liquidation proceeds of most of its collateral in the tax year before filing the bankruptcy while allowing the farmer to avail himself of the favorable tax provisions of 11 U.S.C. § 1222(a)(2)(A).  All parties to debt restructuring negotiations should be prepared to accept reality, make reasonable concessions and consider the needs of the other party to reach agreement.

This is just a sample of one of the numerous issues that Joe and I will discuss at the law school seminar on February 1.  Again, if you can’t attend in-person, you can watch a live simulcast over the web of our presentations.  Here’s the link for registration information:   http://washburnlaw.edu/farmersandrancherscleregister

January 12, 2017 | Permalink | Comments (0)

Tuesday, January 10, 2017

C Corporation Penalty Taxes – Time To Dust-Off and Review?

Overview

C corporations were all the rage in agriculture in the 1960s and 1970s.  Many farming operations were structured that way in those decades and farmland was placed inside them.  However, with the advent of limited liability companies in the late 1970s in Wyoming and Colorado (and, later, all states) and other unique entity forms, and a change in the tax law in 1986, they became less popular.  2017, however, could be the start of renewed interest in the C corporate form.  A primary driver of what might cause some to reconsider the use of the C corporation is that President-elect Trump campaigned in part on reducing the corporate tax rate.  Similarly, in the summer of 2016, the U.S. House Ways and Means Committee released a proposed “blueprint” for tax reform that also contained a lower corporate tax rate.  If that happens, the use of C corporations may be back in vogue to a greater extent than presently.

If C corporations do gain in popularity, there are a couple of C corporate “penalty” taxes that practitioners need to remember are lurking in the background.  In addition, a recent IRS Chief Counsel Advice (C.C.A. 201653017 (Sept. 8, 2016)) illustrates that the IRS hasn’t forgotten that these penalty taxes exist.  Today’s post takes a look at the basic rules of the accumulated earnings tax and the personal holding company tax – two C corporate penalty taxes that can be problematic. 

Accumulated Earnings Tax

The accumulated earnings (AE) tax is in addition to a corporation's regular income tax. I.R.C. §531.  The AE tax is designed to prevent a corporation from being used to shield its shareholders from the individual income tax through accumulation of earnings and profits, and applies to “accumulated taxable income” of the corporation (taxable income, with certain adjustments.  I.R.C. §535).  There is substantial motivation, even in farm and ranch corporations, not to declare dividends because of their unfavorable tax treatment.  Dividends are taxed twice, once when they are earned by the corporation and again when corporate earnings are distributed as dividends to the shareholders.  This provides a disincentive for agricultural corporations (and other corporations) to make dividend distributions.  Consequently, this leads to a build-up of earnings and profits within the corporation.

The AE tax (at a rate of 20 percent) applies only to amounts unreasonably accumulated during the taxable year.  Indeed, the computation of “accumulated taxable income” is a function of the reasonable needs of the business.  So, the real issue is the extent to which corporate earnings and profits can accumulate before triggering application of the accumulated earnings tax.  To that end, the statute provides for an AE credit which specifies that all corporations are permitted to accumulate earnings and profits of $250,000 without imposition of the tax.  I.R.C. §535(c)(2)(A).  However, the credit operates to ensure that service corporations (fields of health, law, engineering, architecture, accounting, actuarial science, performing arts and consulting) only have $150,000 leeway.  I.R.C. §535(c)(2)(B).  But, remember, not every corporation that exceeds $250,000 (or $150,000) of accumulated earnings and profits will trigger application of the accumulated earnings tax.  That’s because 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. 

Reasonable business needs.  For agricultural corporations, it is important that legitimate business reasons for accumulating earnings and profits in excess of $250,000 be sufficiently documented in annual meeting minutes and other corporate documentation.  IRS regulations concede that some accumulations may be proper, and agricultural corporations should try to base their need for accumulating earnings and profits on the IRS guidelines.  Treas. Reg. §1.537-2(b).  For instance, an acceptable reason for accumulation is to expand the business through the purchase of land, the building of a confinement unit or the acquisition of additional machinery or equipment.  Similarly, earnings and profits may be accumulated to retire debt, hire additional people, provide necessary working capital, or to provide for investments or loans to suppliers or customers in order to keep their business.  Conversely, the IRS specifically targets some accumulations as being improper.  Treas. Reg. §1.537-2(c).  These include loans to shareholders or expenditures of funds for the benefit of shareholders, loans with no reasonable relationship to the business, loans to controlled corporations carrying on a different business, investments unrelated to the business and accumulations for unrealistic hazards.  Thus, while there are many legitimate business reasons for accumulating excess earnings and profits, there are certain illegitimate reasons for excess accumulations which will trigger application of the accumulated earnings tax. 

This all means that it is very important that the corporation's annual meeting minutes document a plan for utilization of accumulated earnings and profits.  For example, in Gustafson's Dairy, Inc. v. Comm'r, T.C. Memo. 1997-519, the AE tax was found not applicable to a fourth-generation dairy operation with one of the largest herds in United States at one location.  The corporation had accumulations of $4.6 million for herd expansion, $1.6 million for pollution control, $8.2 million to purchase equipment and vehicles, $2 million to buy land, $3.3 million to retire a debenture, and $1.1 million to self-insure against loss of herd.  The court found those accumulations to be reasonable particularly because the dairy had specific, definite or feasible plans to use the accumulations, which were documented in corporate records.  Those corporate records (minutes) also showed how the corporation computed its working capital needs.  The key point is that the corporation had a specific plan for the use of corporate earnings and profits, knew its working capital needs, and wasn’t simply trying to avoid tax.

Personal Holding Company (PHC) Tax

The other penalty tax applicable to C corporations is the PHC tax.  I.R.C. §§541-547.  This tax is imposed when the corporation is used as a personal investor.  The PHC tax of 20 percent for tax years after 2012 is levied on undistributed PHC income (taxable income less dividends actually paid, federal taxes paid, excess charitable contributions, and net capital gains).

To be a PHC, 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.  The second test is an income test and is satisfied if 60 percent or more of the corporation's adjusted ordinary gross income (reduced by production costs) comes from passive investment sources.  See, e.g., Tech. Adv. Memo. 200022001 (Nov. 2, 1991). 

