Tuesday, March 20, 2018
Normally land is acquired in a transaction where a buyer pays a sum to buy the property and obtain legal title to it. However, if a person without legal title to a tract can claim legal ownership by showing that the person has possessed it for a certain amount of time without the permission of the tract’s true owner. This is known as “adverse possession” and it has been recognized for several centuries, dating back to early English common law.
A concept similar to adverse possession is that of a prescriptive easement. A prescriptive easement is an implied easement for usage of another person’s tract of land where the use occurs without the true owner’s permission, and has lasted for a time period set by statute in the particular jurisdiction. A prescriptive easement can result in title ownership over the area subject to the easement resting in the party (or parties) using the easement.
Adverse possession and prescriptive easements are important to rural landowners. Many cases are brought every year concerning boundary disputes that involve these concepts. Once title is successfully obtained by adverse possession (or by prescription), the party obtaining title can bring a court action to quiet title. A quiet title action ensures that the land records properly reflect the true owner of the property.
Obtaining title to land by adverse possession or by a prescriptive easement. That’s the topic of today’s post.
Obtaining title to property either by adverse possession or easement by prescription has some common requirements. The possession must be “open and notorious” which means the possession is obvious to anyone. In addition, the possession must be actual and continuous. This means that the usage of the property must be uninterrupted for the applicable statutory timeframe (generally from 5 to 20 years, depending on state law). The possession must also be adverse to the rights of the true property owner. Also, in many states, the possession must be hostile – in opposition to the claim of someone else. Also, adverse possession commonly requires that the possession be exclusive, but a prescriptive easement typically only requires that the prescriptive user use the easement in a way that differs from the general public.
There are other points to both adverse possession and easement by prescription such as whether title can be obtained adverse to the government (it generally cannot) or a railroad (again, the answer is generally negative). In addition, a negative easement cannot be created by prescription.
Prescription may also be used to end an existing legal easement. For example, if a servient tenement (estate) holder were to erect a fence blocking a legally deeded right-of-way easement, the dominant tenement holder would have to act to defend their easement rights during the statutory period or the easement might cease to have legal force, even though it would remain a deeded document. Failure to use an easement leading to loss of the easement is sometimes referred to as "non-user."
The adverse possession/prescriptive easement issue came up recently in an Idaho case. In Lemhi County v. Moulton, No. 24 2018, Ida. LEXIS 60 (Idaho Sup Ct. Mar. 13, 2018), the plaintiff, a county, sought declaratory relief to prevent flooding on the Lemhi County Backroad. The Backroad runs generally north-to-south, dividing two ranches - the Skinner Ranch (uphill property) and the Hartvigson Ranch (downhill property). The downhill property spans approximately 200 acres and is situated on the Lemhi Valley floor near the Lemhi River. Most of the downhill property is on the west side of the Backroad, but a small portion extends into a steep draw on the east side (the "Hartvigson Draw"). The water flowing through the draw runs under the Lemhi County Backroad through one of two culverts, across the downhill property, and into a draw that feeds into the Lemhi River. The uphill property is on higher ground on the east side of the Backroad. The uphill property has three drainages, one of which feeds into the Hartvigson draw.
In its declaratory judgment action, the plaintiff claimed that in November 2010, the downhill property obstructed the flow of water from the Hartvigson Draw through the culverts, which caused flooding along that area of the Backroad. The plaintiff noted in its complaint that the failure to allow the water to pass unobstructed was based at least in part on the allegation that the uphill property sent too much water down the draw, which caused damage to the downhill property.
The trial court entered a judgment that the downhill property allow drainage of natural surface water in the amount of 3.25 cubic feet per second (CFS) through the culverts and across its lands. However, that judgment left unresolved how much water, if any, the uphill property could legally send down the Hartvigson Draw. After a three-day bench trial, the court found that the channel through the basin, down the Hartvigson Draw, across the downhill property, and eventually into the Lemhi River was a natural waterway. Additionally, the trial court found that this water flow met the requirements for the uphill property to establish a prescriptive easement. The court entered a judgment permitting the uphill property to send water in the amount of 3.25 CFS down the basin drainage that flowed through the Hartvigson Draw under both an easement and natural servitude theory.
The downhill property owners timely appealed. They claimed that the trial court erred in its prescriptive easement determination on two fronts: (1) the uphill property's water use was not adverse to them; and (2) the plaintiff failed to prove the scope of the easement. They claimed that the use was not adverse because they had a wastewater right for water out of the Hartvigson draw. However, the state Supreme Court determined that the trial court’s factual findings established that the uphill landowners had been sending water down the draw for decades, before and after the established wastewater right. Thus, the Court held that the practice of the uphill landowners of sending water down the draw was under a claim of right and adverse to the downhill property owners. In addition, downhill owners claimed that no witness at trial could testify as to the exact amount of water that had regularly been sent down the Hartvigson Draw, and absent that testimony the trial court lacked clear and convincing evidence to support an easement for 3.25 CFS. However, the Court pointed to testimony by the owner of uphill property that the approximate quantity sent down the draw was between 3 and 3.5 CFS. Thus, the Court held that the trial court did not err in limiting the easement to 3.24 CFS.
The Supreme Court also determined that the trial court’s judgment was not sufficiently clear with respect to the location of the drainage. Therefore, Court remanded the case to the trial court in order to clear up the judgment with regards to the location of the drainage.
Property usage and boundary disputes are, unfortunately, too common in rural settings. Many times, the problem stems from a fundamental lack of communication. But, that’s not always the case. Sometimes, issues can arise through the fault of no one. It is those times that its good to have an experienced ag lawyer in tow.
Friday, March 16, 2018
From an economic standpoint, recent years have not been friendly to many agricultural producers. Low commodity prices for various grains and milk and increasing debt loads have made it difficult for some farmers to continue. Chapter 12 bankruptcy filings have been on the rise. In parts of the Midwest, for instance, filings have been up over 30 percent in the past couple of years compared to prior years.
There are 94 bankruptcy judicial districts in the U.S. In 2017, the Western District of Wisconsin led all of them with 28 Chapter 12 cases filed. Next was Kansas and the Middle District of Georgia with 25 each. Nebraska was next with 20 Chapter 12 filings. Minnesota had 19. Both the Eastern District of Wisconsin and the Eastern District of California had 17. In the “leader” – the Western District of Wisconsin – filings were up over 30 percent from the prior year for the second year in a row.
One of the requirements that must be satisfied for a bankruptcy court to get a Chapter 12 reorganization plan confirmed by the bank. However, it’s becoming a more difficult proposition for some of the Chapter 12 filers.
The feasibility of a Chapter 12 reorganization plan – that’s the focus of today’s post.
Chapter 12 Plan Confirmation
Unless the time limit is extended by the court, the confirmation hearing is to be concluded not later than 45 days after the plan is filed. The court is required to confirm a plan if—(1) the plan conforms to all bankruptcy provisions; (2) all required fees have been paid; (3) the plan proposal was made in good faith without violating any law; (4) unsecured creditors receive not less than the amount the unsecured creditors would receive in a Chapter 7 liquidation; (5) each secured creditor either (a) accepts the plan, (b) retains the lien securing the claim (with the value of the property to be distributed for the allowed amount of the claim, as of the effective date of the plan, to equal not less than the allowed amount of the claim), or (c) the creditor receives the property securing the claim; and (6) the debtor will be able to comply with the plan.
Also, under a provision added by The Bankruptcy Act of 2005, an individual Chapter 12 debtor must be current on post-petition domestic support obligations as a condition of plan confirmation.
Feasibility of the Reorganization Plan
If the court determines that the debtor will be unable to make all payments as required by the plan, the court may require the debtor to modify the plan, convert the case to a Chapter 7, or request the court to dismiss the case. Over the years, numerous Chapter 12 cases have involved the feasibility issue. Most recently, a Chapter 12 case from (you guessed it) the Western District of Wisconsin, involved the question of whether a debtor’s reorganization plan was feasible.
In In re Johnson, No. 17-11448-12, 2018 Bankr. LEXIS 74 (Bankr. W.D. Wisc. Jan. 12, 2018), the debtor was a farmer who primarily raised corn and soybeans. He also was the sole owner of grain farming LLC. The debtor filed a Chapter 12 petition on April 25, 2017, and a Chapter 12 plan on August 22, 2017. On September 25, 2017 a bank objected to plan confirmation. The debtor filed an amended Chapter 12 plan on November 3, 2017 and a second amended Chapter 12 plan on December 14, 2017.
The amended plan proposed payments of $8,150 per month for 12 months, then $11,700 per month for 36 months, and finally $13,700 per month for 12 months. In total the plan proposed payments of $683,400 over 60 months. The debtor claimed that this would pay the creditors in full. However, the court determined that the debtor’s plan was not feasible. At confirmation, the debtor would be required to immediately pay $67,155.70 to cure defaults on leases to be assumed and $40,000 to another creditor. Other than vague testimony that funds were available to satisfy the immediate payments to the other creditor, there was no evidence presented that supported any ability to make the lease cure payments. In addition, the evidence to which the debtor pointed supporting his ability to make payments were his tax returns for the years 2012 through 2015. However, those returns also included crop insurance payments which the debtor was no longer eligible to receive. Yet, according to the debtor’s estimates, he would do better in each of the next three years than he did at any time between 2012 and 2015. The bankruptcy court determined that, based on the picture presented by the debtor’s tax returns and testimony, the debtor’s projections were unpersuasive and lacked credibility.
The debtor also estimated that his gross income from crop sale would swell over the next three years and that his expenses would be less than any of the last four years. Yet, the debtor offered no explanation for how he arrived at these estimates. The debtor claimed that his expenses would decrease because he was no longer paying for crop insurance. However, that would only lower his expenses by approximately $30,000 and there was no reserve for crop loss in the projections, which had ranged from $39,210 to $274,933 in the past. For these reasons, the court determined that the debtor failed to meet his burden in showing that the plan was feasible.
In addition, the debtor’s plan proposed paying the bank’s various secured claims at a 5.5 percent interest rate. The court determined that under Till v. SCS Credit Corp., 541 U.S. 465 (2004), the bank was entitled to a “prime-plus” interest rate. Moreover, in the context of chapter 12 cases, the court noted that risk is often heightened due to the unpredictable nature of the agricultural economy. The court found that the interest rate proposed for the bank in the debtor’s plan was inadequate under Till. The court noted that the current national interest rate was 4.5 percent and the debtor proposed the minimum risk adjustment of 1 percent. The fact that the debtor’s tax returns show that he was consistently reporting losses or barely breaking-even in addition to the many other risk factors led the court to hold that the bank would be subject to a significant degree of risk under the plan and that the debtor’s proposed interest rate was insufficient.
Finally, the court held that because the debtor’s projections lacked any credibility or support it would be impossible for the debtor to propose a confirmable plan. As such, the court dismissed the case.
Chapter 12 bankruptcy is a difficult experience for a farm debtor to experience. But, putting a feasible reorganization plan together is essential for getting a plan confirmed. In the current economic environment, that’s becoming more difficult for many farmers.
Wednesday, March 14, 2018
Most liability events that occur on a farm or ranch are judged under a standard of negligence. However, some are deemed to be so dangerous that a showing of negligence is not required to obtain a recovery. Under a strict liability approach, the defendant is liable for injuries caused by the defendant's actions, even if the defendant was not negligent in any way or did not intend to injure the plaintiff. In general, those situations reserved for resolution under a strict liability approach involve those activities that are highly dangerous. When these activities are engaged in, the defendant must be prepared to pay for all resulting consequences, regardless of the legal fault.
What are those situations that are common to the operation of a farm or ranch, or simply being a rural landowner that can lead to the application of the strict liability rule? That’s the focus of today’s post.
Application of a Strict Liability Rule
Wild animals. In general, landowners are not strictly liable for the acts of wild animals on their property. But, some courts have held that a landowner could be found negligent with regard to the indigenous wild animals that are found on the landowner’s property if the landowner knows or has reason to know of the unreasonable risk of harm posed by the animals. See, e.g., Vendrella v. Astriab Family Limited Partnership, 87 A.3d 546, 311 Conn. 301 (2014).
If an individual keeps wild animals on his or her premises, the individual will be strictly liable for any damages that the animals cause to other persons or their property. In many jurisdictions, the owner or possessor of hard-hoofed animals, such as cattle, horses and donkeys, may also be strictly liable for injuries caused by those animals, at least if known to have a vicious propensity.
Dogs and other domestic animals. Injuries or other damages caused by dogs are handled differently. The owner or possessor of a dog is normally not liable unless the owner knows the animal to be dangerous. Historically, a dog was entitled to its first bite. The dog's owner would not be liable for injuries from the dog's bite until the dog had already bitten someone. Until the dog has bitten someone, it is not known to be dangerous. In recent years, many states have passed statutes changing the common law rule and holding a dog owner (or a person who “harbors” a dog) responsible for the injuries caused by the dog. But see, Augsburger v. Homestead Mutual Insurance Company, et al., 856 N.W.2d 874, 359 Wis. 2d 385 (2014). An exception is usually made, however, for personal injuries caused by a dog if the defendant was trespassing or was committing an unlawful act at the time of the injury. Some state statutes also make a distinction on the basis of whether the dog would attack or injure someone without provocation. Also, under Restatement (Second) of Torts § 518, the owner of a domestic animal who does not know or have reason to know that the animal is more dangerous than others of its class may still be liable for negligently failing to prevent the animal from inflicting an injury. Approximately 20 states follow the Restatement approach.
Of importance to agriculture is that some state “dog-bite” statutes contain a “working dog exception.” The exception contained in the Colorado statute, for example, applies if the bite occurs while the dog is on its owner’s property or while the dog was working under the control of its owner. See, e.g., Legro v. Robinson, 369 P.3d 785, (Colo. Ct. App. 2015).
Maintaining dangerous conditions on property. Strict liability is imposed on persons responsible for activities or conditions on their property that are unreasonably dangerous and cause injury or damage to other persons or their property. For example, if a farmer or rancher decides to create a drainage ditch with explosives, and the resulting rock debris causes damages to a neighbor, the farmer will be strictly liable.
Unnatural land uses. The strict liability approach also includes most activities that are extremely dangerous. Perhaps the most frequent application of the doctrine to agriculture is in situations involving the aerial application of pesticides and other chemicals to crops. See, e.g., Pride of San Juan, Inc. v. Pratt, 548 Ariz. Adv. Rep. 20 (2009); Yancey v. Watkins, 708 S.E.2d 539, 308 Ga. App. 695 (2011). Most states utilize a strict liability rule if damage occurs. A few states purport to require a showing of negligence, but, in reality, even in these jurisdictions it may be difficult for a farmer to escape liability if damage occurs. For example, in Arkansas, violation of aerial crop spraying regulations constitutes evidence of negligence and the negligence of crop sprayers can be imputed to landowners because aerial crop spraying is viewed as an inherently dangerous activity. McCorkle Farms, Inc. v. Thompson, 84 S.W.3d 884 (Ark. Ct. App. 2003). However, the rule remains in Arkansas that the aerial application of chemicals commonly used in farming communities that are available for sale to the general public is not an ultrahazardous activity triggering application of strict liability. See, e.g., Mangrum v. Pique, et al., 359 Ark. 373, 198 S.W.3d 496 (2006).
Also, what is abnormally dangerous can depend on the circumstances and characteristics surrounding the complained-of activity. For example, in Crosstex North Texas Pipeline, L.P. v. Gardiner, 505 S.W.3d 580 (Tex. Sup. Ct. 2016), the Texas Supreme Court held that the operation of an oil and gas pipeline does not constitute an abnormally dangerous activity that would trigger the application of strict liability.