The potential problem of rental income.  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 PHC tax could be triggered.  Thus, farming and ranching corporations engaged predominantly in rental activity may escape application of the PHC tax.  But if the corporation's non-rent personal holding company income (dividends, interests, royalties and annuities) is substantial, the corporation must make taxable dividend distributions to avoid imposition of the PHC 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 PHC tax problem.

For many farm and ranch corporations, the problem of being a PHC is serious.  A common scenario is for a farmer or rancher to retire with a tenant or child continuing to farm or ranch the land and pay rent.  If the operation has been incorporated, the receipt of rents could cause the corporation to be a PHC.  In this situation, it is critical to have the proper type of lease to avoid imposition of the PHC tax.  For example, in Webster Corporation v. Comr., 25 T.C.55 (1955), the IRS argued that a farm corporation had become a personal holding company.  The IRS lost, but only because the lease was a material participation crop share lease and substantial services were being provided by a farm manager.  The farm manager's activities were imputed to the corporation as land owner.  The court held that income under such a lease was business income and not rental income.  However, if the lease is not a material participation share lease, then the landlord receives rent.  Certainly, fixed cash rents will be treated as rent.  If the corporation receives only rental income, the rents are not PHC income.  But if the corporation also receives other forms of investment income, the rents can be converted into personal holding company income.

In the typical farm or ranch corporation setting, there is usually a mixture of rental income and other passive income sources.  Over time, the corporation typically builds up a balance in the corporate treasury from the rental income and then invests that money which produces income from other passive sources.  As a result, there is, at some point in time, a mixture of rental income and other passive income sources that will eventually trigger application of the personal holding company tax.  For farming and ranching operations structured as multiple entities, this is one of the major reasons why the landholding entity should not be a C corporation.  The only income that a landholding C corporation entity will have initially is rental income.  However, the tendency to invest the buildup of rental income over time will most likely trigger application of the personal holding company tax down the road.

Taxable income

Finally, a limiting factor in both of these taxes is taxable income. If the corporation doesn’t have taxable income, it isn’t accumulating earnings and is not subject to the AE tax. Also, corporations without taxable income are usually not subject to the PHC tax. Use Form 1120, Schedule PH, as a guide.

Conclusion

A more favorable tax climate for C corporations could spawn renewed interest in their formation and usage.  But, remember the penalty taxes that can apply.  The IRS hasn’t forgotten them, as illustrated by that recent Chief Counsel Advice.  That Chief Counsel Advice referenced earlier also points out that that the AE tax can apply even though the corporation is illiquid.  It doesn’t depend on the amount of cash available for distribution.  It’s based on accumulated taxable income and is not based on the corporation’s liquid assets.  In addition, IRS noted, I.R.C. §565 contains consent dividend procedures that a corporation can use to allow the payment of a deemed dividend when a corporation is illiquid.  In any event, both the AE tax and the PHC tax are penalty taxes that will be strictly construed.  There is no wiggle-room.

So, remember the possible penalty taxes and plan accordingly when utilizing a C corporation.

January 10, 2017 | Permalink | Comments (0)

Friday, January 6, 2017

Top Ten Agricultural Law Developments of 2016 (Five Through One)

Overview

Today we continue our look this week at the biggest developments in agricultural law and taxation during 2016.  Out of all of the court rulings, IRS developments and regulatory issues, we are down to the top five developments in terms of their impact on ag producers, rural landowners and agribusinesses. 

So, here are the top five (as I see them) in reverse order:

(5) Pasture Chiseling Activity Constituted Discharge of “Pollutant” That Violated the CWA. The plaintiff bought approximately 2,000 acres in northern California in 2012. Of that 2,000 acres, the plaintiff sold approximately 1,500 acres. The plaintiff retained an environmental consulting firm to provide a report and delineation map for the remaining acres and requested that appropriate buffers be mapped around all wetlands. The firm suggested that the plaintiff have the U.S. Army Corps of Engineers (COE) verify the delineations before conducting any grading activities. Before buying the 2,000 acres, the consulting firm had provided a delineation of the entire tract, noting that there were approximately 40 acres of pre-jurisdictional wetlands. The delineation on the remaining 450 acres of pasture after the sale noted the presence of intact vernal and seasonal swales on the property along with several intermittent and ephemeral drainages. A total of just over 16 acres of pre-jurisdictional waters of the United States were on the 450 acres – having the presence of hydric soils, hydrophytic vegetation and hydrology (1.07 acres of vernal pools; 4.02 acres of vernal swales; .82 acres of seasonal wetlands; 2.86 acres of seasonal swales and 7.40 acres of other waters of the United States). In preparation to plant wheat on the tract, the property was tilled at a depth of 4-6 inches to loosen the soil for plowing with care taken to avoid the areas delineated as wetlands. However, an officer with the (COE) drove past the tract and thought he saw ripping activity that required a permit. The COE sent a cease and desist letter and the plaintiff responded through legal counsel requesting documentation supporting the COE’s allegation and seeking clarification as to whether the COE’s letter was an enforcement action and pointing out that agricultural activities were exempted from the CWA permit requirement. The COE then provided a copy of a 1994 delineation and requested responses to numerous questions. The plaintiff did not respond. The COE then referred the matter to EPA for enforcement. The plaintiff sued the COE claiming a violation of his Fifth Amendment right to due process and his First Amendment right against retaliatory prosecution. The EPA refused the referral due to the pending lawsuit so the COE referred the matter to the U.S. Department of Justice (DOJ). The DOJ filed a counterclaim against the plaintiff for CWA violations.