Arguably, if a farmer plants a genetically modified (GM) crop with knowledge that the crop is likely to cross-pollinate conventional crops in adjacent fields, the farmer could be held strictly liable for any resulting damages. The situation could be viewed as similar to the problem of pesticide drift. The damages in a cross-pollination case could include, among other things, loss of organic certification, costs associated with breaches of identity preserved crop contracts, and litigation costs of neighboring farmers who are sued by seed companies for “theft” of genetic intellectual property that was actually present in their fields due to wind and cross-pollination. See, e.g., Schmeiser v. Monsanto Canada, Inc.,  S.C.C. 34; Monsanto v. Trantham, 156 F.Supp. 2d 855 (W.D. Tenn. 2001); Monsanto v. McFarling, 302 F.3d 1291 (Fed. Cir. 2002); cert. den., 545 U.S. 1139 (2005). But, if the GM crop at issue had already received appropriate regulatory approval, the plaintiff could be required to prove that the GM crop was unnatural or abnormally dangerous.
While most liability events that occur on a farm ranch are judged based on a negligence standard, strict liability can apply in certain situations. In addition to those events mentioned above, certain environmental violations carry a strict liability standard of liability also. It’s helpful to know the applicable legal standard.
Monday, March 12, 2018
Since the enactment of the Tariff Act of 1789 (signed by President Washington) along with the Collection Act also enacted on the same day, the U.S. has been engaged in protecting trade. Those two 1789 laws were not only designed to protect trade. They were also enacted with the purpose of raising revenue for the federal government. As the soon-to-be first Secretary of the Treasury, Alexander Hamilton took the position that tariffs would encourage industry in the newly-formed country and pointed out that other countries subsidized their industries and that tariffs would protect U.S. businesses from the negative impacts of those subsidies. Later on, the Tariff Act of 1816 addressed concerns about other countries “dumping” their goods in the U.S. at less than fair value to damage U.S. domestic production.
This history points out that the federal government has imposed tariffs practically from the founding of the country. Presently, massive trade deficits with various countries (particularly Mexico and China) and currency manipulation (by China) have posed a serious problem that a pragmatic President is determined to solve.
But, what are the potential implications of the Trump Administration’s recent trade measures on agriculture? Are the recently announced tariffs part of a bigger overall picture? Are they a bargaining chip in negotiating improvements to existing trade deals? These are all important questions.
For today’s post, I have asked Prof. Amy Deen Westbrook, the Kurt M. Sager Memorial Distinguished Professor of International and Commercial Law at Washburn University School of Law, for her thoughts on the matter. She graciously accepted my invitation and is today’s guest blogger. As you will see, Prof. Westbrook is another example of the fine legal instruction that is provided at Washburn Law. I will sum things up in the conclusion at the end.
Multiple Moving Parts – Trade Deals and Tariffs
Renegotiation of NAFTA. Fulfilling one of President Trump’s campaign promises, the Administration launched a renegotiation process of the North American Free Trade Agreement (NAFTA) last August. The United States is seeking a more favorable deal, and has threatened to withdraw from NAFTA if it cannot come to a satisfactory arrangement with Mexico and Canada.
U.S. NAFTA negotiating priorities center on increased minimum regional content requirement for autos to qualify for NAFTA treatment, access to U.S. government procurement opportunities, revised dispute resolution options, an automatic five-year sunset provision for NAFTA, and more advantageous agriculture provisions. In particular, the United States has requested that Canada dismantle its system of tariffs and quotas in the dairy sector. The United States is also seeking authorization for stronger protections for seasonal U.S. produce against Mexican imports.
U.S. agricultural demands reflect the current NAFTA agricultural trade deficit. Although the deficit largely results from the weaker Mexican and Canadian currencies, it also reflects the increasing volume of imports of fruits and vegetables into the United States, particularly counter-seasonal imports of products like tomatoes, peppers and asparagus from Mexico.
Note: Negotiators from all three NAFTA parties wrapped up their seventh round of talks in early March of 2018 in Mexico City, and anticipate an eighth round in Washington, D.C. beginning in April. However, it is unclear when, or even if, a revised agreement will be ironed out.
Use of trade remedies against U.S. trading partners. The Trump Administration has various remedies at its disposal with respect to trade disputes. Recently, for example, the Trump Administration has imposed several different measures on foreign imports. U.S. law, the World Trade Organization (WTO) agreement, and other international obligations provide the United States with an array of remedies to protect U.S. producers from trade practices by other countries. As noted below, the Administration has utilized each of these remedies to-date.
Dumping, subsidies, and other unfair trade practices. In response to a petition by or on behalf of a U.S. industry, U.S. trade regulators can levy anti-dumping duties on foreign goods sold in the United States at unfairly low prices if the sale of those goods materially injures, or threatens to injure, or even retards the establishment of, the domestic industry. Similarly, "countervailing duties" may be levied on foreign goods sold in the United States at unfairly low prices as a result of an impermissible subsidy by the exporting nation. The United States currently has 164 antidumping and countervailing duty orders in effect for steel alone, with another 20 in the pipeline.
Section 301. Section 301 of the Trade Act of 1974 empowers the U.S. Trade Representative (USTR) to impose duties or suspend concessions against a foreign country that takes actions that are unjustifiable, unreasonable or discriminatory and burden or restrict U.S. commerce. In 2017, the United States launched a Section 301 investigation into Chinese practices relating to forced technology transfer, unfair licensing and other intellectual property policies.
Section 201. In addition to remedies for unfair trade practices, the United States can also impose protections for domestic industries against fair trade practices by our trade partners. On January 22, 2018, President Trump approved the imposition of safeguards under Section 201 of the Trade Act of 1974 against foreign solar panels and washing machines. Section 201 relief, which was last granted by the United States 16 years ago, provides temporary protection to a U.S. industry that is being injured by a surge of foreign imports. The measures are intended to last for a couple of years, and in fact the U.S. plan for solar panels is to start tariffs at 30% and let them gradually fall to 15% over four years.
Section 232. Perhaps more significant, at least to the financial markets, than the anti-dumping, anti-subsidy, Section 301 or Section 201 actions, however, was the announcement in early March of 2018 that the U.S. would take measures under Section 232 of the Trade Expansion Act of 1962. An almost-never-used provision, Section 232 enables the President to restrict foreign trade in the interests of national security. In April of 2017, President Trump requested the Secretary of Commerce to review the impact of imported steel and aluminum under Section 232. The Department of Commerce produced its reports in January of 2018, and made them public in February. Unlike the last time the Administration considered Section 232 measures with respect to steel (in 2001), this time the Department of Commerce recommended tariffs be imposed on foreign imports in order to safeguard national security. Upon receipt of the report, the President had 90 days to decide whether to impose measures. On March 8, the President imposed “flexible,” global tariffs (25 percent on steel and 10 percent on aluminum). It is important to note that the President announced the tariffs in the middle of the NAFTA negotiations.
Note: The Section 232 measures have resulted in substantial diplomacy and lobbying by U.S. industries that will be directly affected by the Section 232 measures - such as the auto industry. U.S. industries indirectly affected by the measures, such as agriculture, have also voiced concern, as have U.S. foreign trading partners.
The Section 232 tariffs are seen largely as a measure against China. The United States is the world’s top steel importer. China is the world’s largest producer of both steel and aluminum. Although China accounts for just a fraction of U.S. steel imports, the United States believes that China has flooded the global market for steel and is dragging down prices as a result. In addition, Canada (the largest U.S. source of foreign steel and aluminum) and Mexico (the fourth largest U.S. source of foreign steel and 11th largest aluminum source) are currently exempted from the tariffs, contingent upon successful completion of the NAFTA negotiations. President Trump has also indicated that Australia may be exempted (by virtue of a pending security agreement) and the USTR met in early March of 2018 with representatives of the European Union and Japan about the possibility of exclusion from the tariffs.
Normally, Section 232 tariffs take effect 15 days after the President’s official announcement. That means that right now, and over the next few days, negotiations could occur with a number of U.S. trading partners as they argue for exemptions. The negotiations may be made more dramatic by the fact that the Administration has pledged to block a certain volume of foreign steel from the market, meaning that each time a country is exempted from the tariffs, tariffs presumably must rise on the remaining/non-exempted countries.
Foreign Reactions To The Tariffs – Including Agricultural Impacts
U.S. Secretary of Agriculture Sonny Perdue has expressed concern that U.S. trading partners impacted by the U.S. trade measures, particularly the steel tariffs, will retaliate against U.S. agricultural exports. As expected, foreign reactions to the U.S. measures have not been positive. The European Union (EU) announced a list of $3.5 billion of U.S. products against which it will impose 25% retaliatory tariffs if the U.S. imposes the steel and aluminum measures on the EU. The EU list targeted Harley Davidson motorcycles, jeans, and bourbon, as well as orange juice, corn, cranberries, peanut butter and a variety of other agricultural products. The EU’s announcement echoes its reaction to U.S. Section 201 safeguard measures for steel in 2002, which the EU ultimately successfully challenged at the WTO, resulting in the U.S. removal of the measures before the EU retaliated.
China has also reacted negatively to the Administration's announcement of new U.S. measures. On February 4, 2018 (two weeks after the Section 201 measures on solar panels and washing machines were announced). China announced that it would launch anti-dumping and anti-subsidy investigations of U.S. sorghum exports. U.S. grain sorghum exports to China have increased since 2013, and China currently accounts for approximately 80 percent of U.S. grain sorghum exports.
In addition, on February 7, 2018, Chinese agricultural producers met to study the possibility of launching anti-dumping or anti-subsidy investigations into U.S. exports of soybeans. U.S. soybean exports are particularly vulnerable to Chinese measures. The 30 million tons of soybeans China purchases from the United States represent a third of U.S. production, and make China the largest market for U.S. soybeans. With Brazilian (and, to a lesser extent, Argentinian) beans in plentiful, and relatively cheap, supply, there is concern that China could curb U.S. imports and replace them with South American soybeans (at least for 6-7 months). Other concerns center on U.S. beef exports to China, which restarted only last year after a ban imposed in 2003 because of concerns over bovine spongiform encephalopathy.
The WTO and Other Legal Actions
China, the EU, Japan and South Korea sought consultations with the United States at the WTO following the U.S. imposition of the Section 201 measures against solar panels and washing machines. Canada also sought an injunction against the imposition of the Section 201 safeguards, but its request was rejected by the U.S. Court of International Trade on March 6, 2018.
However, it is unclear whether U.S. trading partners will challenge the Section 232 national security safeguards at the WTO. The EU is reported to be considering a WTO challenge, pending the outcome of its request for an exemption from the Section 232 tariffs. The WTO agreement includes an exception from members’ trade obligations for actions necessary for the protection of a member’s essential security interests. However, key terms such as “necessary” and “essential security interests” are undefined. Countries are reluctant to use and even more reluctant to second-guess their trading partners’ use of the exception for essential security interests. Sovereign countries generally do not want to infringe on the national-security-based policy decisions of other sovereign countries. In addition, there has been a tacit recognition that if the exception is indiscriminately invoked, it has the potential to undermine the entire WTO system. If anything can be an essential security interest, then any country can use the exception at anytime.
Currency manipulation, trade deficits, unfair trade practices, theft and misuse of intellectual property rights, and related issues are not problems that are unique to a particular political party or political ideology. They are American problems that threaten the financial stability of the U.S. and the production of U.S. products and commodities. The open borders trade agenda for at least the past 25 years has negatively impacted U.S. families. For example, just from 2000-2010 (post-NAFTA) the U.S. lost 55,000 factories and 6,000,000 manufacturing jobs across numerous sectors, U.S. wages stagnated, and the associated ingenuity was lost. These are problems that President Trump has identified that need to be fixed in a pragmatic way. These are also problems that hit at the core of the United States as a country – as President Washington identified over 200 years ago.
Should the agricultural industry be concerned? Of course. However, there is a significant chance that the potential for tariffs and other sanctions on other countries is part of an overall attempt to renegotiate existing trade deals for the benefit of America, including agriculture.
Thursday, March 8, 2018
The rules as to what is a “repair” and, therefore, is deductible, and what must be capitalized and depreciated have never provided a bright line for determining how an expense should be handled. The basic issue is finding the line between I.R.C. §162(a) and I.R.C. §263(a). I.R.C. §162(a) allows a deduction for ordinary and necessary expenses paid or incurred during the tax year in carrying on a trade or business, including amounts paid for incidental repairs. Conversely, I.R.C. §263(a) denies a current deduction for any amount paid for new property or for permanent improvements or betterments that increase the value of any property, or amounts spent to restore property.
The line between a currently deductible repair and an expense that must be capitalized is one that farmers and ranchers often deal with. A recent court decision involving a Colorado grape-growing operation illustrates the difficulty in determining the correct tax classification of expenses.
In general, any expense of a farmer associated with the business with a useful life of less than one year is deductible against gross income. Depreciation is required if an asset has a useful life of more than one year. Expenses are current costs, and any cost that produces a benefit lasting for more than one year (such as expenses for improvements that increase the property’s value) is generally not currently deductible. Instead, those items must be depreciated or amortized over the period of benefit or use. Indeed, Treas. Reg. §§1.263(a)-1, (b)-2, 1.461-1(a)(2), an expense must be capitalized if the item has a benefit to the taxpayer extending substantially over one year or adapts the property to a new or different use.
A big issue for farmers and ranchers is whether major engine or transmission overhauls are currently deductible as repairs. Fortunately, there are cases that provide useful authority for the position that major engine or transmission overhauls should be currently deductible as repairs. See, e.g., Ingram Industries, Inc. & Subs. v. Comm’r, T.C. Memo. 2000-323; FedEx Corp. & Subs. v. United States, 121 Fed. Appx. 125 (6th Cir. 2005), aff’g, 291 F. Supp. 2d 699 (W.D. Tenn. 2003). Under these court opinions, engines and transmissions are generally treated as part of the larger machine. This means that the economic life of the engine or transmission is to be treated as co-extensive with the economic life of the larger machine (e.g., a tractor or combine). Because the larger machine cannot function without an engine or transmission, overhaul of the engine or transmission while affixed to the machine can give rise to a current deduction.
In Wells v. Comr., T.C. Memo. 2018-11, the petitioner owned and lived on a 265-acre farm. She had lived there off-and-on since 1965, but continuously from 1983 forward. Before the petitioner came into ownership of the property, her father owned it. She cultivated about 700 white French hybrid rind grapevines on a part of the property. In the good years, the vines produced up to four tons of grapes, but in the lean years production could be as low as one-half ton. The petitioner normally sold the grapes, but when production declined, she began crushing the grapes and selling the juice to local buyers. She grazed animals on other parts of the farm. Her gross farm income for 2010 and 2011 was $305 and $255 in 2010 and 2011 respectively, and her total farming expenses were $208,265 in 2010 and $54,734 in 2011. Many of those claimed deductible expenses were associated with her grape growing activity. Upon audit, the IRS denied a large portion of the petitioner’s claimed expenses, asserting that the they were improvements that should be capitalized.
Underground water line. In 1965, the petitioner’s father installed an underground pipe to convey water from a spring on one part of the farm to supply water to a pasture where animals were grazed as well as to irrigate the grapes. Over time, portions of the two-inch pipe were replaced with new two-inch pipe that was of higher quality and could withstand higher water pressure. The pipeline was completely replaced in 2009 with new pipe, but then started leaking and a section of it was replaced later in 2009. More leaks occurred in 2010 and additional sections of the pipe were replaced and joints repaired. The court determined that the entire water line was replaced at least one time during 2009 and 2010.
The petitioner claimed that neither the pipeline’s useful life was extended nor the value increased. Instead, the petitioner asserted that the pipeline replacement cost was deductible because floods destroyed parts of the pipeline in 2009 and 2010 and she had no other option but to replace the pipeline, and that doing so was simply an accumulation of repairs into 2009 and 2010. She claimed to not have the funds in prior years to make repairs in those earlier years.
The IRS maintained that the pipeline “repair” expense was properly capitalized as an improvement, and the court agreed. The court determined that the pipeline work was part of a “general plan of rehabilitation, modernization, and improvement” to completely repair the pipeline. The court noted that the pipeline was completely replaced, its life was extended and its value was increased (because of the use of higher quality pipe). It was immaterial, the court held, that flooding might have destroyed part of the pipeline leaving replacement as the petitioner’s only option. The court noted that an analogous situation was present in Hunter v. Comr., 46 T.C. 477 (1966), where the cost of a replacement dam had to be capitalized when the old dam had been washed out by flooding.
The court also held that costs associated with work on “road maintenance” and around a barn were also not currently deductible expenses. However, the IRS conceded that $9,000 allocated to repair a culvert, cut trees and spread manure were currently deductible.
Storage yard. The petitioner also deducted over $16,000 for the construction of a storage yard, including funds for fencing work related to the storage yard. The storage yard did not previously exist. The IRS claimed that the amounts expended to create the storage yard was a capital improvement which had to be capitalized. The court agreed. It was new construction on top of previously unimproved land and, as such, was an improvement. The associated costs were not currently deductible.
Burn area. In 2010, a wildfire burned about 26 acres of the petitioner’s property that the petitioner had used, at least in part, for grazing animals. After the fire, it was determined that the fire had made the burned area unable to absorb water. As a result, the petitioner, paid to have burned tree stumps removed along with boulders. The soil of the burned area was cultivated so that the tract could be used for forage. The cost of this work was slightly less than $50,000, which the petitioner deducted on her 2011 return. The IRS denied the deduction claiming instead that the amount was an expense that had to be capitalized as a “plan of rehabilitation.”
The court agreed with the IRS. The evidence, the court determined, showed that the petitioner had a plan to rehabilitate the burn area, and believed that the expenses would improve the land and its value. In addition, the court noted that the work on the burn area was extensive and that a large portion of the burn area, before the fire, had no relation to the petitioner’s business. After the fire, the court noted that the petitioner testified that the entire area would be used as forage. Thus, the burn area was adapted for a new use which meant that the expenses associated with it had to be capitalized.
The case points out how expenses that a taxpayer thinks might be currently deductible may actually be expenses that must be capitalized. The Wells case is a good illustration of how these issues can play out with respect to an agricultural set of facts.
Tuesday, March 6, 2018
Under the Clean Water Act (CWA), a National Pollution Discharge Elimination System (NPDES) permit is required to discharge a “pollutant” from a point source into the “navigable waters of the United States” (WOTUS). Clearly, a discharge directly into a WOTUS is covered. But, is an NPDES permit necessary if the discharge is directly into groundwater which then finds its way to a WOTUS? Are indirect discharges from groundwater into a WOTUS covered? If so, does that mean that farmland drainage tile is subject to the CWA and an NPDES discharge permit is required? The federal government has never formally taken that position, but if that’s the case it’s a huge issue for Midwest and other areas of agriculture.
Recently, a federal court determined that some discharges into groundwater require an NPDES permit. But, other courts have ruled differently. Now the Environmental Protection Agency (EPA) has opened a comment period on whether pollutant discharges from point sources that reach jurisdictional surface waters via groundwater should be subject to CWA regulation.
Possible NPDES discharge permits for groundwater discharges – that’s the focus of today’s post.
CWA Discharge Permit Basics
The CWA recognizes two sources of pollution. Point source pollution is pollution which comes from a clearly discernable discharge point, such as a pipe, a ditch, or a concentrated animal feeding operation. Under the CWA, point source pollution is the concern of the federal government. Nonpoint source pollution, while not specifically defined under the CWA, is pollution that comes from a diffused point of discharge, such as fertilizer runoff from an open field. Control of nonpoint source pollution is to be handled by the states through enforcement of state water quality standards and area-wide waste management plans.
Under 1977 amendments, tile drainage systems were exempted from CWA regulation via irrigation return flows. See, e.g., Pacific Coast Federation of Fishermen’s Associations, et al. v. Glaser, et al., No. CIV S-2:11-2980-KJM-CKD, 2013 U.S. Dist. LEXIS 132240 (E.D. Cal. Sept. 16, 2013). They aren’t considered to be point sources. In addition, several courts have held that the NPDES system only applies to discharges of pollutants into surface water. These courts have held that discharges of pollutants into groundwater are not subject to the NPDES permit requirement even if the groundwater is hydrologically connected to surface water. See, e.g., Umatilla Water Quality Protective Association v. Smith Frozen Foods, 962 F. Supp. 1312 (D. Ore. 1997); United States v. ConAgra, Inc., No. CV 96-0134-S-LMB, 1997 U.S. Dist. LEXIS 21401 (D. Idaho Dec. 31, 1997). Likewise, in another case, the court determined that neither the CWA nor the EPA covered groundwater solely on the basis of a hydrological connection with surface water. Village of Oconomowoc Lake v. Dayton Hudson Corporation, 24 F.3d 962 (7th Cir. 1994), cert. denied, 513 U.S. 930 (1994). See also Rice v. Harken Exploration Co., 250 F.3d 264 (5th Cir. 2001); Cape Fear River Watch v. Duke Energy Progress, Inc., 25 F. Supp. 3d 798 (E.D. N.C. 2014).
But, other courts have taken a different view, finding that the CWA covers pollution discharges irrespective of whether the discharge is directly into a WOTUS or indirectly via groundwater with some sort of hydrological connection to a WOTUS. See, e.g., Idaho Rural Council v. Bosma, 143 F. Supp. 2d 1169 (D. Idaho 2001); Northern California River Watch v. Mercer Fraser Co., No. 04-4620 SC, 2005 U.S. Dist. LEXIS 42997 (N.D. Cal. Sept. 1, 2005); United States v. Banks, 115 F.3d 916 (11th Cir. 1997), cert. denied, 522 U.S. 1075 (1998); Mutual Life Insurance Co. of New York v. Mobil Corp., No. 96-CV-1781 (RSP/DNH), 1998 U.S. Dist. LEXIS 4513 (N.D. N.Y. Mar. 31, 1998).
The issue came up again in a recent case. In Hawai’i Wildlife Fund v. County of Maui, 881 F.3d 754 (9th Cir. 2018), the defendant owned and operated four wells at the Lahaina Wastewater Reclamation Facility (LWRF), which is the principal municipal wastewater treatment plant for a city. Although constructed initially to serve as a backup disposal method for water reclamation, the wells ultimately became the defendant’s primary means of effluent disposal into groundwater and, ultimately, the Pacific Ocean. The LWRF received approximately four million gallons of sewage per day from a collection system serving approximately 40,000 people. That sewage was treated at LWRF and then either sold to customers for irrigation purposes or injected into the wells for disposal.
The defendant injected approximately 3 to 5 million gallons of treated wastewater per day into the groundwater via its wells. The defendant conceded, and its expert, confirmed that wastewater injected into wells 1 and 2 enters the Pacific Ocean. In addition, in June 2013 the EPA, the Hawaii Department of Health, the U.S. Army Engineer Research and Development Center, and researchers from the University of Hawaii conducted a study on wells 2, 3 and 4. The study involved placing tracer dye into Wells 2, 3, and 4, and monitoring the submarine seeps off Kahekili Beach to see if and when the dye would appear in the Pacific Ocean. This study, known as the Tracer Dye Study, found that 64 percent of the treated wastewater from wells 3 and 4 discharged into the ocean. The plaintiff sued, claiming that the defendant was in violation of the Clean Water Act (CWA) by discharging pollutants into navigable waters of the United States without a CWA National Pollution Discharge Elimination System (NPDES) permit. The trial court agreed, holding that an NPDES permit was required for effluent discharges into navigable waters via groundwater.
On appeal, the appellate court held that the wells were point sources that could be regulated through CWA permits despite the defendant’s claim that an NPDES permit was not required because the wells discharged only indirectly into the Pacific Ocean via groundwater. Specifically, the appellate court held that “a point source discharge to groundwater of “more than [a] de minimis” amount of pollutants that is “fairly traceable from the point source . . . such that the discharge is the functional equivalent of a discharge into a navigable water” is regulated under the CWA.” The appellate court reached this conclusion by citing cases from other jurisdictions that determined that an indirect discharge from a point source into a navigable water requires an NPDES discharge permit. The defendant also claimed its effluent injections are not discharges into navigable waters, but rather were disposals of pollutants into wells, and that the CWA categorically excludes well disposals from the permitting requirements. However, the court held that the CWA does not categorically exempt all well disposals from the NPDES requirements because doing so would undermine the integrity of the CWA’s provisions. Lastly, the plaintiff claimed that it did not have fair notice because the state agency tasked with administering the NPDES permit program maintained that an NPDES permit was unnecessary for the wells. However, the court held that the agency was actually still in the process of determining if an NPDES permit was applicable. Thus, the court found the lack of solidification of the agency’s position on the issue did not affirmatively demonstrate that it believed the permit was unnecessary as the defendant claimed. Furthermore, the court held that a reasonable person would have understood the CWA as prohibiting the discharges, thus the defendant’s due process rights were not violated.
Pending Court Cases and EPA Action
The Ninth Circuit’s decision further illustrates the different conclusions that the courts have reached on the matter. In addition, at the present time, the U.S. Circuit Court of Appeals for both the Second and Fourth circuits have cases before them on the issue of whether the CWA applies to indirect discharges of pollutants into a WOTUS from subsurface discharges. This all could lead to an eventual case before the U.S. Supreme Court on the matter.
On February 20, 2018, the EPA issued a Request for Comment on whether pollutant discharges from point sources that reach jurisdictional surface waters via groundwater may be subject to Clean Water Act (“CWA”) regulation. Specifically, EPA seeks comment on whether EPA should consider clarification or revision of previous EPA statements regarding the Agency’s mandate to regulate discharges to surface waters via groundwater under the CWA. As noted above, the EPA has never stated that CWA permits are required for pollutant discharges to groundwater in all cases. Rather, EPA’s position has been that pollutants discharged from point sources that reach jurisdictional surface waters via groundwater or other subsurface flow that has a direct hydrologic connection to the jurisdictional water may be subject to CWA permitting requirements.
As part of its request, EPA seeks comment by May 21, 2018, on whether it should review and potentially revise its previous positions. In particular, the EPA is seeking comment on whether it is consistent with the CWA to require a CWA permit for indirect discharges into jurisdictional surface waters via groundwater. The EPA also seeks comment on whether some or all of such discharges are addressed adequately through other federal authorities, existing state statutory or regulatory programs or through other existing federal regulations and permit programs. Comments can be submitted by identifying them as Docket ID No. EPA-HQ-QW-2018-0063 at http://www.regulations.gov. Follow the online instructions for submitting comments.
Whether an NPDES discharge permit is required for pollution discharges that only indirectly find their way to a WOTUS via groundwater is an important issue for agriculture. It’s a particularly big issue in the Midwest where many farm fields are drained to make crop production possible. The purpose of drain tile is to control groundwater levels by relocating groundwater to surface water. Nitrates in excess of drinking water standards are prevalent in many parts of the Midwest.
Interested farmers, ranchers and rural landowners should give serious consideration to submitting comments on or before May 21.
Friday, March 2, 2018
A significant concern for landlords is the extent of possible liability for injuries that occur on the leased premises. After all, the landlord is the owner of the leased property. Does liability follow legal ownership? If it does, that has serious implications for farm landlords, particularly because farming tends to be a hazardous occupation. Machinery, livestock, chemical application and similar farming activities and features such as farm ponds have the potential for injury.
Landlord liability for injuries occurring on leased premises, that’s the topic of today’s post.
Non-liability. In general, a landlord is not liable for injuries to third parties that occur on premises that are occupied by a tenant. For example, in Leopold v. Boone, No. 06A04-0904-CV-205, 2009 Ind. App. Unpub. LEXIS 1291 (Ind. Ct. App. Sept. 4, 2009), the plaintiff suffered a severe brain injury from a bicycle crash caused by dogs owned by the defendant’s tenant that ran from the leased property onto a public highway where the plaintiff was bicycling. The trial court judgment for the defendant was affirmed because the defendant did not owe a duty to the plaintiff. Importantly, the plaintiff failed to raise a nuisance claim at trial and was thereby precluded from raising the issue on appeal.
Exceptions. The reason for the rule of landlord non-liability is that the tenant has the possession over the leasehold premises during the tenancy and has control over what occurs on the leased property. However, there are at least six well recognized exceptions to this general rule. For example, if the landlord conceals dangerous conditions or defects that cause the third party's injury, then the landlord will be liable. Likewise, if conditions are maintained on the premises that are dangerous to persons outside of the premises, the landlord is liable for any resulting injury. A landlord will also be liable if the premises is leased for admission of the public or if the landlord retains control over part of the leased premises that the tenant is entitled to use. In addition, if the landlord makes an express covenant to repair the leased premises, but fails to do so resulting in injury, the landlord is liable. Similarly, a landlord is liable for injuries resulting from the landlord's negligence in making repairs to items located on the leased premises.
Another exception to the general rule of landlord non-liability for a tenant’s acts is if the landlord knows that the tenant is harming the property rights of adjacent landowners and does nothing to modify the tenant’s conduct or terminate the lease. In that situation, the landlord can be held liable along with the tenant. See, e.g., Tetzlaff v. Camp, et al., 715 N.W.2d 256 (Iowa 2006).
Other principles. In general, a licensee or invitee of the tenant has no greater claim against the landlord than has the tenant. Thus, a landlord's duty to not wantonly or willfully injure a trespasser is usually passed to the tenant who has control of the property. However, a landlord can be held liable where the landlord knew of defects that were likely to injure known trespassers.
A landlord is also usually not held responsible for injuries occurring on the leased premises caused by animals that belong to the tenant. With respect to dogs, it must generally be proven that the landlord had actual knowledge of the animal’s dangerous propensities. See, e.g., Seeley v. Derr, et al., No. 4:12-CV-917, 2013 U.S. Dist. LEXIS 99506 (M.D. Pa. Jul. 17, 2013); Bryant v. Putnam, 908 S.W.2d 338 (Ark. 1995).
A recent Kentucky case illustrates some of the legal principles involved when an injury occurs on leased premises. In Groves v. Woods, No. 2016-CA-001546-MR 2018 Ky. App. LEXIS 59 (Ky. Ct. App. Jan. 26, 2018), the plaintiff and her husband entered into a verbal lease with the defendant for a lease of the defendant’s property. The plaintiff claimed that the lease covered the entire property, but the defendant asserted that the lease only was for the house and abutting yard. Adjacent to the home, the defendant had a pasture and a barn where the defendant boarded a Tennessee Walking Horse. The horse spent time both in the pasture and in the barn. The defendant claimed that he informed the plaintiffs not to go near the horses and to keep their children out of the barn.
Nine days after moving in, the plaintiff and her children went for a walk to see an old graveyard. They cut through the pasture to get to the site. It was disputed whether the plaintiff and the children crossed a fence into the pasture where the horses spend time. The defendant claimed that they crossed onto the pasture, but the plaintiff claimed that they never crossed onto the pasture or traversed the fence. The plaintiff maintained that the horse was running loose, chased her, and stomped her thigh after she fell. The plaintiff filed a complaint against the defendant and the defendant counterclaimed that the plaintiff was contributorily negligent. The defendant moved for summary judgment, which the trial court granted and also denied the plaintiff’s motion to alter, amend, or vacate the summary judgment.
The plaintiff appealed. The court held that the number of lengthy depositions in the case provided no certain evidence to indicate whether the plaintiffs rented the house and the yard or the entire property. With this uncertainty and the fact that the lease was verbal the court decided to accept the assertion that the family rented the entire property. The court held that because the plaintiff testified of knowing about the horse, the defendant could not be liable for failure to warn the plaintiffs about a known latent defect. Thus, the trial court’s grant of the motion for summary judgment was appropriate. In addition, the court held that because the horse’s owner did not know or have reason to know that the horse was abnormally dangerous, the defendant would be liable for the horse’s actions only if the defendant intentionally caused the horse to do harm or was negligent in failing to prevent harm. The court held that the plaintiff did not provide proof that the horse’s owner was negligent under this standard. Thus, the district court’s decision granting summary judgment was affirmed.