The court granted the government’s motion on the due process claim because the cease and desist letter did not initiate any enforcement that triggered due process rights. The court also dismissed the plaintiff’s retaliatory prosecution claim. On the CWA claim brought by the defendant, the court determined that the plaintiff’s owner could be held liable as a responsible party. The court noted that the CWA is a strict liability statute and that the intent of the plaintiff’s owner was immaterial. The court then determined that the tillage of the soil causes it to be “redeposited” into delineated wetlands. The redeposit of soil, the court determined, constituted the discharge of a “pollutant” requiring a national pollution discharge elimination system (NPDES) permit. The court reached that conclusion because it found that the “waters” on the property were navigable waters under the CWA due to a hydrological connection to a creek that was a tributary of Sacramento River and also supported the federally listed vernal pool fairy shrimp and tadpole shrimp. Thus, a significant nexus with the Sacramento River was present. The court also determined that the farming equipment, a tractor with a ripper attachment constituted a point source pollutant under the CWA. The discharge was not exempt under the “established farming operation” exemption of 33 U.S.C. §1344(f)(1) because farming activities on the tract had not been established and ongoing, but had been grazed since 1988. Thus, the planting of wheat could not be considered a continuation of established and ongoing farming activities. Duarte Nursery, Inc. v. United States Army Corps of Engineers, No. 2:13-cv-02095-KJM-AC, 2016 U.S. Dist. LEXIS 76037 (E.D. Cal. Jun. 10, 2016).

(4) Prison Sentences Upheld For Egg Company Executives Even Though Government Conceded They Had No Knowledge of Salmonella Contamination. The defendant, an executive of a large-scale egg production company (trustee of the trust that owned the company), and his son (the Chief Operating Officer of the company) pled guilty as “responsible corporate officers” to misdemeanor violations of 21 U.S.C. §331(a) for introducing eggs that had been adulterated with salmonella into interstate commerce from the beginning of 2010 until approximately August of 2010. They each were fined $100,000 and sentenced to three months in prison. They appealed their sentences as unconstitutional on the basis that they had no knowledge that the eggs at issue were contaminated at the time they were shipped. They also claimed that their sentences violated Due Process and the Eighth Amendment insomuch as the sentences were not proportional to their “crimes.” They also claimed that incarceration for a misdemeanor offense would violate substantive due process.

The trial court determined that the poultry facilities were in poor condition, had not been appropriately cleaned, had the presence of rats and other rodents and frogs and, as a result, the defendant and his son either “knew or should have known” that additional salmonella testing was needed and that remedial and preventative measures were necessary to reduce the presence of salmonella. The appellate court agreed, finding that the evidence showed that the defendant and son were liable for negligently failing to prevent the salmonella outbreak and that 21 U.S.C. §331(a) did not have a knowledge requirement. The appellate court also did not find a due process violation. The defendant and son claimed that because they did not personally commit wrongful acts, and that due process is violated when prison terms are imposed for vicarious liability felonies where the sentence of imprisonment is only for misdemeanors. However, the court held that vicarious liability was not involved, and that 21 U.S.C. §331(a) holds a corporate officer accountable for failure to prevent or remedy “the conditions which gave rise to the charges against him.” Thus, the appellate court determined, the defendant and son were liable for negligently failing to prevent the salmonella outbreak. The court determined that the lack of criminal intent does not violate the Due Process Clause for a “public welfare offense” where the penalty is relatively small (the court believed it was), the defendant’s reputation was not “gravely” damaged (the court believed that it was not) and congressional intent supported the penalty (the court believed it did). The court also determined that there was no Eighth Amendment violation because “helpless” consumers of eggs were involved. The court also found no procedural or substantive due process violation with respect to the sentences because the court believed that the facts showed that the defendant and son “had reason to suspect contamination” and should have taken action to address the problem at that time (even though law didn’t require it).

The dissent pointed out that the government stipulated at trial that its investigation did not identify any corporate personnel (including the defendant and son) who had any knowledge that eggs sold during the relevant timeframe were contaminated with salmonella. The dissent also noted that the government conceded that there was no legal requirement for the defendant or corporation to comply with stricter regulations during the timeframe in issue. As such, the convictions imposed and related sentences were based on wholly nonculpable conduct and there was no legal precedent supporting imprisonment in such a situation. The dissent noted that the corporation “immediately, and at great expense, voluntarily recalled hundreds of millions of shell eggs produced” at its facilities when first alerted to the problem. As such, according to the dissent, due process was violated and the sentences were unconstitutional. United States v. Decoster, 828 F.3d 626 (8th Cir. 2016).

(3) The IRS and Self-Employment Tax. Two self-employment tax issues affecting farmers and ranchers have been in the forefront in recent years – the self-employment tax treatment of Conservation Reserve Program (CRP) payments and the self-employment tax implications of purchased livestock that had their purchase price deducted under the de minimis safe harbor of the capitalization and repair regulations. On the CRP issue, in 2014 the U.S. Court of Appeals ruled that CRP payments in the hands of a non-farmer are not subject to self-employment tax. The court, in Morehouse v. Comr., 769 F.3d 616 (8th Cir. 2014), rev’g, 140 T.C. 350 (2013), held the IRS to its historic position staked out in Rev. Rul. 60-32 that government payments attributable to idling farmland are not subject to self-employment tax when received by a person who is not a farmer. The court refused to give deference to an IRS announcement of proposed rulemaking involving the creation of a new Rev. Rul. that would obsolete the 1960 revenue ruling. The IRS never wrote the new rule, but continued to assert their new position on audit. The court essentially told the IRS to follow appropriate procedure and write a new rule reflecting their change of mind. In addition, the court determined that CRP payments are “rental payments” statutorily excluded from self-employment tax under I.R.C. §1402(a). Instead of following the court’s invitation to write a new rule, the IRS issued a non-acquiescence with the Eighth Circuit’s opinion. O.D. 2015-02, IRB 2015-41. IRS said that it would continue audits asserting their judicially rejected position, even inside the Eighth Circuit (AR, IA, MN, MO, NE, ND and SD).

In 2016, the IRS had the opportunity to show just how strong its opposition to the Morehouse decision is. A Nebraska non-farmer investor in real estate received a CP2000 Notice from the IRS, indicating CRP income had been omitted from their 2014 return. The CP2000 Notice assessed the income tax and SE Tax on the alleged omitted income. The CRP rental income was in fact included on the return, but it was included on Schedule E along with cash rents, where it was not subject to self-employment tax. The practitioner responded to the IRS Notice by explaining that the CRP rents were properly reported on Schedule E because the taxpayer was not a farmer. This put the matter squarely before the IRS to reject the taxpayer’s position based on the non-acquiescence. But, the IRS replied to the taxpayer’s response with a letter informing the taxpayer that the IRS inquiry was being closed with no change from the taxpayer’s initial position that reported the CRP rents for the non-farmer on Schedule E. 