While a landlord will generally not be liable for injuries that occur on leased premises, there are situations where liability could result. Understanding what those situations are, taking steps to avoid their application and making sure appropriate insurance coverage is in place will go along way to avoiding an unhappy result for a landlord.
Wednesday, February 28, 2018
Monday’s post on whether the new tax law indicates that a C corporation should be the entity form of choice generated a lot of interest. Some of the questions that came in surrounded what the tax consequences are when a C corporation is formed. That’s a good question. The tax Code does have special rules that apply when forming a C corporation. If those rules are followed, forming a C corporation can be accomplished without tax consequences.
The tax rules surrounding C corporation formation, that’s the topic of today’s post.
Tax-Free Incorporation Rules
Incorporation of an existing business, such as a sole-proprietorship farming or ranching operation, can be accomplished tax-free. A tax-free incorporation is usually desirable. That’s particularly the case for farming and ranching businesses because farm and ranch property typically has a fair market value substantially in excess of basis. That’s usually the result of substantial amounts of depreciation having been taken on farm assets.
For property conveyed to the corporation, neither gain nor loss is recognized on the exchange if three conditions are met. I.R.C. § 351. First, the transfer must be solely in exchange for corporate stock. Second, the transferor (or transferors as a group) must be “in control” of the corporation immediately after the exchange. This requires that the transferors of property end up with at least 80 percent of the combined voting power of all classes of voting stock and at least 80 percent of the total number of shares of all classes of stock. Third, the transfer must be for a “business purpose.”
Be careful of stock transfers. Because of the 80 percent control test, if it is desirable to have a tax-free incorporation, there can be no substantial stock gifting occurring simultaneously with, or near the time of, incorporation. For example, parents who transfer all of their property to a corporation can destroy tax-free exchange status by gifting more than 20 percent of the corporate stock to children and other family members simultaneously with incorporation or shortly thereafter.
How long is the waiting period before gifts of stock can be made? There is no bright line rule. Certainly, a month is better than a week, and six weeks are better than a month. In addition, care should also be given to avoid shareholder agreements that require stock to be sold upon transfer of property to a corporation. See, e.g., Ltr. Rul. 9405007 (Oct. 19, 1993).
Income Tax Basis Upon Incorporation
The income tax basis of stock received by the transferors is the basis of the property transferred to the corporation, less boot received, plus gain recognized, if any. If the corporation takes over a liability of the transferor, such as a mortgage, the amount of the liability reduces the basis of the stock or securities received. Debt securities are automatically treated as boot on the transfer unless they are issued in a separate transaction for cash. The corporation's income tax basis for property received in the exchange is the transferor's basis plus the amount of gain, if any, recognized to the transferor.
When Is Incorporation A Taxable Event?
If the sum of the liabilities assumed or taken subject to by the corporation exceeds the aggregate basis of assets transferred, a taxable gain is incurred as to the excess. I.R.C. § 357(c). Bonus depreciation and I.R.C. §179 may have been taken on equipment resulting in little-to-no remaining tax basis. This, combined with an operating line, prepaid expenses and deferred income result in taxable income recognition upon the incorporation of a farm. Thus, for those individuals who have refinanced and have increased their debt level to a level that exceeds the income tax basis of the property, a later disposition of the property by installment sale or transfer to a partnership or corporation, will trigger taxable gain as to the excess.
Technique to avoid tax? The liability in excess of basis problem has led to creative planning techniques in an attempt to avoid the taxable gain incurred upon incorporation. One of those strategies involves the transferor giving the corporation a personal promissory note for the difference and claiming a basis in the note equivalent to the note's face value. The IRS has ruled that this technique will not work because the note has a zero basis. Rev. Rul. 68-629, 1968-2 C.B. 154.
While one court, in 1989, held that a shareholder's personal note, while having a zero basis in the shareholder's hands, had a basis equivalent to its face amount in the corporation's hands (Lessinger v. United States, 872 F.2d 519 (2d Cir. 1989), rev'g, 85 T.C. 824 (1985)), that is not a view held by the other courts that have addressed the issue. For example, in Peracchi v. Comm'r, 143 F.3d 487 (9th Cir. 1998), rev'g, T.C. Memo. 1996-191, the taxpayer contributed two parcels of real estate to the taxpayer's closely-held corporation. The transferred properties were encumbered with liabilities that together exceeded the taxpayer's total basis of the properties by more than $500,000. In order to avoid immediate gain recognition as to the amount of excess liabilities over basis, the taxpayer also executed a promissory note, promising to pay the corporation $1,060,000 over a term of ten years at eleven percent interest. The taxpayer remained personally liable on the encumbrances even though the corporation took the properties subject to the debt. The taxpayer did not make any payments on the note until after being audited, which was approximately three years after the note was executed. The IRS argued that the note was not genuine indebtedness and should be treated as an enforceable gift. In the alternative, the IRS argued that even if the note were genuine, its basis was zero because the taxpayer incurred no cost in issuing the note to the corporation. As such, the IRS argued, the note did not increase the taxpayer's basis in the contributed property.
The Peracchi court held that the taxpayer had a basis of $1,060,000 (face value) in the note. As such, the aggregate liabilities of the property contributed to the corporation did not exceed aggregate basis, and no gain was triggered. The court reasoned that the IRS's position ignored the possibility that the corporation could go bankrupt, an event that would suddenly make the note highly significant. The court also noted that the taxpayer and the corporation were separated by the corporate form, which was significant in the matter of C corporate organization and reorganization. Contributing the note placed a million dollar “nut” within the corporate “shell,” according to the court, thereby exposing the taxpayer to the “nutcracker” of corporate creditors in the event the corporation went bankrupt. Without the note, the court reasoned, no matter how deeply the corporation went into debt, creditors could not reach the taxpayer's personal assets. With the note on the books, however, creditors could reach into the taxpayer's pocket by enforcing the note as an unliquidated asset of the corporation. The court noted that, by increasing the taxpayer's personal exposure, the contribution of a valid, unconditional promissory note had substantial economic effect reflecting true economic investment in the enterprise. The court also noted that, under the IRS's theory, if the corporation sold the note to a third party for its fair market value, the corporation would have a carryover basis of zero and would have to recognize $1,060,000 in phantom gain on the exchange even if the note did not appreciate in value at all. The court reasoned that this simply could not be the correct result. In addition, the court noted that the taxpayer was creditworthy and likely to have funds to pay the note. The note bore a market rate of interest related to the taxpayer's credit worthiness and had a fixed term. In addition, nothing suggested that the corporation could not borrow against the note to raise cash. The court also pointed out that the note was fully transferable and enforceable by third parties.
The court did acknowledge that its assumptions would fall apart if the shareholder was not creditworthy, but the IRS stipulated that the shareholder's net worth far exceeded the value of the note. That seems to be a key point that the court overlooked. If the taxpayer was creditworthy, then a legitimate question exists concerning why the taxpayer failed to make payments on the note before being audited. Clearly, the taxpayer never had any intention of paying off the note. Thus, a good argument could have seemingly been made that the note did not represent genuine indebtedness. The court also appears to have overlooked the different basis rules under I.R.C. § 1012 and I.R.C. § 351. An exchanged basis is obtained in accordance with an I.R.C. § 351 transaction which precludes application of the basis rules of I.R.C. § 1012.
Note: After Lessinger and Peracchi were decided, I.R.C. §357 was amended to include subsection (d). That subsection specifies that a recourse liability is to be treated as having been assumed if the facts and circumstances indicate that the transferee has agreed to, and is expected to, satisfy the liability (or a portion thereof) regardless of whether the transferor has been relieved of the liability. Non-recourse liabilities are to be treated as having been assumed by the transferee of any asset subject to the liability.
What about other entities? The Peracchi court was careful to state that the court's rationale was limited to C corporations. Thus, the opinion will not apply in the S corporation setting for shareholders attempting to create basis to permit loss passthrough. However, Rev. Rul. 80-235, 1980-2 C.B. 229, specifies that a partner in a partnership cannot create basis in a partnership interest by contributing a note. This all means that the IRS is likely to continue challenging “basis creation” cases on the ground that the contribution of a note is not a bona fide transfer.
Different strategy? A similar technique designed to avoid gain recognition upon incorporation of a farming or ranching operation (where liabilities exceed basis) is for the transferors to remain personally liable on the debt assumed by the corporation, with no loan proceeds disbursed directly to the transferors. However, gain recognition is not avoided unless the corporation does not assume the indebtedness. Seggerman Farms, Inc. v. Comm’r, 308 F.3d 803 (7th Cir. 2002), aff’g, T.C. Memo. 2001-99.
As the above discussion indicates, a good rule of thumb is that property should never be transferred to a new entity without first determining whether there is enough basis to absorb the debt. If it is discovered that the debt exceeds the aggregate basis of the property being transferred to the entity, several options should be considered for their potential availability. These include not transferring some of the low basis assets to the new entity or consulting with the lender and leaving some of the debt out of the entity, permitting it instead to run against the individual shareholders, or having the shareholders later pledge their stock to secure the debt. Alternatively, cash can be contributed to the entity in lieu of some of the low basis assets or in addition to the assets. Cash is all basis.
Monday, February 26, 2018
The “Tax Cuts and Jobs Act” (TCJA) enacted in late 2017, cuts the corporate tax rate to 21 percent. That’s 16 percentage points lower than the highest individual tax rate of 37 percent. On the surface, that would seem to be a rather significant incentive to form a C corporation for conducting a business rather than some form of pass-through entity where the business income flows through to the owners and is taxed at the individual income tax rates. In addition, a corporation can deduct state income taxes without the limitations that apply to owners of pass-through entities or sole proprietors.
Are these two features enough to clearly say that a C corporation is the entity of choice under the TCJA? That’s the focus of today’s post – is forming a C corporation the way to go?
The fact that corporations are now subject to a corporate tax at a flat rate of 21 percent is not the end of the story. There are other factors. For instance, the TCJA continues the multiple tax bracket system for individual income taxation, and also creates a new 20 percent deduction for pass-through income (the qualified business income (QBI) deduction). In addition, the TCJA doesn’t change or otherwise eliminate the taxation on income distributed (or funds withdrawn) from a C corporation – the double-tax effect of C-corporate distributions. These factors mute somewhat the apparent advantage of the lower corporate rate.
Under the new individual income tax rate structure, the top bracket is reached at $600,000 for a taxpayer filing as married filing joint (MFJ). For those filing as single taxpayers or as head-of household, the top bracket is reached at $500,000. Of course, not every business structured as a sole-proprietorship or a pass-through entity generates taxable income in an amount that would trigger the top rate. The lower individual rate brackets under the TCJA are 10, 12, 22, 24, 32 and 35 percent. Basically, up to about $75,000 of taxable income (depending on filing status), the individual rates are lower than the 21 percent corporate rate. So, just looking at tax rates, businesses with relatively lower levels of income will likely be taxed at a lower rate if they are not structured as a C corporation.
As noted, under the TCJA, for tax years beginning after 2017 and before 2026, an individual business owner as well as an owner of an interest in a pass-through entity is entitled to a deduction of 20 percent of the individual’s share of business taxable income. However, the deduction comes with a limitation. The limitation is the greater of (a) 50 percent of the W-2 wages paid with respect to the qualified trade or business, or (b) the sum of 25 of percent of the W-2 wages with respect to the qualified trade or business plus 2.5 percent of the unadjusted basis, immediately after acquisition, of all qualified property. I.R.C. §199A. Architects and engineers can claim the QBI deduction, but other services business are limited in their ability to claim it. For them, the QBI deduction starts to disappear once taxable income exceeds $315,000 (MFJ).
Clearly, the amount of income a business generates and the type of business impacts the choice of entity.
Another factor influencing the choice between a C corporation or a flow-through entity is whether the C corporation distributes income, either as a dividend or when share of stock are sold. The TCJA, generally speaking, doesn’t change the tax rules impacting qualified dividends and long-term capital gains. Preferential tax rates apply at either a 15 percent or 20 percent rate, with a possible “tack-on” of 3.8 percent (the net investment income tax) as added by Obamacare. I.R.C. §1411. So, if the corporate “double tax” applies, the pass-through effective rate will always be lower than the combined rates applied to the corporation and its shareholders. That’s true without even factoring in the QBI deduction for pass-through entities. But, for service businesses that have higher levels of income that are subject to the phase-out (and possible elimination) of the QBI deduction, the effective tax rate is almost the same as the rate applying to a corporation that distributes income to its shareholders, particularly given that a corporation can deduct state taxes in any of the 44 states that impose a corporate tax (Iowa’s stated corporate rate is the highest).
C corporations that have taxable income are also potentially subject to penalty taxes. 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.
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).
What if the Business Will Be Sold?
If the business will be sold, the tax impact of the sale should be considered. Again, the answer to whether a corporation or pass-through entity is better from a tax standpoint when the business is sold is that it “depends.” What it depends upon is whether the sale will consist of the business equity or the business assets. If the sale involves equity (corporate stock), then the sale of the C corporate stock will likely be taxed at a preferential capital gain rate. Also, for a qualified small business (a specially defined term), if the stock has been held for at least five years at the time it is sold, a portion of the gain (or in some cases, all of the gain) can be excluded from federal tax. Any gain that doesn’t qualify to be excluded from tax is taxed at a 28% rate (if the taxpayer is in the 15% or 20% bracket for regular long-term capital gains). Also, instead of a sale, a corporation can be reorganized tax-free if technical rules are followed.
If the sale of the business is of the corporate assets, then flow-through entities have an advantage. A C corporation would trigger a “double” tax. The corporation would recognize gain taxed at 21 percent, and then a second layer of tax would apply to the net funds distributed to the shareholders. Compare this result to the sale of assets of a pass-through entity which would generally be taxed at long-term capital gain rates.
Use of the C corporation may provide the owner with more funds to invest in the business. Also, a C corporation can be used to fund the owner’s retirement plan in an efficient manner. In addition, fringe benefits are generally more advantageous with a C corporation as compared to a pass-through entity (although the TCJA changes this a bit). A C corporation is also not subject to the alternative minimum tax (thanks to the TCJA). There are also other minor miscellaneous advantages.
So, what’s the best entity choice for you and your business? It depends! Of course, there are other factors in addition to tax that will shape the ultimate entity choice. See your tax/legal advisor for an evaluation of your specific facts.
Thursday, February 22, 2018
Leasing is of primary importance to agriculture. Leasing permits farmers and ranchers to operate larger farm businesses with the same amount of capital, and it can assist beginning farmers and ranchers in establishing a farming or ranching business.
Today’s post takes a brief look at some of the issues surrounding farmland leases – economic; estate planning; and federal farm program payment limitation planning.
Common Types of Leases
Different types of agricultural land leasing arrangements exist. The differences are generally best understood from a risk/return standpoint. Cash leases involve the periodic payment of a rental amount that is either a fixed number of dollars per acre, or a fixed amount for the entire farm. Typically, such amounts are payable in installments or in a lump sum. A flexible cash lease specifies that the amount of cash rent fluctuates with production conditions and/or crop or livestock prices. A hybrid cash lease contains elements similar to those found in crop-share leases. For example, a hybrid cash lease usually specifies that the rental amount is to be determined by multiplying a set number of bushels by a price determined according to terms of the lease, but at a later date. The tenant will market the entire crop. The landlord benefits from price increases, while requiring no management or selling decisions or capital outlay. However, the rental amount is adversely affected by a decline in price. The tenant, conversely, will not bear the entire risk of low commodity prices, as would be the case if a straight-cash lease were used, but does bear all of the production risk and must pay all of the production costs.
Under a hybrid-cash lease, known as the guaranteed bushel lease, the tenant delivers a set amount of a certain type of grain to a buyer by a specified date. The landlord determines when to sell the grain, and is given an opportunity to take advantage of price rises and to make his or her own marketing decisions. However, the landlord must make marketing decisions, and also is subject to price decreases and the risk of crop failure. For tenants, the required capital outlay will likely be less, and the tenant should have greater flexibility as to cropping patterns. While the rental amount may be less than under a straight-cash lease, the tenant will continue to bear the risk of crop failure.
Another form of the hybrid-cash lease, referred to as the minimum cash or crop share lease, involves a guaranteed cash minimum. However, the landlord has the opportunity to share in crop production from a good year (high price or high yield) without incurring out-of-pocket costs. For a tenant, the minimum cash payment likely will be less than under a straight-cash lease because the landlord will receive a share of production in good years. The tenant, however, still retains much of the production risk. In addition, the tenant typically does not know until harvest whether the tenant will receive all or only part of the crop. This may make forward cash contracting more difficult.
Under a crop-share leasing arrangement, the rent is paid on the basis of a specified proportion of the crops. The landlord may or may not agree to pay part of certain expenses. There are several variations to the traditional crop-share arrangement. For example, with a crop share/cash lease, rent is paid with a certain proportion of the crops, but a fixed sum is charged for selected acreage such as pasture or buildings, or both. Under a livestock-share leasing arrangement, specified shares of livestock, livestock products and crops are paid as rent, with the landlord normally sharing in the expenses. For irrigation crop-share leases, rent is a certain proportion of the crops produced, but the landlord shares part of the irrigation expenses. Under labor-share leases, family members are typically involved and the family member owning the assets has most of the managerial responsibility and bears most of the expenses and receives most of the crops. The other family members receive a share of yield proportionate to their respective labor and management inputs.
Estate Planning Implications
Leasing is also important in terms of its relation to a particular farm or ranch family's estate plan. For example, with respect to Social Security benefits for retired farm-landlords, pre-death material participation under a lease can cause problems. A retired farm-landlord who has not reached full retirement age (66 in 2018) may be unable to receive full Social Security benefits if the landlord and tenant have an agreement that the landlord shall have “material participation” in the production of, or the managing of, agricultural products.
While material participation can cause problems with respect to Social Security benefits, material participation is required for five of the last eight years before the earlier of retirement, disability or death if a special use valuation election is going to be made for the agricultural real estate included in the decedent-to-be's estate. I.R.C. §2032A. A special use valuation election permits the agricultural real estate contained in a decedent's estate to be valued for federal estate tax purposes at its value for agricultural purposes rather than at fair market value. The solution, if a family member is present, may be to have a nonretired landlord not materially participate, but rent the elected land to a materially participating family member or to hire a family member as a farm manager. Cash leasing of elected land to family members is permitted before death, but generally not after death. The solution, if a family member is not present, is to have the landlord retire at age 65 or older, materially participate during five of the eight years immediately preceding retirement, and then during retirement rent out the farm on a nonmaterial participation crop-share or livestock-share lease.
Farm Program Payments
Leases can also have an impact on a producer's eligibility for farm program payments. In general, to qualify for farm program payments, an individual must be “actively engaged in farming.” For example, each “person” who is actively engaged in farming is eligible for up to $125,000 in federal farm program payments each crop year. A tenant qualifies as actively engaged in farming through the contribution of capital, equipment, active personal labor, or active personal management. Likewise, a landlord qualifies as actively engaged in farming by the contribution of the owned land if the rent or income for the operation's use of the land is based on the land's production or the operation's operating results (not cash rent or rent based on a guaranteed share of the crop). In addition, the landlord's contribution must be “significant,” must be “at risk,” and must be commensurate with the landlord's share of the profits and losses from the farming operation.
A landowner who cash leases land is considered a landlord under the payment limitation rules and may not be considered actively engaged in farming. In this situation, only the tenant is considered eligible. Under the payment limitation rules, there are technical requirements that restrict the cash-rent tenant's eligibility to receive payments to situations in which the tenant makes a “significant contribution” of (1) active personal labor and capital, land or equipment; or (2) active personal management and equipment. Leases in which the rental amount fluctuates with price and/or production (so-called “flex” leases) can raise a question as to whether or not the lease is really a crop-share lease which thereby entitles the landlord to a proportionate share of the government payments attributable to the leased land.
Under Farm Service Agency (FSA) regulations (7 C.F.R. §1412.504(a)(2)), a lease is a “cash lease” if it provides for only a guaranteed sum certain cash payment, or a fixed quantity of the crop (for example, cash, pounds, or bushels per acre).” All other types of leases are share leases. In April 2007, FSA issued a Notice stating that if any portion of the rental payment is based on gross revenue, the lease is a share lease. Notice DCP-172 (April 2, 2007). However, according to FSA, if a flex or variable lease pegs rental payments to a set amount of production based on future market value that is not associated with the farm’s specific production, it’s a cash lease. Id. That was the FSA’s position through the 2008 crop year. Beginning, with the 2009 crop year, FSA has taken the position that a tenant and landlord may reach any agreement they wish concerning “flexing” the cash rent payment and the agreement will not convert the cash lease into a share-rent arrangement.
There are many issues that surround farmland leasing. Today’s post just scratches the surface with a few. Of course, many detailed tax rules also come into play when farmland is leased. The bottom line is that the type of lease matters, for many reasons. Give your leasing arrangement careful consideration and get it in writing.
Tuesday, February 20, 2018
For over the past decade I have conducted at least one summer tax conference addressing farm income tax and farm estate and business planning. The seminars have been held from coast-to-coast in choice locations – from North Carolina and New York in the East to California and Alaska in the West, and also from Michigan and Minnesota in the North to New Mexico in the South. This summer’s conference will be in Shippensburg, Pennsylvania on June 7-8 and is sponsored by the Washburn University School of Law. Our co-sponsors are the Kansas State University Department of Agricultural Economics and the Pennsylvania Institute of CPAs. My teaching partner again this year will be Paul Neiffer, the author of the Farm CPA Today blog. If you represent farm clients or are engaged in agricultural production and are interested in ag tax and estate/succession planning topics, this is a must-attend conference.
Today’s post details the seminar agenda and other key details of the conference.
The first day of the seminar will focus on ag income tax topics. Obviously, a major focus will be centered on the new tax law and how that law, the “Tax Cuts and Jobs Act” (TCJA), impacts agricultural producers, agribusinesses and lenders. One of points of emphasis will be on providing practical examples of the application of the TCJA to common client situations. Of course, a large part of that discussion will be on the qualified business income (QBI) deduction. Perhaps by the time of the seminar we will know for sure how that QBI deduction applies to sales of ag products to cooperatives and non-cooperatives.
Of course, we will go through all of the relevant court cases and IRS developments in addition to the TCJA. There have been many important court ag tax court decisions over the past year, as those of your who follow my annotations page on the “Washburn Agricultural Law and Tax Report” know first-hand.
Many agricultural producers are presently having a tough time economically. As a result, we will devote time to financial distress and associated tax issues – discharged debt; insolvency; bankruptcy tax; assets sales, etc.
We will also get into other issues such as tax deferral issues; a detailed discussion of self-employment tax planning strategies; and provide an update on the repair/capitalization regulations.
On Day 2, the focus shifts to estate and business planning issues for the farm client. Of course, we will go through how the TCJA impacts estate planning and will cover the key court and IRS developments that bear on estate and business planning. We will also get into tax planning strategies for the “retiring” farmer and farm program payment eligibility planning.
The TCJA also impacts estate and business succession planning, particularly when it comes to entity choice. Should a C corporation be formed? What are the pros and cons of entity selection under the TCJA? What are the options for structuring a farm client’s business? We will get into all of these issues.
On the second day we will also get into long-term care planning options and strategies, special use valuation, payment federal estate tax in installments, and the income taxation of trusts and estates.
The seminar will be held at the Shippensburg University Conference Center. There is an adjacent hotel that has established a room block for conference attendees at a special rate. Shippensburg is close to the historic Gettysburg Battlefield and is not too far from Lancaster County and other prime ag production areas. Early June will be a great time of the year to be in Pennsylvania.
Attend In-Person or Via the Web
The conference will be simulcast over the web via Adobe Connect. If you attend over the web, the presentation will be both video and audio. You will be able to interact with Paul and I as well as the in-person attendees. On site seating is limited to the first 100 registrants, so if you are planning on attending in-person, make sure to get your spot reserved.
You can find additional information about the seminar and register here: http://washburnlaw.edu/employers/cle/farmandranchincometax.html
If you have ag clients, you will find this conference well worth your time. We look forward to seeing you at the seminar either in-person or via the web.
Friday, February 16, 2018
I am often asked the questions at lay-level seminars whether a person can write their own will. While the answer is “yes,” it probably isn’t the best idea. Why? One of the primary reasons is because unclear language might be inadvertently used. Some words have multiple meanings in different contexts. Other words may simply be imprecise and not really require the executor or trustee to take any particular action concerning the decedent’s assets. The result could be that the decedent’s property ends up being disposed of in a way that the decedent hadn’t really intended.
Sometimes these problems can still occur when a will or trust is professionally prepared. A recent Texas case involving the disposition of ranch land illustrates the problem. Because of the imprecise language in a will and trust, a ranch ended up being sold without the decedent’s heirs having an option to purchase the property so that the land would stay in the family.
Imprecise language in wills and trusts and the problems that can be created - that’s the topic of today’s post.
The Peril of Precatory Language
In the law of wills and trusts, precatory words are words of wish, hope or desire or similar language that implores an executor or trustee of the decedent’s estate to dispose of property in some particular way. These types of words are not legally binding on the executor or trustee. They are merely “advisory.” However, words such as “shall” or “must” or some similar mandatory-type words are legally binding. Other words such as “money,” “funds,” or “personal property” are broad terms that can mean various things unless they are specifically defined elsewhere in the will or trust. Litigation involving wills and trusts most often involves ambiguous terms.
In Estate of Rodriguez, No. 04-17-00005-CV, 2018 Tex. App. LEXIS 254 (Tex. Ct. App. Jan. 10, 2018), a beneficiary of a trust sued the trustee to prevent the sale of ranchland that was owned by the decedent’s testamentary trust. The decedent died in early 2015 leaving a will benefitting his four children and a daughter-in-law. A son was named as executor and the trustee of a testamentary trust created by the decedent’s will. The primary property of the decedent’s residuary estate (after specific bequests had been satisfied) was the decedent’s ranchland. The residuary estate passed to the testamentary trust. Three of the children and the daughter-in-law were named as beneficiaries of the trust.
The trustee decided to sell the ranchland, and the daughter-in-law attempted to buy the ranch to no avail. She sued, seeking a temporary restraining order and an injunction that would prevent the trustee from selling the ranch to a third party that the trustee had accepted an offer to purchase from. The third party also got involved in the lawsuit, seeking specific performance of the purchase contract. The daughter-in-law claimed that the contract between the trustee and the third party violated a right-of-first-refusal that the trust language created in favor of the trust beneficiaries. The trial court disagreed and ordered the trustee to perform the contract. The daughter-in-law appealed.
The appellate court noted the following will language: “I hereby grant unto my…Executor…full power and authority over any and al of my estate and they are hereby authorized to sell…any part thereof…”. The trust created by the will also gave the trustee the specific power to sell the corpus of the trust, but the language was imprecise. The pertinent trust language stated, “My Trustee can sell the corpus of this Trust, but it [is] my desire my ranch stay intact as long as it is reasonable.” Another portion of the trust stated, “If any of the four beneficiaries of his estate wants to sell their portion of the properties they can only sell it to the remaining beneficiaries.” The daughter-in-law claimed the trust language was mandatory rather than precatory, and the mandatory language granted the trust beneficiaries the right-of-first-refusal to buy the ranchland. She claimed that the decedent desired that the ranchland stay intact, and had mentioned that intent to others during his life.
The appellate court disagreed with the daughter-in-law. Neither of the trust clauses, the court noted, required the trustee to offer to anyone, much less the beneficiaries, the chance to buy the ranchland on the same terms offered to another potential buyer. While the language limited a beneficiary’s power to sell to anyone other than another beneficiary, it didn’t restrict the trustee’s power to sell. There was simply nothing in the will or trust that limited the trustee’s power to sell by creating a right-of-first-refusal in favor of the trust beneficiaries. The decedent’s “desire” to keep the ranchland intact was precatory language that didn’t bar the trustee from selling it to a third party. In addition, there was no right-of-first-refusal created for the beneficiaries. The contract to sell the ranchland to the third party was upheld.
For many farm or ranch families, a major objective is to keep the farmland/ranchland in the family. That might be the case regardless of whether the family members will be the actual operators down through subsequent generations. However, the recent Texas case points out how important precise language in wills and trusts is in preserving that intent.
Wednesday, February 14, 2018
Farmer and ranchers regularly engage in secured transactions. For instance, the typical farmer doesn’t have enough cash on hand to buy high-priced farm machinery and equipment outright. That means that the seller extends credit to finance the purchase or the farmer finds acceptable financing elsewhere to make the purchase. In either situation, the parties execute a security agreement evidenced by a financing statement that is then filed of public record. The filing allows other potential creditors to check if a lien already exists on the debtor’s property before extending credit.
The public filing means that the debtor must be identified. The proper identification of the debtor is key, and many creditors have learned the hard way that a slight slip up in properly identifying the debtor in the financing statement can change their secured interest to an unsecured one.
The property identification of the debtor in a financing statement, that’s the topic of today’s post.
Perfecting a Security Interest
Normally, a security interest in tangible property is perfected (made effective against other creditors) by filing a financing statement or by filing the security agreement as a financing statement. Indeed, filing a financing statement usually is the only practical way to perfect when the debtor is a farmer or rancher. An effective financing statement merely indicates that the creditor may have a security interest in the described collateral and is sufficient if it provides the name of the debtor, (UCC §9-502(a)(1)) gives the name and address of the secured party from which information concerning the security interest may be obtained, gives the mailing address of the debtor and contains a statement indicating the types or describing the items of collateral.
Note: An adequate description of the collateral is critical if there is to be attachment and perfection. UCC §9-108. This is an important point that can arise in an agricultural context with respect to real estate, livestock and equipment that can be used either directly or indirectly in agricultural production activities.
Name of the debtor. The name of the debtor is the key to the notice system and priority. The financing statement is indexed under the debtor’s name. If the debtor is a registered organization, only the name indicated on the public record of the debtor’s jurisdiction or organization is sufficient. For example, in In re EDM Corporation, 431 B.R. 459 (B.A.P. 8th Cir. 2010), a bank identified a corporate debtor on the financing statement as "EDM Corporation D/B/A EDM Equipment” and the court held that the identification was seriously misleading because a search conducted by using standard search logic did not reveal the bank's interest. The court also held that the addition of the debtor's trade name to its registered organization name violated Rev. UCC 9-503. But, federal tax liens appear not to be subject to the same exact match standard. The test is whether a reasonable searcher would find the lien notwithstanding the use of on abbreviation. See, e.g., In re Spearing Tool and Manufacturing Co., 412 F.3d 653 (6th Cir. 2005), rev’g, 302 B.R. 351 (E.D. Mich. 2003), cert. den.sub nom, ,Crestmark Bank v. United States, 127 S. Ct. 41 (2006). Under UCC § 9-506, a financing statement is effective even if it has minor errors or omissions unless the errors or omissions make the financing statement seriously misleading. A financing statement containing an incorrect debtor’s name is not seriously misleading if a search of the records of the filing office under the debtor’s correct legal name, using the filing office’s standard search logic, if any, discloses the financing statement filed under the incorrect name. However, some states have regulations defining the search logic to be used and may require that the debtor’s name be listed correctly. See, e.g., In re Kinderknecht, 308 B.R. 47 (Bankr. 10th Cir. 2004), rev’g, 300 B.R. 47 (Bankr. D. Kan. 2003); Pankratz Implement Co. v. Citizens National Bank, 130 P.3d 57 (Kan. 2006), aff’g, 33 Kan. App. 2d 279, 102 P.3d 1165 (2004); In re Borden, 353 B.R. 886 (Bankr. D. Neb. 2006), aff’d, No. 4:07CV3048, 2007 U.S. Dist. LEXIS 61883 (D. Neb. Aug. 20, 2007); Corona Fruits & Veggies, Inc. v. Frozsun Foods, 143 Cal. App. 4th 319, 48 Cal. Rptr. 3d 868 (2006).