On the capitalization and repair issue, taxpayers can make a de minimis safe harbor election that allows amounts otherwise required to be capitalized to be claimed as an I.R.C. §162 ordinary and necessary business expense. This de minimis expensing election has a limit of $5,000 for taxpayers with an Applicable Financial Statement (AFS) and $2,500 for those without an AFS. Farmers will fall in the latter category. In both cases, the limit is applied either per the total on the invoice, or per item as substantiated by the invoice. One big issue for farmers and ranchers is how to report the income from the sale of purchased livestock that are held for productive use, such as breeding or dairy animals for which the de minimis safe harbor election was made allowing the full cost of the livestock to be deducted. It had been believed that because the repair regulations specify when the safe harbor is used, the sale amount is reported fully as ordinary income that is reported on Schedule F where it is subject to self-employment tax for a taxpayer who is sole proprietor farmer or a member of a farm partnership. In that event, the use of the safe harbor election would produce a worse tax result that would claiming I.R.C. §179 on the livestock.

An alternative interpretation of the repair regulations is that the self-employment tax treatment of the gain or loss on sale of assets for which the purchase price was deducted under the de minimis safe harbor is governed by Treas. Reg. §1.1402(a)-6(a). That regulation states that the sale of property is not subject to selfemployment tax unless at least one of two conditions are satisfied: (1) the property is stock in trade or other property of a kind which would properly be includible in inventory if on-hand at the close of the tax year; or (2) the property is held primarily for sale to customers in the ordinary course of a trade or business. Because purchased livestock held for dairy or breeding purposes do not satisfy the first condition, the question comes down to whether condition two is satisfied – are the livestock held primarily for sale to customers in the ordinary course of a trade or business? The answer to that question is highly fact-dependent. If the livestock whose purchase costs have been deducted under the de minimis rule are not held primarily for sale to customers in the ordinary course of the taxpayer’s trade or business, the effect of the regulation is to report the gain on sale on Part II of Form 4797. This follows Treas. Reg. §1.1402(a)-6(a) which bars Sec. 1231 treatment (which would result in the sale being reported on Part I of Form 4797). In that event, the income received on sale would not be subject to self-employment tax.

In 2016, the IRS, in an unofficial communication, said that the alternative interpretation is the correct approach. However, the IRS was careful to point out that the alternative approach is based on the assumptions that the livestock were neither inventoriable nor held for sale, and that those assumptions are highly fact dependent on a case-by case basis. The IRS is considering adding clarifying language to the Farmers’ Tax Guide (IRS Pub. 225) and/or the Schedule F Instructions.

(2) TMDLs and the Regulation of Ag Runoff. Diffused surface runoff of agricultural fertilizer and other chemicals into water sources as well as irrigation return flows are classic examples of nonpoint source pollution that isn’t discharged from a particular, identifiable source. A primary source of nonpoint source pollution is agricultural runoff. As nonpoint source pollution, the Clean Water Act (CWA) leaves regulation of it up to the states rather than the federal government. The CWA sets-up a “states-first” approach to regulating water quality when it comes to nonpoint source pollution. Two key court opinions were issued in 2016 where the courts denied attempts by environmental groups to force the EPA to create additional federal regulations involving Total Maximum Daily Loads (TMDLs). The states are to establish total maximum daily TMDLs for watercourses that fail to meet water quality standards after the application of controls on point sources. A TMDL establishes the maximum amount of a pollutant that can be discharged or “loaded” into the water at issue from all combined sources on a daily basis and still permit that water to meet water quality standards. A TMDL must be set “at a level necessary to implement water quality standards.” The purpose of a TMDL is to limit the amount of pollutants in a watercourse on any particular date. Two federal court opinions in 2016 reaffirmed the principle that regulation of nonpoint source pollution is left to the states and not the federal government.

In Conservation Law Foundation v. United States Environmental Protection Agency, No. 15-165-ML, 2016 U.S. Dist. LEXIS 172117 (D. R.I. Dec. 13, 2016), the plaintiff claimed that the EPA’s approval of the state TMDL for a waterbody constituted a determination that particular stormwater discharges were contributing to the TMDL being exceeded and that federal permits were thus necessary. The court, however, determined that the EPA’s approval of the TMDL did not mean that EPA had concluded that stormwater discharges required permits. The court noted that there was nothing in the EPA’s approval of the TMDL indicating that the EPA had done its own fact finding or that EPA had independently determined that stormwater discharges contributed to a violation of state water quality standards. The regulations simply do not require an NPDES permit for stormwater discharges to waters of the United States for which a TMDL has been established. A permit is only required when, after a TMDL is established, the EPA makes a determination that further controls on stormwater are needed.

In the other case, Gulf Restoration Network v. Jackson, No. 12-677 Section: “A” (3), 2016 U.S. Dist. LEXIS 173459 (E.D. La. Dec. 15, 2016), numerous environmental groups sued the EPA to force them to impose limits on fertilizer runoff from farm fields. The groups claimed that many states hadn’t done enough to control nitrogen and phosphorous pollution from agricultural runoff, and that the EPA was required to mandate federal limits under the Administrative Procedure Act – in particular, 5 U.S.C. §553(e) via §303(c)(4) of the CWA. Initially, the groups told the EPA that they would sue if the EPA did not write the rules setting the limits as requested. The EPA essentially ignored the groups’ petition by declining to make a “necessity determination. The groups sued and the trial court determined that the EPA had to make the determination based on a 2007 U.S. Supreme Court decision involving the Clean Air Act (CAA). That decision was reversed on appeal on the basis that the EPA has discretion under §303(c)(4)(B) of the CWA to decide not to make a necessity determination as long as the EPA gave a “reasonable explanation” based on the statute why it chose not to make any determination. The appellate court noted that the CWA differed from the CAA on this point. On remand, the trial court noted upheld the EPA’s decision not to make a necessity determination. The court noted that the CWA gives the EPA “great discretion” when it comes to regulating nutrients, and that the Congressional policy was to leave regulation of diffused surface runoff up to the states. The court gave deference to the EPA’s “comprehensive strategy of bringing the states along without the use of federal rule making…”.