The issue of the property identification of the debtor came up again in a recent case. In In re Pierce, No. 17060154, 2018 Bankr. LEXIS 287 (Bankr. S.D. Ga. Feb. 1, 2018), a bank financed a debtor’s purchase of a manure spreader. The bank properly filed a financing statement listing the debtor’s name as “Kenneth Pierce.” At the time of the filing, the debtor’s driver’s license identified him as “Kenneth Ray Pierce, but the debtor would always sign his licenses as either “Kenneth Pierce” or as “Kenneth Ray Pierce.” Approximately two years after the bank filed, the debtor filed Chapter 12 bankruptcy. The bank filed a proof of claim in the amount of $14,459.81 and attached the financing statement. The debtor filed an objection claiming that because the bank failed to correctly identify him as “Kenneth Ray Pierce” on the financing statement, the bank’s security interest was unsecured along with its claim. After determining that the debtor had standing to use the trustee’s avoidance powers and bring an action under 11 U.S.C. §544, the court found the bank’s interest to be unsecured. The court noted that Georgia Code §11-9-503(a)(1)-(4) required an individual debtor’s name on a financing statement to match the debtor’s name on the debtor’s driver’s license. The court noted that such imprecise match was seriously misleading and that Georgia law required that debtor’s name on the financing statement match the typed name on the debtor’s driver’s license. The court also pointed out that had the bank followed the Georgia UCC-1 Financing Statement Form which instructs the use of the debtor’s exact full name, the debtor would have been identified the same as the typed name on the debtor’s driver’s license.
Properly identifying the debtor on a filed financing statement is critical to ensuring that a creditor has perfected its interest in the collateral. An exact match is required. Lenders must be careful.
Monday, February 12, 2018
Although the loss of livestock due to disease does not occur that frequently, when it occurs the loss can be large. Fortunately, the tax Code provides a special rule for the handling of the loss. The rule is similar to the rules that apply when excess livestock are sold on account of weather-related conditions.
Today’s post takes a look at the tax rule for handling sale of livestock on account of disease.
Treatment as an Involuntary Conversion
Gain deferral. Similar to the drought sale rules, livestock that are sold or exchanged because of disease may not lead to taxable gain if the proceeds of the transaction are reinvested in replacement animals that are similar or related in service or use (in other words, dairy cows for dairy cows, for example) within two years of the close of the tax year in which the diseased animals were sold or exchanged. I.R.C. §1033(d). More specifically, the replacement period ends two years after the close of the tax year in which the involuntary conversion occurs and any part of the gain is realized. I.R.C. §1033(a)(2)(B)(i). In that event, the gain on the animals disposed of is not subject to tax. Instead, the gain is deferred until the replacement animals are sold or exchanged in a taxable transaction. The taxpayer's basis in the new animals must be reduced by the unrecognized gain on the old animals that were either destroyed, sold or exchanged. Treas. Reg. §1.1033(b)-1.
Note: Involuntary conversion treatment is available for losses due to death of livestock from disease. It doesn’t matter whether death results from normal death loss or a disease causes massive death loss. Rev. Rul. 61-216, 1961-2 C.B. 134. In addition, involuntary conversion treatment applies to livestock that are sold or exchanged because they have been exposed to disease. Treas. Reg. §1.1033(d)-1.
When is gain recognized? Gain is realized to the extent money or dissimilar property is received in excess of the tax basis of the livestock. For farmers on the cash method of accounting, raised livestock has no tax basis. Therefore, gain is realized upon the receipt of any compensation for the animals. See, e.g., Decoite v. Comr., T.C. Memo. 1992-665. Thus, if there is gain recognition on the transaction, it occurs to the extent the net proceeds from the involuntary conversion are not invested in qualified replacement property. I.R.C. §1033(a)(2)(A). The gain (or loss) is reported on Form 4797. A statement must be attached to the return for the year in which gain is realized (e.g., the year in which insurance proceeds are received). Treas. Reg. 1.1033(a)-2(c)(2). The statement should include the date of the involuntary conversion as well as information concerning the insurance (or other reimbursement) received. If the replacement livestock are received before the tax return is filed, the attached statement must include a description of the replacement livestock, the date of acquisition, and their cost. If the animals will be replaced in a year after the year in which the gain is realized, the attached statement should evidence the taxpayer’s intent to replace the property within the two-year period.
Disease is not a casualty. Under the casualty loss rules, a deduction can be taken for the complete or partial destruction of property resulting from an identifiable event of a sudden, unexpected or unusual nature. Rev. Rul. 72-592, 1972-2 C.B. 101. Livestock losses because of disease generally would not be eligible for casualty loss treatment because the loss is progressive rather than sudden. Thus, casualty loss treatment under I.R.C. §165(c)(3) does not apply. However, this provision doesn’t apply to losses due to livestock disease. I.R.C. §1033(d). Stated another way, the “suddenness” test doesn’t have to be satisfied to have involuntary conversion treatment apply. See Rev. Rul. 59-102, 1959-1 C.B. 200.
What is a “disease”? While a livestock disease need not be sudden in nature for the sale or exchange of the affected livestock to be treated under the involuntary conversion rules, a genetic defect is not a disease. Rev. Rul. 59-174, 1959-1 C.B. 203. However, livestock that consume contaminated feed and are lost as a result can be treated under the involuntary conversion rules. Rev. Rul. 54-395, 1954-2 C.B. 143.
What qualifies as “replacement animals”? I.R.C. §1033(d) says that if “livestock” are destroyed, sold or exchanged on account of disease then involuntary conversion treatment can apply. But, what is the definition of “livestock” for involuntary conversion purposes? The definition of “livestock” under I.R.C. §1231 applies for involuntary conversion treatment. Treas. Reg. §1.1231-2(a)(3). Under that regulation, “livestock” includes “cattle, hogs, horses, mules, donkeys, sheep, goats, fur-bearing animals and other mammals.” It does not include “poultry, chickens, turkeys, pigeons, geese, other birds, fish, frogs, reptiles, etc.” The IRS has ruled that honeybees destroyed due to nearby pesticide use qualified for involuntary conversion treatment. Rev. Rul. 75-381, 1975-2 C.B. 25.
Environmental contamination. If it is not feasible to reinvest the proceeds from involuntarily converted livestock into other like-kind livestock due to soil or other environmental contamination, the proceeds can be invested into non-like-kind farm property or real estate used for farming purposes. I.R.C. §1033(f). A communicable disease may not be considered to be an environmental contaminant. Miller v. United States, 615 F. Supp. 160 (E.D. Ky. 1985).
While the destruction, sale or exchange of livestock on account of disease is uncommon, it does occur. When it does, the financial impact on the farming or ranching business can be substantial. Fortunately, there is a tax rule that helps soften the blow.
Thursday, February 8, 2018
The Spousal Qualified Joint Venture – Implications for Self-Employment Tax and Federal Farm Program Payment Limitations
As noted in Part 1 of this two-part series on the spousal qualified joint venture (QJV), some spousal business ventures can elect out of the partnership rules for federal tax purposes as a QJV. I.R.C. §761(f). In Part 1, I looked at the basics of the QJV election and how it can ease the tax reporting requirements for spousal joint ventures that can take advantage of the election. Today, in Part 2, I look at how the election impacts self-employment tax and, for farmers, eligibility for federal farm program payments.
The QJV Election and Self-Employment Tax
Under I.R.C. §1402(a), net earnings from self- employment are subject to self-employment tax. Net earnings from self-employment are defined as income derived by an individual from any trade or business carried on by such individual. But, real estate rental income is excluded from the general definition of net earnings from self-employment. I.R.C. §1402(a)(1). Thus, for rental property in a partnership (or rental real estate income of an individual), self- employment tax is not triggered.
The QJV election and rental real estate. I.R.C. §1402(a)(17) specifies that when a QJV election has been made, each spouse’s share of income or loss is taken into account as provided for in I.R.C. §761(f) in determining self-employment tax. I.R.C. §761(f)(1)(C) specifies that, “each spouse shall take into account such spouse’s respective share of such items as if they were attributable to a trade or business conducted by such spouse as a sole proprietor.” That means that the QJV election does not avoid the imposition of self-employment tax.
However, the exception from self-employment tax for rental real estate income remains intact. The IRS instructions to Form 1065 state that if the QJV election is made for a spousal rental real estate business, "you each must report your share of income and deductions on Schedule E. Rental real estate income generally isn’t included in net earnings from self-employment subject to self-employment tax and generally is subject to the passive loss limitation rules. Electing qualified joint venture status doesn’t alter the application of the self-employment tax or the passive loss limitation rules.” See also CCA Ltr. Rul. 200816030 (Mar. 18, 2008).
While the QJV election may not be a problem in a year when a loss results, the self-employment tax complication can be problematic when there is positive income for the year. That’s because it is not possible to simply elect out of QJV treatment in an attempt to avoid self-employment tax by filing a Form 1065. The QJV election cannot be revoked without IRS consent. Likewise, it’s probably not possible to intentionally fail to qualify for QJV status (by transferring an interest in the business to a non-spouse, for example) to avoid self-employment tax in an income year after a year (or years) of reducing self-employment by passed-through losses. Such a move would allow IRS to assert that the transfer of a minimal interest to a disqualified person or entity violates the intent of Subchapter K
Tax Reporting and Federal Farm Program Participation - The "Active Engagement" Test
For farm couples that participate in federal farm programs where both spouses satisfy the “active
engagement” test, each spouse may qualify for a payment limitation. 7 U.S.C. §§1308-1(b); 1308(e)(2)(C)(ii); 1400.105(a)(2). To be deemed to be actively engaged in farming as a separate person, a spouse must satisfy three tests: (1) the spouse’s share of profits or losses from the farming operation must be commensurate with the spouse’s contribution to the operation; (2) the spouse’s contributions must be “at risk;” and (3) the spouse must make a significant contribution of capital, equipment or land (or a combination thereof) and active personal labor or active personal management (or a combination thereof). For the spouse’s contribution to be “at risk,” there must be a possibility that a non-recoverable loss may be suffered. Similarly, contributions of capital, equipment, land, labor or management must be material to the operation to be “significant contribution.” Thus, the spouse’s involvement, to warrant separate person status, must not be passive.
While the active engagement test is relaxed for farm operations in which a majority of the “persons” are individuals who are family members, it is not possible for a spouse to sign up for program payments as a separate person from the other spouse based on a contribution of land the spouse owns in return for a share of the program payments. That’s because, the use of the spouse’s contributed land must be in return for the spouse receiving rent or income for the use of the land based on the land’s production or the farming operation’s operating results.
What this all means is that for spouses who sign up for two separate payment limitations under the farm programs, they are certifying that they each are actively involved in the farming operation. Under the farm program rules, for each spouse to be actively involved requires both spouses to be significantly involved in the farming operation and bear risk of loss.
From a tax standpoint, however, the couple may have a single enterprise the income from which is reported on Form 1040 as a sole proprietorship or on a single Schedule F with the income split into two equal shares for self- employment tax purposes. In these situations, IRS could assert that a partnership filing is required (in common-law property states). That’s where the QJV election could be utilized with the result that two proprietorship returns can be filed. As mentioned above that’s a simpler process than filing a partnership return, and it avoids the possibility of having penalties imposed for failing to file a partnership return. But, the filing of the QJV election will subject the income of both spouses (including each spouse’s share of government payments) to self-employment tax. That will eliminate any argument that at least one spouse’s income should not be subjected to self-employment tax on the basis that the spouse was only actively involved (for purposes of the farm program eligibility rules), but not engaged in a trade or business (for self-employment tax purposes).
Separate “person” status and material participation. Can both spouses qualify for separate “person” status for federal farm program purposes, but have only one of them be materially participating in the farming operation for self-employment tax purposes? While the active engagement rules are similar to the rules for determining whether income is subject to self-employment tax, their satisfaction is meaningless on the self-employment tax issue according to the U.S. Tax Court.
In Vianello v. Comr., T.C. Memo. 2010-17, the taxpayer was a CPA that, during the years in issue, operated an accounting firm in the Kansas City area. In 2001, the petitioner acquired 200 acres of cropland and pasture in southwest Missouri approximately 150 miles from his office. At the time of the acquisition, a tenant (pursuant to an oral lease with the prior owner) had planted the cropland to soybeans. Under the lease, the tenant would deduct the cost of chemicals and fertilizer from total sale proceeds of the bean and pay the landlord one- third of the amount of the sale. The petitioner never personally met the tenant during the years at issue, but the parties did agree via telephone to continue the existing lease arrangement for 2002. Accordingly, the tenant paid the expenses associated with the 2001 and 2002 soybean crops, and provided the necessary equipment and labor. The tenant made all the decisions with respect to raising and marketing the crop, and paid the petitioner one-third of the net proceeds. As for the pasture, the tenant mowed it and maintained the fences. Ultimately, a disagreement between the petitioner and the tenant resulted in the lease being terminated in early 2003, and the petitioner had another party plow under the fall-planted wheat in the spring of 2004 prior to the planting of Bermuda grass. Also, the petitioner bought two tractors in 2002 and a third tractor and hay equipment in 2003, and bought another 50 acres from in late 2003.
The petitioner did not report any Schedule F income for 2002 or 2003, but did claim a Schedule F loss for each year - as a result of depreciation claimed on farm assets and other farming expenses. The petitioner concluded, based on a reading of IRS Pub. 225 (Farmer’s Tax Guide) that he materially participated in the trade or business of farming for the years at issue. The petitioner claimed involvement in major management decisions, provided and maintained fences, discussed row crop alternatives, weed maintenance and Bermuda grass planting with the tenant. The petitioner also pointed out that his revocable trust was an eligible “person” under the farm program payment limitation rules as having satisfied the active engagement test. The petitioner also claimed he bore risk of loss under the lease because an unsuccessful harvest would mean that he would have to repay the tenant for the tenant’s share of chemical cost.
The Tax Court determined that the petitioner was not engaged in the trade or business of farming for 2002 or 2003. The court noted that the tenant paid all the expenses with respect to the 2002 soybean crop, and made all of the cropping decisions. In addition, the court noted that the facts were unclear as to whether the petitioner was responsible under the lease for reimbursing the tenant for input costs in the event of an unprofitable harvest. Importantly, the court noted that the USDA’s determination that the petitioner’s revocable trust satisfied the active engagement test and was a co- producer with the tenant for farm program eligibility purposes “has no bearing on whether petitioner was engaged in such a trade or business for purposes of section 162(a)…”. The Tax Court specifically noted that the Treasury Regulations under I.R.C. §1402 “make it clear that petitioner’s efforts do not constitute production or the management of the production as required to meet the material participation standard” [emphasis added]. That is a key point. The petitioner’s revocable trust (in essence, the taxpayer) satisfied the active engagement test for payment limitation purposes (according to the USDA), but the petitioner was not engaged in the trade or business of farming either for deduction purposes or self-employment tax purposes. As noted below, however, the USDA’s determination of participation is not controlling on the IRS.
Vianello reaffirms the point that the existence of a trade or business is determined on a case-by-case basis according to the facts and circumstances presented, and provides additional clarity on the point that satisfaction of the USDA’s active engagement test does not necessarily mean that the taxpayer is engaged in the trade or business of farming for self-employment tax purposes. In spousal farming operations, Vianello supports the position that both spouses can be separate persons for payment eligibility purposes, but only one of them may be deemed to be in the trade or business of farming for self-employment tax purposes. The case may also support an argument that satisfaction of the active engagement test by both spouses does not necessarily create a partnership for tax purposes. But that is probably a weaker argument – Vianello did not involve a spousal farming situation.