Also, in 2016 the U.S. Supreme Court declined to review a decision of the U.S. Court of Appeals for the Third Circuit which had determined in 2015 that the EPA had acted within its authority under 33 U.S.C. §1251(d) in developing a TMDL for the discharge of nonpoint sources pollutants into the Chesapeake Bay watershed.  American Farm Bureau, et al. v. United States Environmental Protection Agency, et al., 792 F.3d 281 (3d Cir. 2015), cert. den., 136 S. Ct. 1246 (2016).

(1) The Election of Donald Trump as President and the Potential Impact on Agricultural and Tax Policy. Rural America voted overwhelmingly for President-elect Trump, and he will be the President largely because of the sea of red all across the country in the non-urban areas. So, what can farmers, ranchers and agribusinesses anticipate the big issues to be in the coming months and next few years and the policy responses? It’s probably reasonable to expect that same approach will be applied to regulations impacting agriculture. Those with minimal benefit and high cost could be eliminated or retooled such that they are cost effective. Overall, the pace of the generation of additional regulation will be slowed. Indeed, the President-elect has stated that for every new regulation, two existing regulations have to be eliminated.

Ag policy.  As for trade, it is likely that trade agreements will be negotiated on a much more bi-lateral basis – the U.S. negotiating with one other country at a time rather than numerous countries. The President-elect is largely against government hand-outs and is big on economic efficiency. That bodes well for the oil and gas industry (and perhaps nuclear energy). But, what about less efficient forms of energy that are heavily reliant on taxpayer support? Numerous agricultural states are heavily into subsidized forms of energy with their state budgets littered with numerous tax “goodies” for “renewable” energy.” However, the President-elect won those states. So, does that mean that the federal subsidies for ethanol and biodiesel will continue. Probably. The Renewable Fuels Standard will be debated in 2017, but will anything significant happen? Doubtful. It will continue to be supported, but I expect it to be reviewed to make sure that it fits the market. Indeed, one of the reasons that bio-mass ethanol was reduced so dramatically in the EPA rules was that it couldn’t be produced in adequate supplies. What about the wind energy production tax credit? What about the various energy credits in the tax code? Time will tell, but agricultural interests should pay close attention.

The head of the Senate Ag Committee will be Sen. Roberts from Kansas. As chair, he will influence the tone of the debate of the next farm bill. I suspect that means that the farm bill will have provisions dealing with livestock disease and biosecurity issues. Also, I suspect that it will contain significant provisions crop insurance programs and reforms of existing programs. The House Ag Committee head will be Rep. Conaway from Texas. That could mean that cottonseed will become an eligible commodity for Agricultural Risk Coverage (ARC) and Price Loss Coverage (PLC). It may also be safe to assume that for the significant Midwest crops (and maybe some additional crops) their reference prices will go up. Also, it now looks as if the I.R.C. §179 issue involving the income limitation for qualification for farm program payments (i.e., the discrepancy of the treatment between S corporations and C corporations) will be straightened out. Other federal agencies that impact agriculture (EPA, Interior, FDA, Energy, OSHA) can be expected to be more friendly to agriculture in a Trump Administration.

Tax policy. As for income taxes, it looks at this time that the Alternative Minimum Tax might be eliminated, as will the net investment income tax that is contained in Obamacare. Individual tax rates will likely drop, and it might be possible that depreciable assets will be fully deductible in the year of their purchase. Also, it looks like the corporate tax rate will be cut as will the rate applicable to pass-through income. As for transfer taxes, President-elect Trump has proposed a full repeal of the federal estate tax as well as the federal gift tax. Perhaps repeal will be effective January 1, 2017, or perhaps it will be put off until the beginning of 2018. Or, it could be phased-in over a certain period of time. Also, while it appears at the present time that any repeal would be “permanent,” that’s not necessarily a certainty. Similarly, it’s not known whether the current basis “step-up” rule would be retained if the estate tax is repealed. That’s particularly a big issue for farmers and ranchers. It will probably come down to a cost analysis as to whether step-up basis is allowed. The President-elect has already proposed a capital gains tax at death applicable to transfers that exceed $10 million (with certain exemptions for farms and other family businesses). Repeal of gift tax along with repeal of estate tax has important planning implications. There are numerous scenarios that could play out. Stay tuned, and be ready to modify existing plans based on what happens. Any repeal bill would require 60 votes in the Senate to avoid a filibuster unless repeal is done as part of a reconciliation bill. Also, without being part of a reconciliation bill, any repeal of the federal estate tax would have to “sunset” in ten years.

January 6, 2017 | Permalink | Comments (0)

Wednesday, January 4, 2017

Top Ten Agricultural Law and Tax Developments of 2016 (Ten Through Six)

Overview

This week we are looking at the biggest developments in agricultural law and taxation for 2016.  On Monday, we highlighted the important developments that just missed being in the top ten.  Today we take a look at developments 10 through six.  On Friday, we will look at the top five. 