So, while Vianello may eliminate the need to make a QJV election in spousal farming situations, without the election it is possible that IRS could deem spouses to be in a partnership triggering the requirement to file a partnership return.
The QJV election can be used to simplify the tax reporting requirement for certain spousal businesses that would otherwise be required to file as a partnership. That includes spousal farming operations where each spouse qualifies as a separate person for payment limitation purposes. But, the election does not eliminate self-employment tax on each spouse’s share of income.
Tuesday, February 6, 2018
Some spousal business ventures can elect out of the partnership rules for federal tax purposes as a qualified joint venture (QJV). I.R.C. §761(f). While the election will ease the tax reporting requirements for husband-wife joint ventures that can take advantage of the election, the Act also makes an important change to I.R.C. §1402 as applied to rental real estate activities that can lay a trap for the unwary.
When is making a QJV election a good planning move? When should it be avoided? Are their implications for spousal farming operations with respect to farm program payment limitation planning? Is there any impact on self-employment tax? This week I am taking a look at the QJV. Today’s post looks at the basics of the election. On Thursday, I will look at its implications for farm program payment limitation planning as well as its impact on self-employment tax.
The QJV election is the topic of today’s post.
Joint Ventures and Partnership Returns
A joint venture is simply an undertaking of a business activity by two or more persons where the parties involved agree to share in the profits and loss of the activity. That is similar to the Uniform Partnership Act’s definition of a partnership. UPA §101(6). The Internal Revenue Code defines a partnership in a negative manner by describing what is not a partnership (I.R.C. §§761(a) and 7701(a)(2)), and the IRS follows the UPA definition of a partnership by specifying that a business activity conducted in a form jointly owned by spouses (including a husband-wife limited liability company (LLC)) creates a partnership that requires the filing of an IRS Form 1065 and the issuance to each spouse of separate Schedules K-1 and SE, followed by the aggregation of the K-1s on the 1040 Schedule E, page 2. The Act does not change the historic IRS position.
Note: Thus, for a spousal general partnership, each spouse’s share of partnership income is subject to self-employment tax. See, e.g., Norwood v. Comr., T.C. Memo. 2000-84.
While the IRS position creates a tax compliance hardship, in reality, a partnership return does not have to be filed for every husband-wife operation. For example, if the enterprise does not meet the basic requirements to be a partnership under the Code (such as not carrying on a business, financial operation or venture, as required by I.R.C. §7701(a)(2)), no partnership return is required. Also, a spousal joint venture can elect out of partnership treatment if it is formed for “investment purposes only” and not for the active conduct of business if the income of the couple can be determined without the need for a partnership calculation. I.R.C. §761(a).
A spousal business activity (in which both spouses are materially participating in accordance with I.R.C. §469(f)) can elect to be treated as a QJV which will not be treated for tax purposes as a partnership. In essence, the provision equates the treatment of spousal LLCs in common-law property states with that of community property states. In Rev. Proc. 2002-69, 2002-2 C.B. 831, IRS specified that husband-wife LLCs in community property states can disregard the entity.
Note: The IRS claims on its website that a qualified joint venture, includes only those businesses that are owned and operated by spouses as co-owners, and not those that are in the name of a state law entity (including a general or limited partnership or limited liability company). So, according to the IRS website, spousal LLCs, for example, would not be eligible for the election. However, this assertion is not made in Rev. Proc. 2002-69. There doesn’t appear to be any authority that bars a spousal LLC from making the QJV election.
With a QJV election in place, each spouse is to file as a sole proprietor to report that spouse’s proportionate share of the income and deduction items of the business activity. To elect QJV status, five criteria must be satisfied: (1) the activity must involve the conduct of a trade or business; (2) the only members of the joint venture are spouses; (3) both spouses elect the application of the QJV rule; (4) both spouses materially participate in the business; and (5) the spouses file a joint tax return for the year I.R.C. §761(f)(1).
Note: “Material participation” is defined in accordance with the passive activity loss rules of I.R.C. §469(h), except I.R.C. §469(h)(5). Thus, whether a spouse is materially participating in the business is to be determined independently of the other spouse.
The IRS instructions to Form 1065 (the form, of course, is not filed by reason of the election) provide guidance on the election. Those instructions specify that the election is made simply by not filing a Form 1065 and dividing all income, gain, loss, deduction and credit between the spouses in accordance with each spouse’s interest in the venture. Each spouse must file a separate Schedule C, C-EZ or F reporting that spouse’s share of income, deduction or loss. Each spouse also must file a separate Schedule SE to report their respective shares of self-employment income from the activity with each spouse then receiving credit for their share of the net self-employment income for Social Security benefit eligibility purposes. For spousal rental activities where income is reported on Schedule E, a QJV election may not be possible. That’s because the reporting of the income on Schedule E constitutes an election out of Subchapter K, and a taxpayer can only come back within Subchapter K (and, therefore, I.R.C. §761(f)) with IRS permission that is requested within the first 30 days of the tax year.
In general, electing QJV status won’t change a married couple’s total federal income tax liability or total self-employment tax liability, but it will eliminate the need to file Form 1065 and the related Schedules K-1. In that regard, the QJV election can provide a simplified filing method for spousal businesses. It can also remove a potential penalty for failure to file a partnership return from applying. That penalty is presently $200 per partner for each month (or fraction thereof) the partnership return is late, capped at 12 months.
Friday, February 2, 2018
On April 16, 1677, the English Parliament passed the “Statute of Frauds.” The new law required that certain contracts for the sale of goods be in writing to be enforceable. In the United States, nearly every state has adopted, and retained, a statute of frauds. Most recently, state legislatures have had to amend existing laws to account for electronic communications and specify whether those communications satisfy the writing requirement.
A type of contract that must be in writing to be enforceable is one that involves the sale of goods worth $500 or more. Obviously, this type of contract will involve many contracts involving the sale agricultural commodities and other agricultural goods. But, there are exceptions to the writing requirement for contracts that would otherwise have to be in writing to be enforceable. One of those exceptions turns on whether a farmer is a merchant or not, and the rule involving the matter is known as the “merchant’s confirmatory memo rule.” It often comes up in situations involving the sale of grain under a forward contract.
That’s the focus of today’s post – the merchant’s confirmatory memo rule.
The Writing Requirement and the UCC
The writing requirement for sales of goods is found in a particular state’s version of § 2-201 of the Uniform Commercial Code (UCC). The official version, adopted by most states, is applicable only when the goods have a price of $500 or more. In addition, under UCC § 1-206, there is an overall statute of frauds for every contract involving a contract for the sale of personal property having a value in excess of $5,000. Thus, for personal property except “goods” a contract is not enforceable beyond $5,000 unless there is some writing signed by the party against whom enforcement is sought.
Contracts involving merchants. As indicated above, a contract for the sale of goods for $500 or more is generally not enforceable unless there is some writing signed by the party against whom enforcement is sought sufficient to indicate that the contract had been made between the parties. For contracts between merchants, it is common for one merchant to send the other merchant a letter of confirmation, or a pre-printed form contract. This confirmation will be signed by the party who sent it, thus leaving one party at the other party’s mercy. The UCC remedies this situation by providing that unwritten contracts between merchants are enforceable if a writing in confirmation of the contract is received within a reasonable time unless written notice of objection to the contents of the writing is given within ten days. UCC § 2-201(2); see also Topflight Grain Cooperative, Inc. v. RJW Williams Farms, Inc., No. 4-12-1079, 2013 Ill. App. Unpub. LEXIS 1753 (Ill. Ct. App. Aug. 13, 2012).
Thus, the effect of this “merchants” exception is to take away from a merchant who receives a writing in confirmation of a contract the statute of frauds defense if the merchant does not object to the confirmation. In any event, the sender of the written confirmation must still be able to persuade a jury that a contract was in fact made orally, to which the written confirmation applies.
Consider the following example:
In December of 2017, Jesse telephoned his local elevator for a price quote on wheat. During their telephone conversation, Jesse and the elevator agreed that Jesse would sell the elevator 25,000 bushels of wheat at a specified quality at the December price next June, with performance to be completed no later than June 30, 2018. The elevator sent Jesse a written confirmation asking that it be signed and returned within ten days. Jesse did not sign the written confirmation. Because of unexpected market conditions, the June 2018 wheat price was substantially higher than the December 2017 price. Jesse refused to perform in accordance with the forward contract, preferring instead to sell his wheat crop at the higher current market price. The elevator sued to enforce the forward contract. Jesse asserted the statute of frauds as a defense – because they didn’t have a written contract, he didn’t have to deliver.
If Jesse is a merchant with respect to the kind of goods contemplated in the forward contract (wheat), he will be bound by the oral contract. If Jesse is not a merchant, the elevator might be able to recover if it can establish that it changed its position in reliance on Jesse’s conduct, that Jesse knew or reasonably should have known the elevator would sell the forward contract, or can demonstrate that Jesse’s nonperformance was based on his desire to benefit from a higher market price.
When Is A Farmer a Merchant?
A “merchant” is defined as one who deals in goods of the kind being sold, or one who by occupation holds himself or herself out as having knowledge or skill peculiar to either the goods involved or the practice of buying and selling such goods. Courts are divided on the issue of whether a farmer or rancher is a merchant, with the outcome depending on the jurisdiction and the facts of the particular case. See, e.g., Huprich v. Bitto, 667 So.2d 685 (Ala. 1995); Smith v. General Mills, Inc., 968 P. 2d 723 (Mont. 1998); Brooks Cotton Co., Inc. v. Wilbine, 381 S.W.3d 414 (Tenn. Ct. App. 2012).
Unfortunately, in many instances, farmers and ranchers cannot know with certainty whether they are merchants without becoming involved in legal action on the issue. Courts consider several factors in determining whether a particular farmer is a merchant. These factors include (1) the length of time the farmer has been engaged in marketing products on the farm; (2) the degree of business skill demonstrated in transactions with other parties; (3) the farmer’s awareness of the operation and existence of farm markets; and (4) the farmer’s past experience with or knowledge of the customs and practices unique to the marketing of the product sold. For a couple of courts opinions on the issue of whether a farmer is a merchant that reached different outcomes, see Nelson v. Union Equity Co-Operative Exchange, 548 S.W.2d 352 (Tex. 1977) and Harvest States Cooperatives v. Anderson, 217 Wis. 2d 154 (Wis. Ct. App. 1998)
Whether a farmer is a merchant or not is the key to determining whether an oral conversation involving the sale of goods is enforceable. Just another one of those interesting aspects of agricultural law – with its roots dating back to 1677.
Wednesday, January 31, 2018
Some taxpayers strive to convert a hobby or minor occupation into a more typical business operation. Doing so doesn’t present any problems with the IRS if the business makes money and, of course, all taxes are properly paid. But, what if the business activity loses money? If the losses stack-up over a length of time (deductions from the activity exceed income), the IRS may take the position that the activity is a hobby that is not engaged in with a profit intent as would be a legitimate business.
What is the consequence of being classified by the IRS as a hobby? Deductions that are attributable to an activity that is not engaged in for profit are significantly limited. I.R.C. §183(a). Certain deductions will remain available because they aren’t tied to whether the activity is a hobby or not. Those include state and local property taxes, home mortgage interest and casualty losses, for example. See Treas. Reg. §1.183-1(d)(2). But, deductions associated with conducting the activity will be limited to the excess of gross income from the activity over those expenses that are deductible regardless of whether the activity is entered into for profit. In addition, for hobby activities, allowed expenses are deducted on Schedule A (Form 1040) as a miscellaneous itemized deduction subject to the 2 percent-of-AGI (adjusted gross income) floor. This is the rule through 2017. For tax years beginning after 2017, there are no deductions against the hobby income due to the elimination of the 2 percent-of-AGI floor. If the activity isn’t a hobby, deductible expenses are business expenses that are deductible (even if they exceed income) on Schedule C. If the activity is a hobby, however, the income is reported as "other income" and is not subject to self-employment tax. But, the critical point is that if an activity is not engaged in for profit, then losses from the activity can’t be used to offset other income.
Note: Where property is used in several activities, and one or more of the activities is determined not to be engaged in for profit, deductions relating to the property must be allocated between the various activities on a reasonable and consistently applied basis. Treas. Reg. §1.183-1(d)(2).
In recent months, indications are that the IRS is pushing the hobby loss rules harder, particularly with respect to farming operations. In early 2017, I wrote about a pilot program that IRS was initiating involving Schedule F expenses for small business/self-employed taxpayer examinations. The program started on April 1, 2017 and will go through March of 2018. The focus will be on “hobby” farmers, and it could be an indication that the IRS is looking to increase the audit rate of returns with a Schedule F.
The hobby loss rules and farming/ranching operations, that’s the topic of today’s post.
The Hobby Loss Rules
The key question is where the line is drawn between a hobby and a business. In general, as noted above, a “hobby” is any activity that is not engaged in primarily for profit. If a taxpayer’s gross income from an activity exceeds deductions for three or more of the last five years, a presumption arises that the activity is not a hobby. In other words, an activity is presumed to be a business if there are profits for three or more of the last five years. For activities consisting of breeding, training, showing or racing horses, however, the presumption arises if there is a profit in any two out of the last seven years. The IRS can rebut the presumption by carrying the burden of proof and establishing a lack of profit motive. Thus, for farms or ranches operated for pleasure or recreation and not as commercial enterprises, the deduction of expenses is permitted if a profit occurs over a long enough period.
If the presumption does not resolve the issue of whether a farm is being operated for pleasure or recreation and not as a commercial enterprise, a determination must be made as to whether the taxpayer was conducting the activity with the primary purpose and intention of realizing a profit. The expectation of profit need not be reasonable, but there must be an actual and honest profit objective. Whether the requisite intention to make a profit is present is determined by the facts and circumstances of each case with the burden of proof on the taxpayer attempting to deduct the losses. See, e.g., Ryberg v. Comr., T.C. Sum. Op. 2012-24.
Nine-Factor Test of the Regulations
The hobby loss rules won't apply if the facts and circumstances demonstrate that the taxpayer has a profit-making objective. The IRS has developed nine factors) that are to be examined in determining whether the requisite profit motive exists. See, e.g., Treas. Reg. §1.183-2(b).
Business-like manner. The first IRS factor is concerned with the manner in which the activity is conducted. Is the activity being conducted in a manner that demonstrates that the taxpayer had a business purpose in mind, or is the taxpayer really conducting the activity as would be expected of someone engaged in a hobby? For instance, does the taxpayer keep adequate records and use them in a manner that is designed to aid the profitability of the business? See, e.g., Knudsen v. Comm’r, T.C. Memo. 2007–340. If the activity is conducted in a “business-like” manner, with accurate and complete records and books of account, the hiring of experienced supervisors or managers, or the seeking of expert advice, this factor will weigh in the taxpayer’s favor.
Expertise. The second factor focuses on the taxpayer’s expertise. If the taxpayer or an advisor has expertise in the particular agricultural area involved, a profit intent is shown. If, for example, the taxpayer has a small beef herd, does the taxpayer know anything about beef breeding or nutrition? What about health problems, etc.?
Time commitment. The third factor involves an examination of how much time the taxpayer devotes to the activity. Sufficient manual labor by the taxpayer may overcome an IRS argument that the taxpayer was engaged in a hobby operation. The question often boils down to whether the taxpayer put in enough time into the activity to reduce or eliminate successive years’ worth of losses.
Expectation of asset appreciation. The fourth factor recognizes that a realistic expectation of asset appreciation can show an intent to profit overall from the activity. See, e.g., Stromatt v. Comm’r, T.C. Sum. Op. 2011-42
Experience. The sixth factor looks at whether the taxpayer has been involved in a loss venture in the past that was turned around into a profitable venture. With respect to this factor, it is appropriate to examine the history of income on all sides of the activity.