  1. Court Obscures Rational Basis Test To Eliminate Ag Exemption From Workers' Compensation Law. While this is a state Supreme Court decision, its implications are significant. Most, if not all, states have a statutory exemption from workers’ compensation for employers that are engaged in agriculture. The statutory exemption varies in scope from state to state and, of course, an employer that is otherwise exempt can choose to be covered by the statute and offer workers’ compensation benefits to employees. In this case, the plaintiffs claimed that their on-the-job injuries should be covered under the state (NM) workers' compensation law. One plaintiff tripped while picking chile and fractured her left wrist. The other plaintiff was injured while working in a dairy when he was head-butted by a cow and pushed up against a metal door causing him to fall face-first into a concrete floor and sustain neurological damage. The plaintiffs' claims for workers' compensation benefits were dismissed via the exclusion from the workers' compensation system for employers. On appeal, the appellate court reversed. Using rational basis review (the standard most deferential to the constitutionality of the provision at issue), the court interpreted Sec. 52-1-6(A) of the New Mexico Code as applying to the primary job duties of the employees (as opposed to the business of the employer and the predominant type of employees hired), and concluded the distinction was irrational and lacked any rational purpose. The appellate court noted that the purpose of the law was to provide "quick and efficient delivery" of medical benefits to injured and disabled workers. Thus, the court determined that the exclusion violated the constitutional equal protection guarantee. The court further believed that the exclusion for workers that cultivate and harvest (pick) crops, but the inclusion of workers that perform tasks associated with the processing of crops was a distinction without a difference. The appellate court made no mention that the highest court in numerous other states had upheld a similar exclusion for agriculture from an equal protection constitutional challenge.  On further review, the state Supreme Court affirmed. The Court determined that there was nothing to distinguish farm and ranch laborers from other ag employees and that the government interest of cost savings, administrative convenience and similar interests unique to agriculture were not rationally related to a legitimate government interest. The court determined that the exclusion that it construed as applying to ag laborers was arbitrary discrimination. A dissenting judge pointed out that the legislature’s decision to allow employers of farm and ranch laborers to decide for themselves whether to be subject to workers’ compensation or opt out and face tort liability did not violate any constitutionally-protected right. The dissent noted that such ability to opt out was a legitimate statutory scheme that rationally controlled costs for New Mexico farms and ranches, and that 29 percent of state farms and ranches had elected to be covered by workers’ compensation. The dissent also noted that the majority’s opinion would have a detrimental economic impact on small, economically fragile farms in New Mexico by imposing an additional economic cost of $10.5 million annually (as projected by the state Workers’ Compensation Administration). On this point, the dissent further pointed out that the average cost of a claim was $16,876 while the average net farm income for the same year studied was $19,373. The dissent further concluded that the exemption for farming operations was legitimately related to insulating New Mexico farm and ranches from additional costs. In addition, the dissent reasoned that the majority misapplied the rational basis analysis to hold the act unconstitutional as many other state courts and the U.S. Supreme Court had held comparable state statutes to satisfy the rational basis test. The dissent pointed out forcefully that the exclusion applied to employers and that the choice to be covered or not resided with employers who predominately hired ag employees. As such there was no disparate treatment between ag laborers and other agricultural workers. Rodriguez, et al. v. Brand West Dairy, et al., 378 P.3d 13 (N.M. Sup. Ct. 2016), aff’g., 356 P.3d 546 (N.M. Ct. App. 2015).
  • 9.  COE Jurisdictional Determination Subject to Court Review. The plaintiff, a peat moss mining company, sought the approval of the Corps of Engineers (COE) to harvest a swamp (wetland) for peat moss to use in landscaping projects. The COE issued a jurisdictional determination that the swamp was a wetland subject to the permit requirements of the Clean Water Act (CWA). The plaintiff sought to challenge the COE determination, but the trial court ruled for the COE, holding that the plaintiff had three options: (1) abandon the project; (2) seek a federal permit costing over $270,000; or (3) proceed with the project and risk fines of up to $75,000 daily and/or criminal sanctions including imprisonment. On appeal, the court unanimously reversed, strongly criticizing the trial court's opinion. Based on Sackett v. Environmental Protection Agency, 132 S. Ct. 1367 (2012), the court held that COE Jurisdictional Determinations constitute final agency actions that are immediately appealable in court. The court noted that to hold elsewise would allow the COE to effectively kill the project without any determination of whether it's position as to jurisdiction over the wetland at issue was correct in light of Rapanos v. United States, 547 U.S. 715 (U.S. 2006). The court noted that the COE had deliberately left vague the "definitions used to make jurisdictional determinations" so as to expand its regulatory reach. While the COE claimed that the jurisdictional determination was merely advisory and that the plaintiff had adequate ways to contest the determination, the court determined that such alternatives were cost prohibitive and futile. The court stated that the COE's assertion that the jurisdictional determination (and the trial court's opinion) was merely advisory ignored reality and had a powerful coercive effect. The court held that the Fifth Circuit, which reached the opposition conclusion with respect to a COE Jurisdictional Determination in Belle Co., LLC v. United States Army Corps. of Engineers, 761 F.3d 383 (5th Cir. 2014), cert. den., 83 U.S.L.W. 3291 (U.S. Mar. 23, 2015), misapplied the Supreme Court's decision in Sackett. Hawkes Co., Inc., et al. v. United States Army Corps of Engineers, 782 F.3d 984 (8th Cir. 2015), rev'g., 963 F. Supp. 2d 868 (D. Minn. 2013). In a later decision, the court denied a petition to rehear the case en banc and by the panel. Hawkes Co., Inc., et al. v. United States Army Corps of Engineers, No. 13-3067, 2015 U.S. App. LEXIS 11697 (8th Cir. Jul. 7, 2015).  In December of 2015, the U.S. Supreme Court agreed to hear the case and affirmed the Eighth Circuit on May 31, 2016. The Court, in a unanimous opinion, noted that the memorandum of agreement between the EPA and the Corps established that jurisdictional determinations are “final actions” that represent the Government’s position, are binding on the Government in any subsequent Federal action or litigation involving the position taken in the jurisdictional determination. When the landowners received an “approved determination” that meant that the Government had determined that jurisdictional waters were present on the property due to a “nexus” with the Red River of the North, located 120 miles away. As such, the landowners had the right to appeal in Court after exhausting administrative remedies and the Government’s position take in the jurisdictional determination was judicially reviewable. Not only did the jurisdictional determination constitute final agency action under the Administrative Procedure Act, it also determined rights or obligations from which legal consequences would flow. That made the determination judicially reviewable. United States Army Corps of Engineers v. Hawkes Company, 136 S. Ct. 1807 (2016).  
  • 8.  Proposed Regulations Under I.R.C. §2704. In early August, the IRS issued new I.R.C. §2704 regulations that could seriously impact the ability to generate minority interest discounts for the transfer of family-owned entities. Prop. Reg. – 163113-02 (Aug. 2, 2016). The proposed regulations, if adopted in their present form, will impose significant restrictions on the availability of valuation discounts for gift and estate tax purposes in a family-controlled environment. Prop. Treas. Regs. §§25.2704-1; 25.2704-4; REG- 163113-02 (Aug. 2, 2016). They also redefine via regulation and thereby overturn decades of court decisions honoring the well-established willing-buyer/willing-seller approach to determining fair market value (FMV) of entity interests at death or via gift of closely-held entities, including farms and ranches. The proposed regulations would have a significant impact on estate, business and succession planning in the agricultural context for many agricultural producers across the country and will make it more difficult for family farm and ranch businesses to survive when a family business partner dies. Specifically, the proposed regulations treat transfer within three years of death as death-bed transfers, create new “disregarded restrictions” and move entirely away from examining only those restrictions that are more restrictive than state law. As such, the proposed regulations appear to exceed the authority granted to the Treasury by Congress to promulgate regulations under I.R.C. §2704 and should be withdrawn. A hearing on the regulations was held in early December.  
  • 7.  Capitalization Required For Interest and Real Property Taxes Associated with Crops Having More Than Two-Year Preproductive Period. The petitioner (three partnerships) bought land that they planned to use for growing almonds. They financed the purchase by borrowing money and paying interest on the debt. They then began planting almond trees. They deducted the interest and property taxes on their returns. The IRS objected to the deduction on the basis that the interest and taxes were indirect costs of the “production of real property” (i.e., the almonds trees that were growing on the land. The Tax Court agreed with the IRS noting that I.R.C. §263A requires the capitalization of certain costs and that those costs include the interest paid to buy the land and the property taxes paid on the land attributable to growing crops and plants where the preproductive period of the crop or plant exceeds two years. I.R.C. §263A(f)(1) states that “interest is capitalized where (1) the interest is paid during the production period and (2) the interest is allocable to real property that the taxpayer produced and that has a long useful life, an estimated production period exceeding two years, or an estimated production period exceeding one year and a cost exceeding $1 million.” The corresponding regulation, the court noted, requires that the interest be capitalized under the avoided cost method. The court also noted that the definition of “real property produced by the taxpayer for the taxpayer’s use in a trade or business or in an activity conducted for profit” included “land” and “unsevered natural products of the land” and that “unsevered natural products of the land” general includes growing crops and plants where the preproductive period of the crop or plant exceeds two years. Because almond trees have a preproductive period exceeding two years in accordance with IRS Notice 2000-45, and because the land was “necessarily intertwined” with the growing of the almond trees, the interest and tax cost of the land is a necessary and indispensable part of the growing of the almond trees and must be capitalized. Wasco Real Properties I, LLC, et al. v. Comr., T.C. Memo. 2016-224.

6.         No Recapture of Prepaid Expenses Deducted in Prior Year When Surviving Spouse Claims Same Deduction in Later Year. The decedent, a materially participating Nebraska farmer, bought farm inputs in 2010 and deducted their cost on his 2010 Schedule F. He died in the spring of 2011 before using the inputs to put the spring 2011 crop in the ground. Upon his death, the inputs were included in the decedent’s estate at their purchase price value and then passed to a testamentary trust for the benefit of his wife. The surviving spouse took over the farming operation, and in the spring of 2011, took a distribution of the inputs from the trust to plant the 2011 crops. For 2011, two Schedule Fs were filed. A Schedule F was filed for the decedent to report the crop sales deferred to 2011, and a Schedule F was filed for the wife to report the crops sold by her in 2011 and claim the expenses of producing the crop which included the amount of the inputs (at their date-of-death value which equaled their purchase price) that had been previously deducted as prepaid inputs by the husband on the couple’s joint 2010 return. The IRS denied the deduction on the basis that the farming expense deduction by the surviving spouse was inconsistent with the deduction for prepaid inputs taken in the prior year by the decedent and, as a result, the “tax benefit rule” applied. The court disagreed, noting that the basis step-up rule of I.R.C. §1014 allowed the deduction by the surviving spouse which was not inconsistent with the deduction for the same inputs in her deceased husband’s separate farming business. The court also noted that inherited property is not recognized as income by the recipient, which meant that another requisite for application of the tax benefit rule did not apply. Estate of Backemeyer v. Comr., 147 T.C. No. 17 (2016).

Conclusion

Those were developments ten through six, at least as I see it for 2016.  On Friday, we will list the five biggest developments for 2016.

January 4, 2017 | Permalink | Comments (0)

Monday, January 2, 2017

The Most Important Agricultural Law and Tax Developments of 2016

Overview

This week we will be taking a look at what I view as the most significant developments in agricultural law and agricultural taxation during 2016.  There were many important happenings in the courts, the IRS and with administrative agencies that have an impact on farm and ranch operations, rural landowners and agribusinesses.  What I am writing about this week are those developments that will have the biggest impact nationally.  Certainly, there were significant state developments, but they typically will not have the national impact of those that result from federal courts, the IRS and federal agencies. 

It’s tough to get it down to the ten biggest developments of the year, and I do spend considerable time going sorting through the cases and rulings get to the final cut.  Today we take a quick look at those developments that I felt were close to the top ten, but didn’t quite make the list.  Later this week we will look at those that I feel were worthy of the top ten.  Again, the measuring stick is the impact that the development has on the ag sector as a whole. 

Almost, But Not Quite

Those developments that were the last ones on the chopping block before the final “top ten” are always the most difficult to determine.  But, as I see it, here they are (in no particular order):