History of income or loss. The sixth factor involves an examination of the history of income or loss from the activity. While start-up losses are to be expected in many ventures, continuing losses beyond the period usually required to achieve profitability may indicate a lack of a profit motive. There must be a prospect, not only for earning future profits, but for profits sufficient to offset losses sustained during the early years of operation. A taxpayer's subjective intent must be demonstrated with objective facts, such as comparing the taxpayer's income and loss numbers to comparable neighboring operations.
Amount of profit. The seventh factor examines the amount of profits earned from the activity. Activities generating large losses that occasionally produce a profit are not necessarily indicative of a profit intent. Also important are whether the only gross receipts are federal farm program payments.
Financial status. If the taxpayer has sufficient non-farm income to maintain a comfortable standard of living even with the losses from the “farming” activity, the factor will weigh in the favor of the IRS.
Elements of recreation and/or pleasure. If a taxpayer derives pleasure or recreational benefits from the activity, this factor will cut in favor of the IRS.
Two recent cases illustrate the application of the hobby loss rules to agricultural activities.
Large losses don’t necessarily negate profit intent. In Welch, et al. v. Comr., T.C. Memo. 2017-229, the taxpayer was a professor that taught at several universities over a 40-year span. In the 1970s he founded a consulting business. In the early 1980s he formed another business that provided software to researchers, and developed a statistical program in 2007 to assist businesses in their hiring practices. In 1987, he purchased an initial 130-acre tract with the original intent to grow hay as a cash crop and to raise some cattle.
Over time, the ranch grew to become a multi-operational, 8,700-acre ranch with 25 full-time employees. The ranch also had a vet clinic that provided services for large and small animals. In addition, the ranch had a trucking operation and owned numerous 18-wheel trucks that were used to move cattle and hay around the ranch and to transport cattle to and from market and perform backhauls. The ranch also conducted timber operations and employed a timber manager.
The taxpayer subscribed to numerous professional publications, and changed the type of cattle that the ranch raised to increase profitability. Steadily increasing herd size. The hay operation was also modified to maximize profitability due to weather issues. In addition, the ranch built its own feed mill that was used to chopping and dry storage of the hay. In 2003, the taxpayer also started construction of a horse center as part of the ranch headquarters, including a breeding facility that operated in tandem with the veterinary clinic. Ultimately, the taxpayer’s horses were entered in cutting competitions, with winnings increasing annually from 2007 to 2010.
The IRS issued notices of deficiency for 2007-2010. For those years, the taxpayer had total losses of approximately $15 million and gross income of approximately $7 million. Also, for those years, the taxpayer’s primary expense was depreciation. The IRS claimed that the ranching activity was not engaged in for profit and the expenses were deductible only to the extent of income.
The Tax Court determined that all of the taxpayer’s activities were economically intertwined into a single ranching activity. On the profit issue, the court determined that none of the factors in the Treasury Regulations favored the IRS. Accordingly, the taxpayer’s ranching activity was held to be conducted for-profit and the losses were fully deductible. The court specifically rejected the IRS argument that a profit motive could not be present when millions of dollars of losses were generated.
Reasonable jury could find profit intent. In Wicks v. United States, No. 16-CV-0638-CVE-FHM, 2018 U.S. Dist. LEXIS 9352 (N.D. Okla. Jan. 22, 2018), the plaintiff owned and operated a company that provided mechanical inspection services for major oil refineries and gas plants. That business was quite profitable. In addition to his business, the plaintiff, in the late 1990’s, started in the cattle business when he bought 80 acres of land containing a dilapidated barn and unusable fence. He repaired the fence and barn and purchased two longhorn heifers, built a new barn, bought and adjacent 180-acre tract so he could increase the herd to make the venture ultimately profitable, and improved the entire property by replacing fence, enlarging an existing pond, installing rural water and constructing a cattle working facility and loafing shed. The plaintiff also consulted with a successful local rancher regarding profitable methods of cattle ranching. He also purchased 20 cows to crossbreed so as to produce quality milk and beef, knowing that obtaining a crossbreed would take at least four years. The plaintiff also purchased new hay baling equipment and feed bins.
The plaintiff performed all of the labor and spent three to four days weekly working on the ranching activity. However, the cattle ranching activity never showed a year of profitability, with total gross receipts from 1997 through 2015 totaling $32,602 and net losses totaling $807,380. The plaintiff did not establish a written business plan or have any written financial projections, and did not use any accounting software or form a business entity for the cattle operation, although he did use a spreadsheet to track his expenses. He also did not market or promote the cattle operation, insure the herd against catastrophic loss or consult a financial advisor. Before 1997, the plaintiff’s only experience with cattle was feeding and working them as a child. He sold cattle in 2013, after the cattle market had rebounded from prior lows, and also attended seminars on cattle breeding and pasture management and read as much as he could about raising cattle. He also joined two different state cattlemen’s associations.
For 2010 and 2011, the IRS denied the loss deductions from the plaintiff’s cattle ranching activity, and assessed penalties with the total amount of tax and penalties (including interest) due being $89,838.09. The plaintiff paid the deficiency (plus interest) and sued for a refund, claiming that he engaged in the cattle ranching activity with profit intent). The IRS moved for summary judgment, arguing that the activity was not engaged in for profit and the resulting losses were non-deductible under the hobby loss rules of I.R.C. §183. On an evidentiary question, the court allowed tax return information from post-2011 years into evidence because it was relevant in showing whether the plaintiff had a profit intent for the tax years in issue. The court also allowed into evidence testimony of an ag economist for the plaintiff to the extent the testimony bore on economic conditions and their impact on the plaintiff’s cattle ranching activity.
The court examined each of the nine factors in the regulations and ultimately determined that, based on the totality of the circumstances, and viewing the evidence in the light most favorable to the plaintiff, a reasonable jury could conclude that the plaintiff engaged in the cattle ranching activity with a profit intent. The court denied the IRS motion for summary judgment.
The IRS is looking closely at agricultural activities that it believes might be a hobby. Operating the activity in conformity with the regulations is a must for maintaining full deductibility of expenses associated with the activity.
Monday, January 29, 2018
The Economic Recovery Tax Act of 1981 introduced the “Credit for Increasing Research Activities.” The credit is better known as the research and development credit, or simply the “R&D” credit. It’s a general business credit that, for a business with under $50 million in average annual gross receipts, offsets both regular tax and alternative minimum tax. For certain defined smaller businesses, it can offset the employer portion of Social Security taxes up to $250,000 (with some limitations). The purpose of the credit as enacted is still the same today – to incentivize research and experimentation by providing a tax credit for activities that develop a new component of a taxpayer’s business or improve an existing component’s performance, functionality, reliability or quality. I.R.C. §41(d)(3)(A).
While the credit is available to a wide array of businesses, including farming businesses, what is the scope of its application? Does it apply to a farmer that utilizes cover crops or installs a bioreactor? What about a farmer that uses nitrification inhibitors? If the farmer receives a cost-share amount from the government, does that impact the ability to claim the R&D credit?
Today’s post takes a look at the R&D credit and its potential application to farming and ranching operations.
Mechanics of The Credit
As noted above, the R&D credit applies to activities (including research and software development) that develop a new business component or improve an existing component’s performance, functionality, reliability or quality. Treas. Reg. §1.41-4(a). What is a business component? It’s “any product, process, computer software, technique, formula, or invention which is to be held for sale, lease, or license,” or which is used by the taxpayer in the taxpayer’s trade or business. An activity qualifies for the credit by means of a four-part test: (1) the activity must develop or improve the functionality, quality, etc., of a business component; (2) the activity must rely on technological principles; (3) substantially all of the activity must employ a process of experimentation that is designed to evaluate one or more alternatives; and (4) the process of experimentation must be designed to eliminate uncertainty (regarding the company’s capability, methodology, or appropriateness of design of a business component). I.R.C. §41(d).
Expenses that are incurred with respect to a qualified activity are used to compute the R&D credit and are termed “qualified research expenditures” (QREs). QREs can result for in-house activity as well as expenses incurred via contract. For in-house activity, QRE includes W-2 wages paid to employees that are either directly involved in an activity (including research) that develops a new business component, or supervise it or support it, as well as the cost of supplies and payments for qualified services (e.g., consultants and engineers). I.R.C. §41(b); see also Suder v. Comr., T.C. Memo. 2014-201.
Note: Under certain federal farm programs, especially those programs designed to provide environmental benefits, the USDA shares in part of the expense associated with complying with the program. While the expense associated with establishing a conservation/environmental structure/program on the farm might otherwise qualify as a QRE, the portion that the government subsidizes (via I.R.C. §126) would not be a QRE because the taxpayer did not incur the cost. In addition, as noted below, qualified expenses would be limited to a test plot rather than applying to expenditures incurred for the entire farm.
Once the qualified activities and QREs are determined, the credit is six percent of eligible expenses for each of the first three years that qualified research activities are conducted. I.R.C. §41(c)(5)(B)(ii). After that, the alternative simplified method that sets the R&D credit at 14 percent of the excess of QREs for the tax year over 50 percent of the average QREs for the three preceding tax years multiplied by 65 percent (factoring in a reduction via I.R.C. §280C). I.R.C. §§41(c)(5); I.R.C. §41(h).
Bill is trying to determine his R&D credit for 2018. Assume that Bill incurs QREs of $50,000 in 2015; $62,500 in 2016 and $75,000 in 2017. The average over those three years is $62,500. 50 percent of that three-year average is $31,250. For 2017, he incurred $75,000 of QREs. From that amount, Bill subtracts 50 percent of the average QREs for the prior three years, or $31,250. That amount is then multiplied by 14 percent (.14 x $31,250 = $4,375). The $4,375 amount is then multiplied by 65 percent (the I.R.C. §280C credit reduction), which yields an R&D credit of $2,843.75.
The R&D credit is claimed on Form 6765 and the associated instructions are instrumental in properly computing the credit and completing Form 6765 properly.
If a farmer doesn’t incur at least the level of QREs that Bill did in the example, it may not be worth the extra recordkeeping and tax preparation cost of claiming the credit.
As an additional point, for privately held businesses that have $50 million or less in average gross receipts for the three preceding tax years can use the R&D credit to offset the alternative minimum tax. Also, start-up companies, or those with less than $5 million in gross receipts for the current tax year and no gross receipts for the five preceding years may use R&D credits against their payroll tax liability up to $250,000.
Application to Agriculture
As noted above, the R&D credit applies costs incurred associated with research to develop new products or improve existing ones. It’s important that the research involves technological information or some sort of application that is intended to develop new or improved business products or processes. It’s also important that the research activities have a process of experimentation that relates to a new or improved function, performance, reliability, efficiently or quality.
So what kind of research activities on a farm will generate qualified expenses for the R&D credit? It is those research activities that are new to the farm and involves testing of something before it can be used on a larger scale. For farmers, the credit could potentially have a wide application – farmers often are “tinkering” or investigating ways to improve productivity or efficiency of crop and/or livestock production. Common examples might include testing new fungicides and seed treatment in an attempt to control insect disease; testing precision planting equipment in an effort to find ways to increase efficiency and/or yield; experimenting with organic fertilizer or with a with a cover crop to determine the impact on soil fertility and/or soil erosion; trying new cultivation techniques such as strip tillage; experimenting with irrigation and drainage and determining the impact on soil productivity and/or erosion; coming up with new weed/pest management techniques; experimenting with crop genetics; testing various planting dates, plant population, and row spacing to determine the impact on plant growth and development; testing combines and other harvesting equipment to minimize crop waste and/or decrease harvest time; working on customized animal feed formulations; developing customized software; researching and designing new grain bins. The list could go on, but you get the point.
The R&D credit can have a broad application to many activities that occur on a farm or ranch. But, don’t expect the IRS to allow the R&D credit to be applied to the whole farm. The credit is for research and development – in other words something that would occur in a laboratory. The entire farm is not a laboratory, but a test plot is. It is likely that the IRS will argue that the qualified research activities (which give rise to QREs) would have to occur in a test plot, with expenses (including qualified wages, and the cost of chemicals, fertilizer, seed, etc.) allocated to the specific area of the test plot. That will result in a small number for most farmers, especially in the Midwest. Higher value crops, such as potatoes, onions and fruits, might have bigger numbers, but the point remains that the QREs (and, hence the R&D credit) must be associated with a test plot and not the entire farm.
Thursday, January 25, 2018
A taxpayer can elect to deduct currently the amount of certain reasonable research or experimentation (R&E) expenses paid or incurred in connection with a trade or business. This is I.R.C. §174. The R&D credit, computed based upon qualified research expenditures, is a general business tax credit which reduces tax liability (rather than reducing taxable income), if allowed. I.R.C. §41.
Can farmers use the credit? Does it apply for the “testing” of chemicals and fertilizers on crops? If so, the credit could be a very valuable tax planning tool. That’s particularly the case because the credit offsets alternative minimum tax (AMT) and can also offset payroll tax in lieu of income tax (if certain tests are met). Does the recently enacted Tax Cuts and Jobs Act (TCJA) assist farming operations in utilizing the credit?
The benefit from R&E expenditures in farming operations – that’s the topic of today’s post.
Deductions for R&E Expenses
Under prior law, taxpayers could elect to deduct currently the amount of certain reasonable research or experimentation (R&E) expenditures paid or incurred in connection with a trade or business. Instead of making the election, a taxpayer could forgo a current deduction, capitalize their research expenses, and recover them ratably over the useful life of the research, up to five years. Alternatively, an election could be made to recover them over a period of 10 years. By doing so, the taxpayer would avoid AMT preferences and adjustments.
Generally, no current deduction under I.R.C. §174 is allowable for expenditures for the acquisition or improvement of land or of depreciable or depletable property used in connection with any research or experimentation. In addition, no current deduction is allowed for research expenses incurred for the purpose of ascertaining the existence, location, extent, or quality of any deposit of ore or other mineral, including oil and gas.
What is qualified research? It’s basically related to developing a product that can be used in the taxpayer’s trade or business. It’s an activity or project that a taxpayer undertakes to create a new or improved component of the taxpayer’s business utilizing a systemic experimentation process that relies on principles of physical or biological sciences, engineering or computer science that is designed to evaluate one or more alternatives to achieve a result that was uncertain when the research activity began.
R&E Expenses under the TCJA?
The TCJA specifies that for amounts paid or incurred in tax years beginning after Dec. 31, 2021, “specified R&E expenses” incurred in the United States must be capitalized and amortized ratably over a 5-year period beginning with the midpoint of the tax year in which the specified R&E expenses were paid or incurred. TCJA, Sec. 13206, amending I.R.C. §174. In addition, it’s treated as a change in the taxpayer's accounting method (I.R.C. §481) initiated by the taxpayer, and made with IRS's consent. If the expenses are incurred in tax years beginning after Dec. 31, 2025, the provision is applied on a cutoff basis. That means that there would be no adjustment under I.R.C. §481(a) for expenses paid or incurred in tax years that begin before 2026.
So, in essence there isn’t any change in the mix for the R&E expenditures until 2022.
Application to Farming and Ranching Operations
Ag businesses deduct R&E expenditures every year, as farmers experiment with different chemicals and fertilizers, the benefit of which depend upon weather, soil types and hardiness of the plants. Expenses associated with product development activities can count, and they may also generate an R&D credit. Over the years, numerous products have been created by innovations developed by a farmer or rancher. Expenses associated with innovative activities that develop a new business product are deductible R&E expenditures, even though the innovations provide future benefits. That can also apply to activities that develop a new chemical that can be applied to seed or crops that enhances productivity. In short, due to the R&E expenditures, the farmer doesn’t need to determine if the expense provides only a current benefit, or a benefit that may last into the future. That’s what I.R.C. §174 is all about: allowing current deductions for researching better ways of doing things.
For farmers, researching and experimenting with different products and procedures generates current tax deductions. The R&D credit is another provision and the topic of my next post.