  • HRA Relief for Small Businesses. Late in 2016, the President signed into law H.R. 6, the 21st Century Cures Act.  Section 18001 of the legislation repeals the restrictions included in Obamacare that hindered the ability of small businesses (including farming operations) to use health reimbursement arrangements (HRAs).  The provision allows   a "small employer" (defined as one with less than 50 full-time employees who does not offer a group health plan to any employees) to offer a health reimbursement arrangement (HRA) that the employer funds to reimburse employees for qualified medical expenses, including health insurance premiums. If various technical rules are satisfied, the basic effect of the provision is that, effective for plan years beginning after December 31, 2016, such HRAs will no longer be a violation of Obamacare's market "reforms" that would subject the employer to a penalty of $100/day per affected person). It appears that the relief also applies to any plan year beginning before 2017, but that is less clear.  Of course, all of this becomes moot if Obamacare is repealed in its entirety in 2017. 
  • More Obamacare litigation.  In a somewhat related development, in May the U.S. District Court for the District of Columbia ruled in United States House of Representatives v. Burwell, No. 14-1967 (RMC), 2016 U.S. Dist. LEXIS 62646 (D. D.C. May, 12, 2016), that the Obama Administration did not have the power under the Constitution to spend taxpayer dollars on "cost sharing reduction payments" to insurers without a congressional appropriation.  The Obama Administration had argued that congressional approval was unnecessary because the funds were guaranteed by the same section of Obamacare that provides for the premium assistance tax credit that is designed to help offset the higher cost of health insurance as a result of the law.  However, the court rejected that argument and enjoined the use of unappropriated funds due insurers under the law.  The court ruled that the section at issue only appropriated funds for tax credits and that the insurer payments required a separate congressional appropriation.   The court stayed its opinion pending appeal.  A decision on appeal is expected in early 2017, but would, of course, be mooted by a repeal of Obamacare.
  • Veterinary Feed Directive Rule. The Food and Drug Administration revised existing regulations involving the animal use of antibiotics that are also provided to humans.  The new rules arose out of a belief of bacterial resistance in humans to antibiotics even though there is no scientific proof that antibiotic resistant bacterial infections in humans are related to antibiotic use in livestock. As a result, at the beginning of 2017, veterinarians will be required to provide a “directive” to livestock owners seeking to use or obtain animal feed products containing medically important antimicrobials as additives. A “directive” is the functional equivalent of receiving a veterinarian’s prescription to use antibiotics that are injected in animals.  21 C.F.R. Part 558.
  • Final Drone Rules.  The Federal Aviation Administration (FAA) issued a Final Rule on UASs (“drones”) on June 21, 2016. The Final Rule largely follows the Notice of Proposed Rulemaking issued in early 2015 (80 Fed. Reg. 9544 (Feb. 23, 2015)) and allows for greater commercial operation of drones in the National Airspace System. At its core, the Final Rule allows for increased routine commercial operation of drones which prior regulations required commercial users of drones to make application to the FAA for permission to use drones - applications the FAA would review on a case-by-case basis. The Final Rule (FAA-2015-0150 at 10 (2016)) adds Part 107 to Title 14 of the Code of Federal Regulations and applies to unmanned “aircraft” that weigh less than 55 pounds (that are not model aircraft and weigh more than 0.5 pounds). The Final Rule became effective on August 29, 2016.
  • County Bans on GMO Crops Struck Down.  A federal appellate court struck down county ordinances in Hawaii that banned the cultivation and testing of genetically modified (engineered) organisms.  The court decisions note that either the state (HI) had regulated the matter sufficiently to remove the ability of counties to enact their own rules, or that federal law preempted the county rules. Shaka Movement v. County of Maui, 842 F.3d 688 (9th Cir. 2016) and Syngenta Seeds, Inc. v. County of Kauai, No. 14-16833, 2016 U.S. App. LEXIS 20689 (9th Cir. Nov. 18, 2016).
  • Insecticide-Coated Seeds Exempt from EPA Regulation Under FIFRA.  A federal court held that an existing exemption for registered pesticides applied to exempt insecticide-coated seeds from separate regulation under the Federal Insecticide, Rodenticide Act which would require their separate registration before usage.  Anderson v. McCarthy, No. C16-00068, WHA, 2016 U.S. Dist. LEXIS 162124 (N.D. Cal. Nov. 21, 2016).
  • Appellate Court to Decide Fate of EPA’s “Waters of the United States” Final Rule.  The U.S. Court of Appeals for the Sixth Circuit ruled that it had jurisdiction to hear a challenge to the EPA’s final rule involving the scope and effect of the rule defining what waters the federal government can regulate under the Clean Water Act.  Murray Energy Corp. v. United States Department of Defense, 817 F.3d 261 (6th Cir. 2016).
  • California Proposition Involving Egg Production Safe From Challenge.  California enacted legislation making it a crime to sell shelled eggs in the state (regardless of where they were produced) that came from a laying hen that was confined in a cage not allowing the hen to “lie down, stand up, fully extend its limbs, and turn around freely.”  The law was challenged by other states as an unconstitutional violation of the Commerce Clause by “conditioning the flow of goods across its state lines on the method of their production” and as being preempted by the Federal Egg Products Inspection Act.  The trial court determined that the plaintiffs lacked standing and the appellate court affirmed.  Missouri v. Harris, 842 F.3d 658 (9th Cir. 2016).
  • NRCS Properly Determined Wetland Status of Farmland.  The Natural Resource Conservation Service (NRCS) determined that a 0.8-acre area of a farm field was a prairie pothole that was a wetland that could not be farmed without the plaintiffs losing farm program eligibility.  The NRCS made its determination based on “color tone” differences in photographs, wetland signatures and a comparison site that was 40 miles away.  The court upheld the NRCS determination as satisfying regulatory criteria for identifying a wetland and was not arbitrary, capricious or contrary to the law.  Certiorari has been filed with the U.S. Supreme Court asking the court to clear up a conflict between the circuit courts of appeal on the level of deference to be given federal government agency interpretive manuals.  Foster v. Vilsack, 820 F.3d 330 (8th Cir. 2016).
  • Family Limited Partnerships (FLPs) and the “Business Purpose” Requirement. In 2016, there were two cases involving FLPs and the retained interest section of the Code.  That follows one case late in 2015 which was the first one in over two years.  In Estate of Holliday v. Comr., T.C. Memo. 2016-51, the court held that the transfers of marketable securities to an FLP two years before the transferor’s death was not a bona fide sale, with the result that the decedent (transferor) was held to have retained an interest under I.R.C. §2036(a) and the FLP interest was included in the estate at no discount.  Transferring marketable securities to an FLP always seems to trigger issues with the IRS.  In Estate of Beyer v. Comr., T.C. Memo. 2016-183, the court upheld the assessment of gift and estate tax (and gift tax penalties) with respect to transfers to an FLP because the court determined that every benefit allegedly springing from the FLP could have been accomplished by trusts and other arrangements.  There needs to be a separate non-tax business purpose to the FLP structure.  A deeper dive into the court opinions also points out that the application of the “business purpose” requirement with respect to I.R.C. §2036 is very subjective.  It’s important to treat the FLP as a business entity, not put personal assets in the FLP, or at least pay rent for their use, and follow all formalities of state law. 

Conclusion

These are the developments that were important, but just not big enough in terms of their overall impact on the ag sector to make the list of the “top ten.”  The next post will take a look at developments ten through six. 

January 2, 2017 | Permalink | Comments (0)